Recent Developments in Estate Planning: Part II

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




  • The IRS issued regulations providing guidance on the election to allow a surviving spouse to use his or her deceased spouse’s unused estate tax exemption (the portability election).
  • The Tax Court held that, for federal estate tax purposes, a discount should be applied in the valuation of a decedent’s fractional interests in 64 works of art.
  • In Windsor , a case involving the estate tax marital deduction, the Supreme Court held that part of the Defense of Marriage Act (DOMA) is unconstitutional because it violates the Fifth Amendment’s Due Process Clause by denying equal protection to same-sex couples who are lawfully married in their states.
  • The IRS issued a letter ruling holding that Sec. 1014(a) applied to step up the basis of non-U.S. situs assets in a foreign grantor trust.

This is the second in a two-part article examining developments in estate, gift, and generation-skipping transfer (GST) tax and compliance between June 2012 and May 2013. Part I, in the September issue, discussed gift tax and trust developments, the extension of a number of expiring favorable estate and gift tax provisions by the American Taxpayer Relief Act of 2012, the taxation of trusts subject to the new 3.8% net investment income tax, and inflation adjustments for 2013. This part covers developments in estate tax and GST tax.

Estate Tax

Portability Regulations

One of the provisions in the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 1 amended Sec. 2010 to allow for portability of the estate tax exemption between spouses. Sec. 2010(c) generally allows the surviving spouse of a decedent dying after Dec. 31, 2010, to use the decedent’s unused estate tax exemption in addition to the surviving spouse’s own estate tax exemption.

For example, if a decedent died in 2011 (when the estate tax exclusion amount was $5 million) with a taxable estate of $3 million, the decedent’s estate could make the portability election so the decedent’s surviving spouse would have an exclusion amount of $2 million from the decedent in addition to his or her own exclusion amount. Thus, the election eliminates the need for spouses to retitle property and create trusts solely to take full advantage of each spouse’s estate tax exemption. The portability provision was made permanent by the American Taxpayer Relief Act of 2012. 2

On June 18, 2012, temporary 3 and proposed 4 regulations were issued to provide guidance on the portability of the deceased spousal unused exclusion (DSUE) amount, including how to make the portability election and how a surviving spouse uses the DSUE amount. The portability election must be made by timely filing an estate tax return, Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return , which is due nine months after the date of the decedent’s death unless an extension of time to file is obtained. The regulations clarify that, to make the portability election, the estate tax return must be filed within this time period even if the estate would not otherwise be required to file a return (because the decedent’s gross estate is less than $5.25 million for 2013).

If the executor chooses not to make the portability election, the executor must check the box in Section A of Part 6 of Form 706 to opt out of the portability election. If no estate tax return is required to be filed, taxpayers avoid making the election by not filing a timely return. Once made, the election is irrevocable.

The executor is the one who must make the election. If there is no appointed executor, any person in actual or constructive possession of any of the decedent’s property (a nonappointed executor) may file the estate tax return and make the election. A portability election made by a nonappointed executor cannot be superseded by a contrary election made by another nonappointed executor.

To make the election, the estate tax return must be complete and properly prepared. The temporary regulations provide that if the estate is not otherwise required to file an estate tax return, the estate tax return does not have to report the value of certain property that qualifies for the marital or charitable deduction. In such a situation, the executor will be required to report only the description, ownership, and/or beneficiary of that property along with the information necessary to establish the estate’s right to the marital or charitable deduction for that property.

If the executor chooses this filing option, the executor must estimate the total value of the gross estate, based on a determination made in good faith and with due diligence of the value of all the assets includible in the gross estate. The executor must identify the particular range applicable to the gross estate using the ranges of dollar values that are provided in the Form 706 instructions.

The executor must compute the DSUE amount in Section C of Part 6 of Form 706, using the basic exclusion amount in effect in the year of the death of the decedent whose DSUE amount is being calculated. If the decedent paid gift tax on taxable gifts because these gifts exceeded the applicable exclusion amount at the time of the gift, the gifts are excluded from adjusted taxable gifts for purposes of computing the decedent’s DSUE amount. This adjustment is necessary so that the decedent’s exclusion amount is not used for amounts on which gift tax was paid. The temporary regulations do not address how the DSUE amount is affected by other available estate tax credits (i.e., Sec. 2013 credit for tax on prior transfers, Sec. 2014 credit for foreign death taxes, and Sec. 2015 credit for death taxes on remainder), instead requesting comments before regulations are issued on the issue.

If the portability election is made, the surviving spouse can use the DSUE amount for transfers occurring after the decedent’s date of death. The temporary regulations also address who is the “last deceased spouse” of the surviving spouse. The last deceased spouse is the most recently deceased individual who was married to the surviving spouse at that individual’s death, provided the individual died after Dec. 31, 2010. The surviving spouse’s remarriage does not affect who will be considered the last deceased spouse and does not prevent the surviving spouse from including in the surviving spouse’s applicable exclusion amount the DSUE amount of the deceased spouse who most recently preceded the surviving spouse in death.

The identity of the last deceased spouse is not affected by whether the estate of the last deceased spouse makes the portability election or has any DSUE amount available. When a surviving spouse has more than one deceased spouse, the temporary regulations apply an ordering rule. Any gifts a surviving spouse makes use up the DSUE amount of the last deceased spouse (identified as of the date of the gift) before using up any of the surviving spouse’s own basic exclusion amount. The surviving spouse’s DSUE amount then becomes the DSUE amount of the last deceased spouse (identified as of the date of a subsequent gift or the death of the surviving spouse) plus any DSUE amount actually applied to the surviving spouse’s taxable gifts to the extent it was from a decedent who is no longer the last deceased spouse. Examples in the temporary regulations illustrate how these provisions work.

The temporary regulations confirm that the IRS may, at any time, examine the returns of each deceased spouse of the surviving spouse to adjust or eliminate the DSUE amount, but may assess additional estate tax on those prior returns only if the period of limitation on assessments under Sec. 6501 is still open.

The temporary regulations also address the application of the portability rules when the decedent’s assets are transferred to a qualified domestic trust (QDOT) for the benefit of a surviving spouse who is not a U.S. citizen. Under Sec. 2056A, the decedent’s estate tax is ultimately imposed when taxable distributions are made from the QDOT. The tax generally equals the amount of additional estate tax that would have been imposed if the amount of the taxable distribution had been taxable in the decedent’s estate (and not deductible as part of the marital deduction). The amount of estate tax that would have been imposed is computed by determining the net tax after the allowance of any credits, including the applicable credit amount.

Because portability is available to a surviving spouse only to the extent the decedent’s exclusion amount is not used by the decedent’s estate, the temporary regulations provide that the decedent’s applicable exclusion amount is available to the decedent’s estate until the decedent’s final estate tax liability is computed. Consequently, the executor will compute a DSUE amount on a preliminary basis on the decedent’s estate tax return for purposes of electing portability, and this amount will subsequently be redetermined on the final distribution from the QDOT or other taxable event on which the estate tax under Sec. 2056A is imposed (e.g., death of the surviving spouse). The DSUE amount, if any is left, will be available for transfers occurring by reason of the surviving spouse’s death and will be available in only limited circumstances for gifts during the surviving spouse’s life.

Valuation of Art Interests

In Estate of Elkins , 5 the Tax Court held that a 10% fractional interest discount in artwork applied to the decedent’s fractional ownership interest in art, dismissing the IRS’s long-held position that no discounts should be allowed for fractional interests in art. The decedent and his wife, who together purchased 64 works of art, each created a grantor retained income trust (GRIT) funded by each spouse’s undivided 50% interest in three of the works of art (the transfers occurred before Sec. 2702 applied, which assigns a zero value to property transferred to trusts for the benefit of a member of the transferor’s family). Each GRIT was for a 10-year pe riod, during which the grantors retained the use of the art. At the end, the grantors’ interests in the art were to pass to their three children, one-third each. The decedent’s wife died before the end of the 10-year period. When the decedent survived his wife, the art in the wife’s GRIT went to the decedent (to obtain the marital deduction) instead of the three children. Because the decedent survived the 10-year period, the property in his GRIT passed equally to his three children so that each received a 16.667% interest in the GRIT art.

After the decedent’s GRIT expired, the decedent and his children executed a lease covering two of the pieces of art, which effectively allowed the decedent to retain the art all year. The lease provided that the lessors and lessees agreed not to sell their interests in the art during the term of the lease unless they all agreed to sell the art. The lease further stated that the rights under the lease could not be transferred or assigned without the consent of all parties, which was binding upon the lessors and lessees and their respective “heirs, representatives, successors, and assigns.”

Under the decedent’s wife’s will, her interest in the other 61 works of art went to the decedent, but the decedent disclaimed a portion of those interests equal to the value of the wife’s unused unified credit, which resulted in the disclaimed property going to the three children. As a result of the disclaimer, the decedent retained a 73.055% interest in the art (50% owned outright and 23.055% from his wife’s estate), and the children collectively received a 26.945% interest in the art. After the disclaimer was executed, the decedent and his children entered into a “cotenants’ agreement” for the disclaimed art, which prohibited the cotenants from selling any of the art without unanimous consent. After the expiration of the decedent’s GRIT, the agreement was amended to cover the one piece of art that was not otherwise covered by the lease.

Upon the decedent’s death, his interest in the art went to his children while the rest of the estate went to the family’s charitable foundation. The decedent’s es tate tax return valued his 73.055% interest in the 61 works of partially disclaimed art that was subject to the original cotenants’ agreement at $9,497,650, and his 50% interest in the three works of art in the GRIT (two of which remained subject to the art lease) at $2,652,000. Those amounts were derived by, first, determining the decedent’s pro rata share of the fair market value (FMV) of the art and then applying a 44.75% combined fractional interest discount (for lack of control and lack of marketability). The IRS disallowed the discounts under two theories: (1) The restrictions on the sale of art subject to the cotenants’ agreement and fractional interests in art subject to the art lease should be disregarded under Sec. 2703(a)(1); and (2) the discounts used in valuing the decedent’s interest in the art were overstated, and no discount was appropriate.

Sec. 2703(a) provides that the value of property for transfer tax purposes is determined without regard to: (1) any option, agreement, or other right to acquire or use property for a price less than its FMV or (2) any restrictions on the sale or use of the property. The estate essentially conceded this issue with regard to the lease agreement because it did not oppose the IRS’s position that the sale restriction in the agreement should not be considered.

As to the cotenants’ agreement, the IRS argued that the restriction on the sale of the art was purely for testamentary purposes. The decedent’s estate argued that because the cotenants’ agreement did not restrict the sale of the decedent’s fractional interest in the art (as opposed to the restriction on the actual art pieces), Sec. 2703 did not apply.

The Tax Court dismissed both arguments and noted the testimony of the estate’s expert on partition in which he stated that by entering into the cotenants’ agreement, the cotenants had given up their right to have the property partitioned. The court then ruled that, under the cotenants’ agreement, the decedent had effectively waived his right to institute a partition action and, in so doing, relinquished an important use of his fractional interest in the art. Therefore, it held that Sec. 2703(a)(2) applied to the restriction in the cotenants’ agreement that did not allow a cotenant to sell his or her fractional interest in the art and would be disregarded for estate tax valuation purposes.

As a result, the cotenants’ agreement could not be read as restricting the hypothetical seller’s right to sell the decedent’s interests in the art, but the hypothetical buyer’s ability to monetize those interests on a discounted basis remained subject to the cotenants’ agreement to sell the underlying art and a pro rata splitting of the proceeds or the need to institute a partition action to achieve that result. The court first looked at whether any discount was permissible in this case, noting that there was precedent in both the Tax Court and Fifth Circuit (to which the case was appealable) allowing discounts in valuing a fractional interest in property for federal estate tax purposes where there are potential impediments to a fair market sale of the interest, as was the case before it.

The Tax Court next turned to the amount of the discount and what a hypothetical willing buyer and a willing seller would agree on as the price for the art. The decedent’s children testified that they would spend whatever was necessary to retain their minority interests in the art. However, given the children’s undisputed financial resources to do so, they would be willing to spend even more to acquire the decedent’s fractional interests and thereby preserve 100% ownership of the art for themselves.

The court determined that a hypothetical willing buyer and seller of the decedent’s interests in the art would agree upon a price at or fairly close to the pro rata FMV of those interests. Because the hypothetical seller and buyer could not be certain, however, regarding the children’s intentions (i.e., because they could not be certain that the decedent’s children would seek to purchase the hypothetical buyer’s interests in the art rather than be content with their existing fractional interests) and because the hypothetical buyer could not be certain that, if the children did seek to repurchase the decedent’s interests in the art, the children would agree to pay the full pro rata FMV for those interests, the court determined that a 10% discount was appropriate.

The Tax Court’s decision may leave readers scratching their heads as to how it arrived at the discount. It seems to have pulled the discount out of thin air, which the court has been known to do on occasion despite the testimony of valuation experts. The court also used some “unique” facts about a “hypothetical” willing buyer and willing seller, taking into consideration the family’s desire to retain ownership of the art—based on the testimony of only one of the decedent’s three children.

As with any matter involving valuation, the issue of art valuation is far from settled, but taxpayers should be reminded that good valuations are very important in the estate and gift tax area due to courts’ inclination to substitute their own opinion as to value.

Valuation of Business Interests and Deductibility of Interest

Estate of Koons 6 involved two issues—the valuation of a business and the deductibility of interest on a loan to pay transfer taxes—in which the Tax Court’s decision was heavily influenced by the percentage interest in a limited liability company (LLC) that the decedent’s estate would own after certain redemptions occurred after his death. Before he died, the decedent and his family members, directly and indirectly, owned a corporation that was a bottler and distributor of Pepsi products and operated a large vending machine business. The corporation and Pepsi were involved in litigation, and, as part of the settlement, the corporation agreed to sell its soft drink and vending businesses to a Pepsi affiliate.

In anticipation of the sale, the corporation created an LLC to which all of the corporation’s assets, other than the soft drink and vending business, were transferred. The decedent owned a 46.94% voting interest and a 51.59% nonvoting interest in the corporation and the LLC.

Around the time of the sale negotiations, the decedent decided to liquidate his children’s interests in the business and changed the terms of his revocable trust to eliminate them as beneficiaries, leaving only his grandchildren as beneficiaries. As a result, the children were presented with an agreement to sell their shares conditioned on the LLC’s agreement to offer to redeem their LLC interests. Each child agreed to the sale and redemption agreement before the decedent died even though the actual redemptions of the LLC interests did not take place until shortly after his death. After the redemptions, the estate owned 70.42% voting control of the LLC.

The Tax Court addressed the disagreement between the IRS and the estate on the value of the LLC interests owned by the revocable trust at the decedent’s death. (Because the soft drink and vending businesses were sold before the decedent died, the assets in the LLC consisted mainly of cash.) The estate valued the LLC interest using a 31.7% discount for lack of marketability, whereas the IRS’s expert argued that the lack of marketability discount should be only 7.5%. The IRS’s expert assumed that the redemption of the children’s interests would occur, but the estate’s expert assumed that it would not.

The Tax Court agreed with the IRS’s assumption that the redemptions would occur because the redemption offers were binding contracts by the time the decedent died. The LLC had made written offers to all of the children to redeem their interests, and they all had signed them. Therefore, the children were required to sell their LLC interests to the LLC. Once the Tax Court accepted the IRS expert’s 7.5% discount for lack of marketability, the resulting increase in the value of the LLC interests affected not only the estate tax but also the GST tax due at the decedent’s death. Because the decedent had eliminated the children as beneficiaries of his revocable trust, the trust became a skip person and GST tax was due at the decedent’s death.

The other issue the Tax Court addressed was the deductibility of interest incurred on a loan, the proceeds of which were used to pay the estate’s transfer tax liabilities. When a decedent’s estate consists of mostly illiquid assets, finding funds to pay federal and state estate and GST taxes becomes an issue. The decedent’s revocable trust borrowed $10.75 million from the LLC to pay the decedent’s estate and GST taxes. Under the terms of the loan, interest and principal payments were to be made in 14 equal, semiannual installments beginning 18 years after the loan was executed; prepayment was prohibited. The estate claimed a deduction under Sec. 2053(a)(2) for the total amount of interest due on the loan ($71,419,497), believing that this was a transaction similar to the one the Tax Court approved in Estate of Graegin . 7

Under Regs. Sec. 20.2053-3(a), to be deductible by the estate under Sec. 2053(a), an administrative expense must be actually and necessarily incurred in the administration of the decedent’s estate. If the estate incurs the loan to pay the estate tax liability to avoid having to sell illiquid assets, the loan generally will be considered reasonable and necessary in administering the estate. 8 In Estate of Graegin , the Tax Court allowed a deduction for the full amount of interest on a loan to pay estate taxes from a wholly owned subsidiary of the decedent’s closely held corporation. Payment of all principal and interest was due in a balloon payment at the end of the 15-year term of the loan (to coincide with the life expectancy of the surviving spouse, upon whose death assets would become available to repay the loan). The loan agreement prohibited prepayment of the principal and interest.

In Koons , the Tax Court explained that interest payments on loans can be deducted if the loan is necessary to raise money to pay the estate tax without liquidating assets at forced-sale prices. In this case it was not necessary to borrow from the LLC because at the time of the loan the revocable trust had 70.42% voting control over the LLC and the LLC had more than $200 million in highly liquid assets. Voting control meant the revocable trust had the power to force the LLC to make a pro rata distribution to its members. As a result, the loan was unnecessary. The estate argued that the loan was preferable to a cash distribution from the LLC because a cash distribution would leave the LLC with less cash to buy businesses, but the court noted that the loan also depleted the LLC’s cash. In addition, the lending merely postponed the necessity for the LLC to make a distribution because the revocable trust would have to get distributions from the LLC in the future to repay the loan. 

The Tax Court’s decision on both issues was affected greatly by the estate’s owning a controlling interest in the LLC. Redeeming the children’s interest certainly reduced the amount of the valuation discount. The discount for lack of marketability would have been higher if the estate had continued to own the same minority voting interest that the decedent owned before the children’s interests were redeemed. In addition, if the estate had only a minority voting interest, the court could not have so summarily dismissed the interest deduction because the estate could not have forced the LLC to distribute cash to its owners to pay the transfer taxes. Also, eliminating the children as beneficiaries of the trust caused the immediate payment of GST tax, which is the last thing that estate planners want to happen.

Marital Deduction

In Windsor , 9 the taxpayer challenged the constitutionality of Section 3 of the Defense of Marriage Act (DOMA) 10 because it required her to pay federal estate tax on her same-sex spouse’s estate that would not be due for a heterosexual married couple. Section 3 provides that for purposes of determining the meaning of any act of Congress or pronouncement of any U.S. government agency, the word “marriage” means only a legal union between one man and one woman as husband and wife and the word “spouse” refers only to a person of the opposite sex who is a husband or a wife.

Windsor and her partner were married in Canada, which permitted couples of the same sex to marry. At the time of their marriage and until her partner’s death in 2009, Windsor and her partner lived in New York, which (courts have found) recognized foreign same-sex marriages before the state legalized same-sex marriage in 2011. When Windsor’s partner died, her estate passed to Windsor. Because of DOMA, the bequest to Windsor did not qualify for the unlimited marital deduction under Sec. 2056(a), and the estate was required to pay federal estate tax.

Windsor, as executor of the estate, paid the estate tax and then filed a claim for refund, arguing that Section 3 of DOMA deprived her of the equal protection of the laws, as guaranteed by the Fifth Amendment to the U.S. Constitution. The Second Circuit Court of Appeals concluded that Section 3 of DOMA was unconstitutional as applied to Windsor and that the estate was entitled to a refund of the federal estate taxes. The Supreme Court granted certiorari and heard oral arguments on the case on March 27, 2013.

On June 26, 2013, the Supreme Court issued a 5–4 decision, written by Justice Anthony Kennedy, holding that DOMA is unconstitutional because it violates the Fifth Amendment’s Due Process Clause by denying equal protection to same-sex couples who are lawfully married in their states. In the opinion, Kennedy wrote that, since the nation’s founding, states have possessed full power over the subject of marriage and divorce, subject to constitutional limitations (citing Loving v. Virginia , 388 U.S. 1 (1967)). 11 DOMA affects more than 1,000 federal statutes in which the definition of marriage is at issue. It interferes with the states’ power to regulate marriage by forcing “same-sex couples to live as married for the purpose of state law but unmarried for the purpose of federal law, thus diminishing the stability and predictability of basic personal relations the State has found it proper to acknowledge and protect.” 12

Basis Step-up for Foreign Grantor Trust

U.S. citizens and residents are subject to estate tax on their worldwide assets owned at death. Conversely, nonresident, non-U.S. citizens (nonresident aliens) are subject to U.S. estate tax on only U.S.-situs assets owned at death, including real and personal, tangible and intangible property located in the United States. Other assets, such as foreign real property and stock of a non-U.S. corporation, are not subject to U.S. estate tax when a nonresident alien dies.

Sec. 1014(a) provides a general rule allowing a step-up in basis to FMV at the date of death for property acquired from a decedent, applying the principle that a taxpayer’s basis in property should increase when tax is paid, and therefore assets that are subject to the estate tax should receive a basis step-up in the transferee’s hands. The connection between taxation and basis increase is not as clear when the decedent is a nonresident alien and the assets are not subject to U.S. estate tax, raising the question whether U.S. resident heirs should benefit from the Sec. 1014(a) basis step-up following a decedent’s death.

The IRS recently issued a letter ruling 13 stating that non-U.S. situs assets held by a foreign grantor trust can receive a basis step-up to FMV at the date of the decedent’s death. The taxpayer, who was a citizen and resident of a foreign country and a nonresident alien for U.S. estate tax purposes, proposed to transfer assets to an irrevocable foreign trust, including cash and stock of companies that were publicly traded on an exchange in a foreign country and would be non-U.S. situs assets. The trust was to pay income to the taxpayer for life and could pay principal to the taxpayer at the trustee’s discretion. The taxpayer retained the power to appoint the assets remaining in the trust at his death by deed or will to his issue in any proportion he chose. If the taxpayer did not exercise this power, the assets would remain in trust for the benefit of the taxpayer’s issue. During the taxpayer’s lifetime, no adverse party was eligible to serve as trustee.

The taxpayer requested a ruling on whether Sec. 1014 would step up the basis of the trust’s assets to FMV as of the date of the taxpayer’s death. Sec. 1014(a) permits a basis step-up for property that is acquired from or passes from a decedent. Sec. 1014(b) defines property acquired from a decedent, including Sec. 1014(b)(9), which requires that the property be included in the decedent’s U.S. taxable estate to receive the basis step-up. Sec. 1014(b)(9)(C) provides an exception to this requirement for property, such as non-U.S. situs property, if the property is described in other subparagraphs of Sec. 1014(b). Relevant to this ruling, Sec. 1014(b)(1) provides that any property that is acquired by bequest, devise, or inheritance at a taxpayer’s death (including via a power of appointment) will receive the basis step-up provided by Sec. 1014(a). Because the taxpayer holds the power to appoint the trust property via will or deed at death, the property will be received by the taxpayer’s heirs via bequest, devise, or inheritance. Therefore, the IRS concluded that the Sec. 1014(b)(9)(C) exception has been met, and the property will receive a basis step-up even though the property will not be includible in the decedent’s U.S. taxable estate.

The taxpayer also requested a ruling on whether the trust qualifies as a foreign grantor trust. Sec. 672(f)(1) and its regulations provide that the grantor trust rules apply to a foreign trust if the only amounts distributable from the trust during the life of the grantor are distributable to the grantor or the grantor’s spouse. The IRS ruled that the trust agreement met this condition and that the trust should be treated as a foreign grantor trust for U.S. income tax purposes.

With careful planning, heirs can receive a basis step-up for assets transferred at death by nonresident alien decedents regardless of whether those assets are includible in the decedent’s U.S. estate. This letter ruling confirms the step-up may be available even where the property is transferred to an irrevocable trust during the nonresident alien decedent’s lifetime. Receiving the basis step-up will be especially significant when the transferee is or becomes a U.S. resident following the decedent’s death.

Although Sec. 1014(b)(9) requires that property be included in the decedent’s gross estate to obtain the basis step-up, Sec. 1014(b)(9)(C) contains an exception for all property described in the other paragraphs of Sec. 1014(b), which includes, but is not limited to, property transferred by bequest, devise, or inheritance (Sec. 1014(b)(1)); property transferred to a revocable trust that pays income for life to or at the direction of the decedent (Sec. 1014(b)(2)); and property passing on the exercise of a general power of appointment by the decedent (Sec. 1014(b)(4)). These paragraphs generally describe assets that would be includible in the decedent’s gross estate if they were U.S. situs assets or the decedent were a U.S. person, but may not describe all such assets. Therefore, estate planning for nonresident aliens, especially those with heirs in the United States, should consider whether the nonresident alien’s assets are described in Secs. 1014(b)(1) through (8) to determine whether these assets will be eligible for the basis step-up at the decedent’s death.

Foreign grantor trusts are the most tax efficient type of trust for U.S. resident beneficiaries because distributions from those trusts are treated as income tax-free gifts from the grantors instead of taxable distributions from foreign trusts (which are potentially subject to high tax rates and an interest charge). Additionally, foreign grantors are subject to U.S. income tax only on U.S.-source income to the trusts. However, under Sec. 672(f)(2), to be a foreign grantor trust, either (1) the power to revest title in the grantor to trust property is exercisable solely by the grantor without the approval or consent of any other person or with the consent of a related or subordinate party who is subservient to the grantor, or (2) the trust distributions must be limited to distributions to the grantor or the grantor’s spouse. In the letter ruling, the taxpayer’s trust met the second requirement, and the IRS ruled that it was a foreign grantor trust.

The narrow rules described in Sec. 672(f)(2) result in most foreign trusts being treated as nongrantor trusts, which is unfavorable taxwise for U.S. resident beneficiaries. Therefore, it is important when creating a foreign trust and analyzing all distributions from a foreign trust to consider whether the Sec. 672(f)(2) exceptions are met.

Generation-Skipping Transfer Tax

Automatic Allocations

In 2010, as part of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, the applicable rate under Sec. 2641(a) was zero—all generation-skipping transfers made in 2010 effectively were not subject to the GST tax. However, unless the transferor made an election not to allocate GST exemption, the exemption would continue to be automatically allocated to direct and indirect skips.

In Letter Ruling 201250005, 14 the transferor did not elect to not allocate GST exemption to a transfer to a direct skip trust. The ruling cites Notice 2011-66, 15 which provides that the taxpayer’s timely filing of a Form 709 reporting an outright, inter vivos direct skip made in 2010 or the termination of an estate tax inclusion period (ETIP) in 2010, not in trust, other than by reason of the donor’s death, is sufficient to prevent an allocation of GST exemption to that inter vivos direct s kip. Therefore, it ruled that the allocation of GST exemption to the taxpayer’s transfer to the trust in 2010 was void.

Although the ruling cites Notice 2011-66, the notice should not apply to the facts in the letter ruling because the transfer was to a trust, not outright. If this trust had beneficiaries in additional generations beyond the generation of the transferor’s grandchildren, the transferor would probably have wanted the automatic allocation rules to apply as they did. Under the “move down” rule in Sec. 2653(a), the transferor would have moved down one generation, and there would still be beneficiaries who were two or more generations below the transferor (such as great-grandchildren).

Sec. 2642(g) gives the IRS the authority to grant taxpayers an extension of time to make an election under Sec. 2632(b)(3) (automatic allocation of GST exemption to direct skips) and Sec. 2632(c)(5) (automatic allocation of GST exemption to indirect skips). The letter ruling does not cite the availability of relief under this section. Thus, even if the reasoning of the letter ruling was not right, the result was correct.

Obama’s Budget Proposals

On April 10, 2013, President Barack Obama released his FY 2014 budget. It included the following gift, estate, and GST tax revenue raisers.

  • Estate tax reform: Even though the American Taxpayer Relief Act of 2012 made permanent changes to the gift, estate, and GST tax regimes, the budget seeks to modify some of these provisions. The budget would increase the maximum tax rate from 40% to 45% and reduce the exemption amount from $5.25 million to $3.5 million for estate and GST tax purposes and $1 million for gift tax purposes. It would continue to allow portability of the DSUE amount to the decedent’s surviving spouse. The budget would make these proposed changes effective for decedents dying, and for transfers made, after Dec. 31, 2017.
  • Minimum GRAT term: The administration has again proposed a new minimum term requirement of 10 years for grantor retained annuity trusts (GRATs). This would make a GRAT a riskier planning technique because the transfer tax benefits of GRATs are typically achieved when the grantor outlives the GRAT term. The maximum term of the GRAT could not be longer than the life expectancy of the grantor, plus 10 years, which would prohibit the 99-year GRATs that some taxpayers have created to ensure that the amount includible in the grantor’s estate under Sec. 2036 is very small. The proposal would also require the remainder interest of a GRAT to have a value other than zero, but does not give a required minimum amount. Finally, the proposal would prohibit any decrease in the amount of the annuity during the annuity term to prevent front-loading a GRAT.
  • Coordination of income and transfer tax treatment for grantor trusts: This proposal would provide that if a grantor engages in a transaction that constitutes a sale or exchange that is disregarded for income tax purposes, the portion of the trust attributable to property received in the transaction (including all retained income, appreciation, and reinvestment net of the amount of consideration received by the grantor) will be subject to gift or estate tax when the property is no longer subject to the grantor trust rules. Any gift or estate tax payable due to this proposal would be borne by the trust. The proposal is targeted at shutting down the gift and estate tax benefit of sales to intentionally defective grantor trusts. It is much narrower than last year’s proposal, which would have subjected a transfer to a grantor trust to gift or estate tax when there was a distribution from the trust or when the trust ceased to be a grantor trust.
  • Limit duration of GST exemption: This proposal would terminate the GST exemption of a trust no later than the 90th anniversary of its creation. After the 90th anniversary, the trust would have an inclusion of one. The proposal is an attempt by the administration to deal with many states that have changed or repealed their rules providing for a maximum term for a trust. When the GST tax regime was enacted, most states used the common law rule against perpetuities, which required the term of the trust to last no longer than 21 years after the death of a person in being at the time the trust was created. Many states have now removed or revised the common law rule against perpetuities and have opted for longer or unlimited terms.
  • Consistency in valuations: This proposal would limit the basis of property for income tax purposes to the value reported by a decedent’s estate for estate tax purposes or by a donor for gift tax purposes. If donors or decedents are required to file a gift or estate tax return, they would be required to furnish basis information to the recipient and to the IRS.
  • Extend liens on estate tax deferrals: This proposal would extend the general estate tax lien that applies to all estate tax liabilities under Sec. 6323 to continue past the normal 10-year period until the deferral period the decedent’s estate has elected under Sec. 6166 expires. The proposal seeks to reduce the complexities and costs of requiring additional security once the normal lien period expires as well as secure the government’s rank among creditors of the estate and its assets. This proposal is in response to the Tax Court’s decision in Estate of Roski , 16 in which the court held that the IRS had abused its discretion by requiring that all estates electing to pay estate tax in installments under Sec. 6166 provide a bond or lien. The court ruled that it was Congress’s intent that the IRS determine, on a case-by-case basis, whether the government’s interest is at risk prior to requiring security from an estate making an election under Sec. 6166.
  • Clarify GST tax treatment of health and education exclusion trusts (HEETs) (new): Sec. 2503(e) excludes from gift tax any payments made directly to the provider of medical care and payments made directly to an educational institution for tuition. Sec. 2611(b)(1) excludes from GST tax any transfer made under Sec. 2503(e). HEETs provide for the payment of medical and tuition expenses for beneficiaries in multiple generations. Because they are exclusively for purposes described in Sec. 2503(e), there is no need to allocate GST exemption to them because distributions from them would be excluded from GST tax. This proposal would clarify that Sec. 2611(b)(1) applies only to a payment by a living donor.

One interesting proposal that has appeared in all of the president’s prior proposed budgets but was dropped from this year’s budget was the proposal to create an additional category of “disregarded restrictions” under Sec. 2704 that would be ignored in valuing an interest in a family partnership. Previous proposals would have added the following categories of disregarded restrictions to Sec. 2704 that would be ignored in valuing transferred interests: (1) limitations on the right to liquidate an interest if it was more restrictive than standards set forth in regulations and (2) any restriction on a transferee’s ability to be admitted as a full partner or a holder of an equity interest in the entity. The restriction would have been ignored if, after transfer, the restriction may lapse or may be removed by the transferor or the transferor’s family.

Authors’ note: The authors thank Ben Wright, Justin Lynch, and Ashley Weyenberg in the Personal Financial Services group in the National Tax Department of Ernst & Young LLP for their contributions to this article.

The views expressed in this article by Mr. Ransome are his own and do not necessarily represent the views of Ernst & Young LLP.


1 Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L 111-312.

2 American Taxpayer Relief Act of 2012, P.L. 112-240.

3 T.D. 9593.

4 REG-141832-11.

5 Estate of Elkins, 140 T.C. No. 5 (2013).

6 Estate of Koons, T.C. Memo. 2013-94.

7 Estate of Graegin, T.C. Memo. 1988-477.

8 See Rev. Rul. 84-75, 1984-1 C.B. 193.

9 Windsor, No. 12-307 (U.S. 6/26/13), aff’g 699 F.3d 169 (2d Cir. 2012).

10 Defense of Marriage Act, P.L. 104-199.

11 Windsor, slip op. at 16.

12 Windsor, slip op. at 22.

13 IRS Letter Ruling 201245006 (11/9/12).

14 IRS Letter Ruling 201250005 (12/14/12).

15 Notice 2011-66, 2011-35 I.R.B. 184.

16 Estate of Roski, 128 T.C. 113 (2007).


Justin Ransome is a partner in the National Tax Department of Ernst & Young LLP in Washington, D.C. Frances Schafer is a retired managing director at Grant Thornton LLP. For more information about this article contact Mr. Ransome at or Ms. Schafer at


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