This two-part article examines developments in estate, gift, and generation-skipping transfer (GST) tax and trust income tax between June 2012 and May 2013. It discusses legislative developments, cases, rulings, the American Taxpayer Relief Act of 2012, and inflation adjustments for 2013. Part II, in the October issue, will cover estate and GST tax issues.
Estate Tax Reform
The uncertainty about transfer-tax rates and exemption amounts that has plagued taxpayers and practitioners since 2001 was finally settled in 2013. On Jan. 2, 2013, President Barack Obama signed the American Taxpayer Relief Act of 2012 (ATRA), 1 which, for estate, gift, and generation-skipping transfer (GST) tax purposes:
- Makes permanent certain income and transfer-tax provisions in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA); 2
- Makes permanent income tax provisions in the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA); 3 and
- Makes permanent income and certain transfer-tax provisions in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (2010 Tax Act). 4
In most instances the effective date of the act is Jan. 1, 2013.
ATRA resets the gift tax rate schedule to mirror the estate tax rate schedule with a top rate of 40%. Before EGTRRA was enacted, the exemption amount for both gift and estate tax was the same, or “unified.” EGTRRA decoupled them. After EGTRRA, the estate tax exemption amount steadily increased while the gift tax exemption amount remained at $1 million. The 2010 Tax Act temporarily reunified the gift tax and the estate tax exemption amounts—ATRA makes that permanent and also makes permanent the $5 million gift tax exemption, which is indexed annually for inflation and is $5.25 million for 2013.
ATRA sets the top estate tax rate at 40% with lower rates still in effect for estates less than $1 million, but these lower rates affect the calculation of the estate tax only for an estate in excess of the estate tax exemption amount (currently $5.25 million). It also makes the portability election, which allows a surviving spouse to use the unused estate tax exemption amount of the first spouse to die, permanent.
Generation-Skipping Transfer (GST) Tax
The GST tax applies the highest estate tax rate, which is now 40%. The GST exemption amount is the same as the estate tax exemption amount (currently $5.25 million). In addition, ATRA repeals the EGTRRA sunset provisions, thereby making the following taxpayer-favorable GST tax provisions permanent:
- Automatic allocation of GST exemption to indirect skips;
- Sec. 9100 relief for missed GST allocations and elections;
- Substantial compliance for allocations of GST exemption;
- Retroactive allocations of GST exemption for unnatural orders of death; and
- Trust severances for GST tax purposes.
Annual Exclusion Gifts
As part of its continued attacks on family limited partnerships (FLPs), the IRS has argued with some success that gifts of interests in an FLP do not qualify for the gift tax annual exclusion. Sec. 2503(b) excludes from gift tax the first $14,000 for 2013 of present-interest gifts a donor makes to any person during a calendar year. Regs. Sec. 25.2503-3(b) provides that a present interest is the unrestricted right to the immediate use, possession, or enjoyment of property or the income from property.
In Estate of Wimmer, 5 the decedent and his wife created an FLP. The FLP agreement generally restricted the transfer of partnership interests and limited the instances in which a transferee could become a substitute limited partner, except for transfers to related parties. The decedent and his wife made gifts of FLP interests from 1996 through 2000 to their children, nieces, and nephews, and to a trust for the benefit of their grandchildren, grandnieces, and grandnephews. The trust beneficiaries were given the right to withdraw a specified amount of each gift; therefore, the parties stipulated that the transfers to the trust qualified as gifts of present interests if the Tax Court determined that the transfer of the FLP interests qualified as gifts of present interests.
The FLP agreement provided that all distributions of net cash flow were to be shared among the partners in proportion to their FLP interests. The FLP assets consisted of publicly traded, dividend-paying stock. During its first three years of operation, the FLP made distributions to pay the partners’ federal income taxes. Beginning in 1999, the FLP continuously distributed all dividends, net of expenses, to the partners. In addition to the distribution of income, limited partners had access to capital account withdrawals and used those withdrawals to, among other things, pay their residential mortgages.
In Hackl , 6 the Tax Court established the test to determine whether the transfer of property is a gift of a present interest—the gift must confer on the donee a substantial present economic benefit by reason of use, possession, or enjoyment of either (1) the property or (2) the income from the property. To satisfy the first requirement, the taxpayer must prove that the facts and circumstances establish that possessi ng the interest renders an economic benefit available to the donee (via sale, acquisition, or otherwise). To satisfy the second requirement, the taxpayer must prove (1) that income will, in fact, be produced; (2) that some portion of that income will flow steadily to the beneficiary; and (3) that the portion of income flowing out to the beneficiary can be ascertained.
In Wimmer, the FLP agreement generally restricted the transfer of partnership interests and limited the instances in which a transferee could become a substitute limited partner. Thus, the Tax Court had little trouble concluding the donees did not receive unrestricted and noncontingent rights to the immediate use, possession, or enjoyment of the FLP interests.
The Tax Court next turned to the question whether the donees received rights in the FLP’s income. The court found that the estate met the first prong of the income test (proving that the FLP expected to generate income) because the FLP had, since its inception, owned publicly traded, dividend-paying stock.
For the second prong (whether some portion of that income will flow steadily to the donees), the Tax Court examined the fiduciary relationship between the general partners and the trustee (a bank). The only asset in the trust was the FLP interest, so the trust had no source of funds to pay the federal income tax on its distributive share of the FLP income unless the FLP made distributions to it. The court determined that the necessity of an FLP distribution in these circumstances comes within the purview of the general partners’ fiduciary duties and, therefore, the general partners were obligated to distribute a portion of partnership income each year to the trustee. Because distributions were required to be made pro rata under the FLP agreement, any distribution to the trustee triggered proportionate distributions to the other partners. As a result, the estate proved that some portion of FLP income was expected to flow steadily to the limited partners.
For the third prong (whether the portion of income flowing to donees can be ascertained), the court determined that because the FLP owned publicly traded, dividend-paying stock, each donee could estimate its share of the dividends based on the stock’s dividend history and its percentage of ownership in the FLP. Finding that the facts established that the donees of the FLP interests had the immediate use, possession, or enjoyment of the income from property, the court concluded that the donees received a substantial present economic benefit sufficient to render the gifts of the FLP interests as gifts of present interests that qualified for the gift tax annual exclusion.
This is the first litigated case in which taxpayers have been successful in establishing that gifts of FLP interests qualified for the gift tax annual exclusion. In Hackl, the FLP owned timberland that had little or no existing salable timber when the gifts were made, so the taxpayers did not pass the income test. Because the Wimmer FLP held publicly traded, dividend-paying stock, the Tax Court was satisfied that there would be income. And because the FLP had to make distributions sufficient for the donees to satisfy their income tax obligations from their share of the FLP, the mandatory distribution was sufficient to convince the court that a portion of the FLP income would flow steadily to the donees. While the duty to make distributions to satisfy the partners’ income tax liability was based on the general partners’ fiduciary duties under state law, it could easily be a requirement of the FLP agreement. Even if, for estate planning purposes, the FLP does not want to distribute all its income currently, FLPs as a matter of course usually distribute enough for the partners to cover their income tax liability.
The Wimmer case also highlights the importance of reporting annual exclusion gifts on a gift tax return to begin running the statute of limitation on the gifts and the annual exclusions. Because these gifts had not been reported on a gift tax return, Sec. 6501(c)(9) (which prohibits the statute of limitation from running on gifts that are not disclosed) applied and the statute of limitation never began to run. If these gifts had been adequately disclosed on gift tax returns, only the gifts made in 1996 (before the effective date of Sec. 6501(c)(9)) would have been subject to adjustment when the decedent died in 2004.
Disclaimer by a Nonresident Alien
Under Sec. 2518, if a person makes a “qualified disclaimer” of an interest in property, the disclaimed interest is treated for transfer-tax purposes as if the interest had never been transferred to that person. The person making a qualified disclaimer will not incur gift tax as a result because he or she is ignored for gift tax purposes. Letter Ruling 201250001 7 addresses the U.S. tax consequences when a noncitizen, nonresident of the United States makes a disclaimer that is not a qualified disclaimer.
The donor, who was never a U.S. resident or a lawful permanent resident, was the sole income beneficiary of certain irrevocable subtrusts that her father created before Sept. 25, 1985 (the date on which the current GST tax regime went into effect). The donor’s children were t he remainder beneficiaries of the subtrusts. Upon the donor’s death and until the subtrusts terminated on the later of the death of the donor or the donor’s brother, the income of the trusts was payable to the respective child of the donor for whom the subtrust was created. Upon termination, the assets of the subtrusts would be distributed to the remainder beneficiaries of the subtrusts. The donor intended to release her in come interest in the subtrusts. (Although not stated in the facts, the trust must have been a domestic trust.)
The first requested ruling was that the donor’s release of her income interest in the subtrusts would not be subject to U.S. gift tax. Although the requirements to make a qualified disclaimer under Sec. 2518 had not been met, the IRS found that, because the donor was a noncitizen, nonresident of the United States, no gift tax would be due if the property was considered intangible property. Under state law, the beneficial interest in a trust was intangible property and thus not taxable.
The second requested ruling was that the release of the donor’s income interests in the subtrusts would not be considered a constructive addition to the subtrusts for GST tax purposes. Under Regs. Sec. 26.2663-2 a transfer by a noncitizen, nonresident of the United States is subject to GST tax only to the extent that the transfer is subject to gift or estate tax. The trust was irrevocable on a date prior to Sept. 25, 1985, and the donor represented that there were no additions to the trust since Sept. 25, 1985. Having previously ruled that the donor had not made a gift subject to U.S. gift tax, the IRS ruled that the release of the donor’s income interests did not constitute a constructive addition to the trust and would not cause GST tax to apply to the trust.
In Estate of Kite, 8 the Tax Court addressed the gift tax consequences of an elaborate estate plan involving the creation of FLPs, the termination of qualified terminable interest property (QTIP) trusts, and the sale of FLP interests for a private annuity.
The estate plan involved transactions among five trusts. First, the decedent created an inter vivos QTIP trust (QTIP 1) for the benefit of her husband just a week before he died. The decedent filed a gift tax return reporting the transfer and claiming a marital deduction for the transferred property. QTIP 1 provided a life estate for the decedent’s husband followed by a life estate for the decedent. Upon the husband’s death approximately one week later, the assets of QTIP 1 were included in his estate under Sec. 2044 and received a basis step-up under Sec. 1014(a).
The second, third, and fourth trusts were created upon the husband’s death. The Shelter Trust was funded with the husband’s remaining estate tax exemption. The QTIP 2 trust was funded with the husband’s remaining GST tax exemption, and a QTIP election was made for the trust under Sec. 2056(b)(7). The rest of the husband’s estate passed to the Marital Trust, in which the decedent had a general power of appointment, allowing the trust to qualify for the marital deduction under Sec. 2056(b)(5). The fifth trust was the decedent’s revocable trust (Living Trust).
In 1996, the five trusts created and funded an FLP (FLP) in return for 99% limited partnership interests. The decedent and her children then created a corporation, which transferred property to FLP in return for a 1% general partnership interest. As a trustee of the trusts that held FLP’s limited partner interests, the decedent made gifts of one-third of FLP to her three children, along with a portion of the corporation. The opinion does not discuss the fact that the decedent was not authorized to make these transfers (at least with respect to the trusts other than Living Trust). The decedent reported these gifts on her 1997 tax year gift tax return and paid nearly $1.5 million in gift tax.
In 1998, the five trusts sold their remaining two-thirds interest in FLP to the decedent’s three children in return for $12.5 million of secured and full recourse promissory notes, which required the children (individually or through their trusts) to make quarterly payments of principal and interest at 5.81% for nearly 15 years. The five trusts then contributed the notes to a newly created Texas general partnership (GP) in return for a 99% interest in GP. The corporation (the general partner of FLP) contributed property to GP in return for a 1% interest in GP and was GP’s manager.
In 2001, the decedent implemented a private annuity transaction with her children. First, the decedent removed the current trustees of QTIP 1, QTIP 2, and Marital Trust, and named her children as successor trustees. The children liquidated these trusts and distributed the assets to Living Trust. The Tax Court did not address any potential gift tax issues regarding the children, as trustees, liquidating QTIP 1 and QTIP 2 and giving all the trust property to the decedent even though she was entitled only to an income interest in the trusts (in a footnote, the court noted that the IRS did not raise the issue).
Next, FLP (now owned by the children or their trusts) contributed $13.6 million to GP for a 55.8% interest. Living Trust sold its entire interest in GP, which held the notes and the assets contributed by FLP, to the decedent’s children for deferred unsecured private annuities. The children were personally liable for the annuity payments, which would begin 10 years after the sale. The decedent, who was almost 75, had a life expectancy of 12.5 years under the IRS’s actuarial tables, and the children had sufficient assets, not counting the amount transferred by the decedent in return for the private annuity, to make the annuity payments for the first three years. However, if the decedent survived longer than 13 years, the children would become insolvent, considering their then-current personal assets. The decedent’s physician signed a letter concluding that there was “at least a 50% probability that she will survive for 18 months or longer.”
The decedent died a little over three years after executing the transaction, having received no annuity payments. The decedent’s estate tax return reflected an estate of approximately $3 million, excluding from the decedent’s gross estate the notes and the private annuity. The IRS issued a gift tax notice of deficiency for 2001 of approximately $6 million and an estate tax notice of deficiency of approximately $5 million.
The IRS challenged the private annuities primarily on three points. First, the IRS asserted that the transfers were disguised gifts because the decedent had declining health and did not actually outlive the 10-year deferral period. Therefore, the value of the private annuities should not have been based on the IRS’s actuarial tables. The Tax Court disagreed for a number of reasons. The court found that the decedent and her children reasonably expected her to live through the life expectancy determined under the tables. It also found that use of the IRS’s actuarial tables is proper unless an individual is terminally ill. Under Regs. Sec. 1.7520-3(b)(3), an individual is terminally ill if she has an incurable illness or other deteriorating physical condition with at least a 50% probability of death within a year, but if the individual survives for 18 months or longer, the individual is presumed to be not terminally ill unless the contrary is established by clear and convincing evidence. Finally, the court noted that the decedent’s doctor executed a written statement that he believed that, at the age of 75, the decedent was not terminally ill.
Second, the IRS asserted that the transfers were illusory. The Tax Court’s analysis focused on whether the transfers for the private annuities were bona fide transfers for full and adequate consideration—an analysis usually used for estate tax purposes under Secs. 2036 through 2038, even though this was a gift tax case. The court determined that the private annuity agreements between the decedent and her children were enforceable, that the parties demonstrated their intentions to comply with their terms, and that the decedent demonstrated that she expected to receive the payments. The court also found that the decedent’s profit motive was underscored by her access to other financial assets, making her interests in GP dispensable and available for a potentially risky investment. For these reasons, along with the fact that the decedent was independently wealthy and possessed sophisticated business acumen, the court determined that the private annuity transactions were bona fide sales for adequate and full consideration.
Third, the IRS asserted that the private annuities lacked economic substance. The Tax Court concluded that the transactions had economic substance for the same reasons the transactions were bona fide sales for adequate and full consideration.
Thus, the Tax Court held that the private annuity transactions were valid and not a taxable gift, in what may be the first case deciding the validity of a deferred private annuity transaction. In theory, a deferred private annuity could be structured so that it is deferred for up to two years prior to the life expectancy of the annuitant (at least two payments are required to have an annuity). If the client is relatively healthy, this could provide a windfall to a decedent’s heirs. However, if the individual is too healthy, these payments could end up being a reverse estate plan where more assets end up in the older generation’s estate.
Kite illustrates some imaginative inter vivos planning that may be done with trusts that qualified for the marital deduction in the first-to-die spouse’s estate. The court’s affirmation of the deferred private annuity transaction serves to confirm that these transactions are valid and useful transactions for estate planning purposes.
Tax on Net Investment Income
Sec. 1411, added to the Code by the Health Care and Education Reconciliation Act of 2010, 9 and effective for tax years beginning after Dec. 31, 2012, imposes a tax on unearned income from investments of certain individuals, estates, and trusts whose income is above statutory threshold amounts. For an estate or trust, the tax is 3.8% of the lesser of the undistributed net investment income for the tax year, or the excess of the adjusted gross income (AGI) over the dollar amount at which the highest tax bracket in Sec. 1(e) begins for that tax year ($11,950 for 2013). Proposed regulations were issued on Dec. 5, 2012. 10
Trusts, which are required to use the calendar year, were subject to the Sec. 1411 tax for tax years beginning Jan. 1, 2013. Estates and qualified revocable trusts that elect to be treated as part of the estate under Sec. 645 may choose a fiscal year. To postpone the imposition of the Sec. 1411 tax, these entities should choose a tax year ending Nov. 30, so that the Sec. 1411 tax would first apply to tax years beginning Dec. 1, 2013.
The Sec. 1411 tax applies to regular trusts, including pooled income funds, cemetery perpetual care funds, qualified funeral trusts, and Alaska Native Settlement Trusts, but the regulation preamble requested comments on whether these trusts should be excluded. The AICPA has recommended 11 that all four of these types of trusts be excluded from the Sec. 1411 tax.
Business trusts that are classified as business entities, Sec. 584 common trust funds, and Sec. 468B designated settlement funds are not subject to the Sec. 1411 tax at the entity level. The Sec. 1411 tax also does not apply to any trust or fund exempt from income tax, including wholly charitable trusts and qualified plans. Although the tax does not apply to a charitable remainder trust at the entity level, distributions to the annuity or unitrust recipient are considered net investment income to the recipient.
Foreign estates and foreign nongrantor trusts are generally not subject to the Sec. 1411 tax. To the extent that the foreign trust or estate distributes net investment income currently to a U.S. beneficiary, the beneficiary takes this net investment income into account along with that beneficiary’s net investment income from other sources. The preamble to the proposed regulations asked for comments on how Sec. 1411 should apply to net investment income earned by a foreign trust or estate and accumulated for the benefit of a U.S. beneficiary. Issues include whether the foreign trust or estate should be subject to the Sec. 1411 tax currently on its undistributed net investment income and whether an accumulation distribution should be considered to retain its character as net investment income in the hands of the U.S. beneficiary when distributed, even though generally an accumulation distribution does not retain its tax character.
The net investment income of a grantor trust is taken into account by the grantor or other person who is considered the deemed owner of the trust along with that person’s net investment income from other sources.
Net investment income includes interest, dividends, royalties, and rents. Net investment income also includes any income derived in the ordinary course of a trade or business, if the trade or business is a passive activity (within the meaning of Sec. 469) for the taxpayer, and any income derived from a trade or business of trading in financial instruments or commodities (as defined in Sec. 475(e)(2)). Net investment income also includes net gain attributable to the disposition of property other than property held in a trade or business that is not a passive activity and not trading in financial instruments or commodities. Deductions allowed for income tax that are properly allocable to gross income or net gain are deductible in arriving at net investment income. For a trust or estate, the need to determine whether there is material participation in a trade or business owned directly or indirectly by the trust or estate will put renewed emphasis on an area for which there have been no regulations for the 27 years during which Sec. 469 has applied to losses incurred by these entities. 12
Undistributed net investment income is the trust’s or estate’s net investment income less the share of the net investment income treated as distributed to the beneficiaries under Sec. 651 or Sec. 661 and the share of net investment income allocated to the Sec. 642(c) charitable deduction. When a trust or estate has both net investment income and non-net investment income, the amount of net investment income treated as distributed to the beneficiaries and to charity must be allocated pro rata between the two types of income in a manner similar to the distribution deduction rules under Regs. Sec. 1.661(b)-1 and the charitable deduction rules under Regs. Sec. 1.642(c)-2(b).
Prop. Regs. Sec. 1.1411-3(f) provides examples of these rules. Be aware that Examples 1 and 2 reduce the trust’s distributable net income (DNI) by the amount of the individual retirement account (IRA) distribution allocated to principal under applicable local law. This is incorrect because whether an item of income (other than capital gain) is allocated to income or principal for fiduciary accounting purposes is irrelevant in determining the trust’s DNI. Sec. 643(a) provides that DNI is the taxable income of the estate or trust generally reduced by capital gains under Sec. 643(a)(3). The fact that a portion of the IRA distribution is allocated to principal for fiduciary accounting purposes has no effect on the computation of DNI.
Generally, trust capital gains are allocated to corpus for fiduciary accounting purposes and are deducted in computing the trust’s DNI. As a result, the trust, not the beneficiaries, is generally taxed on the capital gains. Regs. Sec. 1.643(a)-3(b) provides the rules for when capital gains allocated to corpus are included in DNI: capital gains are included in DNI to the extent they are, under the governing instrument and local law, or under the fiduciary’s reasonable and impartial exercise of discretion, allocated to corpus but treated consistently by the fiduciary on the trust’s books, records, and tax returns as part of a distribution to a beneficiary. The low threshold on adjusted gross income before Sec. 1411 applies to trusts may cause trustees to use this provision to treat distributions in excess of trust accounting income as distributions of capital gains.
The trust’s or estate’s AGI is computed similarly to the AGI of an individual, with certain additional deductions: for the personal exemption, the amount of DNI distributed to the beneficiaries under Sec. 651 or 661, and the costs the estate or trust paid or incurred that would not have been incurred if the property were not held by the trust or estate. For estates and trusts whose income is all net investment income and that make no distributions to beneficiaries during the year, the 3.8% tax will be applied to AGI reduced by the threshold amount of $11,950 for 2013. As a result, the correct determination of AGI will be important to those entities.
As previously mentioned, the Sec. 1411 tax does not apply to charitable remainder trusts at the entity level. The proposed regulations require that a distribution to an annuity or unitrust recipient be considered first to come from net investment income (current and accumulated) before applying the normal ordering rules of Sec. 664(b) and Regs. Sec. 1.664-1(d)(1). The preamble to the proposed regulations states that this is an easier method than applying the normal ordering rules. The proposed regulations are in conflict with Sec. 664, and it is unclear how there is authority to override the statute. It is unusual for the rules contained in Sec. 664 and the regulations to be overruled by a rule buried in the Sec. 1411 regulations. If this is just a rule to determine the character of the distribution to compute the Sec. 1411 tax and the normal rules apply to compute the regular income tax on the distribution, this rule would be anything but simple. In any event, the proposed regulations provide that net investment income includes only income that is received by the trust after Dec. 31, 2012, so that items that would be net investment income received and accumulated before 2013 will not be net investment income when distributed after 2012.
The 3.8% tax is added to the 39.6% tax on ordinary income and the 20% tax on capital gains for trusts with retained income in excess of $11,950 for 2013. It applies to beneficiaries with modified AGI over $250,000 for a married couple and $200,000 for an individual. The highest individual tax rate of 39.6% applies only after the married couple’s taxable income exceeds $450,000 or the single individual’s taxable income exceeds $400,000. Trustees may want to minimize these high tax rates on trusts. For discretionary trusts, trustees should consider making distributions to beneficiaries to take advantage of the lower tax rates for those individual beneficiaries who are not themselves subject to the highest tax rates. In addition, investments that generate tax-exempt income will now be more attractive for trusts. If possible, a trust should try to materially participate in any trade or business that it owns either directly or through a passthrough entity so the income will not be net investment income.
For losses from a trade or business to be fully deductible, Sec. 469 requires that a taxpayer must “materially participate” in the trade or business so that the taxpayer’s involvement in the activity is “regular, continuous, and substantial.” 13 The passive activity rules contained in Sec. 469 have long been a problem for fiduciaries and beneficiaries of trusts and estates, particularly the material participation requirements, mainly because of the lack of guidance. Temp. Regs. Sec. 1.469-5T(g) was reserved for regulations applying the material participation requirement to trusts and estates, but the regulations project was never completed and was closed.
In Mattie K. Carter Trust, 14 the District Court determined that the activities of a trust (through its trustee, employees, and agents) in a ranch it owned met the material participation requirement of Sec. 469. The IRS took the position that only the activities of the fiduciaries (i.e., the trustees) should be considered in determining whether a trust had met the material participation requirement, based on a statement in the legislative history: “An estate or trust is treated as materially participating in an activity . . . if an executor or fiduciary, in his capacity as such, is so participating.” 15 The court stated that it had studied the “snippet of legislative history” the IRS supplied that purports to lend insight on congressional intent. The court explained, however, that legislative history is important only where the statutory language is unclear, and it determined that there was no statutory ambiguity here. The court found that the trust was the taxpayer, and when the trust’s activities were taken into account (including the activities of its trustees, employees, and third-party agents), it was a material participant in the business.
In Technical Advice Memorandum (TAM) 200733023, 16 the IRS stated that it disagreed with the Carter Trust case and reasserted its position that only the activities of the fiduciaries of a trust may be considered in determining whether a trust has met the material participation requirement. In the TAM, the trustees appointed “special trustees” to assist in operating the business the trust owned. The IRS equated the special trustees to employees and determined that their activities did not equate to activities performed by the trustees of the trust. In Letter Ruling 201029014, 17 the IRS concluded that a trust materially participates if the trustee is involved in the operations of the business on a regular, continuous, and substantial basis. The ruling cites, as authority, the above-quoted sentence from the legislative history. The ruling does not mention the Carter Trust case or that the District Court summarily dismissed this “snippet of legislative history.”
The IRS recently restated its position on this issue in TAM 201317010. 18 In the memorandum, a couple created two trusts for the benefit of their children and lineal descendants that own stock of X , an S corporation. One of the children, A , owned the remaining stock of X , which owned a qualified subchapter S subsidiary, Y . The child served as the special trustee of both trusts, having control over the activities related to X ’s common stock that the trusts owned. As special trustee, A had the power to make all decisions on the sale, retention, and voting of X ’ s common stock, but no other fiduciary powers. A was also Y ’ s president and was involved in the day-to-day operations of its trade or business activities. B , another child who served as the trustee of both trusts, was not involved in the operations of the relevant activities of X or Y on a regular, continuous, and substantial basis.
The IRS examining agent argued that the trusts did not materially participate in X’s activities because only the activities A and B performed in their capacity as fiduciaries of the trusts should be taken into account. In addition, the agent asserted that A’s time spent serving as the president of Y did not count toward the material participation requirement because A was not performing those activities as a trustee of the trusts. The agent pointed out that the trust agreements limited A’s powers to certain delineated acts and A did not have unlimited discretionary authority to bind the trusts to any course of action without B’s consent.
The taxpayers argued that A’s involvement in Y’s activities should be considered for purposes of determining whether the trusts materially participated in X’s and Y’s activities. The taxpayers argued that A’s roles as president, individual shareholder, and special trustee were interrelated, that it was impossible to differentiate A’s time in each different capacity in which A served, and that A was fulfilling his obligations for those roles simultaneously. Therefore, the taxpayers argued that A’s total time spent involved in the operations of X and Y should count toward meeting the material participation requirements of Sec. 469(h)(1).
Because A’s powers as special trustee were restricted by the trust agreements, the IRS determined that A lacked the power to commit the trusts to any course of action or to control trust property beyond selling or voting the stock. The IRS also determined that A’s work as president of Y was performed as an employee of the S corporation and not in A’s fiduciary role. Thus, A’s activities as president did not count in determining whether the trusts materially participated in X’s and Y’s trade or business activities. Additionally, the IRS concluded that A’s time spent serving as a special trustee would count for purposes of determining the trusts’ material participation, but A’s time spent performing the special trustee’s functions were not regular, continuous, and substantial.
The determination of whether a trust or estate materially participates in an activity has much greater importance now because it determines whether income from a trade or business will be subject to the net investment income tax. The IRS’s position that the 500-hour and other quantitative tests for material participation that apply to individuals do not apply to nongrantor trusts may make it more difficult for trustees of nongrantor trusts to meet the regular, continuous, and substantial standard of Sec. 469(h)(1) if the participation that counts is limited solely to that undertaken in the trustees’ fiduciary capacity. The law in this area will probably continue to develop.
As this body of law develops, despite the IRS’s position, Mattie K. Carter Trust is still good law and should be considered when determining whether a trust meets the material participation standard—the activities of its trustees, employees, and agents of the trust may be taken into account. However, in that decision, the employees were directly employed by the trust, not by the entity in which the trust held an interest. The IRS can be expected to challenge taxpayers who take the position that a nongrantor trust meets the material participation standard based upon the activities of persons other than the trust’s fiduciaries.
Purchase of Life Insurance
Estate planning with life insurance often involves the transfer of life insurance policies among related parties. In many instances, taxpayers transfer the ownership of existing policies to trusts to prevent the policy proceeds from being included in the gross estate of the insured. However, when transferring these policies either by purchase or by gift, there are many income, gift, and estate tax rules that must be satisfied to prevent unintended tax consequences. Letter Ruling 201235006 19 illustrates a successful navigation of these rules.
In the ruling, the taxpayer’s parents created an irrevocable, nongrantor trust (Trust A) for the taxpayer’s primary benefit. During the taxpayer’s life, the trustee had the discretion to make distributions to the taxpayer and her descendants for their health, education, maintenance, and support (HEMS). Upon the taxpayer’s death, Trust A would terminate, and its remaining assets would be distributed to the taxpayer’s descendants. The taxpayer created an irrevocable, grantor trust (Trust B) for her descendants’ benefit. During the taxpayer’s life, the trustees could make distributions to the taxpayer’s descendants for their HEMS, and trustees with no interest in the trust had absolute discretion to make distributions from the trust to the taxpayer’s descendants. Trust B would terminate upon the taxpayer’s death, and the remaining assets were to be distributed to the taxpayer’s descendants. As to additions to Trust B, the trust agreement gave the beneficiaries of the trust the power to withdraw those additions up to the amount of the gift tax annual exclusion.
Trust A owned a life insurance policy on the taxpayer’s life. The letter ruling states that Trust A intended to sell its interest in the policy to Trust B for an amount equal to the policy’s interpolated terminal reserve value (as described in Regs. Sec. 25.2512-6(a)) on the date of the transfer. The taxpayer would fund Trust B with an amount necessary to purchase the policy from Trust B.
The taxpayer first asked the IRS to rule that Trust B was the taxpayer’s grantor trust and no part of Trust B was the taxpayer’s daughter’s grantor trust (the daughter was a beneficiary and a trustee of Trust B). The IRS ruled that Trust B’s governing instrument authorized the taxpayer to reacquire trust property by substituting other property of an equivalent value in a nonfiduciary power (a substitution power)—a power that would treat Trust B as a grantor trust as to the taxpayer under Sec. 675(4)(C). As is the case with rulings by the IRS in this area, the IRS declined to rule on whether the power held by the taxpayer was exercised in a nonfiduciary capacity as such a determination is a question of fact to be determined after the filing of the income tax returns of the parties involved. As to the withdrawal right held by the taxpayer’s daughter, the IRS ruled that, under Sec. 678(a) those rights would result in the beneficiaries being treated as owners of the portions of Trust B subject to their respective withdrawal powers, unless, as provided in Sec. 678(b), the grantor was treated as the owner. The IRS noted that if Trust B is a grantor trust under Sec. 675(4) with respect to the taxpayer, it is a grantor trust in its entirety with respect to the taxpayer notwithstanding the withdrawal rights the beneficiaries held that would otherwise make them owners under Sec. 678(a).
Second, the taxpayer asked the IRS to rule that the sale of the life insurance policy by Trust A to Trust B would not trigger the transfer-for-value rule in Sec. 101(a)(2) and, thus, the proceeds would not be subject to income tax upon the taxpayer’s death. An exception to the transfer-for-value rule is provided in Sec. 101(a)(2)(B) when the life insurance policy is transferred to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer. Because Trust B was a grantor trust (and, thus, assets in the trust were treated as owned by the taxpayer), the IRS ruled that the transfer of the life insurance policy to Trust B did not trigger the transfer-for-value rule due to the exception in Sec. 101(a)(2)(B) (i.e., the policy was transferred to the insured).
Third, the taxpayer asked the IRS to rule that the taxpayer’s substitution power would not be considered an incidence of ownership in the life insurance policy under Sec. 2042(2), which would require it to be includible in the taxpayer’s gross estate for estate tax purposes. The IRS ruled in Rev. Rul. 2011-28 20 that a substitution power under Sec. 675(4)(C) would not be an incidence of ownership under Sec. 2042(2) as long as the substituted property and the trust property were of an equivalent value and under local law the trustee had a fiduciary duty to ensure that the properties were of equivalent value. Because these requirements were met in this case, the IRS ruled that the taxpayer’s substitution power would not result in the taxpayer possessing incidents of ownership in the life insurance policy that would cause it to be included in the taxpayer’s gross estate.
Finally, the taxpayer asked the IRS to rule that the principal of Trust B would not be includible in the taxpayer’s gross estate under Sec. 2033 (inclusion in gross estate of all interests in property), Sec. 2036 (inclusion in gross estate of transfers with a retained life estate), and Sec. 2038 (inclusion in gross estate of revocable transfers)—the focus being on the taxpayer’s substitution power. The IRS ruled that Trust B’s principal would not be included in the taxpayer’s gross estate because the taxpayer’s circumstances mirrored the circumstances in Rev. Rul. 2008-22, 21 in which the IRS held that a power to substitute assets would not cause estate tax inclusion under Secs. 2033, 2036, and 2038 based on the same requirements set forth in Rev. Rul. 2011-28.
In Letter Rulings 201310002 through 201310006, 22 the IRS ruled that a trust grantor may make an incomplete gift to a nongrantor trust, a type of trust that is commonly referred to as a Delaware incomplete nongrantor (DING) trust. These rulings represent the IRS’s first commentary on this type of trust in almost six years since Letter Ruling 200729025 23 was issued. The significance of these rulings is to reduce some of the uncertainty regarding the IRS’s willingness to grant ruling requests for this type of trust.
Historically, DING trusts were designed to minimize or eliminate state income tax. In a typical arrangement, a person in a state that imposes an income tax will transfer assets (in most instances, investment assets) to a trust situated in a state that does not impose a state income tax or that does not tax the accumulation of income in a trust (e.g., Delaware). To the extent no distributions are made to beneficiaries of the trust (which generally include the grantor), no current state income tax will be payable on income earned by the trust.
In the letter ruling, an individual (the Grantor) created irrevocable trusts (the Trusts) for the benefit of himself, his four sons, and their heirs. A corporate trustee (the Trustee) was the sole trustee of each Trust. During the Grantor’s lifetime, the Trustee was required to distribute the Trusts’ net income and principal to the Grantor or his heirs as directed by the Distribution Committee and/or the Grantor, pursuant to the following powers:
- Distribute specific amounts of income or principal to the Grantor or his heirs upon direction of a majority of the Distribution Committee members and the written consent of the Grantor (the Grantor’s Consent Power);
- Distribute specific amounts of income or principal to the Grantor or his heirs upon direction of all members of the Distribution Committee (the Unanimous Committee Power); or
- Distribute specific amounts (or all) of the principal to the Grantor’s heirs in the Grantor’s nonfiduciary capacity as the Grantor deems advisable to provide for the heirs’ HEMS (the Grantor’s Sole Power).
The Distribution Committee was allowed to direct that distributions be made equally or unequally to beneficiaries and to or for the benefit of any one or more of the beneficiaries of the Trusts to the exclusion of the other beneficiaries.
The Distribution Committee was initially composed of the Grantor and his four sons and was required at all times to consist of at least two “Eligible Individuals,” which was defined as a member of the class consisting of the adult issue of the Grantor, the parent of a minor issue of the Grantor, and the legal guardian of a minor issue of the Grantor. If there were fewer than two Eligible Individual members of the Distribution Committee, the committee was deemed not to exist. The Distribution Committee would cease to exist upon the Grantor’s death.
Upon the Grantor’s death, each Trustee was required to distribute any remaining trust assets as the Grantor directed in his will, except that no such distribution was allowed to be made to the Grantor’s estate, the Grantor’s creditors, or the creditors of the Grantor’s estate (i.e., a testamentary limited power of appointment). If the Grantor did not exercise his testamentary limited power of appointment, each Trustee was required to distribute the remaining trust property to the Grantor’s then living issue in further trust, per stirpes.
Without much analysis, the IRS determined that under the terms of the trust agreements the Grantor was not treated as the owner of the Trusts under Sec. 673 (reversionary interests in property), Sec. 674 (power to control beneficial enjoyment), Sec. 676 (power of revocation), and Sec. 677 (benefits retained by grantor). As is generally the case, the IRS refused to rule on the application of Sec. 675 (a settlor’s administrative powers) as it deems the applicability of Sec. 675 a question of fact—the determination of which must be deferred until the income tax returns of the parties involved have been examined by the IRS.
The IRS also found that the members of the Distribution Committee could not be deemed owners of the Trusts under Sec. 678 because no member had a power exercisable solely by himself to vest income or corpus of any Trust in him. Thus, the IRS ruled that the trust agreements did not create a grantor trust as to the Grantor or members of the Distribution Committee.
The IRS concluded that the Grantor’s contributions of property to each Trust would constitute completed gifts subject to federal gift tax only if, upon contribution, the Grantor relinquished all dominion and control over the contributed property. In determining whether the Grantor had made a completed gift, the IRS looked to Regs. Sec. 25.2511-2 and the Supreme Court’s decision in Estate of Sanford 24 for guidance, focusing on the Grantor’s three powers to effect distributions from each Trust.
Because of the Grantor’s Sole Power, the IRS found that the Grantor could change the interests of the beneficiaries. Therefore, the IRS determined that the retention of this power caused the property’s transfer to the Trusts to be wholly incomplete for gift tax purposes.
Under Regs. Sec. 25.2511-2(e), a donor is considered to have a power if it is exercisable by him in conjunction with any person not having a substan tial adverse interest in the disposition of the transferred property or the income therefrom. Under Regs. Sec. 25.2514-3(b)(2), a co-holder of a power is considered as having an adverse interest only when he may possess the power after the possessor’s death and may exercise it at that time in favor of himself, his estate, his creditors, or his estate’s creditors. The IRS found that the members of the Distribution Committee were not takers in default—they were merely co-holders, and they could not possess the power after the Grantor’s death because the Distribution Committee ceased upon the Grantor’s death. Therefore, the IRS determined that the members of the Distribution Committee did not have adverse interests to the Grantor and ruled that the Grantor’s Consent Power caused the transfers of property to the Trusts to be wholly incomplete for gift tax purposes.
Further supporting this conclusion was the fact that the Grantor also retained a limited testamentary power of appointment. The IRS explained that, under Regs. Sec. 25.2511-2, the retention of the power to appoint the remainder of each Trust was considered the retention of dominion and control over trust property. Accordingly, it ruled that retaining this power also caused the transfer of property to the Trusts to be wholly incomplete with respect to the remainder in the Trust for gift tax purposes.
As to whether the Distribution Committee’s Unanimous Committee Power might make the transfer of property to each Trust complete (although a member of the Distribution Committee, the Grantor was excluded from the exercise of this power), the IRS determined that the power was not a condition precedent to the powers held by the Grantor. Until the Distribution Committee members took that action, the Grantor retained all powers over the trust property. Accordingly, the IRS ruled that the Unanimous Committee Power did not serve to limit the Grantor’s power and, therefore, did not alter the incomplete nature of the transfers.
Because the Grantor’s original transfers to the Trusts were incomplete gifts, the IRS found that any distributions to the Grantor were not gifts but a return of the Grantor’s property and that, upon the Grantor’s death, the property in the Trusts would be includible in the Grantor’s gross estate for federal estate tax purposes. Thus, the IRS ruled that distributions to the Grantor would not be a gift by any member of the Distribution Committee.
Because the Grantor created each Trust without the involvement of others, the key to determining whether the exercise of the Unanimous Committee Power or the Grantor’s Consent Power would treat members of the Distribution Committee as having made completed gifts subject to gift tax to other beneficiaries was whether the powers were general powers of appointment under Sec. 2514.
The Grantor’s Consent Power was exercisable by the Distribution Committee only in conjunction with the Grantor, who created the power. Because under Sec. 2514(c)(3)(A) a power exercisable only in conjunction with the creator of the power is not a general power of appointment, the IRS ruled that the members of the Distribution Committee did not possess general powers of appointment on account of the Grantor’s consent power.
The IRS determined that the Unanimous Committee Power was a power that permitted the members of the Distribution Committee to make distributions of property to which they had substantial adverse interests. Because under Sec. 2514(c)(3)(B) a power not exercisable except in conjunction with a person having a substantial interest in the property that is adverse to the exercise of the power in favor of the possessor is not a general power of appointment, the IRS ruled that the members of the Distribution Committee did not possess general powers of appointment on account of their Unanimous Committee Power. Therefore, the IRS concluded that all distributions of property as directed by the Distribution Committee were not completed gifts by any member of the Distribution Committee, but were completed gifts by the Grantor to a receiving beneficiary.
In 2007, the IRS announced it was reconsidering a series of letter rulings (of which Letter Ruling 200729025 was the last) as to whether beneficiaries of a trust who direct distributions of a trust had general powers of appointment. 25 The IRS said it was considering whether its rulings regarding the application of Sec. 2514 were consistent with Rev. Rul. 76-503 26 and Rev. Rul. 77-158. 27 These revenue rulings involved the estate counterpart to Sec. 2514 (Sec. 2041) and indicate that because the committee members are replaced if they resign or die, they would be treated as possessing general powers of appointment over the trust corpus. The announcement noted that a distinguishing fact in the letter rulings may be that the grantor’s gift to the trust is incomplete since the grantor retains a testamentary limited power of appointment. The issuance of the current letter ruling indicates that the IRS may no longer be concerned about this particular issue—or at least that it is still willing to rule on these types of trusts.
With the new net investment income tax, practitioners may begin to see interest in DING trusts from a federal planning perspective. Most often the gift of assets into a trust that is incomplete for gift tax purposes also results in a grantor trust for income tax purposes. For purposes of Sec. 1411, when a grantor trust owns an interest in a trade or business activity (e.g., stock in an S corporation), material participation will be determined by looking at the trust grantor. If a grantor will not be a material participant in a trade or business activity, but would still like to have any transfer treated as an incomplete gift, using a DING trust would shift the determination of material participation away from the grantor to the activities of the trustees where the material participation threshold might be met.
In Letter Ruling 201243001, 28 the IRS considered whether a court-ordered reformation of a trust agreement would be respected for federal transfer-tax purposes. In the letter ruling, a revocable trust created by a couple provided that upon the death of the first spouse the trust would be divided into a credit shelter trust and a revocable trust (Trust 2). Trust 2 provided that upon the death of the last spouse to die x% of the trust would pass outright to the couple’s son. After the death of her husband, the decedent and the son consulted with an attorney to amend Trust 2. The amendment provided that if the son disclaimed x%, the amount disclaimed would pass to another trust (Trust 3) of which the son and his descendants were the beneficiaries. Under the terms of Trust 3, the trustee could distribute to the son and his descendants so much of the income and principal as needed for the beneficiaries’ HEMS. The trust would terminate upon the son’s death, and the assets would be distributed to the son’s descendants.
More than a year after the decedent’s death, the son in his capacity as trustee petitioned the local court to reform the provisions of Trust 2 retroactively as of the date of the decedent’s death. Under the court-ordered reformation effected as of the date of the decedent’s death, x % of the trust would be distributed to Trust 3, contingent upon the taxpayers receiving a favorable ruling from the IRS. The court considered evidence that the decedent wanted the assets to pass to a trust in which the son would have a beneficial interest but would not be includible in the son’s estate for transfer-tax purposes. The attorney had suggested this could be accomplished by use of a disclaimer and amended Trust 2 accordingly. After the decedent’s death, the attorney became aware that a disclaimer was not a qualified disclaimer if the disclaimed property passes to a trust for the benefit of the person making the disclaimer unless the person making the disclaimer is the spouse of the grantor. 29
In the ruling request, the taxpayer took the position that the amendment to Trust 2 created an ambiguity or a scrivener’s error due to a mistake of law or fact and, accordingly, the reformation should be recognized retroactively for federal tax purposes. The IRS found that the reformation of a trust by a state trial court would be recognized for federal tax purposes only if it was consistent with state law as applied by the highest court in the state. After reviewing the applicable law, the IRS concluded that the reformation of Trust 2 by the state trial court did not meet this standard. Thus, the IRS ruled that the reformation would not be recognized retroactively for transfer-tax purposes.
Annual Inflation Adjustments
The IRS released Rev. Proc. 2012-41 30 and Rev. Proc. 2013-15 31 setting forth inflation adjustments for various tax items for 2013. The following is a list of items that may be of interest to estate planning professionals serving individual clients:
- Unified credit against estate tax. For an estate of any decedent dying during calendar year 2013, the basic exclusion amount is $5.25 million for determining the amount of the unified credit against estate tax under Sec. 2010. This is also the amount of the gift tax exemption and the GST tax exemption.
- Valuation of qualified real property in decedent’s gross estate. For the estate of a decedent dying in calendar year 2013, if the executor elects to use the special-use valuation method under Sec. 2032A for qualified real property, the aggregate decrease in the value of the qualified real property resulting from electing to use Sec. 2032A cannot exceed $1,070,000.
- Gift tax annual exclusion. The gift tax annual exclusion for gifts of a present interest increases to $14,000 beginning in 2013. The gift tax annual exclusion for gifts of a present interest to a spouse who is not a U.S. citizen is $143,000.
- Interest on a certain portion of the estate tax payable in installments. For an estate of a decedent dying in 2013, the dollar amount used to determine the “2-percent portion” (for purposes of calculating interest under Sec. 6601(j)) of the estate tax extended as provided in Sec. 6166 is $1,430,000.
Authors’ note: The authors thank Ben Wright, Justin Lynch, and Ashley Weyenberg in the Personal Financial Services group in the National Tax Department of Ernst & Young LLP for their contributions to this article.
1 American Taxpayer Relief Act of 2012, P.L. 112-240.
2 Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16.
3 Jobs and Growth Tax Relief Reconciliation Act of 2003, P.L. 108-57.
4 Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312.
5 Estate of Wimmer, T.C. Memo. 2012-157.
6 Hackl, 118 T.C. 279 (2002), aff’d, 335 F.3d 664 (7th Cir. 2003).
7 IRS Letter Ruling 201250001 (8/10/12).
8 Estate of Kite, T.C. Memo. 2013-43.
9 Health Care and Education Reconciliation Act of 2010, P.L. 111-152.
10 REG-130507-11, 77 Fed. Reg.72612 (12/5/12).
12 See discussion of the next issue in this article.
13 Sec. 469(h)(1).
14 Mattie K. Carter Trust, 256 F. Supp. 2d 536 (N.D. Tex. 2003).
15 S. Rep’t No. 99-313, 99th Cong., 2d Sess. 735 (May 26, 1986).
16 IRS Technical Advice Memorandum 200733023 (8/27/07).
17 IRS Letter Ruling 201029014 (7/23/10).
18 IRS Technical Advice Memorandum 201317010 4/26/13).
19 IRS Letter Ruling 201235006 (2/27/12).
20 Rev. Rul. 2011-28, 2011-49 I.R.B. 830.
21 Rev. Rul. 2008-22, 2008-1 C.B. 796.
22 IRS Letter Rulings 201310002 through 201310006 (11/7/12).
23 IRS Letter Ruling 200729025 (4/10/07).
24 Estate of Sanford, 308 U.S. 39 (1939).
25 IRS News Release IR-2007-127 (7/9/07).
26 Rev. Rul. 76-503, 1976-2 C.B. 275.
27 Rev. Rul. 77-158, 1977-1 C.B. 285.
28 IRS Letter Ruling 201243001 (10/26/12).
29 See Sec. 2518(b)(4).
30 Rev. Proc. 2012-41, 2012-45 I.R.B. 539.
31 Rev. Proc. 2013-15, 2013-5 I.R.B. 444.
Justin Ransome is a partner in the National Tax Department of Ernst & Young LLP in Washington, D.C. Frances Schafer is a retired managing director at Grant Thornton LLP. For more information about this article contact Mr. Ransome at firstname.lastname@example.org or Ms. Schafer at email@example.com.