Recent Developments in Estate Planning: Part I

By Justin P. Ransome, J.D., MBA, CPA, and Frances Schafer, J.D.




  • In Turner, the Tax Court held that no notice of withdrawal rights must be given to trust beneficiaries for there to have been a gift of a present interest.
  • In the past year, there were three cases involving definition clauses, in all of which the courts upheld the clauses as valid means of reducing unintended gift tax consequences.
  • The IRS issued final regulations that apply to charitable lead trusts, requiring that a provision in a governing instrument or in local law specifically mandating the source out of which amounts are to be paid to charity must have economic effect independent of income tax consequences to be respected for federal income tax purposes.
  • The IRS issued inflation adjustments for 2012 for estate, gift, and generation-skipping transfer tax purposes.

This two-part article examines developments in estate planning and compliance between June 2011 and May 2012. Part I discusses developments regarding gift tax and trusts, an outlook on estate tax reform, and annual inflation adjustments for 2012 relevant to estate, gift, and generation-skipping transfer (GST) tax. Part II, in the October issue, will cover developments in estate tax.

Estate Tax Reform

On Dec. 17, 2010, the president signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act. 1 With regard to gift, estate, and GST taxes, the act reunifies the gift and estate tax; increases the gift, estate, and GST tax exemption amount to $5 million (indexed for inflation); provides for a top gift, estate, and GST tax rate of 35%; allows portability between spouses of their estate tax exemption amounts; and preserves the taxpayer-favorable GST tax rules contained in the Economic Growth and Tax Relief Reconciliation Act of 2001. 2 Without action by Congress this year, these provisions will expire on Dec. 31, 2012, and the gift, estate, and GST tax regimes in existence in 2000 will return. The exhibit illustrates those changes.

A number of bills have been introduced in Congress regarding estate tax reform, but there has been no action yet on any of them. While there will be efforts to address the estate tax reform before the current gift, estate, and GST tax provisions expire, there are no guarantees. Given this legislative uncertainty, taxpayers should be planning to take advantage of the favorable rules now.

Gift Tax

Annual Exclusion for Transfers toTrusts

Under Sec. 2503(b), a donor may exclude the first $13,000 of gifts made to each donee during a calendar year in determining the total amount of gifts for that calendar year (the gift tax annual exclusion). For a transfer to qualify for the gift tax annual exclusion, Sec. 2503(b) requires that the transfer be the gift of a present interest. Under Regs. Sec. 25.2503-3(b), a gift of a present interest requires that the donee have an unrestricted right to the immediate use, possession, or enjoyment of property, or the income from, the property.

In general, most transfers to trusts fail to qualify as the gift of a present interest because the donee does not have an unrestricted right to the immediate use, possession, or enjoyment of property, or the income from the property. In order to have transfers to a trust qualify as the gift of a present interest and, thus, be eligible for the gift tax annual exclusion, the trust’s governing instrument generally contains a provision giving certain persons “withdrawal rights” with respect to transfers to the trust. This withdrawal right is drafted with the attributes acknowledged by the Ninth Circuit in Crummey , 3 as meeting the requirements of the gift of a present interest.

Although Crummey did not explicitly so hold, the IRS’s position is that the present interest requirement is not satisfied unless a beneficiary has actual notice of the withdrawal right and a reasonable time within which to exercise the right prior to its lapse. In Rev. Rul. 81-7, the IRS ruled that if a beneficiary is not informed of the right to withdraw transfers to the trust, the beneficiary’s right to the immediate possession and enjoyment of the property is postponed, and he or she effectively receives a future interest at the time the gift is made. Given the IRS’s notice requirement, most trusts to which transfers are intended to qualify for the gift tax annual exclusion contain a provision in their trust instruments requiring that beneficiaries with a Crummey power be given notice of the right to exercise this power by the trustees of the trust. 4

In a recent case, 5 the Tax Court ruled that such notice is not required. In Turner , the decedent, during his life, created a trust to own life insurance policies on his life for the benefit of his children and grandchildren. The trust instrument provided that after a direct or indirect transfer to the trust, the beneficiaries of the trust had the right to withdraw the lesser of: (1) the gift annual exclusion amount; or (2) the amount of the direct or indirect transfer divided by the number of beneficiaries. The facts do not indicate whether the trustees were required to give notice of the withdrawal power to the beneficiaries who possessed the power. For the years in question (the three years prior to the decedent’s death), the decedent made premium payments directly to the insurance companies on life insurance policies owned by the trust. The trust instrument provided that upon notice of a beneficiary’s exercise of his or her withdrawal power, the trustees were authorized to distribute cash or other trust property or to borrow against the cash value of any life insurance policies to obtain cash to distribute to the requesting beneficiary.

The IRS included the life insurance policy premiums in the decedent’s adjusted taxable gifts because it concluded that the payments did not qualify for the gift tax annual exclusion. The IRS argued that the withdrawal rights were illusory for two reasons: (1) the decedent did not deposit money with the trustees of the trust but, instead, paid the life insurance premiums directly and (2) the beneficiaries did not receive notice of the transfers.

The Tax Court summarily dismissed both of the IRS’s arguments. The court stated that the fact that the decedent did not transfer money directly to the trust was “irrelevant.” It further stated that the fact that some or all of the beneficiaries of the trust may not have known they had the power to withdraw sums from the trust did not affect their legal right to do so. In support of its conclusion on the notice requirement, the court cited Crummey and Estate of Christofani. 6

On the first issue regarding transfers to the insurance companies, it seems logical that the gift tax annual exclusion should be allowed for indirect gifts to a trust as long as the trust has sufficient assets to satisfy the withdrawal powers of beneficiaries that arise when a particular transfer has been made to a trust. The Tax Court’s more surprising conclusion is that notice of the withdrawal power is not required to be given to a beneficiary possessing such power. Further, the court’s conclusion is supported by little analysis—just one sentence and cites of two cases that did not directly address the issue. Given the court’s lack of reasoning, it is difficult to determine whether taxpayers can rely on the case. The IRS is still likely to enforce the notice requirement, and the safe course of action is to continue to advise clients to give notice if a gift tax annual exclusion is being claimed for a transfer to a trust. However, if the notice requirement is not satisfied for a particular transfer to a trust, the taxpayer now has an argument that notice is not required.

Formula Clauses to Limit Gift Tax Consequences

Taxpayers use formula clauses to avoid unintended gift, estate, and GST tax consequences when transferring property. There are two general types of formula clauses: (1) a definition formula clause (or defined value clause), which defines a transfer by reference to the value of a possibly larger, identified property interest and (2) an adjustment formula clause, which retroactively adjusts the value of a transfer to reflect a later valuation determination. The IRS has succeeded in having adjustment clauses disregarded as against public policy because they prevent the IRS from properly administering the Code. As the following cases will highlight, the IRS has not been successful using this same argument with definition clauses.

The definition clause is a relatively new clause being used in estate planning. These types of formula clauses generally fall into two categories: (1) a defined transfer clause, which defines the amount of the transfer with any excess property resulting from a different valuation than the original valuation used to make the transfer returning to the donor; and (2) a defined allocation clause, which defines the amount of the transfer with any excess property resulting from a different valuation than the original valuation used to make the transfer being reallocated among the transferees. The courts that have addressed these types of formula clauses have generally respected them for gift, estate, and GST tax purposes. There were three cases over the past year involving definition clauses and the taxpayers were successful in all.

Estate of Petter

In Estate of Petter, 7 a case involving a defined allocation clause, the Ninth Circuit upheld the Tax Court’s determination that the formula clause was effective to determine the amount of property transferred to the taxpayer’s heirs and the amount transferred to charity. The taxpayer transferred stock she had inherited to a family limited liability company (LLC) and then created two intentionally defective grantor trusts (IDGTs) for the benefit of each of her two children and their descendants. The taxpayer and the IDGTs entered into transactions commonly referred to as sales to an IDGT. These transactions generally involve two transfers, a gift followed by a sale. Two public charities were also included in the transactions, primarily to prevent unintended gift tax consequences.

In the gift transactions, the taxpayer gifted a specific number of LLC units to be divided between the trusts and the charities. The total amount of LLC units gifted to the trusts was intended to be 10% of the value of the LLC units that eventually would be sold to the trusts. Under the transfer documents, the number of LLC units gifted to each trust was the amount of units equal to one-half of the maximum amount that could pass free of gift tax by use of what was left of the taxpayer’s $1 million gift tax exemption amount. The rest of the LLC units passed to the charity.

The gift documents also provided that if the value of the LLC units that each trust initially received exceeded the amount each was to receive when the value of the units was finally determined for federal gift tax purposes, the trustee would transfer the excess units to the charity. Each charity also agreed to transfer units to the trust if the gift tax value of the LLC units was determined to be less than originally determined. Shortly after the gift transactions, the taxpayer sold to the two trusts LLC units intended to make up 90% of each trust’s assets in return for promissory notes from the trusts. Language similar to that used in the gift transactions was included in the sales agreements so that the trusts were required to transfer any units valued in excess of the stated sale price to the charity.

All the transactions were disclosed on the taxpayer’s gift tax return. The IRS audited the return, and the parties agreed on an increased value for the LLC units. Under the formula clause, additional units would be reallocated from the trusts to the charities based on the agreed upon value of the LLC units. The taxpayer argued that such excess amount passing to the charities qualified for the gift tax charitable deduction and, therefore, there was no additional gift tax.

The IRS argued, however, that the taxpayer was not entitled to a charitable deduction under Sec. 2522 and that the formula clauses were void because they were contrary to public policy for the reasons set forth in Procter. 8 The Tax Court held that the formula clauses used to effect the additional transfers to charity were not subject to a condition precedent denying the taxpayer a gift tax charitable deduction for the additional transfers and that the formula clauses were not void as against public policy. 9

On appeal, the IRS argued only that the transfers to the charities were subject to a condition precedent, namely an IRS audit, and did not qualify for the gift tax charitable deduction. The Ninth Circuit disagreed with the IRS because the number of units transferred to the charities never changed. A mathematical formula gave the charities the remaining LLC units after a specific dollar value of units was subtracted from the total units transferred. The particular number of units given to the charities was the same when the units were first appraised as when the IRS conducted its audit because the fair market value of the LLC units on the date of the gift and sale never changed.

If the IRS had not audited the value of the LLC units, the charities may not have received all the units that they were initially entitled to under the transfer agreements, but the IRS audit in no way granted them rights to receive additional units. The Ninth Circuit concluded that the additional LLC units, which passed to the charities after the value of the units was agreed to, qualified for the gift tax charitable deduction.

In a footnote, the Ninth Circuit noted that the IRS had dropped its Procter public policy argument and, therefore, it did not address whether the taxpayer’s formula clauses were void as against public policy. Thus, it cannot be determined whether the Ninth Circuit would rule favorably for the taxpayer if the IRS were to argue the void-as-against-public-policy argument in another definition formula clause case.


Hendrix 10 also involved a defined allocation clause. The grantors assigned a specific number of shares of stock in the family S corporation to trusts for the benefit of the grantor’s family members and a community foundation. The trusts were assigned shares with a fair market value of a specific dollar amount and the community foundation was assigned the rest of the shares. The assignment agreements required some of the trusts to pay proportionally any gift taxes imposed as a result of the transfer. In addition, the assignment agreements required the trustees to sign promissory notes obligating the trustees to pay a specified dollar amount to the grantors; so the assignments of shares to the trusts were part-sales (to the extent of the gift tax obligation) and part-gifts (for the rest of the transferred stock).

Under the assignment agreements, the grantors had no right or responsibility for allocating the shares among the donees. The allocation was left to the donees with any disputes to be resolved by arbitration. The community foundation hired an appraiser, who determined that the value for the stock set forth in the appraisal prepared for the grantors was reasonable and fair. The trusts and the community foundation entered into a confirmation agreement allocating the shares between them based on the appraised value. The IRS challenged the validity of the formula clauses because they were not reached at arm’s length and they were contrary to public policy.

First, the Tax Court determined that where a third party is involved (here the community foundation), there must be credible evidence that the parties colluded or had side deals or that the form of the transactions otherwise differed from the substance to find that a transaction was not at arm’s length. There was no such credible evidence. The fact that the grantors and their children were “close,” that the grantors’ estate plan benefited their children, or that there was no negotiation or adverse interests did not necessarily mean that the transaction failed to be reached at arm’s length. The court took note of the economic and business risk incurred by the trusts if the stock was overvalued and the trusts were paying too much for their shares.

The court also found no collusion between the grantors and the community foundation. The community foundation had bargained for the grantors to pay any taxes and penalties if the S corporation failed to make distributions sufficient to pay those taxes. It was represented by its own counsel and hired its own appraiser to value the stock. The community foundation also had fiduciary duties under federal and state laws to receive the number of shares it was entitled to under the formula clauses.

Second, the IRS relied on Procter to argue that the arrangement was against public policy. The Tax Court, however, distinguished the present situation from Procter because definition formula clauses impose no condition subsequent that would defeat the transfer and the clauses further the fundamental public policy of encouraging gifts to charity. Finally, the court noted that it had recently ruled in Estate of Christiansen 11 that very similar formula clauses were not contrary to public policy and that it found no legitimate reason to distinguish this case from Christiansen.


In Wandry, 12 a case involving a defined transfer clause, a couple formed a family limited partnership (FLP), eventually distributed its assets to an LLC, and embarked on a program of annually gifting interests in the LLC to their descendants. Their estate planning attorney advised them that: (1) the number of LLC units equal to the desired value of their gifts on any given date could not be known until a later date when a valuation could be made of the LLC’s assets; (2) all gifts should be given as specific dollar amounts, rather than specific numbers of LLC units; and (3) all gifts should be given on Dec. 31 or Jan. 1 of a given year so that a midyear closing of the books would not be required.

Based on this advice, the amount of the annual transfers was based on a formula clause that transferred LLC units whose fair market value equaled a specified dollar amount. If the IRS or a court determined that the number of gifted units exceeded the specified dollar amount, the number of gifted units was to be adjusted so that the value of the number of units gifted equaled the specified dollar amount in the same manner as would occur if an estate tax formula marital deduction amount were adjusted for a valuation redetermination by the IRS or a court.

In 2004, consistent with the transfer documents, the gift tax returns reported total gifts of $1,099,000 and the attached schedules reported net transfers from each of the couple of $261,000 and $11,000 to their children and grandchildren respectively (consistent with the specific dollar amounts in the formula clauses). However, the schedules described the gifts to the children and grandchildren as percentage interests in the LLC (not specific dollar amounts).

The IRS audited the couple’s gift tax returns and determined that the transferred membership interests were worth $315,800 and $13,346 based on the percentage interests listed in the schedules to each of the couple’s gift tax returns (not the specific dollar amounts in the formula clauses). In support of its deficiency determination, the IRS determined that the formula clauses created a condition subsequent to the completed gifts and were void for federal tax purposes as contrary to public policy.

The Tax Court first took note that it had ruled in previous cases that formula clauses were valid to limit the value of a completed transfer. The court then reviewed its opinion in Petter , in which it analyzed Procter and other cases to draw a distinction between a “savings clause,” which a taxpayer may not use to avoid gift tax, and a “formula clause” which was valid to limit the value of the assets transferred. A savings clause is void because it creates a scenario in which the taxpayer tries to take property back, whereas a formula clause merely transfers a fixed set of rights with uncertain value. The difference depends on an understanding of what the donor was trying to transfer. It further noted that in Petter , it ruled the formula clauses were valid because the ascertainable dollar value of stock transferred was a fixed set of rights even though the LLC units had an unknown value. It also noted that the Ninth Circuit affirmed the holding that, although the value of each LLC unit was unknown on the date of the gift, the value of an LLC unit on any given date was constant. Therefore, under the terms of the formula clauses at issue, the donees received a fixed number of LLC units and no contingencies existed that would render the transfers ineffective on the date of transfer.

The IRS attempted to distinguish Wandry from Petter , arguing that, unlike in Petter , where the taxpayers transferred a fixed set of rights with uncertain value, these taxpayers transferred an uncertain set of rights. It further argued that the formula clauses were void as savings clauses because they operated to take back property upon a condition subsequent—a gift tax audit.

The Tax Court concluded that the IRS’s interpretation of Petter was misguided. It was inconsequential that the formula clause reallocates LLC units among the taxpayers and the donees rather than a charitable organization because the reallocations do not alter the transfers. As of the date of the transfer, each donee was entitled to a pre-defined LLC percentage interest expressed through a formula. The court concluded that the transfer documents do not allow the petitioners to take property back. Instead, the documents correct the allocation of LLC units among the taxpayers and the donees because the LLC appraisal understated the LLC’s value. Therefore, the court ruled that the formula clauses were valid.

The Tax Court next addressed the public policy concerns expressed in Procter. It concluded that there was no well-established public policy against definitional clauses. It reasoned that the IRS’s role is to enforce tax laws, not merely to maximize tax receipts. It further reasoned that mechanisms outside the IRS audit existed to ensure accurate valuation reporting—the most significant of which was that the members of the LLC had an interest in ensuring that they were allocated their fair share of profits and not allocated any excess losses. As to other concerns in Procter, the court determined that a judgment in favor of the taxpayers would not undo the gift as they transferred a fixed set of interests to the donees and neither the taxpayers nor the transfer documents contained the power to undo anything; it would simply reallocate LLC units among the taxpayers and the donees.

Wandry is significant because it is the first case in which a court upheld a defined transfer type of definition clause. Previous cases involving definition clauses dealt with the defined allocation type, which reallocated closely held interests among the donees. Once the donors parted with the transfers, the clauses did not operate to reallocate any interest back to the donor. In these other cases, charities were among the donees, so that any excess transfers over and above the specified dollar amount would be reallocated to the charity, which made the excess transfer eligible for the gift tax charitable deduction, and thereby avoided any unintended gift taxes. The Tax Court’s ruling in Wandry would alleviate the need to use a charity as a donee when using a definition clause.



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 itemized deductions) so that the amount deductible is the amount by which the aggregate of the miscellaneous itemized deductions exceeds 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 that of an individual except that deductions that are: (1) paid or incurred in connection with the administration of the trust or estate, and (2) that would not have been incurred if the property were not held in a trust or estate, are treated as allowable in arriving at AGI.

In Knight, 13 the Supreme Court settled a split among the courts of appeals and put to rest the issue whether investment advisory fees are fully deductible under Sec. 67(e) or are deductible under Sec. 67(a), and therefore subject to the 2% AGI floor. The 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) (requiring that the expense “would not have been incurred if the property were not held in the trust”) had not been met.

Before the Supreme Court’s decision in Knight, the IRS had issued Prop. Regs. Sec. 1.67-4, 14 in which it addressed which expenses of a trust or an estate it considered to be deductible under Sec. 67(a) or deductible under Sec. 67(e)(1). These proposed regulations addressed for the first time the issue of “bundled trustee fees,” which are charges billed to a trust bundled together, some of which may be fully deductible and some of which may normally be subject to the 2% floor. The IRS was concerned that fiduciaries were combining into one fee certain fees that may not otherwise be deductible under Sec. 67(e)(1). The proposed regulations required fiduciaries to “unbundle” these fees and then deduct them under Sec. 67.

The IRS withdrew these proposed regulations and issued new ones. 15 The new proposed regulations provide that a cost is subject to the 2% AGI floor if it would be commonly or customarily incurred by a hypothetical individual owning the same property. These costs include ones that do not depend on the identity of the payor and specifically include costs incurred in defense of a claim against the estate, the decedent, or the non-grantor trust that are unrelated to the existence, validity, or administration of the trust or estate.

The costs for all estate and GST tax returns, fiduciary income tax returns, and the decedent’s final individual income tax return are not subject to the 2% AGI floor. Investment advisory fees are generally subject to the 2% floor. However, incremental costs of investment advice are fully deductible if charged solely because the investment advice is rendered to a trust or estate (instead of to an individual) and is attributable to an unusual investment objective or the need for a specialized balancing of interests of the various parties (beyond the usual balancing between current beneficiaries and remaindermen).

In certain situations, a single fee (such as a fiduciary’s commission, attorney’s fee, or accountant’s fee) must be unbundled and treated in accordance with its component parts. Any reasonable method may be used to allocate a bundled fee between costs that are subject to the 2% floor and those that are not. However, any portion of a bundled fee attributable to payments made from the bundled fee to third parties for expenses subject to the 2% floor is readily identifiable and must be pulled out of the bundled fee. There is an exception to the unbundling requirement for a bundled fee that is not computed on an hourly basis. In that situation, the portion of the fee that is attributable to investment advice must be pulled out as well as any payments made from the bundled fee to third parties for expenses subject to the 2% floor. This portion is then subject to the 2% floor while the remainder of the fee is fully deductible.

These rules are effective for tax years beginning on or after the final regulations are published. Until then, Notice 2011-37 16 provides that trusts and estates are not required to unbundle fiduciary fees for any tax year beginning before the date that final regulations are published.

Grantor Trusts

In Letter Ruling 201216034, 17 the IRS determined that the beneficiary was treated as the owner of a trust under Sec. 678. The trust agreement provided that the beneficiary had the right to withdraw the entire amount of any contribution made to the trust. Each year, the beneficiary’s power of withdrawal lapsed with respect to the greater of $5,000 or 5% of the value of the trust corpus (this provision prevented a gift by the beneficiary to the trust that might occur upon the lapse of a general power of appointment under Sec. 2514(e)). The beneficiary was also the trustee of the trust. The trust agreement provided that the trustee could pay to the beneficiary income and principal subject to an ascertainable standard. The beneficiary had the power, in a non-fiduciary capacity, to acquire the trust corpus by substituting other property of an equivalent value as determined by an independent appraiser.

Sec. 678(a)(1) provides that a person other than the grantor is treated as the owner of any portion of the trust for which he or she has the power, exercisable solely by himself or herself, to vest the corpus or the income therefrom in himself or herself. Similarly, if that individual releases that power and thereafter retains an interest in the trust such that he or she would be treated as the owner if he or she were the grantor, that individual is treated as owner of all or a portion of the trust under Sec. 678(a)(2). Sec. 678(b), however, provides that Sec. 678(a) does not apply to a power over income if the grantor is otherwise treated as the owner under the grantor trust provisions (i.e., Secs. 671 through 679) other than Sec. 678.

Sec. 675(4) provides that a grantor will be treated as the owner of a trust for federal income tax purposes if any person in a non-fiduciary capacity (and without the approval or consent of any person in a fiduciary capacity) has the power to reacquire the trust corpus by substituting assets of an equivalent value.

The letter ruling concludes that the beneficiary is treated as the owner of the portion of the trust over which his withdrawal right has not lapsed under Sec. 678(a)(1). In addition, to the extent the withdrawal right lapses each year, the beneficiary is treated as having released the power, while retaining a power of administration, exercisable in a non-fiduciary capacity, to acquire trust corpus by substituting other property of an equivalent value. Such a provision could make the beneficiary the owner of the rest of the trust under Sec. 678(a)(2). The IRS typically will not rule on whether a substitution power is exercisable in a non-fiduciary capacity because it believes that this is a question of fact that must be deferred until the IRS has examined the federal income tax returns of the parties involved. Nevertheless, the ruling states that, if the circumstances indicate that the power of administration is exercisable in a non-fiduciary capacity, the primary beneficiary will be treated as the owner of the entire trust under Sec. 678.

The IRS has always taken the position that upon the lapse of a withdrawal right the beneficiary is treated as releasing the withdrawal power and therefore the provisions of Sec. 678(a)(2) come into play. What is novel about this letter ruling is that it fails to mention Sec. 678(b). If the grantor has a grantor trust power, that power trumps any provision that would treat the beneficiary as the owner of the trust. The power of substitution under Sec. 675(4) if exercisable by any person in a non-fiduciary capacity makes the grantor, not the beneficiary, the owner of the trust. This ruling seems to be in conflict with the language of Sec. 675(4) and previous IRS rulings and other published guidance in which it has held that persons other than the grantor who hold powers of substitution create grantor trust status in the grantor. 18

Charitable Deductions

A trust or estate is allowed a deduction under Sec. 642(c) for any amount of gross income that, under the terms of the governing instrument, is paid for a charitable purpose during the tax year. This deduction is in lieu of the charitable deduction allowed an individual under Sec. 170. T.D. 9582 amends the regulation under Sec. 642 to address the question of when a governing instrument provision dictating the order in which the types of income will be distributed to charity will be respected for federal income tax purposes.

The governing instrument of most charitable lead trusts (CLTs) contains a provision that dictates the order in which classes of income items are treated as distributed to charity upon the payment of the annuity or unitrust amount. Generally, the payment is to consist of the following class of items until each class has been exhausted: (1) ordinary income other than qualified dividend income, (2) qualified dividend income and capital gain, (3) other income (including tax-exempt income), and (4) corpus. Some governing instruments provide that income that is not unrelated business taxable income is to be distributed before income that is unrelated business taxable income. The goal of these ordering rules is to maximize the benefit of the charitable deduction under Sec. 642(c). Because a CLT is a taxable trust, any amount of income not paid to charity through the annuity or unitrust payment is taxable to the CLT. Thus, the ordering rules attempt to distribute income subject to higher tax rates to charity so income taxed at lower rates or not taxable at all is retained by, and taxable to, the trust.

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) read together 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 will be respected only if it has economic effect independent of income tax consequences. Accordingly, the IRS has ruled that the ordering rules in the governing instruments of CLTs generally do not have economic effect independent of income tax consequences and will not be respected for federal income tax purposes.

The final regulations incorporate this position into the Sec. 642 regulations. The regulations require that a provision in a governing instrument or in local law that specifically mandates 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 income tax purposes. If the 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.

Varied CLAT Annuity Payments

In Letter Ruling 201216045, 19 the IRS determined that a judicial construction of the provisions of a trust establishing a charitable lead annuity trust (CLAT) would not adversely affect the trust’s qualification for the estate tax charitable deduction or the deductibility of the income paid to charity on the trust’s income tax return and would not violate any of the private foundation rules applicable to the trust.

The decedent’s will establishing the CLAT provided that the annual annuity amount payable to charity is the amount that will produce a present value for the remainder interest equal to zero or as close to zero as possible. The trustees, with the consent of the beneficiaries of the trust and the state’s attorney general, sought a court order to construe the formula for determining the annuity amount to permit variable ascending annuity payments. Thus, the amount paid to charity each year would be 120% of the amount of the prior year’s payment, rather than having the same amount paid each year. Submitted with the ruling request were schedules showing that the charity would receive more using the variable ascending annuity payment method than the straight-line method. The state probate court issued an order construing the terms of the trust as permitting variable ascending annuity payments, subject to the condition that the trustees receive a favorable private letter ruling from the IRS. The letter ruling was favorable on all issues.

The IRS has not previously ruled regarding variable annuity payments in the context of CLATs. The ability to increase the annuity payment each year by 20% over the prior year’s payment has its genesis in Regs. Sec. 25.2702-3(b)(1)(ii), which defines a qualified annuity interest. This method of computing the annual annuity is commonly used in grantor retained annuity trusts (GRATs). There is no similar limitation on the amount of the annual increase permissible for CLATs so many believe that any structure for the annuity amount is permissible. The IRS has blessed the 20% increase for CLATs; the jury is still out as to whether it will bless variances exceeding 20% of the preceding year’s annuity payment.

Other Developments

Annual Inflation Adjustments

The IRS has released Rev. Proc. 2011-52 20 setting forth inflation adjustments for various tax items for 2012. The following is a list of items that may be of interest to individual taxpayers:

  • For an estate of any decedent dying during calendar year 2012, the basic exclusion amount is $5,120,000 for determining the amount of the unified credit against estate tax under Sec. 2010 (up from $5,000,000 in 2011). This amount also applies to the exemptions for gift and GST taxes.
  • The gift tax annual exclusion for gifts of a present interest is $13,000 (the same as 2011).
  • The gift tax annual exclusion for gifts of a present interest to a spouse who is not a U.S. citizen is $139,000 (up from $136,000 in 2011).
  • The ceiling on special use valuation in Sec. 2032A is $1,040,000 (up from $1,020,000 in 2011).
  • For an estate of a decedent dying in 2012, the dollar amount used to determine the “2% portion” (for purposes of calculating interest under Sec. 6601(j)) of the estate tax extended as provided in Sec. 6166 is $1,390,000 (up from $1,360,000 in 2011).

Sec. 7520 Tables

T.D. 9540 updates the actuarial tables used to value annuities, life interests, and remainder or reversionary interests. The regulations affect the valuation of inter vivos and testamentary transfers of partial interests that are dependent on one or more measuring lives. As required by Sec. 7520(c)(3), every 10 years the IRS revises the actuarial tables to use the most recent mortality experience available at the time of the revision. The new tables are based on the mortality experience derived from the 2000 census. The new tables are generally effective for transfers made on or after May 1, 2009.



1 Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act, P.L. 111-312.

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

3 Crummey, 397 F.2d 82 (9th Cir. 1968).

4 Rev. Rul. 81-7, 1981-1 C.B. 474.

5 Turner, T.C. Memo. 2011-209.

6 Estate of Christofani, 97 T.C. 74 (1991).

7 Estate of Petter, 653 F.3d 1012 (9th Cir. 2011), aff’g T.C. Memo. 2009-280.

8 Procter, 142 F.2d 824 (4th Cir. 1944).

9 Estate of Petter, T.C. Memo. 2009-280.

10 Hendrix, T.C. Memo. 2011-133.

11 Estate of Christiansen , 130 T.C. 1 (2008), aff’d, 586 F.3d 1061 (8th Cir. 2009).

12 Wandry, T.C. Memo 2012-88.

13 Knight, 552 U.S. 181 (2008).

14 REG-128224-06, 72 Fed. Reg. 41243 (7/7/07).

15 REG-128224-06, 76 Fed. Reg. 55322 (9/7/11).

16 Notice 2011-37, 2011-20 I.R.B. 785.

17 IRS Letter Ruling 201216034 (4/20/2012).

18 See, e.g., Rev. Proc. 2007-45, §8.09, 2007-2 C.B. 89; IRS Letter Ruling 9126015 (3/29/91); IRS Letter Ruling 200434012 (8/20/04).

19 IRS Letter Ruling 201216045 (1/23/12).

20 Rev. Proc. 2011-52, 2011-45 I.R.B. 701.



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

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