Recent developments in estate planning: Part 1

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

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

Gift tax

Adjustment of exemption amounts after Windsor

Before the Supreme Court issued its decision in Windsor,¹ same-sex marriages were not recognized for federal tax purposes, and, therefore, same-sex spouses (1) were not treated as married for gift, estate, or GST tax purposes; (2) could not claim a marital deduction for gifts or bequests to one another; and (3) were required to determine generation assignments for GST tax purposes based on age rather than on familial relationship with their spouse. Following Windsor, the IRS published Rev. Rul. 2013-17, ruling that same-sex couples who are legally married in state and foreign jurisdictions recognizing same-sex spouses would be treated as married for U.S. federal tax purposes prospectively as of Sept. 16, 2013. On Sept. 2, 2016, the Treasury Department and the IRS issued final regulations² amending the regulations under Sec. 7701 to reflect that same-sex marriages are recognized for federal tax purposes.

In Notice 2017-15, the IRS provides special administrative procedures for allowing certain taxpayers and the executors of certain estates to recalculate a taxpayer’s remaining applicable exclusion amount and remaining GST exemption to the extent the exclusion or exemption was allocated to certain transfers made while the taxpayer was married to a person of the same sex.

Gift and estate taxes: Sec. 2501 imposes a gift tax on gratuitous transfers by U.S. citizens or residents. The donor may claim the applicable credit amount under Sec. 2505 against the gift tax imposed by Sec. 2501.³ The applicable credit amount is defined in Sec. 2010(c) as the tentative tax on the applicable exclusion amount. Currently, the applicable exclusion amount is $5,490,000, and the applicable credit amount is $2,141,800. The applicable exclusion amount may be increased by the deceased spousal unused exclusion (DSUE) amount under Sec. 2010(c)(2). Sec. 2523 generally allows an unlimited marital deduction for gifts to spouses as long as the spouse is a U.S. citizen.

Sec. 2001(a) imposes an estate tax on the transfer of the taxable estate of every decedent who was a U.S. citizen or resident at the time of death. The estate may claim a credit under Sec. 2010(a) for an applicable credit amount against the estate tax to the extent the applicable exclusion amount has not been used against gifts made during the decedent’s lifetime. Sec. 2056 generally allows an unlimited marital deduction for bequests to spouses, as long as the spouse is a U.S. citizen.

A taxpayer is generally allowed to file an amended gift tax return or a supplemental estate tax return to claim a marital deduction for a gift or bequest to the taxpayer’s same-sex spouse and to restore the applicable exclusion amount allocated to the transfer, as long as the limitation period for filing a claim for credit or refund under Sec. 6511 has not expired. Notice 2017-15 provides that, if the limitation period has expired, the taxpayer may recalculate his or her remaining applicable exclusion amount as a result of recognizing his or her same-sex marriage. However, once the limitation period on assessment of tax has expired, neither the value of the transferred interest nor any position concerning a legal issue (other than the existence of the marriage) related to the transfer can be changed under Notice 2017-15, and no tax credit or refund will be paid on the marital transfer if the limitation period has expired for requesting a credit or refund.

A taxpayer must recalculate any remaining applicable exclusion amount by (1) using a Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, an amended Form 709, or a Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return; (2) writing at the top of the form that the return is “filed pursuant to Notice 2017-15”; and (3) attaching a statement supporting the claim and detailing the taxpayer’s recalculation.

GST tax: Sec. 2601 imposes a tax on generation-skipping transfers, which are defined under Sec. 2611(a) as a taxable distribution, a taxable termination, or a direct skip, all of which are transfers to or for the benefit of one or more skip persons.⁴ A skip person is defined in Sec. 2613(a) as (1) a person assigned to a generation that is two or more generations below the generation assignment of the transferor (e.g., grandchildren); or (2) a trust, if all interests in the trust are held by skip persons, or if no person holds an interest in the trust and at no time after the transfer a distribution may be made from the trust to a non-skip person. Under Sec. 2651, a person’s generation is determined based on the transferee’s familial relationship to the transferor or the transferor’s spouse, or if there is no such relationship, then based on the difference in age between the transferor and transferee.

Prior to the Supreme Court’s decision in Windsor, determinations regarding a person’s generation with regard to same-sex spouses were made based on the individuals’ ages, as no family relationship was recognized under federal law. In light of Windsor, determinations regarding generations with regard to same-sex spouses will be made according to familial relationship, just as these determinations are made with regard to opposite-sex spouses.

A taxpayer should recalculate (also taking into account the GST implications of any interim transfers) and report any available GST exemption (1) using a Form 709, an amended Form 709, or a Form 706; (2) writing at the top of the form that the return is “filed pursuant to Notice 2017-15”; and (3) attaching a statement indicating that the taxpayer’s allocation of GST exemption in a prior year is void pursuant to Notice 2017-15, a copy of the computation of the resulting exemption allocation(s), and the amount of the exemption remaining available to that taxpayer.

The notice states that the IRS will post on its website (irs.gov) worksheets and instructions to Forms 706 and 709 to be used to properly calculate and report both the recalculated applicable exclusion amount and remaining GST exemption amount.

Comment: Prior to the decision in Windsor, same-sex couples who were legally married could not take advantage of the marital deduction for gift and estate tax purposes that would have negated any gift or estate taxes resulting from gratuitous transfers between them. The transfers likewise may have been subject to GST tax because the determination of whether the transfer is to a skip person was based on the age difference between the spouses. As a result of the federal government’s not respecting the marriage of same-sex couples for federal tax purposes, same-sex couples were forced to use their applicable credit amount and possibly their GST exemption amount to negate any gift, estate, and/or GST taxes that may have resulted from a transfer between them. The notice explains how the IRS will give retroactive effect to the decision in Windsor and allow same-sex couples to reclaim any applicable credit amount and possibly any GST exemption amount that they may have used regarding gratuitous transfers between them in years prior to Windsor. It makes clear, however, that if the statute of limitation has run on any gift or estate tax return that has been filed, the IRS will not refund any amounts that may have been paid with the filing of these returns. Instead, such amounts will be recognized as gift tax paid or payable for purposes of computing the estate tax. The notice also provides that it does not extend the statute of limitation on a gift tax return that has been filed to allow an individual to elect to split gifts between spouses.

Adequate disclosure

In Chief Counsel Advice 201643020, the taxpayer reported a current-year gift on a gift return but omitted several gifts made and reported in prior years. The taxpayer’s omission caused an underassessment of gift tax due on the current-year gift. The IRS did not catch this error until the three-year statute of limitation for gift tax assessment had expired.

The IRS Office of Chief Counsel concluded that while unreported current-year gifts cause the statute of limitation for assessment of gift tax to remain open indefinitely under Sec. 6501(c)(9) for those unreported gifts, a taxpayer’s omission of prior-year gifts on a return does not cause the statute of limitation for assessment to remain open indefinitely under Sec. 6501(c)(9) for the current-year gifts properly reported on a timely gift tax return.

Comment: The IRS got it right here. The adequate-disclosure rules under Sec. 6501(c)(9) only refer to the adequate disclosure of a gift on a tax return. They do not address the proper reporting of gifts in prior years, nor do they address the proper calculation of gift tax regarding a particular return. All that Sec. 6501(c)(9) requires for the statute of limitation to run on a gift reflected on a return is that it be disclosed “in a manner adequate to apprise the Secretary of the nature of such item.”

Estate tax

Family limited partnerships

The IRS was successful in arguing that Sec. 2036 applied in two unrelated cases involving family limited partnerships (FLPs). One of the cases was a fully reviewed Tax Court opinion in which the court explained the interaction between Secs. 2036 and 2043.

Powell: In that case, Estate of Powell,⁵ the Tax Court granted partial summary judgment for the IRS, concluding that a gross estate included the value of a limited partnership interest (approximately $10 million) that the decedent’s son attempted to transfer to a charitable lead annuity trust (CLAT) on behalf of the decedent shortly before she died. Also granting partial summary judgment for the estate, the court concluded that the value of the limited partnership interest was not subject to gift tax. Although all 17 of the judges who reviewed the case agreed that the entire value of the decedent’s partnership interest that her son attempted to donate to the CLAT was includible in the decedent’s gross estate, nine of the judges concurred in the result only, and one drafted a concurring opinion with which six judges agreed, explaining where their reasoning diverged from the majority’s opinion.

Facts: The decedent died on Aug. 15, 2008, leaving her son as the executor of her estate. On Aug. 6, 2008, her son formed an FLP. Two days later, the son (1) acted on his mother’s behalf in transferring approximately $10 million in cash and securities from her revocable trust to the FLP, in exchange for a 99% limited partner interest; and (2) purported to act on his mother’s behalf under a power of attorney (POA) by transferring her limited partnership interest to the CLAT. Under the CLAT’s terms, the mother’s foundation was entitled to a specified annuity for the remainder of the decedent’s life, and the remaining CLAT assets would be divided equally upon her death between two trusts established for her two sons. The POA (1) permitted the decedent’s son to convey the decedent’s property, if she was incapacitated, to the full extent of the federal annual gift tax exclusion under Sec. 2503(b); and (2) included a ratification provision stating that the decedent ratified and confirmed all actions done by or caused to be done by the son under the POA. The decedent was incapacitated during the period at issue.

A gift tax return filed for the decedent’s 2008 tax year reported a $1.66 million taxable gift stemming from the purported transfer of the 99% interest to the CLAT. This amount was based on an appraiser’s valuation that the trust corpus (the 99% limited partnership interest) was worth approximately $7.52 million. This value reflected a 25% discount for lack of control and marketability applied to the approximately $10 million balance in the FLP’s accounts at the time of the transfer to the CLAT.

In separate deficiency notices, the IRS determined a $5.87 million estate tax deficiency and a $2.96 million gift tax deficiency for 2008. The IRS asserted that the 99% limited partner interest was worth approximately $8.52 million on the date of death and that the sons’ total remainder interest in the CLAT was worth approximately $8.36 million because the decedent was terminally ill when the gift was made.

The estate moved for summary judgment in the Tax Court, asserting there was no estate or gift tax deficiency. The IRS also moved for partial summary judgment, arguing that the value of the cash and securities transferred from the decedent’s revocable trust to the FLP in exchange for the 99% limited partnership interest was includible in the decedent’s gross estate under Sec. 2038(a), Sec. 2036(a)(1), or Sec. 2036(a)(2), or that the value of the limited partnership interest that the decedent received was includible in her gross estate because her son did not have authority to transfer that interest to the CLAT.

Whether Sec. 2036(a) or Sec. 2035(a) applied: Generally, Sec. 2036 requires the value of property that a decedent transfers to be included in the gross estate if the decedent retains for life a right to income from the property or can designate that right. Sec. 2038 generally requires the value of transferred property to be included in the gross estate if, on the date of death, the decedent held the right to alter, amend, revoke, or terminate the transferee’s enjoyment of the property.

The IRS contended that (1) Sec. 2036(a)(1) applied to the son’s transfer of cash and securities to the FLP because the transfer was subject to an implied agreement through which the decedent retained possession or enjoyment of the transferred property or the right to the income from it; and (2) Sec. 2036(a)(2) applied because the decedent could have dissolved the partnership and designated who would receive the transferred property or income from it. Further, the IRS asserted that the bona fide sale exception to Sec. 2036(a) did not apply because the estate did not show a significant nontax purpose for creating the FLP and, due to the claimed valuation discount, the transfer was not made for full and adequate consideration. The Tax Court agreed with the IRS’s Sec. 2036(a)(2) argument and therefore did not consider the Sec. 2036(a)(1) argument.

In response to the Sec. 2036(a)(2) argument, the estate asserted that the decedent did not retain her interest in the FLP at the time of death because, although her interest included the right to designate beneficiaries of the transferred assets, she did not retain that right for the remainder of her life (and the brief period for which she held the right was not ascertainable only by reference to her death).

Rejecting the estate’s argument that the gross estate should not include any portion of the value of the cash and securities transferred to the CLAT, the Tax Court noted that (1) the estate’s position assumed that the transfer to the CLAT was valid, and (2) even if the transfer had been valid, Sec. 2035(a) requires transfers to which Sec. 2036 might apply that occur within three years of a decedent’s death to be included in the estate. The court cited Estate of Strangi⁶ as supporting its conclusion that the decedent’s ability, with her sons, to dissolve the FLP constituted a right in conjunction with others to designate those who would possess or enjoy the property she transferred or the income from that property, within the meaning of Sec. 2036(a)(2).

Further, because the estate did not challenge the IRS’s assertion that the transfer did not constitute a bona fide sale for adequate and full consideration, the court noted that (1) if the decedent retained rights to the transferred cash and securities at the time of her death, their value must be included in her gross estate to the extent required under Sec. 2036(a); and (2) if her gift to the CLAT was valid (and she had actually given up all rights to the cash and securities), the assets’ value must nonetheless be included in her estate under Sec. 2035(a) because the transfer occurred less than three years before she died.

Sec. 2043(a) limits inclusions under Sec. 2036(a) or Sec. 2035(a): The Tax Court found that both Secs. 2036(a) and 2035(a) must be read in conjunction with Sec. 2043(a), which provides that, if a transfer like the one at issue involves insufficient consideration, the gross estate includes only the excess of the fair market value (FMV) of the property at the time of the decedent’s death over the consideration the decedent received for it. In other words, if the decedent received inadequate consideration for a transfer, Sec. 2043(a) requires the estate to be made whole by including the amount by which the transfer depletes the decedent’s estate.

However, because the estate did not challenge the IRS’s contention that the decedent’s son had no significant nontax reason for creating the FLP, the transfer did not constitute a bona fide sale for adequate and full consideration. As a result, the inclusion in the decedent’s gross estate by either Sec. 2036(a)(2) or Sec. 2035(a), limited by Sec. 2043(a), also included the amount of any discounts applied in valuing the limited partner interest (an amount the court stated could be characterized as the “hole” in the doughnut). Nonetheless, if the gift to the CLAT were void or revocable, Sec. 2038(a) would apply, and the value of the gross estate would also include the value of that interest (the “doughnut”).

Majority’s application of “recycling of value” theory: The majority opinion noted that this is the first time the Tax Court has applied Sec. 2043(a) to limit the amount includible in the value of a decedent’s gross estate under either Sec. 2036(a) or Sec. 2038(a) involving a transfer to an FLP, because in cases in which the decedent continues to own the FLP interest at death, the IRS generally includes the value of the assets transferred to the FLP instead of the value of the FLP interest that the decedent actually owned at death. Because, in this case, the IRS challenged the validity of the gift (i.e., the donation to the CLAT) that the decedent used to dispose of her FLP interest, the court now had the opportunity to explain why a double inclusion in the decedent’s estate (i.e., the FLP interest and the FLP assets) is illogical and not allowed under Sec. 2043(a).

The Tax Court stated that in Estate of Harper⁷ it had previously considered Sec. 2043(a) and suggested that a partnership interest did not qualify as consideration for purposes of either Sec. 2036(a) or Sec. 2043(a) “if the formation of the partnership did not involve a genuine pooling of assets so that the value of the partnership interest issued to the decedent ‘derived solely’ from the assets he contributed.”⁸ The court reasoned in Harper that fact patterns such as this represent a “recycling of value” rather than a true payment of consideration. However, the court went on to explain, the pooling of assets is relevant to the applicability of the bona fide sale exception in Sec. 2036(a) to a transfer to an FLP and is not a factor in the adequacy of the partnership interest as consideration for the transferred assets (which was relevant to the current case because the IRS challenged the gift of the FLP interests to the CLAT).

Whether the gift to the CLAT was valid: Ultimately, the Tax Court concurred with the IRS’s claim that the decedent’s son lacked the authority under the POA to transfer the decedent’s limited partnership interest to the CLAT, and, therefore, state (California) law deemed the gift as either void or revocable. Although the POA permitted the son to dispose of the decedent’s property, it also limited his power to dispose by gift only to the extent of the annual federal gift tax exclusion.

Rejecting the estate’s assertion that the POA’s ratification provision authorized the son to make the gift to the CLAT, the Tax Court noted that a ratification generally occurs only after the agent acts within the powers granted under the POA. Having already concluded that the son made the transfer outside the authority granted to him in the POA, the court determined that the ratification provision did not apply. Concluding that the transfer to the CLAT was either void or revocable, the court agreed with the IRS’s contention that the entire value of the partnership interest was includible in the gross estate, either under Sec. 2033 (regarding property owned by a decedent at death) if the transfer was void, or under Sec. 2038 (regarding revocable transfers) if it was revocable.

Concurring opinion: The concurring opinion explains why seven of the 17 judges who participated in this case would reach the same conclusion but for quite different reasons and felt the need to write separately to emphasize what the court “did not decide and to highlight what the court need not have decided.”⁹ (Two other judges concurred with the majority opinion in conclusion only but did not participate in the concurring opinion, bringing to nine the total number who disagreed with the majority’s reasoning.)

What the majority did not decide: The concurring opinion notes that the majority never addressed whether the FLP was a valid partnership, pointing out that, although the decedent contributed $10 million in cash and securities, her sons only contributed unsecured promissory notes. Further, when the son transferred the decedent’s assets to the FLP, he was essentially negotiating with himself, as he signed the partnership agreement as a general partner of the FLP for his mother under the POA. The concurring opinion states that the invalidity of the FLP was not addressed because the IRS did not articulate the issue, and addressing it might require resolving disputed facts (which would have made the issue inappropriate for summary judgment).

What the majority need not have decided: The concurring opinion agreed that Sec. 2036(a)(2) applied but did not agree with the majority’s “double inclusion” problem. Instead, the concurring opinion viewed the FLP as an empty box into which $10 million of property was placed. Once the $10 million was included in the gross estate under Sec. 2036(a)(2), the partnership interest had no value distinct from the property transferred to it. The concurring opinion found precedent for its approach in a string of Tax Court cases it cited and saw no double-inclusion problem if Sec. 2036(a)(2) is read (as it should be read) to disregard a transfer and include in the decedent’s estate the property that was the subject of the purported transfer. Finally, the concurrence took the majority to task for declining to take a simple, straightforward path to its result and instead adopting Sec. 2043(a) as the basis of its analysis of the value that was includible in the decedent’s estate—a provision neither party cited in its brief.

Comment: This is a fully reviewed opinion because the Tax Court wanted to articulate the interaction between Sec. 2036 (or, if applicable, Sec. 2035) and Sec. 2043. Although the court has ruled on several occasions that Sec. 2036 applies to transfers to FLPs created during a decedent’s life, this was the first situation in which the decedent did not own at death the partnership interests received in the creation of the FLP.

Sec. 2043 includes in a decedent’s gross estate transfers for insufficient consideration. However, the inclusion is limited to the difference between the value of the assets at the date of the decedent’s death and the value of the consideration received by the decedent in transactions to which Sec. 2036 may apply. In other words, the amount of any discounts and the appreciation of the assets between the date of transfer and the date of the decedent’s death (the doughnut hole) are included in the decedent’s gross estate. The gross estate does not include the assets actually transferred (the doughnut). The majority’s theory is that to include the assets actually transferred would create a double-counting in the decedent’s gross estate—the assets transferred for insufficient consideration and the consideration received for the assets transferred (i.e., the partnership interest).

The concurring opinion admonished the majority for taking an unnecessarily complex route to reach a conclusion that it could have arrived at using the straightforward approach that the court had used in several prior cases. The concurring opinion reasoned that, once the assets representing the partnership interest were included in the decedent’s gross estate, the partnership had no value separate and apart from the assets. Therefore, there was no double-counting, as the majority opinion contended.

Under either theory, the amount includible in the decedent’s gross estate was the date-of-death value of the assets transferred to the FLP. The concurring opinion perceives the majority opinion as validating the discounts in valuing the FLP interests for estate tax purposes and potentially inviting “overly aggressive tax planning.”¹⁰ Although that may be true, the majority opinion seems to correctly apply the rules under Sec. 2036 (or Sec. 2035) and Sec. 2043.

Beyer: In Estate of Beyer,¹¹ the Tax Court held that the decedent’s gross estate must include assets transferred to an FLP because the transfer was not a bona fide sale and there was an implied right that the decedent would continue to have the beneficial enjoyment of the property.

On June 8, 1999, the decedent created the Edward G. Beyer Trust (the “1999 Trust”) and contributed to it stock in various publicly traded companies, the largest block of which was Abbott Laboratories, where the decedent had worked most of his life. A provision in the 1999 Trust required it to pay all expenses of the decedent’s estate, including any estate tax liability. On Oct. 13, 2003, the decedent formed the Edward G. Beyer Limited Partnership (EGBLP) and transferred to it the securities held by the 1999 Trust. EGBLP later deposited 75% of its assets in a restricted management account in the Capital Trust Co. of Delaware. Capital Trust could sell the shares held in the restricted management account without the direction of EGBLP; however, EGBLP did not have such a power. The decedent died on May 19, 2007. The issues before the Tax Court were whether the assets transferred to EGBLP should be included in the decedent’s gross estate under Sec. 2036, and, if so, the value of the included assets.

Sec. 2036 includes in a decedent’s gross estate the value of any interest in property transferred by the decedent in which the decedent retained or reserved for life (1) the use, possession, or right to the income or other enjoyment of the transferred property; or (2) the right to designate the person who shall possess or enjoy the transferred property or its income. Sec. 2036(a) excepts from its application transfers that are a bona fide sale for adequate and full consideration in money or money’s worth.

In addressing whether the bona fide sale exception has been satisfied, the Tax Court uses the test set forth in Bongard,¹² which requires that two criteria be met: (1) There is a legitimate and significant nontax reason for creating the FLP; and (2) the transferors receive interests in the FLP proportionate to the value of their transferred property. If the court determines that the exception has not been met, it must then determine whether there was an express or implied agreement or understanding that the transferor retained possession or enjoyment of the transferred property.

Bona fide sale: The estate argued that the decedent’s legitimate and significant nontax purposes for creating EGBLP were (1) to keep the contributed stock in a block and keep the decedent’s investment portfolio intact; (2) to transition the decedent’s nephew into managing his assets; and (3) to achieve continuity of management by the nephew after the decedent’s death.

Regarding the decedent’s desire to keep the investment portfolio intact, the estate contended that if the decedent had not transferred assets held by the 1999 Trust to EGBLP, those assets would have been divided upon termination of the 1999 Trust and distributed among various family members. The Tax Court did not buy the argument. The court noted that while it was true that the investment portfolio would have been so divided, the decedent could have amended the 1999 Trust instrument at any time to prevent those distributions. It further noted that forming and transferring assets to EGBLP did not achieve the decedent’s desire to maintain his investment portfolio intact because EGBLP’s agreement did not require it to continue to hold the investment portfolio intact before or after his death. In fact, the decedent’s estate acknowledged that the nephew (as manager of EGBLP) could have sold the stock in the investment portfolio if he deemed it necessary. Therefore, the court determined that the decedent’s desire to keep the investment portfolio intact was not a legitimate and significant nontax reason for creating EGBLP.

Regarding the decedent’s desires to transition his nephew into managing his assets and to ensure continuity of their management, the estate argued that forming EGBLP and designating the nephew as a co-trustee of the general partner of EGBLP would allow him to manage the decedent’s assets, and that if EGBLP were not formed, the 1999 Trust assets would be not continue to be managed by the same managers. The court also did not buy these arguments. Before the decedent formed EGBLP and transferred assets to it, the court noted, the nephew could, and in fact did, manage the 1999 Trust’s assets, because of a POA by which the decedent gave his nephew broad management powers over his affairs. Moreover, the court noted that the decedent could have amended the 1999 Trust agreement and named his nephew as the trustee or co-trustee of that trust during the decedent’s lifetime, regardless of whether he formed EGBLP.

Having determined that the decedent had no legitimate and significant nontax reason for creating EGBLP, the court ruled that the bona fide sale exception had not been satisfied.

The Tax Court further determined that even if the estate established a legitimate and significant nontax reason for creating EGBLP, the decedent’s estate still would not qualify for the bona fide sale exception because the adequate and full consideration criterion was not satisfied. The court concluded that it was not met because the record did not establish that EGBLP established and maintained respective capital accounts for its partners or show in those accounts the respective interests that those partners received in exchange for any initial and subsequent contribution they made to EGBLP.

Possession or enjoyment: The Tax Court next had to determine whether there was an express or implied agreement or understanding that the transferor retained possession or enjoyment of the transferred property. In determining that there was an implied agreement, the court noted that EGBLP made various distributions to the decedent (via his revocable trust) at a time when the trust held no interest in EGBLP. It also found that the 1999 Trust was required to pay the decedent’s estate tax liability but did not retain sufficient funds, nor did the decedent contribute additional funds to ensure that the 1999 Trust could pay the liability. Finally, the court determined that the decedent did not retain sufficient funds to pay his personal liabilities.

Valuation: Having determined that the assets transferred to EGBLP were includible in the decedent’s estate under Sec. 2036, the Tax Court then had to determine the value of these assets—the complicating factor being that 75% of the assets were held in a restricted management account. To do so, the Tax Court relied on Estate of Kahn¹³ and Estate of Foster.¹⁴ In Kahn, the decedent’s individual retirement accounts (IRAs) were able to sell marketable securities they held. The court determined that FMV was the appropriate value of the IRA accounts for purposes of the decedent’s estate and did not apply a discount to the securities’ value. Similarly, in Foster, the FMV of assets in the decedent’s marital trust was included in her gross estate without a discount because the trust’s trustees had the authority to buy and sell the assets.

Here, the assets held in the restricted management account by Capital Trust were subject to two provisions in the investment agreement: Dividends and interest on assets held in the account were required to be distributed to EGBLP, and distribution of principal from the account to EGBLP was prohibited. However, Capital Trust still could sell the assets. Therefore, the Tax Court determined that the assets’ undiscounted FMV was includible in the decedent’s gross estate.

Comment: This is not the first case in which the Tax Court has found that the nontax purposes for creating an FLP could have been accomplished by trusts or entities that already existed. Perhaps the court does not fully appreciate the rigidity of many states’ trust codes and that business entities are more conducive to managing income-producing assets. In the end, making distributions to the decedent (via his revocable trust) when he did not own an interest in the FLP doomed this FLP.

This is the first time, however, the Tax Court has addressed the valuation of assets held in a restricted management account. Back in the early 2000s, many who created these accounts believed that because the depositor was giving up access to the assets in them, discounts should apply for gift and estate tax purposes. The court, however, treated these accounts as similar to IRAs and determined that, as long as assets can be bought and sold inside the account, no discounts should apply.

Administrative expenses

In Estate of Koons,¹⁵ the Eleventh Circuit affirmed the Tax Court’s ruling,¹⁶ holding that (1) the decedent’s estate could not deduct as an administrative expense interest payments on a loan to pay its estate tax liability because they were not a necessary expense; and (2) the Tax Court properly relied on the IRS’s expert’s valuation of a limited liability company (LLC) interest owned by the estate.

Prior to his death, the decedent and his family members, directly and indirectly, owned a corporation that was a bottler and distributor of Pepsi products and operated a large vending machine business. The corporation and Pepsi were involved in litigation, and as part of a settlement, the corporation agreed to sell its soft drink and vending businesses to a Pepsi affiliate. In anticipation of the sale, the corporation created an LLC to which it transferred its assets other than the soft drink and vending businesses. The decedent owned a 46.9% voting interest and a 51.5% nonvoting interest in the corporation and the LLC. Around the time of the negotiations for the sale, the decedent decided to liquidate his children’s interests in the business and changed the terms of his revocable trust to eliminate them as beneficiaries, leaving only his grandchildren as beneficiaries. As a result, the children were presented with an agreement to sell their shares, conditioned on the LLC’s agreement to offer to redeem their LLC interests. Each child agreed to the sale and redemption agreement prior to the decedent’s death, even though the actual redemptions of the LLC interests did not take place until shortly after his death. After the redemptions, the estate owned 70.42% voting control of the LLC.

Deductibility of interest paid on loan: When a decedent’s estate consists of mostly illiquid assets, the source of funds to pay federal and state estate taxes and GST taxes becomes an issue. The decedent’s revocable trust borrowed $10.75 million from the LLC to pay the decedent’s estate and GST taxes. Under the terms of the loan, the revocable trust was to make interest and principal payments in installments beginning 18 years after the loan was executed. The terms of the loan prohibited prepayment. The estate claimed a deduction under Sec. 2053(a)(2) for the total amount of interest due on the loan ($71.4 million). These types of loans are generally referred to as Graegin loans because they are similar to the loan transaction approved by the Tax Court in Estate of Graegin.¹⁷

Under Regs. Sec. 20.2053-3(a), an estate is permitted to deduct expenses that are actually and necessarily incurred in the administration of the decedent’s estate. Expenses incurred to prevent financial loss to an estate resulting from a forced sale of its assets to pay estate taxes are deductible administration expenses. Interest payments are not a deductible expense if the estate would have been able to pay the debt using the estate’s liquid assets but instead elected to obtain a loan that will eventually be repaid using those same liquid assets.

The Eleventh Circuit found that it was not necessary for the revocable trust to borrow from the LLC because at the time of the loan (1) the LLC had over $200 million of liquid assets, and (2) the revocable trust had 70.42% voting control over the LLC, which would allow the trust to compel the LLC to make a pro rata distribution to its members. That is, the estate had sufficient liquid assets to pay the estate tax liability. Additionally, the Eleventh Circuit reasoned that the lending merely postponed the necessity for the LLC to make a distribution because the revocable trust would have to rely on future distributions from the LLC to repay the loan. Further, the Eleventh Circuit rejected the estate’s argument that courts must defer to an executor’s business judgment in all instances. Finally, the Eleventh Circuit concluded that a pro rata distribution from the LLC to pay the estate tax liability, compelled by the revocable trust, would not violate the trust’s fiduciary duties to minority shareholders under applicable state law.

Valuation of estate’s interest in the LLC: The Eleventh Circuit next addressed the value of the LLC interests owned by the revocable trust at the decedent’s death. Generally, the value of an asset for estate tax purposes is its FMV at the decedent’s date of death. Because the soft drink and vending businesses were sold before the decedent’s death, the LLC’s assets consisted mainly of cash. The estate valued the LLC interest using a 31.7% discount for lack of marketability. The IRS’s expert argued that the lack-of-marketability discount should be only 7.5%. One difference between the two approaches was that the IRS’s expert assumed that the redemption of the children’s interests would occur, while the estate’s expert assumed that the redemption would not occur.

The Eleventh Circuit agreed with the assumption that the redemptions would occur because the redemption offers were binding contracts by the time the decedent died. The LLC had made written offers to each child to redeem his or her interest, and each had signed the offer. Once signed, the offer letters required the children to sell their interests to the LLC. The court accepted the IRS’s expert’s 7.5% lack-of-marketability discount. The resulting increase in the value of the LLC interests affected not only the estate tax due but also the GST tax due at the decedent’s death. Because the decedent had eliminated the children as beneficiaries of his revocable trust, the trust became a skip person, and GST tax became due at the decedent’s death.

Comment: The Eleventh Circuit’s decision on both issues relies heavily on the estate’s owning a controlling interest in the LLC. Buying out the children when the decedent did certainly affected the amount of the valuation discount and the deductibility of the interest. The lack-of-marketability discount would have been higher if the estate had continued to own the minority voting interest that the decedent owned before the children were bought out. In addition, if the estate had only a minority voting interest, the court could not have so summarily dismissed the interest deduction because the estate could not have forced the LLC to make a cash distribution to its owners that could be used to pay the transfer taxes. In addition, eliminating the children as beneficiaries or even potential beneficiaries of the trust caused the immediate liability for GST tax—definitely an unfortunate result for the decedent’s estate.

QTIP election

In Rev. Proc. 2016-49, the IRS outlines the circumstances under which it will disregard for transfer-tax purposes a qualified terminable interest property (QTIP) election that was not needed to reduce the estate tax liability to zero.

Sec. 2056(a) provides an estate tax marital deduction for property passing to the decedent’s surviving spouse. Sec. 2056(b)(1), however, provides that this deduction is not permitted for a terminable interest passing to the surviving spouse. Sec. 2056(b)(7) provides an exception—the terminable interest rule does not apply to a QTIP.

In some cases, a QTIP election was made when the taxable estate (before allowance of the marital deduction) was less than the applicable exclusion amount under Sec. 2010(c). The QTIP election was not necessary because no estate tax would have been imposed whether or not the QTIP election was made. In other cases, the decedent’s will provided for a “credit shelter trust” to be funded with an amount equal to the applicable exclusion amount under Sec. 2010(c), with the balance of the estate passing to a marital trust intended to qualify under Sec. 2056(b)(7). The estate made QTIP elections for both the credit shelter trust and the marital trust.

The QTIP election for the credit shelter trust was not necessary, because no estate tax would have been imposed whether or not the QTIP election had been made for that trust. In these situations, as a consequence of the unnecessary QTIP election, the property subject to the election would be included in the surviving spouse’s gross estate under Sec. 2044(a) or, if that spouse disposed of the income interest, would be subject to gift tax under Sec. 2519. Further, in the absence of a “reverse QTIP” election under Sec. 2652(a)(3), the surviving spouse would be treated as the transferor of the property for GST tax purposes under Sec. 2652(a).

Due the adverse effects of an unnecessary QTIP election, the IRS received requests for relief in situations where an estate had made an unnecessary QTIP election. In response to these requests, Rev. Proc. 2001-38 was issued, providing that the IRS would disregard and treat as null for estate, gift, and GST tax purposes a QTIP election that was unnecessary to reduce the estate tax liability to zero.

Portability elections were introduced in 2010, when Congress amended Sec. 2010(c) to permit an executor to elect to apply the DSUE amount to the surviving spouse’s subsequent transfers, whether as gifts in life or bequests at death. Some executors who elect portability of the DSUE amount will also make the QTIP election, even though the QTIP election is unnecessary to reduce the estate tax liability to zero. By making the QTIP election, decedents make a larger DSUE amount available to the surviving spouse. The question, however, arises whether an estate may make an otherwise unnecessary QTIP election to maximize the available DSUE amount.

When issuing final regulations¹⁸ in June 2015 addressing requirements for electing portability of a DSUE amount, Treasury and the IRS stated that later guidance would address whether a QTIP election made under Sec. 2056(b)(7) may be disregarded and treated as null and void (under Rev. Proc. 2001-38) when an executor has elected portability of the DSUE amount.

Rev. Proc. 2016-49 now confirms the procedures under which the IRS will disregard a QTIP election, but it provides that these procedures are unavailable if a portability election was made for the DSUE amount under Sec. 2010(c)(5)(A). Thus, if the executor makes a portability election, the QTIP election will not be treated as null and void even if the QTIP election is unnecessary to reduce the federal estate tax liability to zero.

Reasonable cause for filing a late return

In Estate of Hake,¹⁹ a district court held that executors’ reliance on their attorney’s advice constituted reasonable cause for late filing of Form 706 and ordered a refund of previously made penalty payments.

The decedent died on Oct. 2, 2011. Her two sons were the executors of her estate. Neither son had experience with probate law, federal estate taxation, or related matters. The estate was large enough to require the filing of an estate tax return. Form 706 must be filed within nine months of the decedent’s death. An executor can file Form 4768, Application for Extension of Time to File a Return and/or Pay U.S. Estate (and Generation-Skipping Transfer) Taxes, to seek a six-month extension to file the return and a one-year extension to pay estate tax. The executors’ attorney timely filed Form 4768 on June 21, 2012, seeking extensions of time to file Form 706 and to pay any estate tax due. After the IRS approved the extension request, the attorney correctly informed the executors that they had been granted a one-year extension—until July 2, 2013—to pay any estate tax due. However, the attorney mistakenly informed the executors that they also had been granted a one-year extension to filethe return, when the extension actually was only for six months (until Jan. 2, 2013).

The estate made a prepayment of estate taxes on Feb. 12, 2013, approximately five months before the extended payment deadline. This payment was accompanied by a letter in which the executors represented that they had an extension for filing Form 706 until July 3, 2013. The IRS did not contact the executors or the attorney about this inaccurate assertion. The estate filed Form 706 on July 2, 2013, the date the executors were told it was due. The IRS assessed a penalty of $197,868 and interest of $17,202, which were partially offset by the estate’s overpayment of estate tax of $108,527. Thus, the IRS sought to collect $106,544 in penalties and interest from the estate.

When a taxpayer fails to file a tax return by the due date, including any extension of time for filing, a late penalty applies unless it is shown that such failure is due to reasonable cause and not willful neglect. Reasonable cause will excuse a failure to file only if the taxpayer exercised ordinary business care and prudence and was nevertheless unable to file the return within the prescribed time.

There are three categories of late-filing cases, as described by the Supreme Court in Boyle²⁰and further explained by the Third Circuit in Estate of Thouron.²¹ In the first, a taxpayer delegates the task of filing a return to an agent, only to have the agent file the return late or not at all. Reliance upon the agent to file a timely return is not reasonable cause to excuse the late filing. Second, a taxpayer, relying on the advice of an accountant or attorney, files a return after the actual due date but within the time that the lawyer or accountant advised the taxpayer was available. Third, a taxpayer is advised by an accountant or attorney on a matter of tax law.

As an appeal of the case would have been heard by the Third Circuit, the district court relied on the Third Circuit’s interpretation of Boyle in Thouron. Boyle foreclosed reasonable cause only in the first line of cases. The Thouron court read Boyle narrowly and did not interpret it to foreclose reasonable cause in the second or third line of cases.

The district court in Hake determined that the executors were inexperienced and endeavored to exercise care in administering the estate and relied on the advice of the attorney to aid them in that effort. In addition, the court noted that nothing in the record suggested that the executors were cavalier in their attention to the tax rules or were seeking to do anything other than ensure that the estate paid its taxes. Thus, the district court determined that the executors’ late filing of Form 706 was due to reasonable cause because they relied on their attorney’s advice regarding its the due date.

Verification an estate tax return has been closed

In Notice 2017-12, the IRS provides guidance on the methods available to confirm that an examination of an estate tax return has been closed and announces that an account transcript may be used as a substitute for an estate tax closing letter.

Until June 1, 2015, the IRS issued an estate tax closing letter for every estate tax return filed, stating the amount of the net estate tax, the state death tax credit or deduction, and any applicable GST tax liability. On June 1, 2015, the IRS began issuing estate tax closing letters only if asked to do so by the estate at least four months after the estate tax return was filed.

Acknowledging that executors, local probate courts, state tax departments, and others have come to rely on estate tax closing letters to confirm that the IRS’s examination of the estate tax return has been completed and the IRS file has been closed, the Service announced in the notice that an account transcript may substitute for an estate tax closing letter and is available at no charge.

If the IRS examination of the estate tax return has been closed, the estate’s account transcript will include the code 421 and the explanation, “closed examination of tax return.” The IRS explains that an account transcript showing transaction code 421 can serve as the functional equivalent of an estate tax closing letter.

To request an account transcript, an estate representative may file Form 4506-T, Request for Transcript of Tax Return, by mail or fax. To allow time for processing the estate tax return, the IRS suggests requests be submitted no sooner than four months after filing the return. If the estate would like an estate tax closing letter, it may request a letter by calling the IRS at least four months after filing the estate tax return.

Comment: The IRS’s practice of no longer automatically issuing a closing letter puts the duty on the executor to obtain the information necessary to close the estate and so be relieved of liability as the estate’s representative. It might be a best practice to ask agencies or entities that require proof of the IRS’s acceptance of the decedent’s estate tax return whether they will accept the account transcript.

Modified carryover basis

On Jan. 19, 2017, Treasury and the IRS issued final regulations²² that modify the Treasury regulations involving basis rules by including a reference to Sec. 1022 where appropriate. The final regulations adopt the proposed regulations²³ without modification.

Generally, under Sec. 1014(a), the basis of property in the hands of a person who receives property from a decedent is the FMV of the property at the date of the decedent’s death. However, if the decedent died in 2010 and the decedent’s executor made a “Sec. 1022 election,” then the basis of property in the hands of a person acquiring the property from that decedent is governed by Sec. 1022 and not by Sec. 1014.

Sec. 1022(a)(1) generally provides that property acquired from a decedent (within the meaning of Sec. 1022(e)) is treated as having been transferred by gift. If the decedent’s adjusted basis is less than or equal to the property’s FMV determined as of the decedent’s date of death, the recipient’s basis is the adjusted basis of the decedent. If the decedent’s adjusted basis is greater than the FMV, the recipient’s basis is limited to its FMV. Although Sec. 1022 applied only to decedents dying in calendar year 2010, basis determined pursuant to Sec. 1022 will continue to be relevant until all of the property whose basis is determined under that section has been sold or otherwise disposed of. Accordingly, the long-term effects of a Sec. 1022 election could be relevant for taxpayers for decades to come.

The final regulations incorporate into the existing regulations, as appropriate, references to basis as including basis determined under Sec. 1022. One of the more substantive modifications is that of Regs. Sec. 1.684-3(c). Sec. 684 generally requires gain be recognized on any transfer of appreciated property by a U.S. person to a foreign nongrantor trust or foreign estate. For decedents dying in 2010, Sec. 684 also applies to certain transfers of property by reason of death to nonresident aliens. Gain is determined by reference to the FMV of the property over the adjusted basis of such property in the hands of the transferor. Regs. Sec. 1.684-3(c) provides that, in the case of a transfer of property by reason of death of a U.S. transferor to a foreign nongrantor trust, no gain recognition is required if the basis of the property in the hands of the trust is determined under Sec. 1014(a). If the executor of a U.S. decedent did not make a Sec. 1022 election, the regulations confirm that the general exception to gain recognition applies. If the executor of a U.S. decedent made a Sec. 1022 election, the regulations provide, consistent with Rev. Proc. 2011-41 and Notice 2011-66, that there is gain recognition. Any basis increase that the executor allocates under Sec. 1022 will reduce the amount of gain in that property for purposes of Sec. 684.  

Footnotes

¹Windsor, 133 S. Ct. 2675 (2013).

²T.D. 9785.

³Sec. 2505(a).

⁴See also Regs. Sec. 26.2612-1.

⁵Estate of Powell, 148 T.C. No. 18 (2017).

⁶Estate of Strangi, T.C. Memo. 2003-145.

⁷Estate of Harper, T.C. Memo. 2002-121.

⁸Estate of Powell, 148 T.C. No. 18 (2017), slip op. at 30.

⁹Id., slip op. at 48.

¹⁰Id., slip op. at 53.

¹¹Estate of Beyer, T.C. Memo. 2016-183.

¹²Estate of Bongard, 124 T.C. 95 (2005).

¹³Estate of Kahn, 125 T.C. 227 (2005).

¹⁴Estate of Foster, 565 F. App’x 654 (9th Cir. 2014).

¹⁵Estate of Koons, No. 16-10648 (11th Cir. 4/27/17).

¹⁶Estate of Koons, T.C. Memo. 2013-94.

¹⁷Estate of Graegin, T.C. Memo. 1988-477.

¹⁸T.D. 9725.

¹⁹Estate of Hake, No. 1:15-cv-01382 (M.D. Pa. 2/10/17).

²⁰Boyle, 469 U.S. 241 (1985).

²¹Estate of Thouron, 752 F.3d 311 (3d Cir. 2014).

²²T.D. 9811.

²³REG-107595-11.