Recent developments in estate planning: Part 1

By Justin Ransome, CPA, J.D.

PHOTO BY ASCENTXMEDIA/ISTOCK
PHOTO BY ASCENTXMEDIA/ISTOCK
 

EXECUTIVE
SUMMARY

 
  • Notable developments concerning trusts in the 12 months ending in June 2019 include the U.S. Supreme Court's affirmation of an N.C. Supreme Court holding that the state could not tax the income of a trust solely on the basis that a contingent beneficiary resided in the state. A similar case in Minnesota was denied certiorari.
  • An IRS notice clarified the deductibility of certain expenses incurred by estates and nongrantor trusts in the wake of the suspension of miscellaneous itemized deductions subject to a threshold of 2% of adjusted gross income, by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97.
  • The IRS also issued a letter ruling concerning the effect of a trustee's power to allocate the unitrust amounts of a charitable remainder unitrust (CRUT) and designate its charitable class on the CRUT's qualifying as a charitable remainder trust under Sec. 664.
  • Final regulations by the IRS address the addition of nonresident aliens as permissible potential current beneficiaries of an electing small business trust, another TCJA change.
  • Several IRS letter rulings granted relief sought for various inadvertent drafting errors in trust instruments for purposes of generation-skipping transfer tax.

This is the first in a two-part article examining developments in estate, gift, and generation-skipping transfer (GST) tax and fiduciary income tax between June 2018 and June 2019. Part I discusses trusts, GST tax, and inflation adjustments for 2019. Part II will discuss estates and gifts.

Trusts

State taxation of trusts

In North Carolina Department of Revenue v. Kaestner 1992 Family Trust,1 the U.S. Supreme Court unanimously affirmed the N.C. Supreme Court's ruling that the state could not tax the income of a trust based solely upon the presence of a contingent in-state beneficiary.

The settlor formed the trust for the benefit of his children in his home state of New York. The trustee later divided the trust into three trusts, one for the benefit of each of the settlor's children. One of the resulting trusts was the Kimberley Rice Kaestner 1992 Family Trust. The beneficiary, Kimberley Rice Kaestner, became a resident of North Carolina, where she resided during the period at issue (2005 through 2008). The trust was governed by New York law and administrated in the state of New York. The trust did not have a physical presence, make any direct investments, or hold any real property in North Carolina. Furthermore, the trust instrument, financial books and records, and legal records were kept in New York, and all tax returns and trust accountings were prepared there. The custodians of the trust's assets resided in Massachusetts, and all trust income was generated from investments outside North Carolina. For the years at issue, the trustee resided in Connecticut. Under the trust instrument, the trustee had absolute discretion to distribute trust assets. The beneficiary had no right to any distributions and did not receive any while she resided in North Carolina.

North Carolina law taxes a trust's income that is for the benefit of a resident of the state. The North Carolina Department of Revenue interpreted this to mean that a trust owes income tax whenever its beneficiaries live in the state, even if they received no income from the trust, had no right to demand it in the relevant tax year, and could not count on ever receiving it. Thus, North Carolina assessed more than $1.3 million in tax on the trust's accumulated income, based solely on the beneficiary's residence in the state.

The trust paid the assessment and sought a refund of tax paid for 2005 through 2008, arguing that the North Carolina law as applied to the trust was unconstitutional. The N.C. Business Court, the N.C. Court of Appeals, and the N.C. Supreme Court2 each ruled in favor of the trust, holding that the statute, as applied to the trust, violated the Due Process Clauses of both the U.S. Constitution and the N.C. Constitution. The N.C. Department of Revenue appealed the decision to the U.S. Supreme Court.

The issue before the U.S. Supreme Court was whether the Due Process Clause of the U.S. Constitution prohibits states from taxing trusts based solely on the residency of the trust's beneficiaries. The Court limited its holding to the specific facts presented and concluded that North Carolina's taxation of a New York—based trust violated the Due Process Clause because the presence of in-state beneficiaries alone does not empower a state to tax trust income that has not been distributed to the beneficiaries, where the beneficiaries have no right to demand that income and are uncertain to receive it.

The Court began its discussion of the Due Process Clause by citing Quill Corp. v. North Dakota3 and favorably quoted the observation made in Quill that "[t]he [Due Process] Clause 'centrally concerns the fundamental fairness of governmental activity.' "4 Citing additional precedent, the Supreme Court stated that, although the ability to tax is a fundamental power of the states, taxation is legitimate only when it directly correlates to opportunities and/or benefits provided by the state. The Court found, citing Quill, that for a tax to satisfy due-process requirements, first, there must be some minimum connection between a state and the person, property, or transaction it seeks to tax, and, second, the income attributed to the state must be rationally related to values connected with the taxing state.

In the trust beneficiary context, the Court found that the due-process analysis of state trust taxes focuses on the extent of the in-state beneficiary's right to control, possess, enjoy, or receive trust assets. Here, the Court was unpersuaded that the beneficiary's residence in North Carolina supplied the minimum contacts to sustain the tax because the beneficiary did not receive any income during the years in question; had no right to demand trust income or otherwise control, possess, or enjoy the trust assets in those years; and could not count on receiving any specific amount of income from the trust in the future. Thus, the Court held that the tax violated due process.

Many trust practitioners had speculated that the Court might make a sweeping decision regarding the ability of states to tax the income of a trust and the necessary contacts. Instead, the opinion was limited to the law of North Carolina and may be applied only to states that tax in a similar manner, which the Court noted in a footnote were only five — three of which did not base tax solely on the residency of the beneficiary and one of which was phasing out a similar rule, leaving only California, which, unlike North Carolina, taxes trusts only when the beneficiary is noncontingent.

Another, perhaps even more interesting, state trust tax case, Fielding v. Commissioner of Revenue,5 was appealed to the Supreme Court and, at the time of the Kaestner decision, was awaiting a decision whether the Court would grant certiorari.6 In Fielding, the Minnesota Supreme Court analyzed the case under the second prong of Quill's Due Process Clause analysis, which was not addressed in Kaestner — whether a "rational relationship" existed between the income subject to tax and the protections and benefits conferred by the state.

Minnesota claimed that the trusts in dispute in Fielding had the minimum connections with the state for nexus under the Due Process Clause analysis identified in Quill: The grantor was a Minnesota resident when the trusts were established and subsequently, when they became irrevocable trusts; the trust documents relied on Minnesota law; all the assets of the trusts (i.e., stock of an S corporation that was sold) were in Minnesota; and the underlying business was in Minnesota.

The trusts, on the other hand, claimed that the connections between the trust and the state were not sufficient, noting that no trustee had been a Minnesota resident, the trusts had not been administered in Minnesota, the records of the trusts' assets and income had been maintained outside of Minnesota, some of the trusts' income was derived from investments with no direct connection to Minnesota, and three of the four trust beneficiaries resided outside of Minnesota.

The Minnesota Supreme Court agreed with the trusts, finding that the contacts on which the state relied were either irrelevant or too attenuated to establish that Minnesota's tax on the trusts' income from all sources complied with due process. According to the court, attributing all income, regardless of source, to Minnesota for tax purposes would not, as required by the second prong of the Quill due-process analysis, bear a rational relationship with the limited benefits received by the trusts from Minnesota during the tax year at issue. Therefore, it struck down the imposition of state tax on the Fielding trusts as "resident trusts." The Minnesota Supreme Court, however, did not devise a formula to determine how much, if any, income should be apportioned to Minnesota. The U.S. Supreme Court turned down the opportunity to hear the case just one week after having decided Kaestner, thus paving the way for continued litigation by trusts regarding a state's ability to tax them based on contacts with the state.

Deduction of trust and estate administration expenses

In Notice 2018-61, the IRS announced it intended to issue regulations clarifying the effect of new Sec. 67(g) on the deductibility of certain expenses described in Secs. 67(b) and (e) that are incurred by estates and nongrantor trusts.

Added to the Code by the law known as the Tax Cuts and Jobs Act (TCJA),7 Sec. 67(g) suspends the deduction of certain miscellaneous itemized deductions for tax years 2018 through 2025. For purposes of Sec. 67, miscellaneous itemized deductions are defined as itemized deductions other than those listed in Secs. 67(b)(1) through (12), personal exemptions, Sec. 199A deductions, and above-the-line deductions.

The AGI of an estate or trust generally is computed for Sec. 67 purposes in the same manner as that of an individual, although certain additional deductions are allowed. Specifically, Sec. 67(e) provides that the following items may be factored into determining AGI: (1) costs paid or incurred in connection with the administration of the trust or estate that would not have been incurred if the property were held by an individual; and (2) deductions available under Sec. 642(b) (the personal exemption), Sec. 651 (income distribution deduction for trusts distributing current income only), and Sec. 661 (income distribution deduction for estates and trusts accumulating income or distributing corpus). Regs. Sec. 1.67-4(a) further explains that the first exception described above is for miscellaneous itemized deductions for costs paid or incurred in the administration of an estate or nongrantor trust if the costs would not have been incurred had the property been held by an entity other than an estate or nongrantor trust.

In the notice, the IRS points out that some commentators have read new Sec. 67(g) as forbidding estates and nongrantor trusts to deduct any expenses described in Sec. 67(e)(1) and Regs. Sec. 1.67-4 for tax years during which the application of Sec. 67(a) is suspended. The notice states that Treasury and the IRS believe this is incorrect. The notice explains that neither the above-the-line deductions used to arrive at AGI nor the expenses listed in Secs. 67(b)(1) through (12) are miscellaneous itemized deductions.

Thus, because AGI for an estate or trust, as determined under Sec. 67(e), treats expenses described in Sec. 67(e)(1) (those paid or incurred in connection with the administration of an estate or trust that would not have been incurred if the property were not held by the trust or estate) as above-the-line deductions allowable in determining AGI, the suspension of the deductibility of miscellaneous itemized deductions under Sec. 67(a) does not affect the deductibility of payments described in Sec. 67(e)(1).

Noting that nothing in Sec. 67(g) affects the determination of what expenses are described in Sec. 67(e)(1) or inhibits the estate or trust from taking an itemized deduction under Sec. 67(b), the notice states that Treasury and the IRS intend to issue regulations clarifying that estates and nongrantor trusts may continue to deduct expenses described in Sec. 67(e)(1) and amounts allowable as deductions under Sec. 642(b), 651, or 661, including the appropriate portion of a bundled fee, in determining the estate or nongrantor trust's AGI for tax years 2018 through 2025. Further, the notice states that the regulations will clarify that deductions listed in Secs. 67(b) and (e) continue to remain outside the definition of miscellaneous itemized deductions and, thus, are unaffected by Sec. 67(g).

Citing some concerns that Sec. 67(g) could affect a beneficiary's ability to deduct Sec. 67(e) expenses when a trust or estate terminates, as provided in Sec. 642(h), the notice further states that Treasury and the IRS are studying whether Sec. 67(e) deductions and any other deductions that would not be subject to the limitations imposed under Secs. 67(a) and (g) in the hands of an estate or trust should continue to be treated as miscellaneous itemized deductions when they are included as a Sec. 642(h)(2) excess deduction.

This notice should provide comfort to fiduciaries concerned that Sec. 67(g) might prohibit trusts and estates from deducting Sec. 67(e) expenses, such as trustee fees or executor commissions. Given that fiduciaries can rely on the notice for tax years 2018 through 2025, issuing the proposed regulations might not be a high priority for the government, compared with other TCJA projects.

Sprinkling unitrust payments of a CRUT

In Letter Ruling 201845014, the IRS ruled that a provision in the trust agreement of a charitable remainder unitrust (CRUT) empowering the independent trustee to allocate part of the unitrust amount between noncharitable and charitable beneficiaries would not prevent the trust from being a charitable remainder trust under Sec. 664, nor would a provision in the trust agreement allowing the granting of a power to designate the charitable class.

Two CRUTs, whose agreements had substantially similar terms, were created by the same grantor. CRUT 1 required the payment of the unitrust interest for the life of the grantor. CRUT 2 required the payment of the unitrust interest for the life of the grantor and the grantor's spouse, subject to the grantor's right to revoke his spouse's interest.

The CRUT 1 agreement provided that the trustee was to distribute to the grantor: (1) a fixed percentage of the unitrust amount; and (2) such additional portion of the unitrust amount, if any, as the independent trustee determined necessary to ensure the total portion of the unitrust amount distributed to the grantor in each tax year was not de minimis under the facts and circumstances. The CRUT 2 agreement provided for the same, except that the amount distributed was to the grantor or, after the grantor's death, the grantor's wife, if she survived the grantor and he had not revoked the survivor unitrust interest.

Under both CRUT agreements, after providing for distribution of a minimum amount by the trustee to the grantor or, in the case of CRUT 2, the grantor's spouse, the trustee was to distribute the balance of the unitrust amount to (1) the grantor (in the case of CRUT 1) or the grantor and then the grantor's spouse (in the case of CRUT 2) and (2) one or more charitable organizations included in the charitable class and in such portions as the independent trustee would select in his sole discretion. The CRUT agreements defined the charitable class as one or more charitable organizations that the grantor designated or, if the grantor did not designate a charitable class before the payment date, one or more charitable organizations as the independent trustee, in his sole discretion, would determine.

The grantor requested rulings that: (1) the independent trustee's power to allocate a portion of the unitrust amount between noncharitable and charitable beneficiaries would not prevent the CRUTs from qualifying as qualified charitable remainder trusts under Sec. 664; and (2) the grantor's power to designate the charitable class of the CRUTs would not prevent the CRUTs from qualifying as charitable remainder trusts.

As explained in the letter ruling, Sec. 674(a), which provides the general rule that the grantor is treated as the owner of any portion of a trust in respect of which the beneficial enjoyment of the corpus or the income from it is subject to a power of disposition, exercisable by the grantor or a nonadverse party, or both, without the approval or consent of an adverse party. However, Sec. 674(c) provides that the general rule in Sec. 674 does not apply to a power solely exercisable, without the approval or consent of any other person, by a trustee or trustees, none of whom is the grantor, and no more than half of whom are related or subordinate parties who are subservient to the wishes of the grantor: (1) to distribute, apportion, or accumulate income to or for a beneficiary or beneficiaries, or to, for, or within a class of beneficiaries; or (2) to pay out corpus to or for a beneficiary, beneficiaries, or class of beneficiaries. Sec. 674(b)(4) provides that the general rule in Sec. 674 also shall not apply to a power to determine the beneficial enjoyment of the corpus or its income if the corpus or income is irrevocably payable for a purpose specified in Sec. 170(c) (relating to the definition of charitable contributions).

The IRS concluded that the provisions in the trusts that gave the independent trustee the power to allocate a portion of the unitrust amount between noncharitable and charitable beneficiaries fell under the exception in Sec. 674(c) to the rule in Sec. 674(a), and thus the provisions did not prevent the trusts from qualifying as CRUTs under Sec. 664(d)(2). The IRS also concluded that the provisions in the trusts giving the grantor power to designate the charitable class of the trusts fell under the exception in Sec. 674(b)(4) to Sec. 674(a), and, therefore, those provisions would not prevent them from qualifying as CRUTs under Sec. 664(d)(2).

This letter ruling highlights that the distribution of the unitrust amount among unitrust recipients need not be expressly stated in the CRUT agreement; an independent trustee may be given the power to sprinkle the unitrust amount among recipients. However, because Sec. 664(a) requires at least one unitrust recipient to be a noncharitable recipient, a specific amount of the annual unitrust amount must be designated for the noncharitable recipient in the CRUT agreement. In previous private letter rulings,8 the IRS required this amount to be non-de minimis. The IRS has never defined what amount is "non-de minimis," and the letter rulings redact the amounts that were the subject of the ruling requests. This ruling request set forth a specific amount that was to go to the grantor (a noncharitable recipient) and then provided for an additional amount that would make the amount going to the grantor "non-de minimis."

ESBTs and nonresident aliens

On June 18, 2019, Treasury and the IRS issued final regulations9 regarding the addition of nonresident aliens (NRAs) to the class of permissible potential current beneficiaries of an electing small business trust (ESBT). Adopting in their entirety proposed regulations issued in April 2019,10 the final regulations implicitly confirm that a grantor trust deemed to be owned by an NRA may own stock in a corporation without causing the corporation to not qualify as an S corporation, as long as the trust validly elects to be an ESBT. The regulations ensure that an S corporation's income will be subject to U.S. federal income tax when an NRA is a deemed owner of a grantor trust that elects to be an ESBT.

Pursuant to Sec. 1361, only a small business corporation can elect and maintain S corporation status. A small business corporation may not have an NRA as a shareholder. Certain trusts are permissible S corporation shareholders, including certain grantor trusts and ESBTs. Generally, the deemed owner of a grantor trust and each potential current beneficiary of an ESBT is treated as a shareholder for purposes of determining if a corporation qualifies as a small business corporation. Thus, prior to a change enacted by the TCJA, the ownership of stock by a grantor trust deemed owned by an NRA or by a trust with an NRA as a potential current beneficiary precluded the corporation from qualifying as a small business corporation eligible to be an S corporation. The TCJA amended Sec. 1361 to provide that the rule treating each potential current beneficiary as a shareholder does not apply for purposes of the rule prohibiting an NRA from being a shareholder in an S corporation.

Regs. Sec. 1.641(c)-1 provides that the portion of an ESBT consisting of S corporation stock (the S portion) is treated as a separate trust for purposes of determining the trust's liability for income tax. Generally, an S corporation's items of income, gain, deduction, loss, and credit (S items) are taken into account by the S portion of the trust and taxed at the trust level. However, if the ESBT is also a grantor trust, S items allocated to the grantor trust portion of the trust are taken into account by the grantor and not the trust. In other words, when an ESBT is also a grantor trust, the grantor trust rules override the ESBT rules so the grantor of the grantor trust portion is taxed on the trust's income.

When an NRA is a deemed owner of a grantor trust that has elected to be an ESBT, the regulations provide that the ESBT's S corporation income continues to be subject to U.S. federal income tax. To reach this result, the regulations change the allocation rules under Regs. Sec. 1.641(c)-1 to require the ESBT's S corporation income to be included in the S portion of the ESBT if the grantor trust rules would have otherwise allocated the income to an NRA deemed owner.

After the enactment of the TCJA but prior to the issuance of these regulations, many practitioners questioned whether a grantor trust with an NRA as a deemed owner could be a permissible S corporation shareholder by making an ESBT election. This was because, although the TCJA change permits an NRA to be a potential current beneficiary of an ESBT, it did not eliminate the general prohibition on NRAs as shareholders, and in the case of a grantor trust, the deemed owner of the trust is considered a shareholder. Neither the preamble nor the regulations explicitly addressed this concern, but by providing specific rules addressing the taxation of S corporation items allocated to a grantor trust deemed owned by an NRA, the regulations imply that ownership of stock by a grantor trust with an NRA as a deemed owner will not preclude a corporation from qualifying as a small business corporation if the trust validly elects to be an ESBT.

Ultimately, the goal of these regulations is to prevent non-U.S.-source income from flowing through an S corporation and escaping U.S. taxation in the hands of an NRA. The universe of individuals who may be affected by these regulations is fairly narrow because: (1) the trust must be a domestic trust for U.S. tax purposes, meaning that it must satisfy the court and control tests under Sec. 7701(a)(30)(E); and (2) the trust must be a grantor trust as to the NRA because distributions may only be made to the grantor or the grantor's spouse during the NRA grantor's lifetime.

GST tax

Allocations of GST exemption

Erroneous allocation of GST exemption: In Letter Ruling 201836007, the IRS ruled GST tax exemption allocations made by the taxpayer were void when the trusts had no GST tax potential with respect to the taxpayer because each trust beneficiary, not the taxpayer, would be the transferor of any payments made from each trust after the death of the beneficiary.

In year 1, the taxpayer established three irrevocable trusts for his three children. Under the three trusts' terms, which were substantially identical, the trustee could make discretionary distributions of income for the benefit of the primary beneficiary. Following the death of the second of the taxpayer and his spouse to die, the trustee could make discretionary distributions of principal for the benefit of each primary beneficiary. Each primary beneficiary had the right to withdraw certain proportions of trust principal at certain ages.

Furthermore, each trust granted each primary beneficiary a testamentary general power to appoint the assets held in the trust. If the primary beneficiary died before the complete distribution of the trust, the trustee would, subject to the provisions of the testamentary general power of appointment, distribute the trust assets to the primary beneficiary's then-living descendants.

The taxpayer made gifts to the trusts in years 1 and 2. The taxpayer and his spouse each filed a timely gift return for both years. On each return, the taxpayer and his spouse signified their consent to treat the year 1 and 2 transfers as having been made one-half by each spouse. On both years' returns, they erroneously allocated GST exemption to the transfers to the trusts. The taxpayer requested a ruling that the allocations of GST exemption were void because there was no GST potential with respect to the transfers to the trusts.

Sec. 2041(a)(2) includes in the gross estate all property over which the decedent has at the time of his or her death a general power of appointment created after Oct. 21, 1942. Sec. 2652(a)(1)(B) provides that in the case of property subject to gift tax, the donor is the transferor for GST purposes.

Regs. Sec. 26.2632-1(b)(4)(i) provides that an allocation of GST exemption to property transferred during the transferor's lifetime, other than in a direct skip, is made on a gift tax return. A timely allocation of GST exemption becomes irrevocable after the due date of the return. Except as provided in Regs. Sec. 26.2642-3 (relating to charitable lead annuity trusts), an allocation of GST exemption to a trust is void to the extent the amount allocated exceeds the amount necessary to obtain an inclusion ratio of zero with respect to the trust. An allocation is also void if it is made with respect to a trust that at the time of the allocation has no GST tax potential with respect to the transferor making the allocation. For this purpose, a trust has GST tax potential even if its possibility is so remote as to be negligible.

The IRS ruled that at the time of the allocation of GST exemption to the three trusts, the trusts had no GST tax potential with respect to the taxpayers. The primary beneficiary of each trust was a child of the taxpayer. The trustee was authorized to make payments of income and principal to the primary beneficiary, and the primary beneficiary would withdraw amounts of principal from the primary beneficiary's trust at certain ages. None of the payments would be considered made to skip persons, and they were, therefore, not GSTs with respect to the taxpayers.

When the primary beneficiary died, payments from the trust were subject to the primary beneficiary's testamentary general power of appointment, causing the trust to be includible in the child's gross estate under Sec. 2041(a)(2). As a result, under Sec. 2652(a)(1)(B), the primary beneficiary, and not the taxpayer, would be the transferor of any payments made from the trust after the death of the primary beneficiary. Accordingly, the IRS concluded that the taxpayer's allocation of GST exemption to the three trusts was void under Regs. Sec. 26.2632-1(b)(4)(i).

A trust that is payable solely to a non-skip person (as to the transferor's child) during his or her life and includible in the non-skip person's estate cannot have a GST tax event. This is a common mistake among preparers of gift tax returns. In many instances, the preparers list these trusts in Schedule A, Part 3, of Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, as "GST trusts" and elect to have or not have GST exemption allocated to the trusts. However, these trusts should be listed in Schedule A, Part 1, as "gifts subject only to gift tax." Note that it was not necessary to obtain this letter ruling other than to appease the taxpayer and/or his adviser. The remaining GST exemption amount could have been cleared up on the next gift tax return, along with an explanation why the GST exemption amount was different from the previously filed return.

Redetermination of direct vs. indirect skips: In Letter Ruling 201921004, the IRS determined that transfers to trusts were direct skips, not indirect skips, and were subject to the automatic allocation rules despite the taxpayer's election to opt out of the GST exemption automatic allocation rules.

The taxpayer established a trust for each of his eight grandchildren. The trusts were identical and included the following provisions: (1) The trustees of the trusts could make distributions to each trust's respective grandchild beneficiary, as the trustees determined; (2) the trusts were to terminate when their respective grandchild beneficiaries reached the age of 30; and (3) if a beneficiary died before reaching the age of 30, his or her separate trust would be terminated and be distributed in the following order: (a) to the deceased grandchild's living issue; (b) to the living issue of the deceased grandchild's most immediate ancestor who was a child of the taxpayer; or (c) to the taxpayer's surviving grandchildren.

The taxpayer transferred partnership interests to each trust. The taxpayer and his spouse each filed a federal gift tax return and consented to treat the transfers as being made one-half by each spouse under Sec. 2513 (split gifts). On the returns, the transfers were incorrectly reported as indirect skips, and the taxpayers included a statement pursuant to Sec. 2632(c)(5)(A)(i) and Regs. Sec. 26.2632-1(b)(2)(iii) that the GST exemption automatic allocation rules would not apply to any transfers to the trusts.

The taxpayer requested a ruling from the IRS on whether the taxpayer's unused GST exemption was automatically allocated to the transfers to the trusts.

Sec. 2601 imposes a tax on every GST, defined under Sec. 2611(a) as: (1) a taxable distribution; (2) a taxable termination; and (3) a direct skip. A direct skip under Sec. 2612(c)(1) is a transfer subject to U.S. federal estate or gift tax of an interest in property to a skip person. Sec. 2613(a) defines a "skip person" as a natural person assigned to a generation that is two or more generations below the generation assignment of the transferor, or a trust if all "interests" in the trust are held by skip persons.

Sec. 2632(b)(1) provides that if any individual makes a direct skip during his or her lifetime, any unused portion of the individual's GST exemption is allocated to the property transferred, to the extent necessary to make the inclusion ratio for that property zero. If the amount of the direct skip exceeds the unused portion, the entire unused portion is allocated to the property transferred. Sec. 2632(b)(3) provides that an individual may elect to have this automatic allocation rule not apply to a transfer. Regs. Sec. 26.2632-1(b)(1)(i) provides that if a direct skip occurs during the transferor's lifetime, the transferor's GST exemption not previously allocated (unused GST exemption) is automatically allocated to the transferred property (but not in excess of the fair market value (FMV) of the property on the date of the transfer).

The IRS determined that, under the terms of the trusts, discretionary distributions of corpus and principal could be made to the beneficiary grandchild until the age of 30. If the grandchild did not reach the age of 30, then the distribution would be made to a grandchild or more remote descendant of the taxpayer, which means the transfers were not indirect skips but rather direct skips. The IRS determined that the taxpayer and his wife did not elect out of the automatic allocation to direct skips under Sec. 2632(b)(3) (which would have required them to pay GST tax), and their election for indirect skips was irrelevant because the transfers were direct skips. Therefore, the IRS determined that the taxpayer's unused GST exemption was automatically allocated to the transfers to the trusts under Sec. 2632(b).

Scrivener's error

Trust reformation and modification: In Letter Ruling 201920003, the IRS ruled that the judicial reformation and modification of several trusts: (1) did not cause any of the trusts' corpus to be included in the grantor's spouse's gross estate for federal estate tax purposes; (2) did not endow the trusts' beneficiaries with general powers of appointment; and (3) did not constitute the exercise or release of any general power of appointment resulting in a Sec. 2514 gift.

In year 1, the grantor created three irrevocable trusts for the benefit of his grandchildren, with their parents serving as trustees. Each trust instrument provided that its trustee would immediately separate it into trusts of equal parts for each grandchild beneficiary that would terminate upon the death of that beneficiary. Upon termination, the remaining principal and any undistributed income of each separate trust would be distributed as the deceased beneficiary might have appointed by a provision of the beneficiary's will that expressly referred to the power of appointment given by the trust agreement. Any portion of the remaining principal and any undistributed income of the separate trust that was not validly appointed in this manner would be distributed to the then-living lineal descendants of the beneficiary, per stirpes; and, if there were none, then to the living lineal descendants of the parents of the beneficiaries, depending upon the beneficiary's trust, per stirpes.

The trust instrument also provided that, notwithstanding the above provisions, when any property was initially placed in or later added to the trust, each living beneficiary would have the unrestricted right to demand and receive from the trust the share of the property that was allocated to that beneficiary's trust. The trustee would notify each beneficiary of the existence of this right within 14 days from its receipt of the property. Beneficiaries were required to exercise this right by a written instrument delivered to the trustee within 30 days from the date the notice was given, or the right would lapse.

The grantor and his spouse each made gifts to the trusts in years 1 through 7 and 9 through 11. They elected to split gifts under Sec. 2513. The grantor died in year 11 and bequeathed a portion of his estate to each trust. Following the grantor's death, in years 12 through 19, the grantor's spouse continued to make gifts to each trust. The grantor's spouse died in year 19.

Several years after the grantor's death, the trustees became aware that the trust instruments lacked the language necessary to prevent an appointment of trust property to non-family members and that the broad language could be construed as granting a general power of appointment to the beneficiaries. This would result in inclusion of trust property in each beneficiary's gross estate, contrary to the grantor's intent.

One of the grantor's sons, in his capacity as the trustee or representative of the trusts, petitioned a court to reform the trusts to include the necessary language to qualify each beneficiary's power of appointment as limited, expressly prohibiting the appointment of trust assets to a beneficiary, the beneficiary's estate or creditors, and the creditors of the beneficiary's estate. The grantor's accountant and his law firm each swore that the grantor intended the trusts to be GST-tax-exempt, and the grantor had not recognized that including the power-of-appointment language would result in including the trust assets in each beneficiary's gross estate.

The court issued an order that retroactively limited the power-of-appointment language as requested and subsequently issued an amended order clarifying that the trusts would terminate at the death of each named grandchild and that per stirpes distributions were to be outright and in fee. The amended order clarified that each separate trust held for a beneficiary would terminate upon the death of that beneficiary. This was consistent with the provisions of each trust as originally executed.

Further, the amended order clarified that upon termination, each trust's remaining principal and undistributed income would be distributed as the deceased beneficiary had appointed to or for the benefit of one or more of the lineal descendants of the grantor's child who was a lineal ascendant of that beneficiary, but excluding that beneficiary, the beneficiary's estate and creditors, and the creditors of the beneficiary's estate. The default provisions of each trust were otherwise unchanged. Both orders were issued contingent upon a favorable ruling from the IRS.

The court later issued a second amended order reforming the trust instrument to limit the beneficiary's withdrawal right to the lesser of: (1) the amount equal to the greater of the amount that, under Sec. 2514(e), would not be considered a release of a power of appointment as the result of a lapse of the power, or the amount that under Sec. 2503(b) could be excluded in computing the total amount of gifts made during the calendar year; or (2) the FMV of any property, determined as of the date of the gift, added to the trust by gift during that calendar year. This order was also contingent upon a favorable ruling from the IRS.

Accordingly, the taxpayer requested the following rulings from the IRS:

  1. The judicial reformation and modification of the trusts would not cause the corpus of those trusts to be included in the gross estate of the grantor's spouse for federal estate tax purposes;
  2. The trusts, as reformed and modified, did not provide the beneficiaries with general powers of appointment over their assets under Sec. 2514 or 2041, and, upon the death of the beneficiary, the assets of the deceased beneficiary's trust would not be includible in that beneficiary's gross estate under Sec. 2041;
  3. The reformation and modification of the trusts did not constitute the exercise or release of any general powers of appointment by a beneficiary resulting in a gift under Sec. 2514; and
  4. The trusts were skip persons and, accordingly, the deemed allocation rules of Sec. 2632(b)(1) applied to automatically allocate the grantor's and the spouse's GST exemption to the gifts and bequests to the trusts in years 1 through 7 and 9 through 19.

As to the first ruling request, the IRS noted that the trusts were irrevocable. During years 1 through 7 and 9 through 11, the grantor and his spouse were each treated as the transferor of one-half of the total transfers to the trusts. During years 12 through 19, the spouse was the transferor. However, the spouse did not retain any right, interest, or beneficial interest in the trusts or the right to alter, amend, revoke, or terminate them. The spouse also did not retain the right to designate who would possess or enjoy the property or income derived from the trusts. The IRS noted that the reformation and modification of the trusts were made pursuant to the court orders and not as a result of rights retained by the spouse. Thus, the IRS ruled that the judicial reformation and modification of the trusts would not cause the corpus of the trusts to be included in the gross estate of the spouse under Secs. 2036(a) and 2038(a)(1).

Regarding the second and third ruling requests, the IRS cited Sec. 2041(b) (defining a general power of appointment and its lapse), Sec. 2514(b) and its regulations (release of a general power of appointment is deemed as a transfer of property), and the relevant state statute, which provided that a court may reform the terms of a trust to conform to the settlor's intent if it is proved by clear and convincing evidence that both the accomplishment of the settlor's intent and the terms of the trust were affected by a mistake of fact or law. In determining the settlor's original intent, the court may consider evidence relevant to that intent even if it contradicts an apparent plain meaning of the trust instrument.

After examining the relevant trust instruments, affidavits, and representations of the parties, the IRS found that they strongly indicated that the grantor and his spouse did not intend for the trust beneficiaries to have inter vivos or testamentary general powers of appointment. In reforming the trusts, the court found that there was clear and convincing evidence that the language in the trust instrument indicating otherwise were scrivener's errors, that the reformation and modification of the trusts were necessary and appropriate to achieve the grantor's objectives, and that the reformation was not contrary to the grantor's intentions.

Therefore, the IRS concluded that the trusts, reformed and modified pursuant to the court's orders, did not provide the beneficiaries with either inter vivos or testamentary general powers of appointment over the assets of each respective beneficiary's trust under Secs. 2041(b) and 2514(c). Accordingly, the IRS ruled that the judicial reformation and modification of the trusts did not constitute the exercise or release of a general power of appointment by a beneficiary resulting in a gift under Sec. 2514 and that the assets of the deceased beneficiary's trust would not be includible in the beneficiary's gross estate under Sec. 2041.

As to the fourth ruling request, the IRS noted that Sec. 2652(a)(2) provides that gifts that an individual and spouse elect to split are so treated for purposes of GST tax. Because the trust beneficiaries and their lineal descendants were assigned to a generation two or more generations below that of the grantor, the beneficiaries were skip persons as defined under Sec. 2613(a)(1). Therefore, the IRS concluded the three trusts were skip persons as defined under Sec. 2613(a)(2) and that the gifts to the trusts were direct skips as defined in Sec. 2612(c)(1).

Because the grantor and his spouse elected to split the year 1 through 7 and 9 through 11 gifts to the trusts under Sec. 2652(a)(2), the IRS concluded that the deemed allocation rules under Sec. 2632(b) applied to allocate their unused GST exemption to one-half each of the gifts to the trusts in those years, to allocate the grantor's unused GST exemption to the bequests to the trusts in year 11, and to allocate the spouse's unused GST exemption to the gifts to the trusts in years 12 through 19.

Correcting withdrawal powers: In Letter Ruling 201845029, the IRS determined that a state court's reformation of a trust did not result in gift or GST tax consequences to the original grantor, the grantor's spouse, or the beneficiaries of the trust.

The settlor executed an irrevocable trust with the assistance of an attorney for the benefit of the settlor's grandchildren and their descendants. The settlor intended to: (1) provide for the grandchildren; (2) reduce transfer taxes by ensuring the trust's assets were not included in the grandchildren's gross estates; and (3) minimize the amount subject to GST tax by using the settlor's GST exemption. The attorney made two drafting errors that provided that each grandchild had the right to withdraw the full value of an addition to his or her separate portion of the trust made during a year, with this right lapsing at the end of the year.

Both the settlor and the settlor's spouse timely filed gift tax returns and elected to split the gifts. The gift tax returns incorrectly reported the transfers as indirect skips (the transfer to the trust was a direct skip because all beneficiaries of the trust were two or more generations below the settlor and the settlor's spouse to which GST exemption was automatically allocated). However, both allocated their GST exemption to the trust. The settlor's spouse made transfers to the trust in year 2 that she did not elect to treat as split gifts with the settlor but allocated her remaining GST exemption to the transfers.

After year 2, a subsequent attorney realized that the trust did not reflect the settlor's original intent in creating it because: (1) a beneficiary's ability to withdraw the full value of the addition to his or her separate portion of the trust was a general power of appointment (which would cause all amounts subject to the withdrawal to be included in the beneficiary's estate); and (2) the lapsing of a grandchild's right to withdraw would be a taxable transfer by the grandchild to the extent the property that could have been withdrawn exceeded in value the greater of $5,000 or 5% of the aggregate value of the assets subject to withdrawal (i.e., the lapse would be a gift to the extent it exceeded the "five or five" power in Sec. 2514(e)). The subsequent attorney filed a petition in state court to reform the trust to cure the drafting errors in the trust by amending the withdrawal language to limit the annual lapse of the withdrawal right to the greater of $5,000 or 5% of the value of the trust's assets.

The settlor requested the following rulings:

  1. The judicial reformation of the trust did not result in the settlor's grandchildren having general powers of appointment (within the meaning of Secs. 2514 and 2041) over their respective shares of the trust (except to the extent of each grandchild's withdrawal right under the reformed trust instrument);
  2. The judicial reformation of the trust did not constitute an exercise by the grandchildren of a general power of appointment for gift and estate tax purposes;
  3. The lapse of any grandchild's withdrawal right did not result in a gift for gift tax purposes;
  4. The trust's property would not be included in the grandchildren's estates (except to the extent of each grandchild's withdrawal rights under the reformed trust instrument exercisable at the grandchild's death); and
  5. The settlor and spouse substantially complied with Sec. 2632(a) to allocate their available GST exemption to the year 1 gift to the trust.

Regarding requested rulings 1 through 4, the IRS noted that Sec. 2033 generally provides that a gross estate includes the value of all property to the extent of the decedent's interest in it at death. Pursuant to Sec. 2041(a)(2), a gross estate includes the value of all property over which the decedent has, at the time of his or her death, a general power of appointment, or with respect to which the decedent has at any time exercised or released such a power of appointment by a disposition that, if it were a transfer of property owned by the decedent, that property would be includible in the decedent's gross estate under Secs. 2035 through 2038. Furthermore, the power of appointment is considered to exist on the date of the decedent's death even if its exercise is subject to a precedent giving of notice or takes effect only after a stated period.

The IRS determined that the original withdrawal powers of the grandchildren were the result of a scrivener's error. The state court reformed the trust to correct the error and not to alter or modify the trust instrument. Therefore, the IRS concluded that the grandchildren did not possess general powers of appointment over the trust, except to the extent of each grandchild's withdrawal rights under the reformed trust instrument. Additionally, the IRS determined that the lapse of the grandchildren's withdrawal rights did not result in a gift for gift tax purposes. ­Finally, the IRS determined that the assets of each grandchild's portion of the trust would not be includible in their respective gross estates under Sec. 2041.

Regarding ruling request 5, the IRS determined that the settlor and the settlor's spouse elected to split gifts on a timely filed gift tax return in year 1 and, thus, were each treated as the transferor of one-half of the assets gifted to the trust in that year.

Here, the settlor and the settlor's spouse incorrectly reported the gift to the trust as an indirect skip, but they did allocate their GST exemption to the year 1 gift to the trust. Therefore, they did not literally comply with the instructions to Form 709 to properly allocate their remaining GST exemption to the year 1 gift to the trust. However, the IRS found, citing Hewlett-Packard Co.,11 that literal compliance with election procedures is not always necessary, and an allocation election will be deemed valid if the information on the return is sufficient to indicate that the donor intended to make the allocation and the taxpayer complied with the essential requirements of a regulation. The IRS determined that the settlor and the settlor's spouse both provided sufficient information on their Form 709 for year 1 to indicate that they intended to make the allocation. Thus, the IRS concluded that the settlor and the settlor's spouse substantially complied with the requirements of Sec. 2632(a) to allocate their respective GST exemption to the year 1 gift to the trust.

Inflation adjustments

Rev. Proc. 2018-57 sets forth inflation adjustments for various tax items for 2019:

  • Unified credit against estate tax:The basic exclusion amount is $11,400,000 for determining the amount of the unified credit against estate tax under Sec. 2010.
  • Valuation of qualified real property in decedent's gross estate: 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 for purposes of the estate tax cannot exceed $1,160,000.
  • Gift tax annual exclusion: The gift tax annual exclusion for gifts of a present interest is $15,000. The gift tax annual exclusion for gifts of a present interest to a spouse who is not a U.S. citizen is $155,000.
  • Interest on a certain portion of estate tax payable in installments: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 $1,550,000.

   

Footnotes

1North Carolina Dep't of Rev. v. Kimberley Rice Kaestner 1992 Family Trust, No. 18-457 (U.S. 6/21/19).

2The Kimberley Rice Kaestner 1992 Family Trust v. North Carolina Dep't of Rev., 814 S.E.2d 43 (N.C. 2018), aff'g 789 S.E.2d 645 (N.C. Ct. App. 2016), aff'g 12 CVS 8740 (N.C. Sup. Ct. (Bus.) 4/23/15).

3Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

4Id. at 312.

5Fielding v. Commissioner of Revenue, 916 N.W.2d 323 (Minn. 2018).

6Bauerly v. Fielding, No. 18-664 (U.S. 6/28/19) (cert. denied).

7P.L. 115-97.

8See IRS Letter Rulings 201117005, 200832017, 200813023, and 200813006.

9T.D. 9868, 84 Fed. Reg. 28214.

10REG-117062-18, 84 Fed. Reg.16415.

11Hewlett-Packard Co., 67 T.C. 736 (1977), acq. in result, Action on Decision 1979-78.

 

Contributors

Justin Ransome, CPA, J.D., is a partner in the National Tax Department of Ernst & Young LLP in Washington, D.C. He was assisted in writing this article by professionals from Ernst & Young's National Tax Department in Private Client Services — David Kirk, Todd Angkatavanich, Marianne Kayan, Joe Medina, Rosy Lor, Caryn Friedman, John Fusco, Nickolas Davidson, Ankur Thakkar,and Utena Yang. For more information about this article, contact thetaxadviser@aicpa.org.

 

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