2011 Federal Estate and Gift Planning - Tax Act Provisions and Planning - Part 1

April 08, 2011

The annual Heckerling Institute (“Institute”) on Estate Planning is one of the largest estate and trust planning conferences in the United States. The Institute is a forum for estate planning professionals to discuss current and emerging federal and state individual income tax and transfer tax planning developments. This article summarizes 2011 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 article is presented in three sections; the first section discusses recent developments, including the estate and gift tax provisions of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act (“2010 Act”). The second section discusses recent developments that could present significant opportunities considering the current economic climate. Section three contains state tax planning developments and observations. 

Section 1: The 2010 Tax Act Provisions and 2011 Planning Considerations

Institute panelists discussed significant developments, including the following:

    1. Estate and Gift Tax Provisions of the 2010 Tax Act

The enactment of the federal 2010 Tax Act on December 17, 2010 is only a two year estate and gift tax provisions patch, expiring at December 31, 2012. As we do not know what will happen legislatively leading into 2012, there will be much uncertainty, with a Presidential election and a lame duck Congress and possibly continuing uncertain economic conditions. 

Observation: As the 2010 Tax Act provides a degree of planning certainty for 2011 and 2012, clients should act now to consider applicable 2010 Act provisions to maximize wealth transfer and tax minimization opportunities, and before December 31, 2012.   

  • A. 2010 through 2012 Tax rates, exemption amounts, and carryover basis

For individuals dying in 2011 and 2012, the estate tax exemption is $5 million per individual, with a 35% tax rate on the amount exceeding the exemption amount. The gift tax exemption is now unified with the estate tax exemption, so that an individual can make gifts in 2011 and 2012 in an amount of up to $5 million in total and cumulatively, with no resulting gift tax. The Generation Skipping Transfer (“GST”) tax exemption is also $5 million for transfers made in 2011 and 2012. All three exemptions will be indexed for inflation after 2011, based on 2010 amounts and only increasing in $10,000 increments. 

For estates of 2010 decedents, there is an elective step-up in the basis of assets accompanied by a 35% estate tax on assets in excess of $5 million.  However, an election is available to 2010 estates whereby the federal estate tax is treated as repealed for 2010, with the modified carryover basis at death for purposes of the capital gains tax, and a permissive allocation of $1.3 million of increased basis allocated to the decedent’s assets in general, and $3 million of increased basis to the decedent’s spouse.  Several factors will need to be considered in order to determine which election is optimal for 2010; the election of no estate tax, or the election of applying the 2011 estate tax rules to 2010. If the 2010 taxable estate is under $5 million, fiduciaries may not want to apply the 2011 rules resulting in no tax in any case, but enabling the estate to take advantage of the step-up in basis rules; the full step-up in basis applies in 2011 and 2012. 

If the 2010 taxable estate is in excess of $5 million, fiduciaries should calculate how much appreciation was in the estate at the decedent’s death, in order to determine if it is better to use carryover basis, which is the lesser of the fair market value or basis. However, it may still make sense to make the election to apply the 2011 rules and avoid a 35% estate tax on the excess over $5 million, and benefit from the capital gains tax of 15% on the future sales of assets. Also, where a trust has to be funded or a bequest needs to be made using a formula clause, the fiduciary may not want to make the election to apply 2010 rules, as the exemption amount would be zero, thus causing mayhem with the formula clause.

Observation: Under the 2010 Act, on January 1, 2013, the law reverts to the $1 million exemption and a top rate of 55%.  

Institute panelists (panelists) also discussed a controversial calculation issue, whereby there could be a recapture or claw-back of taxes at the decedent’s death if the estate exemption is reduced after 2012 and the individual had made lifetime gifts of $5 million.  Generally, the federal estate tax is calculated by adding prior-year taxable gifts to the estate assets at the date of death, and then reducing the estate tax by the exemption amount that is in effect at the time of decedent’s death. If the exemption amount is less than the $5 million amount in a future year, there is a question as to whether the estate is required to pay the tax on a portion of the lifetime gifts that was excluded from tax at the time the gift was made; that is, is there a claw-back of pre-death gifts that would be subject to an estate tax. Another concern is that if the additional estate taxes are required to be paid, how would the additional estate taxes be apportioned among the recipients under the will and the donees of the lifetime gifts?  Allocating a portion of the estate tax to donees of lifetime gifts may not be collectible, as transferee liability does not usually reach this class of individuals. The scenario where the exemption amount is reduced in a future year has never happened in the past. Panelists felt that the statute of the new law did not support a claw-back provision and that, ultimately, a claw-back of prior tax-free gifts would not be an issue. 

For estates of decedents dying between January 1, 2010 and December 16, 2010 the estate or GST tax return, payment date of estate and/or GST tax, and time for making any disclaimer of property passing by reason of the decedent’s death, is extended to no earlier than nine months after the date of enactment of the 2010 Act, or September 19, 2011. Current law provides that the carryover basis report is required to be filed with the decedent’s final income tax return; the due date for filing this report is not extended by the 2010 Act. Panelists speculated that the IRS may separately extend the due date to nine months after the date of enactment. 

Observation: All of the GST relief provisions, including the so-call 9100 relief provisions, have also been extended through December 31, 2012. 

  • B. Portability

The executor of a deceased spouse’s estate may transfer any of the decedent’s unused estate exemption to the surviving spouse. Portability applies in 2011 and 2012, and allows a surviving spouse to shelter up to $10 million from estate tax (the decedent’s unused $5 million exemption and the surviving spouse’s $5 million exemption). Portability only extends from the last deceased spouse; one cannot obtain a portable exemption through remarriage.  No portability is available for the GST Tax.  

Observation:  There is a concern that if the surviving spouse dies many years later, and a new tax regime is imposed with a lower exemption amount, the estate of the survivor who obtained an unused  exemption from a decedent spouse may not be able to utilize a $10 million combined exemption amount at his or her (the survivor) death.   

Although portability may be considered a viable alternative to the credit shelter trust, since assets owned by spouses no longer need to be allocated to maximize exemption amounts, trust planning is still necessary for other reasons. For example, the credit shelter trust can be used as a hedge to receive $5 million of assets and ensure that future appreciation in excess of $5 million escapes estate tax, especially where there is no certainty a $5 million exemption will exist after 2012. Other reasons for establishing trusts include asset protection, since assets in a trust are generally exempt from creditors of the beneficiaries. Trusts can also protect assets from exposures that could arise in divorce or remarriage scenarios, and trusts can provide a formal structure to manage estate assets and avoid asset mismanagement. And, it may make sense to use disclaimers for trusts created under smaller estates. Or, delaying asset transfer decisions until death may be prudent, as there may be certainty of estate tax rules at that time. An available planning idea may be to fund a testamentary credit shelter trust with an option to make distributions to the surviving spouse, thereby effectively moving the trust assets to the surviving spouse’s estate.  

  • C. Specific Planning Opportunities

Gift planning in 2011 and 2012 provides a unique opportunity to transfer substantial wealth to younger generations. Individuals who have exhausted their $1 million gift tax exclusion as of December 31, 2010 can now gift up to another $4 million (in total) in 2011 and 2012. However, there is a possibility as discussed above, that gift taxes “saved” during life may have to be paid upon the decedent’s death if the estate exemption amount is later reduced below the 2011 and 2012 amount of $5 million.  

Observation: 2011 and 2012 gifts should enable the transfer any future appreciation of gifted assets devoid of a future estate tax.

What if an individual had gifted more than $ 1million in 2010 and now has to pay a gift tax in April 2011? If she had waited to make the gift in 2011, there would be no gift tax due. Panelists suggested that it may be possible to rescind a 2010 gift, thereby eliminating the gift tax that would be due April 15, 2011, and then re-gifting the property in 2011 where there is no gift tax (if under the available 2011 $5 million gift exemption amount). Rescissions based on a mistake of law have been held as valid by the courts in prior years.

However, many states may not hold for rescissions based on a mistake of law. The better solution may be for the donee to disclaim the gift.  However, can a disclaimer be effectuated if there was a gift acceptance? Panelists suggest that perhaps the disclaimer will be successful if the individual returns the gift, so that the asset is owned (by the donor) as it was before the gift. As far as reporting requirements are concerned, under the gift tax regulations an incomplete gift is not reported on a gift tax return; however, if no gift tax return is filed, the statute of limitations will not run on this type of transaction. 

Of course, if the individual was planning on gifting at least another $4 million of assets in future years, then there is really nothing wrong with incurring a gift tax on the $4 million of gifts that were made in 2010, and at the lower gift tax rate of 35%, thereby removing assets from the estate and having the future appreciation be estate-tax free. 

GST planning. The increased GST exemption of $5 million in 2011 and 2012 provides generation-skipping wealth transfer opportunities. An individual can make use of the disclaimer extension to September 19, 2011 to take advantage of the zero GST tax in 2010.  In addition, a late allocation of the GST exemption can be made with regard to transfers in prior years. With a direct skip transfer in 2010, a donor can elect out of the automatic allocation rules that were in effect for 2010, since a donor would not want to allocate exemption to a transfer with zero tax rate. 

Grantor Retained Annuity Trusts (“GRATs”) remain an effective tool as they are a vehicle to leverage available exemptions, especially in the current low interest rate environment. In 2010 Congress had separately planned to limit the attractiveness of GRATs by imposing a minimum gift value for the remainder, such as 10%, or/and requiring a minimum GRAT term of ten years thereby increasing the likelihood that the grantor will die during the GRAT term, and that assets would be included in the decedent’s estate. These proposals were not included in the 2010 Tax Act. Congress may revisit limiting the use of GRATs in the future and perhaps with the above terms as proposed in 2010.  

Observation: Individuals who have underappreciated assets that they desire to pass onto their beneficiaries should take advantage of GRATs now while current provisions and low interest rates are still available.  

State estate tax implications. Twenty-one states, including New York and New Jersey and Connecticut, still impose separate estate taxes. States are unlikely to follow federal law in these tough economic times and are more likely to increase estate tax exemption amounts or maintain current tax rates.

Many states had provided that for decedents who died in 2010, it is presumed they had died as of December 31, 2009, thereby applying the 2009 laws for 2010. This state tax approach led to many complications for 2010 decedents, especially when dealing with formula clauses in wills, notwithstanding what the executor elects to do at the federal level, and forcing the funding of the trust to be $3.5 million. In Virginia, the statute states that if an individual died in 2010 the $3.5 exemption is to be used, unless there was federal law enacted to the contrary. So, Virginia would grant a $5 million exemption unless an election would be made to apply the 2010 estate tax rules.  In Florida, the situation would be determined by the Courts. 

Observation: The future value of assets transferred to grantor trusts can be magnified by leveraging the amounts transferred, by a sale to a grantor trust compared to a gift to a grantor trust. Further, increased leverage can be attained by using property valuation discounts.   

Consider also Qualified Personal Residence Trusts (“QPRTs”).  Further, gifts of undivided interests in real estate result in the donated interest being valued at a discount, and the remaining interest owned by the grantor at death would also receive an undivided valuation discount (Estate of Stewart, 106 AFTR2d 2010-5710 (2d Cir. 2010)).  The increased estate and gift exemption amounts can allow for increased life insurance coverage (in the form of higher premium funding) that can pass free of transfer tax to beneficiaries.  The increased $5 million gift tax exclusion can also provide for increased transfer of assets to same-sex partners, who lack a gift or estate tax marital deduction. 

    1. Treasury-IRS Priority Guidance Plan

As also discussed by Institute panelists, following is a discussion of selected items contained in the 2011 Treasury-IRS Priority Guidance Plan. Although not officially in the 2011 plan, the IRS plans to issue guidance on portability. 

  • A. Regulations under IRC Section 67 regarding 2% haircut on miscellaneous itemized deductions of a trust/estate

IRC Section 67(e)(1) exempts from the 2% floor costs which would not have been incurred if the property were not held in a trust or estate. The panelists reviewed the history of this section as evidenced in numerous court cases: O’Neill, Mellon Bank, Rudkin, and Knight.   

Proposed Reg. Section 1.67-4(d) published in 2007 would apply the 2% floor to all expenses of an estate/trust except expenses that are “unique” to an estate/trust. The proposed regulations would require the unbundling of unitary fiduciary fees or commissions so as to identify the portion thereof as “unique.”

The IRS had received written comments on the above-proposed regulations and held a public hearing in 2007. On February 27, 2008, the IRS issued Notice 2008-11 extending the comment period through May 27, 2008, and that in the interim there would be no requirement to unbundle fees. On December 11, 2008, the IRS issued Notice 2008-116 extending relief from unbundling for 2008 returns. On April 1, 2010, the IRS released Notice 2010-16 extending relief to 2009 returns. 

  • B. Revenue ruling regarding the consequences under various income, estate, gift, and generation-skipping transfer tax provisions by using a family owned company  as a trustee of a trust 

Many families with large trusts are opting to use privately owned and operated trust companies. In Notice 2008-63 (2008-31, I.R.B. 261, released July 11, 2008), the IRS 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 addressed five tax issues faced by trusts of which a private trust company serves as a trustee: 

        1. Inclusion of the value of trust assets in a grantors’ gross estate by reason of a retained power or interest under IRC Section 2036 or 2038.
        2. Inclusion of the value of trust assets in a beneficiary’s gross estate by reason of a general power of appointment under IRC Section 2041.
        3. Treatment of transfers to a trust as completed gifts.
        4. Effect on a trust’s status under the GST tax either as a “grandfathered” trust or as a trust to which GST exemption has been allocated.
        5. Treatment of a grantor or beneficiary as the owner of a trust for income tax purposes.

Panelists commented that it was encouraging to see the grantor trust treatment addressed. The proposed revenue ruling (Notice 2008-63) described the desired attributes of a private trust company, and that the private trust company avoided tax problems by the use of certain “firewall” techniques, such as the “Discretionary Distribution Committee” (“DDC”) with exclusive authority to make all decisions regarding discretionary distributions. 

Comments from the public revealed that there remain several problems with privately owned and operated trust companies, one of which was the inconsistency between federal and state law. As a result, the IRS is going back to the drawing board with regard to this matter, in an effort to address inconsistencies. 

  • C. Guidance under IRC Section 2032(a) regarding imposition of restrictions on estate assets during the six-month alternate valuation period

Should post-death events other than market conditions be taken into account under the alternate valuation method?

In Flanders v. United States, 347 F. Supp. 95 (N.D. Cal. 1972), the trustee of the decedent’s formerly revocable trust entered into a land conservation agreement on real estate held by the trust after the decedent’s death but before the alternate valuation date (“AVD”). The conservation agreement reduced the value of the real estate by 88%. The Court ruled that the value reducing the result of the postmortem act of the surviving trustee may not be considered in applying the alternate valuation.   

Contrast this case to the Kohler v. Commissioner (T.C. Memo. 2006-152, nonacq., 2008-9 I.R.B. 481), where the executor had received stock in a tax-free corporate reorganization that had been under consideration prior to the decedent’s death, but that was not completed until after the decedent’s death. The Court rejected the IRS’ attempt to base the estate tax on the value of the stock surrendered in the reorganization, relying on Regulation Sec. 20.2032-1(c)(1) which says that such surrender is not “as otherwise disposed of” for purposes of IRC Section 2032(a)(1).

The proposed regulations do not change Reg. Section 20-2032-1(c)(1), but invoke that “the general purpose of the statute” is to clarify and emphasize that the benefits of the alternate valuation date are limited to changes in value due to market conditions. Sec. 2032(a) prevents the use of the alternate valuation date in cases where there is a change in value due to “mere lapses of time.” The proposed regulations add “post-death events other than market conditions” to “mere lapses of time.” 

The impact may be seen in situations where a valuation discount by distributing or otherwise disposing of a minority or other noncontrolling interest within the six-month post-death period, and leaving another minority or noncontrolling interest to be valued six months after death; such an action would not create a discount for AVD purposes.  

Observation: When finalized, the regulations are scheduled to be effective April 25, 2008.

  • D. Guidance under IRC section 2036 regarding graduated GRATs

The focus of this project applies to a GRAT, where there can be a large difference between i) the present value of the unpaid annuity amounts, and ii) the amount needed to generate the prescribed annuity without depleting the principal (Rev. Rul. 82-105, 1982-1 C.B. 133, which described the portion of a charitable remainder trust that is included in the gross estate), and iii) the entire value of the trust assets that the IRS has viewed as included in the gross estate under IRC section 2039. 

The proposed regulations were published on June 7, 2007, which took the position that the IRS would apply IRC section 2036 and refrain from applying IRC section 2039. Final Regulations sections 20.2036-1(c) and 20.2039-1(e) took the same view.  

Observation: The final regulations indicated that the amount includible in the gross estate with respect to a retained interest in trust is the same amount needed to generate the retained interest without invasion of principal--that is, in perpetuity and up to the entire date-of-death value of the trust assets. 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 purpose of the project was to provide additional guidance on using a graduated GRAT.  As a result, proposed regulations were published on April 30, 2009 and provided that, in the case of a graduated GRAT, the amount includible in an estate, 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. This is the same as the rule under the current regulations. The additional amount includible with respect to each annual increment in future years (called the “periodic addition” for each year) is the amount required to make that incremental payment in perpetuity, discounted for the passage of time before that increment takes effect.  

Observation: The total amount includible in the gross estate is the sum of the base amount and all the periodic additions, but not to exceed the total fair market value of the trust property on the date of the decedent’s death.  The proposed regulations also provide rules for valuing the annuity payments when those payments are paid for the joint lives of the decedent and another recipient, or to the decedent following the life of another recipient. 

  • E. Final Regulations under IRC section 2053 regarding the extent to which post-death events may be considered in determining the deductible amount of a claim against the estate

This project addresses the valuation of claims against the estate, especially claims being pursued in litigation that was pending at the date of the decedent’s death. Proposed regulations published April 23, 2007 would have allowed a deduction of otherwise deductible claims only if, and when, they are paid or ascertainable with reasonable certainty. If these conditions do not occur before the statute of limitations runs, the appropriate recourse is to file a protective claim for refund. If these conditions occur before the estate tax statute of limitations runs, the executor’s recourse is to file a protective claim of refund.

Observation: A court decree will be respected if the court reviews the relevant facts and its decision is consistent with applicable law. A consent decree will be respected if the consent is a bona fide recognition of the validity of the claim and is accepted by the court as 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. Claims by family members will be presumed to be nondeductible. The presumption may be rebutted by evidence of circumstances that would reasonably support a claim by an unrelated person.   

Final Regulations section 20.2053-1(b)(3)(iv) was released on October 16, 2009 and dropped the requirement in the proposed regulations that a settlement be within the range or reasonable outcomes. The cost and delay of seeking a possible better outcome may be taken into account to justify a settlement. 

The final regulations also eliminate the presumption that claims by family members are nondeductible, but provide that deductible expenses and claims must be bona fide in nature and not be a masked gift. Regulations section 20.2053-1(b)(2)(ii) list the following five factors that will indicate a bona fide nature:  

  1. The transaction underlying the claim or expense occurs in the ordinary course of business, is negotiated at arm’s length, and is free from donative intent.
  2. The nature of the claim or expenses is not related to an expectation or claim of inheritance.
  3. 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.
  4. 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 agreement can be substantiated.
  5. 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.

However, no deductions are allowed for claims not adjudicated, settled, or ascertainable before the estate tax statute of limitations runs, thereby encouraging the use of protective claims for refund. Regulations Section 20.2053-1(d)(5)(i) states that no dollar amount is needed on the claim; only the identification of the claim or expense and why it was not paid is needed. 

The Treasury will publish an I.R.B. citing further procedural guidance on protective claims, and are contemplating a change in the Form 706 to permit a protective claim to be made on Form 706. The IRS released Notice 2009-84 (2009-44 I.R.B. 592), providing a limited administrative exception to the IRS’ right to deny a claim for refund to the extent it finds offsetting increases in tax that reduce or eliminate the overpayment, even when the statute of limitations would normally prevent the assessment of additional tax. 

  • F.  Regulations under IRC section 2642(g) regarding extensions of time to make allocations of the GST tax exemption

IRC section 564(a) of the EGTRRA added a subsection (g)(1) to section 2642, directing Treasury to publish regulations providing for extensions of time to allocate GST exemption to or elect out of statutory allocations of GST exemption, when those actions are omitted on the applicable return, or a return is not filed. Before EGTRRA, similar extensions under Regulations section 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.

Rev. Proc. 2004-46 (2004-2 C.B. 142) provides a simplified method of dealing with pre-2001 gifts. Post-2000 gifts are addressed by the expanded deemed allocation rules of IRC section 2632(c) enacted by EGTRRA. Proposed Regulations section 26.2642-7, published in April 16, 2008, will oust the 9100 relief provision in GST exemption cases, and became the exclusive means to seek extensions of time. The general standard of the proposed regulations is still 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. 

  • G. Guidance under IRC section 2704 regarding restrictions on the liquidation of an interest in a corporation or partnership

This project will address IRC section 2704(b)(4), which states, in the context of corporate or partnership restrictions that are disregarded, that the Secretary may provide that other restrictions 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 for these purposes, and does not ultimately reduce the value of such interest to the transferee. 

  • H. Guidance on whether a grantor’s retention of a power of substitute trust assets in exchange for assets of equal value will cause insurance policies held in the trust to be includible in the grantor’s estate under IRC section 2042

In Estate of Jordahl v. Commissioner (65 T.C. 92 (1975), acq., 1977-1 C.B. 1), the 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 IRC section 2038 or 2042.

Rev. Rul. 2008-22 (2008-16, I.R.B. 796) indicated 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 IRC section 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 itself that the properties acquired and substituted by the grantor are in fact of equivalent value and that the substitution power cannot be exercised in a manner that shifts benefits among the beneficiaries.

The project will address the fact that the inclusion of life insurance in the gross estate is governed by IRC section 2042, and not section 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. 

  • I. Guidance under IRC section 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 mark-to-market rule for income tax purposes, when someone expatriates after June 17, 2008. A new succession tax is imposed on anyone who received a gift or bequest from someone who expatriated on or after June 17, 2008. The IRS intends to issue guidance under section 2801, and new Form 708 on which to report the receipt of gifts and bequests subject to IRC section 2801. 

  1. Other developments:  Federal Tax Court Cases and Rulings

The following are additional developments discussed by Institute panelists: 

  • A. Built-in Capital Gains

In Estate of Jensen v. Commissioner (T.C. Memo 2010-182.), the Tax Court permitted a dollar-for-dollar discount for built-in capital gains tax in valuing stock of a C corporation. 

The issue revolved around the amount of the discount for the built-in long-term capital gains tax that would be allowable as a stock valuation discount in computing the fair market value of the estate’s 82% stock interest in a C corporation.  The estate valued and claimed a dollar-for-dollar discount for the long-term capital gains liability, and also claimed a 5% lack of marketability discount.  

The estate argued that the IRS approach of using closed-end funds to determine the appropriate discount for built-in long-term capital gains was misplaced. Closed-end funds are typically invested in various sectors and asset classes. In contrast, the asset in question was a single parcel of real estate with improvements and equipment. TheTax Court agreed with the estate and allowed the full discount but did so by taking a present value approach instead of the dollar-for-dollar approach.

  • B. Family Limited Partnerships (“FLPs”)

Taxpayer successes in the FLP area have resulted when there was strong evidence of substantial nontax reasons for the sale of a FLP interest, and where sale attributes demonstrate a bona fide sale for full and adequate consideration (Estate of Black v. Commissioner, 133 T.C. 15 (2009) and Estate of Shurtz v. Commissioner, T.C. Memo 2010-21). Valid nontax and bona fide sale reasons include centralized long-term management of the family’s holdings, to preserve the decedent’s buy-and-hold investment philosophy as evidenced by the lack of turnover of stock following contribution to the partnership, to pool the family’s stock so that it could be voted as a block, and to protect the stock from creditors and from the son’s divorce. 

  • C. IRC Section 2703

The Eighth Circuit affirmed the Tax Court’s ruling that transfer restrictions in a partnership agreement must be disregarded in valuing partnership interests for gift tax purposes (Holman v. Commissioner, 601 F. 3d 763 (8th Cir. 2010), aff’g 130 T.C. 170 (2008).

In the Holman case, stock was transferred to a family limited partnership, and partnership interests were then transferred to a trust. The IRS said that because all the transfers happened so quickly (within six days), in substance the stock was gifted and not the discounted family limited partnership interest. 

The Court ruled that these six days were adequate to demonstrate the substance of separate transfers, the transfer restrictions should be regarded for purposes of valuing the gift.

  • D. Step Transaction Doctrine 

In Pierre v. Commissioner (T.C. Memo 2010-106), the Tax Court applied the step transaction doctrine to a part gift/sale of limited liability corporation (“LLC”) interests, and reduced the minority interest and lack of marketability discounts. 

This is the second of two cases involving transfers of membership interests of the Pierre Family LLC. In the first case, the Tax Court held that a single member LLC is not disregarded for gift tax valuation purposes under the “check the box” regulations. Consequently a transfer of interests in a single-member LLC is subject to discounts for lack of control and marketability, rather than being treated as the transfer of a proportionate share of the underlying assets of the LLC at the fair market value of those assets.

In the second case, the Tax Court addressed whether the step transaction doctrine applied to collapse the separate gift and sale transfers into single transfers of two 50% interests, and what was the amount of the lack of control and marketability discounts in the transactions.

The gift and sale were combined together as one transaction by the Tax Court under the step transaction doctrine. However, the discounts did not change materially, so there was a taxpayer victory in this regard.

Observation: Based on the Pierre court case, the planning opportunity is to allow as much time as possible between the two transactions in order to prevent application of the step transaction.   

  • E. Annual Gift Tax Exclusion

Courts held that gifts of limited partnership or LLC interests do not qualify for the gift tax annual exclusion (Price v. Commissioner, T.C. Memo 2010-2 and Fisher v. United States, 105 AFTR2d 2010-1347(S.D. Ind. 2010).

Taxpayers have not been allowed annual exclusion gift transfers where the partnership agreement stated that (1) no partner could not sell or transfer his or her interest; (2) there is a first right of refusal by the partnership in the case of assignments; and (3) no distributions were required to be made. Consideration must be made to the features that go into a partnership agreement.  

Observation: If the individual (partner) desires to obtain the annual gift tax exclusion, the partnership agreement would be written in a more liberal manner (allowing transfers, no rights of first refusal, and allowable distributions); however, if there is a desire to avoid IRC section 2036 argument and secure a valuation discount, the agreement may need to be written in a more restrictive manner (no transfers, allowing rights of first refusal, and no allowable distributions).  

  • F. Adjustments Made to Gifts Within Three Years of Death  

Estate of Morgens v. Commissioner (133 T.C. No. 17) related to net gifts.  The husband created a QTIP trust for the benefit of the surviving spouse. This trust was later divided into two trusts: Trust A and Trust B. Trust A received a portion of the assets relating to publicly traded securities. The wife made gifts of her qualifying income interest in both trusts which in turn triggered deemed transfers of the QTIP remainder under IRC section 2519. IRC Section 2207A(b) permits the surviving spouse to recover the gift tax attributable to the deemed transfer from recipients of the QTIP, and in Morgens the trustee of the remainder trusts paid a gift tax on the transfer. The surviving spouse died two years after the assignments of her income interest.

The IRS determined that the amount of gift tax paid by the recipients of the QTIP remainder were includible in the surviving spouse’s estate under IRC section 2035(b) and accordingly assessed a multi-million dollar deficiency. The estate argued that including the gift tax in the estate was contrary to the purpose of section 2207A(b) and should not be allowed.

The Court held that because of the QTIP election, the decedent is deemed to be the donor of the trust’s assets. Accordingly, the gift tax from the transfer of the QTIP is the decedent’s liability, not that of the remainder beneficiaries. Section 2207A(b) does not provide that the donees of the QTIP should be liable for the applicable gift tax, but rather refers to the right to recover the gift tax. The Court further cited that the gift tax paid by the donee of a “net gift” is included in the gross estate of the donor under IRC section 2035(b) if paid within three years of the donor’s death. The donee’s payment of tax under IRC section 2207A is no different.

  • G. Transfers with Retained Life Estates

In Estate of Stewart v. Commissioner (617 F.3d 148 (2d Cir. 2010), rev’g and rem’g T.C. Memo 2006-25), the Second Circuit vacated and remanded a Tax Court decision which included the full value of a building in the decedent’s gross estate, despite a gift of a 49 percent tenancy-in-common interest.

Mother and son owned a building (Property A) as joint tenants with the rights of survivorship. The building was rented and the owners (mother and son) split the net rental income.  Mother also owned another building (Property B) and conveyed a 49% interest to her son as tenant-in-common; the deed was never located. Mother and son lived in the bottom two floors and rented the other three floors (she retained 100% of the rental income) of Property B. She died soon thereafter.

On mother’s federal estate tax return, the entire value of the Property A was included in her estate under IRC section 2040 since she had provided all of the consideration in the acquisition of the joint tenancy property.

The estate return also reflected 51% of Property B and a 40% fractional interest discount was taken. The IRS argued that section 2036 should apply to bring the entire value of Property B into the estate. The Tax Court held that although there was a completed gift, there was an implied agreement for the retained possession by the mother with respect to the 49% Property B interest that was transferred to the son. The Second Circuit however, vacated and remanded the case for further action, finding clear error in the determination that the decedent had retained the beneficial enjoyment of the residential portion of Property B. The Court noted that the decedent clearly retained no legally enforceable power to receive the income. The fact that the mother retained the other 51% interest in Property B did not mean that she also had possession of the other 49% portion. There are two types of interest: the income interest which is clearly the retained right of the mother and reportable on her return, and the property interest. However, the Court held that the mother did not retain an interest in the two floors of Property B where the mother and son lived since she did not have exclusive use of that portion or excluded her son’s use.

  • H. Jointly Owned Property 

At the time of the wife’s death (she predeceased the decedent), the decedent and wife owned real estate as tenants by the entireties, and as a result the entire value of the property was to be included in the decedent’s estate at the time of decedent’s subsequent death (Estate of Goldberg v. Commissioner, T.C. Memo 2010-26).  

The decedent received an undivided interest in two pieces of real property together with his siblings as tenants in common, from his mother. The decedent later transferred his entire interest in each property to joint ownership with his wife. The wife died and her estate was split between the decedent and a credit shelter trust. The decedent died three years later. The issue was whether the decedent owned a one half interest in each of the properties with the trust, or instead owned the entire interest in each property since the wife’s interest as a tenant by the entireties was immediately extinguished upon her death, in which case the value of the decedent’s estate would be increased to include the entire amount. 

The Court held that the entire value of the property interest should be includible in the decedent’s estate. 

  • I. Private Letter Rulings 201029011, 201002013, 201038004, 201038005, and 201038006 — The Delaware Tax Trap

The applicable IRC section is 2041(a)(3), the purpose of which is to prohibit a trust in Delaware which could exist in perpetuity, by virtue of the trust’s use of multiple powers of appointment. Section 2041(a)(3) states that if the power of appointment can be exercised without regard to the rules against perpetuity applied to the original grantor, then it is a general power of appointment.

 Observation: Letter Ruling 201029011 illustrates the use of the Delaware Tax Trap, and shows how the exercise of a power of appointment should be analyzed to determine applicability. However there is an important distinction between  (1) when the Delaware tax trap creates a taxable power of appointment for estate or gift tax purposes, and when (2) it creates a constructive addition to the grandfathered generation-skipping trust.  For estate and gift tax purposes, the new period must be ascertainable only with regard to the date of the creation of the first power. For example, a power of appointment under a trust that requires that all interests vest in outright ownership not later than 90 years following the date the trust was created might be used to create a new power of appointment that can extend another 500 years, without generating an estate or gift tax.  However, under Regulations section 26.2601-1(b)(1)(v)(B), the exercise of a special power of appointment over a grandfathered trust may forfeit grandfathered protection without violating the Delaware tax trap if it has the effect of extending the perpetuities period beyond a life or lives in being on the date that the fist power was created plus twenty-one years.  One may broaden the class of lives in being on the date the old trust was created, but not change the end of the perpetuities period to a date later than 21 years after a class of persons that were alive when the old trust was created.  

Letter Ruling 201002013 permits reformation of a trust to eliminate a general power of appointment. Letter Rulings 201038004, 201038005 and 201038006 provide guidance on the treatment of a third party as the owner of a trust for income tax purposes and on inclusion of property subject to power of withdrawal at the third party’s death.

Observation: The significance of the Delaware Tax Trap is that it includes assets in the estate of the beneficiary of the trust, if the beneficiaries create a power of appointment in someone else that extends the trust’s existence past the grantor’s in-life prohibition against perpetuity. Use then of The Delaware Tax Trap can provide for flexible planning opportunities.

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

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

Have Questions or Comments?

If you have any questions, we'd like to hear from you.

Primary Contacts