Significant Recent Developments in Estate Planning

By Justin P. Ransome, J.D., MBA, CPA; and Vinu Satchit, CPA

Executive Summary

  • Both the Pension Protection Act of 2006 and the Tax Relief and Health Care Act of 2006 included changes significant for estate planners.
  • In Rosen, the Tax Court analyzed the factors needed to evidence a true debtor-creditor relationship between an FLP and a decedent.
  • The Service proposed regulations providing guidance under Sec. 2053 on the extent to which post-death events may be considered in determining a taxable estate’s value.
  • By agreeing to review the Second Circuit’s decision in Rudkin, the Supreme Court will resolve the issue of whether investment advisory fees paid to outside advisers are fully deductible by a trust.

This article examines developments in estate and gift tax planning and compliance between June 2006 and May 2007. It discusses legislative developments, cases and rulings, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) changes taking place in 2007, and the annual inflation adjustments for 2007 relevant to estate and gift tax.

Legislative Developments

Major tax legislation signed by President Bush includes the Pension Protection Act of 2006 (PPA ’06) and the Tax Relief and Health Care Act of 2006 (TRAHCA ’06). The major changes in these acts that are of significance to estate planners are as follows:

UBTI and Charitable Remainder Trusts

In general, a charitable remainder trust (CRT) that meets the requirements set forth in Sec. 664 is a tax-exempt entity. This exempt status, however, is lost in any year in which a CRT has unrelated business taxable income (UBTI). If a CRT has UBTI, the CRT is treated as a complex trust (described in Sec. 661) and is taxed on its net income for the year. TRAHCA amends Sec. 664 to provide that a CRT does not lose its tax-exempt status in a year in which it has UBTI. Instead, a CRT must pay a 100% excise tax on any UBTI it may have in a given year.

For many years, practitioners advocated for a change in the law that caused a CRT to lose its exempt status due to its having UBTI, because of the potential double tax on the CRT’s income for a particular year in which such status was lost. The amendment accomplishes this purpose with regard to income that is not UBTI. However, the amendment continues to impose a double tax on UBTI, as the excise tax paid by a CRT on its UBTI is allocated to corpus. The amendment is effective for tax years beginning after December 31, 2006. (For more on this issue, see Tax Clinic, p. 500.)

Employer-Owned Life Insurance

Life insurance proceeds are generally excluded from a recipient’s gross income. PPA ’06 added Sec. 101(j), which provides that in the case of employer-owned life insurance contracts on the life of certain employees,1 the amount excluded from the applicable policyholder’s income as a death benefit cannot exceed the premiums and other amounts paid by the employer for the contract. The excess death benefit is included in income.

The provision, however, allows numerous exceptions. When new notice and consent requirements (discussed below) are met, the income-inclusion rule does not apply if the insured was an employee during the 12-month period before the insured’s death or, at the time the contract was issued, was a “highly compensated employee” or a “highly compensated individual.”2 In addition, the rules do not apply if the death benefits are paid to the insured’s family, any individual designated by the insured (or to trusts for the benefit of either), or the in-sured’s estate, or if the proceeds are used to purchase an equity interest in the company that owns the policy. The last exception should cover most buy-sell agreements.

The notice (by the employer) and consent (by the employee) requirements3 provide that before the issuance of the contract, the employee must be notified, in writing, that the employer intends to insure the employee’s life, the maximum face amount of the policy for which the employee could be insured, and that the employer will be the beneficiary of the policy. The employee must provide written consent to being insured and must agree that the employer may continue coverage even after the insured terminates employment.

Sec. 101(j) applies to contracts issued after August 17, 2006 (except for certain tax-free Sec. 1035 exchanges) and to preexisting policies with significant increases in death benefits after that date (this may commonly occur in buy-sell situations). The provision also adds new reporting requirements on the employer for contracts issued after that date (see Sec. 6039I(a)).

Valuation Penalties

PPA ’06 decreases the thresholds at which substantial or gross valuation misstatements occur. For returns filed after August 17, 2006, substantial valuation misstatement will apply if the value of any property claimed on the estate or gift tax return is 65% or less of the amount determined to be correct (up from 50% under prior law). Gross valuation misstatement will occur if the value of any property claimed on the estate or gift tax return is 40% or less of the amount determined to be correct (up from 25% under prior law).

Significant Cases and Rulings


The IRS has successfully argued for including assets transferred to family limited partnerships (FLPs) in a transferor’s gross estate under Sec. 2036(a)(1). Successful cases invariably have involved transferors (usually terminally ill or in poor health) who transferred almost all of their assets to an FLP, but still continued to enjoy access to the transferred property (or its income). One factor that the courts have found as indicative of continued access to the transferred assets is the transferor’s retention of insufficient assets to meet his or her living expenses after the transfer, coupled with substantial disbursements from the FLP to the transferor. What if the disbursements were classified as loans and evidenced by a written note? The Tax Court analyzed the factors required to evidence a true debtor-creditor relationship in Rosen. 4

Rosen: Rosen had all the typical facts of a successful Sec. 2036(a) case: an elderly decedent (age 88) suffering from a terminal illness (Alzheimer’s) at the time of the FLP’s formation; virtually all of the decedent’s assets transferred to the FLP; insufficient funds (less than 5% of total assets) retained by the transferor; and FLP disbursements to the transferor to pay for living expenses. However, the disbursements during the decedent’s lifetime were classified as loans and evidenced by a single note—unsecured, payable on demand, with interest accruing at the federal blended rate. On the decedent’s death (four years after the FLP’s formation), the IRS sought to include the entire value of the FLP’s assets in the decedent’s estate. The estate argued: (1) that the transfer met the bona-fide-sale exception, citing several nontax reasons (management of assets, creditor protection, ease of gifting); and, alternatively, (2) that even if the bona-fide-sale exception was not met, the decedent did not continue to “enjoy” the assets post-transfer, as any disbursements she received were the result not of distributions from the FLP but of loans—i.e., the clear obligation to pay back the amounts precluded a finding that she enjoyed the funds.

The court stated that, while a written note weighs toward a true debtor-creditor relationship, it was not sufficient to create a true debtor-creditor relationship. The other factors the court cited in determining if there was no genuine debt included: (1) the absence of a fixed maturity date and a fixed obligation to repay; (2) no reasonable (or market) interest rate; (3) repayments that depend solely on the FLP’s success; (4) absence of security; and (5) the inability to obtain comparable financing from an independent source.

Some factors used by the court to justify its conclusion that the bona-fide-sale exception did not apply are not only inconsistent with existing law, but also unnecessary to reach the intended result—that there was no bona-fide sale.

Kimbell: In Kimbell, 5 the Fifth Circuit rejected concepts such as “mere recycling,” “lack of legitimate negotiations,” “pooling of assets,” and “legitimate and significant business or nontax reasons” as essential to the bona-fide-sale exception inquiry because these tests placed undue emphasis on the taxpayer’s subjective motives. Instead, the court formulated a three-pronged test. While the third prong does scrutinize the transaction to make sure it is not a sham, the nature of the inquiry is limited to an examination of objective facts that would confirm or deny the taxpayer’s assertion that the transfer is bona fide. Thus, the presence of some potential benefit other than estate tax advantages should be sufficient to meet the third prong of the test, as long as there is no factual evidence of the retention of prohibited rights. The court in Rosen unnecessarily considered some of the rejected concepts (e.g., no legitimate business operations,6 no negotiations, and de minimis contributions by the children) to justify its conclusion that the bonafide-sale exception does not apply.

Korby: On December 8, 2006, the Eighth Circuit, in Korby,7 became the latest appeals court to confirm the application of Sec. 2036(a)(1) to FLPs (joining the First, Third, and Fifth Circuits). This is not surprising, given the “bad” facts in this case, which included taxpayers in poor health transferring virtually all of the assets to their FLP; commingling of personal and FLP property; and the FLP’s payment of not only substantial disbursements to the transferors, but also their living expenses directly. Unlike Rosen, in which the taxpayers purported that the disbursements were loans, the Korby estate claimed that the payments—which represented 27%–50% of FLP income per year—were management fees instead of distributions (despite the fact that there was no management agreement and the taxpayers did not include any of it as self-employment income for the first three years).


Stock Aggregation in Determining FMV

The IRS stated in a technical advice memorandum (TAM)8 that the stock owned outright by a decedent should be aggregated with the stock held in a trust (in which the decedent retained an income interest for life) in determining the fair market value (FMV) of all stock included in the decedent’s gross estate. The Service reasoned that, in view of the trust terms under which the decedent retained the right to receive trust income as well as to designate (among his descendants and a charity) the beneficiary of the trust remainder, the decedent’s transfers to the trust were wholly incomplete gifts.

In addition to the retained beneficial interest and dispositive power, the IRS noted that the decedent, as trustee, retained significant additional control over the trust corpus until death. The trustee possessed broad powers to allocate receipts and disbursements between principal and income; any such items allocated to income (such as sales proceeds) would be required under the trust to be distributed to the decedent. Further, trust assets could be registered in the name of an individual trustee. The Service noted that under the trust instrument, these powers could be exercised unilaterally by the decedent. Thus, the IRS concluded that the beneficial interest in and control over the stock did not pass from the decedent until the decedent’s death, at which time the decedent’s interest in and control over the trust terminated.

The Service ruled that the decedent’s retained interest in the trust and powers over trust corpus caused the trust’s corpus to be includible in the decedent’s gross estate under Secs. 2036 and 2038. As is the case with Sec. 2035, the IRS noted that Secs. 2036 and 2038 are intended to prevent estate tax avoidance by including in the gross estate transfers that are essentially testamentary in nature. Accordingly, it concluded that the rationale underlying Rev. Rul. 79-7 regarding inter vivos transfers includible in the gross estate under Sec. 2035 was equally applicable to inter vivos transfers includible in the gross estate under Secs. 2036 or 2038.

The Service distinguishes the facts in the TAM from those in Bonner 9 and Mellinger 10 (dealing with aggregation of qualified terminable interest property trusts with the income beneficiary’s estate), in which the decedent did not create the trust or control its disposition. In the TAM, the IRS noted that it was the decedent alone who created the trust, retained the beneficial enjoyment of the trust corpus, and retained the power, until death, to designate who would enjoy the trust remainder. It also noted that in Mellinger, in concluding that aggregation was not appropriate with respect to property subject to inclusion under Sec. 2044, the Tax Court contrasted property includible under Secs. 2035 and 2036.

Valuing S Corporation Stock

“Tax-affecting” is the practice of reducing projected S corporation earnings or cashflow by the projected shareholder-level income taxes on the S corporation’s earnings prior to applying a capitalization rate (on the assumption that the corporation will lose its S status). Proponents of this practice argue that a hypothetical buyer would take such taxes into account because the buyer will be taxed on the S corporation’s earnings regardless of whether it receives distributions. In Gross, 11 a split Sixth Circuit upheld a Tax Court decision that shareholders must value their S stock without tax affecting the S corporation’s income. The Tax Court revisited the issue in Dallas. 12

Dallas : In Dallas , the taxpayer produced two expert witnesses. One reduced the S corporation’s projected earnings by 40% for the taxes it was likely to pay if it lost its S status; the other reduced projected earnings by 35% for shareholder-level taxes on the S corporation income. Finding no evidence in the record that the corporation expected to lose its S status, the court rejected the first appraiser’s reduction. It also rejected the second appraiser’s adjustment because the corporation had a strong history of distributing sufficient earnings to the shareholders to cover their income tax liabilities.

Note: This area will continue to be controversial. Nevertheless, the two victories are bound to encourage the Service to challenge all valuations involving tax-affecting of S stock.

Importance of Quality Appraisals

The Tax Court has lately more often than not disregarded the valuations provided by qualified appraisers and substituted its own opinion as to the value of “hard to value” assets (i.e., assets for which market quotes are not readily ascertainable). In the transfer tax area, the court’s decision to interject its own determination of value presents a huge dilemma for estate planners and their clients, who rely on qualified appraisers to provide them with accurate valuations in order to make estate planning decisions.

Kohler 13 is one of those rare cases (given the Tax Court’s recent ten dency) in which the court determined that the taxpayer’s qualified appraisers had accurately determined the value of the decedent’s closely held stock. It also highlights the benefits of a qualified appraisal from a reputable and experienced appraiser.

In Kohler, the decedent was the grandson of the founder of Kohler Company. At the time of his death, the decedent owned approximately 13% of the company’s outstanding stock. Also at that time, Kohler was undergoing a reorganization designed to bring all of its stock under the control of the Kohler family and to ensure that the stock would remain under the family’s control. Under the reorganization plan (which was completed approximately two months after the decedent’s death), new classes of stock were issued, with varying restrictions on transferability and participation.

The decedent’s estate elected under Sec. 2032 to value the estate’s assets as of six months after the decedent’s death. As a result, the valuation of the estate’s stock in Kohler took into consideration the new restrictions resulting from the company’s reorganization. The decedent’s estate valued its Kohler stock at approximately $47 million (which included a 75% discount); the IRS valued the stock at $145 million (which included a 20% discount).

The Tax Court gave no weight to the appraisal on which the Service made its determination because it was based on a limited review of Kohler’s operations and the appraiser’s creditability. The court then reviewed the estate’s two expert appraisals and determined that they were creditable and were made with far lengthier review of Kohler’s business operations than that of the IRS’s appraiser.

Impact of Post-Death Events on Valuation

The Service has published proposed regulations (REG-143316-03) providing guidance under Sec. 2053 on the extent to which post-death events may be considered in determining a taxable estate’s value. Under Sec. 2053(a), that value 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 as to the extent to which post-death events are to be considered in valuing such claims. In general, the courts have vacillated between one line of cases that follows a date-of-death valuation approach and another that restricts deductible amounts to those amounts actually paid by the estate in satisfaction of the claim.

The proposed regulations indicate 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 proposed 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 proposed regulations also provide that an estate may file a protective claim for refund for some contested or contingent claims 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 proposed regulations also update provisions on the deduction for some state death taxes to reflect EGTRRA amendments to Secs. 2053(d) and 2058. These regulations apply to the estates of decedents dying on or after the date the final regulations are published in the Federal Register.

Basis of Inherited Property

In general, Sec. 1014 provides that the adjusted basis of property included in a decedent’s gross estate for estate tax purposes is the property’s FMV at the decedent’s date of death. Thus, regardless of the adjusted basis a decedent may have had in property prior to his or her death, Sec. 1014 allows the heir of such property to use its FMV at the decedent’s date of death to measure the gain or loss the heir must recognize on the property’s subsequent sale. In Janis, 14 the Second Circuit considered what is FMV for Sec. 1014 purposes.

The taxpayer inherited an undivided one-half interest in an art collection—consisting of 464 works by various artists—that was included in his father’s estate for estate tax purposes. In preparing the father’s estate tax return, the executor had each piece of art appraised separately and then as a collection. The FMV of the collection included a “blockage discount” of approximately 62% of the artworks’ cumulative value, under the theory that if the entire collection of art had been sold on the date of the father’s death, the estate would not have been able to command the same price as if it had placed each piece of art on the market separately.

The taxpayer subsequently sold certain pieces of the collection. In reporting the gain on the sale, the taxpayer used the artworks’ undiscounted FMVs as his adjusted basis, alleging that the theory underlying the blockage discount at the father’s death was inapplicable to the separately placed sale of the artworks. The Service assessed an income tax deficiency, alleging that the taxpayer’s adjusted basis in the art for gain or loss purposes was the value of such art as reflected on the father’s estate tax return (i.e., adjusted basis reflected the blockage discount).

The Second Circuit, affirming the Tax Court, held that FMV for Sec. 1014 purposes was the value of the property that appeared on the decedent’s estate tax return from which the property was transferred. In making its determination, the Second Circuit reasoned that Sec. 1014 prevents the double taxation of the appreciation in the value of property that occurred prior to death, noting that the estate tax taxes this unrealized capital gain. Without Sec. 1014, the unappreciated capital gain would be taxed a second time by the income tax. Based on this consistency, the Second Circuit held that Sec. 1014 only provides a step-up in the adjusted basis of property received from a decedent by the amount reflected on the decedent’s estate tax return.

Defined-Value Gifts

The IRS has vehemently argued for disregarding defined-value gift formulas (e.g., the gift is expressed as $X of the value of an interest to one beneficiary, with the remainder of the value to a charity) on multiple fronts, including the substance-over-form and violation-of-public-policy doctrines. Although it left many unanswered questions, the Fifth Circuit’s pro-taxpayer decision in McCord 15 provides an excellent analysis of the issues involved.16

McCord: In McCord, the taxpayers gifted all of their limited-partner (LP) interests via an assignment agreement that allocated LP interests with an aggregate FMV of a specified dollar amount to various family beneficiaries. If the net FMV of the gifted LP interests exceeded that dollar amount, the excess value passed to charities. Based on an appraisal of a 1% LP interest, the various beneficiaries (and the charities) entered into a confirmation agreement that translated the dollar value of the gifts provided in the assignment agreement into percentages of LP interests. The charities’ interests were later redeemed. The Service disputed the valuation of the LP interest. The taxpayers argued that, even if the IRS valuation was correct, the issue was moot because an increase in the value of the gifts would result in an increase in the taxpayers’ charitable deduction due to the fixed value of the gifts to the various family beneficiaries.

The Service argued against the increased charitable deduction based on the doctrine of reasonable probability of receipt, as the charities’ interests had already been redeemed at a significantly lower price. The Tax Court held for the IRS, using an argument never advanced by the Service. It first independently revalued the 1% LP interest and then applied that value to the percentages allocated to each beneficiary in the confirmation agreement (i.e., the percentages that were determined using the original valuation) to determine the value of the gift.

The Fifth Circuit reversed the Tax Court on the basis that the methodology used was flawed (as it essentially suspended the valuation date of the gifted property from the date of gift to the date of the confirmation agreement). Although the Fifth Circuit does not explicitly address whether the applicability of the doctrines referred to prohibit defined-value gifts, the court’s comment, in dicta, that these doctrines were “overarching,” and the careful consideration it gave to the facts in McCord (or rather, the lack of facts evidencing anything other than an arm’s-length agreement), seem to indicate that the court will not explicitly ban the use of formula clauses, but instead will review each fact pattern for evidence of non-arm’s-length or abusive transactions.

Other Developments

Private Annuities

Responding to perceived abuses by some taxpayers who inappropriately avoid or defer gain on the exchange of highly appreciated property for the issuance of an annuity contract, Treasury and the IRS issued proposed regulations (REG-141901-05, 71 Fed. Reg. 61441) that effectively revoke the “open transaction” doctrine for certain annuity contracts. Many of the transactions that are the focus of these proposed regulations involve private annuity contracts issued by family members or by business entities owned, directly or indirectly, by the annuitants themselves or by family members.

In a typical transaction targeted by these proposed regulations, a senior family member (“matriarch”) sells a highly appreciated, low-basis asset to a trust for the benefit of her descendants in return for a private annuity with a value (determined under Sec. 7520) equal to the value of the appreciated asset. The trust then sells the asset and invests the proceeds in a portfolio of assets. Under the open-transaction doctrine, the gain on the appreciated asset’s sale would be deferred over the life of the annuity, much like the deferral of gain that would occur in an installment sale. The trust would not recognize gain on the sale of the appreciated asset because its basis in the appreciated asset (equal to the value of the annuity transferred to the matriarch) was equal to its FMV. This subsequent sale circumvents the related-party installment sale rule, which otherwise would require the matriarch to recognize gain on the appreciated asset’s subsequent sale (Sec. 453(e)).

The proposed regulations provide that, if an annuity contract is received in exchange for property (other than money): (1) the amount realized attributed to the annuity is its FMV on the date of exchange; (2) the entire amount of gain or loss, if any, is recognized at the time of exchange; and (3) for purposes of determining the initial investment in the contract under Sec. 72(c)(1), the aggregate amount of premiums or other consideration paid for the annuity equals the amount realized attributable to the annuity.

It is the second consequence of the exchange that effectively closes the open-transaction doctrine for “typical transactions.” These proposed regulations apply to exchanges that occur after October 18, 2006, with a six-month limited exception for certain exchanges.

IRAs and QTIP Trusts

In Rev. Rul. 2006-26, the IRS addresses state law definitions of trust income and the qualification of a trust for the qualified terminable interest property (QTIP) election in Sec. 2056(b)(7), in which the trust is an IRA’s named beneficiary. The ruling also addresses the same issue for other defined-contribution retirement plans.

Rev. Rul. 2006-26 sets forth three scenarios addressing different state law definitions of trust income. In each scenario, the trust is a typical QTIP trust in which the surviving spouse has an income interest for life; on his or her death, the trust’s assets are to be distributed to the decedent’s children. The surviving spouse is given the power to compel the trustee to withdraw from the IRA an amount equal to all of its income and distribute such income to the surviving spouse. If the surviving spouse exercises this power, the trustee must withdraw the greater of the IRA’s income or the annual minimum required distribution (MRD) and distribute at least the IRA’s income to the surviving spouse. If the surviving spouse does not exercise the power to compel a withdrawal, the trustee must withdraw from the IRA only the MRD.

In the first scenario, in determining trust income, the state has adopted Section 104(a) of the Uniform Principal and Income Act of 1997 (UPIA), allowing a trustee to adjust between principal and income if the trust cannot otherwise be administered impartially between income and remainder beneficiaries. The state has also adopted UPIA Section 409(c) (allocating 10% of an IRA distribution to income and the other 90% to principal) and UPIA Section 409(d) (providing for an additional allocation to income in excess of 10% if necessary to obtain an estate tax marital deduction for the IRA).

In this scenario, in determining trust income under UPIA Section 104(a), the trustee must determine trust income of the non-IRA assets of the trust separately from the trust income of the IRA assets. The former must be distributed to the surviving spouse currently. If the surviving spouse exercises his or her withdrawal power, the trustee must withdraw the income of the IRA (or the MRD, if greater) and must currently distribute such income to the surviving spouse. It is important to note that the revenue ruling essentially states that the allocation provided in UPIA Section 409 is irrelevant in determining trust income for QTIP election purposes.

In the second scenario, the state has adopted a provision that allows a trust’s governing instrument to define trust income as a unitrust amount of 4% of the FMV of the trust’s assets valued annually. The revenue ruling generally applies the same reasoning as in the first scenario, providing that the 4% unitrust amount must be determined separately for the non-IRA assets and the IRA assets.

In the third scenario, the state has a traditional definition of trust income and has not adopted a unitrust provision or UPIA Section 104(a). The revenue ruling again generally applies the same reasoning as in the first scenario that trust income must be determined separately for the non-IRA assets and the IRA assets.

Finally, the revenue ruling provides that, in states that allow a trust to choose between determining trust income under UPIA Section 104(a) or a unitrust amount, the reasoning in the first or second scenario may be used to determine trust income. Although not stated in the revenue ruling, once the choice between the two has been made, it should be applied consistently.

Deducting Investment Advisory Fees

The question of whether investment advisory fees paid to outside advisers are fully deductible by a trust, or deductible only to the extent they exceed 2% of the trust’s adjusted gross income, has created a split in the various circuits. The issue concerns the proper interpretation of Sec. 67(e), which provides an exception from the application of the 2% floor for certain expenses. The Sixth Circuit ruled that Sec. 67(e) applies to costs “incurred because of fiduciary duties”; the Fourth and Federal Circuits ruled that the statute applies to costs “not commonly incurred by individuals.” In Rudkin, 17 the Second Circuit, affirming the Tax Court, ruled that the expenses exempt from the 2% floor are “costs that individuals are incapable of incurring”; thus, investment advisory fees are subject to the 2% floor. While the standard (i.e., costs that individuals are incapable of incurring) sounds impossibly high to meet, the examples given by the court (trustee fees, judicial accounting, and fiduciary income tax returns) are essentially the same as the examples provided by the Fourth Circuit. The Supreme Court will resolve this controversial issue; on June 25, 2007, it agreed to review the Second Circuit’s decision in Rudkin.

Generation-Skipping Transfer Tax

In Gerson, 18 the Tax Court held that the exercise of a testamentary general power of appointment by a decedent in favor of her grandchildren was subject to generation-skipping transfer tax (GSTT). In so holding, the Tax Court ruled that Regs. Sec. 26.2601-1(b)(1)(i) was a reasonable interpretation of the grandfathering provisions in the Tax Reform Act of 1986 (TRA).

In Gerson, the decedent’s husband created a testamentary marital trust for the benefit of the decedent. The trust provided for the distribution of income and principal to the decedent during her lifetime and granted her a general power of appointment on her death. The decedent’s husband died on July 22, 1973, and, thus, was not subject to the GSTT regime created under the TRA because of its grandfathering provisions. The decedent died on October 20, 2000, and exercised her general power of appointment in favor of a trust for the benefit of her grandchildren.

Under TRA Section 1433(a), the GSTT generally applies to all GSTs made after October 22, 1986 (the date the TRA was enacted). TRA Section 1433(b)(2) provides certain exceptions to this general rule. One of these exceptions provides that the GSTT does not apply to any transfer from a trust irrevocable on September 25, 1985, to the extent the transfer is not made out of additions to the trust after that date. As interpretive of this provision, Treasury promulgated Regs. Sec. 26.2601-1(b)(1)(i), which provides that the grandfathering rule does not apply to a transfer of property under the exercise, release, or lapse of a general power of appointment that is treated as a taxable transfer for gift or estate tax purposes. Regs. Sec. 26.2601-1(b)(1)(i) treats such a transfer as made by the person holding the power at the time the exercise, release, or lapse becomes effective and not as a transfer under a trust irrevocable on September 25, 1985.

Under Regs. Sec. 26.2601-1(b)(1)(i), the IRS held that the decedent’s exercise of her general power of appointment made the property covered by such power subject to the GSTT. The decedent’s estate argued that Regs.

Sec. 26.2601-1(b)(1)(i) was an invalid attempt by Treasury to rewrite TRA Section 1433(b)(2) and to override the judicial construction of the statute’s plain language. The Tax Court looked at prevailing case law, legislative history, and Treasury’s general authority to promulgate interpretive regulations and ruled that Regs. Sec. 26.2601-1(b)(1)(i) was a valid interpretation of TRA Section 1433(b)(2). Thus, because the property subject to the decedent’s general power of appointment was includable in her estate for estate tax, such property was also subject to the GSTT.

Life Insurance

In Rev. Rul. 2007-13, the Service addresses two scenarios involving the transfer of life insurance policies not subject to the transfer-for-value rule under Sec. 101(a)(2). In general, Sec. 101(a)(1) provides that gross income does not include amounts received under a life insurance contract, if such amounts are paid by reason of the death of the insured. Sec. 101(a)(2) provides, however, that if a life insurance contract, or any interest therein, is transferred for valuable consideration, the exclusion from gross income provided by Sec. 101(a)(1) is limited to an amount equal to the sum of the actual value of the consideration received and the premiums and other amounts subsequently paid by the transferee (the transfer-for-value rule).

In the first scenario, a life insurance policy is transferred for value between two wholly owned grantor trusts that have the same grantor. The IRS determines that the transfer-for-value rule does not apply because, under Rev. Rul. 85-13, the two wholly owned grantor trusts are disregarded entities for income tax purposes. Thus, the transfer is not recognized. In the second scenario, a non-grantor trust transfers a life insurance policy for value to a wholly owned grantor trust of the insured. The Service determines that the transfer-for-value rule applies; however, this type of transfer is excepted from that rule under Sec. 101(a)(2)(B), which provides that the rule does not apply to a transfer of a life insurance policy to the insured.

The revenue ruling codifies into authority (on which a taxpayer may rely) the IRS’s decisions in several letter rulings that have been issued over the past few years. These rulings mainly dealt with transfers to or between irrevocable life insurance trusts (ILITs) that were wholly owned grantor trusts, and thus disregarded entities for income tax purposes but not disregarded for gift tax purposes. Because ILITs are irrevocable, a grantor generally cannot change the terms of their governing instruments. However, the grantor can create a new ILIT and have the old ILIT sell the life insurance policy to the new ILIT. The transfer for value negates the gift tax consequences of the transfer, while the ILIT’s disregarded-entity status shields the transfer from the transfer-for-value rule and, thus, the recognition of income.

Procedure and Administration

Form 706: The Service released a revised version of Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, in October 2006. Among other changes, the instructions state that the executor must now file Form 706 at the Cincinnati Service Center, regardless of whether the decedent was a U.S. citizen residing in the U.S., a resident alien, or a nonresident U.S. citizen.

Form 706 also has a new question, 12e, in Part 4: “Did decedent at any time during his or her lifetime transfer or sell an interest in a partnership, limited liability company, or closely held corporation to a trust described in question 12a or 12b?” The question is probably intended to provide the IRS with information on the sale of property to intentionally defective grantor trusts.

EGTRRA Changes Taking Effect in 2007

The estate tax applicable exclusion amount remains at $2 million for taxpayers dying in 2007 and 2008; it increases to $3.5 million in 2009. The top estate and gift tax rate is reduced to 45% (from 46% in 2006) for individuals dying (or making gifts) in 2007, 2008, and 2009 (see Secs. 2010(c), 2001(c)(2)(B)).

Annual Inflation Adjustments
Various dollar amounts and limitations relevant to estate and gift tax are indexed for inflation: (1) the annual exclusion for present interest gifts is unchanged (from 2006) at $12,000; (2) the exclusion for transfers to noncitizen spouses is $125,000 ($117,000 for 2006); (3) the ceiling on special-use valuation is $940,000 ($900,000 for 2006); and (4) the Sec. 6166 amount eligible for the 2% rate is $1.25 million ($1.2 million for 2006) (see Rev. Proc. 2006-53, 2006-48 IRB 996).

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1 This group includes officers, directors, and highly compensated employees, as defined in Sec. 414(q).

2 This group includes greater-than-5% owners, employees earning over $100,000 in the preceding year, directors, or any employees in the top 35% of employees ranked by pay.

3 Sec. 101( j)(4).

4 Estate of Rosen, TC Memo 2006-115.

5 David A. Kimbell, Sr., 371 F3d 257 (5th Cir. 2004).

6 Note that even the Tax Court majority rejected a similar concept in Wayne C. Bongard, 124 TC 95 (2005).

7 Estate of Korby, 471 F3d 848 (8th Cir. 2006), aff’g TC Memo 2005-102.

8 IRS Letter Ruling (TAM) 200648028 (8/4/06).

9 Estate of Bonner, 84 F3d 196 (5th Cir. 1996).

10 Estate of Mellinger, 112 TC 26 (1999).

11 Walter L. Gross, Jr., 272 F3d 333 (6th Cir. 2001), aff ’g TC Memo 1999- 254.

12 Robert Dallas, TC Memo 2006-212.

13 Herbert V. Kohler, Jr., TC Memo 2006-152.

14 Carroll Janis, 469 F3d 256 (2d Cir. 2006), aff ’g TC Memo 2004-117.

15 Succession of Charles T. McCord, Jr., 461 F3d 614 (5th Cir. 2006), rev’g and rem’g 120 TC 358 (2003).

16 See Satchit, “McCord: Defined-Value Gifts at the Crossroads,” 38 The Tax Adviser 86 ( February 2007 ).

17 William L. Rudkin Testamentary Trust, 467 F3d 149 (2d Cir. 2006).

18 Estate of Gerson, 127 TC 139 (2006).

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