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

Mar 21, 2012

The 2010 Tax Act and its Fallout: Observations and Considerations
Other Federal Legislative Matters
State Estate Taxes
2011 - 2012 Treasury and IRS Priority Guidance Plans
Transfer Tax Developments
Valuation Cases
Update on Family Limited Partnerships
Other Cases

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.

This Outline summarizes the 2012 Institute 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 of which summarizes recent developments; the second summarizes select topics and recent developments that could present significant opportunities in the current economic climate for the upcoming year. This Outline focuses on Part I Recent Developments; Part II will be released in due course.

1. The 2010  Tax Act and its Fallout:  Observations and Considerations

  • Introduction: The Panelists opened this session with a discussion of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 ("The 2010 Act"). Enacted in December 2010 and effective to December 31, 2012, the Act permitted the 2001 and 2003 income tax cuts ("Bush tax cuts") to be extended for two years to December 31, 2012 in addition to enacting a one-year 2 percent payroll tax reduction, a 13 month extension of employment benefits, and an extension of the estate tax for 2011 and 2012 with a $5 million estate, gift and generation skipping tax ("GST") exemption.  The 2010 Act also enacted a 35 percent top transfer tax rate.

Observation: On February 17, 2012 the U.S. House and Senate passed the Middle Class Tax Relief and Job Creation Act of 2012 (H.R. 3630), a compromise legislation that, according to the Administration, will extend jobless benefits for approximately 160 million workers. Additional benefits will be generated by extending the 2 percentage-point cut in payroll taxes, and a renewal of jobless benefits that is estimated to deliver about $300 a week to people out of work for more than six months. However, the legislation does reduce the maximum number of weeks that jobless benefits will be received by workers in states with the highest jobless rates, from 99 weeks to 73 weeks by the end of 2012.

The federal estate tax did not apply in 2010, and was reinstated in 2011. However, under The 2010 Act, the estate tax exemption of $5 million ($10 million for married couples) and the estate tax top rate of 35 percent applied on an elective basis. Executors of 2010 estates had an opportunity to elect out of the estate tax and apply the 2010 carryover basis rules. While the GST exemption for 2010 was set at $5 million, the GST tax rate for 2010 was set at zero.

Indexing of the $5 million exemption for inflation occurred beginning in 2012, and the portability of the unified credit ("exemption") from a deceased spouse to the surviving spouse was instituted for 2011 and 2012 estates. The 35 percent top rates take effect at a level of a taxable estate of $500,000. The indexed applicable exclusion amount for the estate tax, gift tax and GST tax in 2012 is $5,120,000 (Rev. Proc. 2011-52, Sec. 3.29, 2011-45 I.R.B. 701).

  • The Election out of the Estate Tax into Carryover Basis for 2010 Estates: Panelists also discussed the abrupt introduction of the modified carryover basis regime of Internal Revenue Code ("IRC") Sec. 1022 for 2010 estates, without technical corrections, regulations, guidance, forms or instructions. The complexity and discomfort of the impending carryover basis regime was cited in 2009 by congressional supporters of legislation, to make the 2009 law permanent and prevent the 2010 tax law enacted in 2001 from taking effect (i.e., preventing no estate tax in 2010 as provided for in the 2010 legislation). However, because Congress did not act in 2009, the modified carryover basis applies to property passing from a decedent who died in 2010 and whose executor elects that the estate tax will not apply.

As more fully discussed below, to effectuate the 2010 carryover basis treatment as cited above, in 2011 the IRS has issued Form 8939, Allocation of Increase in Basis for Property Acquired from a Decedent, and long-awaited guidance for executors of decedents who died in 2010 and who were deciding whether to elect out of the estate tax and apply the carryover basis rules. The IRS expected 7,000 executors to file Form 8939 by the January 17, 2012 due date.

IRC Sec. 1022 provides that an executor can elect for a decedent's basis in appreciated property to remain equal to the decedent's basis in the property (where the fair market value of an asset on the date of death is less than the decedent's basis). Otherwise, if the fair market value of an asset on the date of death is less than the decedent's basis, the basis will be stepped down to the fair market value at the date of death. The rule is applied separately to each item of property.
IRC Sec. 1022(a) provides that carryover basis applies to property acquired from a decedent, as defined in IRC Sec. 1022(e). This definition does not cover all property that would be included in the estate, such as property from a QTIP election under IRC Sec. 2056(b)(7) or property included under IRC Sec. 2036 resulting from the decedent being both the grantor and beneficiary of a grantor retained annuity interest ("GRAT").
Notice 2011-66, 2011-35 I.R.B. 170, released on August 5, 2011 and Notice 2011-76, 2011-40 I.R.B. 479, released on September 13, 2011 provided much needed guidance, and stated that Form 8939, Allocation of Increase in Basis for Property Acquired From a Decedent, would be used to make the Section 1022 election out of the estate tax, as well as to report the value and basis of property as required by IRC Sec. 6018 and to allocate basis increases. As cited above, Form 8939 was required to be filed by January 17, 2012 by the executor of the estate (or other equivalent). The IRS did not grant any extensions to file the Form 8939, and will not accept a late-filed form. Once made, the Section 1022 election and basis increase allocations will be irrevocable. However, Notice 2011-66 provided certain relief provisions:

      • The executor may file supplemental Forms 8939 to make additional allocations of Spousal Property Basis Increase as additional property is distributed to the surviving spouse. Each supplemental Form 8939 is due no later than 90 days after such distribution.
      • The executor may make other changes to a timely filed Form 8939, except making or revoking the Section 1022 election, on or before July 17, 2012 (six months after the January 17, 2012 due date).
      • The IRS may grant "9100 relief" allowing an executor to amend or supplement a Form 8939 to allocate any basis increase that has not previously been validly allocated if assets are discovered or assets are revalued in an IRS audit, after Form 8939 is filed. Because such audit could occur years later when the asset is sold, the Panelists opined that most attempted "formula" allocations would be ill-advised, and that there would be no "protective" elections effectuated.

Observation: Other estate tax experts have previously taken a different position, and advocated for inclusion of a protective election and a formula allocation disclosure included with the Form 8939 filing. This question remains unsettled.

    • The IRS retains the discretion under "9100 relief" procedures, to allow an executor to amend or supplement a Form 8939 or even to file a Form 8939 late.

The executor must furnish the required information to each recipient, using a Schedule A attached to the Form 8939, no more than 30 days after the original Form 8939 (or any amended or supplemental form) is filed. Assets not distributed are treated as received by the executor, and the executor must furnish the required information to each recipient as distributions in kind are made.
If a Section 1022 election is made, the IRC Section 645 election to treat a qualified revocable trust as part of a decedent's estate will apply effective from the date of death until two years after the date of death.
Rev. Proc. 2011-41, (2011-35 I.R.B. 188, released on August 5, 2011), provided further guidance:

    • Section 4.06(1) provides that the recipient's holding period of property subject to the carryover basis rules includes the decedent's holding period, whether or not the executor allocates any basis increase to the property.
    • Section 4.06(2) provides that such property generally retains the character it had in the hands of the decedent.
    • Section 4.06(3) provides that the depreciation of property in the hands of the recipient is determined in the same way it was in the hands of the decedent, using the same depreciation method, recovery period, and convention.
    • Section 4.06(4) states that a suspended loss under the passive activity loss rules is added to basis immediately before death. This section seems to assume that a deduction and an addition to basis is equivalent. However, by denying a deduction that could have been taken against ordinary income, this provision could convert capital gain to ordinary income.
    • Section 4.06(5) says that if appreciated property is distributed to satisfy a pecuniary bequest, the gain recognized is limited by IRC Sec. 1040 to post-death appreciation even if the basis is less than the date-of-death value.
    • Section 4.06(6) says that if IRC Sec. 684 applies, so as to impose sale or exchange treatment on transfers to a nonresident alien, the allocation of basis rules are deemed to occur before the application of Sec. 684.
    • Section 4.07 states that a testamentary trust that otherwise qualifies as a charitable remainder trust under IRC Sec. 664 will still qualify if the executor makes a Sec. 1022 election, even though the election out of the estate tax will mean that no estate tax deduction under IRC Sec. 2055 will be allowable (which would appear to have disqualified the trust under Reg. Sec. 1.664-1(a)(1)(iii)(a).
    • Section 4.01(3)(i)  clarifies that property subject to general power of appointment defined in IRC Sec. 2041 is subject to carryover basis.

Two modifications in IRC Sec. 1022 lessen the harshness of the 2010 carryover basis regime:

    • A modification applying to property passing to any one or more individuals, referred to as the "General Basis Increase." This is the sum of the aggregate basis increase of $1.3 million and the "carryovers/unrealized losses increase" which consists of the amount of a decedent's unused capital loss carryovers and net operating loss carryovers and the sum of the amount of any and all losses that would have been allowable under IRC Sec. 165 (if the property acquired from the decedent had been sold at fair market value immediately before the decedent's death). The executor must make an election to take advantage of this increase and allocate it to specific assets on the Form 8939. The basis increases may not increase the basis of any asset in excess of the fair market value of that asset as of the date of the decedent's death. Also noteworthy is that property interests that are not held through simple outright ownership will qualify for the General Basis Increase, including a portion of joint tenancy property, the decedent's half of community property, and property held in trusts that are revocable by the grantor. However, the General Basis Increase cannot be applied to some property the value of which would have been included in the decedent's estate if the election out of the estate tax had not been made (such as a QTIP trust of which the decedent is the beneficiary or the GRAT of which the decedent was the grantor).  Further, property acquired by a decedent by gift within three years of the decedent's date of death from anyone other than his or her spouse does not qualify for the General Basis Increase (IRC Sec. 1022(d)(1)(C)). An executor may allocate basis increase to property that has already been distributed or sold (Rev. Proc. 2011-41, Section 4.03).
      • A modification applying to property passing to a surviving spouse. IRC Sec. 1022(c) says that a $3 million increase in basis for property passing to the surviving spouse ("Spousal Property Basis Increase") is allowed. The basis or property eligible for the General Basis Increase may be increased by an additional $3 million, but not in excess of the fair market value of the property as of the date of the decedent's death, if such property is transferred to the surviving spouse outright or as a "qualified terminable interest property" for the exclusive benefit of the surviving spouse. IRC Sec. 1022 provides its own definition of "qualified terminable interest property" and does not simply refer to the definition contained in IRC Sec. 2056. Because the QTIP election provided in Sec. 2056(b)(7)(B)(i)(III) is omitted from sec. 1022(c)(5)(A), a so-called Clayton QTIP trust in which the spouse's mandatory income interest is conditioned on the executor's QTIP election is not eligible for the Spousal Property Basis Increase (see Estate of Clayton v. Commissioner,  976 F. 2d 1486 (5th Cir. 1992) and Reg. Sec. 20.2056(b)-7(d)(3)(i)). A general power of appointment marital trust that would qualify for the marital deduction for estate tax purposes will satisfy the requirements for the Spousal Property Basis Increase since it is not a terminable interest. The three-year rule does not apply to property acquired by the decedent from the decedent's spouse unless, during the three-year period, the transferor spouse acquired the property by gift or inter vivos transfer. Also, an executor may allocate the basis increases to property already distributed or sold.

Observation: Although carryover basis rules directly affects 2010 estates, its impact will be felt for years to come as these assets are later sold. For low basis assets, it is always necessary to compare the estate tax saved with the capital gains tax that may be incurred at a later date. Further, there is no certainty that after 2012 tax rates attributable to capital gains will be lower than ordinary income tax rates. If future estate tax rates are likely to be higher than capital gains tax rates, the spread between the two will be smaller if assets are sold soon after death.

  • Extension of Time for Performing Certain Acts:Section 301(d) of the 2010 Tax Act provided that the due date for certain acts as listed below was September 17, 2011:
    • Filing an estate tax return for a decedent who died after December 31, 2009 and before December 17, 2010
    • Making any election on the estate tax return of a decedent who died after December 31, 2009 and before December 17, 2010
    • Paying any estate tax with respect to a decedent who died after December 31, 2009 and December 17, 2010
    • Making any disclaimer of an interest in property passing by reason of death of a decedent who died after December 31, 2009 and before December 17, 2010 (care should be provided in this area)
    • Filing a return reporting generation-skipping transfers after December 31, 2009 and before December 17, 2010
    • Making any election required to be made on a return reporting generation-skipping transfers after December 31, 2009 and before December 17, 2010
  • Gift Tax Observations:Beginning January 1, 2011, the gift tax no longer has its own unified credit, and is now the same amount as the estate tax unified credit and rates. The Panelists predict that there will be a surge in gift-giving in 2012 to take advantage of the increased exemptions. Many donors may accomplish gifting through outright gifts, or in trust. Since the GST exemption is at the same amount, gifts can be made without worry of imposing either the gift tax or the GST tax. And of course, the ability to leverage gifts through the use of such techniques as life insurance, installment sales, AFR loans and resulting forgiveness, "Grantor Retained Annuity Trusts" (GRATs), "Qualified Personal Residence Trusts" (QPRTs), and the use of entity-based valuation discounts (applicable to interests as in closely-held businesses and family limited partnerships), can provide a dramatic opportunity to make large gifts, given the current $5 million exemption.

The possibility of a surge in 2012 gifts followed by a return to a $1 million applicable exclusion amount in 2013 (if Congress does not extend the 2010 Act provisions) has also created concerns that current gift tax savings would be recaptured or clawed back in the future, by an increased estate tax at death. What has fueled this concern is the scheduled reinstatement of IRC Sec. 2001(b)(2) in 2013, which states that after calculating a tentative tax on the sum of the taxable estate and adjusted taxable gifts, there is a subtraction for the aggregate amount of tax which would have been payable under the gift tax chapter with respect to gifts made by the decedent after December 31, 1976 (if certain provisions had been applicable at the time of such gifts). Panelists were of the view that it was highly unlikely that there would be a later recapture of gift tax, as this seemed not to be the intent of Congress. A technical correction may be enacted in the future to fix any misconceptions, but until there are forms, instructions, and other published guidance from the IRS on this subject, there will always be a certain risk, with regard to gifts made in 2011 and  gifts that are made in 2012, that there could be a claw back in a future year.

Notwithstanding these concerns, the unprecedented opportunity to make large 2012 wealth transfers with no current tax cost should be strongly considered, as the benefit may be for 2012 only. Unless Congress acts, the applicable exclusion is scheduled to decrease to $1 million in 2013. Even if Congress does act, the applicable exclusion may still be reduced to an amount lower than the current levels. And even if there was a recapture of the gift tax at death, the tax deferral still provides a significant benefit as the appreciation on the transferred assets will definitely escape estate tax.

Some 2012 gifting ideas include:

  • Lifetime credit shelter trust: Funding a credit shelter trust now that permits discretionary distributions to the spouse and/or other beneficiaries is a means to utilize the $5 million exclusion while providing support to the spouse.
  • Use of dynasty trusts as a means to provide a safety net for those taxpayers worried about future downturns in the economy. Assets can accumulate in the trust and no distributions made in a good economy, and distributions can be made from each spouse's trust in an economic downturn as a hedge. This outcome can be obtained where the husband sets up a trust for the benefit of the wife, and the wife sets up a trust for the benefit of the husband; however, advisors and taxpayers must be concerned over the reciprocal trust rule; one remedy is to add children as co-beneficiaries of one of the trusts.
  • Domestic asset protection trusts could be considered. These self-settled spendthrift trusts may be considered in jurisdictions that allow distributions to the settlor, with discretionary powers held by independent trustee, without subjecting the trust to claims of the settlor's creditors, thereby resulting in no estate inclusion. The trust can be in effect a rainy day fund without triggering IRC Sec. 2036(a)(1). The following states have adopted these domestic asset protection trust provisions: Alaska, Delaware, Hawaii, Missouri, Nevada, New Hampshire, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah and Wyoming.
  • Forgiving a loan and note balance is an effective gifting technique.
  • A surviving spouse renouncing his/her rights to the qualified income interests of QTIP trusts. Under IRC Sec. 2519, the gift of a qualified income interest is deemed to be a gift of the remainder of the trust. If the combined gift of the income interest and the remainder exceeds $5 million, the surviving spouse can sell the income interest as Sec. 2519 is triggered by any disposition of the qualified income interest. The surviving spouse would be gifting only the remainder of the QTIP trust. If the surviving spouse has a zero basis in the qualified income interest, any amount received (via a payment) for the interest would be includable in gross income of the surviving spouse.
  • Make a large gift to a beneficiary or a grantor trust, and then loan funds to the trust, or sell (based as a qualifying appraisal) assets to a trust in exchange for a note requiring the payment of interest at the applicable federal rate. If the loaned funds generate a higher rate of return than the applicable federal rate required to be paid to the donor, the excess represents additional wealth transferred at no cost.
  • Prepay premiums to life insurance trusts.
  • Portability of the Unified Credit ("Exemption"): Portability of a deceased spouse's unused exemption to a surviving spouse was instituted for 2011 and 2012 estates. The 2010 Tax Act amended IRC Sec. 2010(c) to permit a surviving spouse to use the unified credit amount of a predeceased spouse that the predeceased spouse did not use. This portability of the unified credit is administered through the medium of a "Deceased Spousal Unused Exclusion Amount" (DSUEA). Portability is only available if the predeceased spouse died after December 31, 2010 and is available to the surviving spouse only through the end of 2012. IRC Sec. 2010(c)(5)(A) states that portability is not allowed unless the executor of the estate of the deceased spouse files an estate tax return on which such amount is computed and makes an irrevocable election on the return that such amount may be taken into account (the amount is the decedent's unused exemption amount). No election can be made if the estate tax return is filed late. Such an election will keep the statute of limitations on that estate tax return open forever, but only for the purpose of determining the amount of unused exemption, not to make adjustments to that return itself. Portability is limited to just one predeceased spouse—the last such deceased spouse. The portability election is only available where both spouses are United States citizens. For a more detailed analysis of portability, see the discussion in Part II of this Summary.
  • Comparison with a Credit Shelter Trust: The credit shelter trust, also known as the bypass trust, still offers the following advantages over portability:
    • Professional management and asset protection during the surviving spouse's life
    • Protection of children's interest from diversion of assets by the surviving spouse, including in the circumstance of remarriage of the surviving spouse
    • Sheltering intervening appreciation and accumulated income from estate tax
    • Preservation of the predeceased spouse's exemption even if the surviving spouse remarries, or the exemption is reduced, or portability sunsets
    • Use of the predeceased spouse's GST exemption, because portability applies only to gift and estate taxes
    • Avoiding the filing of an estate tax return for the predeceased spouse's estate, if the estate otherwise would not have required a return

Observations: Portability is advantageous over credit shelter trusts in the following respects: a) simplicity, including relief of any concern over titling of assets, b )avoidance of state estate tax on the first estate, in states with an estate tax and no state-only QTIP election, and c) a second step-up in basis for appreciated assets.

2. Other Federal Legislative Matters

  • Ban on Tax Strategy Patents: On September 16, 2011, President Obama signed the "America Invents Act." The Act provides that tax strategies are not patentable because they are deemed insufficient to differentiate as a claimed invention from the prior art. However, there are exceptions in the Act for tax preparation software and for financial management systems. The provision applies to any pending patents or patents issued after the date of enactment. Therefore, the well-known "SOGRAT" patent that deals with the transfer of nonqualified stock options to a GRAT was not invalidated by the Act. However, the director of the U.S. Patent and Trademark Office has instituted a formal review of the validity of the 2003 SOGRAT Patent.

  • The Administration's Revenue Proposals: The "General Explanations of the Administration's Fiscal Year 2012 Revenue Proposals," also known as the Greenbook, was released on February 14, 2011. The Greenbook included five proposals:

    • Make the portability of unused exemption between spouses permanent. The Greenbook supports portability at an exemption level of $3.5 million ($7 million for a married couple). It states that without the portability provision, spouses are often required to divide and retitle assets into each spouse's separate name, and create complex trust instruments in order to allow the first spouse to die to take full advantage of his/her exclusion. Such division may be difficult or impossible to achieve and may not be consistent with the way in which married couples would prefer to handle their financial affairs. It also provides that the exemption should be portable (transferable) only from the last predeceased spouse. The Treasury estimates that this proposal would reduce federal revenues by approximately $3.7 billion over fiscal years 2012-2021.
    • Require consistency in value for transfer and income tax purposes. Under IRC Sec. 1014(a)(1), the basis of property acquired from a decedent is the fair market value of the property at the date of the decedent's death, with appropriate adjustments in Sec. 1014 where the alternate valuation date is elected. For income tax purposes, however, an inconsistency arises when the recipient of property from a decedent claims for income tax purposes that the executor obtained an estate tax value that was too low, and that the recipient's basis should be greater than the estate tax value. Such claims are usually made after the statute of limitations have run on the estate tax return, and may include appraisals and other evidence of a revised date-of-death value. The Greenbook proposes that the income tax basis of property received from a decedent (or donor) to be equal to the estate tax value (or the donor's basis). It also provides that the executor or donor would be required to report the necessary information to both the recipient and the IRS. Regulations could extend this reporting requirement to annual exclusion gifts, and estates for which no estate tax return is required, and could provide relief for the surviving joint tenant or other recipient who has more accurate information than the estate executor. This proposal is estimated to raise tax revenue by $2.1 billion over ten years.
    • Modify Rules on Valuation Discounts. IRC Sec. 2701-2704 were enacted to curb techniques designed to reduce the transfer tax value, but not reduce the economic benefit to the recipients. Sec. 2704(b) provides that certain applicable restrictions that would otherwise justify valuation discounts are ignored in intra-family transfers of interests in family-controlled corporations and partnerships. However, judicial decisions and enactment of state statutes have effectively made the application of Sec. 2704(b) inapplicable in many situations. The IRS has identified certain arrangements designed to circumvent the application of Sec. 2704, and since 2003, a project under Sec. 2704 has been on the Treasury-IRS Priority Guidance Plan. The Greenbook proposes to create a more durable category of disregarded restrictions, which would include restrictions on liquidation of an interest that are measured against Treasury standards and not against a default state law. The proposal would apply to transfers made after the date of enactment and it is estimated to raise revenues by $18.2 billion over ten years.
    • Require a Minimum Term for GRATs. The Greenbook notes that taxpayers have become adept at maximizing the benefit of GRATs, often by minimizing the term of the GRAT thus reducing the risk of the grantor's death during the trust's term.

    Observation: Death during the GRAT term will result in inclusion of trust's assets in the decedent's estate. Under current law, short term GRATs utilizing also presently low applicable interest rates should be considered in 2012 as effective asset transfer vehicles.

    Taxpayers also retain annuity interests significant enough to reduce the gift tax value of the remainder interest to zero, or to a number small enough to generate only a minimal gift tax liability. In the past, there has been proposed legislation to limit the attractiveness of GRATs by imposing a term of years for a GRAT and a minimum gift tax value for the remainder (for example, 10 percent). The Greenbook proposes to increase the mortality risk of GRATs by requiring a minimum ten-year term. The Greenbook discussion seems to concur with the use of the zeroed-out GRAT, within the constraint of a minimum ten-year term. This proposal would increase revenue by approximately $3 billion over ten years and would apply to GRATs created after the date of enactment.

    Observation: As GRATs remain on the IRS short list of tax planning techniques that would be cutback, GRATs should be entered into in 2012 where appropriate, as the ability to utilize GRATs may not last forever.

    • Limit Duration of GST Tax Exemption: The Greenbook proposes to limit the duration of the GST exemption to 90 years, requiring the inclusion ratio of a trust to reset to zero on the 90th anniversary of the creation of the trust.

The General Explanations of the Administration's Fiscal Year 2013 Revenue Proposals was released on February 2012 and will be the subject of a future outline.

3. State Estate Taxes

The Panelists covered major recent changes that have occurred in many states throughout the United States. The following changes impact states in our immediate region:

    • California: The estate tax is tied to the federal state death tax credit.
    • Connecticut: Connecticut has its own separate estate tax. As part of the state's budget bill in 2011, Connecticut lowered its threshold for its state estate tax from $3.5 million to $2 million, retroactive to January 1, 2011. Also, as part of the state's two year budget that became law on September 8, 2009, the estate tax rates were reduced to a spread of 7.2% to 12% and for decedents dying on or after January 1, 2010, the tax is due six months after the date of death.
    • Florida: Tax is tied to the federal state death tax credit.
    • New Jersey: The state has a pick-up tax and an inheritance tax. For decedents dying after December 31, 2002, the pick-up tax was frozen at the federal state death tax credit in effect on December 31, 2001. The pick-up tax is $675,000 and imposed on estates exceeding the federal applicable amount in effect on December 31, 2001, not including scheduled increases under pre-EGTRRA law, even though that amount is below the lower EGTRRA applicable exclusion amount. The executor has the option of paying this pick-up tax or a similar tax prescribed by the New Jersey Division of Taxation. In Oberhand v. Director, Div. of Tax, 193 N.J. 558 (2008), the retroactive application of New Jersey's decoupled estate tax to the estate of a decedent dying prior to the enactment of the tax was declared manifestly unjust, where the will included marital formula provisions. In Estate of Stevenson v. Director, 008300-07 (N.J. Tax 2-19-2008) the New Jersey Tax Court held that in calculating the New Jersey estate tax where a marital disposition was burdened with estate tax, creating an interrelated computation, the marital deduction must be reduced not only by the actual New Jersey estate tax, but also by the hypothetical federal estate tax that would have been payable if the decedent had died in 2001. A QTIP election for New Jersey estate tax purposes is only allowed to the extent permitted to reduce federal estate tax.
    • New York: The pick-up tax applies only. The tax is frozen at the federal state death tax credit in effect on July 22, 1998. In 2002 and 2003 the tax was imposed only on estates exceeding the EGTRRA application exclusion amount. Thereafter, tax is imposed on estates exceeding $1 million. Effective in 2004, the New York estate tax is applied on a pro rata basis to non-resident decedents with property subject to New York estate tax. On March 16, 2010, the New York Office of Tax Policy Analysis Taxpayer Guidance Division issued a notice permitting a separate estate QTIP election when no federal estate tax return is required to be filed, such as in 2010 when there was no estate tax or when the value of the gross estate is too low to require the filing of a federal return. Separately, Advisory Opinion (TSB-A-08(1)M) issued in October 2008 provided that an interest in an S corporation owned by a non-resident and containing a condominium in New York is an intangible asset as long as the S corporation has a real business purpose. If the S corporation has no business purpose, it appears that New York would look through the S corporation and subject the condominium to New York estate tax, in the estate of the non-resident. There would likely be no business purpose if the sole reason for forming the S corporation was to own a New York situs condominium for use by an individual.
    • Pennsylvania: An inheritance tax applies. The tax is tied to the federal state death tax credit to the extent that the available federal state death tax credit exceeds the state inheritance tax. The state had decoupled its pick-up tax in 2002, but has now recoupled retroactively. The recoupling does not affect the Pennsylvania inheritance tax which is independent of the federal state death tax credit. Pennsylvania recognizes a state QTIP election.

4. 2011-2012 Treasury-IRS Priority Guidance Plan:

The Plan was issued on September 2, 2011, and addresses a range of issues important to individuals and businesses, and identifies how the Treasury and the IRS expect to allocate resources and provide guidance on issues that are of concern tax administrators. The following are some of the more pertinent issues cited in the Plan.

      • Regulations under IRC Sec. 67 regarding miscellaneous itemized deductions of trusts and estates. IRC Sec. 67(a) provide that miscellaneous itemized deductions may be deducted only to the extent they exceed 2 percent of adjusted gross income. Sec. 67(e)(1) provides an exception for costs of estates or trusts that would not have been incurred if the property were not held in such estate or trust. The Supreme Court in Knight v. Commissioner, 552 U.S. 181 (2008) interpreted Sec. 67(e)(1) to apply to expenses that are not commonly incurred by individuals. Newly proposed regulations include the following:
        • The allocation of costs of a trust or estate that are subject to the 2-percent floor is based not on whether the costs are unique to trusts or estates, but whether the costs "commonly or customarily" would be incurred by a hypothetical individual holding the same property.
        • In making the "commonly or customarily incurred" determination, the type of product or service actually rendered controls, rather than the description of the cost.
        • "Commonly or customarily incurred" expenses that are subject to the 2-percent floor include costs in defense of a claim against the estate that are unrelated to the existence, validity or administration of the estate or trust.
        • Ownership costs that apply to any owner of a property such as condominium fees, real estate taxes, insurance premiums, and other costs are subject to the 2-percent floor.
        • A safe harbor is provided for tax return preparation costs. Costs of preparing estate and GST tax returns, fiduciary income tax returns, and the decedent's final income tax return are not subject to the 2-percent floor. Costs of preparing all other returns are subject to the 2-percent floor.
        • Investment advisory fees for trusts or estates are generally subject to the 2 percent floor, except for additional fees that are attributable to an unusual investment objective, such as the need to address a special interest of various parties, other than current beneficiaries and remaindermen.
        • Bundled fees such as trustee or executor commissions, attorneys' fees or accountants' fees, must be allocated between costs that are a) subject to the 2-percent floor and b) those that are not.
        • A safe harbor is provided in making the allocation of bundled fees. If a bundled fee is not computed on an hourly basis, only the portion of the fee that is attributable to investment advice is subject to the 2-percent floor. The balance is not subject to the 2-percent floor.
        • Any reasonable method may be used to allocate bundled fees. Detailed time records are not necessarily required. The IRS is requesting comments for the types of methods for making a reasonable allocation.

          Following the issuance of the Knight case, Notice 2008-32 provided interim guidance stating that fiduciary fees would not have to be unbundled for any tax years before 2008. Notices 2008-116 and 2010-32 provided that unbundling fiduciary fees was not required for the 2009 and 2010 tax years and Notice 2011-37 extended the period to taxable years that begin before the final regulations are issued. The IRS is asking for comments on the newly proposed regulations.

      • Final regulations under IRC Sec. 642(c) concerning the ordering rules for charitable payments made by a charitable lead trust. Proposed regulations Sec. 1.642(c)-3(b)(2) and 1.643(a)-5(b) would allow provisions in the governing instrument of an estate or trust that specify the source from which income amounts are to be paid to charities, be respected for federal tax purposes only when the provisions have economic effect independent of income tax consequences. In the absence of effective specific provisions in the governing instrument or in local law, the amount of income distributed to each charitable beneficiary will consist of the same proportion of each class of items of income of the estate or trust as the total of each class bears to the total of all classes. The proposed regulations provide no example of an ordering regime that affects the amount that is paid to charity and, as such, are in substance a prohibition. The IRS believes that the result of the proposed regulations is already required by the law and regulations. When publishing sample charitable lead unitrust forms in July 2008, the IRS stated that a provision in the governing instrument of a charitable lead trust, that provides for the payment to charity to consist of different classes of income determined on a non pro rata basis, will not be respected because such a provision does not have economic effect independent of the income tax consequences of the payment. These rules are to be distinguished from the ordering rules mandated by IRC Sec. 664(b) and applied within statutory classes with explicit reference to tax rates under Regulations Sec. 1.664-1(d). Those ordering rules apply to distributions to non-charitable beneficiaries from charitable remainder trusts. By statute, the treatment of charitable remainder trusts and charitable lead trusts is not symmetrical in this respect.

      • Guidance concerning adjustments to sample charitable remainder trust forms under IRC Sec. 664. The IRS intends to review previously issued sample forms to reflect updates in the law, practice and thinking with respect to charitable remainder trusts.

      • Guidance concerning private trust companies. Privately owned and operated trust companies have become an option that families with large trusts are using and state law authority is being continually refined. Separately, Notice 2008-63, 2008-31 I.R.B. 261, released July 11, 2008, solicited public comment on a proposed revenue ruling, affirming favorable tax conclusions with respect to the use of a private trust company. The proposed revenue ruling addresses five tax issues faced by trusts where a private trust company serves as trustee:
        • Inclusion of the value of trust assets in a grantor's gross estate by reason of a retained power or interest under IRC Sec. 2036 or 2038.
        • Inclusion of the value of trust assets in a beneficiary's gross estate by reason of a general power of appointment under Sec. 2041.
        • Treatment of transfers to a trust as completed gifts.
        • Effect on a trust's status under the GST tax either as grandfathered trust, or as a trust to which GST exemption has been allocated.
        • Treatment of a grantor or beneficiary as the owner of a trust for income tax purposes.

The proposed revenue ruling posits several trusts, illustrating both the introduction of a private trust company as a trustee of a preexisting trust, and the creation of new trusts. The trusts have the following features:

  • The trustee has broad discretionary authority over distributions of both income and principal.
  • Each successive primary beneficiary has a broad testamentary power of appointment
  • The grantor or primary beneficiary may unilaterally appoint but not remove trustees, with no restrictions other than an ability to appoint oneself.

The proposed revenue ruling provides that the private trust companies generally avoid tax problems by the use of certain firewall techniques. An example is a "Discretionary Distribution Committee" (DDC) with exclusive authority to make all decisions regarding discretionary distributions. Anyone may serve on the DDC, but no member of the DDC may participate in the activities of the DDC with respect to a trust of which that DDC member or his/her spouse is a grantor or beneficiary, or of which the beneficiary is a person to whom that DDC member or his/her spouse owes an obligation of support.

Observation: While awaiting further IRS guidance on private trust companies, the SEC adopted a final Family Office Rule under the Investment Advisers Act of 1940 that exempts certain family offices from the definition of an investment adviser. Although private trust companies and family offices differ, advisors who represent families with such operations should consult the SEC rule and, when the IRS releases additional private trust company guidance, pay careful attention to the degree of coordination or deviance between the SEC and IRS pronouncements (as well as other statutes and legislation).


  • Regulations under IRC Sec. 1014 Regarding Uniform Basis of Charitable Remainder Trusts. IRC Sec. 1001(e) and Regulations Sec. 1.1014-4 and -5 provide that the basis of property held in trust or otherwise shared by holders of term and remainder interests is apportioned among the beneficial interests in proportion to the actuarial value of the interests. Sec. 1001(e) and Regulations Sec. 1.1001-2(f) provide that when an interest in property for life or a term of years, or an income interest in property in a trust is sold, its basis is generally disregarded, unless the sale is a part of a transaction in which the entire interest in property is transferred. The Guidance Plan intended to address the outcome when the income and remainder beneficiaries of a charitable remainder trust sell their respective interests in a coordinated sale designed to circumvent the rules governing commutation of CRT interests. Notice 2008-99, 2008-47 I.R.B. 1194 identified this type of transaction as a reportable transaction of interest for purposes of Sections 6111 and 6112 and Regulations Section 1.6011-4(b)(6). In Rev. Proc. 2010-3, 2010-1 I.R.B. 110, the IRS identified whether the termination of a charitable remainder trust before the end of the trust term as defined in the trust's governing instrument, in a transaction in which the trust beneficiaries receive their actuarial shares of the value of the trust assets, causes the trust to have ceased to qualify as a charitable remainder trust within the meaning of Sec. 664; this is an area in which rulings or determination letters will not ordinarily be issued.
  • Regulations under IRC Sec. 2032(a) Regarding Imposition of Restrictions on Estate Assets during the Six Month Alternate Valuation Period. This Guidance Plan project first appeared in the 2007-2008 Plan, but stalled after April 2008 when proposed regulations were first released before the  Treasury retracted the original proposals in November 2011 and released newly proposed regulations. The original impetus for these changes was Kohler v. Commissioner, (T.C. Memo 2006-152, nonacq., 2008-9 I.R.B. 481), which focused on the transfer tax issue and the requirement of IRC Sec. 2032, that an asset valued on the alternate valuation date must be the same as the asset that was included in the decedent's gross estate at death. Postmortem changes that alter the nature of the includible asset cannot be reflected in the alternate valuation.

Observation: Kohler (the decedent) and two survivors were among the family members who held 96 percent of the stock in their privately held company. The decedent died in March and the company completed a tax-free reorganization in May. An alternate valuation date in September was undertaken to determine if it was better to value the stock pre-reorganization, or considering the post-reorganization replacement stock. This made a difference because the reorganization forced outsiders to sell their stock and it imposed transfer restrictions and granted purchase options that were designed to keep the stock (post-reorganization) within the family's control. As it turned out, the value of the stock pre- and post- the reorganization date was the same, but the value of the new stock declined thereafter and before the alternate valuation date. At that time, Regulation Sec. 20.2032-1(c)(1) provided that a Sec. 368(a) tax-free reorganization is a "mere change of form" and not a disposition that accelerates the alternate valuation date. The court held that valuation of post-reorganization stock owned on the alternate valuation date was appropriate because it meant only the form of the stock had changed, and the values of the old and new stock remained unchanged on the date of the reorganization.

    • The government's response: Rather than appeal the decision, the government acquiesced to Kohler and then issued proposed changes to the Sec. 2032 regulations. The proposed regulations sought to prohibit what the government anticipated to be abuses in valuation determinations, stating that changes will affect the federal estate tax of includible assets only if they are attributable to economic or market conditions, or uncompensated theft or casualty losses. Voluntary acts or manipulations would be ignored in valuing a decedent's gross estate. The revised (Guidance Plan) proposal now essentially abandons the proposed approach in the regulation and instead describes events that will accelerate the valuation date under Sec. 2032(a)(1), which triggers valuation at the moment before the acceleration event, and then prohibits valuations that reflect the postmortem event. Acceleration events include sale, reinvestment or estate distribution, creation, recapitalization, reorganization or merger of an entity, redemptions or other changes in ownership structure of an entity that alter the value of the decedent's interest in an entity, or postmortem distribution of a fractional interest in an asset or in an entity that otherwise would justify a fractional or minority interest discount.
    • Effective date:When finalized, the newly proposed regulations will be applied after they are published as final regulations.
  • Final Regulations After IRC Sec. 2036 Regarding Graduated Grantor Retained Annuity Trusts. These regulations were published on November 8, 2011 and are effective on that date. The regulations provide that the amount includible in the gross estate with respect to a retained interest in a trust is the amount needed to generate the retained interest without invasion of principal (in perpetuity) up to the entire date-of death value of the trust assets (Regulations Sec. 20.2036-1(c)(2)(i)). In the case of a GRAT, this will usually result in inclusion of the entire value of the assets, unless the assets have increased enormously in value. The Treasury and IRS rejected the argument that Sec. 2036 is not applicable to a retained annuity interest in a GRAT to the extent the annuity is not payable from trust income. Proposed regulations (REG-119532-08) were published in the Federal Register in April 2009. Proposed Regulations Sec. 20.2036-1(c)(2)(ii) provided that in the case of a graduated GRAT, the amount includible with respect to the amount payable for the year of the decedent's death (called the "base amount") is the amount required to make that payment in perpetuity. The additional amount includible with respect to each annual increment in future years (the "periodic addition") is the amount required to make that incremental payment in perpetuity, discounted for the passage of time before the increment takes effect. The amount included in the gross estate is the sum of the base amount and any periodic additions. The proposed regulations had provided rules for valuing the annuity payments when those payments are paid for the joint lives of the decedent and another recipient, or the decedent following the life of another recipient. The final regulations were effective November 8, 2011.
  • Revenue Ruling on Whether a Grantor's Retention of a Power to Substitute Trust Assets in Exchange for Assets of Equal Value, Held in a Non-fiduciary Capacity, Will Cause Insurance Policies Held in the Trust to be Includible in the Grantor's Gross Estate Under IRC Sec. 2042. This project first appeared in the 2009-2010 Priority Guidance Plan, and this year's Plan is the first to specify that guidance will be in the form of a revenue ruling. A power of substitution is often used to make a trust a grantor trust under Sec. 675(4)(C). In Estate of Jordahl v. Commissioner (65 T.C. 92 (1975), acq., 1977-1 C.B. 1), the Tax Court held that a grantor's power to reacquire an insurance policy from a trust and substitute other property of equal value was not the retention of incidents of ownership in the policy and therefore did not bring the insurance proceeds into the insured's gross estate under section 2038 or 2042.

Observation: Rev. Rul. 2008-22, (2008-16 I.R.B. 796), cited Jordahl and ruled that a grantor's retained power, exercisable in a nonfiduciary capacity, to acquire property held in trust by substituting property of equivalent value will not by itself cause the value of the trust corpus to be includible in the grantor's gross estate under Sec. 2036 or 2038, provided that the trustee has a fiduciary obligation to ensure the grantor's compliance with the terms of this power by satisfying himself/herself that the properties acquired and substituted by the grantor are in fact of equivalent value. The Revenue Ruling further provided that the substitution power cannot be exercised in a manner that can shift benefits among the trust beneficiaries. A substitution power cannot be exercised in a manner that can shift benefits if the trustee has both the power to reinvest the trust corpus and a duty of impartiality with respect to trust beneficiaries, or where the nature of the trust's investments does not impact the respective interests of the beneficiaries such as when the trust is administered as a unitrust or when distributions from the trust are limited to discretionary distributions of principal and income.

    • Because the inclusion of life insurance in the gross estate is governed by Sec. 2042 and not Sec. 2036 or 2038, the insured's right to withdraw an insurance policy from a trust for equivalent value is not directly addressed by Rev. Rul. 2008-22. This project is intended to fill that gap.
  • Guidance Under IRC Sec. 2053 Regarding Personal Guarantees and the Application of Present Value Concepts in Determining the Deductible Amount of Expenses and Claims Against the Estate. This project contemplates the use of present value concepts in determining the amounts of expenses or claims deductible against the estate. The use of the present value concepts is likely to diminish the usefulness of so-called "Graegin loans."
    • Revenue Procedure Providing Procedures for Filing Protective Claims for Refunds for Amounts Deductible under IRC Sec. 2053. This project was completed by the issuance of Rev. Proc. 2011-48, 2011-42 I.R.B. 527, which was released on October 14, 2011. This project is also an outgrowth of the project that led to the amendments of the Sec. 2053 regulations in October 2009, which addressed a conflict among the federal Courts of Appeals regarding the valuation of claims against an estate, especially those claims being pursued in litigation pending at the date of the decedent's death. The regulations allow a deduction of otherwise deductible claims only if and when they are paid, or ascertainable with reasonable clarity;  if these conditions do not occur before the estate tax statute of limitations runs, the executor's recourse is to file a protective claim of refund (prior to the closing of the estate tax return statute of limitation). A court decree (in establishing "ascertainable with reasonable clarity") will be respected if the court reviews the relevant facts and its decision is consistent with applicable law. A consent decree will be respected where the decree is a bona fide recognition of the validity of the claim, and is accepted by the court as demonstrating satisfactory evidence upon the merits. A settlement will be respected if it resolves an active and genuine contest and is the product of arm's-length negotiations by parties with adverse interests.
      • Amended Reg. 20.2053-1(b)(2)(i) provides that deductible expenses and claims must be bona fide in nature and that no deduction is permissible to the extent it is based on a transfer that is essentially donative in character except to the extent the deduction is for a claim that would be allowable as a deduction under Sec. 2055 as a charitable bequest.
      • Reg. 20.2053-1(b)(2)(ii) cites five factors that describes a "bona fide nature":
        • The transaction underlying the claim or expense is in the ordinary course of business, negotiated at arm's length, and is free from donative intent.
        • The nature of the claim or expense is not related to an expectation, or claim of inheritance.
        • The claim or expense originates pursuant to an agreement between the decedent and the family member, related entity, or beneficiary, and the agreement is substantiated with contemporaneous evidence.
        • Performance by the claimant is pursuant to the terms of an agreement between the decedent and the family member, related entity, or beneficiary, and the performance and the agreement can be substantiated.
        • All amounts paid in satisfaction or settlement of a claim or expense are reported by each party for federal income and employment tax purposes, to the extent appropriate, in a manner that is consistent with the reported nature of the claim or expense.
      • The regulations permit no deductions for claims that are not adjudicated, settled, or ascertainable before the estate tax statute of limitations runs, relegating executors in such cases to filing protective claims for refund. However, the regulations provide some relief to these rules, as follows:
        • Guidance on protective refund claims state that a dollar amount does not need to be stated. The claim needs only to identify the expense and why it has not been paid. This is helpful in cases where information regarding a claim could be subject to discovery and damage to the estate's defense against the claim. Also, Regulations Sec. 20.2053-1(d)(5)(ii) confirms that if a protective claim is filed, a claim payable from a share that otherwise would qualify for a marital or contribution deduction will not reduce such deduction until the claim is paid and the protective claim for refund is perfected.
        • Regulations Sec. 20.2053-4(b)(1) provide that the executor may deduct the current value of the claim that is integrally related to a particular asset or assets, where the value of which is greater than 10 percent of the gross estate. Regulations Sec. 20.2053-4(c) allows the deduction of the current value of a claim(s) if the total of such amount is not greater than $500,000. For both of these exceptions, the value of the claim must be supported by a "qualified appraisal" by a "qualified appraiser,"  in the same manner as required for an income tax deduction for certain charitable contributions under IRC Sec. 170(f)(11) and Regulations Sec. 1.170A-13. Also, the values of the deductible claims may be adjusted during an audit taking into consideration postmortem developments.

Observation: Notice 2009-84, (2009-44 I.R.B. 592) provides a limited administrative exception to the well-established right of the IRS (even when it is prevented by the statute of limitations from assessing additional tax) to deny a claim for refund to the extent that it finds offsetting increases in tax that reduce or eliminate the overpayment (and where the claim is the only acceptable basis for a refund). This Notice prohibits the IRS from offsetting refunds with tax increase adjustments.

    • Rev. Proc. 2011-48 provides procedural guidance regarding protective claims for refunds. It covers the following:
      • The protective claim may be filed at any time within the period of limitations for filing a claim for refund under Sec. 6511(a), which is the later of a) three years after date the return is filed, or b) two years after payment of tax.
      • There must be documentation of the authority of the person (i.e., the estate's representative) filing the claim on behalf of the estate. If the same fiduciary that filed the Form 706 also files the protective claim, a statement affirming that the person is still acting in a representative capacity will suffice.
      • For estates of decedents dying after 2011, two approaches are available regarding protective claims:
        • Attach Schedule PC to the Form 706 at the time of filing the estate tax return, or
        • File Form 843 with the notation "Protective Claim for Refund under Section 2053" written at the top of the form. This method may result in a faster response from the IRS as it is required to acknowledge receipt within 60 days of receipt.
      • For estates of decedents dying between October 20, 2009 and December 31, 2011, the Form 843 method must be used.
      • The Revenue Procedure provides certain procedures for curing inadequately identified claims.
      • A separate protective claim for refund (for each separate claim or expenses) should be filed on a separate form.
      • Ancillary expenses such as attorney fees, court costs, appraisal fees, and other expenses, that are related to resolving, defending, or satisfying the identified claim or expense are automatically included as part of the claim for refund without the need for separate identification of these types of expenses.
      • The IRS does not do a substantive review of the protective claim for refund until it is notified that the claim has been paid, or the amount is ascertained. The IRS may however reject the initial claim if preliminary procedural requirements are not met. The IRS will acknowledge receipt within 60 days of filing a Form 843 and 180 days of filing Schedule PC. If not received, the filer must notify the IRS within 30 days after the expiration of those periods. Failure to contact the IRS timely will cause the estate to lose the limited scope of review. Regarding Schedule PC and Form 843 submissions, the IRS limits its review of the related Form 706 to the deduction under Sec. 2053 that was the subject of the protective claim. However, if the procedures set forth in connection with the claim are not followed, the limited review will not apply.
      • The IRS must be notified within 90 days after the date on which the amount of the claim or expense is paid or becomes certain and is no longer subject to any contingency. If the IRS is not notified timely, or reasonable cause is established for the delay, the claim for refund is barred forever.
      • The effective date applies to protective claims for refund under Section 2053 for decedents dying on or after October 20, 2009.
  • Notice on Decanting Trusts Under Sec. 2501 and 2601. This is a new project. Revenue Procedure 2011-3, (2011-1 I.R.B. 111) provided a new Section 5.17 which included decanting trusts in circumstances which are under study, or in areas in which rulings or determination letters will not be issued until the IRS resolves the issue through publication of revenue rulings, revenue procedures, or regulations.
    • Final Regulations Under IRC Sec. 2642(g) Regarding Extensions of Time to Make Allocations of the GST Tax Exemption. First appearing in the 2007-8 Priority Guidance Plan, the genesis of this project is Section 564(a) of EGTRRA, which added subsection (g)(1) to IRC Sec. 2642, and directed the Treasury to publish guidance on providing extensions of time to allocate GST exemptions,  or to elect out of statutory allocations of GST exemptions. Prior to EGTRRA, similar extensions of time to file under Regulations Sec. 301.9100-3 (so-called "9100 relief") were not available because the deadlines for taking such actions were prescribed by the Code and not the regulations. Shortly after the enactment of EGTRRA, Notice 2001-50, (2001-2 C.B. 189), acknowledged Section 2642(g)(1) and stated that taxpayers may seek extensions under Regulations Sec. 301.9100-3.
      • In addition, Revenue Procedure 2004-46, (2004-2 C.B. 142) provided a simplified method of dealing with pre-2001 gifts that meet the requirements of the annual gift tax exclusion under Sec. 2503(b), but not the tax-vesting requirements applicable for GST tax purposes for gifts in trust under IRC Sec. 2642(c)(2).
      • Proposed Regulations Sec. 26.2642-7 (REG-147775-06) was published in April 2008 and will supersede Regulations Sec. 301-9100-3 when finalized. The proposed Regulations Sec. 26.2642-7(d)(1) provide that the general standard is still demonstrating that the transferor or the executor of the transferor's estate acted reasonably and in good faith, and that the grant of relief will not prejudice the interests of the government.

Observation: The regulations set forth a nonexclusive list of factors to determine whether the transferor or the executor acted in good faith:

  • The intent of the transferor to make a timely allocation or election,
  • Intervening events beyond the control of the transferor,
  • Lack of awareness of the need to allocate GST exemption to the transfer, despite the exercise of reasonable diligence,
  • Consistency by the transferor, and
  • Reasonable reliance on the advice of a qualified tax professional

The regulations also set forth a nonexclusive list of factors to determine whether the interests of the Government are prejudiced, including:

  • The extent to which the request for relief reflects hindsight,
  • The timing of the request for relief, and
  • Any intervening taxable termination or taxable distribution  








    • IRC Sec. 2642(g)(1) is scheduled to sunset on January 1, 2013.
  • Regulations Under Sec. 2704 Regarding Restrictions on the Liquidation of an Interest in Certain Corporations and Partnerships. This project has been carried over from many prior years' plans and is intended to address Sec. 2704(b)(4), which states that the Secretary may by regulations, provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor's family, if such restriction has the effect of reducing the value of the transferred interest. The proposed regulations would presumably provide guidance on the types of restrictions that the IRS would disregard.
  • Guidance Under IRC Sec. 2801 Regarding the Tax Imposed on U.S. Citizens and Residents Who Receive Gifts or Bequests From Certain Expatriates. The Heroes Earnings Assistance and Relief Tax Act of 2008 (the "HEART" Act) enacted a new income tax "mark to market" rule when an individual expatriates on or after June 17, 2008, and enacts a new succession tax on anyone who receives a gift or bequest from an individual who expatriates on or after June 17, 2008. Announcement 2009-57 which was released in July 2009, stated that the IRS intended on providing guidance under Section 2801 as well as a new Form 708 on which to report the receipt of gifts and bequests subject to Section 2801.
  • Final Regulations Under Sec. 7520 Updating the Mortality-Based Actuarial Tables to be Used in Valuing Annuity Interests for Life, or Term of Years, and Remainder or Reversionary Interests. TheTreasury, as required by Sec. 7520(c)(3), has finalized the temporary regulations updating its actuarial tables, to reflect the mortality data produced by the 2000 U.S. census. The new data reflects an increased life expectancy for all persons under age 95. This increases the value of lifetime interests and decreases the value of remainders and reversions following lifetime interests. Thus, charitable remainder trusts and qualified personal residence trusts will be slightly less desirable, while charitable lead trusts, private annuities and self-cancelling installment notes will be slightly more attractive. The new tables apply to transfers for which the valuation date is on or after May 1, 2009.

5. Transfer Tax Developments

  1. Transfers with Retained Enjoyment:
    1. Estate of Van v. Commissioner, T.C. Memo 2011-22 demonstrates the basic premise that actually living in a house is a tough fact to overcome. The decedent lived in a specific house for many years, and during these years the title to the house was transferred several times between her and other family members or friends. A year prior to the decedent's death, the house was conveyed from a revocable trust to the decedent's daughter and grandchildren. The estate took the position that no portion of the house should be included in decedent's gross estate. The IRS took a different position, asserting that the decedent had a beneficial interest in the property because she had lived in the house rent-free from 1973 until her death in 2000. Although she had no legal title to the house at the time of her death, the decedent's continued occupancy of the house required inclusion in her gross estate under IRC Sec. 2036(a).

    2. Estate of Riese v. Commissioner, T.C. Memo 2011-60 deals with the circumstance of living in the house after the termination of a qualified personal residence trust (QPRT). In this case, a three year term QPRT was established in 2000, and upon the end of the QPRT term in 2003, the property passed equally to three separate trusts for each of the decedent's daughters. The decedent continued to live in the residence after the termination of the QPRT term, for six months until her sudden death. At the time of the decedent's death, the decedent's daughters were in the process of working with an attorney to determine an appropriate rent amount, however the decedent did not pay any rent during the last six months of her life; she also did not pay any real estate taxes, maintenance expenses, or other expenses. The executor of the estate took the position to not include the value of the residence in the gross estate, and also claimed a Sec. 2053 deduction (as a debt) for $46,298 (for the net fair market value of $7,500 in monthly rent due from the decedent from date of the termination of the QPRT until the decedent's death). The estate also claimed a Sec. 2053 administration expense deduction of $46,452 for the net fair market value of the rent from the day after the decedent's death through April 30, 2004. The estate also deducted $125,000 for investment management fees. The IRS included the property in the gross estate and disallowed the deductions. The Tax Court found that there had been an agreement among the parties for the decedent to pay fair market rent, the amount of which was to be determined and payments to begin by the end of 2003. The Tax Court also noted that the Treasury has yet to issue regulations or guidance on how and when rent should be paid upon the termination of a QPRT. The Court noted several steps to establish the fair rental amount and indicated that rent would have been paid, except for the fact that the decedent died in the interim.

  2. Powers of Appointment
    1. In Estate of Chancellor v. Commissioner, T.C. Memo 2011-172, the decedent's husband had previously died, leaving a will that created a credit shelter trust, and naming the decedent as co-trustee together with a bank. The co-trustees were given the power to distribute principal to and among the beneficiaries for necessary maintenance, education, health care, sustenance, welfare or other appropriate expenditures of the beneficiaries, taking into consideration the standard of living to which they were accustomed and any income available to them from other sources. The credit shelter trust was created to convey the maximum portion of the estate that would be exempt from federal transfer tax. The IRS contended that the value of the trust assets should be includible in the gross estate for federal estate tax purposes because the decedent's power over the trust fund (as a co-trustee) constituted a general power of appointment. The Tax Court disagreed and held for the estate, finding that the decedent's power over the trust was subject to an ascertainable standard relating to the trust beneficiaries' health, education, support, and maintenance under state law and within the meaning of Sec. 2041(b)(1)(A) and Regulations Sec. 20.2041-1(c)(2). The Court also ruled that the phrase "other appropriate expenditures needed by the beneficiaries" created a non-general power of appointment particularly when preceded by a list of necessary support-related purposes. The term "welfare" was construed to be an ascertainable standard.

    2. In Letter Ruling 201132017 (Aug. 12, 2011), the IRS accepted a state court reformation to correct an inadvertent general power of appointment. A joint revocable trust was created between D and S (settlors, a married couple), providing that, on the death of the first settlor to die, the trust would be divided into a Marital Trust, a By-Pass Trust, and a Survivor's Trust. The instrument also stated that, on the death of the surviving spouse, the trustee shall pay from the decedent's estate the surviving spouse's debts, expenses, and death taxes due by reason of his or her death, and charge those payments against property in the By-Pass Trust. The trustee was prohibited from using any insurance proceeds, qualified retirement plan distributions, or other assets otherwise excludable from federal estate tax to pay debts, expenses, death taxes, or any other obligations enforceable against the Surviving Trustor's estate to pay debts, expenses and estate taxes. The instrument also gave the surviving spouse a general testamentary power to appoint the balance of the Survivor's Trust to anyone, including his or her estate or creditors. D died, survived by S and three children. S became executor of D's estate and trustee of all of the trusts. S consulted with an attorney and determined that the trust language incorrectly provided that expenses, debts and taxes would be charged against the By-Pass Trust, which was not the intent of the decedent. S, as trustee, brought an action in state court to have the language of the trust reformed so as to charge these expenses to the Survivor's Trust. The local court granted the petition for modification, retroactively reforming the trust to charge debts, taxes, and expenses against the Survivor's Trust rather than the By-Pass Trust. The trustee then asked the IRS to rule that the By-Pass Trust, as modified, did not give S a general power of appointment, and that modification of the trust pursuant to the court's order was not an exercise or release of a general power of appointment for gift tax purposes, and that S was not deemed to have made a gift of an interest in the trust as a result of the court order. The IRS granted the requested relief explaining that a power of appointment exercisable to meet the estate tax and any other taxes, debts, or charges which are enforceable against the estate, is a general power of appointment. However, a mistake by a draftsman in reducing the intent of the parties to writing is grounds for reformation, as it is to correct errors; a reformation is used only when necessary to correct a clear mistake and prevent injustice. The IRS therefore concluded that the trust, as modified, did not give S a general power of appointment, so that the modification cannot constitute the release or exercise of such power. Further, it cannot constitute a deemed taxable gift.>

    3. Property Transfers Incident to Divorce: PLR 201116006. This PLR considered the estate tax consequences of a property settlement placed in trust. The spouses' property settlement was incorporated into their divorce decree. The property settlement transfer was made to a trust that paid the taxpayer income for life, and principal in the trustee's discretion. The taxpayer had a non-general power of appointment, and the remainder passed (in default of appointment) to the taxpayer's descendants. The IRS confirmed that there was no estate tax inclusion of the trust in the taxpayer's gross estate at death. The IRS did conclude that there was a taxable gift on creation of the trust, in the amount of the value of the remainder interest passing to the taxpayer's descendants, made by the taxpayer's spouse, who created the trust. The ruling treated the transfer to the trust as both a property settlement that Sec. 2516 regarded as made for adequate and full consideration and therefore not a taxable gift, as well as a partial satisfaction of the spouse's support obligation to the taxpayer. The value of the remainder interest would have been includible in the taxpayer's gross estate at death if the spouses had simply divided their assets, and then the taxpayer placed a portion of those assets into the same trust, retaining a life estate; in this scenario the division of assets and the subsequent creation of the trust would have been tax free. The result cited in the ruling was better for the taxpayer, except perhaps for the fact that the trust was irrevocable from its creation, meaning that the taxpayer did not have direct access to the trust corpus during life, but was dependent on the trustee for distributions. The taxpayer might have benefitted from a power to appropriate trust assets inter vivos subject to an ascertainable standard, which would prevent inclusion in the taxpayer's gross estate under Section 2041.

6. Valuation Cases

  • In Estate of Giustina v. Commissioner, T.C. Memo 2011-41, the Tax Court reviewed the value of a limited partnership interest in a partnership holding timberland, with a focus on the relative weighing of both net asset and discounted cash flow values methods.
    • The Tax Court valued the decedent's revocable trust's 41.128 percent interest in the limited partnership's operations at $27.5 million, determined with a 75 percent weighting to a cash flow method and 25 percent to an asset method. The cash flow method value was determined using a 12.25 percent rate to discount future cash flow to present value, and a 25 percent discount for lack of marketability. The court applied no discount for lack of marketability to the asset method value, believing that applying a percentage weighting to the net asset method already accounted for lack of control, since an existing valuation determine by partnership protocols utilized a 40 percent absorption discount used in determining the stipulated value of timberland owned by the partnership and already accounted for lack of marketability. The Court also held that the 20 percent undervaluation penalty under Sec. 6662(a) did not apply even though the value reported on the estate tax return was less than 50 percent of the determined value, because of application of the reasonable cause/good faith exception of Sec. 6664(c). The factors considered in determining whether the taxpayer acted reasonably included the methodology and assumptions underlying the appraisal, the circumstances under which the appraisal was obtained, and the appraiser's relationship to the taxpayer (the appraiser was hired by the estate tax attorney).

    Observation: As one the panelists in this session noted, the Court's insistence on assuming a 25 percent likelihood that the partnership's assets would be sold, despite the fact that the owners had a long history of retaining the partnership's timberland and continuing forestry operations, is reminiscent of cases that made similar behavioral assumptions about possible sales that have been reversed by courts of appeal.

  • In Estate of Gallagher v. Commissioner, T.C. Memo 2011-148, the Tax Court valued a minority interest in a media business using discounted cash flow with appropriate discounts. The Tax Court, in its analysis of dueling appraisals of a media company, looked at the following factors:
    • The date of the financial information relevant to the date-of-death valuation.
    • The appropriate adjustments of historical financial statements.
    • The propriety of relying upon the guideline company method in valuing the units.
    • The application of the discounted cash flow valuation method.
    • The appropriate adjustments to the enterprise value.
    • The proper type and size of the applicable discounts.

First the court specifically rejected the IRS' use of the guideline company method to value the decedent's minority interests (units) owned. It concluded that the four guideline companies used by the IRS were not sufficiently comparable. Second, the Court disagreed with both experts in terms of the appropriate factors to consider in applying the discounted cash flow method. The Court determined that a 23 percent minority interest discount should be applied to the equity value of the company and found a 31 percent lack of marketability discount to be appropriate. Accordingly, the Court found that the value of the units to be $35.8 million, compared to $34.936 million reported on the estate tax return.

It is important to consider the elements of the Court's analysis:

  • The Court viewed the value listed on the estate tax return as inconsistent with a later position taken by the taxpayer.
  • The Court concluded to use financial information closest to the date of death, even though the financial information was not publicly available on the date of death. Later financial information accurately depicted market conditions on the valuation date and there was no intervening event between the valuation date and the date of publication of the financial statements that would cause them to be incorrect.
  • The Court rejected the guideline company method, which is a market-based approach that estimates the value of the subject company by comparing it to similar public companies. While the Court acknowledged that publicly held companies that are similar may be guideline companies, the ones that were selected in this particular case were not similar enough.
  • The Court performed its own discounted cash flow analysis rather than accepting the analysis of either the IRS or the taxpayer. Both sides' experts used the weighted average cost of capital in determining an appropriate discount rate. The Court resolved differences between the experts regarding the cost of equity capital and the cost of debt capital. The cost of equity capital was determined using the build-up method which utilized an interest rate based on the interest rate paid on governmental obligations, and increases that rate to compensate the investor for the disadvantages of the proposed investment. The Court also decided that the appropriate percentage of debt capital and equity capital was 75-25, and using book value instead of market values.
  • Not allowing tax-affecting of cash flows from the S corporation. The taxpayer's appraiser made adjustments because the LLC had previously been an S corporation, tax affected for the benefits to the shareholder of the S election. The Court rejected such adjustments.
  • Substantial minority and marketability and overall discounts. The Court ultimately allowed a 23 percent minority discount and a 31 percent marketability discount for an overall discount of 46.8 percent in valuing the estate's 15 percent LLC interest.
  • In Estate of Levy v. United States, (402 Fed. Appx. 979, 106 AFTR 2d 2010-7205 (5th Cir. Dec. 1, 2010), aff'g 2008 WL 5504695 (W.D. Tex. 2008), cert. denied, 2011 WL 1481312, 79 USLW 3610 (2011)), the Fifth Circuit upheld a jury verdict valuing real estate with regard to a subsequent contract, rezoning and sale. The Court noted that offers from identified sophisticated developers who could be reasonably expected to have investigated the value of the land before making a proposal is relevant and admissible. Offers to buy are admissible to establish fair market value when they are part of ongoing negotiations, and resulting in a contract with substantially the same terms. A contract to sell the actual property is relevant and admissible, even when a contract to sell comparable property may not. While the estate also argued that the final sales price should be inadmissible because the sale was contingent on rezoning, the chances of obtaining approval for rezoning was remote on the date of death. The Court countered that the rezoning effort at date of death was unrealistic and aggressive, whereas the subsequent rezoning was realistic and within the locality's comprehensive plan.
  • In Estate of Mitchell v. Commissioner,T.C. Memo 2011-94, the Tax Court determined the fair market values of a 95 percent interest in real estate owned by the decedent on the date of death and a 5 percent interest in the same real estate given to the decedent's children prior to death. The parties agreed that the real property interests were to be valued, in contrast to valuing fee simple interests. A leased fee interest describes the landlord's rights in leased property, including the right to receive lease payments and the reversionary interest upon the expiration of the lease. The Court noted that it had to determine the value of the 100 percent leased fee interest of the real properties at issue, to determine the value of the 95 percent interests owned by the decedent and the 5 percent interests given the children's trust. The Court found the estate's experts calculation of the present value of the lease payments for the property for a 20-year lease term to be the most accurate. The case is noteworthy because the court's opinion does not address whether the fact that the 5 percent undivided interest that was gifted only six days before the decedent's death was a factor in whether to recognize the undivided interests at all for valuation purposes. In Estate of Murphy v. Commissioner, T.C. Memo 1990-472, the minority discount was not recognized where the sole reason for the gift 18 days before death was to create a minority interest. In Estate of Frank v. Commissioner, T.C. Memo 1995-132, a minority discount was allowed where the decedent's son made gifts under a power of attorney two days before date of death. And in Pierre v. Commissioner, T.C. Memo 2010-106, the step transaction doctrine applied to aggregate gifts and sales made to trusts, to value gift and sale interests to each of two trusts as combined 50 percent interests. For the IRS position, see Technical Advice Memorandum 9146002.
  • Transfers with Retained Enjoyment. In Estate of Adler v. Commissioner, T.C. Memo 2011-28, land is not subject to fractional interest discounts in the gross estate of a decedent who had a retained a life estate in the property. Here, the decedent owned property which he deeded an undivided one-fifth interest to each of his five children as tenants in common. The decedent continued to use the property during his life and none of his children resided there or attempted to interfere with his use, possession, or enjoyment of the property. He paid all expenses and made improvements to the property, without any of children's consent. The estate claimed that the estate owned five separate tenancy-in-common interests and applied a 32 percent marketability discount and a 16 percent minority-interest discount. The Tax Court held for the IRS that no discounts were appropriate and noted that the three conditions for the application of Sec. 2036(a)(1) were met:
    • The decedent transferred an interest in the property during life
    • The transfer was not a sale, and
    • The decedent retained possession or enjoyment of the property for life.

The general purpose of Sec. 2036 is to include the value of property in the value of the gross estate where the decedent transfers the property during life and the transfer is essentially testamentary in nature (the transferor controls the disposition of the property at death but possesses and enjoys the property during life). The Court also agreed that when a person dies holding a fractional interest in property, it is often appropriate to discount the value of the interest because lack of control and liquidity decreases the property's value. Whether property should be valued as a whole or  separate fractional interests depends on when the interests are separated. If ownership is split during lifetime, the interest retained is valued separately. If the split occurs only at death, the property is valued with no discount. The retention of a lifetime use of the property rendered the division testamentary in character, and negated any marketability or control discounts.

  • The Tax Court Sustains the Use of a Defined Value Clause. In Hendrix v. Commissioner, T.C. Memo 2011-133, the taxpayers wanted to make gifts to trusts, for the benefit of their daughters and more remote descendants, of nonvoting shares of the stock of a closely-held S corporation. The taxpayers also established a donor-advised fund (Foundation). The Foundation was sent a draft of an assignment agreement, and a dispute resolution and buy-sell agreement, executed by the corporation and its shareholders. The draft agreement indicated that the taxpayers would give shares of the nonvoting stock to the Foundation and would transfer other shares of the same stock to trusts for the daughters. The draft agreement indicated a formula clause would set a dollar amount, to determine the portion of the stock to be transferred to the trusts, with the balance going to the donor advised fund foundation. The Tax Court upheld the use of the defined value formula clauses to fix the transferred amount of the stock, because it found that the parties conducted themselves on an arm's length basis. The IRS argued that the defined valuation clauses were invalid as contrary to public policy. The Court did not agree with the IRS. The fundamental public policy of encouraging gifts to charity was evidenced.

Observation: The panelists discussed the IRS' primary position that these types of valuation formula clauses should not be recognized for tax purposes on the basis of public policy because they reduce the IRS' incentive to audit returns. The IRS has been losing this argument in the courts. This is the fourth recent case in which the court has recognized the binding effect of defined value clauses for tax purposes.

  • PLR 201109014: The IRS reverses itself and grants an extension of time to elect alternate valuation even when the request is filed more than a year after a tax return is timely filed. The personal representatives of a decedent's estate hired an accountant to prepare the decedent's estate tax return. The return was prepared and filed, valuing the assets on the date of the decedent's death. Over 18 months after the due date of the return, including extensions, the personal representatives of the estate realized that the estate could have benefitted from an alternate valuation date election. The representatives asked the IRS to grant additional time to make the alternate valuation date election under Sec. 2032. The IRS denied the request citing that the alternate valuation date election cannot be made later than one year after the time prescribed by law for filing such return under Sec. 2032(d)(2). In Letter Ruling 201109014, the IRS reversed its position, granting relief to the decedent's estate. The one-year limitation in Sec. 2032(d)(2) applies only to late-filed returns, and therefore should not limit the availability of relief under Sacs. 301.9100-1 and 301.9100-3, but failed to make the election on the return. The taxpayers could make a request for 9100 relief and would be eligible because the original return was filed timely.
    • The IRS followed this approach in another case in which the return was timely filed but the request is filed more than a year later. See PLR 201118013.
    • The IRS also granted an extension of time to elect the alternate valuation date; see PLR 201122009.

7. Update on Family Limited Partnerships

  • In Linton v. United States(630 F. 3d 1211 (9th Cir. 2011), aff'gin part, rev'g in part, and rem'g 638 F Supp 2d 1277 (D. Wash. 2009)), the Ninth Circuit rejects a formulaic step transaction analysis. The issue is whether the taxpayers gave interests in a limited liability company to trusts for their children at a discount or gave the underlying assets on an undiscounted basis. The district court granted the government's motion for summary judgment that gifts made were made of the underlying property at an undiscounted value, under the step transaction doctrine. The Ninth Circuit reversed.
  • The failure to follow partnership formalities will result in the deemed retention of beneficial enjoyment and inclusion of the undiscounted value of the underlying assets in the donor's gross estate. Numerous cases illustrate the resultant estate inclusion, as follows: 
    • In Estate of Jorgensen v. Commissioner, (107 AFTR 2d 2011-2069 (9th Cir. 2011)) aff'g by unpub'd op. T.C. Memo 2009-66), the decedent, Mrs. Jorgensen, died on April 25, 2002.  Her late husband was Colonel Jorgensen; her daughter was Jerry Lou and her son was Gerald.  During their lives, the Colonel was responsible for managing the family's investments (marketable securities). A family partnership JMA-1 was formed during the Colonel's lifetime to hold investments: a second partnership was formed as well.  The Colonel was actively involved in picking stocks, managing Mrs. Jorgenson's and additional family members' investments held in the partnership, and engaging in the family's estate planning.  Mrs. Jorgensen was not interested in these matters.

From the Court's decision:

"On June 30, 1995, Colonel and Ms. Jorgensen each contributed marketable securities valued at $227,644 to JMA-I in exchange for 50-percent limited partnership interests. Gerald and Jerry Lou, along with their father, were the general partners. Colonel and Ms. Jorgensen had six grandchildren; three were Gerald's and three were Jerry Lou's. Gerald, Jerry Lou, and the six grandchildren were listed as limited partners and received their initial interests by gift. Neither Gerald, Jerry Lou, nor any of the grandchildren made a contribution to JMA-I, although each was listed in the partnership agreement as either a general or a limited partner. During his lifetime Colonel Jorgensen made all decisions with respect to JMA-I." (Emphasis added.)

The Colonel died on November 12, 1996 and Mrs. Jorgenson died on April 25, 2002. After the formation of JMA-1 and during its existence and through Mrs. Jorgenson's death, JMA-1 did not operate a business and was generally a passive investor in the assets it owned. The operation of JMA-1 possessed many bad facts; as an example, Gerald, who was cited in the agreement as a limited partner and had not contributed property to obtain his limited interest, had borrowed money from the partnership and for two years thereafter made no loan repayments; his loan repayments loan were to be funded from Gerry's partnership interest, however he did not possess (own) a partnership interest as he never contributed assets in exchange for an interest in JMA-1.     

Considering the facts of JMA-1's formation and history of operations, the Court held that the entire value of JMA-1 was includible in Mrs. Jorgenson's estate under IRC Sec. 2036(a). The Court cited in its analysis there was no legitimate and significant nontax reason for creating the family limited partnership, and that the Jorgenson's children and grandchildren did not make contributions to receive their partnership interests and as a result, transfers to the partnerships in exchange for partnership interests were not in the form of a bona fide sale (transfer) for adequate and full consideration. Additionally, the Court cited that the partnership a) was not designed to help Mrs. Jorgenson manage her assets because her revocable trust and power of attorney already served that function, and did not b) provide means for a financial education to the children and grandchildren, c) encourage family unity since some of the members were general partners and some were limited partners, d) pool assets for more investment opportunities, e) protect against creditors' claims, and f) perpetuate the family's buy- and-hold investment philosophy because there are no special skills taught so to adhere to such a philosophy. Also, none of the partnership formalities were followed, such as maintaining books and records, the absence of formal meetings between and among partners, no meeting minutes were kept, and partnership assets were used to pay personal expenses.

In Estate of Turner v. Commissioner,T.C. Memo 2011-209, a husband and wife transferred cash, certificates of deposit and publicly traded securities to a family limited partnership that they created. Each donor (partner) received a 0.5 percent general partnership interests and 49.5 percent limited partnership interest. The donors retained adequate assets outside of the partnership to support themselves comfortably. Over a two-day period less than five weeks prior to the husband's death, limited partnership interests were gifted to the children, and to grandchildren. The IRS argued that the undiscounted value of 50 percent of the partnership assets should be included in the decedent's gross estate. The Tax Court held for the Service under both Sec. 2036(a)(1) and 2036(a)(2), because the partnership was not created for a significant nontax reason. The court also stated that the partnership was not formed to consolidate assets for management purposes, and did not allow or provide for someone other than the family members to maintain and manage the family's assets for future growth pursuant to an investment policy. The court stated that consolidated asset management may be a legitimate and significant nontax purpose, but it is not generally a significant nontax purpose where the sole purpose is to provide active asset management.The court also held that the partnership was not formed to facilitate resolution of family disputes though equal sharing of information which may be a legitimate and significant nontax reason for creating a family partnership. Instead, there was ill will among the children and there was no interest in the children managing their parents' assets. The Court also held that the partnership format did not protect the family assets from one of the grandsons, who had a drug problem. Also, the decedent had an implied agreement to retain possession or enjoyment of the transferred assets, based on the continued use of the partnership assets for personal purposes, and he received disproportionate distributions.

  • In Estate of Liljestrand v. Commissioner, T.C. Memo 2011-259, the taxpayers formed a family limited partnership (FLP) and transferred real estate into the entity. The decedent, through a revocable trust, held his 99.98 percent interest in the partnership in the form of general partnership units, class A limited partnership units, and all but one of the class B limited partnership units. A son who managed the decedent's real estate and was co-trustee of the revocable trust, received one class B unit. Subsequent to formation, the decedent gifted limited partnership interests to irrevocable trusts established for his children. The Tax Court held that the decedent had retained the beneficial enjoyment of the assets transferred to the partnership and included the undiscounted value of the partnership assets in his gross estate under Sec. 2036(a)(1). The Court stated that the assets were not transferred to the partnership in a bona fide sale for an adequate and full consideration in money or money's worth. There was no legitimate and significant nontax reason for creating the partnership. The Court noted the following:
    • Forming the FLP did not ensure that the real estate would be centrally managed by the son, which was already assured by the son's separate employment agreement with the trust which was in existence prior to the formation of the FLP. In addition, the son had a conflict of interest since he was still a co-trustee of the revocable trust.
    • The FLP appeared not to be formed in accordance with state law because most of the real estate was outside of the state, and not subject to the state law under which the partnership was formed. Therefore, the property could not be partitioned or divided amongst the partners via the partnership vehicle.
    • There was no evidence that the decedent or any of the other partners were particularly concerned with creditor claims.
    • The formation of the FLP was not a bona fide sale since the partnership did not follow basic formalities. It commingled assets during the first two years of its existence, held only one partnership meeting in over 12 years, had no other formal meetings between the partners, kept no minutes, used partnership assets for the decedent's personal expenses, did not make proportionate distributions, and made numerous loans to partners without receiving promissory notes or repayment.
    • The decedent was financially dependent upon partnership distributions to maintain his lifestyle and pay his living expenses.
    • There was no adequate and full consideration for the receipt of the partnership interests in exchange for assets contributed.

8. Other Cases

  • In Private Letter Ruling 201117005, the taxpayer intended to create two trusts upon his death. The first was a charitable remainder unitrust (CRUT), and the second was a qualified terminable interest property trust (QTIP). If the spouse survived the taxpayer, the QTIP was to receive a fixed amount of assets. Also under the intended estate plan, immediately upon creation of the trusts, the assets would be divided between Fund A (containing the residence) and Fund B (containing all interests in an LLC that held tangible assets and cash).
    • Fund A provided for the surviving spouse to live in the residence and for the QTIP trustees to be able to purchase another residence for the spouse to live in and pay the net income of the trust to the surviving spouse. The trustees of Fund A could distribute to Fund B any or all of the Fund A assets that are not invested.
    • Fund B provided for the payment of a 4 percent CRUT (unitrust) amount to the surviving spouse. The spouse had the exclusive right to use all of the assets owned by the LLC for as long as any interests in the LLC were held directly or indirectly in Fund B. Fund B also provided that the trustee could distribute principal for the spouse's health, support and maintenance.
    • The CRUT provided that upon the taxpayer's death, if the spouse survived, the CRUT was to be funded with a fixed amount. The unitrust amount was to be distributed under a somewhat unique formula. One-fifth of the unitrust amount would go to the surviving spouse and four-fifths of the unitrust amount would be distributed to the spouse or to the foundation that was the charitable remainderman in the trustee's discretion. If the spouse remarried after the decedent's death, the spouse was to only receive the one-fifth portion and a portion of the four-fifths portion so as not to have a de minimis distribution.
    • The IRS first held that the QTIP trust would qualify as valid, as long as a valid QTIP election was made.
    • The IRS then concluded that the transfer to Fund B of the initial pecuniary amount in Fund A and of any reinvestments of the pecuniary amount or any net proceeds of sale form property would not be considered a disposition under Sec. 2519 and treated as a gift by the surviving spouse.
    • The IRS then held that Sec. 678(a) would not apply to the CRUT.
    • The IRS then held that the provision of the CRUT that gave the trustees the discretion to pay the annual unitirust amount in one or more equal or unequal payments would not disqualify the CRUT as a valid charitable remainder trust under Sec. 664.
    • The IRS noted that the ability to split a unitrust amount between charitable and non-charitable beneficiaries is well established. Also, where an independent trustee has the power to allocate the unitrust amount among charitable and non-charitable beneficiaries on an annual basis such is not inconsistent with the Internal Revenue Code.
    • The IRS then held that the provision of the CRUT that limited the portion of the unitrust amount payable to the surviving spouse during the period of her remarriage would not disqualify the CRUT. This provision is similar to a qualified contingency.
    • The IRS then held that the entire value of assets distributed to the CRUT would be included in the decedent's estate. The portion of the CRUT going to the remainder charitable interest would qualify for the estate tax charitable deduction under sec. 2055 and the value of the spouse's unitrust interest would qualify for the marital deduction under sec. 2056(b)(8).

  • The IRS Continues to Ignore Unnecessary QTIP Elections. See Private Letter Rulings 201112001, 201131011 and 201119004. In the last letter ruling, the IRS continues to allow divisions of QTIP trusts and the termination of estate tax exposure for one of the divided trusts by a renunciation of the interest in that trust.

  • In Estate of Duncan v. Commissioner, T.C. Memo 2011-255, the Tax Court permits the deduction of interest on a Graegin loan; the facts and observations of the TCM follow.
    • Vincent Duncan established a trust in 2001 and died in 2006. Vincent's son and the Northern Trust Company were the executors of the estate. At the time of his death, Vincent was the beneficiary of an irrevocable trust established by his father. The 2001 trust provided that taxes and expenses are to be paid from the trust. Both trusts (the 2001 trust, and the trust established by Vincent's  father) provide for the division of assets into separate trusts for Vincent's six children upon Vincent's death. To cover anticipated federal estate taxes, the 2001 trust borrowed money from the trust formed by Vincent's father, using a secured note with a 15-year term and a 6.7 percent interest rate. The note was a form of Graegin note, pursuant to which the prepayment of interest and principal was prohibited.
    • Vincent's estate claimed a deduction for interest owned on the note on the federal estate tax return. In addition, a deduction for estate settlement services fees paid to both executors was also taken on the estate tax return. The estate filed a supplemental return reducing the value of the gross estate and listed additional expenses to be deducted.
    • The IRS denied the deduction for the interest on the Graegin note, on the basis that the loan was not a bona fide debt under the 15 factors cited in Estate of Rosen v. Commissioner, T.C. Memo 2006-115.
    • The Tax Court held that the interest could be deducted. While recognizing that the factors in Estate of Graegin v. Commissioner, T.C. Memo 1988-477 could be helpful, the court here said that the ultimate questions were whether there was a genuine intention to create a debt with a reasonable expectation of repayment, and whether that intention fit the economic reality of creating a debtor-creditor relationship under Litton Bus, Sys., Inc. v. Commissioner, 61 T.C. 377 (1973).
    • The Court did not treat the two trusts as a single trust, with trustees free to transfer money between the two trusts. The Court ruled the trusts were separate legal entities, and that assets were not comingled and there was no basis in federal tax law for treating the two trusts as a single trust. 
    • The Court held the loan created a bona fide debt.

  • Return or Reverse QTIPS: PLRS 201118014, 201129017, 201131006 and 201144001: In Letter Ruling 201144026, the Settlor deeded his interest in his residence to a QPRT, retaining the use of the residence for a term period under the terms of the QPRT. After the term, if the Settlor is still living, his retained interest will expire and the trust will continue for the benefit of his issue. On his death, the trust will terminate and trust assets will be distributed per stirpes to the Settlor's issue. The Settlor, the sole trustee, with the consent of his four children, executed a modification, providing that after the retained use period his children are granted the power to appoint an equal share of the trust corpus to themselves, or by unanimous agreement, to amend and restate the trust to provide a term interest to the Settlor, the Settlor's spouse, or both, as a gift by the children. The children exercised this power to grant the Settlor the right to use the residence for a term of years, renewable with the consent of the remainder beneficiaries.
    • The IRS stated that Sec. 2701(a)(1) and 2702(a)(2) will not apply to the modification and amendment and restatement of the trust, as long as they transfer a term interest in the residence to the Settlor in a form substantially similar to the example cited in Revenue Procedure 2003-42, 2003-2 C.B. 993, and the residence qualifies as a personal residence under the QPRT regulations.
    • There are additional letter rulings that are similar.
  • Charitable Out-of-Pocket Expenses. In Van Dusen v. Commissioner, 136 T.C. No. 25 (2011), the taxpayer provided foster care for Fix Our Ferals, a qualified charity that spays and neuters feral cats and then returns them to the wild. During their recovery, the cats are placed in foster homes. Van Dusen provided a foster home for many of these cats and paid most of the expenses related to this charitable work using her own funds. For the year in question, Van Dusen had between 70 to 80 cats, of which seven were pets. The expenses were extensive due to the large volume of cats, and also included large utility bills, cleaning, and running a special ventilation system to ensure fresh air for the cats. Van Dusen deducted these expenses as a charitable deduction, which the IRS disallowed. The Tax Court held that the expenses were made incident to the rendition of services to a charity and they were eligible for deduction, subject to showing substantiation and limits under Sec. 170.

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



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