Recent Developments in Estate Planning: Part 2

This is the second part of a two-part article examining developments in estate, gift, and generation-skipping transfer (GST) tax, and trust income tax between June 2015 and May 2016. Part 1, in the September issue, discussed legislative and gift and estate tax developments. Part 2 discusses GST tax and trust tax developments as well as President Barack Obama’s budget proposals and inflation adjustments for 2016.

Generation-Skipping Transfer Tax

Finality of Returns

In IRS Letter Ruling 201523003, a husband created the trusts shown in the exhibit below.

The husband and his wife both filed gift tax returns for year 1 and made gift-splitting elections for the transfers to Family Trust, Trust 1, and Trust 2. They also elected out of an automatic GST tax exemption allocation for Family Trust and, instead, allocated GST exemption to a portion of Family Trust, resulting in an inclusion ratio of other than zero (0) or one (1). They did not make any GST exemption allocations for Trust 1 or Trust 2 because the estate tax inclusion period (ETIP) was still open for those trusts at the time of the year 1 filings. In year 2, the husband filed a Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, reporting Trust 1 pouring into Family Trust. The wife did not file a Form 709. No GST exemption allocations occurred.

In year 3, the husband and wife filed gift tax returns and made gift-splitting elections for the transfers to Trust 3 and Trust 4; they did not allocate GST exemption because the ETIP remained open. However, the couple did affirmatively allocate GST exemption to their portions of the transfers from Trust 2 to Family Trust. Additionally, they each noted that for year 2, Sec. 2632(c) operated to automatically allocate GST exemption to the transfers from Trust 1 to Family Trust (covered on the husband’s year 2 gift tax return). At the time of the ruling, the couple had not filed gift tax returns for year 4 for Trust 3 and Trust 4 pouring into Family Trust, and the statute of limitation had expired for gift tax returns for year 1 and year 2, but not for year 3 or year 4.

The IRS ruled that, even though the elections to split gifts on the transfers to Family Trust, Trust 1, and Trust 2 were improperly made, the time for determining whether gift-splitting treatment is effective had expired. In reaching this conclusion, the IRS began by noting that gifts cannot be split if one spouse’s interest in the gift is not severable. Relying on Rev. Rul. 56-439, the IRS reasoned that the wife’s interests in the income and principal of Family Trust are not susceptible to valuation and, therefore, not severable from the interests that the other beneficiaries have in Family Trust. However, the Sec. 6501 statute of limitation had already expired, so the gift-splitting election is irrevocable for the initial transfer to Family Trust and the subsequent transfers from Trust 1 and Trust 2 to Family Trust.

Further, the IRS ruled that the couple’s election out of the automatic GST exemption allocation rules for contributions to Family Trust was effective, as were their individual affirmative allocations of GST exemption to a portion of the one-half treated as made by each of them. Additionally, the automatic allocation rules for GST exemption applied to allocate the couple’s GST exemptions to one-half of the transfer of property from Trust 1 to Family Trust at the close of their respective ETIPs. Finally, the couple’s affirmative allocation of GST exemption to the value of Trust 2 transferred to Family Trust was proper.

Because the statute of limitation had not expired for the transfers to Trusts 3 and 4, the husband and the wife can alter their elections by filing supplemental gift tax returns to report the transfers as being made solely by the husband. Further, the husband can file a gift tax return to allocate his available GST exemption to the transfers from Trusts 3 and 4 to Family Trust at the close of the ETIPs for those trusts.

The result of strict adherence to a closed limitation period may surprise some practitioners because it operates in limited circumstances to permit legally improper elections to stand. However, the IRS’s ruling is proper based on the language in the preamble to the final Sec. 2504 regulations,¹ which states that the final regulations preclude adjustment with respect to all issues once the gift tax statute of limitation expires for a particular gift, and the regulations themselves state that this rule applies to adjustments involving all issues relating to the gift, including valuation and legal issues. This letter ruling was a great result for the taxpayers, but it also means there is less certainty as to the finality of erroneous elections and allocation of GST exemption.

GST Exemption Allocation

In Letter Ruling 201536012, the IRS concluded that prior allocations of GST exemptions were void because the donor did not make gifts that would otherwise be subject to GST tax.

Donors were the parents of an adult child who died and was survived by two children. Over the years after the adult child’s death, the donors made transfers directly to their grandchildren and filed timely gift tax returns to report the gifts. The donors also elected to split the gifts to their grandchildren, and each donor allocated GST exemption to these gifts. After one of the donors died, the personal representative of his estate requested a ruling that the allocations of GST exemptions to gifts made outright to the grandchildren were void because there was no GST tax potential for those transfers.

In general, an allocation of GST exemption made on a timely filed return becomes irrevocable after the due date of the return. However, Regs. Sec. 26.2632-1(b)(4)(i) provides that certain allocations of GST exemption are void. For example, an allocation of GST exemption made to a trust is void if the allocation is made to a trust that has no potential to be subject to GST tax at the time of the allocation.

The IRS began its analysis by noting that Sec. 2601 imposes a tax on every GST, including a direct skip, which is a transfer of an interest in property subject to gift or estate tax made to a “skip person.” A skip person is a natural person assigned to a generation two or more generations below the generation assignment of the transferor. However, under Sec. 2651(e)(1), if an individual is a descendant of a parent of the transferor, and the individual’s parent (who is a lineal descendant of the parent of the transferor) is deceased at the time of the transfer, the individual is treated as if he or she were a member of the generation that is one generation below the lower of the transferor’s generation or the generation assignment of the youngest living ancestor of the individual who is also a descendant of the transferor’s parent (the “predeceased parent rule”). Regs. Sec. 26.2651-1(c), Example 1, illustrates the rule in Sec. 2651(e)(1). In Example 1, Grandchild (GC) is not treated as a skip person because GC’s parent, C, was deceased at the time of the transfer and, as a result, GC was treated as a member of the generation who is one generation below the transferor’s generation.

The IRS concluded that at the time the donors made outright transfers to their grandchildren, their parent (and the donors’ child) was deceased. Therefore, the grandchildren were treated as members of the generation that was one generation below the donor (i.e., the generation of the grandchildren’s parent). Due to the predeceased parent rule, the grandchildren were not skip persons at the time of the transfers, and the transfers were not direct skips. Therefore, the transfers to the grandchildren had no potential to be subject to GST tax at the time of the transfers, and, accordingly, the allocations of GST exemption were void.

Although an allocation of GST exemption is irrevocable after the due date of Form 709, the ruling confirms that an allocation of GST exemption to an outright transfer that has no GST tax potential is void. Even though the express language of Regs. Sec. 26.2632-1(b)(4)(i) does not involve outright transfers, the IRS reasonably interpreted the regulation to reach this result.

Trusts and Estates

Charitable Deduction

Dieringer: In Estate of Dieringer,² the Tax Court concluded that the estate was liable for a deficiency of $4,124,717 in federal estate tax because the estate’s charitable contribution was less than the date-of-death value of the property. Although the date-of-death value normally dictates the value of charitable deductions, in this case, numerous events occurred between the decedent’s death and the day the property was donated, which contributed to the reduction in value.

When the decedent died unexpectedly on April 14, 2009, she owned 425 out of 525 voting shares and 7,736.5 out of 9,220.5 nonvoting shares of Dieringer Properties Inc. (DPI), a closely held real property management corporation. The other shareholders were the decedent’s two sons. The two sons were officers and members of the board of directors, and the decedent was an officer and chairman of the board.

Before the decedent’s death, DPI’s shareholders discussed buying some of her shares and she had suggested she wanted to sell, but at the time of her death there was no discussion regarding the number of shares to be redeemed or the price.

The decedent’s will left her entire estate in trust with the sons as trustees. Under the terms of the trust, $600,000 of assets was to be donated to various charitable organizations. The decedent’s sons received some of her personal effects (but no money). The remainder, mostly DPI stock and promissory notes, went to a family foundation.

After the decedent died, the estate hired an appraiser to appraise the value of the decedent’s DPI stock on the date of her death. At the time, DPI was a C corporation with an adjusted net asset value of $17,777,626. The appraisal valued the decedent’s DPI voting and nonvoting shares at $14,182,471; $1,824 per voting share (with no discount) and $1,733 per nonvoting share (with a 5% discount for lack of voting power).

Effective Nov. 30, 2009 (7½ months after the decedent died), DPI elected S corporation status. In addition, after consultation with an attorney and the board, DPI decided that a redemption would allow the value of the shares to be frozen in a promissory note, which would lessen the risk of the stock’s value continuing to decline due to the collapse in real estate values. Since the foundation would be DPI’s preferred creditor, once the promissory notes were transferred to it, DPI concluded that it should redeem the decedent’s shares. On Nov. 30, 2009, DPI agreed to redeem all of the decedent’s bequeathed shares from the trust for $779 per voting share and $742 per nonvoting share based on a 2002 appraisal. The sons, on DPI’s behalf, signed a $2,250,000 short-term promissory note and a $3,776,558 long-term promissory note, both payable to the trust.

The estate’s lawyer hired the appraiser who had done the earlier appraisal to appraise the DPI stock for the redemption. The appraisal specified that it was valuing a minority equity interest in DPI (as one of the sons instructed) as of Nov. 30, 2009, and it treated DPI as a C corporation. The March 24, 2010, appraisal valued the DPI voting shares at $916 per share and the nonvoting shares at $870 per share. Both classes of stock were discounted 15% for lack of control and 35% for lack of marketability (which was not done for the date-of-death valuation) and an additional 5% discount for the nonvoting shares for lack of voting power. The net asset value of DPI was $16,159,167 as of Nov. 30, 2009 (approximately $1.6 million less than the date-of-death net asset value).

At the same time as the redemption, another son purchased additional DPI shares so DPI could pay off the promissory notes, paying share prices based on the March 24, 2010, redemption appraisal. On April 12, 2010, DPI and the trust amended the redemption agreement to reduce the number of nonvoting shares DPI would redeem (to ensure DPI could afford the transaction). In addition, the long-term promissory note was reduced to $2,968,462.

The estate filed Form 706 on July 12, 2010, reporting no estate tax liability and a charitable contribution deduction of $18,812,181, which included the date-of-death value of the decedent’s DPI shares. On Jan. 1, 2011, the foundation reported that it had received a noncash contribution of 2,163 nonvoting DPI shares, and on Jan. 24, 2011, the trust assigned the amended long-term promissory note and short-term promissory note to the foundation. On its 2011 Form 990-PF, Return of Private Foundation, the foundation reported that it had received a noncash contribution of DPI stock with a fair market value (FMV) of $1,858,961, a long-term note receivable with an FMV of $2,921,312, and a short-term note with an FMV of $2,250,000.

On Sept. 17, 2013, the IRS issued a notice of deficiency that reduced the allowable charitable deduction because the value of the property that was actually donated to the foundation ($7,030,273) was less than the value of the DPI shares reported as a charitable deduction on the estate tax return.

The Tax Court focused its analysis on the value of a charitable deduction under Sec. 2055. Generally, the date-of-death value determines the amount of the deduction, but sometimes it is not appropriate to use the date-of-death value. The statute does not necessarily require equal valuation of property included in the gross estate and reported as a charitable deduction. For example, if a trustee has the power to divert property from a charitable to a noncharitable beneficiary, the charitable deduction should exclude that property.

The Tax Court noted that numerous events occurred between the decedent’s death and the time the DPI shares were transferred to the foundation that changed the nature of the charitable contribution, including the S election, the redemption, and the sons’ later purchase of the stock. The court noted that all of these actions were taken for valid business reasons, but they did not result in a substantially reduced share value of DPI stock. Because the sons controlled the estate, the trust, and the foundation, the decedent’s majority interest was redeemed from the trust for a fraction of its value and, consequently, the trust neither transferred the decedent’s bequeathed shares nor the value of the bequeathed shares to the foundation.

The court heightened its scrutiny of this transaction because it was an interfamily transaction with a closely held corporation and found that the sons altered the decedent’s testamentary plan by reducing the value of assets that were eventually transferred to the foundation. It concluded that Congress did not intend to allow as great a charitable contribution deduction where persons divert a decedent’s charitable contribution, ultimately reducing the value of property transferred to a charitable organization.

The court also concluded that the estate was liable for the Sec. 6662(a) accuracy-related penalty because the estate was negligent in failing to inform the appraiser that the DPI shares being redeemed were for a majority interest. The court also rejected the estate’s claim that relying on its attorney’s advice was reasonable cause because the estate did not rely on its attorney’s advice in good faith.

This fully reviewed Tax Court opinion highlights the fact that the value of an estate tax deduction used to fund a charitable bequest may differ from the value of the property included in the decedent’s estate if certain post-death events arise. Fluctuations in market value alone should not alter the deduction’s value, but specific changes to the nature of the property that reduce the value of property actually donated may not be respected. Practitioners should consider this concept with respect to the estate tax marital deduction as well. Interestingly, the court did not discuss whether the IRS should impose a self-dealing excise tax due to the redemption, perhaps because an Oregon circuit court had approved the redemption and confirmed that the redemption would not violate Sec. 4941.

Green: In Green,³ a district court held that a trust’s income tax charitable deduction under Sec. 642(c)(1) was not limited to the adjusted basis of the real property contributed. Instead, it was based on the FMV of the property on the date of contribution.

The trust wholly owned a single-member limited liability company (LLC), which was a disregarded separate entity. The trust was also a 99% limited partner in a limited partnership (LP), which owned or operated many Hobby Lobby stores. The LLC purchased real property using ordinary business income distributed from the LP to the trust.

During 2004, the LLC made several charitable donations to public charities of appreciated real property purchased before 2004. The trustee of the trust timely filed the trust’s 2004 income tax return, claiming a charitable contribution deduction of $20,526,383, the adjusted basis of the contributed property. In 2008, the trustee filed an amended income tax return valuing the donated properties at each property’s FMV, increasing the charitable contribution deduction to $29,654,233, and claiming a $3,194,748 refund. The IRS disallowed the refund claim because it believed that the trustee inappropriately calculated the trust’s charitable contribution deduction by valuing the donated properties using their FMVs rather than their adjusted bases. Sec. 642(c)(1) limits a trust’s deduction to the amount of gross income it contributed to charity, which does not include unrealized appreciation; and a liberal construction of Sec. 642(c)(1) allowing fair market valuation would negate the gross income derivative requirement.

The district court stated that Sec. 642 should be read in light of the basic principles of Sec. 170, except where expressly contradictory. Sec. 642(c)(1) provides:

there shall be allowed as a deduction in computing [a trust’s] taxable income (in lieu of the deduction allowed by section 170(a) . . . ) any amount of the gross income, without limitation, which pursuant to the terms of the governing instrument is, during the taxable year, paid for a purpose specified in section 170(c) . . .

One of the main distinctions between Sec. 642 and Sec. 170 is that Sec. 642 allows for an income tax deduction “without limitation.” However, the court noted that the IRS sought to limit the deduction in a manner Congress did not intend. Citing Old Colony Trust Co.,⁴ which construed Sec. 642(c)(1)’s predecessor, the court reasoned that Sec. 642(c)(1) does not limit the deduction to something actually paid from that year’s gross income. Thus, even though the donated properties were purchased in a year before they were donated, that does not disqualify the donated properties from being treated as charitable donations derived from gross income. The court also noted that the donated properties were all purchased with distributions from the LP to the trust. Each distribution was part of the LLC’s gross income for the year in which it was distributed. Therefore, the donated properties were purchased with an amount of the trust’s gross income.

Furthermore, the district court did not agree with the IRS’s argument that capital appreciation is not considered in the donated properties’ valuation because it constitutes unrealized gains. The court declined to liken the donated properties to cash gifts not fully derived from gross income or donations made from the trust’s corpus, because it found that each of the donated properties was derived from the trust’s gross income. Finally, the court held that the trustee was correct in using the donated properties’ FMV to calculate the trust’s charitable contribution deduction. The court reasoned that Sec. 170 uses FMV to calculate the charitable contribution deduction for donations of noncash property, noting that Sec. 642(c)(1) does not specify a different standard (e.g., adjusted basis).

The district court’s analysis and holding in Green reminds practitioners and the IRS that statutes regarding charitable deductions are liberally construed in the taxpayer’s favor. Sec. 642(c)(1), read in conjunction with Sec. 170, is very taxpayer-friendly, allowing trusts to deduct the appreciated value of real property without having to recognize capital gains.

DiMarco: In Estate of DiMarco,⁵ the Tax Court held that an estate was not entitled to deduct certain bequests to charity because active litigation prevented the funds in the residuary estate, which was the source of the charitable bequest, from being permanently set aside for a charitable purpose.

The decedent’s will conveyed 100% of the residuary estate to two churches that he regularly attended. The terms of the will did not specifically provide for gross income to be permanently set aside or separated into distinct accounts. For the 2010 tax year, the estate reported $335,854 of total income and claimed a $314,942 charitable contribution deduction. The IRS denied the charitable contribution deduction and determined a deficiency of $108,588.

When the estate filed its 2010 income tax return, legal battles were ongoing between the decedent’s relatives who were making claims against the estate. The decedent never married and did not have any lineal descendants, so his heirs at law challenged the will in surrogate’s court. The New York state attorney general meanwhile tried to probate the will on behalf of the charitable beneficiaries and engaged in several settlement discussions with the heirs until they reached two separate settlements, one designating the estate’s beneficiaries and another settling legal fees and administrative expenses. These two settlements did not occur until after the estate filed its 2010 income tax return. The sole issue before the Tax Court was whether the estate was entitled to a $314,942 charitable contribution deduction claimed on the estate’s 2010 income tax return under Sec. 642(c)(2).

Under Sec. 642(c)(2), an estate may claim an income tax charitable deduction for amounts permanently set aside for a charitable purpose, but Regs. Sec. 1.642(c)-2(d) requires the estate to prove that the possibility that the amount set aside for charitable beneficiaries would go to noncharitable beneficiaries is so remote as to be negligible.

The Tax Court found that during the year at issue, the estate was in the midst of an ongoing legal controversy that was not fully resolved at the time the estate filed its 2010 income tax return and therefore did not satisfy those requirements. Thus, the court, agreeing with the IRS, denied the estate’s claimed income tax charitable contribution deduction and upheld the $108,588 deficiency.

This case illustrates the importance of timing for purposes of claiming the income tax charitable contribution deduction under Sec. 642(c), especially when litigation is ongoing. It is unlikely that the IRS will allow an estate to amend its income tax return to claim the income tax charitable deduction after a settlement is reached, even if the amended return is timely filed and the settlement does not cause funds that would have otherwise gone to a charitable beneficiary to be paid to noncharitable beneficiaries. To the extent possible, it may be beneficial for the executor to make at least a partial payment to the charitable beneficiary to qualify for the income tax charitable contribution deduction in tax years where the estate is involved in ongoing litigation.

Charitable Remainder Trusts

T.D. 9729: On Aug. 18, 2015, the Treasury and the IRS issued final regulations⁶ under Sec. 1014 that provide rules for determining a taxable beneficiary’s basis in a term interest in a charitable remainder trust (CRT) upon a sale or other disposition of all interests in the trust to the extent that basis consists of a share of adjusted uniform basis. The regulations are in response to a transaction that was 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 final regulations apply to sales and other dispositions of interests in CRTs occurring on or after Jan. 16, 2014, except for sales or dispositions occurring under a binding commitment entered into before that date.

In the first part of this CRT transaction of interest, to which the final regulations are a response, a taxpayer creates a CRT under Sec. 664 by transferring a highly appreciated, low-basis asset to the CRT and taking back an annuity or unitrust interest. The taxpayer gives the remainder interest to a charity and receives a Sec. 170 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 the CRT makes annuity or unitrust payments to the taxpayer.

In the second part of the transaction, the taxpayer and the charity sell their interests in the CRT to a third party for an amount that approximates the FMV 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 is disregarded in determining the gain or loss from the disposition of the interest.

An exception applies in Sec. 1001(e)(3) when the disposition of the income interest is 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 under Regs. Secs. 1.1014-5 and 1.1015-1(b) apply so that the bases of the assets in the CRT are apportioned between the income and remainder interests. Thus, when the taxpayer sells his or her annuity or unitrust interest in the CRT, his or her gain will be determined by the difference between the proceeds received from the sale and the basis the taxpayer derives from the basis the CRT had in its assets before the sale.

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

The final 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, 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 final regulations do not affect the CRT’s basis in its assets but rather the taxable beneficiary’s gain arising from a transaction described in Sec. 1001(e)(3).

Schaefer: In Estate of Schaefer,⁷ the Tax Court, in a fully reviewed opinion, ruled that an estate was not entitled to a charitable deduction for two net income with makeup charitable remainder unitrusts (NIMCRUTs) established before the decedent’s death because the remainder interest did not satisfy the CRT requirements in Sec. 664; specifically, the values of the remainder interests were not at least 10% of the value of the assets transferred to the CRT.

Before he died, the decedent created two NIMCRUTs that held interests in a family business. The decedent was the initial income beneficiary of both, and then the decedent’s two sons became income beneficiaries of the NIMCRUTs until the later of their deaths or 20 years. During the unitrust term, the NIMCRUT agreements provided for distributions to the beneficiaries equal to the lesser of the net trust accounting income for the year or a percentage of the net FMV of the trust’s assets, valued annually. One NIMCRUT specified a fixed percentage of 10%, the other 11%.

Under Sec. 664(d)(2)(D), for transfers to a CRT to qualify for the income tax charitable deduction, the charitable remainder interest must be at least 10% of the net FMV of the assets initially transferred to the trust. The only issue before the Tax Court was the proper method to value the remainder interest.

The estate argued that since net income was likely to be less than the fixed percentages in the trust instrument of 10% and 11%, the Sec. 7520 rate (the rate used to value the interests of the beneficiaries) should be used to value the expected income distributions. The court acknowledged that this approach yields a remainder interest value that is possibly closer to what the charity will ultimately receive but that there was no statutory basis for that approach. The IRS argued that the percentages in the trust instrument must be used to compute expected distributions. To that, the court noted the potential for undervaluing the remainder interest because it assumes the maximum distribution even though that amount is only distributed if the trust produces sufficient income.

The court looked to Sec. 664(e), which provides that remainder interests in CRTs are valued using distribution rates “equal to 5 percent of the net fair market value of its assets (or a greater amount, if required under the terms of the trust instrument)” but found this provision ambiguous.

To resolve this ambiguity, the court looked to the regulations, legislative history, and IRS guidance. The regulations were similarly unclear, but the legislative history and IRS guidance were abundantly clear. The Senate Report⁸ for Sec. 664 made clear that the distribution rate set forth in the trust instrument is to be used for valuation purposes even though distributions may be limited by net income. Similarly, in Rev. Rul. 72-395 and Rev. Proc. 2005-54, the IRS explicitly states that the fixed percentage in the trust instrument is to be used, “without regard to the possibility that a smaller or larger amount of trust income may be the amount distributed.” In light of these authorities, the court ruled that the estate was required to value the remainder interests using annual distribution amounts of 10% and 11%, respectively, which resulted in both trusts failing to yield a remainder interest of at least 10% of the trust’s initial net FMV.

Foreign Trusts

Superannuation fund: In Letter Ruling 201538007, the IRS determined that a fund whose sole purpose was to provide superannuation (i.e., pension) benefits to its members and their beneficiaries and was sourced from employer contributions, employee contributions, and income from investments was classified as a trust for federal income tax purposes under Regs. Sec. 301.7701-4(a).

The fund was organized as a trust under the laws of a foreign country (presumably Australia) to provide superannuation benefits to its members in that country. The organizing documents provided that the sole purpose of the fund was to provide the superannuation benefits to its members and their beneficiaries. The fund was a combination of employer and employee contributions, and income from investments. Under the plan documents, a party was obligated to manage the fund responsibly to protect and conserve it, and that party must provide an annual information statement as required by the foreign country’s law. The fund was also subject to an annual audit by an approved auditor appointed by the party. The members of the fund could not unilaterally assign or transfer their benefits under the fund to another person. The fund requested a ruling from the IRS that it be classified as a trust under Regs. Sec. 301.7701-4.

Regs. Sec. 301.7701-4(a) details that an arrangement will be 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 and, therefore, are not associates in a joint enterprise for the conduct of business for profit. For income tax purposes, if an entity has both associates and a business purpose, it cannot be classified as a trust. The IRS concluded that the fund did not have associates that were engaged in the joint enterprise for the conduct of a business profit and, therefore, the fund was classified as a trust for federal income tax purposes.

This letter ruling is important for the tax and reporting implications of people who hold certain retirement and investment accounts in other countries, such as Australia. The IRS’s conclusion is based on four key facts: (1) The sole purpose of the fund was to provide superannuation benefits to its members and their beneficiaries; (2) the fund was made up of employer and employee contributions, as well as income from investments; (3) under the organizing documents, a party was directed to protect and conserve the fund; and (4) the members of the fund could not unilaterally assign or transfer their benefits to another person. Although the IRS ruled that this type of fund is considered a trust, further analysis will have to be done regarding the tax treatment of the fund in the United States. What this ruling does not answer is what the federal income tax consequences are to a person who has made contributions to this type of fund (e.g., is this trust an exempt plan under Sec. 402(b), is the trust a grantor or nongrantor trust, or what are the possible reporting requirements under the passive foreign investment company rules?).

Grantor trust: In Letter Ruling 201532023, the IRS ruled that a trust created by a controlled foreign corporation (CFC) that had a U.S. corporation as a parent was a trust for federal income tax purposes and that the trust was a grantor trust owned by the CFC.

A U.S. corporation created a CFC in a country where it operates a business. The CFC created a trust under the laws of the foreign country where it operated. The CFC established the trust to satisfy the foreign country’s law requiring it to segregate, hold, and invest assets to ensure the CFC is able to meet its business obligations. A separate LLC was formed in the foreign country solely to act as trustee of the trust.

Under the trust agreement, the trustee has broad powers to manage the trust’s assets, including the power to buy and sell assets; a duty to preserve and protect the trust’s assets under the foreign country’s laws; and an investment agreement with an external asset manager, which provides the trust’s investment policy must comply with those laws. Further, the trust agreement provided that all of the trust’s net income was required to be distributed annually to the CFC, as the trust’s sole unitholder. The trustee had the discretion to distribute principal to the CFC. The CFC could redeem its interest in the trust and could amend or revoke the trust. The CFC had at all times been the sole unitholder of the trust and could not unilaterally assign or transfer any portion of its interest in the trust without the trustee’s consent. The U.S. corporation represented that, given the purpose of the trust, it was not contemplated that the CFC would transfer its interest in the trust.

The U.S. corporation asked the IRS to rule (1) whether an entity that was formed in a non-U.S. country by a CFC would be treated as a trust for U.S. tax purposes; and (2) whether the CFC would be treated as the owner of that trust

As to the first issue, the IRS noted that in general, Regs. Sec. 301.7701-4(a) provides that the term “trust” refers to an arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the trust’s beneficiaries. Usually, beneficiaries merely accept the benefits from the trust but, in certain cases, may also be the creators of the trust if the trust was created to protect or conserve the trust property for the beneficiaries just as if someone else had created the trust for them. As the IRS concluded that the trust’s main purpose was to secure the trustees with the responsibility of protecting and conserving the property for the CFC (i.e., the beneficiary), which itself cannot discharge that responsibility and, as such, is not an associate in a joint enterprise for the conduct of business for profit, it ruled that the trust should be considered a trust for U.S. tax purposes under Regs. Sec. 301.7701-4(a).

As to the second issue, the IRS noted that Sec. 671 indicates that if the grantor or another person is treated as the owner of any portion of a trust, the grantor or the individual will include in his or her individual taxable income, the income, deductions, and credits against tax of the trust that are attributable to that portion of the trust. Generally, Sec. 672(f)(1) and Regs. Sec. 1.672(f)-1 provide that this only applies to the extent that the “grantor” or “another person” is a citizen or resident of the United States or a domestic corporation so as to ensure U.S. taxation. However, Sec. 672(f)(3)(A) provides an exception under which a foreign corporation that is a CFC is treated as a domestic corporation for purposes of Sec. 672(f)(1). As such, a CFC can be treated as the owner of the trust, even though it is a foreign corporation.

Additionally, it must be evaluated whether the facts around the CFC’s ownership of the trust would deem it to be the owner of the trust. Generally, Sec. 676(a) indicates a grantor will be considered the owner of any portion of the trust where, at any time, the power to revest in the grantor title to that portion is exercisable by the grantor or a nonadverse party, or both. Sec. 677(a) provides that the grantor is considered the owner of any portion of the trust income that may be distributed to the grantor or accumulated for future distribution to the grantor or the grantor’s spouse. The IRS noted that the trust’s net income is required to be distributed annually to the CFC, the trustee has the discretion to distribute principal only to the CFC, the CFC may redeem its interest in the trust, and the CFC has the ability to amend or revoke the trust. As a result, it ruled that the CFC will be treated as the owner of the trust under Secs. 676(a) and 677(a).

Trust Reformation

In Letter Ruling 201544005, the IRS allowed retroactive reformation of a trust due to a scrivener’s error, ruling that past and future transfers to the trust were completed gifts for gift tax purposes and that none of the trust’s assets were includible in the grantors’ gross estates for estate tax purposes under Sec. 2036 or Sec. 2038.

The taxpayers created a trust for the benefit of their two children and intended to have the transfers to the trust treated as completed gifts to exclude the trust’s assets from their estates. However, a couple of the provisions in the trust agreement, as originally drafted, frustrated those intentions: (1) The taxpayers were the trustees of the trust and had the discretionary power to withhold distributions; and (2) the taxpayers had the power to amend the trust agreement. The taxpayers petitioned the state court having jurisdiction over the trust to reform the trust to reflect their estate planning intentions retroactive to the date when the trust was created, which the court granted. They then requested a ruling from the IRS that the reformation be given retroactive effect.

The IRS determined that the reformations to the trust agreement were effective as of the date of the taxpayers’ initial transfers to the trust for federal tax purposes. In making this determination, the IRS applied the Supreme Court’s holding in Estate of Bosch,⁹ which held that determining property interests is based on state law, and the state’s highest court is the best authority. But if there is no higher state court decision, the IRS must interpret the lower court decision and apply what it finds to be state law after giving “proper regard” to the state trial court’s determination and to relevant rulings of other courts of the state. In this respect, the federal agency may be said, in effect, to be sitting as a state court.

The IRS determined that, under state law, a state court would allow extrinsic evidence to determine the taxpayers’ intent because of conflicting provisions in the trust agreement as originally drafted. For example, the original agreement stated both that the trust was irrevocable and that the taxpayer had the power to amend the trust. The extrinsic evidence that convinced the IRS to allow reformation of the trust included (1) the taxpayers’ representation that their intent was to leverage the unified credit and transfer the maximum amount to their children without incurring gift tax; (2) that retaining a reversionary interest or a distribution power not limited to an ascertainable standard was contrary to that intention because these provisions caused the transfers to the trust to be incomplete gifts under Regs. Sec. 25.2511-2; (3) that the attorney who originally drafted the trust signed an affidavit attesting to the transferors’ intent and that the original draft contained scrivener’s errors that thwarted this intent; and (4) that the taxpayers filed gift tax returns reporting their transfers to the trust as completed gifts. Thus, the IRS ruled that the original transfers to the trust and any future transfers will be completed gifts for gift tax purposes. The IRS also ruled that the reformed trust agreement eliminated the provisions that would have caused the trust’s assets to be includible in the taxpayers’ gross estates.

The IRS was very generous in allowing retroactive reformation, as these “scrivener’s errors” were much more extensive than what practitioners typically associate with the term. The fact that the attorney who originally drafted the trust fell on his proverbial sword most likely played a big part in the IRS coming to its taxpayer-friendly conclusion.

Transferee Liability

Singer: In Singer,¹⁰ the Tax Court held that the executor of an estate probated in New York is entitled to include the equitably apportioned contribution of estate tax from those receiving property from the estate when determining whether an estate is insolvent.

When the decedent died on Aug. 24, 1990, he had a federal income tax liability of $4,023,213 and an estate tax liability of $1,842,592. The decedent’s will had the following provisions: (1) to his estranged wife, an elective share, under New York law, to be held in trust and $10,000; (2) to his current partner, one-third of his estate, a cooperative apartment, his automobile, his boat, a mortgage held on a property in New Jersey, and his racehorses; (3) to his grandchildren, the residue of his estate; and (4) to his law firm partner, who also happened to be his brother, the interest in his joint tax practice. In addition to the assets disposed of in his will, the decedent held a brokerage account with his current partner as joint tenants with a right of survivorship.

After the decedent’s death, the Surrogate’s Court of the State of New York restrained the $2 million brokerage account in response to the executor’s request in a petition because it appeared that the testamentary estate would be insufficient to pay the creditors’ claims.

On Feb. 10, 1993, the IRS filed a proof of claim of $1,221,902 and $1,775,370 for the unpaid estate and income tax, respectively. The executor submitted an offer in compromise to satisfy the decedent’s unpaid federal income tax, which the IRS accepted. The surrogate’s court permitted the executor to take the agreed-upon income taxes as well as his fees from the brokerage account. Subsequently, on Feb. 5, 1999, the IRS filed an amended proof of claim for the remaining estate tax due as well as interest and penalties of $3,846,635.

On April 15, 1999, the executor applied for the release of $753,321 from the brokerage account to pay (1) $251,107 to the estate of the decedent’s estranged wife; (2) $446,772 to the IRS; and (3) $171,587 to the New York Department of Taxation. The IRS issued a notice of fiduciary liability to the executor for the amounts paid to the wife and the New York Department of Taxation for a total of $422,694.

Under Sec. 3713 (often referred to as the “federal priority statute”), U.S. government claims must be paid first if the estate of the decedent is insolvent, meaning liabilities exceed assets. Fiduciary liability for unpaid claims to the U.S. government exists under Sec. 6901 if (1) the executor distributed assets of the estate; (2) the estate was insolvent at the time of the distribution or the distribution rendered the estate insolvent; and (3) the executor had notice of the U.S. government’s claim. In this case, only the solvency of the estate was at issue.

The Tax Court determined that the IRS had the burden of proof in showing the estate was insolvent. The court also applied New York Estate Powers and Trust Law Sec. 2-1.8(a), which states that if a fiduciary is required to pay a federal or state estate tax liability, the estate is entitled to contribution equitably apportioned among the parties receiving property from the gross taxable estate. Additionally, the estate solvency is determined at the date of the distribution, which was April 15, 1999.

The IRS claimed the executor was liable for the amount distributed before the estate taxes were paid in full. However, the IRS did not include the equitably attributed contribution of the individuals receiving distributions from the estate. When factoring in those contributions, the estate’s assets exceeded the value of the liabilities, and therefore the estate was not rendered insolvent. Thus, the court found the executor was not liable as a fiduciary for the distribution of $422,694.

Marshall: In Marshall,¹¹ the Fifth Circuit held that a donee’s transferee liability under Sec. 6324(b) is limited to the amount of the gift. More specifically, the court construed Sec. 6324(b) based on the plain language of the statute and declined to interpret it in conjunction with Sec. 6601 or Sec. 6901. The Fifth Circuit withdrew its own prior decision in Marshall,¹² which held that a donee’s transferee liability under Sec. 6324(b) included the original amount of the gift plus interest and penalties.

In 1995, the taxpayer sold stock in Marshall Petroleum Inc. (MPI) back to the company. The IRS determined that the sale was an indirect gift to MPI’s shareholders because the taxpayer sold the stock back for a price below its FMV, thus increasing the value of the stock for the remaining shareholders. After lengthy litigation and negotiations, the IRS entered into a stipulation with the taxpayer’s estate regarding the estate’s tax liability, providing that the 1995 transfer resulted in $84,191,754 of indirect gifts to MPI’s remaining shareholders. In 2008, the Tax Court issued decisions finding deficiencies in the taxpayer’s 1995 gift taxes, but the taxpayer and his estate never paid the gift taxes.

In 2010, the IRS tried to collect the unpaid gift tax from the donees of the indirect gift. One of the donees paid approximately $45 million toward the unpaid gift tax. The other donees did not contribute.

The issue ultimately found its way to the district court, which found the donees’ debt under Sec. 6324(b) (regarding liens on gift property for the payment of gift tax) was a liability independent from that of the donor’s unpaid gift tax and the donees had incurred interest on that independent liability under Sec. 6601 (interest on the nonpayment of tax) and Sec. 6621 (determining the interest rate).

In the 2014 appeal to the Fifth Circuit, the donees argued that the language of Sec. 6324(b) was clear on its face and that it imposes only a single liability on the donees for the donor’s tax and interest. However, the IRS argued and the Fifth Circuit agreed that two distinct liabilities existed: (1) the donor’s liability; and (2) the donees’ liability. Specifically, to understand the donees’ liability for the unpaid gift tax, the court must look beyond Sec. 6324(b) and read it in conjunction with Secs. 6601 and 6901 (liability for tax on transferred assets). As a result, the amount of a donee’s personal liability under Sec. 6324(b) is subject to the same provisions as the gift tax that gave rise to that liability, such as the Sec. 6601 interest provisions.

However, in 2015 the Fifth Circuit withdrew its 2014 opinion, in relevant part, as it pertained to the limit on transferee liability. The court noted that Sec. 6324(b) is the sole basis for the imposition of liability on a donee for gift taxes unpaid by the donor. Sec. 6324 provides that “if the tax is not paid when due, the donee of any gift shall be personally liable for such tax to the extent of the value of such gift.” The court stated that the natural reading of this sentence is that a donee’s personal liability is capped at the amount of the gift.

The court disagreed with the IRS’s argument that Sec. 6901 extends the donees’ liability to interest above and beyond the value of the gifts because Sec. 6901 is a procedural provision for tax collection that does not create any substantive liability. Further, the court determined that Sec. 6601 does not apply to donee liability because it is a general rule that is controlled by the specific rules set forth in Sec. 6324(b); that is, since specific law controls over general law, the court applied Sec. 6324(b) because it is directly on point to the issue being litigated.

Thus, in its 2015 opinion, the Fifth Circuit sided with the taxpayers and held that donee liability for unpaid gift tax is capped at the value of the gift. This includes the tax and accrued interest. The donees were not held liable for interest above and beyond the value of the gifts.

The Fifth Circuit limited liability under Sec. 6324(b) to the amount of the initial gift. For example, assuming the donor had exhausted his or her lifetime exemption, a donee who receives a gift of $10 million, which creates an initial gift tax liability of $4 million, could potentially be liable to the IRS under Sec. 6324(b) for $10 million (the amount of the original tax liability plus any accrued interest and penalties).

President’s Budget Proposals

On Feb. 9, 2016, President Obama released his 2016 budget containing the following gift, estate, and GST tax proposals. Most of the proposals are the same as last year; however, some of them contain modifications.

Estate tax reform: The budget would increase the maximum rate from 40% to 45% and reduce the exemption amount from $5,450,000 to $3,500,000 for estate and GST tax purposes and $1,000,000 for gift tax purposes with no indexing for inflation. It would also continue to allow portability, which allows a surviving spouse to include any unused estate tax exemption of a predeceased spouse in determining the surviving spouse’s exemption for gift and estate tax purposes; however, it would be limited during the surviving spouse’s life to the amount of remaining exemption the decedent could have applied to his or her gifts made in the year of his or her death.

Treat gifts and bequests as sales: The budget would treat gifts and bequests as sales, effectively taxing as capital gain the difference between the donor’s or decedent’s basis in the property and the property’s FMV on the date of the gift or the date of the decedent’s death. The proposal would effectively eliminate the Sec. 1014 step-up in basis for property acquired from a decedent and would allow a decedent’s estate a deduction for the capital gains tax on the decedent’s estate tax return. Decedents (not donors) would be allowed a $200,000 per couple ($100,000 per individual) capital gains income exclusion, as well as a $500,000 per couple ($250,000 per individual) exclusion for personal residences. The exclusion noted above for transfers at death would not apply to lifetime gifts. The proposal would exclude tangible personal property, except for art and similar collectibles (e.g., bequests or gifts of furniture or other household items), from capital gains income. Families that inherit small, family-owned and -operated businesses would not owe tax on the gains until the assets were sold, and closely held businesses would be allowed to pay the tax on gains over 15 years. Where the gift or bequest is made to the donor/decedent’s spouse, the donor/decedent’s basis would carry over, and the deemed sale would occur when the spouse disposes of the asset during his or her lifetime or bequeaths it at death.

Minimum GRAT term: This proposal would set a 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. This would prevent 99-year GRATs, which some taxpayers have created so that the amount includible in the grantor’s estate under Sec. 2036 is very small. The value of the remainder interest on the date the GRAT is created must be equal to the greater of 25% of the assets contributed to the GRAT or $500,000 (but not more than the value of the assets contributed). This required minimum value would effectively render the technique useless in many estate plans. The proposal also would prohibit any decrease in the amount of the annuity during the annuity term to prevent front-loading a GRAT. Finally, the proposal would prohibit the grantor from engaging in a tax-free exchange of any asset held in the trust, essentially eliminating the grantor’s ability to substitute assets in a GRAT.

Coordination of income and transfer–tax treatment for grantor trusts: This proposal is combined with the GRAT proposal in this year’s budget. It 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 (including transfers to pour-over trusts and decanted trusts). After the 90th anniversary, the trust would have an inclusion ratio of one. The proposal is an attempt by the administration to deal with many states that have changed or repealed their rules against perpetuities, which provide the maximum duration of a trust. When the GST tax regime was enacted, most states used the common law rule against perpetuities, which requires the term of the trust 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 or revised the common law rule and now allow longer terms.

Consistency in valuations (new): While the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, P.L. 114-41, made basis consistency law, the budget would expand this law to include (1) property qualifying for the estate tax marital deduction (provided an estate tax return is required to be filed) and (2) property transferred by gift (provided a gift tax return is required to be filed).

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.

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 by a living donor.

Simplify gift tax annual exclusion for gifts to trusts: 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 2015, excludes the first $14,000 of gifts made to a donee. In Crummey,¹³ the Ninth Circuit ruled 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 the right exists for only a limited period of time (typically 30 days). This proposal would create a new category of transfers to which a $50,000 per donor annual limit would apply. In addition to transfers to trusts, the new category would include transfers of interests in passthrough entities, transfers of interests subject to a prohibition on sale, and other transfers that, without regard to withdrawal, put, or other rights in the donee, cannot immediately be liquidated by the donee.

Expand applicability of definition of executor: 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 that role, any person in actual or constructive possession of any of the decedent’s property. This proposal would make the definition applicable for all tax purposes, not just estate tax purposes, to allow the executor to take care of any of the decedent’s tax matters, including those that arose before the decedent’s death.

Inflation Adjustments

The IRS released Rev. Proc. 2015-53 setting inflation adjustments for various tax items for 2016. The following is a list of items that may be of interest to estate planning professionals:

Unified credit against estate tax: For an estate of any decedent dying during calendar year 2016, the basic exclusion amount is $5,450,000 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 2016, if the executor elects to use the special-use valuation method under Sec. 2032A for qualified real property, the aggregate decrease in the value of the qualified real property cannot exceed $1,110,000.

Gift tax annual exclusion: The gift tax annual exclusion for gifts of a present interest remains $14,000 in 2016. The gift tax annual exclusion for gifts of a present interest to a spouse who is not a U.S. citizen is $148,000.

Interest on a certain portion of the estate tax payable in installments: For an estate of a decedent dying in 2016, the dollar amount used to determine the “2-percent portion” (for purposes of calculating interest under Sec. 6601(j)) of the estate tax, extended as provided in Sec. 6166, is $1,480,000.

Footnotes

¹T.D. 8845.

²Estate of Dieringer, 146 T.C. No. 8 (2016).

³Green, No. CIV-13-1237-D (W.D. Okla. 11/4/15), later proceedings, No. CIV-13-1237-D (W.D. Okla. 2/10/16) (government’s motion for summary judgment denied).

⁴Old Colony Trust Co., 301 U.S. 379 (1937).

⁵Estate of DiMarco, T.C. Memo. 2015-184.

⁶T.D. 9729.

⁷Estate of Schaefer, 145 T.C. 134 (2015).

⁸S. Rept. No. 91-552, 91st Cong., 1st Sess., at 87 (1969).

⁹Estate of Bosch, 387 U.S. 456 (1967).

¹⁰Singer, T.C. Memo. 2016-48.

¹¹Marshall, 798 F.3d 296 (5th Cir. 2015).

¹²Marshall, 771 F.3d 854 (5th Cir. 2014).

¹³Crummey, 397 F.2d 82 (9th Cir. 1968).