Recent Developments in Estate Planning: Part 2

By Justin Ransome, J.D., MBA, CPA, with contributions by: David Kirk, Marianne Kayan, Ben Wright, Justin Lynch, Ashley Weyenberg, Caryn Gross, and Laercio Guimaraes


Photo by DNY59/iStock

  • Final regulations on the deductibility of costs incurred by trusts and estates require trustees to unbundle bundled fees to separate them between costs that are subject to the 2%-of-adjusted-gross-income floor and those that are not.
  • In a case of first impression, the Tax Court held in Frank Aragona Trust that a trust could materially participate in a real estate activity and qualify as a real estate professional.
  • A private letter ruling on incomplete nongrantor trusts illustrates that the IRS is continuing to approve the use of these strategies, which generally have been used to lower state or local taxes but now may also be a helpful method to reduce exposure to the net investment income tax.
  • Proposed regulations attack transactions in which holders of appreciated assets minimize their gain on the sale of assets through the use of charitable remainder trusts and the uniform basis rules.
  • The IRS ruled that Mexican Land Trusts, which U.S. taxpayers must use to buy some real property in Mexico, are not foreign trusts subject to the applicable U.S. reporting requirements.

This is the second in a two-part article examining developments in estate, gift, and generation-skipping transfer tax and trust income tax between June 2013 and May 2014. Part 1, which appeared in the September issue, discussed gift, estate, and generation-skipping transfer tax developments. Part 2 covers trust developments, the taxation of trusts under the new 3.8% net investment income tax, President Barack Obama's estate and gift tax proposals, and inflation adjustments for 2014.

Expenses Subject to 2%-of-AGI Limitation

On May 9, 2014, final regulations 1 were issued on which costs incurred by estates or nongrantor trusts are subject to the 2%-of-adjusted-gross-income (AGI) floor for miscellaneous itemized deductions under Sec. 67(a). The regulations require a bundled fee to be unbundled by allocating the fee between costs that are subject to the 2%-of-AGI floor and those that are not. The regulations, which are effective for tax years beginning after Dec. 31, 2014, 2 adopt, with minor modifications, the reproposed regulations 3 published in 2011. The regulations also supersede interim guidance in Notice 2008-32, Notice 2008-116, Notice 2010-32, and Notice 2011-37, which generally provided that until the final regulations were published, the unbundling of fees was not required.

Under Sec. 67(a), miscellaneous itemized deductions incurred by an individual are deductible only to the extent that the aggregate of those deductions exceeds 2% of AGI. Sec. 67(b) excludes certain itemized deductions from the definition of "miscellaneous itemized deductions." Sec. 67(e) requires the AGI of an estate or trust to be computed in the same manner as an individual's AGI, but Sec. 67(e)(1) allows an above-the-line deduction for costs paid or incurred in connection with the administration of the estate or trust that would not have been incurred if the property were not held in an estate or trust. Therefore, the deductions described in Sec. 67(e)(1) are not subject to the 2%-of-AGI floor.

In Knight, 4 the Supreme Court settled a split among the circuit courts of appeals and put to rest the issue of whether investment advisory fees are fully deductible under Sec. 67(e) or are deductible under Sec. 67(a), making them subject to the 2%-of-AGI floor. The Supreme Court ruled that investment advisory fees were not "uncommon (or unusual, or unlikely)" for a hypothetical individual to incur and, therefore, 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, proposed regulations 5 that were published in 2007 addressed for the first time the issue of "bundled trustee fees." The IRS and Treasury were concerned that fiduciaries were combining into one fee certain fees that were not deductible under Sec. 67(e)(1). Those proposed regulations would have required fiduciaries to "unbundle" these fees.

In 2011, the IRS withdrew the 2007 proposed regulations and issued new ones. 6 The new proposed regulations provided that a cost is subject to the 2%-of-AGI floor if it would be commonly or customarily incurred by a hypothetical individual owning the same property. These costs included ones that do not depend on the payer's identity and specifically included costs incurred in defense of a claim against the estate, the decedent, or the nongrantor trust that are unrelated to the existence, validity, or administration of the trust or estate. The final regulations retain these rules but removed the reference to costs that do not depend on the payer's identity.

Ownership costs that are commonly or customarily incurred by individual property owners continue to be subject to the 2%-of-AGI floor under the final regulations. However, the final regulations clarify examples in the proposed regulations used to illustrate ownership costs. In addition, in the final regulations, the IRS added to the list of costs incurred by a trust or estate that are not subject to the floor appraisal fees for appraisals needed to determine value as of the date of a decedent's death, value for purposes of making distributions, or value as otherwise required to properly prepare a trust's or estate's tax returns.

The 2011 proposed regulations provided that, for tax preparation fees, the costs for all estate and generation-skipping transfer (GST) tax returns, fiduciary income tax returns, and the decedent's final individual income tax return are not subject to the 2%-of-AGI floor. In response to comments, the final regulations retain this rule but clarify it by including an exclusive list of tax return preparation costs that are not subject to the 2%-of-AGI floor. The final regulations also retain unchanged the rule that investment advisory fees are generally subject to the 2%-of-AGI floor. But 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. Under the final regulations, a taxpayer may use any reasonable method to allocate a bundled fee between costs that are subject to the 2%-of-AGI 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%-of-AGI floor that is readily identifiable must be pulled out of the bundled fee.

Unbundling is not required for fees 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 that would have been subject to the 2%-of-AGI floor if they had been paid directly by the estate or trust, and any separately assessed fees that are commonly or customarily incurred by an individual owner of such property. This portion is then subject to the 2%-of-AGI floor while the remainder of the fee is fully deductible.

The unbundling requirement in the final regulations applies only to tax years beginning after Dec. 31, 2014. Therefore, Notice 2011-37, which provides that trusts and estates are not required to unbundle fees, remains in force for 2013 and 2014 fiduciary income tax returns. As a result, fiduciaries should consider charging bundled fees for services they will provide in 2015 in December 2014 to maximize the deductibility for the estate or trust. When considering the trust's overall tax liability between 2014 and 2015, this strategy may also lessen an estate's or trust's overall net investment income tax and alternative minimum tax liabilities.

Once these final regulations are fully in effect, trustees and executors will need to keep more detailed records regarding the expenses of the trust or estate—separating those expenses that are subject to the 2%-of-AGI floor from those that are not. Trustees and executors will further have to address how they will apportion their fees (as well as other professionals' fees) between those fees subject to the floor and those that are not, and be aware that they will need to be able to justify the "reasonableness" of their apportionment method.

Material Participation

In Frank Aragona Trust, 7 the Tax Court held that a trust qualified as a "real estate professional" under Sec. 469(c)(7) and materially participated in the real estate activity for purposes of the passive loss rules under Sec. 469. This decision is important for nongrantor trusts that own interests in passthrough entities that conduct a trade or business for both the passive activity rules and the determination of the Sec. 1411 net investment income tax.

The trust owned rental real estate properties and also engaged in other real estate activities. After the grantor died, his five children and an independent trustee became the new trustees. The trustees managed and made all major trust decisions, and each trustee received trustee fees. Three trustees worked full time and received wages from an LLC owned by the trust that was a disregarded entity. The LLC managed most of the trust's real estate properties and employed several other people. Two trustees held minority interests in some of the real estate entities the trust also owned. The trust conducted its rental real estate activities directly, through wholly owned entities, and through entities in which the two trustees/sons also owned minority interests. In the 2005 and 2006 tax years, the trust treated its losses from its rental real estate properties as losses from nonpassive activities. The IRS issued a notice of deficiency in which it determined the trust's rental real estate activities were passive activities.

Sec. 469(a) disallows passive activity losses in excess of passive activity income. Sec. 469(c)(1)(A) provides that the term "passive activity" means any activity that involves the conduct of any trade or business in which the taxpayer does not materially participate. Secs. 469(c)(2) and (c)(4) together provide that any rental activity is considered a passive activity, even if the taxpayer materially participates in the activity. However, under Sec. 469(c)(7), the rental activities of a taxpayer that qualifies as a real estate professional are not automatically considered passive.

Sec. 469(c)(7)(B) provides two tests, both of which a taxpayer must meet, to be classified as a real estate professional. The first test is met if more than one-half of the "personal services" the taxpayer performed in trades or businesses during the tax year are performed in real property trades or businesses in which the taxpayer materially participates. Regs. Sec. 1.469-9(b)(4) provides, in part, that "personal services" means any work performed by an "individual" in connection with a trade or business. The second test is met if the taxpayer performs more than 750 hours of services during the year in real property trades or businesses in which the taxpayer materially participates.

The requirements of Sec. 469(c)(7)(B) can be met only by a taxpayer who materially participates in a "real property trade or business." Sec. 469(c)(7)(C) defines the term "real property trade or business" as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. Sec. 469(h) provides that a taxpayer materially participates in an activity only if the taxpayer is involved in the operations of the activity on a basis that is regular, continuous, and substantial. Sec. 469(h) does not explain how a trust may materially participate in an activity, and no regulations on the material participation of trusts and estates have been issued. In 2003, a district court in Mattie K. Carter Trust 8 held that the activities of a trust's trustees and nontrustee employees may be considered in determining whether the trust materially participated in a ranching activity. The IRS has not followed Mattie K. Carter Trust.

The IRS argued that no trust could qualify for the real estate professional exception because a trust cannot perform "personal services," since personal services means work performed by an "individual" and only a natural person could be considered an "individual" in the performance of personal services. The Tax Court rejected this argument, finding that the trustees were individuals and their work for the trust qualified as personal services by the trust. The court noted that if Congress had wanted to exclude trusts from the passive activity loss exception, it could have done it explicitly by limiting the exception to "any natural person," as Congress had done in a different provision of Sec. 469. Because Congress did not clearly specify that only natural persons could qualify for the Sec. 469(c)(7) exception, the court determined that Congress did not intend to exclude trusts from it.

In the alternative, the IRS argued that even if some trusts qualified for the Sec. 469(c)(7) exception, the current trust did not because it did not materially participate in its real property business. Pointing to the absence of regulations, the Tax Court found that the trust would be treated as materially participating in its real estate trade or businesses if it participated in the activities in the trust's real estate operations on a regular, continuous, and substantial basis. The IRS argued that only the trustees' activities in their fiduciary capacity should count toward material participation.

The court disagreed, reasoning that the trustees' fiduciary activities for the trust, including their activities as employees of the LLC, should be considered because the trustees were not relieved of their duties of loyalty to the trust's beneficiaries by conducting activities through a corporation wholly owned by the trust. In essence, the court determined that a trustee cannot change hats or disregard fiduciary duties even when working as a trust employee. Therefore, all of the trustees' activities were considered in determining a trust's material participation in an activity. In addition, the court declined the IRS's invitation to discard the activities of two of the trustees who held minority interests in some of the trust's entities because their combined interests were not majority interests, their interests as owners were generally compatible with the trust's goals, and they were involved in managing the trust's real estate operations.

Because the IRS limited its arguments to those discussed above, the Tax Court concluded there was no need to consider the two-part test of Sec. 469(c)(7)(B). Therefore, the court held that the trust met the passive activity loss exception for the years at issue and its activities were nonpassive.

The holding, which is helpful for trusts, is that if one or more trustees of a trust work in the underlying business as employees, the activities of those trustees may be taken into account in determining whether a trust materially participates. The holding is important in two respects. First, in the case of a business that generates losses, the material participation of trustees will allow the losses from the nonpassive activity to offset other trust income, such as interest or dividends, and may even result in a net operating loss (as in the present case). Second, the nonpassive nature of a business activity will significantly minimize a trust's Sec. 1411 net investment income tax on the earnings from that business. Furthermore, if the trust distributes that nonpassive income to a beneficiary, the income will not be considered net investment income when the beneficiary calculates his or her net investment income tax.

Net Investment Income

On Dec. 2, 2013, the IRS issued final 9 and proposed regulations 10 under Sec. 1411, which was enacted as part of the Health Care and Education Reconciliation Act of 2010 11 and imposes a 3.8% tax on net investment income 12 for tax years beginning after Dec. 31, 2012. The final regulations mostly adopt, with some changes, the proposed regulations issued on Dec. 5, 2012. However, a taxpayer may generally rely on the final regulations (or the proposed regulations) for tax years beginning before Jan. 1, 2014.

Sec. 1411 imposes a tax on the net investment income of individuals, estates, and trusts. It does not apply to a nonresident alien or to a trust in which all of the unexpired interests are devoted to one or more charitable purposes under Sec. 170(c)(2)(B). Sec. 1411(a)(2) provides that in the case of an estate or trust, the tax is 3.8% of the lesser of the undistributed net investment income for the tax year, or the excess of the AGI over the dollar amount at which the highest tax bracket in Sec. 1(e) begins for the tax year ($12,150 for 2014).

Sec. 1411(c)(1) defines net investment income as the excess of (1) the sum of gross income from (a) interest, dividends, annuities, royalties, and rents other than income derived in the ordinary course of a trade or business, (b) other gross income derived from a trade or business that is a passive activity or trading in financial instruments or commodities, and (c) net gain attributable to the disposition of property that produces income in (a) or (b); over (2) the deductions allowed under subtitle A (i.e., income tax) that are properly allocable to the gross income or net gain.

The original proposed regulations provided that the net investment income tax applied to regular trusts, which currently include pooled income funds, cemetery perpetual care funds, qualified funeral trusts, and Alaska native settlement trusts. The preamble requested comments on whether there were administrative reasons for excluding these trusts. The AICPA, in its comments (submitted May 8, 2013) to the IRS and Treasury concerning the proposed regulations as they apply to trusts and estates, requested that all four of these types of trusts be excluded from the net investment income tax. 13 The final regulations exclude certain estates and trusts from Sec. 1411, including cemetery perpetual care funds; electing Alaska native settlement trusts; and charitable purpose estates in which all of the unexpired interests are devoted to one or more of the purposes described in Sec. 170(c)(2)(B). Pooled income funds and qualified funeral trusts (taxable under Sec. 685) were discussed in the preamble to the final regulations but were not excluded.

Business trusts that are classified as business entities, Sec. 584 common trust funds, and Sec. 468B designated settlement funds are not subject to the net investment income tax at the entity level. The net investment income tax does not apply to any trust or fund exempt from tax under subtitle A, including wholly charitable trusts and qualified plans. The tax also does not apply to a charitable remainder trust (CRT) at the entity level, but distributions from the CRT to the annuity or unitrust recipient will be considered net investment income.

Foreign estates and foreign nongrantor trusts are generally not subject to the net investment income tax. To the extent that the foreign trust or estate distributes net investment income currently to a U.S. beneficiary, the beneficiary will take net investment income into account along with that beneficiary's net investment income from other sources. The preamble to the proposed regulations asked for comments on how Sec. 1411 should apply to net investment income earned by a foreign trust or estate and accumulated for the benefit of a U.S. person.

The final regulations retain the rule that Sec. 1411 does not apply to foreign estates or trusts but that U.S. beneficiaries receiving distributions of accumulation distributions from foreign estates or trusts are not exempt. The IRS plans to issue additional guidance on how Sec. 1411 should apply to accumulation distributions from foreign estates or trusts to U.S. beneficiaries. Until then, the final regulations provide that Sec. 1411 will not apply to accumulation distributions (however, distributions will still be subject to Sec. 1411 to the extent the character of the income is includible in net investment income).

As in the proposed regulations, under the final regulations, the net investment income of a grantor trust is taken into account by the grantor or other person who is considered the deemed owner of the trust along with that person's net investment income from other sources. The final regulations also, like the proposed regulations, continue to treat undistributed net investment income as the trust's or estate's net investment income reduced by the share of the net investment income treated as distributed to the beneficiaries under Sec. 651 or Sec. 661 and the share of net investment income allocated to the Sec. 642(c) charitable deduction. When a trust or estate has both net investment income and income that is not net investment income, the amount of net investment income treated as distributed to the beneficiaries and to charity must be allocated pro rata between the two types of income similar to the distribution deduction rules under Regs. Sec. 1.661(b)-1 and the charitable deduction rules under Regs. Sec. 1.642(c)-2(b).

Generally, capital gains of a trust are allocated to corpus for fiduciary accounting purposes and are deducted in computing the trust's distributable net income (DNI). As a result, the trust, rather than the beneficiaries, generally is taxed on the capital gains. Regs. Sec. 1.643(a)-3(b), which remains unchanged from the proposed regulations in the final regulations, provides rules for situations in which capital gains allocated to corpus are included in DNI. Under this provision, capital gains are included in DNI to the extent they are, under the terms of the governing instrument and local law, or under the fiduciary's reasonable and impartial exercise of discretion, allocated to corpus but treated consistently by the fiduciary on the trust's books, records, and tax returns as part of a distribution to a beneficiary. The wide discrepancy in the thresholds at which the net investment income tax applies to trusts and individuals may result in trustees' using this provision to treat distributions in excess of trust accounting income as distributions carrying out capital gains to increase the amount of net investment income taxable to the beneficiaries.

As previously mentioned, the net investment income tax does not apply to CRTs at the entity level. The proposed regulations required that a distribution to an annuity or unitrust recipient be considered first to come from net investment income (current and accumulated) before applying the normal ordering rules of Sec. 664(b) and Regs. Sec. 1.664-1(d)(1). The preamble to the proposed regulations stated that this is an easier method than applying the normal rules. The proposed regulations also provided that net investment income is only the income that the trust receives after Dec. 30, 2012, so that items the trust received and accumulated before 2013 will not become net investment income when distributed in 2013 or thereafter.

Based on comments it received, in the final regulations the IRS removed the requirement to use the special computational rules for the classification of CRT income and distributions and permit trustees to use the existing Sec. 664 category and class system. However, CRTs do not have to amend any returns that relied on the proposed regulations. The IRS also issued additional proposed regulations that provide rules enabling a CRT to choose between the simplified method in the originally proposed regulations and the rules under Sec. 664 for categorizing and distributing net investment income.

Incomplete Nongrantor Trusts

In Letter Ruling 201410010, the IRS ruled on the income, gift, and estate tax consequences of an incomplete nongrantor (ING) trust. The ruling is similar to Letter Rulings 201310002 through 201310006 issued last year.

ING trusts are designed to minimize or eliminate state income tax. In a typical arrangement, a person in a state that imposes an income tax will transfer assets (usually investment assets) to a trust situated in a state that does not impose a state income tax or that does not tax the accumulation of income in a trust (e.g., Delaware and Nevada). To the extent no distributions are made to the trust beneficiaries (which generally include the grantor), no current state income tax is payable on income the trust earned.

In the letter ruling, the taxpayer created an irrevocable trust for the benefit of herself, her children, her stepchildren, and their heirs. A corporate trustee was the sole trustee. During the taxpayer's lifetime, the trustee is required to distribute the trust's net income and principal to the taxpayer or her heirs as directed by the distribution committee and/or the taxpayer as follows:

  1. Distribute specific amounts of income or principal to the taxpayer or her heirs upon direction of a majority of the distribution committee members and the taxpayer's written consent (the taxpayer's consent power);

  2. Distribute specific amounts of income or principal to the taxpayer or her heirs upon direction of all members of the distribution committee other than the taxpayer (the unanimous committee power); or

  3. Distribute specific amounts (or all) of the principal to the taxpayer's heirs in the taxpayer's nonfiduciary capacity as the taxpayer deems advisable to provide for the health, maintenance, support, and education of her heirs (the taxpayer's sole power).

The distribution committee, which is initially composed of the taxpayer, her children, and her stepchildren, must at all times consist of at least two members other than the taxpayer. If at any time, under the rules for filling committee vacancies, the distribution committee does not include at least two members other than the taxpayer, the committee is deemed not to exist. The distribution committee will also cease to exist upon the taxpayer's death.

Upon the taxpayer's death, the trustee will distribute any remaining trust assets as the taxpayer directs in her will, except that no distribution may be made to the taxpayer's estate, the taxpayer's creditors, or the creditors of the taxpayer's estate (i.e., a testamentary limited power of appointment). If the taxpayer does not exercise her testamentary limited power of appointment, the instrument provides specific rules for the distribution of any remaining trust assets.

The taxpayer requested four rulings from the IRS. First, the taxpayer requested that the IRS rule that neither the taxpayer nor members of the distribution committee are treated as owners of the trust under the grantor trust rules. Without much analysis, the IRS determined that under the terms of the trust agreement, the taxpayer was not the owner of the trust under Sec. 673 (reversionary interests in property), Sec. 674 (power to control beneficial enjoyment), Sec. 676 (power of revocation), and Sec. 677 (benefits retained by grantor). As is generally the case, the IRS refused to rule on the application of Sec. 675 (a settlor's administrative powers) as it deems the applicability of Sec. 675 a question of fact—the determination of which must be deferred until the IRS has examined the income tax returns of the parties involved. The IRS further determined that the members of the distribution committee could not be deemed owners of the trust under Sec. 678 because no member had a power exercisable solely by itself to vest income or corpus of the trust in it. Thus, the IRS ruled that the trust agreement did not create a grantor trust as to the taxpayer or members of the distribution committee.

Second, the taxpayer requested that the IRS rule that transfers of property to the trust by the taxpayer are not completed gifts. The IRS determined that the taxpayer's contributions of property to the trust would constitute completed gifts subject to gift tax only if, upon contribution, the taxpayer relinquished all dominion and control over the contributed property. The IRS looked to Regs. Sec. 25.2511-2 and the Supreme Court's decision in Estate of Sanford 14 for guidance in determining whether the taxpayer had made a completed gift. The IRS focused on the taxpayer's power to effect distributions to the trust. Under the trust agreement, the taxpayer retained three powers to direct the income and/or principal of the trust: (1) the taxpayer's sole power over principal; (2) the taxpayer's consent power over income and principal; and (3) the taxpayer's testamentary limited power to appoint trust property.

The IRS determined that the taxpayer's retention of the first and second powers prevented the transfers to the trust from being completed gifts. Under the taxpayer's sole power, the taxpayer retained the sole power to direct the distribution of the principal of the trust. The IRS noted this power allows the taxpayer to change the interests of the beneficiaries. As such, the IRS determined that the retention of the taxpayer's sole power caused the transfer of property to the trust to be wholly incomplete for gift tax purposes.

Under the taxpayer's consent power, the taxpayer retained the power to direct distributions of trust property in conjunction with the distribution committee members. The IRS noted that, under Regs. Sec. 25.2511-2(e), a donor is considered to have a power if it is exercisable by him in conjunction with any person not having a substantial adverse interest in the disposition of the transferred property or the income therefrom. Under Regs. Sec. 25.2514-3(b)(2), a co-holder of a power is considered as having an adverse interest only where he may possess the power after the possessor's death and may exercise it at that time in favor of himself, his estate, his creditors, or the creditors of his estate. The IRS determined that the members of the distribution committee were not takers in default—they were merely co-holders. It also noted that the distribution committee ceased upon the taxpayer's death. Therefore, the IRS determined that the distribution committee members did not have adverse interests to the taxpayer and that the retention of the taxpayer's consent power caused the transfers of property to the trust to be wholly incomplete for gift tax purposes.

The taxpayer also retained a testamentary power to appoint the property in the trust to any person or persons or entity or entities, other than her estate, her creditors, or her estate's creditors. The IRS noted that under Regs. Sec. 25.2511-2, the retention of this power to appoint the remainder of the trust is considered the retention of dominion and control over trust property. Accordingly, it ruled that the retention of this power caused the transfers of property to the trust to be wholly incomplete with respect to the trust remainder for gift tax purposes.

The IRS also determined that even though members of the distribution committee collectively possessed the unanimous committee power to distribute trust income or principal, the power was not a condition precedent to powers the taxpayer held. Until the distribution committee members took such action, the taxpayer retained all powers over the trust property. As a result, the IRS ruled that the unanimous committee power did not serve to limit the taxpayer's power and, therefore, did not alter the incomplete nature of the transfers.

Based on the foregoing, the IRS determined that the taxpayer had not relinquished dominion and control over either trust income or principal, essentially retaining both a lifetime general power of appointment and a testamentary limited power of appointment. The retention of those powers caused the transfers to be wholly incomplete for gift tax purposes.

Third, the taxpayer requested the IRS rule that distributions to the taxpayer by the distribution committee will not be completed gifts by any member of the distribution committee. Because the taxpayer's original transfers to the trust were incomplete gifts, the IRS determined that any distributions to the taxpayer were not gifts but a return of the taxpayer's property. Further, upon the taxpayer's death, the property in the trust would be includible in the taxpayer's gross estate for estate tax purposes. Thus, the IRS ruled that distributions to the taxpayer would not be a gift by any member of the distribution committee.

Fourth, the taxpayer requested the IRS rule that distributions to beneficiaries (other than the taxpayer) by the distribution committee will not be completed gifts by any member of the distribution committee. Because the taxpayer created the trust without the involvement of others, the key to determining whether members of the distribution committee would be treated as having made completed gifts subject to gift tax to other beneficiaries under their distribution powers is whether or not those members held general powers of appointment under Sec. 2514. If the distribution committee members are not viewed as exercising general powers of appointment when directing trust distributions, the taxpayer, as creator of the trust and source of original funding, would continue to be treated as the donor of property to the trusts. Upon receipt of such distributions by a beneficiary, the taxpayer will have made a completed gift subject to gift tax.

As previously stated, the members of the distribution committee had two methods of directing distributions: (1) the taxpayer's consent power and (2) the unanimous committee power. With respect to trust distributions under the taxpayer's consent power, the IRS determined that the power was exercisable only in conjunction with the taxpayer, creator of the power. Because the members of the distribution committee act in conjunction with the taxpayer, the IRS ruled that under Sec. 2514(c)(3)(A), they did not possess general powers of appointment. With respect to trust distributions under the unanimous committee power, the IRS determined that the power was a power that permitted them to make distributions of property to which they had substantial adverse interests. Consequently, the IRS ruled that under Sec. 2514(c)(3)(A), the unanimous committee power was not a general power of appointment. Therefore, the IRS concluded that all distributions of property as directed by the distribution committee were not completed gifts by any member of the distribution committee, but were completed gifts by the taxpayer to a receiving beneficiary.

With the advent of the net investment income tax, ING trusts may be a good choice from a federal planning perspective. Most often the gift of assets to a trust that is incomplete for gift tax purposes also results in a grantor trust for income tax purposes. For purposes of Sec. 1411, where a grantor trust owns an interest in a trade or business activity (e.g., stock in an S corporation) material participation is determined by reference to the grantor. If a grantor will not materially participate in a trade or business activity, but would still like to have any transfer treated as an incomplete gift, using an ING trust would shift the determination of material participation away from the grantor to the activities of the trustees where the material participation threshold might be met.

Basis in Interest in Charitable Remainder Trusts

On Jan. 17, 2014, the IRS issued proposed regulations 15 providing rules for determining a taxable beneficiary's basis in a term interest in a CRT upon a sale or other disposition of all interests in the trust to the extent that basis consists of a share of the trust's adjusted uniform basis. The regulations are in response to a transaction that it identified as a "transaction of interest" in Notice 2008-99, in which the unitrust/annuity interest holders used the uniform basis rules to minimize the gain on the sale of their unitrust/annuity interest. The proposed regulations apply to sales and other disposition of interests in CRTs occurring on or after Jan. 16, 2014, except for sales or dispositions occurring under a binding commitment entered into before Jan. 16, 2014.

First, a taxpayer creates a CRT by transferring a highly appreciated, low-basis asset. Under the CRT's terms, the taxpayer will receive an annuity or unitrust interest, and the remainder interest will pass to a charity for which the taxpayer will usually receive an income tax charitable deduction for the present value of the remainder interest. The CRT will then sell the appreciated asset and invest the proceeds in a diversified portfolio. Because the CRT is a tax-exempt entity, it will not recognize gain on the sale of the appreciated asset. The taxpayer will recognize the gain as annuity or unitrust payments are received.

Second, the taxpayer and the charity sell their interests in the CRT to a third party for an amount that approximates the fair market value of the CRT's assets. Under Sec. 1001(e), if a taxpayer disposes of an income interest (e.g., an annuity or unitrust interest) in a trust, any adjusted basis the taxpayer may have in the interest is disregarded in determining the gain or loss from the disposition. An exception applies in Sec. 1001(e)(3) when the income interest is disposed of as part of a transaction in which the entire interest in the property is transferred to a third party. In that case, Regs. Sec. 1.1001-1(f)(3) provides that the uniform basis rules, which apportion the CRT's assets' bases between the income and remainder interest, apply. Thus, when the taxpayer sells his or her annuity/unitrust interest in the CRT, the gain will be determined by the difference between the proceeds received from the sale and the basis the taxpayer derives from the CRT's assets.

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

The proposed regulations provide a special rule for determining the basis in certain CRT term interests in transactions to which Sec. 1001(e)(3) applies. In these cases, Prop. Regs. Sec. 1.1014-5(c) provides that the basis of a term interest of a taxable beneficiary is the portion of the adjusted uniform basis assignable to that interest reduced by the portion of the sum of the following amounts assignable to that interest: (1) the amount of undistributed net ordinary income described in Sec. 664(b)(1); and (2) the amount of undistributed net capital gain described in Sec. 664(b)(2). This new rule essentially reduces the basis under the uniform basis rules by the amount of undistributed ordinary income and capital gain under the tier system in Sec. 664(b) at the time of the sale.

The proposed regulations do not affect the CRT's basis in its assets, but rather are for determining a taxable beneficiary's gain arising from a transaction described in Sec. 1001(e)(3). However, the IRS states in the preamble that it may consider whether there should be any change in the treatment of the charitable remainderman participating in such a transaction.

Interest Expense Deduction

In Chief Counsel Advice 201327009, the IRS discusses whether the beneficiary of a qualified subchapter S trust (QSST) can deduct investment interest expense the QSST incurred on a note the QSST used to purchase S corporation stock from a third party. The S corporation stock was the QSST's only asset, and it made timely payments of interest and principal on the note.

Sec. 1366 provides that an S corporation shareholder must report the S corporation's items of income and expense that flow through to the shareholder. However, the interest payment the QSST made is not an item of expense flowing through the S corporation. Generally, when the beneficiary of a trust makes the QSST election, the trust is treated as consisting of two portions—the S corporation's income, deductions, and credits are included in the S portion, and all other income, deductions, and credits are included in the non-S portion. The beneficiary is treated as the owner of the S portion and as the S corporation shareholder.

The IRS examined the rules for allocating deductions for trust expenses and the interest-tracing rules and noted that Sec. 641(c) addresses this issue for an electing small business trust (ESBT). Under those regulations, the interest on debt used to acquire the S corporation stock is allocated to the S portion. Additionally, Sec. 671 provides guidance for the allocation of tax items between grantor and nongrantor portions of a trust. Regs. Sec. 1.671-3(a)(2) provides that where the grantor portion consists of specific property and its income, then all items of expense directly related to that property should be allocated to the grantor. In addition, the regulations under Sec. 652 allocating income and deductions to trust beneficiaries on distributions explain that deductible items related to one class of income are to be allocated to that class. For example, expenses related to a business carried on by the trust are to be allocated to the income of that business. Furthermore, the interest-tracing rules in Sec. 163 indicate that interest related to a trade or business should be deductible against income from that trade or business.

After reviewing the foregoing rules, the IRS determined that the interest expense the QSST incurred on its payments on the note used to purchase the S corporation stock should be allocated to the S portion that is treated as owned by the beneficiary and thus would be deductible by the beneficiary. The IRS expressly limited its conclusion to the set of facts under consideration and specifically did not address the situation where the QSST has significant income-producing assets other than the S corporation stock.

Mexican Land Trusts

Foreign investors are required to establish Mexican Land Trusts (MLTs) to own real property in certain areas of Mexico because the Mexican Constitution prohibits non-Mexican citizens from owning real property within 100 kilometers of Mexico's inland borders or within 50 kilometers of its coastline (the restricted zone). Estate planners have struggled with whether an MLT is classified as a trust for U.S. tax purposes because, if the IRS considers an MLT a trust, Form 1040NR, U.S. Nonresident Alien Income Tax Return; Form 3520, Annual Return to Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts; and Form 3520-A, Annual Information Return of Foreign Trust With a U.S. Owner, must be filed by U.S. citizens and residents. Since the penalties for not filing Form 3520 and Form 3520-A can be severe, many estate planners have recommended that these forms be filed. In Rev. Rul. 2013-14, the IRS ruled that an MLT arrangement is not classified as a trust for U.S. tax purposes.

In the revenue ruling, the IRS presents three hypothetical situations involving an MLT arrangement. In Situation 1, a U.S. citizen is the sole owner of an LLC that is a disregarded entity. The U.S. citizen, through the LLC, would like to purchase Greenacre, which is located in a restricted zone. Under Mexican law, the U.S. citizen and the LLC are not allowed to hold title directly to Greenacre.

The LLC obtained a permit from the Mexican Ministry of Foreign Affairs (Ministry) and signed an MLT agreement with a Mexican bank. The LLC negotiated the sale of Greenacre with the seller and paid the seller directly. The seller had no interaction with the bank. At settlement, legal title of Greenacre was transferred from the seller to the bank, subject to the MLT agreement. Under the terms of the MLT agreement, the LLC may sell Greenacre without the bank's permission, and the bank must grant a security interest in Greenacre to a third party (e.g., a mortgage lender) if the LLC requests it. The LLC is responsible for all taxes and liabilities relating to Greenacre in Mexico. The LLC has the exclusive right to possess Greenacre and to make any desired modifications. If Greenacre is leased, the LLC will receive the income, and the U.S. citizen, as the LLC's owner, will report the income on his or her U.S. federal income tax return. The bank is identified as the fiduciary in the MLT agreement but disclaims all responsibility for Greenacre and has no duty to defend or maintain Greenacre. The bank collects a nominal fee from the LLC.

In Situation 2, the facts are the same as in Situation 1, except the LLC is a corporation for U.S. income tax purposes, and if Greenacre is leased, the corporation will receive the rental income and report it on its U.S. income tax return.

In Situation 3, the facts are the same as Situation 1, except the U.S. citizen deals directly with the bank and individually obtains the permit from the Ministry. The U.S. citizen signed the MLT agreement with the Mexican bank and negotiated the purchase of Greenacre. The provisions of the MLT agreement that apply to the LLC in Situation 1 apply to the U.S. citizen, and, if Greenacre is leased, the U.S. citizen would receive the rental income and report it on his or her federal income tax return. The bank collects a nominal fee from the U.S. citizen.

The IRS noted that Regs. Sec. 301.7701-4(a) defines a "trust" as an arrangement created by a will or an inter vivos declaration in which trustees take title to property for the purpose of protecting or conserving it for beneficiaries. An arrangement is generally treated as a trust "if it can be shown that the purpose of the arrangement is to vest in trustees the responsibility for the protection and conservation of property for beneficiaries who cannot share in the discharge of this responsibility."

The IRS noted that Rev. Rul. 92-105 concluded that a trust was not established when an individual created an Illinois Land Trust and named a domestic corporation as the trustee, because the trustee's sole responsibility was to hold and transfer title at the taxpayer's direction. The taxpayer retained direct ownership of the real property for tax purposes.

As in Rev. Rul. 92-105, the IRS concluded in all three situations that the MLT is not a trust because the bank's only duties under the MLT agreement are to hold legal title to Greenacre and transfer title at the LLC's direction in Situation 1, at the corporation's direction in Situation 2, and at the U.S. citizen's direction in Situation 3.

Since an MLT is not a foreign trust, U.S. citizens and residents with interests in MLTs are not required to file Form 3520 or Form 3520-A. It is important to note that while MLT arrangements similar to the facts in the three scenarios are not trusts for U.S. tax purposes, one should not conclude that all trusts created under Mexican law are MLTs if the trust arrangements differ from those in the revenue ruling.

President's Budget Proposal

On March 4, 2014, President Obama released his 2015 budget proposal, which included the following gift, estate, and GST tax revenue raisers.

Estate tax reform: Even though the American Taxpayer Relief Act of 2012 16 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 from $5,340,000 to $3,500,000 for estate and GST tax purposes and $1,000,000 for gift tax purposes. It would continue to allow portability. The budget would make this proposal effective for decedents dying, and for transfers made, after Dec. 31, 2017.

Minimum GRAT term: This proposal would put a minimum term requirement of 10 years for grantor retained annuity trusts (GRATs), which 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 grantor's life expectancy plus 10 years, which would prohibit the 99-year GRATs that some taxpayers have created so that the amount includible in the grantor's gross estate under Sec. 2036 is very small. The proposal also would require the GRAT's remainder interest to have a value other than zero but does not give a required minimum. 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 the grantor received) 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.

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 ratio of one. The proposal is an attempt by the Obama administration to deal with many states that have changed or repealed their rules imposing 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 be no longer than 21 years after the death of a person in being at the time the trust was created. Many states have removed the common law rule against perpetuities or have amended it to provide for longer trust terms.

Consistency in valuations: This proposal would require the basis of property for income tax purposes to match the value reported by a decedent's estate for estate tax purposes or by a donor for gift tax purposes. It also would give the IRS authority to require a donor or decedent to furnish basis information to the donee of the gift or the beneficiary of the estate 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 to 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, 17 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): 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 medical and tuition expenses of multiple generations, and distributions from them for these purposes are excluded from GST tax. Since they are exclusively for purposes described in Sec. 2503(e), there is no need to allocate GST exemption to them as distributions from them are excluded from GST tax. This proposal would clarify that Sec. 2611(b)(1) only applies to a payment made by a living donor.

Simplify gift tax annual exclusion for gifts to trusts (new): In general, gifts to a trust are not considered gifts of a present interest and, therefore, are not eligible for the gift tax annual exclusion, which, in 2014, excludes the first $14,000 of gifts made to a donee. In Crummey, 18 the Ninth Circuit held that a transfer to a trust that would otherwise be a gift of a future interest is the gift of a present interest if the beneficiary has the unrestricted right to withdraw the contribution to the trust even if that right exists for only a limited period of time (typically 30 days). This proposal would eliminate the present interest requirement for gifts that qualify for the gift tax annual exclusion and impose an annual limit of $50,000 per donor on the donor's transfer of property to a trust. The budget cites as the reason for the proposal a need to simplify recordkeeping regarding these powers as well as a concern about the number of persons who may not be beneficiaries of the trust who have these withdrawal powers allowing for larger gifts to trusts that are covered by the gift tax annual exclusion.

Expand applicability of definition of executor (new): For estate tax purposes, Sec. 2203 defines an executor as the person who is appointed, qualified, and acting as an executor or administrator of the decedent's estate, or, if no one is serving in such a role, any person in actual or constructive possession of any of the decedent's property. This proposal would apply the definition for all tax purposes, not just estate tax, because executors should be able to take care of any of the decedent's tax matters including tax matters that arose before the decedent died.

Require nonspouse beneficiaries to withdraw funds from IRAs and qualified retirement plans within five years of the death of the decedent (new): In general, someone who inherits funds in an individual retirement account (IRA) or qualified retirement plan must withdraw those funds within five years of the death of the owner of the IRA or retirement plan. Exceptions to this rule are for surviving spouses and designated beneficiaries of the account or plan. Designated beneficiaries are generally allowed to "stretch" the payment of the remaining balance in the account or plan over their remaining life expectancies. The proposal would generally require any person (other than a surviving spouse) who inherits an IRA or retirement plan to withdraw the balance in the account or plan within five years of the death of the IRA owner or plan participant. Exceptions are provided for eligible beneficiaries who are disabled, chronically ill, no more than 10 years younger than the IRA owner or plan participant, or a child who has not reached the age of majority. The budget cites as the reason for the change that these preferred accounts were intended to provide retirement security for individuals and their spouses, not tax preferences for nonspouse heirs.

Inflation Adjustments

The IRS released Rev. Proc. 2013-35,setting forth inflation adjustments for 2014. The following is a list of items that may be of interest to estate planning professionals serving individual clients:

Unified credit against estate tax: For an estate of any decedent dying during calendar year 2014, the basic exclusion amount is $5,340,000 for determining the amount of the unified credit against estate tax under Sec. 2010. This is also the amount of the gift tax exemption and the GST exemption.

Valuation of qualified real property in decedent's gross estate: For the estate of a decedent dying in calendar year 2014, if the executor elects to use the special-use valuation method, the aggregate decrease in the value of the qualified real property resulting from electing to use Sec. 2032A cannot exceed $1,090,000.

Gift tax annual exclusion: The gift tax annual exclusion for gifts of a present interest remains $14,000 in 2014. The gift tax annual exclusion for gifts of a present interest to a spouse who is not a U.S. citizen is $145,000.

Interest on a certain portion of the estate tax payable in installments: For an estate of a decedent dying in 2014, 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 $1,450,000.


1 T.D. 9664.

2 On July 17, 2014, in response to comments that fiduciaries needed more time to implement the rules, the IRS changed the effective date of the new regulation from tax years beginning on or after May 9, 2014, to tax years beginning after Dec. 31, 2014 (79 Fed. Reg. 41,636 (July 17, 2014)).

3 REG-128224-06, 76 Fed. Reg. 55,322 (9/7/11).

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

5 REG-128224-06, 72 Fed. Reg. 41,243 (7/27/07).

6 REG-128224-06, 76 Fed. Reg. 55,322 (9/7/11).

7 Frank Aragona Trust, 142 T.C. No. 9 (2014).

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

9 T.D. 9644.

10 REG-130843-13.

11 Health Care and Education Reconciliation Act of 2010, P.L. 111-152.

12 REG-130507-11.

13 AICPA, "Comments on REG-130507-11 Relating to Guidance Under Section 1411" (May 8, 2013).

14 Estate of Sanford, 308 U.S. 39 (1939).

15 REG-154890-03.

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

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

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


Justin Ransome is a partner in the National Tax Department of Ernst & Young in Washington. He was assisted in writing this article by members of Ernst & Young's National Tax Department in Private Client Services—David Kirk, Marianne Kayan, Ben Wright, Justin Lynch, Ashley Weyenberg, Caryn Gross, and Laercio Guimaraes.


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