Significant Recent Developments in Estate Planning (Part II)

By Justin Ransome, J.D., MBA, CPA, and Frances Schafer, J.D.


  • In a number of cases, courts decided whether assets should be excluded from an estate because the decedent had transferred the assets before death to a family limited partnership in a bona fide sale for adequate and full consideration.
  • The IRS once again extended interim guidance allowing trusts and estates to deduct the full amount of bundled fiduciary fees without regard to the Sec. 67(a) 2% of adjusted gross income limitation.
  • There is no federal estate or GST tax for 2010, and a modified carryover basis regime applies to property received by heirs from the estates of all decedents dying in 2010.
  • New Sec. 2511(c) provides that a transfer in trust will be treated as a transfer of property by gift unless the trust is treated as wholly owned by the grantor or the grantor’s spouse under the grantor trust rules. However, the gift tax rules in effect on December 31, 2009, continue to apply to all transfers made to a wholly owned grantor trust to determine whether the gift tax applies.

This two-part article examines developments in estate, gift, and generation-skipping tax planning and compliance between June 2009 and May 2010. Part I, in the September issue, discussed legislative developments, estate tax reform, gift tax, and cases and rulings. Part II covers the estate tax, generation-skipping transfers, trusts, changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001, and the annual inflation adjustments for 2010 relevant to estate and gift tax.

Estate Tax


The IRS has continued its assault on family limited partnerships (FLPs) using Sec. 2036 for estate tax purposes. Under Sec. 2036, assets that a decedent transferred during his or her lifetime are pulled back into the estate because the decedent still derived a benefit from the assets and/or continued to control the beneficial enjoyment of the assets. An exception applies where the transferred assets are part of a “bona fide sale for adequate and full consideration for money or money’s worth” (the bona fide sale exception). 1

The test for determining whether the bona fide sale exception has been met was set forth by the Tax Court in Bongard. 2 The Bongard test requires that two criteria be met: (1) there is a legitimate and significant nontax reason for creating the FLP (the bona fide sale criterion); and (2) the transferors receive interests in the FLP proportionate to the value of their transferred property (adequate and full consideration criterion).

The IRS is generally successful with Sec. 2036 challenges when the case involves “bad facts.” This generally occurs when the decedent fails to respect the FLP as a separate entity and not the decedent’s alter ego or when the decedent does not maintain sufficient assets outside the FLP to maintain his or her customary style of living. This past year’s cases are a mixed bag for taxpayers.

Estate of Shurtz

In Estate of Shurtz, 3 the decedent was the heir of a family with vast holdings in timberland (45,197 acres). In 1993, the decedent’s siblings and their descendants combined their undivided interests in the timberland to form Timberlands FLP. The decedent owned a one-third interest in the corporate general partner (which owned the general interests in Timberlands FLP) and a 16% limited interest in Timberlands FLP.

After the formation of Timberlands FLP, the decedent became increasingly worried about the possibility of litigation against her immediate family members because of a “jackpot justice” mentality she believed existed in the state of Mississippi. Along with her interest in the Timberlands FLP, the decedent’s other major asset was 748 acres of timberland she had inherited directly from her parents. She wanted to gift interests in that property to her children and grandchildren but did not want to create fractional interests in the timberland—one of the reasons that Timberlands FLP was created. To alleviate these concerns, an attorney advised the decedent to create Doulos FLP, the purpose of which was to: (1) reduce the decedent’s estate; (2) provide asset protection; (3) provide for heirs; and (4) provide for the Lord’s work (they were missionaries). Prior to establishment of Doulos FLP, the decedent transferred a 6.6% interest in the 748 acres to her husband. On December 17, 1996, the decedent’s husband contributed his 6.6% interest in the 748 acres to Doulos FLP in return for a 1% general interest, and the decedent contributed her 93.4% interest in the 748 acres as well as her 16% interest in Timberlands FLP to Doulos FLP in return for a 1% general interest and a 98% limited interest.

After the formation of Doulos FLP and prior to her death on January 21, 2002, the decedent made gifts of Doulos FLP in the aggregate of 10.4% to her children and trusts for the benefit of her grandchildren. Doulos FLP maintained a capital account for each partner. Although Doulos FLP did not maintain books of account, as required by the FLP agreement, the decedent’s accountant created “work papers like a trial balance” in creating partnership returns. Doulos FLP did not have its own bank account until four months after it was created. Distributions from Doulos FLP were not always proportional; however, Doulos FLP made up these amounts in subsequent years. The adult members of the decedent’s larger family actively managed Timberland. The family held annual meetings in which they discussed various family business issues such as the cutting, harvesting, and reforestation of the timberland. The decedent and her husband regularly attended and participated in those meetings. The decedent and her husband also actively managed Doulos FLP, which required management similar to the management of Timberland FLP with regard to the 748 acres owned by Doulos FLP. Upon the decedent’s death, the IRS sought to include the value of the assets the decedent contributed to Doulos FLP in her estate for estate tax purposes under Sec. 2036(a).

In applying Bongard, the Tax Court determined that there were legitimate and significant nontax reasons for creating Doulos FLP because: (1) the decedent had a legitimate concern about preserving the family business (i.e., asset protection); and (2) Doulos FLP facilitated the management of the 748 acres the decedent and her husband contributed to Doulos FLP (having multiple undivided ownership interests would impede the management of the timberland). The court acknowledged that only a portion of the property contributed to Doulos FLP required active management; however, citing Kimbell 4 (which contained a working oil and gas interest that comprised 11% of the total value of the FLP), it found this to be sufficient (the 748 acres amounted to 16% of the total value of Doulos FLP).

The Tax Court next determined that the full and adequate consideration criterion had been met because: (1) the partners received interests in Doulos FLP proportionate to the value of their transferred property; (2) the respective assets contributed to Doulos FLP were properly credited to each partner’s respective capital account; and (3) distributions from Doulos FLP required a negative adjustment in the distributee partner’s capital account.

Having determined that the bona fide sale exception had been met, the Tax Court determined that it did not need to consider whether the decedent retained an interest or right in the property contributed to Doulos FLP. Having made such a determination, the Tax Court ruled that the proper property to value in the decedent’s estate was the decedent’s interest in Doulos FLP, not the underlying property contributed to it by the decedent.

Estate of Black

In Estate of Black, 5 the Tax Court addressed several estate tax–related issues, two of which were of importance. One issue concerned the application of Sec. 2036 to stock transferred to an FLP; the other dealt with the deductibility of interest on a loan whose proceeds were to be used to pay federal estate taxes.

For more than 70 years, Mr. Black had been instrumental in the expansion and success of Erie Indemnity Company and took every opportunity to purchase stock in the company, to the point that he and his family became the company’s second largest shareholder. Beginning in 1988, Mr. Black made gifts of stock to his son and to two trusts for the benefit of his grandsons. In the 1990s Mr. Black became concerned that his son and grandsons would dispose of the stock. His son had already pledged a large number of shares on a loan. His grandsons, who would receive the stock when they turned 25 and 30, were already in their twenties, and neither of them exhibited signs of being productive members of society. In addition, Mr. Black was concerned that because of the personal and business bankruptcies of the son’s father-in-law, the in-laws’ need for financial support might force the son to sell his stock. He was also worried about the stock in the event that the son and his wife divorced.

Mr. Black also wanted to keep the family’s stock in one block because of a potential dispute brewing between the founder’s children, who owned 76.2% of the stock; the Black family block of around 13% might be needed as a swing vote to settle any disputes. In 1993, Mr. Black, his son, and the two grandsons’ trusts contributed their stock to an FLP (all the family stock except for the stock the son had pledged on the loan and 20 shares of class B stock held by Mr. Black and his son). Each partner received an interest in the FLP proportionate to the fair market value of the assets contributed.

The IRS argued that the Erie stock, not the FLP interests, was includible in Mr. Black’s gross estate under Sec. 2036(a)(1). The estate argued that it had met the bona fide sale exception in Sec. 2036.

In order for the transfer to meet the bona fide sale requirement, there must be a legitimate and significant nontax purpose for the transfer. The Tax Court discussed Mr. Black’s concerns about possible disposition of stock by the grandsons and by his son in order to satisfy the needs of his in-laws and his wife in the event of a divorce (which actually occurred after Mr. Black’s death). The court concluded that under this unique set of circumstances, the purpose for the transfer—to perpetuate the holding of stock by the family—was a legitimate and significant nontax purpose, so the bona fide sale criterion in Bongard was met. The adequate and full consideration criterion was also met because each of the partners received FLP interests proportionate to the value of the stock they transferred. Thus, because Mr. Black’s transfer of stock to the FLP constituted a bona fide sale for adequate and full consideration, the stock’s fair market value was not includible in his gross estate under Sec. 2036(a)(1) or (2).

When a decedent’s estate consists mostly of illiquid assets, the source of funds to pay federal and state estate taxes becomes an issue. Mr. Black’s wife died shortly after he did, and a substantial estate tax was due for her estate. In order to pay the estate tax, the FLP sold some of its stock in a secondary offering and then loaned Mrs. Black’s estate money to pay the estate tax and administration expenses. Interest on the loan was payable in a lump sum on its due date and could not be prepaid. Mrs. Black’s estate claimed a deduction under Sec. 2053(a)(2) for the amount of the interest, since this was a transaction similar to that approved in Estate of Graegin. 6

Under Regs. Sec. 20.2053-3(a), to be deductible under Sec. 2053(a), an administration expense must be actually and necessarily incurred in the administration of the decedent’s estate. If the loan incurred by the estate to pay the estate tax liability avoids the forced sale of estate assets, the loan generally will be considered to be reasonable and necessary in administering the estate. 7 In Estate of Graegin, the Tax Court allowed a deduction for the full amount of interest on a loan to pay estate taxes from a wholly owned subsidiary of the decedent’s closely held corporation. Payment of all principal and interest was due in a balloon payment at the end of the 15-year term of the loan (the term was set to coincide with the life expectancy of the surviving spouse, upon whose death assets would become available to repay the loan). The loan agreement prohibited prepayment of the principal and interest.

In Estate of Black, the IRS challenged the deduction of interest on the theory that the loan was unnecessary. The Tax Court agreed with the IRS. It looked at the historical income distributions from the FLP and concluded that it would not be possible to repay the loan from the income distributions from the FLP and that it would be necessary to resort to the underlying FLP assets to repay the note.

The court assumed that the FLP would make an actual or deemed distribution of the stock to the estate in partial redemption of its interests and that the estate would return the stock to the FLP in discharge of the note. Such a scenario would demonstrate that the loan was unnecessary because the parties would be in exactly the same position that they would have been if the FLP used stock to redeem part of the estate’s FLP interest. The FLP would actually sell the stock in either scenario in order to fund the estate’s obligations. According to the court, the only reason that the transaction was structured as a loan rather than a partial redemption was to generate a $20 million interest deduction on the estate tax return. The court distinguished Graegin and other similar cases because in those cases the assets of the lender had not been liquidated in order to generate money for the loans, as was done in this case.

This decision calls into question the viability of the Graegin technique, which estates have used to obtain liquid funds to pay estate taxes while also generating interest deductions. The Tax Court’s suggested alternative—for the estate to partially redeem FLP interests—may undermine the estate’s argument under Sec. 2036. Seven cases have viewed the use of partnership assets to pay estate taxes and other post-death liabilities as one of the reasons that the transferred assets were includible in the decedent’s gross estate under Sec. 2036(a)(1). 8

Estate of Malkin

In Estate of Malkin, 9 the decedent created two FLPs and four trusts. The decedent was the general partner of each FLP, and he and two of the trusts were the limited partners. The beneficiaries of the trusts were his two children. The decedent transferred the family business stock to one FLP (FLP1) and the family business stock as well as interests in four limited liability companies (LLCs) to the other FLP (FLP2).

In August 1998, the two trusts that were limited partners of FLP1 entered into a contract with the decedent to purchase limited partnership interests from the decedent for a cash down payment and a self-canceling installment note (SCIN). The trusts executed security agreements granting the decedent a security interest in the limited partnership interests. In September 1999, the decedent and the trustees of the trusts authorized the decedent to pledge FLP1 assets, without limitation, to secure his personal debt. The decedent pledged to the bank almost all the stock owned by FLP1. In December 1999, the decedent executed a personal guaranty promising to use his personal assets to repay his debt and agreed to pay a fee to FLP1 equal to 0.75% of the amount required as security for his debt. A repledging of those assets to another bank occurred the following year.

On February 29, 2000, the decedent and the trustees of two trusts signed the FLP2 agreement, and the decedent transferred interests in four LLCs to FLP2 and executed an agreement to assign interests in FLP2 to the trusts. On March 1, 2000, the decedent executed the documents to establish those trusts. Thereafter, the trustees of the trusts entered into contracts with the decedent to purchase the same interests in the FLP2 in exchange for cash and a nine-year note. A regular note, rather than a SCIN, was used because by that time the decedent was terminally ill. In November 2000, the decedent transferred to FLP2 stock that he had previously pledged to a bank as collateral for his personal loan.

The Tax Court determined that there was nothing to suggest that any express or implied agreement gave the decedent the right to retain the economic benefits of the LLC interests transferred to FLP2. The court determined, however, that there was an implied agreement that the decedent would continue to retain the right to use the stock that he transferred to FLP1 and FLP2. The decedent and the two trusts pledged the stock that he had transferred to FLP1 to secure his personal loan. According to the Tax Court, the estate failed to offer evidence that the amount of the fee paid to FLP1 was reasonable or what the purported business purpose was for FLP1 to allow the decedent to pledge its stock. A different result is not reached with regard to FLP2 merely because the stock was pledged by the decedent to the bank before it was transferred to FLP2.

The Tax Court then considered whether the bona fide sale exception applied and concluded that the decedent had no legitimate and significant nontax reason for transferring the stock to the FLPs. One business purpose advanced by the estate to prevent the sale of any of the stock was dismissed by the Tax Court because only the decedent transferred stock to the FLPs; his son, who also owned a substantial amount of stock in the company, did not transfer it to the FLPs. According to the Tax Court, the decedent did not need the FLPs to control his stock because he already controlled it. The Tax Court also dismissed the purpose of centralized management for the family’s wealth because the decedent contributed almost all the assets to the FLP; thus, there was no pooled wealth to manage. As a result, the Tax Court held that the stock transferred to the FLPs was includible in the decedent’s gross estate under Sec. 2036(a).


In Keller, 10 the district court determined that an FLP had been established before the decedent’s death, even though no assets had been transferred to it at that time. As a result, the estate was entitled to a refund of estate taxes based on valuing the FLP interests with discounts of approximately 47.5%.

For many years the decedent was dedicated to safeguarding the family’s fortune for the benefit of her heirs. She was particularly concerned about the risk of losing control of significant family assets through divorce, having experienced the lengthy and expensive divorce of one of her daughters. She sought to prevent a similar situation by using various trust arrangements and by rigorously tracking family members’ separate and community property for purposes of characterizing them under Texas’s community property regime. This effort paid off during the divorce of another daughter, during which the family was able to avoid ceding significant assets to the daughter’s former spouse.

Following her husband’s death in January 1999, the decedent spent considerable time with her advisers regarding various options for the protection and disposition of some of the assets in two trusts. One trust, for which a qualified terminable interest property (QTIP) election had been made upon her husband’s death, consisted of his separate property and his one-half interest in their community property. The other trust consisted of the decedent’s separate property and her one-half interest in their community property. The discussions centered on the possibility of creating a series of FLPs for the purpose of holding some or all of the family’s real estate, mineral interests, and investment assets, with one FLP to be established for each class of assets. It was clear to the district court that the primary purpose of these FLPs was to consolidate and protect family assets for management purposes and to make it easier for those assets to pass from generation to generation and that any estate tax savings that might result therefrom were merely incidental.

The first FLP was to be formed with approximately $250 million of community property bonds. Each trust was to contribute approximately one-half of that amount in exchange for a 49.95% limited interest in the FLP. A corporation to be formed by the decedent with an initial cash contribution of $300,000 was to own the 0.1% general partner’s interest. The decedent intended to sell her interest in the corporation to family members. Various drafts of the documents were circulated during the fall of 1999.

In March 2000, the 90-year-old decedent was diagnosed with cancer, but it was not believed that her death was imminent. On May 9, 2000, her adviser took the paperwork to her hospital room, and she signed the FLP agreement and various papers for the corporate general partner. The FLP agreement had blanks for the amounts contributed. Her adviser testified that the blank amounts would be filled in when the bonds were actually transferred to the FLP and the values on that date were ascertained. He applied for taxpayer identification numbers (TINs) for the FLP and the corporation, discussed opening brokerage accounts for the FLP assets, and cut a check for $300,000, which the decedent was to sign. The decedent, however, died on May 15, 2000, before the TINs were received, before the brokerage accounts were opened, before assets were transferred to the FLP, and before the decedent signed the check to fund the corporation.

After her death, all action with respect to the FLP ceased until about a year later, when her adviser attended an estate planning seminar and heard a discussion about Estate of Church. 11 In Church, the courts recognized the validity of a partnership even though the certificate of limited partnership was not filed until shortly after the decedent’s death and the corporate general partner was not organized until several months after her death. Buoyed by the success of the estate in Church, the adviser and the family members moved quickly to complete the “formalities that had been left undone a year earlier.”

Following the rationale in the Church case, the district court determined that under well-established principles of Texas law, the intent of an owner to make an asset partnership property will cause the asset to be property of the partnership regardless of whether legal or record title to the property has yet been transferred. Because the estate established that the decedent intended to transfer the community property bonds to the FLP at the time she signed the FLP agreement, the FLP was a valid limited partnership before her death, so the assets were considered partnership property before her death.

The district court then turned to the application of Sec. 2036. The court concluded that the decedent’s transfer of the community property bonds to the FLP was a bona fide sale, based on the lengthy discussions that went into creating the FLP, the primary purpose for creating the FLP to avoid depleting family assets during divorces, and the existence of significant other resources available to the decedent (well over $100 million). In addition, the court determined that the decedent’s transfer was made for full and adequate consideration because the FLP agreement provided that the percentage interests of the partners were proportionate to their respective contributions, the capital accounts were to be credited with the contributions, and upon liquidation the partners were to receive their capital accounts in accordance with their percentage interests.

Estate of Miller

In Estate of Miller, 12 the decedent’s husband had devoted the last 26 years of his life to researching and investing in securities. He spent significant time managing the family’s investments and used a specific investment methodology of charting stocks. Upon the husband’s death in 2000, some of his assets were distributed to a trust for which a QTIP election was made, and the remainder of the assets were distributed to the decedent’s revocable trust. In April 2002, the decedent made transfers to an FLP that constituted about 77% of the decedent’s net assets. One of the decedent’s children was named the general partner, and the FLP employed his company to manage the assets. He worked about 40 hours a week managing the assets according to the charting stock methodology that his father had taught him. The following year, after the decedent broke her hip but before it was discovered that she also had a subdural hematoma as a result of the fall, she transferred almost all her remaining securities to the FLP. Apparently, she was not issued additional FLP units based on the May 2003 transfers.

On the decedent’s federal estate tax return, her units in the FLP were valued based on a 35% discount. The IRS upon audit did not contest the amount of the discount but rather argued that all the assets transferred to the FLP should be includible in her estate under Sec. 2036. The court determined that the April 2002 transfers to the FLP satisfied the bona fide sale exception and were not governed by Sec. 2036. The decedent had legitimate and substantial nontax reasons for forming the FLP and contributing the securities in April 2002 because she wanted to ensure that her assets continued to be managed according to her husband’s investment philosophy. The decedent’s child actively managed the assets in the FLP, as evidenced by the significant trading of the FLP assets.

According to the Tax Court judge who wrote the opinion, for the bona fide sale exception to apply, the activities of the FLP do not need to rise to the level of a “business” under federal income tax laws. This is the third case in which the Tax Court has agreed that establishing or continuing a certain investment philosophy is a legitimate and substantial nontax business reason for forming an FLP. 13

The Tax Court reached the opposite conclusion for the May 2003 transfers of almost all the decedent’s remaining assets. The court concluded that those transfers were precipitated by the decedent’s decline in health and the desire to reduce her taxable estate, so there was no significant nontax reason for those transfers. The court then looked to whether the decedent had retained the possession or enjoyment of, or the right to income from, the property transferred to the FLP in May 2003. The court found it significant that after these transfers the decedent did not retain sufficient funds to pay the estate tax. The court also believed that the decedent would have been given access to the transferred assets if she had recovered from the effects of her fall and needed money for her day-to-day living expenses or medical costs. Because the court concluded that she had retained the economic benefit of the transferred securities, those securities were included in her gross estate under Sec. 2036.

Final Regs. on the Effect of Post-Death Events on Estate Tax Valuation

On October 14, 2009, the IRS issued final regulations 14 providing guidance under Sec. 2053 on the extent to which post-death events may be considered in determining the value of a taxable estate. The final regulations, for the most part, follow the proposed regulations 15 with a few additions and clarifications.

Under Sec. 2053(a), the value of a taxable estate is determined by deducting amounts (such as funeral and administration expenses) from the value of the gross estate. Sec. 2053(a)(3) allows a deduction for claims against a decedent’s estate. Neither Sec. 2053(a) nor the regulations thereunder contain a method for valuing a claim against an estate for estate tax purposes, and there has been little consistency among the courts regarding the extent to which post-death events are to be considered in valuing such claims. In general, the court decisions have floated between one line of cases that follows a date-of-death valuation approach and another line of cases that restricts deductible amounts to those amounts actually paid by the estate in satisfaction of the claim.

The final regulations reflect that the IRS rejects the date-of-death valuation approach and adopts rules based on the premise that an estate may deduct only amounts actually paid in settlement of claims against the estate. Thus, the final regulations “clarify” that events occurring after a decedent’s death are to be considered when determining the amount deductible under all provisions of Sec. 2053 and that such deductions are limited to amounts actually paid by the estate in satisfaction of deductible expenses and claims.

The final regulations also provide that an estate may file a protective claim for refund for some contested or contingent claims that are unresolved as of the date of filing a decedent’s estate tax return. Other provisions provide guidance for specific circumstances, including claims with multiple defendants and unenforceable claims.

The final regulations add to the proposed regulations exceptions to the approach of the proposed regulations to make the application of the approach more administrable. The final regulations include an exception for claims against the estate with respect to which there is an asset or claim includible in the gross estate that is substantially related to the claim against the estate. The final regulations also include an exception for claims against the estate that collectively do not exceed $500,000 (not including those deductible as ascertainable amounts).

The final regulations also update provisions regarding the deduction for some state estate taxes to reflect amendments to Secs. 2053(d) and 2058 by the Economic Growth and Tax Relief Reconciliation Act of 2001. 16 These regulations apply to the estates of decedents dying on or after October 20, 2009.

In conjunction with the release of the final regulations, the IRS released Notice 2009-84, 17 which provides a limited administrative exception to the IRS’s ability to examine a Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, in connection with certain protective claims for refund filed within the time prescribed under Sec. 6511(a). Specifically, in processing a timely filed protective claim for refund of tax based on a deduction under Sec. 2053, if the claim for refund ripens and becomes ready for consideration after the expiration of the period of limitations on assessment prescribed in Sec. 6501, the IRS will limit its review of the Form 706 to the evidence relating to the deduction under Sec. 2053 that was the subject of the protective claim.

Generation-Skipping Transfer Tax

Prop. Regs. on Disclosure of Certain Generation-Skipping Transfers

On August 3, 2007, the IRS issued final regulations under Secs. 6011, 18 6111, 19 and 6112, 20 which amended regulations regarding estate tax, gift tax, employment tax, exempt organizations, qualified pension plans, and public charities to provide that certain taxpayers would be required to disclose transactions of interest, in addition to listed transactions, on their federal tax returns under Sec. 6011. Apparently, the IRS realized that these regulations failed to address generation-skipping transfers (GSTs). Having recognized this omission, on September 11, 2009, the IRS issued proposed regulations 21 to add transactions that reduce or eliminate the GST tax as listed transactions or transactions of interest and require the disclosure of these transactions under Sec. 6011.


Guidance on Trustee Fees

In Notice 2010-32, 22 the IRS for the third year has extended interim guidance on trust fees originally provided in Notice 2008-32. 23 The IRS initially issued Notice 2008-32 in anticipation of issuing final regulations to settle questions raised in the Supreme Court’s decision in Knight 24 and to address the unbundling of fiduciary fees by trusts and estates. The notice provided that trusts and estates would not be required to determine the portion of bundled fiduciary fees that were subject to the 2% of AGI floor for any tax year beginning before January 1, 2008. Notice 2008-116 25 later extended that guidance to tax years beginning before January 1, 2009, and Notice 2010-32 now extends the guidance through tax years beginning before January 1, 2010.

Sec. 212 allows individuals to take a deduction for expenses incurred in connection with property held for investment. Sec. 67(a) limits this deduction (along with other miscellaneous deductions) to 2% of adjusted gross income (AGI). Sec. 67(e)(1) provides that the AGI of a trust or an estate is to be computed in the same manner as for an individual, except deductions that are paid or incurred in connection with the administration of the trust or estate and that would not have been incurred if the property were not held in the trust or estate shall be treated as allowable in arriving at AGI (i.e., deductible above the line).

In Knight, the Supreme Court settled a split among the Circuit Courts of Appeals and put to rest the issue of whether investment advisory fees are fully deductible under Sec. 67(e) or are deductible under Sec. 67(a), making them subject to the 2% AGI floor. The Court ruled that investment advisory fees were not “uncommon (or unusual, or unlikely)” for a hypothetical individual to incur. Therefore, the Court ruled that the second requirement of Sec. 67(e)(1) (requiring that the expense “would not have been incurred if the property were not held in the trust”) had not been met.

Prior to the Supreme Court’s decision in Knight, the IRS had issued Prop. Regs. Sec. 1.67-4, in which it addressed expenses of a trust or an estate that it believed to be deductible under Sec. 67(a) or Sec. 67(e)(1). The IRS also addressed for the first time the issue of bundled trustee fees. It is concerned that trustees are combining into one trustee fee some fees that may not be deductible under Sec. 67(e)(1). The proposed regulations would require trustees to unbundle these fees and then deduct them according to Sec. 67.

Although the Supreme Court was aware of Prop. Regs. Sec. 1.67-4, it did not address the regulation in its decision. Specifically, the Court did not address the issue of bundled trustee fees. This left many practitioners who specialize in fiduciary income tax accounting in the uncomfortable position of trying to decide whether to take a taxpayer-unfavorable position and abide by Prop. Regs. Sec. 1.67-4 or a taxpayer-favorable position contrary to the regulation on returns filed for a trust’s 2007 tax year.

The guidance in Notice 2008-32 and its successor notices responded to this uncertainty. They provide that trusts and estates are not required to determine the portion of bundled fiduciary fees that is subject to the 2% of AGI floor for any tax year beginning before January 1, 2010. Instead, for each such tax year, trusts and estates may deduct the full amount of the bundled fiduciary fee without regard to the floor. There is one exception. Payments by a trustee or executor to third parties for expenses subject to the 2% AGI floor are readily identifiable, and must be treated separately from the otherwise bundled trustee fee.

Conversion of Nongrantor Trust to Grantor Trust Is Not a Recognition Event

In CCA 200923024, 26 the Office of Chief Counsel concluded that the conversion of a nongrantor trust to a grantor trust is not a recognition event for federal income tax purposes. However, because the present situation “presents an apparent abuse,” the IRS’s National Office is encouraging the field offices to work together to explore other arguments to attack the transaction.

In the CCA, a parent and three adult children formed an LLC. Each contributed a nominal amount of cash and highly appreciated stock to a family corporation, for which they were anticipating an initial public offering (IPO). Each then created a nongrantor irrevocable trust. The beneficiaries of each trust were the grantor’s then-living issue. The trustees of each trust were the parent’s spouse, an independent trustee, and an independent corporate trustee. A majority of the trustees had the discretionary power to distribute net income to any beneficiary. Each trust terminated on the death of the grantor, and the assets in the trust were to be distributed to the grantor’s living issue.

Prior to 2006, each family member sold his or her LLC interest to his or her respective trust in exchange for a private annuity. At that time, the LLC elected under Sec. 754 to make adjustments to the basis of partnership property. Because of this election, immediately after the transfer of the LLC interests to the trusts, the LLC stepped up its inside basis of the stock to its fair market value, which corresponded to the trusts’ purchase price. Thereafter, the LLC sold all its shares pursuant to the IPO for an amount roughly equal to the LLC’s inside basis for this stock.

On the LLC’s income tax return for the first year, it reported long-term capital gain from the IPO (presumably a small gain). The LLC also reported distributions to each trust approximately equal to the amount of that trust’s annuity payment to the family member. Each family member reported income received from the annuity on his or her individual return for that year and the following year. Thereafter, the corporate trustee was terminated as a trustee and replaced by a trustee represented to be a subordinate trustee under Sec. 672(c)(2). Upon the replacement of the corporate trustee with a related or subordinate trustee, the trustees’ exercise of trustee powers caused the trusts to become grantor trusts under Secs. 674(a) and (c). After the trusts became grantor trusts, the family members reported no further annuity income because as owners of the trusts they were both the payers and the payees on the annuities.

The field office argued that the conversion of a nongrantor trust to a grantor trust is a taxable transaction with respect to both the transferring nongrantor trust and the transferee grantor trust. Taxation to the transferee trust would be essential to generate any tax in this situation; the transferor trust would have little or no gain because its basis in the LLC interest, acquired by purchase, is close to the fair market value of the LLC interest.

The CCA discusses authorities cited by the IRS field office and notes that they discuss the application of Sec. 1001 only to the party who is considered to transfer ownership. None discuss any income tax consequences to the transferee of the assets. In addition, these rules affect only inter vivos lapses of grantor trust status, not a termination of grantor trust status caused by the death of the owner, which is generally not treated as an income tax event. According to the CCA, even if this particular transaction is abusive, asserting that the conversion from a nongrantor trust to a grantor trust results in taxable income to the grantor would have an impact on nonabusive situations and should not be pursued as a position taken by the IRS.

Gift and Estate Tax Consequences of a Transfer to a DAPT

Since Alaska passed the first domestic asset protection trust law in the United States, many states have followed with their own versions of the law, paving the way for the proliferation of domestic asset protection trusts (DAPTs). Individuals create DAPTs to protect their assets from the claims of unknown and future creditors. They are similar in design to foreign asset protection trusts (FAPTs) but do not carry the scrutiny and contempt the U.S. government has for foreign trusts. It remains to be seen whether DAPTs will be as effective as FAPTs at protecting an individual’s assets from creditors because, as opposed to FAPTs, DAPTs are subject to the jurisdiction of U.S. courts.

While DAPTs are generally set up for creditor protection purposes, there are questions as to the income, gift, and estate tax consequences of a DAPT because the person who transfers assets to the DAPT is generally its primary beneficiary. However, the DAPT’s governing instrument is structured such that the grantor has no control over the trust and has no right to demand distributions from the trust. In Letter Ruling 200944002, 27 the IRS was asked to rule on the gift and estate tax consequences of a transfer to a DAPT under the laws of the state in which the DAPT was created.

As to the gift tax consequences, the grantor specifically asked the IRS to rule on whether the grantor had made a completed gift to the DAPT. The grantor requested this ruling because he was a beneficiary of the trust, and Regs. Sec. 25.2511-2(b) provides that a gift is complete only when the donor has so parted with the dominion and control of the property as to leave the donor no power to change its disposition, whether for the donor’s own benefit or the benefit of another person. Regs. Sec. 25.2511-2(c) further provides that a gift is incomplete if the donor reserves the power to revest the beneficial title to the property in himself or herself. Even though the grantor was a beneficiary of the trust, the IRS ruled that transfers he made to the DAPT were completed gifts because: (1) the trustee of the DAPT was independent of the grantor; (2) the grantor could not remove or become the trustee; (3) upon termination of the DAPT, its assets were not payable to the grantor, his estate, his creditors, or creditors of his estate; and (4) under state law, assets of the DAPT could not be used to satisfy claims against him.

Regarding estate tax consequences, the grantor specifically asked the IRS to rule on whether any portion of the DAPT would be includible in his estate for estate tax purposes. The grantor requested this ruling because Secs. 2036–2038 and 2042 include in a decedent’s estate assets that the decedent transferred during life but over which he or she retained some type of benefit or control. In particular, Sec. 2036(a) includes in a decedent’s estate assets that he or she transferred during life and retained the possession or enjoyment of or the right to income from.

The DAPT’s governing instrument contained a provision that allowed him to replace assets of the DAPT with other assets of the same value (this provision creates grantor trust status of the DAPT for income tax purposes). The IRS noted that in Rev. Rul. 2008-16 28 it ruled that such a provision by itself will not cause a trust’s assets to be includible in the grantor’s estate. The DAPT’s governing instrument also prohibited the trustee from reimbursing the grantor for the income tax the grantor was required to pay by reason of the inclusion of the DAPT’s income in the grantor’s income. The IRS cited Rev. Rul. 2004-64 29 for the position that because the trustee is prohibited from reimbursing the grantor for the taxes he paid due to the inclusion of the DAPT’s income in his income, the grantor had not retained a reimbursement right that would cause the DAPT’s assets to be includible in the grantor’s estate. Finally, the IRS noted that the trustee’s discretionary authority to distribute income and/or principal to the grantor by itself did not cause the DAPT’s assets to be includible in the grantor’s estate. The IRS, however, noted that it was not ruling on whether the trustee’s discretion to make distributions to the grantor combined with other facts may cause inclusion of the DAPT’s assets in the grantor’s estate.

This is only the second ruling the authors are aware of in which the IRS has ruled on the gift and estate tax consequences of transfers to a DAPT. The person who co-wrote the DAPT law for Alaska filed for the first ruling was over 11 years ago. In Letter Ruling 9837007, 30 the taxpayer asked only whether the transfer to the DAPT was a completed gift. In general, the IRS will not rule on whether a particular set of facts will cause estate tax inclusion because it does not rule on hypotheticals. Regarding its current ruling on estate tax inclusion, the IRS is simply stating that the structure, as written, would not cause estate tax inclusion. It declined to rule on whether future actions by the DAPT’s grantor or trustee might cause estate tax inclusion.

Reformation of a CRUT Due to a Scrivener’s Error

There are many reasons a taxpayer may want to modify, amend, or reform the governing instrument of an irrevocable trust due to the failure of the trust to operate in the way it was intended or because circumstances change and make a modification, amendment, or reformation desirable. In such instances, the taxpayer (and usually the trustee and beneficiaries of the trust) petitions a court to modify, amend, or reform the governing instrument and, in many cases, asks the court to further rule that the modification, amendment, or reformation is retroactive to the date of the trust’s creation. Courts generally comply with such requests unless someone who has rights in the trust objects.

Whether the IRS recognizes a court’s ruling retroactively for federal tax purposes depends upon whether the IRS believes the ruling would be the ruling of the highest court for the jurisdiction in which the court’s ruling was rendered. 31 Generally, the IRS will retroactively recognize a modification, amendment, or reformation when the trust instrument does not properly reflect a taxpayer’s intentions at the time the trust was created.

In Letter Ruling 200932020, 32 a couple created a charitable remainder unitrust (CRUT) by contributing stock and naming their son as the unitrust recipient and a private foundation as the charitable remainderman. The trust instrument provided that the charitable remainderman must be an organization described in “sections 170(b)(1)(A), 170(c), 2055(a) and 2522(a).” This provision is generally placed in charitable remainder trust instruments to ensure that the charitable remainder interest qualifies for the income, estate, and gift tax charitable deductions. The inclusion of Sec. 170(b)(1)(A) limits the charitable remainderman to a “public charity” to ensure that the income tax charitable deduction is not subject to the basis limitation rules for capital gain property in Sec. 170(e)(1).

Upon the death of the husband, the son noted that the trust instrument, as written, would not allow the remainder interest in the CRUT to be distributed to the private foundation (because private foundations are not public charities). The son, as trustee of the CRUT, petitioned the local court to reform the trust to delete the “section 170(b)(1)(A)” reference due to a scrivener’s error on the part of the attorney. Among other evidence, the attorney executed an affidavit stating that it was the couple’s intention that the private foundation receive the remainder interest in the CRUT if it was in existence upon the termination of the unitrust interest. The court issued a ruling in accordance with the son’s petition. The IRS ruled that the reformation of the trust would be recognized for federal tax purposes retroactive to the date of the CRUT’s creation due to the attorney’s drafting error.

It is surprising that the IRS would recognize the court’s ruling retroactively because the reformation was not necessary for the valid creation of the CRUT, and the ruling prejudices the interests of the government. Although the letter ruling provides no evidence of the income tax charitable contribution deduction the couple took on their income tax return for the year the CRUT was created, the trust instrument as written would not have limited the deduction under Sec. 170(e). The couple contributed capital gain property to the CRUT and, had the Sec. 170(b)(1)(A) reference not been included in the description of the charitable remainderman, the contribution would have limited the couple’s deduction to the basis they had in the contributed stock. Although there is no evidence in the letter ruling that the couple did so, it is quite possible the couple got the best of both worlds—a maximized income tax charitable deduction while at the same time benefiting their private foundation.

Payment of Annuity with Appreciated Property to CLAT

Taxpayers frequently create charitable lead annuity trusts (CLATs) for the purpose of giving an annuity to charity for a set period of time and then passing to the grantor’s designated beneficiaries any property remaining in the trust at the end of the term. The annuity can be set so that the present value of the annuity payments equals the value of the property transferred to the trust. In this situation, the remainder interest passing to the grantor’s beneficiaries has an initial value of zero, and the taxable gift for gift tax purposes is zero. If the property in the trust has a return greater than the discount rate used to value the charitable and remainder interests, any assets remaining in the trust pass to the grantor’s beneficiaries free of any transfer taxes.

A CLAT set up during the grantor’s life can be established as either a grantor trust or a nongrantor trust. If the trust is a nongrantor trust, the grantor receives no charitable deduction for income tax purposes upon the creation of the trust, but the trust, which is a taxable trust, is entitled to an income tax deduction under Sec. 642(c) for amounts of gross income paid to charity as part of the annuity payment. If the trust is a grantor trust, under Sec. 170(f)(2)(B) the grantor is entitled to an income tax deduction for the present value of the charitable interest but has to include the trust’s income in his or her income during the charitable term.

If the CLAT is established with appreciated securities, some of the securities may be sold each year to fund the charitable annuity. If the CLAT is a grantor trust, the grantor would include in income not only the ordinary income attributable to the trust property but any capital gain resulting from the sale of securities. Some have questioned whether a different result would be available if, instead of selling the securities, the trust transferred them in kind to the charitable organization in satisfaction of the annuity payment.

In Letter Ruling 200920031, 33 the taxpayers asked the IRS to conclude that satisfaction of the annuity payment by a transfer to charity of appreciated marketable securities does not trigger gain or loss to the grantor or the trust under the rationale of Rev. Rul. 55-410. 34 This ruling provides that the satisfaction of a mere pledge to charity with property that has either appreciated or depreciated does not give rise to a taxable gain or a deductible loss. Under the rationale of the revenue ruling, a mere charitable pledge does not give rise to a charitable deduction until the pledge is satisfied; therefore, it would be inconsistent with this treatment to require taxation that ordinarily applies when appreciated or depreciated property is used to satisfy a debt.

In the letter ruling, the IRS concluded that Rev. Rul. 55-410 is not applicable because upon the creation of the trust, the charity has a claim against the CLAT’s assets that is satisfied by the transfer of appreciated securities. The IRS cited Kenan, 35 in which the court concluded that the payment by a trust of a specific dollar amount to a noncharitable beneficiary by transferring cash and marketable securities resulted in a taxable exchange to the trust. The IRS also cited Rev. Rul. 83-75, 36 which concludes that a nongrantor CLAT realizes gain when it satisfies the charitable annuity by the transfer of appreciated securities to the charity.

Conspicuously absent from the discussion in the letter ruling is any mention of Rev. Rul. 85-13, 37 which concludes that the grantor of a grantor trust is treated as directly owning the assets in the trust. Under the theory of Rev. Rul. 85-13, it could be argued that the transfer is directly from the grantor to the charity when the appreciated securities are transferred to the charity in satisfaction of the annuity payment, and generally an individual does not recognize gain when the individual transfers appreciated property directly to charity.

EGTRRA Changes Taking Effect in 2010

As of January 1, 2010, there is no federal estate tax or GST tax. 38 Commensurate with the repeal of the estate and GST taxes, a new set of income tax rules applies to determine the basis of property received by heirs from a decedent’s estate.

New Sec. 1022 is applicable to property acquired from a decedent who dies after December 31, 2009. It currently applies to all taxpayers who die in 2010, not just the taxpayers whose estates would have been subject to estate tax if there were one in effect.

The basis of the property is the lesser of the decedent’s basis in the property or the fair market value at the date of the decedent’s death, so there is no step-up in basis under Sec. 1014 if the property has appreciated since the decedent acquired it. But there is a step-down in basis if the property has depreciated since the decedent acquired it. These rules apply separately to each item of property owned by the decedent at the date of his or her death.

The executor can use a basis increase generally equal to $1,300,000 to increase the basis of selected items of property. However, the executor may not increase the basis of any particular item above its fair market value on the date of the decedent’s death. The total basis increase of $1,300,000 is increased by the amount of the decedent’s unused capital loss carryovers and net operating loss carryovers. If the decedent was a nonresident alien, the amount of the basis increase is only $60,000.

Property subject to adjustment is property acquired from a decedent and includes property in the decedent’s probate estate and property in a revocable trust. Excluded from the property for which a basis allocation is available is any property that would have been subject to the decedent’s general power of appointment, any property that would have been includible under Sec. 2044 as QTIP, and property in a grantor retained annuity trust or qualified principal residence trust that would have been includible in the decedent’s gross estate under the estate tax law if the decedent died during the term.

If the decedent was married at the time of his or her death and some of the decedent’s property passes to the surviving spouse, an additional basis increase of $3 million may be used for that property. This is in addition to the $1.3 million available to anyone. To be eligible for this spousal basis increase, the property must pass to the surviving spouse outright or as QTIP. Because there is no estate tax for 2010, Sec. 1022(c)(5) contains its own definition of “qualified terminable interest property.” It is generally the same property that would have qualified for the QTIP election under Sec. 2056(b)(7): all the income to the spouse for life, with no person having a power to appoint any part of the property to any person other than the spouse during the spouse’s life. There is no election that needs to be made as there is for the QTIP marital deduction.

Before 2010, it was not possible to obtain a step-up in the basis of assets by giving them to someone who was terminally ill and then getting them back from the decedent’s estate. If the donor transferred the property to the decedent within one year before the decedent’s death and the donor received the property back upon the decedent’s death, the basis of the property remained the decedent’s basis immediately before death under Sec. 1014(e). Sec. 1022 contains a similar limitation for property acquired by the decedent by gift but includes transfers made to the decedent within three years of the decedent’s death, rather than just one year. This rule does not apply to gifts from the decedent’s spouse, so it is possible for the healthy spouse to gift property to an ill spouse and have the property returned to the healthy spouse using the $3 million spousal basis adjustment.

Another new provision for 2010 is Sec. 2511(c). It provides that, notwithstanding any other provision of Sec. 2511 and except as provided in regulations, a transfer in trust shall be treated as a transfer of property by gift “unless the trust is treated as wholly owned by the grantor or the grantor’s spouse” under the grantor trust rules. Initially, some estate planners interpreted this provision to include its negative implication—namely, if the transfer is to a wholly owned grantor trust, it is not a gift. Such an interpretation would be a windfall for taxpayers making transfers to intentionally defective grantor trusts because the only time such a transfer would be subject to the transfer tax regime is when the assets were transferred to the trust.

The IRS issued Notice 2010-19 39 to alert taxpayers that what seems too good to be true actually is not true. According to the notice, the purpose of Sec. 2511(c) is to treat as completed gifts transfers to trusts that otherwise would not be completed gifts, unless the trust is a wholly owned grantor trust. Thus, a transfer in 2010 to a trust that is not a wholly owned grantor trust of the donor or the donor’s spouse is considered a gift of the entire interest in property under Sec. 2511(c). The gift tax rules in effect on December 31, 2009, continue to apply to all transfers made to a wholly owned grantor trust to determine whether the transfer is subject to gift tax. As a result, a transfer to an intentionally defective grantor trust in 2010 will still be a gift subject to gift tax. The notice provides that Treasury and the IRS will issue regulations to confirm the conclusions set forth in the notice.

This notice shuts the door on the supposed opportunity to transfer assets to an intentionally defective grantor trust without any gift tax consequences. Nevertheless, it may still be a good time to make those transfers if they would be taxable gifts because the gift tax rate is currently at the historically low rate of 35%. Of course, any taxpayer who contemplates trying to take advantage of this low gift tax rate needs to consider the possibility that Congress may retroactively increase this rate as part of a retroactive reinstatement of the estate and GST taxes.

Annual Inflation Adjustments

The IRS has released Rev. Proc. 2009-50, 40 setting forth inflation adjustments for various tax items for 2010. The low rate of inflation over the past year has led to very few IRS adjustments for 2010, meaning that many taxpayers will not enjoy a larger standard deduction, gift tax exclusion, or personal exemption than they did in 2009. The following is a list of items that may be of interest to individual taxpayers:

  • The gift tax annual exclusion for gifts of a present interest is $13,000 (the same as 2009).
  • The gift tax annual exclusion for gifts of a present interest to a spouse who is not a U.S. citizen is $134,000 (up from $133,000 in 2009).
  • The ceiling on special-use valuation is $1,000,000 (the same as 2009).


1 Sec. 2036(a).

2 Bongard, 124 T.C. 95 (2005).

3 Estate of Shurtz, T.C. Memo. 2010-21.

4 Kimbell, 371 F.3d 257 (5th Cir. 2004).

5 Estate of Black, 133 T.C. No. 15 (2009).

6 Estate of Graegin, T.C. Memo. 1988-477.

7 See Rev. Rul. 84-75, 1984-1 C.B. 193.

8 See, e.g., Jorgensen, T.C. Memo. 2009-66; Erickson, T.C. Memo. 2007-107.

9 Estate of Malkin, T.C. Memo. 2009-212.

10 Keller, No. V-02-62 (S.D. Tex. 8/20/09).

11 Estate of Church, No. SA-97-CA-0774-OG (W.D. Tex. 2000), aff’d, 268 F.3d 1063 (5th Cir. 2001) (unpublished opinion).

12 Estate of Miller, T.C. Memo. 2009-119.

13 See also Estate of Mirowski, T.C. Memo. 2008-74; Estate of Schutt, T.C. Memo. 2005-126.

14 T.D. 9468.

15 REG-143316-03.

16 Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16.

17 Notice 2009-84, 2009-44 I.R.B. 592.

18 T.D. 9350.

19 T.D. 9351.

20 T.D. 9352.

21 REG-136563-07.

22 Notice 2010-32, 2010-16 I.R.B. 594.

23 Notice 2008-32, 2008-11 I.R.B. 593. See also Notice 2008-116, 2008-52 I.R.B. 1372.

24 Knight, 552 U.S. 181 (2008).

25 Notice 2008-116, 2008-52 I.R.B. 1372.

26 CCA 200923024 (6/5/09).

27 IRS Letter Ruling 200944002 (10/30/09).

28 Rev. Rul. 2008-16, 2008 I.R.B. 769.

29 Rev. Rul. 2004-64, 2004-2 C.B. 7.

30 IRS Letter Ruling 9837007 (9/11/98).

31 See Estate of Bosch, 387 U.S. 456 (1967).

32 IRS Letter Ruling 200932020 (8/7/09).

33 IRS Letter Ruling 200920031 (5/15/09).

34 Rev. Rul. 55-410, 1955-1 C.B. 297.

35 Kenan, 114 F.2d 217 (2d Cir. 1940).

36 Rev. Rul. 83-75, 1983-1 C.B. 114.

37 Rev. Rul. 85-13, 1985-1 C.B. 184.

38 For more on this, see Part I of this article in the September 2010 issue, p. 631.

39 Notice 2010-19, 2010-7 I.R.B. 404.

40 Rev. Proc. 2009-50, 2009-45 I.R.B. 617.


Justin Ransome is a partner and Frances Schafer is executive director in the National Tax Office of Grant Thornton LLP in Washington, DC. For more information about this article, contact Mr. Ransome at

Newsletter Articles


Directions in Individual Taxation

This article covers recent developments in the area of individual taxation, including the treatment of support payments and IRA and qualified plan distributions, the Sec. 469 material participation rules, and the taxability of state economic development credits.


2015 Tax Software Survey

See how nearly 5,000 paid CPA tax preparers rated the strengths and weakness of major tax preparation software products they used in 2015.