Significant Recent Developments in Estate Planning

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EXECUTIVE SUMMARY

• The fate of the estate and generation-skipping transfer taxes remains in doubt after 2009; currently both taxes are scheduled to be repealed for 2010 and then to be reinstated in 2011, under pre- EGTRRA law.
• The Supreme Court held in the Knight case that investment advisory fees paid by trust are subject to the 2% of adjusted gross income floor under Sec. 67(a). The IRS has issued two notices addressing the unbundling of trustee fees.
• The IRS issued final and proposed guidance on the qualified severance of a trust for generation-skipping transfer tax purposes under Sec. 2642.
• The Sixth Circuit, joining the Fifth Circuit and the Tax Court, reversed a district court and held that a decedent’s remaining lottery prize installments were an annuity that should be valued using the Sec. 7520 tables.
• The IRS issued proposed guidance on private trust companies and a procedure for pursuing a declaratory judgment in the Tax Court under Sec. 7477.

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This article examines developments in estate, gift, and generation-skipping transfer tax planning and compliance between June 2008 and May 2009. It discusses legislative developments, cases and rulings, 2009 changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001¹ (EGTRRA), and the annual inflation adjustments for 2009 relevant to estate and gift tax.

Legislative Developments

Under EGTRRA, the estate tax and the generation-skipping transfer (GST) tax are scheduled to be repealed effective January 1, 2010, but due to the act’s sunset provisions they will be reinstated January 1, 2011, under pre-EGTRRA law (e.g., $1 million applicable exclusion amount; 55% top rate).

There is a strong possibility that Congress will enact legislation this year to address the fate of the estate tax going forward. In its budget proposal, the Obama administration’s “Baseline Projection of Current Policy” assumes that the estate tax would be maintained at its 2009 parameters—with a $3,500,000 per decedent exclusion and a top tax rate of 45%—for 2010 and beyond. Numerous bills introduced in the 111th Congress propose to maintain the estate tax at its 2009 parameters, although with modifications (primarily to index the applicable exclusion amount for inflation and allow portability of the applicable exclusion amount between spouses).

In addition to the fate of the estate tax, there could be other sweeping changes to estate tax planning if other proposals contained in either the Obama administration’s fiscal year 2010 tax proposals or proposed legislation tied to estate tax reform are enacted. Provisions affecting estate and gift taxes in the FY 2010 tax proposals include:

• Imposing a reporting requirement on executors and donors to provide both the IRS and the recipient of property with accurate basis information and also requiring both parties to report basis consistently;
• Disallowing valuation discounts in valuing transfers of family-controlled entities if the discounts are a result of certain restrictions; and
• Imposing a minimum term of 10 years for grantor retained annuity trusts (GRATs).

Proposed legislation tied to estate tax reform has been introduced in Congress to limit the discounts for transfers of family-controlled entities that hold nonbusiness assets.

Trusts

Deduction of Investment Advisory Fees

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

In Knight,² 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. 67(a), making them subject to the 2% AGI floor. The Supreme Court ruled that investment advisory fees were not “uncommon (or unusual, or unlikely)” for a hypothetical individual to incur. Therefore, the Court ruled that the second requirement of Sec. 67(e)(1) (that the expense “would not have been incurred if the property were not held in the trust”) had not been met.

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

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

In response to this uncertainty, the IRS released Notice 2008-32,³ which provided that trusts and estates would 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 trustee fee without regard to the 2% AGI floor. There is one exception: Payments by a trustee or executor to third parties for expenses subject to the 2% AGI floor are readily identifiable and must be treated separately from the otherwise bundled trustee fee.

The IRS had anticipated issuing final regulations in 2008. Realizing that it would not have this guidance issued by the end of the year, it issued Notice 2008-116,⁴ which provides that the guidance in Notice 2008-32 has been extended to tax years beginning before January 1, 2009.

Allocation of Income to Payment to Charity

In general, Sec. 642(c) allows an estate or trust a deduction for payments to charity in lieu of the charitable deduction allowed an individual under Sec. 170. The deduction, however, is limited to the gross income of the estate or trust for the year in which the payment is made to the charity.

Regulations under Sec. 642(c) provide special rules for computing the amount of an estate’s or trust’s charitable deduction. In particular, Regs. Sec. 1.642(c)-3(b)(2) provides that in determining whether an amount of income paid to a charitable beneficiary includes particular items of income not included in gross income (for example, tax-exempt income), provisions in the trust’s or estate’s governing instrument will control if they specify the source out of which amounts are to be paid to the charitable beneficiary. In the absence of specific provisions in the governing instrument or in local law, the amount of income distributed to each charitable beneficiary is deemed to consist of the same proportion of each class of the items of income of the estate or trust as the total of each class bears to the total of all classes.

Sec. 643(a) provides rules for determining an estate’s or trust’s distributable net income (DNI) deduction. Regs. Sec. 1.643(a)-5(b) provides rules for reducing the amount of tax-exempt interest includible in DNI when tax-exempt interest is deemed to be included in a payment to charity. Similar to Regs. Sec. 1.642(c)- 3(b), the regulation provides that if the estate’s or trust’s governing instrument provides as to the source out of which payments are to be made to a charity, the specific provisions control. In the absence of specific provisions, the amount of income distributed to each charitable beneficiary is deemed to consist of the same proportion of each class of the items of income of the estate or trust as the total of each class bears to the total of all classes.

The IRS has generally taken the position in private letter rulings that Regs. Secs. 1.642(c)-3(b)(2) and 1.643(a)-5(b) require that if an estate’s or a trust’s governing instrument or local law has a specific provision addressing the sourcing of payments to be made to a charity, that provision must have economic effect independent of income tax consequences. REG-101258-08⁵ incorporates this position into these regulations. The proposed regulations require that a provision in a governing instrument or in local law that specifically provides the source out of which amounts are to be paid to charity must have economic effect independent of income tax consequences in order to be respected for federal tax purposes. If such a provision does not have economic effect, income distributed for a charitable purpose will consist of the same proportion of each class of the items of income as the total of each class bears to the total of all classes.

The primary target of the proposed regulations is charitable lead trusts (CLTs) and the ordering rules generally contained in a CLT’s governing instrument. Many CLT governing instruments provide that the annuity or unitrust payment is to consist of the following classes of items until such class has been exhausted: (1) ordinary income, (2) capital gain, (3) other income (including tax-exempt income), and (4) corpus. These ordering rules allow for the maximum benefit of the charitable deduction under Sec. 642(c). Because a CLT is a taxable entity, any amount of income not paid to charity through the annuity or unitrust payment is taxable to the CLT. Thus, the ordering rules ensure that taxable income is exhausted through the payment of the annuity or unitrust interest prior to the use of nontaxable sources such as tax-exempt income and corpus. In numerous private letter rulings, the IRS has declared that these ordering rules generally do not have economic effect independent of income tax consequences. The proposed regulations clarify and incorporate this position in the existing regulations, including an example specifically dealing with CLTs.

UBTI and CRTs

Under Sec. 664(c), a charitable remainder trust (CRT) is a tax-exempt entity. For tax years beginning before January 1, 2007, Sec. 664(c) provided that a CRT would not be tax exempt for any year in which the CRT had any unrelated business taxable income (UBTI) within the meaning of Sec. 512. The Tax Relief and Health Care Act of 2006⁶ amended Sec. 664 to provide that if a CRT had UBTI in any tax year it would remain tax exempt, but a 100% excise tax would be imposed on its UBTI. The amendment applies to tax years beginning after December 31, 2006.

Under Sec. 664(c)(2)(A), the amount of UBTI is determined according to Sec. 512. Under Sec. 512, UBTI is computed with the modifications set forth in Sec. 512(b), including the $1,000 de minimis deduction in Sec. 512(b)(12). The excise tax imposed under Sec. 664(c)(2)(A) is treated as imposed under the excise tax rules that apply to private foundations and other tax-exempt organizations, other than the rules for abatement of first- and secondtier taxes.

The regulations under Sec. 664(c) were amended to provide that CRTs with UBTI in tax years beginning after December 31, 2006, are exempt from income tax but are subject to a 100% excise tax on the UBTI of the CRT.⁷ 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 annuity or unitrust payment made to the beneficiary under Sec. 664(b). The final regulations provide further examples illustrating the tax effects of UBTI on a CRT.

Tax Consequences of Pro-Rata Division of a CRT

In Rev. Rul. 2008-41,⁸ the IRS rules on the tax consequences of a pro-rata division of a CRT (as defined in Sec. 664). Specifically, the IRS sets forth two scenarios providing for the pro-rata division of a CRT and addresses five questions associated with that division. The revenue ruling essentially consolidates issues that have been the subject of many previous private letter rulings issued by the IRS.

In the first scenario, the CRT (original CRT) provides for the payment of an annuity or unitrust amount (payment) for the lives of two or more individuals. When one individual dies, the remaining individuals are entitled to the entire payment. Upon the death of the last survivor of the payment recipients, the original CRT is to distribute its remaining assets to its charitable remainder beneficiary. The state court having jurisdiction over the original CRT has approved a pro-rata distribution of the original CRT’s assets into separate CRTs (new CRTs), one for each payment recipient. For purposes of the character of distributions from the new CRTs to the payment recipients, each new CRT will have an equal share of the original CRT’s income in each tier described in Sec. 664(b).

The trust instruments of the new CRTs will generally have the same provisions of the original CRT with some changes, the most significant of which is that upon the death of a payment recipient, each asset of the new CRT of that recipient is to be divided equally and transferred to trusts of the remaining living recipients until the last recipient has died, at which point the final recipient’s trust will then terminate and its assets will be distributed to the charitable remainder beneficiary. The second scenario is similar to the first scenario except that the pro-rata distribution is pursuant to a divorce and, upon the death of a payment recipient, the new CRT for that recipient is distributed to the remainder beneficiary (not the surviving payment recipient).

The first issue the IRS addresses is whether the pro-rata division causes the new CRTs to fail to qualify as CRTs under Sec. 664(d). The IRS reasons that the new CRTs generally operate in the same manner as the original CRT, with slight modifications to mirror the result in the original CRT. It notes that after the original CRT’s pro-rata division, the new CRTs continued to meet the definition of a CRT in Sec. 664(d); therefore, the new CRTs did not fail to qualify as CRTs under Sec. 664(d).

The second issue the IRS addresses is the basis and holding period of the assets of the new CRTs. The IRS notes that the pro-rata division of the CRT is not a sale, exchange, or other distribution producing gain or loss. Therefore, the IRS ruled that under Sec. 1015(b) the basis of the assets in the original CRT is carried over to the basis of the assets in the new CRTs; under Sec. 1223(2) the holding period of the assets in the original CRT “tack” to the holding period of the assets in the new CRTs.

The third issue the IRS addresses is whether the pro-rata division of the original CRT terminates the CRT and is therefore subject to the termination tax of Sec. 507. The IRS notes that the new CRTs generally have the same governing provisions and beneficiaries of the original CRT; thus, the termination tax of Sec. 507 does not apply.

The fourth issue is whether the prorata division of the original CRT results in self-dealing under Sec. 4941(d) by the payment recipients. The IRS notes that because the payment beneficiaries receive a payment from the new CRTs equivalent to what they would have received under the original CRT, the pro-rata division of the original CRT is not an act of self-dealing under Sec. 4941(d).

Finally, the IRS addresses whether the pro-rata division of the original CRT is a taxable expenditure under Sec. 4945(d) and subject to excise of Sec. 4945(a). The Service ruled that because the costs of the pro-rata division of the CRT will be borne by the payment recipients, there is not a taxable expenditure to the original CRT that would be subject to the tax of Sec. 4945(a).

CRT Transaction a Transaction of Interest

In Notice 2008-99,⁹ the IRS describes a transaction involving the creation of a CRT and the subsequent sale of the interests in the CRT to a third party. The notice states that the IRS believes the transaction may have the potential for tax avoidance and has labeled it a “transaction of interest” as defined in Regs. Sec. 1.6011-4(b)(6).

In the first part of the transaction, a taxpayer creates a CRT under Sec. 664 by transferring a highly appreciated, lowbasis asset to the CRT and taking back an annuity or unitrust interest. The taxpayer gives the remainder interest to a charity. The taxpayer will usually receive an income tax charitable deduction under Sec. 170 for the present value of the remainder interest transferred to charity. The CRT will then sell the appreciated asset and invest the proceeds in a diversified portfolio. Because the CRT is a tax-exempt entity, it will not recognize gain on the sale of the appreciated asset. The taxpayer will recognize the gain as the annuity or unitrust payments are made to the taxpayer.

In the second part of the transaction, the taxpayer and the charity sell their interests in the CRT to a third party for an amount that approximates the fair market value of the assets held by the CRT. Under Sec. 1001(e), if a taxpayer disposes of an income interest (e.g., an annuity or unitrust interest) in a trust, the taxpayer disregards any adjusted basis he or she may have in that interest in determining the gain or loss from the disposition of the interest. An exception applies when the disposition of the income interest is part of a transaction in which the taxpayer transfers the entire interest in the property to a third party. In such cases, Regs. Sec. 1.1001-1(f)(3) provides that the uniform basis rules under Regs. Secs. 1.1014-5 and 1.1015(b) apply. Under these rules, the bases of the assets in the CRT are apportioned between the income and the remainder interests. Thus, when the taxpayer sells his or her annuity or unitrust interest in the CRT, his or her gain will be the difference between the proceeds received from the sale and the basis the taxpayer derives from the assets in the CRT.

In effect, the sale eliminates much of the gain from the sale of the highly appreciated, low-basis asset the taxpayer would have otherwise recognized when he or she received annuity or unitrust payments from the CRT. In addition, had the taxpayer not sold his or her annuity or unitrust interest in the CRT simultaneously with the charity, the taxpayer would have no basis under the rules in Sec. 1001(e), and the entire proceeds from the sale of the annuity or interest would have been recognized as capital gain.

One can understand the IRS’s concern if the sale of the annuity interest in the CRT was contemplated at the time the CRT was created. In recent years, the Service has issued many favorable rulings in which the taxpayer sought to exit a CRT by selling his or her annuity or unitrust interest in the CRT to the CRT. In those rulings, the IRS decided that the sale of the interest resulted in the recognition of gain to the extent of the proceeds of the sale because, under Sec. 1001(e), the taxpayer’s basis in the annuity or unitrust interest was zero. It is unclear why the IRS did not think the exception in Sec. 1001(e) should apply when both the taxpayer and the charity sell their interests in the CRT to a third party, assuming there was no intent to terminate the CRT at the time it was created.

Gift Tax

Disclaimers

Under Sec. 2518, if a person makes a qualified disclaimer with respect to an interest in property, the disclaimed interest is treated for gift, estate, and generationskipping transfer tax purposes as if the interest had never been transferred to that person. If a person makes a qualified disclaimer, that person will not incur gift tax consequences as a result because he or she is ignored for gift tax purposes.

Sec. 2518 defines “qualified disclaimer” as an irrevocable and unqualified refusal by a person to accept an interest in property, but only if:

• The disclaimer is in writing;
• The disclaimer is received by the transferor of the interest, his or her legal representative, or the holder of the legal title to the property to which the interest relates not later than the date that is nine months after the later of (1) the date on which the transfer creating the interest in the person is made or (2) the day on which the person attains age 21;
• The person has not accepted the interest or any of its benefits; and
• As a result of the disclaimer, the interest passes without any direction on the part of the person making the disclaimer either to the decedent’s spouse or to a person other than the person making the disclaimer.

Letter Ruling 200846003¹⁰ highlights how tricky it can be to meet the fourth requirement for a qualified disclaimer and the disastrous tax consequences that may occur if all the requirements of a qualified disclaimer are not met. In the letter ruling, the children of the decedent disclaimed their interests as beneficiaries of an individual retirement account (IRA). The IRA custodial agreement provided that if the children predeceased the decedent, the decedent’s estate would be the beneficiary of the IRA. As a result of the disclaimer and by operation of state law, the children were treated as having predeceased the decedent.

The decedent’s will specifically provided that the IRA was to pass to a trust for the benefit of the decedent’s spouse during his life (Trust 1). Upon the death of the decedent’s spouse, the assets of Trust 1 were to pass to another trust, of which the children were the beneficiaries (Trust 2). The children failed to disclaim their interests in Trust 2. The objective of the children’s disclaimers was to have the IRA pass to Trust 1, which would qualify for the estate tax marital deduction under Sec. 2056.

The IRS noted that because the children did not disclaim their interests in Trust 2, they had not disclaimed their entire interest in the IRA. Thus, the IRS ruled that the children’s disclaimers were not qualified disclaimers for purposes of Sec. 2518. The IRS also noted that in order for Trust 1 to qualify for the marital deduction, the IRA must have passed from the decedent. Thus, it ruled that for gift tax purposes, the children had made a taxable gift of the IRA’s fair market value and accordingly, for estate tax purposes, the IRA passed from the children, not the decedent. Therefore, the decedent’s estate was not entitled to a marital deduction for the assets in Trust 1.

Practice tip: This letter ruling highlights the importance of making sure that estate planners follow the flow of the assets to their ultimate disposition when contemplating a disclaimer. When a disclaimer results in property passing to an entity other than a natural person, the estate planner must look through the entity until the property rests in the hands of a natural person. Failure to do so may lead to the negative tax consequences of this letter ruling. In this instance, not only was the IRA subject to estate tax in the decedent’s estate, it was also subject to gift tax because the children made a valid disclaimer for state law purposes but failed to make a qualified disclaimer for federal gift tax purposes.

QPRTs

A qualified personal residence trust (QPRT) is an estate tax freeze technique similar to a GRAT in which a senior family member transfers assets to a trust, retaining an income interest in the trust for a term and transferring the remainder interest to junior family members. Regs. Sec. 25.2702-5 specifically authorizes QPRTs. If properly structured, a QPRT allows the income interest to be valued in determining the value of the remainder interest that is subject to gift tax. If a personal residence trust is not properly structured as a QPRT, the transfer of the residence to the trust will be subject to Sec. 2702 and thus the entire value of the residence will be subject to gift tax.

A QPRT accomplishes its estate planning goal only if the senior family member survives the term of the income interest. If he or she does not survive, the QPRT will be includible in the estate of the senior family member under Sec. 2036. If the senior family member survives the term, he or she must either move out of the residence upon expiration of the term or pay the fair value rent of the property in order to remain in the residence. If he or she does not leave the residence or pay fair value rent, the residence will be includible in the senior family member’s estate and the estate planning goal of the QPRT will have been defeated. But if either of these two options is not viable, is there an alternative? Letter Ruling 200904022¹¹ provides a third possible option.

In that ruling, the senior family member outlived the QPRT’s initial term. After the term’s expiration, the senior family member (who was both grantor and trustee of the QPRT) and the junior family members executed an amendment to the QPRT. The amendment provided that upon the expiration of the income interest and the direction by a majority of the current remainder beneficiaries, the trustee may liquidate the QPRT or provide a gift to anyone that a majority of the current remainder beneficiaries so choose of the term interest in any real property of the QPRT that will be occupied by the term interest holder as his or her principal residence. The junior family members then created an irrevocable trust to which they transferred their interest in the residence and transferred to the senior family member a term interest to occupy the residence. The letter ruling requested a ruling that Sec. 2702 did not apply to the transfer.

With little analysis, the IRS ruled that Sec. 2702 will not apply to the transfer of the residence to the irrevocable trust if the trust instrument is substantially similar to the sample in Rev. Proc. 2003-42, §4, the trust operates in a manner consistent with the terms of the trust instrument, the trust is a valid trust under applicable local law, and the residence qualifies as a personal residence as defined in Regs. Sec. 25.2702-5(c)(2). The creation of a second trust with the transfer of a term interest to the senior family member alleviates the need of the senior family member to vacate the residence or pay fair value rent for the duration of the second term. Although not addressed in the letter ruling (because such a ruling was not requested), the transfer of an income interest by the junior family members to the senior family member will have gift tax consequences to the junior family members to the extent of the value of the term interest given to the senior family member.

Estate Tax

FLPs and Sec. 2036

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) if the facts surrounding the transfer of property and the subsequent use of property show that the transferor implicitly retained the right to enjoy the property or its income (prohibited rights).

Case law has established various factors— including transferring substantially all one’s assets to the FLP, commingling personal and FLP assets and funds, and failing to respect partnership formalities— as clear evidence of the retention of prohibited rights. Nevertheless, there are a handful of cases each year in which the FLP and its partners fail to follow these guidelines, and this year was no exception.

In Estate of Hurford,¹² the Tax Court ruled that the assets the decedent transferred to FLPs (she sold the FLP interests in exchange for private annuities to her children) were includible in her estate under Sec. 2036(a)(1). The numerous factors cited by the court as indicative of the failure to meet the bona fide sale exception and of the retention of prohibitive rights included:

• Transferring substantially all the decedent’s assets to the FLPs;
• Commingling funds due to significant delays (over a year) in retitling assets that were transferred to the FLPs;
• Withdrawing money from the FLP to pay the decedent’s estimated income taxes;
• Failing to maintain proper capital accounts; and
• Failing to obtain a contemporaneous valuation of the FLP interests transferred in exchange for the annuities.

Similarly, in Estate of Jorgensen,¹³ the Tax Court ruled that Sec. 2036(a)(1) was applicable to an FLP created by the decedent. The factors the court found indicative of the retention of prohibited rights included:

• The decedent’s check-writing privileges (even though she was not the general partner) and the writing of personal checks out of the FLP accounts (to make gifts);
• No books or records or formal minutes of meetings of the FLP were maintained;
• The general partners did not reconcile checking accounts or maintain check registers; and
• The general partner borrowed money from the FLP to buy a personal residence and never repaid it.

The court also noted that a significant portion of the partnership assets was used to pay the estate taxes and legal expenses of the decedent’s estate.

As in prior cases, 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:

• Is the bona fide sale exception applicable to the transfer?
• 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 retention of the right to enjoy the property—commingling of funds, failure to follow partnership formalities— heavily influence the decision on whether the bona fide sale exception applies (and vice versa). Thus, in cases in which 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), the presence of some potential benefit other than estate tax advantages constitutes a significant and legitimate nontax reason, making the transfer of assets to an FLP sufficient to satisfy 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.

Amount Includible in a Decedent’s Estate for Certain Estate Planning Techniques

The IRS has issued final regulations¹⁴ that provide guidance on the part of a grantor retained (annuity/unitrust/income) trust (GRT) or charitable remainder (annuity/unitrust) trust that is includible in a decedent’s gross estate under Sec. 2036 and/or Sec. 2039. The final regulations adopt, with minor revisions, previously issued proposed regulations.15

Sec. 2036 provides for including in a decedent’s estate certain transfers the decedent made during his or her lifetime in which the decedent retained certain rights in the property. Sec. 2039 provides for including in a decedent’s estate the value of any annuity receivable by a beneficiary by reason of surviving the decedent if the annuity was payable to the decedent. These provisions may overlap in the case of certain estate planning techniques a decedent may have executed during his or her lifetime that were still in existence at the time of the decedent’s death. The determination of value for estate tax purposes can vary significantly depending upon whether Sec. 2036 or Sec. 2039 is applicable to the estate.

The final regulations provide that if a decedent transfers property during life to a GRT or a CRT and retains the right to an annuity, unitrust, or other income payment from, 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. The portion of the trust corpus includible in the decedent’s gross estate is that portion, valued as of the decedent’s death, necessary to yield that annual payment using the appropriate Sec. 7520 interest rate. The final 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.

In the proposed regulations, the IRS acknowledged that while both Sec. 2036 and Sec. 2039 may be applicable to a CRT or a GRT, it believes it is appropriate to provide a regulatory rule under which only one of these sections is to be applied in the future in the interest of ensuring similar tax treatment for similarly situated taxpayers. The IRS gives two reasons for the choice of Sec. 2036. First, Sec. 2039 appears to have been intended to address annuities purchased by or on behalf of the decedent and annuities provided by the decedent’s employer. Second, the interests retained by grantors in a CRT or a GRT are more similar to the interests addressed under Sec. 2036 than those most clearly addressed under Sec. 2039.

Left unanswered in the final regulations is the portion of the trust includible if the grantor’s retained interest increases over time. For example, the retained annuity interest in a GRAT each year may be 120% of the previous year’s annuity.¹⁶ The proposed regulations address this issue and provide examples.¹⁷

Exercise of Power of Substitution

Sec. 675(4)(C) provides that the grantor shall be treated as the owner of any portion of a trust for which the grantor has the power, exercisable in a nonfiduciary capacity without the approval or consent of any person in a fiduciary capacity, to reacquire trust property by substituting property of an equivalent value (power of substitution). A power of substitution is most often used in a trust instrument to create grantor trust status for an intentionally defective grantor trust (IDGT) (a trust that is disregarded for income tax purposes but respected for estate and gift tax purposes). Some commentators question, however, whether a power of substitution exercisable in a nonfiduciary capacity creates inclusion of the trust’s assets in the grantor’s estate for estate tax purposes.

Letter Ruling 200842007¹⁸ provides an alternative to creating an IDGT by including a nonfiduciary power of substitution in the trust instrument that avoids the estate tax consequences associated with such power. In the situation in the letter ruling, the trust instrument of the IDGT gave the grantor a power of substitution over trust assets; however, such power could be exercised only in a fiduciary capacity. The IRS ruled that this did not cause the assets of the trust to be included in the grantor’s estate for estate tax purposes.

In making its determination, the IRS cited Estate of Jordahl,¹⁹ which considered the terms of an inter vivos trust created by the decedent in which the decedent reserved the power to substitute other assets for those held by the trust, provided that the assets substituted were of equal value to the assets replaced. The Tax Court held that the decedent’s reserved power to substitute other assets of equal value was not a power to alter, amend, or revoke the trust within the meaning of Sec. 2038(a) (2). The court further concluded that the requirement that the substituted property be equal in value to the assets replaced indicated that the substitution power was held in trust and was thus exercisable only in good faith and subject to fiduciary standards, such that the decedent was accountable in equity to the trust beneficiaries.

Applying Jordahl, the IRS determined that the grantor had retained the power, exercisable in a fiduciary capacity, to acquire trust assets by substituting other assets of equivalent value to the assets acquired, measured at the time of substitution. Accordingly, the IRS concluded that the retention of the power of substitution would not cause the trust’s assets to be included in the grantor’s estate for estate tax purposes under Secs. 2033, 2036(a), 2038, or 2039. It further determined that the exercise of such power would not have gift or income tax consequences.

While the power of substitution exercisable only in a fiduciary capacity may guard against estate tax consequences associated with the power, it does not create grantor trust status. To create grantor trust status, the trust instrument in Letter Ruling 200842007 provided that the spouse of the grantor was a discretionary beneficiary of the trust. Under Sec. 677(a), a grantor will be treated as the owner of a trust if the trust’s income without the approval or consent of any adverse party is, or at the discretion of the grantor or a nonadverse party may be, distributed to the grantor or the grantor’s spouse. The trustee of the trust was a nonadverse party, as that term is defined in Sec. 672(b). Among other rulings, the grantor requested a ruling on the estate tax consequences of the exercise of the power of substitution.

Letter Ruling 200842007 provides an alternative to using the power of substitution under Sec. 675(4)(C) to create an IDGT if the estate planner is concerned that such a power may cause the inclusion of trust assets in a grantor’s estate for estate tax purposes. However, this alternative is viable only if the grantor is married at the time the trust is created and remains married to the spouse during his or her life (assuming the trust uses “spouse” as a generic term). In Rev. Rul. 2008-22,²⁰ the IRS ruled that a power of substitution, exercisable in a nonfiduciary capacity, will not by itself cause estate tax inclusion under Sec. 2036 or Sec. 2038, provided the trustee has a fiduciary obligation (under local law or the trust instrument) to ensure the grantor’s compliance with the terms of this power. Given this revenue ruling, one assumes grantors will no longer need to use the alternative in the letter ruling if the sole reason for the structure is to create an IDGT.

Generation-Skipping Transfer Tax

Trust Severance

Sec. 2642(a)(3), enacted as part of the generation-skipping transfer tax (GSTT) provisions of EGTRRA, provides rules for severing a trust into two or more trusts so that the resulting trusts will be recognized as separate trusts for GSTT 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 severances permitted in the existing regulations were available only for testamentary trusts or inter vivos trusts included in the decedent’s gross estate, had to be commenced within a prescribed time after the decedent’s death, and had to be authorized specifically by the trust’s governing instrument. A qualified severance as defined in Sec. 2642(a)(3) is applicable to any type of trust and may be done at any time.

On August 2, 2007, the IRS published final²¹ and proposed²² regulations providing guidance on the qualified severance of a trust under Sec. 2642. The final regulations adopt and expand the proposed regulations previously issued by the IRS.²³ The August 2, 2007, proposed regulations responded to new matters raised by commentators to 2004 proposed regulations that the IRS identified as needing further evaluation.

First, the August 2, 2007, proposed regulations provided 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 GSTT purposes if such trusts are recognized under state law. Second, the proposed regulations provided that a trust with an inclusion ratio between one and zero could be split into more than two trusts as long as the resulting trusts have an inclusion ratio of one or zero. Finally, the proposed regulations provided special funding rules for the non-pro-rata division of some assets between or among severed trusts.

Final regulations published on July 31, 2008,²⁴ regarding the August 2, 2007, proposed regulations generally adopt the proposed regulations with certain amendments. Most significantly, the final regulations add an example clarifying that a nonqualified severance (i.e., a severance under Regs. Sec. 26.2654-1(b)) may subsequently be severed in a qualified severance.

Extension to Allocate GST Exemption

Sec. 2642(g)(1) was enacted as part of EGTRRA and allows a taxpayer to seek relief for an extension of time to make certain allocations and elections with regard to his or her GST exemption for GSTT. Specifically, Sec. 2642(g)(1)(A)(i) allows a taxpayer to seek an extension to make a timely allocation of GST exemption where such time has previously expired (see Regs. Sec. 26.2632-1).

After the enactment of Sec. 2642(g) (1), the IRS issued Notice 2001-50²⁵ to be used as guidance in requesting relief under Sec. 2642(g)(1) until it issued regulations. The notice provides that relief under Sec. 2642(g)(1) is to be requested under Regs. Sec. 301.9100-3, which provides that requests for relief will be granted when the taxpayer provides evidence to establish to the IRS’s satisfaction that the taxpayer acted reasonably and in good faith and that granting relief will not prejudice the interests of the government.

For the most part the IRS has been very liberal in granting relief under Sec. 2642(g)(1), and rarely has a letter ruling been published wherein the IRS denied a taxpayer relief. However, in Letter Ruling 200851020²⁶ the IRS denied such relief. The facts state that a couple had created a number of CRTs for the benefit of their grandchildren and charities. The couple failed to allocate any GST exemption to the CRTs on their timely filed gift tax returns for the years in which the CRTs were created. The couple elected to split gifts on all returns. Upon discovering the failure to make the allocation, the husband decided not to request relief under Sec. 2642(g) (1) and instead made a late allocation of his GST exemption to all the CRTs. The facts further reflect that the GSTT associated with annuity/unitrust payments to the grandchildren had been paid or was in the process of being paid. Subsequently, the husband sent the IRS this letter ruling request seeking relief under Sec. 2642(g) (1). The IRS denied the husband relief, citing the fact that he had made late allocations that were irrevocable under Regs. Sec. 26.2632-1(b)(4)(ii)(A)(2).

Observation: A little insight is in order as to the real reason the IRS denied relief in this particular instance. The IRS has generally granted relief to taxpayers to make a timely allocation of GST exemption in cases in which they had previously made a late allocation of GST exemption because this was the only way to minimize the GSTT consequences of not making a timely allocation of GST exemption prior to the enactment of Sec. 2642(g)(1). (Remember that for GSTT purposes, a timely allocation of GST exemption uses the date of transfer value in determining the inclusion ratio of a trust. A late allocation of GST exemption uses the date of allocation value (which means that appreciation in value of the trust must be taken into account).) However, in this case the facts reflect that the late allocation was made by the husband after the enactment date of Sec. 2642(g)(1) and that the husband had considered whether to request relief before making the late allocation and chose to make the late allocation.

This is probably the real reason the IRS denied relief: The husband was not acting in good faith. He did not truly “miss” the timely allocation by mistake. He realized the relief was available when the couple originally discovered they had missed the election but determined that a late allocation was the better alternative. Realizing that the couple was using hindsight in applying for relief, the IRS denied them relief. While it is true that Sec. 2642(g) (1) does not grant relief for a late allocation of GST exemption, the husband was requesting relief from the missed timely election under this section (not the late allocation, which would have been unnecessary), relief for which Sec. 2642(g)(1) is available.

Valuation

Closely Held Interests

While the IRS has not yet been successful in crafting a widely applicable argument to challenge the benefits of an FLP for gift tax purposes, it has recently had some success with its argument that the step transaction doctrine applies to the creation of an FLP and the subsequent gift of limited partnership interests, resulting in an “indirect gift.” 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.

In Gross,²⁷ the taxpayer created an FLP with her two adult children. The taxpayer filed a certificate of limited partnership for the FLP with the state of New York on July 15, 1998; however, the FLP agreement was not signed by all the parties until December 15, 1998. The two children made their initial contributions to the FLP (as stated in the FLP agreement) on July 31, 1998, and the taxpayer made her initial contribution on November 16, 1998. Prior to executing the FLP agreement, the taxpayer made periodic contributions of marketable securities to the FLP, which were properly credited to her capital account.

On the same day the FLP agreement was executed, the taxpayer made a gift of limited interests in the FLP to her two children, representing a 22.25% interest in the FLP to each. She listed the gifts on her 1998 gift tax return reflecting a combined discount of 35% for lack of majority, control, and marketability. The IRS argued that no discount should be applied to the gifts because the transfers to the taxpayer’s children were indirect gifts of the marketable securities that the taxpayer had transferred to the FLP. It made three arguments as to why the transfers should be deemed indirect gifts.

First, the IRS argued that the taxpayer and her children did not create the FLP until December 15, 1998, because, under New York law, execution of the FLP agreement was a condition precedent. The Tax Court noted that under New York law, if the parties seeking to form a limited partnership do not satisfy the requirements necessary to form a limited partnership, they may be deemed to have formed a general partnership if their conduct indicates that they have agreed (whether orally and whether expressly or impliedly) on all the essential terms and conditions of their partnership agreement. The Tax Court found that the evidence indicated that the taxpayer and her two children intended to form a partnership and that at the very least they formed a general partnership on July 15, 1998.

Second, the IRS argued that the transfers were indirect gifts because proportionate to the taxpayer’s interest in the FLP, only 55.50% of the value of the marketable securities was credited to her capital account. The Tax Court found that the IRS disregarded the events that occurred prior to December 15, 1998. It noted that the FLP had properly credited the taxpayer’s contributions to her capital account and that the gift of the limited interests occurred after the contributions had been properly credited to her account.

Finally, the IRS argued that the step transaction doctrine should apply and that the transfers of the limited interests by the taxpayer to her two children were indirect gifts. The IRS previously made this argument in Holman,²⁸ where the Tax Court held that the step transaction doctrine did not apply because there was real economic risk between the date the taxpayer made the contribution to the FLP and the date of the gift of the FLP interests. As in Holman, the assets the taxpayer contributed to the FLP were marketable securities that were actively traded on an established market. Due to the day-to-day economic risk associated with actively traded securities, the Tax Court held that the step transaction doctrine was not applicable and therefore the transfers to the FLP were not indirect gifts. Also as in Holman, the Tax Court reiterated in a footnote that other types of investments may be susceptible to the step transaction doctrine, such as preferred stock or long-term government bonds.

Built-in Gains Tax

While the courts and the IRS have agreed that the built-in gain (BIG) tax on a corporation’s appreciated assets should be taken into account in valuing its stock under the net asset valuation method, they have not agreed on the proper method for quantifying the discount. The IRS has argued successfully before the Tax Court for discounting the BIG tax liability over a period of time when the facts in the case showed that an immediate liquidation of the company was unlikely. However, the Fifth and the Eleventh Circuits have rejected these arguments, stating that 100% of the BIG tax must be taken into account when using the net asset valuation method (regardless of the likelihood of immediate liquidation) because the threshold assumption of that method is that all assets are liquidated as of the date of valuation.

The appropriate amount of BIG tax to take into account was raised in Litchfield.²⁹ Unfortunately, the taxpayer did not ask for a 100% deduction of the BIG tax (a fact that the Tax Court carefully noted), and the dispute was primarily about the projected length of time over which the BIG tax liability was to be discounted. The IRS expert, relying solely on historical sales data, projected an average holding period of close to 54 years, while the estate’s expert, who in addition to historical sales data consulted with management on current and future plans to dispose of assets, projected an average holding period of five years for one company and eight years for the other. The estate’s expert also took into consideration the projected appreciation in the assets over time in computing the BIG tax. The court found the estate expert’s evidence and testimony to be more accurate and credible than the IRS expert’s and ruled for the taxpayer.

Lottery Payments

The value of annuities (other than commercial annuities), life estates, term interests, remainders, and reversions for estate, gift, and income tax is determined using tables issued by the IRS under Sec. 7520. Under what circumstances is a departure from using the Sec. 7520 tables appropriate? The issue has been litigated in the context of valuing the remaining installment 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. The Second and Ninth Circuits have disagreed and allowed for exceptions from using 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. The Sixth Circuit took up the issue in Negron.³⁰

In that case, two out of the three joint winners of a 1991 Ohio Super Lotto $20 million jackpot died during 2001. Both were entitled to 15 additional nonassignable annuity payments of their lottery winnings as of the date of their respective deaths. The executrix for both estates elected to receive a lump-sum payment from the Ohio Lottery Commission (OLC) in lieu of the remaining annuity payments. The lump-sum payments, which the OLC computed using a 9% discount rate (per state valuation tables in effect on the date the lottery was won), were significantly lower than the present value of the annuities computed under the Sec. 7520 tables. For computing the estate tax, the IRS argued that the annuities should be valued using the Sec. 7520 tables regardless of the amounts received. The executrix argued that the tables should not be used because they produced an unreasonable and unrealistic result.

The district court ruled for the taxpayers, but the decision was reversed and remanded by the Sixth Circuit, which stated that the Sec. 7520 tables generally control and that the taxpayer—who had a heavy burden to successfully argue that the tables produce an unreasonable and unrealistic result—did not meet that burden.

Sec. 7520 Tables

Sec. 7520 requires that the IRS revise the mortality assumptions underlying the tables at least once every 10 years to incorporate the most recent available mortality data. New tables were issued on May 7, 2009,³¹ and as expected they reflect slightly improved mortality data. The improved life expectancies affect different planning techniques differently. The new tables apply to transactions occurring on or after May 1, 2009.

In February 2009, the Sec. 7520 rate fell to an all-time low of 2.0%, a rate that was lower than the lowest interest factor in the Sec. 7520 tables at that time. The IRS corrected this problem by issuing Notice 2009-18,³² which supplemented the preexisting tables with factors based on interest rates ranging from 0.2% to 2.0%.

Other Considerations

Equitable Apportionment

In general, state law governs the apportionment of estate taxes to the assets included in a decedent’s estate. In most states, the rule of equitable apportionment applies. Under this rule, estate taxes are charged (or apportioned) only to the property that generates or creates the tax liability unless the decedent’s will or other dispositive documents clearly express a contrary intent. Where such an intent is expressed, the estate tax is borne by the entire estate, not just the property going to certain beneficiaries of the estate.

The importance of whether equitable apportionment applies is realized when there are beneficiaries of the estate for which the estate is entitled to a deduction for property transferred to such beneficiaries. These beneficiaries are generally those who are entitled to the marital deduction under Sec. 2056 (i.e., the surviving spouse) and the charitable deduction under Sec. 2055 (e.g., the American Red Cross). To the extent equitable recoupment applies and there are beneficiaries of the estate who are entitled to these deductions, the estate tax will generally be lower than if equitable recoupment did not apply. This is why the IRS is so interested in whether equitable apportionment applies to a particular estate, as illustrated in McCoy.³³

In that case, the decedent executed a will and a trust dated May 25, 1994. The decedent subsequently divorced his spouse and remarried before his death. The decedent never updated his will after his divorce. However, he amended his trust agreement on December 5, 1999, to provide for distributions to his surviving spouse.

The decedent’s will provided that the residue of his estate would be distributed to his revocable trust. The original trust agreement stated that if the decedent was survived by his wife, payment of the estate taxes and other debts and expenses was to be charged to the nonmarital share of the trust (effectively affirming that equitable recoupment was applicable to the decedent’s estate). The restated trust agreement, however, provided that payment of the estate taxes and other debts and expenses was to be charged against the residue of the trust estate (not just the nonmarital share). After payment of specific bequests, the remainder of the estate was to pass, in trust, to his surviving spouse. The trust agreement did not expressly state whether the provision for the payment of estate taxes and other debts and expenses also applied to how the estate tax burden was to be borne by the trust’s beneficiaries.

The decedent’s estate tax return claimed a marital deduction of $3,933,725. In determining this amount, the trustee charged the specific bequest beneficiaries other than the surviving spouse using equitable apportionment, generally reducing their shares for estate taxes before the shares were distributed. The IRS determined that the marital deduction should be reduced by $837,399 to $3,096,326, resulting in an estate tax deficiency of $412,330. In determining this amount, the IRS concluded that the decedent’s estate improperly failed to reduce the value of the property passing to the surviving spouse by the amount of the estate taxes imposed on the entire estate because the amended trust agreement provided that estate taxes should have been paid by the residue of the estate (in effect concluding that equitable apportionment did not apply).

The Tax Court first noted that under the law of the state governing the decedent’s estate, equitable apportionment applied unless the decedent’s will or other dispositive instrument directed a different method of apportionment. The court acknowledged that ambiguity in the trust agreement created a basis for the positions of both the decedent’s estate and the IRS. The court looked to the law of the state governing the decedent’s estate and determined that if there is ambiguity as to how the estate taxes are to be apportioned, the ambiguity should be resolved in favor of equitable apportionment. After looking at additional case law and noting the provision in the original trust agreement, the court concluded that the law and evidence supported the resolution of the ambiguity in favor of the decedent’s estate.

The moral of this story is that a decedent needs to be clear in his or her will or dispositive documents about how estate taxes are to be apportioned among beneficiaries, especially if bequests to certain beneficiaries entitle the decedent to an estate tax deduction. In many cases, the law defaults to equitable apportionment. However, a decedent should be direct as to apportionment. As this case illustrates, the potential estate tax consequences can be unfortunate, so apportionment should not be left to a court to decide.

Private Trust Companies

For over five years, estate planning professionals have been eagerly awaiting IRS guidance regarding private trust companies (PTCs). Notice 2008-63³⁴ provides this guidance in the form of a proposed revenue ruling and asks for comments regarding the IRS’s conclusions and whether other matters need to be addressed. A PTC is a company that performs the normal trust functions of a commercial trust company (e.g., administration, management of assets, determining and making trust distributions) but generally for a single family whose members typically serve as the owners/ officers/employees of the trust company.

In the proposed revenue ruling, the IRS addresses five issues under two different fact patterns. The operation of the PTC is similar to PTC arrangements that are in use by large families with numerous trusts. The only difference between the fact patterns is that in one fact pattern the PTC’s operation is set by state statute and in the other fact pattern there is no state statute; however, the PTC’s operating agreement contains provisions similar to the state statute.

Under the PTC operating agreement or state statute, the PTC establishes a discretionary distribution committee (DDC) that has the exclusive authority to make all decisions about discretionary distributions over the trusts. No member of the DDC may participate in the activities of the DDC with regard to any trust of which the DDC member or his or her spouse is a grantor or any trust of which the DDC member or his or her spouse is a beneficiary. The fact patterns go on to state other provisions of the trusts and the PTC operating agreement that assist the IRS in making its determinations on the issues presented in the revenue ruling.

As to whether, under either fact pattern, the assets of any trust under the PTC’s management would be subject to estate tax inclusion under Sec. 2036 and/or Sec. 2038, the IRS ruled generally that no parties had the power to control assets they transferred to the trusts or to change the trust agreements. Therefore, the trusts would not be subject to inclusion in the grantors’ estates.

The IRS’s ruling was negative on whether any part of the trusts would be includible in a beneficiary’s gross estate because the beneficiary held a general power of appointment under Sec. 2041, noting that no beneficiary of the trusts had the power to make discretionary distributions to themselves. Therefore, no beneficiary held a general power of appointment.

Regarding whether the discretionary powers held by the PTC resulted in an incomplete gift, the IRS ruled that no member of the DDC could participate in the DDC’s activities for a trust of which the DDC member or his or her spouse is a grantor or any trust of which the DDC member or his or her spouse is a beneficiary. Therefore, the transfers to the trusts by the grantors were completed gifts.

The IRS ruled negatively on whether the former trustees’ resignation and replacement by the PTC had GSTT consequences because the change did not shift a beneficial interest in the trust to a lower generation than the original beneficiaries and the change did not extend the duration of the trusts.

Finally, on the issue of whether the PTC’s service as trustee resulted in grantor trust status of any of the trusts under the PTC’s administration regarding any of the grantors, the IRS reviewed Secs. 671–678 and concluded that the parties who controlled the beneficial enjoyment of the trusts were not grantors of their respective trusts. Therefore, the IRS ruled that the PTC’s service as trustee did not create grantor trust status for any of the trusts.

This proposed revenue ruling sets forth dispositive provisions that should be part of a PTC’s operating agreement to ensure that the PTC arrangement does not run afoul of the issues considered. The revenue ruling embodies the subject matter of several previous favorable private letter rulings by the IRS. Although in proposed form, this revenue ruling should be of great comfort to large families who contemplate establishing a PTC to manage their family assets.

Procedure and Administration

Sample CLUT Forms

In 2007, the IRS released sample forms for both inter vivos and testamentary charitable lead annuity trusts.³⁵ On July 28, 2008, the IRS released sample forms for both inter vivos and testamentary charitable lead unitrusts (CLUTs).³⁶ The revenue procedures provide sample trust instruments (along with annotations) for inter vivos grantor and nongrantor CLUTs (Rev. Proc. 2008-45) and testamentary CLUTs (Rev. Proc. 2007- 46) with a term of years. The revenue procedures also provide samples of certain alternate provisions that may be contained in the trust instruments of the CLUTs (including a unitrust period for the life of one individual).

The revenue procedures state that the value of the charitable lead interest will be deductible under Sec. 2522 and/or Sec. 2055 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 the other deductibility requirements.

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 IRS generally will not issue a letter ruling on whether a CLUT qualifies for a charitable deduction; however, it generally will issue letter rulings relating to the tax consequences of the inclusion in a CLUT instrument of substantive trust provisions other than those contained in the revenue procedures.

Declaratory Judgment for Gift Tax Valuations

Under Secs. 6501(a) and 6501(c)(9), for transfers made after August 5, 1997, if a transfer of property is adequately disclosed on a gift tax return, the statute of limitation for assessment of gift tax for that transfer will commence to run on the date the gift tax return is filed. Once the time for assessment of gift tax has expired, the value reflected on the gift tax return is “finally determined” and the IRS cannot challenge it for purposes of determining a taxpayer’s prior taxable gifts or estate tax liability.

The Taxpayer Relief Act of 1997 enacted Sec. 7477 to provide a declaratory judgment procedure under which taxpayers may contest in Tax Court an IRS determination regarding the value of a gift. In the absence of Sec. 7477, without an actual gift tax deficiency, a taxpayer would be unable to petition the Tax Court to contest the determination or, without an overpayment of tax, file a claim for refund or bring suit for refund in federal court. This might occur, for example, if an increase in gift tax is offset by the taxpayer’s “applicable credit amount” (as defined in Sec. 2505(a)), so that no additional tax would be assessed as a result of the valuation increase. Thus, without Sec. 7477, such a taxpayer would be left without any way to challenge the IRS determination, even though, upon the expiration of the statute of limitation, that determination would become binding for purposes of calculating the cumulative gift tax on all future gifts of that taxpayer, as well as the taxpayer’s estate tax liability.

The IRS issued proposed regulations³⁷ that provide a procedure for pursuing a declaratory judgment in the Tax Court under Sec. 7477. The proposed regulations set forth the following requirements that the taxpayer must meet in order to seek a declaratory judgment:

• The transfer must be shown or disclosed on a gift tax return;
• There must be an actual controversy over an IRS determination;
• The pleading seeking a declaratory judgment under Sec. 7477 must be filed with the Tax Court before the 91st day after the mailing of the notice of determination of value (referred to in the proposed regulations as “Letter 3569”); and
• The taxpayer must exhaust all administrative remedies available to the taxpayer within the IRS with respect to the controversy.

The procedure provided by the proposed regulations applies only in those situations in which an adjustment by the IRS does not result in a gift tax deficiency or refund. When the IRS adjustment results in a proposed tax deficiency or a potential refund, taxpayers are required to follow the procedures already in place to dispute a deficiency or claim a refund under Sec. 6213.

EGTRRA Changes Taking Effect in 2009

The estate tax applicable exclusion amount increases to $3,500,000 in 2009. The top estate and gift tax rate remains at 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 and have been increased for 2009:

• The annual exclusion for present interest gifts is $13,000 (up from $12,000 in 2008).
• The exclusion for transfers to noncitizen spouses is $133,000 (up from $128,000 in 2008).
• The ceiling on special-use valuation is $1 million (up from $960,000 in 2008).
• The Sec. 6166 amount eligible for the 2% rate is $1,330,000 (up from $1,280,000).

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EditorNotes

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. Ransome at justin.ransome@gt.com or Mr. Satchit at vinny.satchit@gt.com.

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Notes

¹ Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16.

² Knight, 552 U.S. 181 (2008).

³ Notice 2008-32, 2008-11 I.R.B. 593.

⁴ Notice 2008-116, 2008-52 I.R.B. 1.

⁵ REG-101258-08, 73 Fed. Reg. 34670 (June 18, 2008).

⁶ Tax Relief and Health Care Act of 2006, P.L. 109-432.

⁷ T.D. 9403, 73 Fed. Reg. 35583 (June 24, 2008).

⁸ Rev. Rul. 2008-41, 2008-30 I.R.B. 170.

⁹ Notice 2008-99, 2008-47 I.R.B. 1194.

¹⁰ IRS Letter Ruling 200846003 (11/14/08).

¹¹ IRS Letter Ruling 200904022 (1/23/09).

¹² Estate of Hurford, T.C. Memo. 2008-278.

¹³ Estate of Jorgensen, T.C. Memo. 2009-66.

¹⁴ T.D. 9414, 73 Fed. Reg. 40173 (July 14, 2008).

¹⁵ REG-119097-05, 72 Fed. Reg. 31487 (June 7, 2007).

¹⁶ See Regs. Sec. 25.2702-3(b)(1)(ii)(B).

¹⁷ REG-119532-08, 74 Fed. Reg. 19913 (April 30, 2009).

¹⁸ IRS Letter Ruling 200842007 (10/17/08).

¹⁹ Estate of Jordahl, 65 T.C. 92 (1975), acq. 1977-1 C.B. 1.

²⁰ Rev. Rul. 2008-22, 2008-16 I.R.B. 796.

²¹ T.D. 9348, 72 Fed. Reg. 42291 (August 2, 2007).

²² REG-128843-05, 72 Fed. Reg. 42340 (August 2, 2007).

²³ REG-145987-03, 69 Fed. Reg. 51967 (August 24, 2004).

²⁴ T.D. 9421, 73 Fed. Reg. 44649 (July 31, 2008).

²⁵ Notice 2001-50, 2001-2 C.B. 189.

²⁶ IRS Letter Ruling 200851020 (12/19/08).

²⁷ Gross, T.C. Memo. 2008-221.

²⁸ Holman, 13 T.C. No. 12 (2008).

²⁹ Litchfield, T.C. Memo. 2009-21.

³⁰ Negron, 553 F.3d 1013 (6th Cir. 2009).

³¹ T.D. 9448, 74 Fed. Reg. 21438 (May 7, 2009).

³² Notice 2009-18, 2009-10 I.R.B. 648.

³³ McCoy, T.C. Memo. 2009-61.

³⁴ Notice 2008-63, 2008-31 I.R.B. 261.

³⁵ See Rev. Proc. 2007-45, 2007-29 I.R.B. 89, and Rev. Proc. 2007-46, 2007-29 I.R.B. 102.

³⁶ See Rev. Proc. 2008-45, 2008-30 I.R.B. 224, and Rev. Proc. 2008-46, 2008-30 I.R.B. 238.

³⁷ REG-143716-04, 73 Fed. Reg. 32503 (June 9, 2008).