Significant Recent Developments in Estate Planning

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


  • The Small Business and Work Opportunity Tax Act of 2007 extended the preparer penalties under Sec. 6694 to cover preparers of estate and gift tax returns.

  • The Supreme Court ruled in Knight that a trust’s investment advisory fees are deductible if they are of a type that would be “uncommon (or unusual, or unlikely)” to be incurred by a hypothetical individual investor.

  • The Tax Court issued several rulings on the tax treatment of family limited partnerships.

  • The IRS issued final and proposed regulations regarding qualified severances for generation-skipping transfer tax purposes.

This article examines developments in estate, gift, and generation-skipping transfer tax planning and compliance between June 2007 and May 2008. It discusses legislative developments, cases and rulings, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) changes taking place in 2008, and the annual inflation adjustments for 2008 relevant to estate and gift tax.

Legislative Developments

President Bush signed the Small Business and Work Opportunity Tax Act of 2007, P.L. 110-28 (SBWOTA), on May 25, 2007. There are two changes that will be of significance to estate planners. First, for tax years beginning after December 31, 2006, an electing small business trust (ESBT) is allowed to deduct interest it incurs on debt to purchase S corporation stock.1 This puts ESBTs on similar footing with qualified subchapter S trusts (QSSTs) and other entities in relation to the deductibility of interest. Second, SBWOTA raised the standards for avoiding preparer penalties under Sec. 6694 and extended these standards to all returns, including estate and gift tax returns.2

Significant Cases and Rulings

Deduction of Investment Advisory Fees
The Supreme Court settled a split among the circuit courts of appeal and put to rest the issue of whether investment advisory fees are fully deductible under Sec. 67(e) or are deductible under Sec. 212 subject to the 2% adjusted gross income (AGI) limitation. In Knight,3 the Court ruled that investment advisory fees similar to those that would have been incurred by a “hypothetical” individual investor are deductible under Sec. 212.

In general, trusts are subject to the same rules for calculating AGI that apply to individuals, with one exception. A trust’s costs are fully deductible, rather than subject to the 2% AGI limitation, if they satisfy the requirements found in Sec. 67(e): (1) they are paid or incurred in connection with the administration of the trust, and (2) they would not have been incurred if the property were not held in such trust.

The courts have split on the issue of whether investment advisory fees incurred by a trust satisfy the second requirement in Sec. 67(e). The Sixth Circuit in O’Neill 4 held that investment advisory fees paid by a trust were unique to the trust’s administration because the trustees of the trust required the expertise of an investment adviser in order to satisfy their fiduciary duties and comply with the prudent investor standard of the state in which the trust was administered. The Second Circuit in Rudkin 5 (from which Knight was appealed), the Fourth Circuit in Scott,6 and the Federal Circuit in Mellon Bank 7 held (applying different tests) that the investment advisory fees were not unique to a trust because such fees are similar to fees routinely incurred by individuals in the management of their assets.

The Supreme Court framed the test of whether a cost would not have been incurred if the property were not held in such trust as whether such cost is “uncommon (or unusual, or unlikely)” for a hypothetical individual investor to incur. The Supreme Court then determined that in the case before it, investment advisory fees were not so unusual or uncommon that an individual investor with the same objectives as the trust would not have incurred such fees if the property were held by such individual.

Prior to Knight, Treasury issued proposed regulations8 providing that costs incurred by a trust that are unique to trusts are deductible under Sec. 67(e)(1). A cost is unique to trusts if an individual could not have incurred the cost in connection with property not held in trust. The proposed regulations also provide that a trust may not circumvent the 2% AGI limitation by bundling costs subject to the limitation into a trustee fee. If a trust bundles such costs, it must “unbundle” them using a reasonable method to allocate the single fee between costs subject to and those not subject to the 2% AGI limitation. The Supreme Court’s decision in Knight rejected the definition of “unique” the IRS incorporated in the proposed regulations, but it did not address the issue of unbundling trustees’ fees.

In response to Knight, the Service released Notice 2008-32,9 which provides that trusts and estates will not be required to determine the portion of unbundled fiduciary fees for any tax year beginning before January 1, 2008. Instead, for each such tax year, trusts and estates may deduct the full amount of the bundled fiduciary fee without regard to the 2% AGI limitation. However, payments by a trustee or executor to third parties for expenses subject to the 2% AGI limitation must be treated separately from the otherwise bundled trustee fee.

The IRS has successfully argued for including the assets transferred to a family limited partnership (FLP) in a transferor’s gross estate under Sec. 2036(a)(1). The Service victories invariably involve cases in which the facts surrounding the transfer of property and the subsequent use of the property show that the transferor implicitly retained the right to enjoy the property (or its income). Transferring substantially all of one’s assets to an FLP, coupled with relying on substantial disbursements from the FLP to meet living expenses, commingling FLP and personal funds, and failing to respect partnership formalities, are factors that the courts have cited as evidence of the retention of the right to enjoy the property.

In Bigelow,10 the Ninth Circuit became the latest circuit court of appeals to accept the Sec. 2036(a)(1) argument.11 In affirming the Tax Court decision, the Ninth Circuit noted that the decedent’s transfer of her major asset—a piece of rental property—left her with insufficient funds to meet her living needs without access to FLP funds as evidenced by an analysis of her monthly income and expenses. Further, the court noted that even though the decedent did not transfer to the FLP the debt secured by the rental property (i.e., she continued to be personally liable for the debt), the FLP made the monthly payments on the debt, and the FLP property continued to secure the decedent’s personal debt.

The Tax Court held for the IRS in two other cases. In Rector,12 the Tax Court ruled that Sec. 2036(a) applied, noting that (1) the decedent retained insufficient assets to meet her living needs, (2) the FLP directly paid the decedent’s living expenses and gift and estate tax liabilities; and (3) the partners failed to observe partnership formalities (there was no business plan or investment strategy, no financial statements were issued, and there were no formal meetings of the partners).

In Erickson,13 the Tax Court cited the delay in funding the FLP; although the agreement called for asset contributions concurrent with the execution of the FLP agreement, many of the assets were not transferred until four months later (just two days before the decedent’s death). In addition, the IRS cited the substantial disbursements to the estate to meet its liabilities; although the disbursements were for the purchase of the decedent’s home and the redemption of FLP units, the estate received funds at a time when no other partner did.

While case law has created a clear list of factors that are evidence of the retention of the right to enjoy the property, there are inconsistencies between the courts (and between Tax Court judges) as to what is required to meet the bona fide sale exception.

In theory, the Sec. 2036(a)(1) inquiry is a two-step process:

1. Does the bona fide sale exception apply?

2. If not, did the transferor retain the right to enjoy the property (or the income from it)?

In practice, the same factors that are probative of the application of Sec. 2036(a)(1)—commingling of funds, failure to follow partnership formalities, retention of insufficient funds by the transferor to meet living needs—heavily influence the court’s decision on whether the bona fide sale exception applies. Thus, in cases that involve commingling of funds (for example), the courts invariably find that the bona fide sale exception does not apply. But instead of using the third prong of the test developed by the Fifth Circuit in Kimbell 14—which demands an examination of the facts that would confirm or deny the taxpayer’s assertion that the transfer is a bona fide sale—to reach the correct conclusion, the courts continue to cite factors that are not only inconsistent with existing law but also unnecessary to reach the intended result. In Rector, the Tax Court cited “mere recycling,” “lack of legitimate negotiations,” “pooling of assets,” and “legitimate and significant business reasons” in reaching its conclusion that the exception did not apply. These concepts were rejected by the Fifth Circuit (and even by the Tax Court majority in Bongard)15 because they place undue emphasis on the taxpayer’s subjective motives.

Thus, where there is no evidence of the retention of the right to enjoy the property (e.g., no commingling of funds, no failure to follow FLP formalities, etc.), the presence of some potential benefit other than estate tax advantages—a benefit that fits the facts of the case—constitutes a significant and legitimate nontax reason sufficient to meet the bona fide sale exception. Where there is evidence of the retention of the right to enjoy the property, the taxpayer will find that no nontax reason will be sufficient to meet the bona fide sale exception.

Mirowski 16 is a perfect example of this theory. In this case, there was no commingling of funds. The partners respected partnership formalities, assets were timely transferred, and the transferor retained sufficient assets outside her estate to meet her living needs. The transferor, however, did not retain sufficient assets to pay estate taxes (the FLP made distributions to the estate). The Tax Court (Judge Chiechi),17 citing the credible nature of the testimony of the transferor’s two daughters, found that joint management of the family’s assets, management of patents and any related litigation, facilitation of lifetime giving, and availability of greater investment opportunities (by maintaining assets in a single pool) constituted legitimate and significant nontax reasons (she noted that any one of the above reasons would be sufficient). Thus, the Tax Court held that the bona fide sale exception was applicable to the transfer of assets to the FLP.


FLP Limited Interests
In Holman,18 the Tax Court considered two issues that have received attention in recent years regarding the valuation of gifts of interests in an FLP. On November 2, 1999, a couple transferred stock in a publicly traded company to an FLP in return for general and limited interests. A trust for the benefit of the couple’s four children also contributed stock in the same company to the FLP in return for limited interests. On November 8, 1999, the couple each transferred a substantial amount of their limited interests in the FLP to the trust as well as to a custodial account for their youngest child. On January 14, 2000, and February 2, 2001, the couple transferred an amount of their limited interests in the FLP to custodial accounts for the benefit of their children equal to their annual gift tax exclusion amounts. For the years in question, the FLP only held stock in the publicly traded company and earned no income in such periods. The couple filed gift tax returns and elected to split the gifts for all three years. The Service challenged the value of the FLP’s limited interests reflected on the couple’s gift tax returns.

The Tax Court first addressed the IRS’s argument that the November 8 transfer was an “indirect gift” of the company stock. Under Regs. Sec. 25.2511-1(h)(1), an indirect gift occurs upon the transfer of assets to an entity (e.g., an FLP) wherein the transferor does not receive a proportionate interest in the entity in return for the transfer. The difference between the value of the assets transferred and the value of the interest received results in a gift to the other members of the entity. The Service argued that the transfer of the assets to the FLP on November 2 and the subsequent gift of limited interests in the FLP on November 8 should be considered one transaction under the step-transaction doctrine, resulting in an indirect gift of the company stock to the trust. The Tax Court rejected the IRS’s argument because the company stock was heavily traded on a day-to-day basis and was highly volatile during the six-day period between the formation of the FLP and the transfer of the limited interests. However, the Tax Court, in a footnote, left the door open for the Service to make the same argument in the case of more stable types of investment, citing preferred stock or long-term government bonds as examples.

The Tax Court then addressed the IRS’s argument that the limited interests in the FLP should be valued for gift tax purposes without regard to the transferability restrictions set forth in the FLP agreement. The restrictions were typical transferability restrictions seen in most FLP agreements. The Service based its argument on the fact that the restrictions did not meet the requirements of Sec. 2703(b). Sec. 2703(a) disregards a restriction on the right to sell or transfer property when valuing such property for gift or estate tax purposes unless it meets the requirements of Sec. 2703(b):

1. It is a bona fide business arrangement;

2. It is not a device to transfer property to family members for less than full and adequate consideration; and

3. Its terms are comparable to similar arrangements entered into at arm’s length.

After a review of the facts, the Tax Court determined that the first two requirements had not been met; therefore, the transferability restrictions in the FLP agreement could not be considered in determining the value of the limited interest for gift tax purposes.

Holman confirms some commentators’ cautions regarding how soon FLP interests should be transferred after the formation of the FLP in order to avoid indirect gift treatment. According to the Tax Court, it depends on the asset transferred to the FLP. Volatility seems to be a key issue for the court. The Tax Court also addressed (the authors believe for the first time) the applicability of Sec. 2703 in valuing limited interests in FLPs. In Strangi,19 the Tax Court held that Sec. 2703 did not apply to the “FLP wrapper” around the assets transferred to the FLP. However, in Holman, the Sec. 2703 inquiry focused on the valuation of the limited interest in the FLP. Holman signals that the Tax Court is willing to disregard transferability restrictions in valuing an FLP interest.

While the courts and the IRS have agreed that built-in gain (BIG) tax on a corporation’s appreciated assets should be taken into account in valuing its stock using the net asset valuation method, they have not agreed on the proper method for quantifying the discount.

In Jelke,20 the decedent owned a 6.44% interest in a closely held corporation whose assets consisted primarily of appreciated securities with a date of death value of $178 million. The estate argued that the entire BIG tax liability of approximately $51 million should be allowed against the fair market value (FMV) of the securities in determining the company’s value using the net asset valuation method. The Tax Court rejected this argument and held that the IRS expert’s method of discounting the BIG tax liability over a 16-year period was reasonable because the facts in the case showed that an immediate liquidation of the company was unlikely given the corporation’s historical asset turnover ratio.

The Eleventh Circuit, following the Fifth Circuit’s reasoning in Dunn,21 reversed, stating that 100% of the BIG tax must be taken into account when using the net asset valuation method (regardless of the likelihood of liquidation) because the threshold assumption of the net asset valuation method is that all assets are liquidated as of the date of valuation. The two appeals court victories give taxpayers a strong position for taking 100% of the BIG taxes into account in valuing C corporation stock.

Sec. 7520 Tables
What is the proper method for valuing the remaining installment payments of lottery winnings after a decedent’s death? The IRS’s position—which has been accepted by the Fifth Circuit and the Tax Court—considers lottery payments as an annuity to be valued using the tables determined under Sec. 7520. Taxpayers have argued successfully before the Second and Ninth Circuits for a departure from the tables and a reduction of the present value of the future installments for illiquidity and lack of marketability because state law restricts (in most cases) the assignment or transfer of lottery winnings. During 2007, two district courts reached opposite conclusions.

In Negron,22 a district court held that using the Sec. 7520 tables was “unrealistic and unreasonable” since “it makes fundamental economic sense that the transferability of an annuity would affect its fair market value.” In Davis,23 a district court held that use of the tables did not lead to an unreasonable result. The court did not view the lack of transferability as significant in valuation, noting that the willing buyer–willing seller model required evaluation of what a willing buyer would pay to have all the rights that the seller holds, rather than those rights that the seller can convey.

The issue of whether nontransferability provisions will justify a departure from use of the Sec. 7520 tables is important because it applies not just to lottery payments but to all types of interests that require valuation by the tables.

Inclusion of Annuities
Sec. 2036 provides for the inclusion in a decedent’s estate of certain transfers the decedent made during his or her lifetime in which the decedent retained certain rights in the property. Sec. 2039 provides for the inclusion in a decedent’s estate of the value of any annuity receivable by a beneficiary by reason of surviving the decedent if such annuity was payable to the decedent.

These provisions may overlap in the case of certain estate planning techniques executed by a decedent during his or her life that were still in place at the time of the decedent’s death. The determination of value for estate tax purposes can vary significantly depending on whether a decedent’s estate applies Sec. 2036 or Sec. 2039 in these cases. The Service issued final regulations24 to provide for the uniform application of Sec. 2036 (over Sec. 2039) in these cases.

The regulations provide that, if a decedent transfers property during life to a trust and retains the right to an annuity, unitrust, or other income payment, or retains the use of an asset in the trust for the decedent’s life, the decedent has retained the right to income from all or a specific portion of the property under Sec. 2036. These transfers involve transfers to a charitable remainder trust (CRT) or a grantor-retained (annuity/unitrust/income) trust (GRT). The portion of the trust corpus includible in the decedent’s gross estate is that portion of the trust corpus, valued as of the decedent’s death, necessary to yield that annual payment using the appropriate Sec. 7520 interest rate. The regulations provide both rules and examples for calculating the amount of the trust to be included in a decedent’s gross estate under Sec. 2036 in such a case.

The position taken by the IRS in these regulations is taxpayer favorable in that the application of Sec. 2036, in some cases, may result in a smaller amount of the CRT’s or GRT’s assets being included in the estate of a decedent than the value that would otherwise be includible under Sec. 2039. Whereas the application of Sec. 2039 will generally result in the inclusion of the entire value of the trust in the decedent’s estate, the application of Sec. 2036 may result in an amount that is less than the entire value of the trust being included in the decedent’s estate.25

Generation-Skipping Transfer Tax

General Powers of Appointment
In Gerson,26 the Sixth Circuit affirmed the Tax Court’s ruling that the exercise of a testamentary general power of appointment (GPOA) by a decedent in favor of her grandchildren was an additional contribution to a grandfathered trust subjecting such addition to generation-skipping transfer tax (GST tax). In so holding, the Sixth Circuit ruled that Regs. Sec. 26.2601-1(b)(1)(i) was a reasonable interpretation of the GST tax grandfathering provisions in the Tax Reform Act of 1986. The case was appealed to the Supreme Court, but the Court declined to review it.

Final and Prop. Regs. for Qualified Severances for GST Tax Purposes

The IRS issued final27 and proposed28 regulations providing guidance on the qualified severance of a trust for GST tax purposes. The final regulations adopt and expand on the proposed regulations29 issued by the Service in 2004. The new proposed regulations respond to new matters raised by comments on the previous regulations that the IRS has identified as needing further evaluation.

Sec. 2642(a)(3), enacted as part of the GST tax provisions of EGTRRA, provides rules for severing a trust into two or more parts so that the resulting trusts will be recognized as separate trusts for GST tax purposes. Sec. 2642(a)(3) expands the previous severance rules for trusts contained in Regs. Sec. 26.2654-1(b) by allowing more time to make the severance, making severances available to more types of trusts, and providing a uniform system of severance.

The major revisions to REG-145987-03 in the final regulations include:

1.Clarifying procedures for the non–pro rata funding of trusts resulting from a qualified severance;

2. Guidance regarding the qualified severance of a trust where there has been an addition to a grandfathered GST trust;

3. Omitting the reporting requirements for a qualified severance; and

4. Expanding the regulations under Sec. 1001 to apply to situations in which one of the resulting trusts from a qualified severance is a skip person and in which a trust beneficiary is granted a contingent testamentary GPOA that is dependent on a trust’s inclusion ratio.

REG-128843-05 sets forth three matters that were not previously addressed by REG-145987-03.

1. The proposed regulations provide that trusts resulting from the severance of a trust that is not a qualified severance will be treated, after the severance, as separate trusts for GST tax purposes if such trusts are recognized under state law;

2. The proposed regulations provide that a trust with an inclusion ratio between one and zero may be split into more than two trusts as long as the resulting trusts have an inclusion ratio of one or zero; and

3. The proposed regulations provide special funding rules for the non–pro rata division of some assets between or among severed trusts.

Prop. Regs. Regarding Relief for Missed GST Exemption Elections
Sec. 2642(g)(1), added to the Code by the EGTRRA, directed the Treasury secretary to issue regulations describing the circumstances and procedures under which an extension of time will be granted to: (1) allocate GST exemption (as defined in Sec. 2631(a)) to a transfer; (2) elect under Sec. 2632(b)(3) to not have the deemed allocation of GST exemption apply to a direct skip; (3) elect under Sec. 2632(c)(5)(A)(i) to not have the deemed allocation of GST exemption apply to an indirect skip for transfers made to a particular trust; and (4) elect under Sec. 2632(c)(5)(A)(ii) to treat any trust as a GST trust for purposes of Sec. 2632(c). Pursuant to such direction the IRS issued proposed regulations30 to satisfy this directive under Sec. 2642(g)(1). The proposed regulations add Prop. Regs. Sec. 26.2642-7.

Prop. Regs. Sec. 26.2642-7(b) provides that if an extension of time to allocate GST exemption is granted, the allocation of GST exemption will be considered effective as of the date of the transfer, and the value of the property transferred for gift or estate tax purposes will determine the amount of GST exemption to be allocated. If an extension of time to elect out of the automatic allocation of GST exemption under Secs. 2632(b)(3) or 2632(c)(5)(A)(i) is granted, the election will be considered effective as of the date of the transfer. If an extension of time to elect to treat any trust as a GST trust under Sec. 2632(c)(5)(A)(ii) is granted, the election will be considered effective as of the date of the first (or each) transfer covered by that election.

Prop. Regs. Sec. 26.2642-7(c) provides that the amount of GST exemption that may be allocated to a transfer pursuant to an extension granted under Sec. 2642(g)(1) is limited to the amount of the transferor’s unused GST exemption as of the date of the transfer. Thus, if the amount of the GST exemption has increased since the transfer date, no portion of the increased amount may be applied by reason of the grant of relief under Sec. 2642(g)(1) to a transfer taking place in an earlier year and prior to the effective date of that increase.

Prop. Regs. Sec. 26.2642-7(d) provides that the relief under Sec. 2632(g)(1) will be granted when the transferor or the executor of the transferor’s estate provides evidence to establish to the Service’s satisfaction that the transferor or the executor acted reasonably and in good faith and that the grant of relief will not prejudice the government’s interests. This section goes on to set forth nonexclusive lists of factors the IRS will consider in determining whether this standard of reasonableness, good faith, and lack of prejudice to the government’s interests has been met so that such relief will be granted. In making this determination, the Service will consider these factors as well as all other relevant facts and circumstances. Prop. Regs. Sec. 26.2642-7(e) sets forth situations in which this standard has not been met and, as a result, relief will not be granted. Finally, Prop. Regs. Sec. 26.2642-7(h) sets forth the procedural requirements to obtain a favorable ruling of relief.

GPOA Not an Interest in a Trust for GST Purposes
In general, Secs. 2601 and 2612 provide that a transfer is subject to GST tax when the transferor makes a transfer to a skip person (i.e., a person two or more generations younger than the transferor). When a transferor makes a transfer to a skip person who is an individual, the transfer is a “direct skip” and GST tax is immediately imposed on the transfer. The same is true when a transfer is made to a trust that has only skip persons as beneficiaries.

Sec. 2631 allows an individual a GST exemption currently equal to $2 million. This exemption permits that individual to exempt up to $2 million in transfers that might otherwise be subject to GST tax. Sec. 2632 provides for the allocation of the GST exemption to transfers that may have GST tax consequences. The proper allocation of the GST exemption requires careful planning on the part of individuals and their tax advisers, especially in the case of transfers to trusts.

For transfers to trusts that may have GST tax consequences, tax advisers generally try to create trusts that are either totally exempt from GST tax (an exempt trust) or entirely subject to GST tax (a nonexempt trust). This is especially true for testamentary transfers to residuary trusts. In the case of a nonexempt trust, a tax adviser might negate the GST tax consequences of the trust by having it distribute its assets to a nonskip person or having it includible in a nonskip person’s estate (via a general power of appointment).

In Letter Ruling 200814016,31 a decedent created a trust for the benefit of his grandchildren (i.e., skip persons). The trust was unfunded until the decedent’s death. Upon his death, the trust was funded and divided into separate shares, one share for each beneficiary. The trust also provided for the separation of the shares into exempt and nonexempt shares for GST purposes. Each separate share was to terminate when the beneficiary reached age 45. The nonexempt shares of the separate shares gave the parents of the beneficiaries testamentary GPOA. The nonexempt shares were not to terminate until after the death of a beneficiary’s parent, regardless of the beneficiary’s age.

None of the beneficiaries of the trust had yet reached age 45 at the time of the transferor’s death. The IRS was asked to rule on whether the transfers to the nonexempt shares were direct skips. The Service ruled that the transfers were direct skips, a result the decedent’s tax adviser had presumably hoped to avoid by giving each beneficiary’s parent (a nonskip person) a testamentary GPOA. The tax adviser’s reasoning may have been that the nonexempt shares would be includible in the estates of the beneficiaries’ parents. Therefore, when the nonexempt shares distributed their assets to their beneficiaries, the transfers would not be subject to GST tax because the beneficiaries were not skip persons with respect to their parents.

Sec. 2652(c) provides that a person has an “interest” in property for GST tax purposes if (at the time the determination is made) such person (1) has a right (other than a future right) to receive income or corpus of the trust, or (2) is a permissible current recipient of income or corpus from the trust. The IRS noted that the parents of the beneficiaries did not have an interest in the nonexempt trusts when the trusts were funded because they had no present right to trust income or corpus. As a result, the only persons having interests in the nonexempt trusts at the time they were funded were skip persons; therefore, the transfers to the nonexempt trust were direct skips.

What the tax adviser should have done in addition to giving the beneficiaries’ parents testamentary GPOAs was to also make the parents discretionary beneficiaries of the nonexempt shares. This would have given the parents an interest in such shares, forestalling the GST tax consequences of the transfers until after the death of the parents, at which time the transfers would not have been subject to GST tax because the transfer would not have skipped a generation.

Other Considerations

Trust Does Not Meet Sec. 469 Material Participation Requirement
In general, in order for losses from a trade or business to escape limitation under the passive activity rules, Sec. 469 requires that a taxpayer must be “actively involved” in the trade or business. In order to determine if the taxpayer is actively involved in a trade or business, the taxpayer must “materially participate” in the trade or business. Sec. 469(h) provides that in order for a taxpayer to meet the material participation requirement, his or her involvement in the activity must be “regular, continuous, and substantial.”

The application of the passive activity rules in Sec. 469 has long been a problem for fiduciaries and beneficiaries of trusts and estates due to the lack of guidance in Sec. 469, the regulations thereunder, or case law. While Temp. Regs. Sec. 1.469-5T(g) has been reserved for regulations applying the material participation requirements to trusts and estates, the IRS has yet to prescribe such regulations.

In Mattie K. Carter Trust,32 a district court determined that the activities the trust conducted (through its trustee, employees, and agents) in a ranch it owned met the material participation requirements of Sec. 469. The IRS took the position that only the activities of the fiduciaries (i.e., trustees) should be considered in determining whether a trust had met the material participation requirements. In Technical Advice Memorandum (TAM) 200733023,33 the Service notes its disagreement with Carter Trust and reasserts its position that only the activities of a trust’s fiduciaries may be considered in determining whether the trust has met the Sec. 469 material participation requirements. In the TAM, the trustees of the trust appointed “special trustees” to assist in the operation of the business owned by the trust. The IRS equated the special trustees with employees and determined that their activities did not equate to activities performed by the trustees of the trust for purposes of Sec. 469.

The IRS did not appeal the decision in Carter Trust, nor did it acquiesce in the decision. The authors believe that TAM 200733023 is the first time the Service has considered the issue since Carter Trust, and it has taken the position that in order for a trust or estate to meet the Sec. 469 material participation requirements, only the activities of the fiduciaries are considered (not their agents or employees). Note that the TAM is not authority, but it does reflect the Service’s position when considering whether to follow Carter Trust. Since Carter Trust was a decision of a district court, not the Tax Court, tax practitioners should carefully consider their positions on the issue.

Election to Prorate Donations to Tuition Accounts
Sec. 529(c)(2)(B) allows a donor to elect to treat the transfer of a contribution to a Sec. 529 college savings plan as having been made ratably over a five-year period for gift tax purposes. This provision essentially allows a donor to make a gift of five times the gift tax annual exclusion amount for the year the gift is made to the Sec. 529 plan and take that gift into consideration over a five-year period. In Letter Ruling 200743001,34 the donor—who failed to check the box on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, to make the election in the year she made gifts to various Sec. 529 plans for the benefit of her grandchildren—requested a ruling that she had substantially complied with the Sec. 529(c)(2)(B) requirements.

The IRS noted that literal compliance with procedural instructions (e.g., instructions in Form 709) to make an election is not always necessary. It then noted that the donor’s gift tax return described the transfers to her grandchildren as a “gift of cash to a Sec. 529 qualified state tuition program.” The Service ruled that based upon the facts, the donor’s gift tax return contained sufficient information to constitute substantial compliance with the requirements for making the election and that she had made a valid and timely election under Sec. 529(c)(2)(B).

Charitable Deduction Pursuant to a Disclaimer
Christiansen 35 provides a lesson in partial disclaimers meant to qualify for the estate tax charitable deduction under Sec. 2055 and the validity of defined-value clauses. The opinion is a fully reviewed opinion in which a majority of the Tax Court held that the partial disclaimer did not qualify for the estate tax charitable deduction and a unanimous Tax Court held that the defined-value clause did not violate public policy and therefore was valid.

In Christiansen, the decedent left the residue of her estate (which included interests in two FLPs) to her daughter. The daughter disclaimed the bequest to the extent the value of the residue exceeded a formula amount determined by reference to a fraction, the numerator of which was the FMV of the gift (before the payment of debts, expenses, and taxes) on the date of the decedent’s death less $6,350,000, and the denominator of which was the FMV of the bequest (before the payment of debts, expenses, and taxes) on the date of the decedent’s death “all as such value is finally determined for federal estate tax purposes.”

The decedent’s will provided that if the daughter disclaimed any portion of the bequest, 75% of the disclaimed portion would go to a charitable lead annuity trust (CLAT) (the annuity interest passing to the family foundation and the remainder interest passing to the daughter, if living at the end of the annuity term) and 25% would go to the family foundation outright.

The Tax Court first addressed whether the 75% passing to the CLAT under the disclaimer was eligible for the estate tax charitable deduction. In general, if a disclaimer meets the requirements of a qualified disclaimer (as defined in Sec. 2518), the bequest to the disclaimant is treated as having never been made. At issue before the Tax Court was the IRS’s contention that the disclaimer did not meet the requirement that the disclaimed property must pass without any direction on the part of the disclaimant and must pass to someone other than the disclaimant. The court ruled that because the contingent remainder interest in the CLAT would pass to the daughter (i.e., the disclaimant), the disclaimer was not a qualified disclaimer. Therefore, the annuity interest in the CLAT passing to charity did not qualify for the estate tax charitable deduction.

The Tax Court next addressed whether the defined-value clause should be given effect. The IRS raised its long-argued position that such clauses are against public policy for the reasons set forth in Proctor 36 and its progeny and that therefore the estate tax charitable deduction for the property passing to the family foundation outright could not be increased due to a revaluation of the property on audit.

The Tax Court distinguished the case before it from Proctor because the defined-value clause would not “undo” the transfer, it would only reallocate the value transferred among the daughter, the CLAT, and the family foundation. The court noted that the Service’s incentive to audit returns affected by such a clause would marginally decrease if the court allowed the increased estate tax charitable deduction and thus would encourage similarly situated taxpayers to lowball the value of the estate to cheat charities. However, the court noted that executors and foundation managers are bound by fiduciary duties that have punitive consequences under state law and federal tax law if those duties are violated.

The second issue addressed by the Tax Court is significant in that it is the first time a court has specifically addressed the validity of a defined-value clause (although the Fifth Circuit tacitly approved (without addressing) a similar clause in McCord).37 A unanimous court distinguished the clause from a savings clause because the clause only reallocated the assets among a group of donees upon the revaluation of the donated property; it did not have the effect of undoing any part of the transfer. Much has been written about whether these types of clauses are valid. The Tax Court gives some comfort that such provisions in donative instruments should be given effect—at least under similar facts.

IRS Issues Proposed Regs. on UBTI and CRTs
The Tax Relief and Health Care Act of 2006, P.L. 109-432, amended Sec. 664 to provide that, for tax years beginning after December 31, 2006, a CRT would remain tax exempt even if it had unrelated business taxable income (UBTI) in a given year. However, a 100% excise tax would be imposed on the UBTI of a CRT. The Service issued final regulations38 that amend the existing regulations to reflect this change. The final regulations also clarify that the excise tax imposed on a CRT with UBTI is treated as paid from corpus and the trust income that is UBTI is income of the trust for purposes of determining the character of the distribution made to the beneficiary under Sec. 664(b).
Proposed Regs. Regarding the Alternate Valuation Date
In general, Sec. 2001 imposes an estate tax on the value of a decedent’s estate as of the date of his or her death. Sec. 2032 allows a decedent’s estate to elect an alternate valuation date (AVD) provided that such date (1) results in a valuation of the decedent’s estate that is lower than its date of death valuation and (2) results in a combined estate and GST tax liability that would have been less than such liability on the decedent’s date of death. For property that is distributed, sold, or otherwise exchanged within six months of a decedent’s date of death, the AVD is the date of the distribution, sale, or exchange. For all other property includible in a decedent’s estate, the AVD is the date that is six months after the decedent’s date of death.

In Kohler,39 the Tax Court held that a difference in value of a business caused by a tax-free reorganization between date of death and the AVD should be taken into account in determining the value as of the AVD. The IRS subsequently issued proposed regulations40 in which it chose not to follow the Tax Court’s holding in Kohler.  The proposed regulations provide that an election to use the AVD may be made only when the decrease in the value of estate property is caused by market conditions. Market conditions are defined as events outside the control of the decedent (or the decedent’s executor or trustee) or other person whose property is being valued that affect the value of the property being valued. Changes in value due to the mere lapse of time or to other post-death events other than market conditions—for example, a reorganization of an entity, a distribution of cash or other property to the estate from such entity, or one or more distributions by the estate of a fractional interest in such entity—will be ignored in determining the value of the estate property on the AVD. The regulations, if adopted as final regulations, would apply to decedents dying on or after April 25, 2008.

Inclusion of Trust Assets When Grantor Has a Power of Substitution
One of the staples of an estate planner is the “intentionally defective grantor trust” (IDGT) wherein the trust is respected for transfer tax purposes (i.e., gift, estate, and GST tax) and disregarded for income tax purposes (i.e., transactions between the grantor and his or her trust produce no income tax consequences). The most often used provision under the grantor trust rules (Secs. 671–679) to create a trust’s status as an IDGT is a power under Sec. 674(4)(C) in the grantor to substitute property transferred to the trust with other property of equivalent value in a nonfiduciary capacity (the power of substitution).

The power of substitution is often used because most estate planners believe that this power does not cause the trust’s assets to be included in the grantor’s estate under Sec. 2036 (regarding transfers with a retained life estate) or Sec. 2038 (regarding the power to alter, amend, revoke, or terminate a transfer). In Rev. Rul. 2008-22,41 the Service confirmed this belief and ruled that a grantor’s power, exercisable in a nonfiduciary capacity, to acquire property held in a trust by substituting property of equivalent value will not, by itself, cause the value of the trust’s assets to be includible in the grantor’s estate under Secs. 2036 or 2038—under certain conditions.

The revenue ruling requires that:

1. The trustee have a fiduciary obligation (under local law or the trust instrument) to ensure the grantor’s compliance with the terms of the power of substitution by satisfying itself that the property acquired and the property substituted by the grantor are of equal value; and

2. The power of substitution cannot be exercised in a manner that shifts benefits among trust beneficiaries.

It further states that a power of substitution will not be deemed to be exercised in a manner that can shift benefits among trust beneficiaries if:

1. The trustee has both the power (under local law or the trust instrument) to reinvest trust corpus and a duty of impartiality with respect to trust beneficiaries; or

2. The nature of the trust’s assets or level of income produced by any or all of the trust’s assets do not affect the respective interests of the beneficiaries.

Procedure and Administration

Sec. 6166 Election
Under Sec. 6166, an estate may make an election to pay the estate tax associated with a closely held business included in the estate in installments. In 2002, the IRS implemented a policy requiring a surety bond or a tax lien under Sec. 6324A as a prerequisite to making a Sec. 6166 election. In Roski,42 the Tax Court held that the Service had abused its discretion by requiring that all estates electing to pay the estate tax in installments under Sec. 6166 must provide a bond or lien. The court ruled that it was Congress’s intent that the IRS determine, on a case-by-case basis, whether the government’s interest is at risk prior to requiring security from an estate making an election under Sec. 6166.

As a result of the Roski decision, the Service released Notice 2007-90,43 which sets forth a list of factors and other relevant facts that it will use on a case-by-case basis to determine whether, at any time and from time to time during the deferral period, the government’s interest in the estate tax deferred under Sec. 6166 is sufficiently at risk to justify the requirement of a bond or lien. These factors are grouped into three broad categories: (1) duration and stability of the business; (2) ability to pay the installments of tax and interest timely; and (3) compliance history.

In General Counsel Memorandum (GCM) 200747019,44 the IRS notes that it may accept closely held stock as collateral for the special lien under Sec. 6324A when: (1) the stock is expected to survive the deferral period; (2) the stock is identified in a written agreement; and (3) the value of the stock as of the agreement date is sufficient to pay the deferred taxes plus required interest. While noting that the memorandum addresses only closely held stock, the Service states that the principals described in the memorandum are equally applicable to interests in a limited liability company or limited partnership.

Sample Lead Trust Forms
The IRS has released sample forms for both inter vivos and testamentary CLATs.45 The revenue procedures state that

• If a trust instrument is substantially similar to one of the sample trust instruments or properly integrates one or more alternate provisions into a trust instrument substantially similar to one of the sample trust instruments;

• Is a valid trust under applicable local law;

• Operates in a manner consistent with the terms of the trust instrument; and

• Satisfies all other deductibility requirements,

the value of the charitable lead interest will be deductible under Sec. 2522 and/or Sec. 2055.

The revenue procedures further state that trust instruments that depart from the sample trust instruments will not necessarily be ineligible for a charitable deduction but also will not be assured of qualification for the appropriate charitable deduction. Finally, the revenue procedures state that the Service generally will not issue a letter ruling on whether a CLAT qualifies for a charitable deduction; however, it generally will issue letter rulings relating to the tax consequences of the inclusion in a CLAT of substantive trust provisions other than those contained in the revenue procedures.

EGTRRA Changes Taking Effect in 2008
The estate tax applicable exclusion amount remains at $2 million for taxpayers dying in 2008; it increases to $3.5 million in 2009. The top estate and gift tax rate is 45% for individuals dying (or making gifts) in 2007, 2008, and 2009.
Annual Inflation Adjustments
Various dollar amounts and limitations relevant to estate and gift tax are indexed for inflation:

• The annual exclusion for present interest gifts is unchanged (from 2007) at $12,000;

• The exclusion for transfers to noncitizen spouses is $128,000 (up from $125,000 in 2007);

• The ceiling on special-use valuation is $960,000 (up from $940,000 in 2007); and

• The Sec. 6166 amount eligible for the 2% rate is $1.28 million (up from $1.25 million in 2007).46


Justin Ransome is a partner in the National Tax Office of Grant Thornton LLP, in Washington, DC. Vinu Satchit is a senior tax manager with Grant Thornton LLP in Charlotte, NC.

For more information about this article, contact Mr. Satchit at

1 Sec. 641(c)(2)(C)(iv).

2 A full discussion of the new standards is beyond the scope of this article. See Tillinger, “An Analysis of the New Preparer Penalty Proposed Regulations,” on p. 576. Also, note that Notice 2007-54, 2007-27 I.R.B. 12, postponed the application of the new standards until January 1, 2008.

3 Knight, 552 U.S. ___, 128 S. Ct. 782 (2008).

4 O’Neill, 994 F.2d 302 (6th Cir. 1993), rev’g 98 T.C. 227 (1992).

5 Rudkin Testamentary Trust, 467 F.3d 153 (2d Cir. 2006), aff’g 124 T.C. 304 (2005).

6 Scott, 328 F.3d 132 (4th Cir. 2003), aff’g 186 F. Supp. 2d 664 (E.D. Va. 2002).

7 Mellon Bank, N.A., 265 F.3d 1275 (Fed. Cir. 2001), aff’g 47 Fed. Cl. 186 (2000).

8 REG-128224-06.

9 Notice 2008-32, 2008-11 I.R.B. 593.

10 Bigelow, 503 F.3d 955 (9th Cir. 2007), aff’g T.C. Memo. 2005-65.

11 The IRS was successful before the First, Third, Fifth, and Eighth Circuits prior to Bigelow.

12 Rector, T.C. Memo. 2007-367.

13 Erickson, T.C. Memo. 2007-107.

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

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

16 Mirowski, T.C. Memo. 2008-74.

17 Judge Chiechi, who also decided Stone, T.C. Memo. 2003-309, in favor of the taxpayer, seems to admonish other Tax Court judges for their failure to apply the bona fide sale exception in Bongard correctly.

18 Holman, 130 T.C. No. 12 (2008).

19 Strangi, 115 T.C. 478 (2000).

20 Jelke, 507 F.3d 1317 (11th Cir. 2007), vact’g and rem’g T.C. Memo. 2005-131.

21 Dunn, 301 F.3d 339 (5th Cir. 2002), vact’g and rem’g T.C. Memo. 2000-12.

22 Negron, 502 F. Supp. 2d 682 (N.D. Ohio 2007).

23 Davis, 491 F. Supp. 2d 192 (D.N.H. 2007).

24 T.D. 9414.

25 This position is contrary to the position the IRS had taken in previous rulings on the issue. See TAM 200210009 (12/19/01) and IRS Letter Ruling 9345035 (8/13/83).

26 Gerson, 507 F.3d 435 (6th Cir. 2007), aff’g 127 T.C. 139. See Ransome and Satchit, “Significant Recent Developments in Estate Planning,” 38 The Tax Adviser 518 (September 2007), for a detailed discussion of the facts of this case.

27 T.D. 9348.

28 REG-128843-05.

29 REG-145987-03.

30 REG-147775-06.

31 IRS Letter Ruling 200814016 (12/19/07).

32 Mattie K. Carter Trust, 256 F. Supp. 2d 536 (N.D. Tex. 2003).

33 TAM 200733023 (8/17/07).

34 IRS Letter Ruling 200743001 (6/15/07).

35 Christiansen, 130 T.C. No. 1 (2008).

36 Proctor, 142 F.2d 824 (4th Cir. 1944).

37 Succession of Charles T. McCord, Jr., 461 F.3d 614 (5th Cir. 2006), rev’g and rem’g 120 T.C. 358 (2003).

38 T.D. 9403.

39 Kohler, T.C. Memo. 2006-152.

40 REG-112196-07.

41 Rev. Rul. 2008-22, 2008-16 I.R.B. 796.

42 Roski, 128 T.C. 113 (2007).

43 Notice 2007-90, 2007-46 I.R.B. 1003.

44 GCM 200747019 (10/11/07).

45 See Rev. Proc. 2007-45, 2007-29 I.R.B. 89, and Rev. Proc. 2007-46, 2007-29 I.R.B. 102.

46 See Rev. Proc. 2007-66, 2007-45 I.R.B. 970.

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