This article is Part II of a two-part article that examines developments in estate planning and compliance between June 2011 and May 2012. Part I, in the September issue, discussed developments regarding gift tax and trusts, an outlook on estate tax reform, and annual inflation adjustments for 2011 relevant to estate, gift, and generation-skipping transfer (GST) tax. This article covers developments in estate tax.
Portability of Exemption
The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 1 permits for the first time portability of the estate tax exemption between spouses so that a surviving spouse may use the unused estate tax exemption of the first-to-die spouse. If made permanent, this provision would eliminate the need for spouses to retitle property and create trusts solely to take full advantage of each spouse’s estate tax exemption. Currently, this provision is effective if the first spouse dies after Dec. 31, 2010, and the second spouse makes gifts or dies before Jan. 1, 2013.
For a surviving spouse to use the deceased spouse’s unused estate tax exemption, Sec. 2010(c)(5)(A) provides that the executor of the deceased spouse must file an estate tax return (Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return ) that computes the unused estate tax exemption and makes the portability election. Notice 2011-82 2 provides guidance on making the election.
Because it is assumed that married couples will want to make the portability election, Notice 2011-82 provides that by timely filing a properly prepared and complete Form 706, an estate is considered to have made the portability election without the need to make an affirmative statement, check a box, or otherwise affirmatively elect. If the estate does not want to make the portability election, it can do so by not filing Form 706. However, if an estate is obligated or chooses to file Form 706, the instructions for Form 706 provide that the executor can either attach a statement to Form 706 indicating that the decedent’s estate is not making the election under Sec. 2010(c)(5) or enter “No Election under Section 2010(c)(5)” across the top of the first page of Form 706.
Note: On June 18, 2012, temporary (T.D. 9593) and identical proposed (REG-141832-11) regulations were issued superseding the notice and providing guidance on the portability of the deceased spouse’s unused exemption (DSUE) amount. These regulations address various aspects of making the portability election and of using the DSUE amount by the surviving spouse.
Generally the value of property includible in a decedent’s gross estate is its fair market value (FMV) on the date of the decedent’s death. Two special valuation provisions may be elected—under Sec. 2032, to value the property on the alternate valuation date (AVD), and under Sec. 2032A, to value real estate used in farming or another business based on its special use, rather than its highest and best use. Reproposed regulations were issued to limit the availability of the alternate valuation date provision, and a district court declared invalid a provision of the special use valuation regulations.
Alternate Valuation Date
A decedent’s estate may elect to use the AVD if that date results in a valuation of the decedent’s estate that is lower than its date-of-death valuation and results in a combined estate and generation-skipping transfer (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 (the transaction date). For all other property includible in a decedent’s gross estate, the AVD is the date that is six months after the decedent’s date of death (the six-month date).
In 2008, the IRS issued proposed regulations 3 under Sec. 2032 in an attempt to change the result in situations similar to Kohler, 4 in which the Tax Court held that valuation discounts attributable to restrictions imposed on closely held stock pursuant to a post-death reorganization of the closely held company should be taken into consideration in valuing the stock on the AVD. On Nov. 18, 2011, these regulations were withdrawn and reproposed. 5
The reproposed regulations would amend Regs. Sec. 2032-1(c) to identify transactions that require the use of the transaction date for purposes of Sec. 2032 (nine types of transactions are listed). If an estate’s property is subject to such a transaction during the alternate valuation period, the estate must value that property on the transaction date. The value included in the gross estate is the FMV of the property on the date of and immediately before the transaction.
Two exceptions to this general rule would allow the estate to use the six-month rule. One exception is for exchanges of interests in the same or different entities provided the FMVs of the interests before and after the exchange are deemed to be equal. The other exception is for distributions from a business entity, bank account, or retirement account in which the decedent held an interest at death provided the FMV of the interest immediately before the distribution equals its FMV immediately after plus the amount of the distribution.
Special Use Valuation
One of the statutory requirements to qualify for the special use valuation is contained in Sec. 2032A(b)(1)(B), which provides that 25% of the estate must consist of real property used in farming or another trade or business. Regs. Sec. 20.2032A-8(a)(2) provides that while a Sec. 2032A election need not be made for all property that qualifies for the election, the property for which the election is made must meet the 25% threshold requirement in Sec. 2032A(b)(1)(B). In Finfrock , 6 more than 25% of the total value of the gross estate consisted of real estate used in a farming business, but the estate chose to make the special use valuation election for only one piece of farmland that, by itself, represented 15% of the total value of the gross estate. The issue before the district court was whether the regulation is a valid interpretation of the statute.
The district court applied the Chevron 7 test to determine whether Congress has directly spoken to the precise question at issue. If the intent of Congress is clear, both the court and the agency must give effect to the expressed intent of Congress. If the statute is silent or ambiguous about the particular issue, a court must then determine whether the agency’s interpretation is based on a permissible construction of the statute.
The district court noted that Sec. 2032A does not require that the election be made for real property constituting 25% or more of the value of the gross estate. The 25%-or-more requirement is only a threshold requirement in order to be able to make the election. Once the threshold is met, the only other requirement to qualify the property for the election is to designate the property in a tax recapture agreement. The court concluded that Congress did not require that the designation be of all or a certain percentage of the real property that otherwise meets the requirements of Sec. 2032A, so the statute unambiguously provides that an estate can elect the special use valuation for any portion of the property that qualifies. Noting that Regs. Sec. 20.2032A-8(a)(2) imposes an additional requirement to make an election under Sec. 2032A that is not included in the statute, the court ruled that the regulation was invalid.
Inclusion of Gift Tax
Sec. 2035(b) includes in a decedent’s gross estate for estate tax purposes the amount of gift tax paid by the decedent or the decedent’s estate on any gift made by the decedent or the decedent’s spouse during the three years prior to the decedent’s death. In Estate of Morgens, 8 the Ninth Circuit affirmed the Tax Court’s decision that gift tax paid within three years of the decedent’s death on transfers of her interests in a qualified terminable interest property (QTIP) trust established upon the death of her husband was includible in her gross estate under Sec. 2035.
When the decedent’s husband died, an election was made under Sec. 2056(b)(7) to treat the trust created at his death as a QTIP trust. Thus, an estate tax marital deduction on the husband’s estate tax return was allowed for the property passing to the trust, and, when the wife died, the value of the trust would be includible in the wife’s gross estate under Sec. 2044. Inclusion in the transfer tax base of the surviving spouse is the quid pro quo for allowing the marital deduction to the estate of the first spouse to die. If the surviving spouse attempts to terminate a QTIP trust during his or her life by giving away the income interest, the value of the income interest is subject to gift tax under Sec. 2511. In addition, Sec. 2519 provides that the surviving spouse is considered to make a gift of the remainder interest in the property. Sec. 2207A authorizes the surviving spouse to recover from the person who receives the remainder interest in the trust the amount of gift tax attributable to the deemed transfer of the remainder interest.
The decedent made a gift of the income interest, and the trust paid the resulting gift tax on the transfer of the remainder interest. The Ninth Circuit agreed with the Tax Court’s conclusion that the surviving spouse is considered to be the deemed owner of the QTIP and as such bears the gift tax liability associated with the transfer of the QTIP. Sec. 2207A does not operate to shift the liability for the gift tax to the remainder beneficiaries but rather allows the surviving spouse the right to recover the gift tax from them.
Surviving spouses who do not need the income interest generated by QTIP trusts may want to give away the income interest during life to take advantage of the tax-exclusive nature of the gift tax (as opposed to the tax-inclusive nature of the estate tax). Based on this decision, the surviving spouse has to live more than three years after the transfer for this technique to work. Unless the surviving spouse is terminally ill, there is nothing lost in trying to outlive the three-year period and potentially a lot to gain.
Family Limited Partnerships
The IRS has continued to attack the viability of family limited partnerships (FLPs) in the estate planning context, usually under Sec. 2036. Sec. 2036(a) pulls assets that are transferred by a decedent during his or her lifetime back into the gross estate if the decedent continued to derive a benefit from the assets and/or continued to control the beneficial enjoyment of the assets. An exception applies if the transferred assets are part of a “bona fide sale for adequate and full consideration in money or money’s worth” (the “bona fide sale” exception).
In determining whether the exception applies, courts apply the Bongard 9 test, which requires that: (1) there is a legitimate and significant nontax reason for creating the FLP; and (2) the transferors receive interests in the FLP proportionate to the value of their transferred property. Taxpayers who satisfy the Bongard test and follow partnership formalities are successful. The IRS, however, is successful when taxpayers have failed to follow the partnership formalities. In one case, the facts were so bad that the assets the decedent had transferred to the FLP were included in her gross estate under Sec. 2033 as assets she owned at death.
In Estate of Lockett, 10 the decedent’s ex-daughter-in-law and an estate attorney advised her to establish an FLP with her two sons. Articles of incorporation were filed to establish an FLP, but no decisions were made about what percentage membership each family member would hold, what assets would be transferred, or even who the members would be. Finally, a couple of years later, the decedent and a trust created for her benefit by her deceased husband transferred assets to the FLP, and the sons claimed they were the general partners.
The Tax Court found that the sons never had an interest in the FLP because they never contributed assets to the FLP, were not gifted interests by the decedent, and did not perform services for the FLP in exchange for interests. A valid partnership was initially formed because of transfers by two parties to the FLP—the decedent and the trust created for her benefit. However, prior to her death, the trust was terminated, and all its assets were transferred to the decedent. At that point the decedent owned 100% of the interests in the FLP, and the partnership terminated under local law. The decedent thereafter was the legal owner of all the assets in the FLP, and according to the Tax Court the assets were includible in her gross estate under Sec. 2033.
In Estate of Turner (Turner I) , 11 the decedent and his wife had accumulated a significant amount of wealth mainly through a family business, but also held a significant amount of stock in a regional bank as well as various other marketable securities and real estate. With the assistance of one of their grandsons, the couple met with estate planning attorneys who suggested the creation of an FLP to hold the couple’s investment assets. Shortly thereafter the couple transferred approximately $8.7 million in cash and marketable securities to the FLP, while retaining more than $2 million in assets to meet their living expenses. Over a two-year period before the decedent’s death, the decedent and his wife gifted limited interests in the FLP to their surviving children and the two children of their predeceased daughter.
The court determined that none of the three reasons advanced by the estate for the creation of the FLP was a legitimate and significant nontax reason for its creation. As to the contention that the FLP would allow the couple’s assets to be managed under a more active and formal investment strategy, the court concluded that the asset management did not change in a meaningful way, as the FLP continued to hold assets contributed to the FLP. As to the contention that the FLP would facilitate resolution of family disputes, the court found that the reason for family discord had nothing to do with money. As to the contention that the FLP would protect the family assets and the decedent’s wife from a grandson (who had an addiction problem) and protect the grandson from himself, the court concluded that the creation of the FLP did little to protect the decedent’s wife, as she still had access to assets not transferred to the FLP to give to her troubled grandson, and the FLP added no more protection for the grandson than the trust that had already been created to help him.
In addition, the court cited the following reasons indicating the transfers were not bona fide sales: (1) The decedent stood on both sides of the transaction, as there was no meaningful bargaining with the decedent’s wife or other anticipated limited partners; (2) the decedent commingled personal and partnership funds; and (3) the transfer of assets to the FLP was not completed until eight months after the creation of the FLP. Because there was not a legitimate and significant nontax reason for the decedent’s transfers to the FLP, the court concluded that the bona fide sale exception did not apply.
The Tax Court concluded that under Sec. 2036(a)(1) there was an express agreement that the decedent would continue to enjoy the assets transferred to the FLP because (1) the FLP agreement provided that the general partners would receive a reasonable management fee, but the fee the couple chose to receive was not reasonable given their involvement with the management of the FLP; and (2) the FLP agreement could be amended by the general partners at any time without the consent of the limited partners. The court also concluded that there was an implied agreement because of (1) the failure to sell a large block of bank stock due to the couple’s sentimental attachment to it; (2) the receipt of management fees from the FLP for no services and the taking of distributions from the FLP at will; (3) the commingling of personal and partnership funds; (4) the disproportionate distributions from the FLP; and (5) the creation of the FLP as a testamentary device given the role it played in the decedent’s estate planning.
The Tax Court concluded that, under Sec. 2036(a)(2), the decedent retained the right to designate who would control the income from the FLP because the decedent (1) was, for all intents and purposes, the sole general partner and the FLP agreement gave him broad authority to manage FLP assets; (2) had the sole discretion to make FLP distributions; (3) could amend the FLP agreement without the consent of the limited partners; and (4) effectively owned more than 50% of the FLP at his death (taking into consideration his wife’s interests) and, therefore, could make any decision requiring a majority vote of the limited partners. Having determined that the bona fide sale exception had not been met and that the decedent retained the enjoyment of and control over the assets he transferred to the FLP, the court determined that the FMV of the assets he transferred to the FLP were includible in his estate.
It seems that this case may have gone the other way if it was decided by a different judge. Nonetheless, this case reflects the IRS’s continuing success challenging FLPs even though there is a large body of law creating a blueprint for how to properly structure and operate an FLP to withstand an IRS challenge. The factors cited in this case as to why the taxpayer lost are similar to factors cited in prior FLP cases.
The estate then sought to claim an increased marital deduction based on the formula clause in the decedent’s will to avoid the imposition of estate tax on the underlying transferred assets in the gross estate. In Estate of Turner (Turner II), 12 the Tax Court addressed the problems created for a normal estate plan by the inclusion in the decedent’s gross estate of assets given away during the decedent’s lifetime to persons other than the decedent’s spouse. Although assets underlying the FLP interests transferred as gifts during the decedent’s life are included in the gross estate under Sec. 2036, neither those assets nor the corresponding FLP interests pass to the surviving spouse. Therefore, the estate was not allowed to recalculate the marital deduction to include the FLP interests transferred to persons other than the spouse or the assets underlying those transferred interests.
In Estate of Liljestrand , 13 the decedent owned (through his revocable trust) interests in numerous pieces of real estate. Most of the real estate was directly managed by local companies, but the decedent’s son provided overall management of all the properties. The decedent wanted to leave his property equally to his four children but wanted to ensure that the one son would continue to manage the property. On the advice of his estate planning attorney, he formed an FLP and transferred his real estate to the FLP in return for a 99.98% interest, with his son receiving the rest. Later, the decedent gifted some FLP interests to trusts established for the benefit of each of his children.
Even after the creation of the FLP and the transfer of the real estate to the FLP, the parties continued to treat the real estate as if it was owned directly by the decedent’s revocable trust. The FLP did not have a bank account for the first two years of its existence and did not file partnership tax returns. Rather, the income from the real estate was reported directly on the decedent’s income tax return. His son continued to manage the real estate just as he had done before the FLP’s creation. Because the decedent had transferred almost all his assets to the trust, his retained assets were insufficient to pay his personal expenses. After it obtained its own bank account, the FLP made disproportionate distributions to the decedent and in some instances directly paid his personal expenses.
The Tax Court determined that none of the three reasons advanced by the estate for the FLP’s creation was a legitimate and significant nontax reason. As to the claim that the FLP allowed the son to centralize his management of the real estate, the court concluded that the son managed the real estate both before and after it was transferred to the FLP, so nothing changed. As to the claim that the FLP would ensure that the real estate would not be subject to partition or division under Hawaii law, the court concluded that because most of the real estate was not located in Hawaii, the Hawaii statutes did not apply; that no inquiry was made into the laws of the states in which the real estate was located before the FLP’s creation; that after the decedent’s death the children had only beneficial interests in the trusts and would not have had outright ownership of the real estate; and that there was no evidence that the children had any interest in seeking a partition. As to the claim that the FLP would protect the real estate from creditors, the court concluded that there was no evidence of any concern about potential creditors.
The Tax Court then cited the following reasons indicating that the transfers were not bona fide sales: (1) The FLP failed to follow even the most basic partnership formalities—no bank account for the first two years, only one partnership meeting, direct payment of decedent’s personal expenses, disproportionate distributions, and the decedent’s financial dependence on FLP distributions; and (2) the decedent was on both sides of the transaction, and there was no arm’s-length bargaining. The court next determined that there was not adequate and full consideration for the transactions because (1) the interests credited to each partner were not proportionate to the FMV of the assets each partner contributed to the FLP and (2) the contributions of each partner were not properly credited to their capital accounts. As a result of this analysis, the court concluded that the bona fide sale exception did not apply.
The Tax Court concluded that, under Sec. 2036(a)(1), there was an implied agreement that the decedent retained enjoyment of the assets transferred to the FLP because there was no change in the decedent’s relationship with the assets once the assets were contributed to the FLP. The decedent received a disproportionate share of the partnership distributions, engineered a guaranteed payment from the FLP equal to the FLP’s expected annual income, and benefited from the sale of the partnership assets to repay his own personal loan. Having determined that the bona fide sale exception had not been met and that the decedent retained the enjoyment of and control over the assets he transferred to the FLP, the court determined that the FMV of the assets he transferred to the FLP were includible in his gross estate. This is another case in which partnership formalities were not followed, generating predictably disastrous results for the estate.
In Estate of Kelly, 14 the decedent, after the death of her husband, owned two quarries, rental real estate, and stocks and bonds. The quarries and the rental real estate required active management, which the decedent’s husband had done while he was alive, and which was taken over by their children after his death. The decedent developed Alzheimer’s disease, and eventually a court appointed the children as co-guardians.
Before that and without knowing what was in the decedent’s will, the children signed a settlement agreement under which the decedent’s estate would be distributed equally among the children. Once they received a copy of the will, they realized that because of uneven appreciation in the value of the decedent’s assets and the acquisition of additional stock, the will no longer provided equally for the children. The children then signed a second settlement agreement agreeing to honor all the specific bequests to anyone who was not a child and then to distribute the remainder equally among the children.
The children began to be concerned about potential liability for the real estate after a lawsuit was filed against the decedent when a dump truck going to the quarry was involved in an accident resulting in significant injuries and bullets were found in a campsite at the decedent’s rural property that also contained a large waterfall and picnic facilities. The children consulted an estate planning lawyer who discussed the nature of the decedent’s assets; the difficulty managing the assets as guardians; their desire that each child share equally in the decedent’s estate; and the liability concerns for the real estate.
The proposed plan was for the decedent, acting through her guardians and with court approval, to create FLPs and transfer her assets to them while retaining liquid assets amounting to $1.1 million. Over the next three years, the decedent made gifts of FLP interests to the children and their descendants. After the creation of the FLPs, the decedent’s expenses were paid by the funds retained in her guardianship account. Each of the children provided services to the FLPs and received a management fee.
The Tax Court determined that the decedent’s primary desire was to ensure her assets were equally distributed to her children and to avoid litigation over the estate, which was also the purpose of the settlement agreements the children signed. In addition, the decedent was legitimately concerned about the effective management of and potential liability for her assets. The court noted that any prudent person would want these assets to be managed in the form of an entity. It determined that because the decedent had valid nontax reasons to contribute property to the FLPs, had received FLP interests equal in value to the assets she contributed, and her contributions were properly credited to her capital account, the value of the property transferred to the FLPs was not includible in her gross estate under Sec. 2036(a).
The IRS also argued that the FLP interests transferred by gift to the children and their descendants should be includible in the decedent’s gross estate under Sec. 2036(a) because there was an implied agreement that the decedent would continue to enjoy the income from the FLPs. The Tax Court disagreed. It noted that the decedent respected the FLPs as separate and distinct legal entities, observed partnership formalities, and retained sufficient assets for personal needs. The court also concluded that the decedent did not retain the income from the FLPs merely because the corporate general partner, of which she owned 100% of the stock, was paid a management fee. The Tax Court stated that the IRS’s position would require the court to disregard the corporation’s existence, the general partner’s fiduciary duty, and the partnership agreements—which the court would not do.
In Estate of Stone, 15 the decedent and her husband owned 740 acres of mostly undeveloped woodlands. Their son acquired real estate near the woodlands parcel and executed an agreement with the local water company to construct a dam on his property in exchange for using a portion of his property for a water treatment plant. The construction of the dam created a man-made lake, and a portion of the woodland parcels was now lakefront property. The decedent and her husband decided they wanted the woodland parcels to become a family asset with the hope that eventually the family would be able to develop and sell homes near the lake. But before the land could be developed, some issues needed to be resolved. The shallow soil depth would make it difficult to connect sewage systems for any potential homes near the lake. In addition, the water company’s operations significantly reduced the level of the lake water during the summer months.
In 1997, the decedent and her husband formed an FLP to hold and manage the woodland parcels. Over a three-year period, the decedent and her husband transferred all the limited FLP units to their 21 children, children’s spouses, and grandchildren. Thereafter, the decedent and her husband each owned a 1% general FLP interest. The decedent died in 2005. At the time of the 2011 trial, the FLP had yet to develop or otherwise improve the woodlands parcels.
The Tax Court determined that the decedent’s desire to have the woodlands parcels held and managed as a family asset so the family could work together to develop and sell homes near the lake constituted a legitimate and significant nontax reason for creating the FLP. The IRS pointed to some instances in which the partnership formalities were not followed, namely: (1) To settle a divorce proceeding, two of the children quitclaimed their interests in the real estate rather than transferring FLP interests; (2) there was some inadequate documentation for the FLP; and (3) the decedent and her husband paid the $700 annual real property taxes out of their personal funds each year.
The Tax Court listed other factors that supported the estate’s contention that a bona fide sale occurred: (1) The decedent and her husband did not depend on distributions from the FLP as no distributions were ever made; (2) the decedent and her husband actually transferred the woodlands parcels to the FLP; (3) there was no commingling of FLP and personal funds; (4) no discounts were claimed in valuing the FLP interests for gift tax purposes; and (5) the decedent and her husband were in good health at the time the FLP was created. The decedent lived eight years after its creation and was healthy enough to teach Sunday school the Sunday before she died, and her husband, even though he was over 80 when the FLP was created, was still alive at the time of the 2011 trial.
The Tax Court next determined that the full and adequate consideration criteria had been met because, having concluded that the decedent had a legitimate nontax purpose for transferring the woodland parcels to the FLP, the transaction was not merely an attempt to change the form in which the decedent held the parcels.
Retained Graduated Interest
The IRS issued final regulations 16 in 2008 providing that when a grantor transfers property to a trust and retains an annuity, unitrust, or income interest for life, the amount includible in the grantor’s gross estate under Sec. 2036 is the portion of the trust corpus necessary to generate a return sufficient to pay the grantor’s interest. Left unanswered in those regulations was the portion of the trust includible if the grantor’s retained interest increases over time. For example, the retained annuity interest in a grantor retained annuity trust (GRAT) each year may be 120% of the previous year’s annuity. 17
The final regulations the IRS issued in November 2011 address the issue of the graduated retained interest. 18 The basic premise in determining the portion of the trust subject to inclusion is that the trust portion must be sufficient to generate the income necessary to pay off the retained amount for the entire period over which the retained interest is payable without reducing or invading principal. As an example, if a decedent dies with three years remaining on the term of the GRAT, the portion of the trust includible in the decedent’s gross estate would be the corpus necessary to generate income sufficient to pay the current annuity amount for the remaining three years plus the corpus necessary to generate income sufficient to pay the increases in the annuity amount, taking into account the delay in time for which the increases will be paid. The amount of the trust includible under this mathematical formula cannot exceed the FMV of the trust on the valuation date for federal estate tax purposes. When the retained interest is payable to the decedent’s estate after the decedent’s death, the final regulations specifically provide that payments that become payable to the decedent’s estate after the decedent’s death (as opposed to payments that are payable to the decedent before the decedent’s death, which are not paid until after) are not subject to inclusion under Sec. 2033, if Sec. 2036 is applied to include all or a portion of the trust corpus in the gross estate.
Substitution Power Over Life Insurance Policy
Many trusts are grantor trusts because the grantor or another person has the power under Sec. 675(4)(C) to reacquire trust property by substituting other property of an equivalent value in a nonfiduciary capacity. There has always been a concern about whether this substitution power would cause the trust’s assets to be included in the grantor’s gross estate under Sec. 2036, 2038, or 2042.
That matter was partially addressed in Rev. Rul. 2008-22, 19 which concludes 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 Sec. 2036 or 2038. The revenue ruling, however, did not address the application of Sec. 2042 to situations where a grantor trust held life insurance policies on the life of the grantor.
Rev. Rul. 2011-28 20 addresses the Sec. 2042 issue. Under the facts of the revenue ruling, a grantor establishes an irrevocable trust for the benefit of his descendants with cash. The trust uses the cash to purchase a life insurance policy on the grantor’s life. The terms of the trust prohibit the grantor from serving as trustee of the trust. The grantor makes gifts every year to the trust, and the trust pays the premium on the insurance policy. The proceeds of the policy are payable to the trust upon the grantor’s death. The terms of the trust give the grantor the power, in a nonfiduciary capacity, to reacquire any property held in the trust by substituting other property of an equivalent value.
The revenue ruling concludes that the grantor’s retention of the substitution power will not, by itself, cause the value of the insurance policy to be includible in the grantor’s gross estate under Sec. 2042. However, the revenue ruling requires (similar to the requirements in Rev. Rul. 2008-22) that (1) the trustee have a fiduciary obligation 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 equivalent 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 a power to reinvest trust corpus and a duty of impartiality to trust beneficiaries; or (2) the nature of the trust’s investments or level of income produced by any or all of the trust’s investments does not affect the beneficiaries’ respective interests.
Claims Against the Estate
Under Sec. 2053(a), the value of the taxable estate is determined by deducting certain amounts, including administration expenses and claims against the estate, from the value of the gross estate. Estate of Duncan 21 addressed the deductibility of interest on a loan to pay estate taxes, while Rev. Proc. 2011-48 22 provides guidance on filing protective claims for refund for contested or contingent claims against the estate that are unresolved when the estate tax return is filed.
In Duncan , the decedent’s estate, held in a revocable trust prior to death, consisted primarily of interests in partnerships that owned oil and gas businesses and commercial real estate. The trust sold all its marketable assets but still needed substantial additional cash to pay its expenses and estate taxes. The trust borrowed money from a trust created for the decedent’s benefit by his father. The loan called for interest at the rate a bank said was the current market rate (a rate in excess of the applicable federal rate (AFR) but less than prime). All interest and principal on the loan were due in 15 years and could not be prepaid. The estate deducted the interest on the loan as an administrative expense under Sec. 2053.
In dismissing the IRS’s first challenge that the loan was not a bona fide debt, the Tax Court stated that the IRS’s argument ignored federal tax law and state law. Even though the same individual and bank were the trustees of both the decedent’s trust and the father’s trust, they were required by state law to maintain the two trusts as separate entities and, therefore, would be required to demand repayment of the loan from the decedent’s trust to the father’s trust. In addition, there is no basis in federal tax law to treat the two trusts as a single trust.
As for whether the loan was actually and reasonably necessary, the Tax Court concluded that the loan was necessary to avoid the decedent’s trust’s selling of illiquid assets (either the partnership interests or the underlying illiquid assets in the partnership). In Estate of Black , 23 the case the IRS relied on in making its argument, the decedent’s estate borrowed money from an FLP that, to raise cash, had sold its marketable securities. That situation was not present in this case because the father’s trust was able to lend the decedent’s estate money without such a sale. The Tax Court also concluded that the terms of the loan were reasonable in part because the volatility of the oil and gas business meant there was no assurance that a shorter term would have been workable and because the use of the lower AFR would not have been a true representation of the decedent’s trust’s cost of borrowing. Because the loan was a bona fide debt, the interest expense was actually and necessarily incurred in the administration of the estate, and the amount of interest was ascertainable with reasonable certainty, the Tax Court held that the estate was entitled to deduct the interest expense under Sec. 2053.
This strategy is often used by an estate if it can obtain a loan at a reasonable rate. It works best if the loan comes from the same economic unit (i.e., an entity owned by the decedent’s estate). The estate tax benefit results from the ability to deduct the interest on the decedent’s estate tax return. This strategy is generally preferable to the deferral/installment method of estate tax payment allowed under Sec. 6166 because the interest paid under Sec. 6166 is not deductible on the decedent’s estate tax return. However, this strategy generally does not work if the decedent’s estate has sufficient liquid assets to pay the estate tax when it is due, because the IRS will challenge the loan as unnecessary and the courts generally agree with the IRS in those situations (see, e.g., Estate of Stick 24 ).
Rev. Proc. 2011-48
To determine the value of claims against the estate, final regulations 25 issued in October 2009 adopt rules based on the premise that an estate may deduct only amounts actually paid in settlement of a claim. Because the amount ultimately payable may not be known when the estate tax return is filed, the estate may need to file a protective claim for refund. Rev. Proc. 2011-48 provides guidance on filing such claims.
Under Rev. Proc. 2011-48, the estate must file the protective claim for refund before the expiration of the period of limitation—generally within three years after the return was filed or two years after the estate tax was paid, whichever is later. For estates of decedents dying on or after Jan. 1, 2012, the claim may be filed by attaching Schedule PC to Form 706. Schedule PC is a new schedule and is expected to be available as part of the 2012 Form 706.
In the alternative, Form 843, Claim for Refund and Request for Abatement , may be filed in the same location where Form 706 was filed with a notation at the top of the first page, stating “Protective Claim for Refund under Section 2053.” The estate must file a separate protective claim for each claim or expense for which a deduction may be claimed in the future under Sec. 2053 and must include considerable detail concerning the claim or expense.
The IRS will provide written acknowledgment that the claim has been received. If the estate does not receive such an acknowledgment, the fiduciary is required to inquire whether the IRS received and processed the protective claim within 180 days of filing the claim on Schedule PC of Form 706 or within 60 days of filing the claim on Form 843. A certified mail receipt or other evidence of delivery of the form to the IRS is not sufficient to ensure and confirm the IRS’s receipt and processing of the protective claim.
Within 90 days after the claim or expense is actually paid or becomes certain and no longer subject to any contingency, whichever occurs later, the fiduciary must notify the IRS that the protective claim for refund is now ready for consideration. The notification may be made by filing a supplemental Form 706 or Form 843.
Justin Ransome is a partner and Frances Schafer is a retired managing director in the National Tax Office of Grant Thornton LLP in Washington, D.C. For more information about this article contact Mr. Ransome at email@example.com.