Recent developments in estate planning: Part 2

Contributors: Members of Ernst & Young LLP’s National Tax Department in Private Client Services (David Kirk, Marianne Kayan, Jennifer Einziger, Caryn Friedman, John Fusco, Nicholas Davidson, and Ankur Thakkar)

This is the second part of a two-part article examining developments in estate, gift, and generation-skipping transfer (GST) tax and fiduciary income tax between June 2016 and May 2017. Part 1, in the September issue, discussed gift and estate tax developments. Part 2 discusses GST tax and trust tax developments, as well as tax reform proposals and inflation adjustments for 2017.

Generation-skipping transfer tax

Substantial compliance

In Letter Ruling 201640013, the IRS concluded that a GST tax exemption allocation election that does not strictly comply with the instructions on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, will still be considered valid if the information on the return shows that the taxpayer intended to make the election.

A couple made gifts to three trusts in year 1 for the benefit of their grandchildren and more remote descendants. The husband made a gift to Trust 1 and Trust 3, while the wife made a gift to Trust 2. The husband wished to allocate GST exemption to the gifts to Trust 1 and wished not to allocate GST exemption to the gifts to Trust 3. The wife wished to allocate GST exemption to the gifts to Trusts2.

In preparing the gift tax returns for the couple for year 1, the couple’s accounting firm prepared the husband’s return properly reflecting the gift to Trust 1 on Schedule A, Part 2, of the return (regarding gifts that are direct skips) and the automatic allocation of GST exemption to the gift and the wife’s return properly reflecting the gift to Trust 2 and the automatic allocation of GST exemption to the gift. However, the accounting firm incorrectly checked the box on both returns to elect out of the automatic allocation of GST exemption to the trusts. With regard to Trust 3, the accounting firm incorrectly listed the transfer on Schedule A, Part 3 (regarding gifts to a trust that may be subject to the GST tax that are not direct skips), and checked the box on the return to indicate a Sec. 2632(c) election was made. However, it did attach a statement to the return electing out of the automatic allocation rules. The couple requested rulings that (1) they made an allocation of GST exemption to Trust 1 and Trust 2, notwithstanding that boxes on the returns had been checked to elect out of the allocation, and (2) that the husband had substantially complied with the requirements to elect out of the automatic allocation of GST exemption to Trust 3.

Regarding the transfers to Trust 1 and Trust 2, the IRS ruled that they were both properly reported on the couple’s respective gift tax returns. It further ruled that the fact that the election-out box was checked for each transfer on the respective returns did not negate the fact that a proper allocation of GST exemption was made.

With regard to the husband’s gift to Trust 3, the IRS noted that the transfer should have been listed on Schedule A, Part 2, of the return indicating a direct skip to which GST exemption is automatically allocated, and not on Part 3 of the return. However, it also noted that the husband’s return contained a statement electing out of the automatic allocation rules. Thus, it determined that although the husband did not literally comply with the instructions to the gift tax return or the requirements for making an election out of the automatic allocation rules, literal compliance with the procedural instructions to make an election is not always required. Citing Hewlett-Packard Co.,¹ the court said, “Elections may be treated as effective where the taxpayer complied with the essential requirements of a regulation (or the instructions to the applicable form) even though the taxpayer failed to comply with certain procedural directions therein.”

Comment: The IRS reached the correct result. Generally, when the box is checked for a gift in Schedule A, Part 2, it indicates the taxpayer did not wish the automatic allocation of GST exemption to apply to a direct skip. Such an election requires the taxpayer to remit the GST tax with the return making the election. The facts do not indicate that the couple made such a payment, and the facts reflect that the return was completed as if there were an automatic allocation of GST exemption to the transfers. If a payment is not remitted with the return making such an election, one would assume that the election would be invalid and the automatic allocation rules would otherwise apply to the direct skips. As to the transfer by the husband to Trust 3, Sec. 2642(g) contains a relief provision for substantial compliance regarding allocations of GST exemption. The IRS concluded that the Form 709 contained sufficient information to constitute substantial compliance, even though the ruling does not cite Sec. 2642(g).

Special valuation rules

Proposed regulations under Sec. 2704

Treasury and the IRS issued long-anticipated proposed regulations² that provide guidance on how the value of interests in corporations, partnerships, limited liability companies (LLCs), and other business entities should be determined for estate, gift, and GST tax purposes. The proposed regulations focus in particular on the treatment of certain lapsing rights and restrictions on liquidation. They affect certain transferors of interests in these entities and are aimed at preventing artificial undervaluation of these interests in transfers among family members. Although these regulations are among eight sets of final or proposed regulations issued since 2016 that Treasury has earmarked in response to a presidential order as potentially burdensome,³ casting doubt on whether they will be finalized substantially in their proposed form, tax advisers should nonetheless familiarize themselves with their provisions and potentially serious constraints on some common strategies in estate planning.

For more than 15 years, the IRS has challenged the use of family-formed entities that it viewed as formed purely for tax reasons—specifically, to reduce the gift and/or estate tax consequences associated with transferring interests in these entities to younger generations. A significant estate tax benefit of creating these entities is the valuation discounts associated with the transfers of these interests. Two discounts are generally associated with the transfer of interests in family-held entities: (1) lack of marketability, derived from restrictions on the transfer of interests in the entity, and (2) lack of control (or minority interest), derived from the limited powers associated with not having control of the entity.

In the past, the IRS has often argued that these discounts should be disregarded under Sec. 2704, which disregards certain lapsing rights or restrictions on liquidations contained in operating agreements of closely held entities for estate and gift tax valuation purposes if certain conditions exist at the time of the transfer of the interest. However, the courts have generally disagreed with the IRS’s interpretation of Sec. 2704. For example, in Kerr,⁴ the Fifth Circuit held that the value of limited partnership interests transferred to the taxpayer’s children and to two trusts for the benefit of the taxpayer’s children was not affected by Sec. 2704 and could be reduced by lack-of-marketability discounts, due to restrictions contained in the partnership agreement on the ability of the partners to liquidate their interests in the partnership.

Sec. 2704 provides rules for valuing transfers among family members of interests in corporations or partnerships that are subject to (1) lapsing voting or liquidation rights or (2) restrictions on liquidation.

Citing Sec. 2704’s legislative history, the preamble to the proposed regulations explains that the section is partly intended to prevent results similar to that in Estate of Harrison,⁵ in which the decedent and two of his children held general partnership interests in a partnership immediately before the decedent died. In addition to a general partnership interest, the decedent held all of the limited partner interests in the partnership. The general partnership interests each carried with them the right to liquidate the partnership. A general partner’s right to liquidate, however, terminated upon that general partner’s death. In determining the estate tax value of the decedent’s limited partnership interests, the court determined that the right of liquidation could not be taken into account because it lapsed at the decedent’s death. As a result, the court concluded that the value of the limited partner interests for transfer tax purposes was lower than its value either to the decedent immediately before he died or to the other general partners immediately after his death.

Under Sec. 2704(a)(1), a lapse of any voting or liquidation right in a corporation or partnership that is controlled by an individual and members of his or her family both before and after the lapse is treated as a transfer by the individual by gift or a transfer includible in the gross estate of the decedent. The amount of the transfer is calculated as the fair market value (FMV) of all of the interests held by the individual immediately prior to the lapse over the FMV of these interests after the lapse. A liquidation right is defined as the right or ability to compel the entity to acquire all or part of the holder’s equity interest in the entity, whether or not this would cause the entity to liquidate.⁶ A lapse of a liquidation right occurs when an exercisable liquidation right is restricted or eliminated.⁷

This rule, however, generally does not apply if the rights with respect to the transferred interest are not restricted or eliminated.⁸ As a result of this exception, if an interest holder who has the aggregate voting power to compel the entity to acquire the holder’s interest makes an inter vivos transfer of a minority interest that results in the loss of the interest holder’s ability to compel the entity to acquire his or her interest, the transfer will not be treated as a lapse.⁹

The preamble to the proposed regulations explains that Treasury and the IRS believe this exception should not apply when the inter vivos transfer that results in the loss of the power to liquidate occurs on the decedent’s deathbed because, although these transfers generally have minimal economic effects, they “result in a transfer tax value that is less than the value of the interest either in the hands of the decedent prior to death or in the hands of the decedent’s family immediately after death.” The purpose of Sec. 2704 was to prevent this loss. Treasury and the IRS assert in the preamble that the exception established in Regs. Sec. 25.2704-1(c)(1) should apply only to transfers occurring more than three years before death, “where the loss of control over liquidation is likely to have a more substantive effect.”

Therefore, under the proposed regulations, the exception regarding transfers of interests that do not result in the restriction or elimination of rights associated with the transferred interest would be limited to transfers that occur more than three years before the transferor’s death.

Under Sec. 2704(b)(1), any “applicable restriction” would be disregarded when valuing an interest in a corporation or partnership that one family member transfers to another family member (or for the benefit of a family member), where the transferor and members of his or her family together control the entity immediately before the transfer. Sec. 2704(b)(2) defines an applicable restriction as a restriction that effectively limits the ability of the entity to liquidate but which, after the transfer, either in whole or in part, will lapse or may be removed by the transferor or the transferor’s family, either alone or collectively. Excepted from this definition is any restriction imposed under federal or state law.¹⁰

The preamble characterizes the current regulations under Sec. 2704 as “rendered substantially ineffective in implementing the purpose and intent of the statute by changes in state laws and by other subsequent developments.” For example, court decisions such as Kerr, described above, have held that under the current regulations, Sec. 2704(b) only applies to restrictions on the ability to liquidate an entity in its entirety, as opposed to the ability to liquidate an interest in the entity that is transferred. In addition, the preamble asserts, taxpayers relying on the state-law exception have attempted to avoid application of Sec. 2704(b) by transferring partnership interests to an assignee instead of a partner (an assignee having only the rights to distributions instead of the rights of a partner). In addition, the preamble states, taxpayers have attempted to avoid Sec. 2704(b) by transferring a nominal partnership interest to a non-family member, thereby ensuring that the power to remove a restriction does not reside with family members alone.

According to the preamble, Treasury and the IRS “have concluded that, as was recognized by Congress when enacting [Sec.] 2704(b), there are additional restrictions that may [adversely affect] the transfer tax value of an interest but that do not reduce the value of the interest to the family-member transferee, and thus should be disregarded for transfer tax valuation purposes.”¹¹ These restrictions include (1) a restriction on the ability to liquidate the transferred interest and (2) any restriction that depends on (a) the nature or extent of the property received in exchange for the liquidated interest, or (b) the timing of the payment of that property.

In addition, Treasury and the IRS assert that Sec. 2704(b) will apply if a non-family member is granted an insubstantial interest in the entity, because the non-family member interest generally does not constrain the family’s ability to remove a restriction on the liquidation of an individual interest. The government contends in the preamble that “the presence of a nonfamily-member interest should be recognized only where the interest is an economically substantial and longstanding one that is likely to have a more substantive effect.” Establishing a bright-line test, the proposed regulations disregard any interest that either (1) is held by a non-family member for less than three years prior to the transfer date; (2) constitutes less than 10% of the value of all of the equity interests; (3) constitutes less than 20% of the value of all of the equity interests when combined with all interests of other non-family members; or (4) does not include a right to “put” the interest to the entity in exchange for a minimum value.

The proposed regulations are also aimed at updating the Sec. 2704 regulations to address the fact that the check-the-box regulations¹² can result in a substantial difference between how an entity is classified for federal tax purposes and how it is structured under local law.

Sec. 2704 uses the terms “corporation” and “partnership.” For purposes of the proposed regulations, a corporation is defined as any business entity described in Regs. Secs. 301.7701-2(b)(1) and (b)(3) through (b)(8); an S corporation¹³; and a qualified Subchapter S subsidiary.¹⁴ In addition, for purposes of the proposed regulations, a partnership is defined as any other business entity described under Regs. Sec. 301.7701-1(a), regardless of how the entity is classified for federal tax purposes.

The proposed regulations also address two situations that go beyond the distinction between corporation and partnership, applying a test to determine control of an entity and a test to determine whether a restriction is imposed under state law. Specifically, for purposes of determining control of an entity and whether a restriction is imposed under state law, the proposed regulations provide that the form of any entity or arrangement that is not a corporation would be determined under local law, regardless of how it is classified for other federal tax purposes or whether it is a disregarded entity.

As a result of these two tests, the proposed regulations would apply to three categories of entities: (1) corporations; (2) general and limited partnerships; and (3) other business entities, including LLCs that are not S corporations, as determined under local law.

Proposed amendments to the existing regulations would:

• Clarify that Sec. 2704 applies to corporations, partnerships, LLCs, and other entities and arrangements that constitute business entities within the meaning of Regs. Sec. 301.7701-2(a), regardless of (1) whether the entity is domestic or foreign; (2) how the entity is classified for other federal tax purposes; and (3) whether the entity is a disregarded entity;
• Clarify that control of an LLC or any entity or arrangement that is not a corporation, partnership, or limited partnership constitutes (1) holding at least 50% of the capital or profits interest or (2) holding any equity interest while having the ability to cause full or partial liquidation (attribution rules under current Regs. Sec. 25.2701-6 would apply);
• Confirm that a transfer resulting in the restriction or elimination of any rights or powers associated with the transferred interest is treated as a lapse within the meaning of Sec. 2704(a);
• Narrow the exception in the definition of a lapse of a liquidation right to transfers that occur three years or more before the transferor’s death that do not restrict or eliminate the rights associated with ownership of the transferred rights;
• Amend the definition of “applicable restrictions” under Sec. 2704(b) to (1) remove the exception in the regulations that limits the definition of “applicable restriction” to limitations that are more restrictive than local law; (2) provide that an applicable restriction includes a restriction imposed under the terms of the entity’s governing documents as well as one imposed under local law; and (3) provide exceptions to the definition of “applicable restrictions” that include (i) a commercially reasonable restriction; (ii) a mandatory restriction imposed by federal or state law; (iii) an option, right to use property, or agreement that is subject to Sec. 2703; and (iv) any put right that allows a holder of an interest in an entity to receive the FMV (less outstanding obligations) of the interest within six months of notice to the entity; and
• Create a new class of restrictions, termed “disregarded restrictions,” that (1) limit the ability of the holder of the interest to liquidate the interest; (2) limit the liquidation proceeds to less than a minimum value; (3) defer the payment of liquidation proceeds for more than six months; or (4) permit the payment of the liquidation proceeds in any manner other than cash or other property (other than certain notes).

With regard to an interest transferred between family members that qualifies for the gift or estate tax marital deduction and must be valued under the special valuation assumptions of Sec. 2704(b), the preamble states, “the same value generally will apply in computing the marital deduction attributable to that interest.”

Comment: The proposed regulations are an attempt by Treasury and the IRS to breathe new life into Sec. 2704, which has been rendered virtually irrelevant by the courts and effective planning. Specifically, the proposed regulations would treat the following as subject to Sec. 2704:

• Deathbed transfers (i.e., transfers within three years of the decedent’s death) that result in the loss of the power to liquidate the decedent’s interest in an entity;
• A restriction on the right of the interest holder to liquidate his or her interest (effectively negating the ruling in Kerr that applied the exception in the regulations to transfers of interests that do not result in the restriction or elimination of rights to liquidations of the entire entity);
• A restriction that is not otherwise mandated by federal or state law (not simply one that is no more restrictive than federal or state law that would apply in the absence of the restriction);
• A restriction providing that the transferee of an interest only holds the rights of an assignee and not those of a partner;
• A restriction on the ability to compel liquidation or redemption of the interest;
• A restriction on the amount that may be received upon liquidation or redemption that is less than FMV (less outstanding obligations of the entity);
• A restriction that defers the payment of liquidation or redemption proceeds for more than six months after notice of intent to liquidate or redeem; and
• A restriction that permits the payment of liquidation or redemption proceeds in any manner other than in cash or property (e.g., notes—with exceptions).

The proposed regulations would also disregard nominal interests held by non-family members in determining whether a family had the ability to liquidate.

The effect of the proposed regulations would be to significantly curtail lack-of-marketability and minority-interest discounts applied to transfers between family members. It is likely that the valuations of these transfers would more closely represent the value of the underlying assets.

The proposed regulations, if and when finalized, would generally apply to transfers that occur after the date on which the regulations become final. The regulations would apply to any governing instruments that were created after Oct. 8, 1990 (the effective date of Sec. 2704).

The proposed regulations have been met with wide criticism due to the breadth of the range of transactions they could cover. At the Treasury and IRS hearing on the proposed regulations on Dec. 1, 2016, nearly 40 people representing a swath of organizations mainly tied to family businesses spoke, largely to request that the proposed regulations be withdrawn and reproposed after consideration of the over 9,000 comment letters submitted as of the time of the hearing. The author spoke on behalf of the AICPA, which echoed this request.¹⁵ Congress has also shown its concern regarding these regulations. In a letter dated Nov. 3, 2016, from the Republican members of the House Ways and Means Committee to then-Treasury Secretary Jacob Lew, the members requested that Treasury withdraw the proposed regulations while it reconsiders how best to approach any identified issues under Sec. 2704 consistent with congressional intent underlying the statute.

On April 21, 2017, President Donald Trump issued Executive Order 13789 instructing Treasury to review significant regulations issued in 2016 and 2017 and to identify those that impose an undue financial burden on U.S. taxpayers, add undue complexity to federal tax laws, or exceed the IRS’s statutory authority. In response to the order, Treasury and the IRS in July 2017 issued Notice 2017-38 identifying eight such sets of final or proposed regulations, including these proposed regulations. The order further directed Treasury to recommend specific actions to mitigate the identified regulations’ burdens. As this issue went to press, whether these proposed regulations would be withdrawn or modified and reissued remained unclear. The deadline for Treasury’s report on specific actions it will take was set by the executive order as 150 days after the order’s issuance, or Sept. 18, 2017.¹⁶ Given the executive order and the volume of objections to various aspects of these proposed regulations, it would seem improbable that the IRS would publish them in substantially their proposed form. But it also seems likely the IRS will continue to assert these positions with respect to these valuation issues, if not in future exercises of its rulemaking authority, at least in taxpayer controversies, including litigation.

Fiduciary income tax

Charitable deductions

In Chief Counsel Advice (CCA) 201651013, the IRS concluded that a trust that was modified pursuant to a state court order was not entitled to a Sec. 642(c) charitable deduction because the deduction was not made “pursuant to the terms of the governing instrument.” In addition, the IRS found that the trust was not entitled to a distribution deduction under Sec. 661 because Sec. 642(c) provides the exclusive mechanism for a deduction for payments made to charity by trusts and estates. However, if the trust were entitled to a Sec. 661 distribution deduction, the IRS found that distributable net income (DNI) for the tax year would include capital gains because the trust terminated and distributed all of its assets.

The trust was created for the benefit of two children during their lives and then for the benefit of their descendants, subject to a testamentary power of appointment granted to each child to appoint the income among descendants, spouses of descendants, and charities. After the death of Child 1, the trustees and beneficiaries of the trust divided it into two trusts, Trust A and Trust B, for the respective benefit of Child 1′s descendants and Child 2. Subsequently, Trust B filed a petition with the state court requesting the following modifications to Trust B: (1) that Child 2′s testamentary power of appointment be changed to an inter vivos power and (2) that Child 2 be allowed to immediately exercise the power to appoint all of the income and principal of Trust B to two private foundations. The court approved the modifications and termination of Trust B. On its original income tax return, Trust B did not claim a charitable deduction for payments made to the foundations. However, it later amended its return to claim a deduction for the entire amount paid to the foundations, less attorney and preparer fees. The amended return included Form 8275-R, Regulation Disclosure Statement, claiming the charitable deduction was allowed under Sec. 642(c)(1) and/or Sec. 642(c)(2), or alternatively, under Sec. 661.

Whether Trust B was entitled to a charitable deduction under Sec. 642(c): Under Sec. 642(c)(1), a trust is allowed as a deduction “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 [Sec.] 170(c).”

The IRS examined case law on whether amounts were paid from a trust “pursuant to the governing instrument.” For example, in Old Colony Trust Co.,¹⁷ the Supreme Court held that for purposes of determining whether a trust was entitled to receive a deduction for charitable contributions, the phrase “pursuant to” does not mean directed or definitely enjoined, but instead should be defined as “acting or done in consequence or in prosecution (of anything); hence, agreeable; conformable; following; according.”¹⁸ In Brownstone,¹⁹ a distribution was made from a marital deduction trust to the deceased wife’s estate, which then passed entirely to charitable beneficiaries under the wife’s will. The Second Circuit concluded that the marital deduction trust was not entitled to a charitable deduction because the “governing instrument” was the husband’s original will, while the charitable payment was made pursuant to the wife’s will. In Emanuelson,²⁰ a will dispute resulted in a written compromise agreement. Payments made to a charity according to the written compromise agreement were held to be made “pursuant to” the will.

Ultimately, the IRS concluded that the case law does not hold that a modification to a governing instrument will be construed to be the governing instrument in situations where the modification does not stem from a conflict. In other words, the IRS’s position is that in order to treat a modified trust as the governing instrument, the modification must have been made as a result of a conflict. In this case, the modified trust was not treated as the governing instrument because the purpose of the court order modifying the trust was not to resolve a conflict but, instead, to obtain an economic benefit. Therefore, Trust B was not entitled to a deduction under Sec. 642(c) for payments made to the foundations.

Whether Trust B was entitled to a distribution deduction under Sec. 661: The IRS next analyzed whether Trust B was entitled to a distribution deduction under Sec. 661 even if it was not entitled to a deduction under Sec. 642(c). Sec. 663(a)(2) and Regs. Sec. 1.663(a)-2 provide that a deduction that is allowed under Sec. 642(c) may not be deducted under Sec. 661. Regs. Sec. 1.663(a)-2 states that any amount paid, permanently set aside, or to be used for the purposes specified in Sec. 642(c) and that is allowable as a deduction under that section is not allowed as a deduction to an estate or trust under Sec. 661 or treated as an amount distributed for purposes of determining the amounts includible in gross income of beneficiaries under Sec. 662. Amounts paid, permanently set aside, or to be used for purposes set for them in Sec. 642(c) are deductible by estates or trusts only as provided in Sec. 642(c).

The IRS analyzed the legislative history to Secs. 661 through 663 and concluded that it does not make the purpose and scope of Sec. 663(a)(2) entirely clear. However, a Senate report does include an example in which an amount paid to a charity is not entirely deductible under Sec. 642(c) because a ratable part of it is attributable to tax-exempt interest (which is not included in gross income), but such amount is not added back for purposes of determining the Sec. 661 distribution deduction.²¹ The IRS then discussed case law, in particular Mott,²² which determined that Regs. Sec. 1.663(a)-2 is reasonable. The case law suggests that Secs. 661 and 662 are incompatible with Sec. 642(c)—the former combine “the pre-1954 conduit theory of trust and estate taxation with a conclusive presumption that distributions are distributions of income (to the extent of DNI),” while the latter “preserves the prior tracing requirements by the explicit reference to ‘gross income.’ ” Ultimately, if a distribution to a charity were deductible under Sec. 661, it is possible that an amount would be allocated to a charitable beneficiary that bears no relationship to the amount of income actually paid to the charity.

While the IRS recognized that commentators are divided on whether the Mott line of cases is correct, it concluded that, pursuant to Regs. Sec. 1.663(a)-2, Sec. 642(c) provides the exclusive means for a trust or estate to take an income tax charitable deduction, for the following reasons: (1) Sec. 642(c) is a specific statute, while Sec. 661 is general, and the specific statute should be controlling; (2) charitable payments are not included in the conduit tax system applicable to trusts and estates, as evidenced by the “gross income” tracing requirement in Sec. 642(c); (3) where both an income and estate tax charitable deduction are claimed, a double benefit could arise if a contribution of corpus were deductible under Sec. 661; and (4) the regulation was enacted shortly after the statute it interprets and has not been subsequently overturned by Congress. Therefore, the IRS concluded that Trust B was not entitled to a deduction under Sec. 661 for payments made to the foundations.

Whether DNI includes capital gains in the year payments are made to the foundations: Although the issue was moot because Trust B was not entitled to a Sec. 661 deduction, the IRS analyzed whether Trust B’s DNI would include capital gains for the year it distributed all of its principal and income to the foundations if a Sec. 661 deduction were allowed. Under Sec. 643(a)(3), gains from the sale or exchange of capital assets are excluded from DNI to the extent such gains are allocated to corpus and are not (1) paid, credited, or required to be distributed to any beneficiary during that tax year or (2) paid, permanently set aside, or to be used for the purposes specified in Sec. 642(c).

Regs. Sec. 1.643(a)-3(b)(3) provides that gains from the sale or exchange of capital assets are included in DNI to the extent they are allocated to corpus but actually distributed to the beneficiary. The regulations provide an example in which a trust distributed all of its assets to its beneficiary upon termination of the trust. In that case, capital gains realized in the year of termination were included in DNI. Ultimately, the IRS concluded that the termination of a trust and distribution of all of its assets is one situation in which capital gains are considered “actually distributed” and, therefore, included in DNI.

Comment: It is questionable whether the IRS’s position regarding Sec. 642(c) is correct. If a trust is properly modified or decanted pursuant to state law, there is nothing the author has found in Sec. 642(c) or case law that would not otherwise give effect to the modification or decanting on a prospective basis. The author is aware of rulings in which the IRS or the courts have determined that a modification of a trust may not be given retroactive effect where there is not a conflict to settle among beneficiaries of a trust; however, there is nothing in these determinations that would not otherwise give prospective effect to a trust modification if it is validly done pursuant to state law. If the IRS is correct, it would seem to call into question whether any modification of a trust that is not done pursuant to a conflict among beneficiaries should otherwise be given effect for tax purposes—an uncertainty the courts should not allow.

Charitable remainder trusts

Probability-of-exhaustion test

The IRS issued Rev. Proc. 2016-42, providing a sample provision that may be included in charitable remainder annuity trust (CRAT) instruments that provide annuity payments for one or more measuring lives followed by the distribution of trust assets to one or more charitable remainder beneficiaries. Rev. Proc. 2016-42 was effective Aug. 8, 2016, and applies to CRATs created on or after that date.

Sec. 664(d)(1) contains the requirements for CRATs. In Rev. Rul. 70-452, the IRS applied those rules to a split-interest charitable remainder trust and ruled that if there is a greater-than-5% probability that payment of the annuity will defeat the charity’s interest by exhausting the trust assets by the end of the trust term, then the possibility that the charitable transfer will not become effective is not so remote as to be negligible (i.e., the “probability of exhaustion test”). Rev. Rul. 77-374 applied the probability-of-exhaustion test to a CRAT. Under the test, if the probability that the life beneficiaries will survive exhaustion of the CRAT assets is greater than 5%, the CRAT’s charitable remainder interest will not qualify for an income, gift, or estate tax charitable deduction, and the CRAT will not be exempt from income tax under Sec. 664(c).

Section 5 of Rev. Proc. 2016-42 contains the sample provision, which allows the trust to satisfy the probability-of-exhaustion test. Under the sample provision, the CRAT will terminate early on the date immediately before the date of an annuity payment that, if made, would reduce the trust corpus value (multiplied by a specified discount factor) to less than 10% of its initial value. Upon termination, the remaining CRAT assets will be distributed to the charitable remainder beneficiary or beneficiaries.

The IRS will treat the sample provision as a qualified contingency under Sec. 664(f). If a CRAT contains a provision that is similar but not identical to the sample provision, the CRAT may not be disqualified, but it will not be assured of qualified contingency treatment.

Comment: Rev. Proc. 2016-42 was issued in response to a low-interest-rate environment that did not exist when the IRS created the exhaustion test in the 1970s. (In fact, the test preceded the use of the applicable federal rates (AFRs) in determining the value of income and remainder interests.) As a result of historically low interest rates on U.S. government debt, CRATs that failed the 5% probability test became so common that they caused CRATs to be unavailable to a segment of the population that could have used them before the 2008 financial crisis. For example, in May 2014, the AFR rate used in valuing the remainder interest of a CRAT was 2.4%. With an AFR of 2.4%, the youngest permitted age for a 5% annual annuity is 56 to meet the 10% minimum remainder requirement in Sec. 664(d)(1)(D) (an 11.2% remainder interest). However, there is a 41.76% probability that the 56-year-old individual will be alive when the trust expires in 28 years. Thus, the trust flunks the 5% probability test.

Both before and after this revenue procedure, CRATs are subject to potential exhaustion because of the negative consequence of even one bad year of performance, due to the annual measurement requirement. Once the qualified contingency language is added, it may result in more CRATs terminating early, which may precede the actual exhaustion of trust assets. Consequently, this new provision results in the charity’s getting some value at the end of the term. Said differently, the new provision causes the charitable remainder’s interest to be more protected, but at the expense of the income beneficiary.

Private foundation rules

In Letter Ruling 201713003, the IRS ruled that a trust structured as a charitable remainder trust (CRT) was not subject to the private foundation rules.

The grantor created a charitable remainder unitrust (CRUT) that would pay the grantor a unitrust interest for 20 years and then would distribute the remainder to a charitable organization. The grantor had never claimed an income, gift, or estate tax charitable deduction with respect to the trust since it was created. The trustee of the trust requested a ruling that Sec. 4947(a)(2) did not apply to the trust.

Regs. Sec. 1.664-1(a)(1)(iii)(a) defines a CRT as a trust to which a deduction is allowable under Sec. 170, 2055, 2106, or 2522 and that meets the description of a CRAT, as described in Regs. Sec. 1.664-2, or a CRUT, as described in Regs. Sec. 1.664-3. This provision does not require that a taxpayer actually take a deduction under one of these sections—it just requires that one be “allowable.”

Sec. 4947(a)(2) provides that in the case of a trust that is not exempt from tax under Sec. 501(a), not all of the unexpired interests in which are devoted to one or more charitable purposes, and for which a charitable deduction has been allowed under Sec. 170, 545(b)(2), 556(b)(2), 642(c), 2055, 2106(a)(2), or 2522, the private foundation rules apply as if such trust were a private foundation. These rules generally include those of Sec. 4941 (taxes on self-dealing), Sec. 4943 (taxes on excess business holdings), Sec. 4944 (investments that jeopardize a charitable purpose), and Sec. 4945 (taxes on taxable expenditures). Regs. Sec. 53.4947-1(a) provides that for purposes of Sec. 4947, a trust is presumed (in the absence of proof to the contrary) to have amounts in trust for which a charitable deduction was allowed under one of the charitable deduction sections if a deduction would have been allowable under one of the sections. Thus, Sec. 4947 essentially prevents a taxpayer from using a CRT to get around the private foundation rules.

The IRS noted that the CRUT was not exempt from tax under Sec. 501(a) (presumably, it was exempt under Sec. 664(c)(1), but the letter does not state that the trust was a qualified CRUT). It then noted that because the remainder interest would be distributed to a charitable organization, part of the CRUT’s unexpired interest was devoted to one or more charitable purposes. It ultimately ruled that the CRUT was not subject to the private foundation rules even though a charitable deduction may have been allowable, because the taxpayer did not, in fact, take a charitable deduction. The IRS added that, for future years, the burden would be on the taxpayer to keep records to show, through the life of the unitrust interest, that no deduction was ever taken. Without such proof, Regs. Sec. 53.4947-1(a) would presume that the taxpayer had taken a deduction, and the private foundation rules would therefore apply.

Comment: It is hard to tell from the letter ruling why the taxpayer created the CRUT, but the taxpayer clearly did not want the private foundation rules to apply. Perhaps the taxpayer was transferring to the CRUT zero-basis stock with an intention to sell it to a disqualified person (e.g., the taxpayer’s child). The taxpayer would not have been entitled to an income tax charitable deduction because of the limitations on capital gain property, but the taxpayer would have been able to take advantage of the deferral of gain allowed for CRTs. Presumably, the gift of the remainder interest was incomplete, such that the gift tax charitable deduction was not applicable at the creation of the trust (but ultimately would be, at the time of the transfer of the remainder interest to charity). Tax practitioners have struggled with the meaning of the terms “allowed” and “allowable.” If a taxpayer is entitled to a deduction and he or she does not take it, is it presumed that the taxpayer took it and, thus, the terms are synonymous? The private foundation rules create such a presumption; however, it is rebuttable. If this result is correct, taxpayers will be able to create CRTs and avoid the private foundation rules by not taking charitable deductions—something Sec. 4947(a)(2) was meant to prevent.

Failure to function exclusively as a CRT

In Letter Ruling 201714003, the IRS ruled that a trust was not a CRUT because it did not function exclusively as a CRT. This result was due to errors and mistakes of the decedent and the decedent’s tax advisers.

The decedent created a net income with makeup provision CRUT (NIMCRUT) that was intended to qualify as a CRUT. The decedent transferred to the CRUT low-basis capital assets that the CRUT would sell. The decedent was the initial unitrust recipient, and another person was named the successor unitrust recipient upon the decedent’s death. The CRUT was not intended to create a taxable gift at its formation; however, it did create a taxable gift because the successor unitrust recipient could not be changed. The CRUT was to make payments to the decedent for the remainder of the decedent’s life or for a term of 20 years, whichever was shorter. If the decedent died prior to the expiration of the 20-year term, the payments would be made for the balance of the term to the successor unitrust recipient. A charitable organization was named the remainder beneficiary.

The tax adviser represented that if the assets of the CRUT were invested as the tax adviser recommended, they would generate a certain annual return. The tax adviser further advised that the decedent would receive a guaranteed certain annual return on the FMV of the CRUT’s assets. While the trust was supposed to be a regular CRUT, it was drafted as a NIMCRUT, which limits the unitrust amount to the net income of the trust.

The CRUT invested in annuities and insurance products. This made it difficult for the CRUT to generate the guaranteed return without including capital gains in income, which it could not do because, under state law, capital gain was allocable to corpus. However, due to erroneous advice, capital gains were allocated to income, leading to unitrust payments exceeding the CRUT’s income.

After the decedent’s death, the successor unitrust recipient sought a state court’s assistance to fix the mess that the tax adviser had created. The state court issued a declaration and order determining that the CRUT was void ab initio,contingent on receiving a favorable ruling from the IRS. The CRUT sought rulings on the following issues:

The trust should not be respected as a CRUT because it did not function exclusively as a CRT throughout its existence: Sec. 664(c)(1) provides that a CRT is not subject to income tax. Regs. Sec. 1.664-1(a)(4) states that for a trust to be a CRT, it must meet the definition of, and function exclusively as, a CRT from the creation of the trust. In Estate of Atkinson,²³ the Tax Court determined that a trust never qualified as a CRT because of improper administration that violated the rules for CRTs. Such improprieties could not be corrected by the trust’s reformation. The IRS ruled that the CRUT failed to operate exclusively as a CRT because excess distributions were made due to improprieties that could not be corrected, and, thus, the CRUT did not function exclusively as a CRT.

The state court’s determination that the trust was void ab initio will not result in any additional federal taxes: In Rev. Rul. 80-58, the IRS stated that the legal concept of rescission refers to the abrogation, cancellation, or voiding of a contract that has the effect of restoring the parties to the relative positions that they would have occupied had no contract been made. However, according to the annual accounting principle, each tax year is treated as a separate unit for tax accounting purposes, regardless of subsequent events. In Rev. Proc. 2016-3, the IRS stated that it would not issue rulings on whether a completed transaction may be rescinded for federal income tax purposes. Therefore, the IRS was unable to give a ruling on whether the state court’s declaration that the CRUT was void ab initio would have no federal tax consequences.

The trust is described in Sec. 4947(a)(2): Here, the CRUT failed to maintain its exemption under Sec. 664 but was still subject to the split-interest trust rules under Sec. 4947(a)(2). The IRS ruled the CRUT was subject to the private foundation rules because (1) the trust was not exempt from tax under Sec. 501(a); (2) not all of the unexpired interests in the CRUT were devoted to charitable purposes; and (3) the CRUT contained an amount in trust for which a deduction was allowed under Sec. 170. The IRS determined that the deductions were considered “allowed” because they were unchallenged by the IRS under Virginian Hotel Corp.,²⁴ in which the Supreme Court held an unchallenged claimed deduction is considered allowed. Thus, the CRUT was required to terminate its private foundation status under Sec. 507 before it could avoid being subject to any taxes related to private foundations.

A judicial termination of the trust will not result in any additional federal income tax: Sec. 4941 imposes an excise tax on a disqualified person where there is self-dealing between a private foundation and a disqualified person for the year in which the self-dealing takes place. Self-dealing includes a transfer from a private foundation to a disqualified person. Sec. 4945 imposes an excise tax on a private foundation on taxable expenditures. Under Sec. 4945(d)(5), a taxable expenditure includes amounts paid by a private foundation that are not for a charitable purpose.

The successor unitrust recipient intended to terminate the trust and distributed its assets to the successor unitrust recipient without regard to the interest of the charitable remainder beneficiary. The IRS ruled that such a distribution before the CRUT’s private foundation status terminates would be a taxable expenditure under Sec. 4945(d)(5) in the amount of the actuarial value of the charitable remainder interest. It further ruled that the successor unitrust recipient was a disqualified person and that a terminating distribution to the successor unitrust recipient would be an act of self-dealing under Sec. 4941 that would have to be corrected in the future. Failure to correct the taxable expenditure on the part of the CRUT and the self-dealing on the part of the successor unitrust recipient would result in additional taxes.

Grantor trusts

Disregarded entity

On June 10, 2016, Treasury and the IRS issued final regulations²⁵ defining the term “taxpayer” for purposes of the exclusions from cancellation-of-debt income in cases of bankruptcy and insolvency under Secs. 108(a)(1)(A) and (B). The final regulations adopt without significant change proposed regulations,²⁶ which were published on April 13, 2011.

Sec. 61(a)(12) provides that income from a discharge of indebtedness is includible in gross income. However, Secs. 108(a)(1)(A) and (B) exclude from gross income any amount that would be includible in gross income by reason of the discharge of indebtedness of the taxpayer if the discharge occurs in a bankruptcy case (the “bankruptcy exclusion”) or to the extent that the taxpayer is insolvent when the discharge occurs (the “insolvency exception”).

Some taxpayers have taken the position that the bankruptcy exception is available if a grantor trust or disregarded entity is under the jurisdiction of a bankruptcy court, even when the owner is not. Similarly, in the case of the insolvency exception, some taxpayers have taken the position that the exception is available to the extent a grantor trust or disregarded entity is insolvent, even when the owner is not.

The final regulations clarify that for purposes of applying Secs. 108(a)(1)(A) and (B) involving a grantor trust or a disregarded entity, the term “taxpayer” refers to the owner(s) of the grantor trust or disregarded entity. Therefore, the debtor in a bankruptcy case is the owner of the grantor trust or disregarded entity, or the insolvent taxpayer is the owner of the grantor trust or disregarded entity. Additionally, the regulation provides that, in the case of a partnership, the ownership rules apply at the partner level to the partners to whom the discharge of indebtedness is allocable.

Modification to include tax reimbursement clause

In Letter Ruling 201647001, the IRS ruled that certain modifications to a grantor trust, including the addition of a tax reimbursement clause, will not cause inclusion in either the grantors’ or the beneficiaries’ respective gross estates.

The trust was an irrevocable grantor trust. The trustees were an independent trustee and three children of the grantors. The independent trustee had the sole discretion to make income and principal distributions to the grantors’ issue. The grantors were not trust beneficiaries.

Due to unanticipated circumstances, the grantors’ payment of the income taxes on the trust’s income had become unduly burdensome. The independent trustee sought court approval to modify the trust. Only the independent trustee had the power to make distributions to trust beneficiaries, and the trust’s dispositive positions were not modified. The IRS made the following rulings with respect to the proposed modifications:

Powers to remove and replace trustees: The grantors would retain the power to remove and replace the trustees, including the independent trustee. In Rev. Rul. 95-58, the IRS ruled that reservation of an unqualified power to remove a trustee and appoint a new trustee will not be considered the reservation by the grantor of the trustee’s discretionary powers of distribution for estate or gift tax purposes if the grantor can only appoint an individual or corporate successor trustee that is not related or subordinate, within the meaning of Sec. 672(c), to the grantor. Thus, such power will not cause (1) estate tax inclusion under Sec. 2036 (regarding transfers with a retained interest) or (2) the independent trustee’s discretionary distribution powers to be attributed to the grantors for gift tax purposes.

After the modifications, the trust would require that any successor independent trustee appointed by the grantors cannot be related or subordinate to the grantors within the meaning of Sec. 672(c). Thus, the grantors’ retained removal and replacement powers will not be considered a reservation of the independent trustee’s power under Sec. 2038 and, therefore, will not cause trust corpus to be included in the grantors’ respective gross estates under Sec. 2038. Further, the family trustees will not possess any powers to distribute income or corpus to the trust beneficiaries. Thus, the grantors’ powers to remove and replace the family trustees will not cause the trust corpus to be included in the grantors’ respective gross estates under Sec. 2038.

Substitution power: Pursuant to Rev. Rul. 2008-22, the corpus of a trust is includible in the grantor’s gross estate under Sec. 2036 or 2038 if the grantor retained the power, exercisable in a non­fiduciary capacity, to acquire property held in the trust by substituting property of equivalent value.

Although the grantors retained such a power, the trust would provide that the trustee has a fiduciary obligation to ensure the grantors’ compliance with the terms of this power by ensuring that properties acquired and substituted are in fact of equivalent value and that the substitution power is not exercised in a manner that can share benefits among trust beneficiaries. Thus, the grantors’ substitution power would not cause trust property to be included in the grantors’ respective gross estates.

Tax reimbursement clause: The IRS has ruled in Rev. Rul. 2004-64 that a trust’s corpus will be includible in the grantor’s gross estate under Sec. 2036 if the trustee must reimburse the grantor for income taxes paid by the grantor with respect to the trust’s income. After the modifications, the independent trustee will have the discretion to reimburse either grantor with respect to the income tax liability actually incurred by the grantor attributable to trust items. Only a trustee who is not related or subordinate to either grantor, within the meaning of Sec. 672(c), will be able to exercise the reimbursement power. Accordingly, assuming there is no understanding, express or implied, between the grantors and the independent trustee regarding the independent trustee’s exercise of discretion, the reimbursement power will not cause inclusion of trust corpus in either grantor’s gross estate.

Family trustees’ ability to remove and replace trustees: A general power of appointment over trust property will cause inclusion of trust property in the power holder’s gross estate under Sec. 2041. Additionally, under Sec. 2514, the exercise of a general power of appointment is deemed to be a transfer of property by the power holder for gift tax purposes. However, a power that cannot substantially affect the beneficial enjoyment of the trust property or income is not a power of appointment.

After the modifications to the trust, the family trustees will have the right to remove any trustee and appoint a successor trustee, provided that the successor may not be related or subordinate within the meaning of Sec. 672(c). The successor family trustees will not have the power to distribute trust income or corpus, and the independent trustee will have full discretion over such distributions. Therefore, the power will not cause the family trustees to hold a general power of appointment within the meaning of Sec. 2041 or 2514.

GST tax consequences: The trust became irrevocable after Sept. 25, 1985. The trustee represented that sufficient GST exemption was allocated to the trust so that the trust had an inclusion ratio of zero. No guidance has been issued concerning changes that may affect the status of GST-exempt trusts because sufficient GST exemption was allocated to the trust to result in an inclusion ratio of zero. The IRS ruled that, at a minimum, the proposed modifications would not affect the GST status of the trust and, therefore, would not affect its exempt status. Further, the IRS noted that the proposed modifications were mostly administrative in nature and would not be considered to shift a beneficial interest to a lower generation in the trust or extend the time for vesting of any beneficial interest in the trust.

Grant of additional powers to grantors: Generally, gain from an exchange of property is included in the transferor’s gross income under Sec. 1001. Ordinarily, to constitute an exchange, a transaction must be a reciprocal transfer of property. The IRS ruled that the trust modifications did not constitute a reciprocal transfer of trust property under Sec. 1001 because (1) the grantors are treated as owners of the entire trust before and after the proposed modifications, and (2) the beneficiaries will have the same beneficial interests in the trust both before and after the proposed modifications.

Comment: The IRS routinely rules favorably on the income, gift, estate, and GST tax impact of trust modifications when they are merely administrative in nature. One of the more recent items on which it has been asked to rule is the tax implications of the addition of a tax reimbursement clause to grantor trusts. These clauses give the trustee of the trust the discretion to reimburse the grantor of the trust for the income tax liability caused to the grantor by the inclusion of the income of the trust in the grantor’s taxable income. Commentators have questioned whether the addition of such a clause causes adverse transfer tax consequences.

If one considers the addition of the clause the equivalent of adding a new beneficiary of the trust, the IRS might argue that the modification had gift or estate tax consequences. However, if one considers the addition of such a clause as allowing the trustee to pay the equivalent of a creditor of the trust, there should be no gift or estate tax consequences. Further, the exercise of such a clause should be considered the payment of an expense of the trust and should not constitute a distribution for income tax purposes. Apparently, the IRS believes the exercise is a payment of an expense.

Tax reform

Just a brief note on tax reform: On April 26, 2017, President Trump released a brief outline of his proposals for tax reform. Contained within this outline is his campaign promise to “repeal the death tax.” The outline contains no details as to what “repeal” encompasses. On the campaign trail, then-candidate Trump provided a somewhat more detailed statement regarding the repeal of the estate tax by proposing to eliminate estate and gift taxes but disallow a step-up in basis for estates over $10 million. Presumably, that would mean that for estates over $10 million, there would be carryover basis. It could, however, mean that, for estates over $10 million, there would be a deemed sale of estate assets, producing an income tax consequence. At this early stage of tax reform, any discussion of likely outcomes is pure speculation.

Inflation adjustments

The IRS released Rev. Proc. 2016-55 setting forth inflation adjustments for various tax items for 2017. The following list 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 2017, the basic exclusion amount is $5,490,000 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 tax exemption.

Valuation of qualified real property in a decedent’s gross estate: For the estate of a decedent dying in calendar year 2017, 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 resulting from the election for purposes of the estate tax cannot exceed $1,120,000.

Gift tax annual exclusion: The gift tax annual exclusion for gifts of a present interest remains $14,000 in 2017. The gift tax annual exclusion for gifts of a present interest to a spouse who is not a U.S. citizen is $149,000.

Interest on a certain portion of the estate tax payable in installments: For an estate of a decedent dying in 2017, 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 $1,490,000.  

Footnotes

¹Hewlett-Packard Co., 67 T.C. 736 (1977).

²REG-163113-02.

³Notice 2017-38.

⁴Kerr, 292 F.3d 490 (5th Cir. 2002).

⁵Estate of Harrison, T.C. Memo. 1987-8.

⁶Regs. Sec. 25.2704-1(a)(2)(v).

⁷Regs. Sec. 25.2704-1(c)(1).

⁸Id.

⁹Id.

¹⁰Sec. 2704(b)(3)(B).

¹¹Preamble, REG-163113-02, citing H.R. Conf. Rep’t No. 101-964, 101st Cong., 2d Sess. 1138 (1990).

¹²Regs. Secs. 301.7701-1 through -3.

¹³Defined in Sec. 1361(a)(1).

¹⁴Defined in Sec. 1361(b)(3)(B).

¹⁵See transcript of hearing; see also AICPA Tax Executive Committee, Comments on REG-163113-02 (Jan. 13, 2017).

¹⁶For updates, readers may consult tax news in The Tax Adviser online at thetaxadviser.com.

¹⁷Old Colony Trust Co., 301 U.S. 379 (1937).

¹⁸Id. at 383, quoting Webster’s New International Dictionary, Unabridged (2d ed. 1935).

¹⁹Brownstone, 465 F.3d 525 (2d Cir. 2006).

²⁰Emanuelson, 159 F. Supp. 34 (D. Conn. 1958).

²¹S. Rep’t No. 1622, 83d Cong., 2d Sess. 351-53 (1954).

²²Mott, 462 F.2d 512 (Ct. Cl. 1972).

²³Estate of Atkinson, 115 T.C. 26 (2000).

²⁴Virginian Hotel Corp., 319 U.S. 523 (1943).

²⁵T.D. 9771.

²⁶REG-154159-09.