Recent developments in estate planning: Part 2

This article is the second of two parts of an annual update on recent developments in trust, estate, and gift taxation. The first part in the October issue covered trust and gift tax issues. This second part covers developments in estate and generation-skipping transfer (GST) taxation, as well as inflation adjustments.

Estate taxBasic exclusion amount

The IRS issued final regulations¹ addressing the effect that changes made by the law known as the Tax Cuts and Jobs Act (TCJA)² have on the basic exclusion amount used in computing federal estate and gift taxes. The final regulations affect donors of gifts made after 2017 and the estates of decedents dying after 2025.

In general, to compute liability for federal gift tax or federal estate tax, the Code applies a unified rate schedule to the taxpayer’s cumulative taxable gifts and taxable estate and arrives at a net tentative tax, which is then reduced by a credit based on the applicable exclusion amount. The applicable exclusion amount is the sum of (1) the basic exclusion amount (BEA) under Sec. 2010(c)(3); and (2) the deceased spousal unused exclusion (DSUE) amount under Sec. 2010(c)(4), if any; and (3) in some cases, a restored exclusion amount under Notice 2017-15.³ The TCJA amended Sec. 2010(c)(3) by doubling the BEA from $5 million to $10 million, adjusted for inflation, for decedents dying and gifts made during calendar years 2018–2025.

The regulations first set forth how gift tax is calculated in a seven-step computation under Secs. 2502 and 2505. The seven steps are:

1. Determine a tentative tax on the sum of all taxable gifts made in the current year or in prior periods;
2. Determine a tentative tax on the sum of all taxable gifts made in all prior periods;
3. Determine the net tentative gift tax on the current-year gifts by subtracting the tentative tax determined in Step 2 from the tentative tax determined in Step 1;
4. Determine a credit equal to the applicable credit amount under Sec. 2010(c);
5. Determine the sum of all of the amounts allowable as a credit to offset the gift tax on gifts the donor made in all preceding calendar periods;
6. Subtract the total credit allowable for prior periods determined in Step 5 from the credit for the current period determined in Step 4; and
7. Subtract the credit amount determined in Step 6 from the net tentative gift tax determined in Step 3.

The regulations next set forth how estate tax is calculated in a five-step computation under Secs. 2001 and 2010:

1. Determine a tentative tax on the sum of the taxable estate and the adjusted taxable gifts (i.e., all taxable gifts made after 1976 other than those included in the gross estate).
2. Determine a hypothetical gift tax on all post-1976 taxable gifts. Under Sec. 2502(c), the credit amount allowable for each gift year is the tentative tax on the applicable exclusion amount for that year but may not exceed the tentative tax on gifts made during that year. The applicable exclusion amount equals the sum of: (1) the BEA in effect for the year in which the gift was made; (2) any DSUE amount as of the date of the gift as computed under Regs. Sec. 25.2502-2; and (3) any restored exclusion amount as of the gift date as computed under Notice 2017-15.
3. Determine the net tentative estate tax by subtracting the gift tax payable determined in Step 2 from the tentative tax determined in Step 1.
4. Determine a credit amount (which may not exceed the net tentative estate tax) equal to the tentative tax on the applicable exclusion amount in effect on the date of death.
5. Subtract the credit amount determined in Step 4 from the net tentative estate tax determined in Step 3 (Sec. 2010(a)).

To address concerns over what the tax consequences would be if a taxpayer were to gift between $5 million and $10 million during calendar years 2018–2025 and die in 2026 or later, when the BEA is only $5 million, the proposed regulations⁴ provided a special rule that would allow the estate to compute its estate tax credit using the higher of: (1) the BEA applicable to gifts made during the decedent’s life, or (2) the BEA applicable on the date of the decedent’s death. The final regulations adopt the special rule from the proposed regulations so that a decedent’s estate is not inappropriately taxed on gifts that were sheltered from gift tax by the increased ($10 million) BEA when the gifts were made. The final regulations also make clarifications and address additional comments made by commentators.

Inflation adjustments: Examples provided in the final regulations reflect hypothetical inflation-adjusted BEA amounts not included in the proposed regulations. The preamble notes that the increased BEA as adjusted for inflation is a use-it-or-lose-it benefit that is available to a decedent who lives beyond the increased BEA period if the decedent used the benefit by making gifts during the increased BEA period.

Example 1 of Regs. Sec. 20.2010-1(c)(2)(i) in the final regulations confirms that a decedent dying after 2025 would not benefit under the special rule from post-2025 inflation adjustments to the BEA to the extent the decedent made gifts large enough to cause the total BEA allowable in the computation of gift tax payable to exceed the date-of-death BEA as adjusted for inflation. To compute estate tax, the preamble notes, the BEA is first applied against the decedent’s gifts as taxable gifts were made; to the extent any BEA remains at the time of death, that remainder applies against the decedent’s estate. Therefore, a decedent who made gifts in a large enough amount to cause the total BEA allowable in the gift tax computation to equal or exceed the date-of-death BEA, no BEA would remain available to be applied to reduce the estate tax. The IRS notes that the special rule does not change (1) the five-step estate tax computation or (2) that only the credit remaining after computing gift tax payable may be applied against the estate tax.

DSUE response: Regs. Secs. 20.2010-1(d)(4) and 20.2010-2(c)(1) confirm that a DSUE amount elected during the increased BEA period will not be reduced, even if the BEA amount decreases after 2025. Reference to “BEA” means the BEA in effect at the time that the deceased spouse dies as opposed to the BEA in effect when the surviving spouse dies. A DSUE election made on the deceased spouse’s estate tax return allows the surviving spouse to take into account the deceased spouse’s DSUE amount as part of the surviving spouse’s applicable exclusion amount, the preamble explains. Ultimately, the sunset of the $10 million BEA, or any other decrease in the $10 million BEA, will not affect the existing DSUE rules or the existing regulations governing the DSUE. Examples 3 and 4 of Regs. Secs. 20.2010-1(c)(2)(iii) and (iv) address this point.

BEA computations: The final regulations provide guidance for determining the extent to which a credit allowable in computing gift tax payable is based solely on the BEA. Specifically, the regulations specify that:

1. The credit may not exceed the amount necessary to reduce the gift tax for the period to zero;
2. Any DSUE amount available to the decedent for the calendar period is deemed applied to the decedent’s gifts before any of the decedent’s BEA is applied to the gifts;
3. In a calendar period in which the applicable exclusion amount allowable for gifts made during the period includes both a DSUE and a BEA, the allowable BEA may not exceed the amount necessary to reduce the tentative gift tax to zero after applying the DSUE amount; and
4. In a calendar period in which the applicable exclusion amount allowable for gifts made during the period includes both a DSUE and a BEA, the portion of the credit based solely on the BEA for the period equals the BEA allocable to those gifts divided by the applicable exclusion amount allocable to those gifts.

GST tax: The preamble states that an increase in the BEA correspondingly increases the GST exemption because it is defined by reference to the BEA. However, issues concerning the late allocation of the increase in the GST exemption to inter vivos trusts created before 2018 and whether the allocation of the increased GST exemption will be affected by the sunsetting of the increased BEA are beyond the scope of the regulation project. The preamble does include a footnote citing the Joint Committee on Taxation’s Blue Book of the TCJA that indicates a late allocation of the GST exemption (increased by the increase in the BEA) may be made.

Regulatory authority: One of the commentators noted that the special rule in the regulations would exceed the scope of congressionally granted authority because the rule is not limited to the treatment of transfers during calendar years 2018–2025. The preamble states this assertion is inconsistent with both Sec. 2001(g) — addressing the effect of changes in tax rates and exclusion amounts in the computation of the estate tax — and Sec. 2001(g)(2) — addressing circumstances that can occur only after Dec. 31, 2025, when the BEA increase sunsets and drops to $5 million. The preamble states that the impact of the sunset of the increased BEA as of Jan. 1, 2026, was the exact reason Congress granted it regulatory authority under Sec. 2001(g)(2) to resolve the issue and to ensure that there would be no imposition of estate tax on inter vivos gifts that were sheltered from gift tax by the increased BEA in effect when the gifts were made.

The problem resolved by the proposed regulations is the same one that many practitioners feared when the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001⁵ increased the BEA from $1 million to $3.5 million but was supposed to sunset and return the BEA from $3.5 million to $1 million. The estate tax calculation does not take into account changes in the BEA that may take place during the taxpayer’s life, whereas the calculation of gift tax does take those changes into consideration by effectively giving the taxpayer credit for the tax on prior taxable gifts regardless of whether the tax was actually paid due to fluctuations in the BEA. A change in the estate tax calculation is needed so that a taxpayer who takes advantage of the fluctuating BEA during his or her lifetime is not subject to estate tax simply because the BEA at the time of the taxpayer’s death is lower than the BEA that existed during the taxpayer’s life (and used by the taxpayer during his or her lifetime). Unlike EGTRRA, the TCJA contemplated this mismatch and directed Treasury and the IRS to draft regulations that would prevent the inequity from occurring.

The final regulations provide a very simple solution to the differences in the way the gift and estate tax are determined by making the BEA the amount that is the greater of the BEA at the taxpayer’s death or the BEA used during the taxpayer’s lifetime.

The final regulations address for the first time how the DSUE amount played into the estate tax calculation set forth in the proposed regulations and retained in the final regulations. The final regulations make clear: (1) the DSUE amount is never lost even if the BEA for the taxpayer is reduced; and (2) the DSUE amount is applied before the surviving spouse’s BEA amount is applied (consistent with the ordering rules in existing Regs. Sec. 20.2010-3(b)). The final regulations add two examples to those contained in the proposed regulations to demonstrate the interplay of the DSUE amount and the BEA.

The final regulations also make clear that Treasury and the IRS believe that these regulations will survive the sunset of the TCJA. Treasury and the IRS explain that the whole reason Sec. 2001(g) (instructing the secretary of the Treasury to prescribe regulations to mitigate adverse tax consequences regarding fluctuations in the BEA) was added to the Internal Revenue Code was to address an issue that would occur only after the TCJA’s sunset. Therefore, Treasury and the IRS conclude that the final regulations will be given effect after the TCJA’s sunset.

Family limited partnership disregarded

In Estate of Moore,⁶ the Tax Court held that the value of a farm a decedent transferred to a family limited partnership (FLP) was includible in the decedent’s estate because the decedent retained the possession and enjoyment of the farm until his death; a loan from the FLP to the decedent was not a bona fide loan; and the decedent’s transfers to his children within the three-year period preceding his death were gifts rather than loans.

The decedent was a successful farmer and landowner with more than 1,000 acres that were consolidated into what became known as Moore Farms. At age 88, the decedent began negotiating with buyers about selling the farm, but before completing the sale he had a serious heart attack and was told he had less than six months to live. In December 2004, while in hospice care, the decedent worked with an estate planning attorney and developed a plan focused on the decedent’s stated estate planning goals — maintaining control and eliminating estate tax. Little to no estate planning had been done before this. On Dec. 20, 2004 (four days after being discharged from the hospital), the decedent created a living trust, a charitable lead annuity trust, a children’s trust, a management trust, an irrevocable trust, and an FLP.

Each entity played a part in Howard Moore’s estate plan. The decedent transferred all real and intangible personal property to the living trust. At the time of his death, the trust provided for a formula transfer to the charitable trust of a fraction of the trust assets to result in the least possible federal estate tax. After paying expenses, claims, taxes, and specific distributions, the balance of the trust assets was to be distributed to the children’s trust. The management trust was an irrevocable trust holding a 1% general partnership interest in the FLP. Upon the decedent’s death, the trust’s assets were to be distributed to the children’s trust.

The irrevocable trust was created by the decedent during his life for the benefit of his children. The FLP was created in December 2004 with initial nominal contributions by the management trust, which received a 1% general partnership interest; the decedent (via the living trust) received a 95% limited partnership interest, and his four children each received a 1% limited partnership interest. The decedent (via the living trust) further transferred a four-fifths interest in the farm and $1.8 million in assets to the FLP in February 2005.

While the decedent was transferring the four-fifths interest of the farm to the FLP, he was also engaged in negotiations with a prospective buyer to sell the farm for approximately $16.5 million. The sale closed shortly after the decedent’s transfer of the interest in the farm to the FLP. Upon the closing of the sale, the FLP transferred its four-fifths interest, and the living trust transferred its one-fifth interest in the farm to the buyer. Under the terms of the deal, the decedent was permitted to continue to live on the property after the sale and operate the farm.

In March 2005, the decedent completed a series of transfers in a frantic effort to implement his estate plan. First, the decedent directed the FLP to transfer $500,000 to each of his four children in return for a five-year note bearing interest at a rate of 3.6%. The notes had no amortization schedule, no payments were made, and the FLP made no effort to collect on the notes. Next, the FLP distributed $2 million to the living trust, which was used to pay expenses, including the decedent’s income tax attributable to the sale of the farm.

Although there was testimony from the decedent’s daughter that she believed this was a loan from the FLP, additional evidence was not provided to substantiate the claim. Additionally, in late February 2005, the living trust transferred $500,000 to the irrevocable trust, which was treated as a $125,000 gift to each of the four children. Lastly, in early March 2005, the living trust transferred its entire limited interest in the FLP to the irrevocable trust in return for $500,000 cash and a note for $4.8 million.

The decedent’s estate tax return reported the following:

• $53,875 for the management trust’s 1% general partnership interest in the FLP;
• $4.8 million for the note receivable from the irrevocable trust;
• $2 million for a debt owed to the FLP;
• $4.8 million for a charitable contribution to the charitable trust;
• $1.5 million in taxable gifts; and
• $475,000 for attorneys’ fees associated with the administration of the decedent’s estate.

The estate also filed a gift tax return for the 2005 tax year. The return reported gifts of $125,000 for each of the decedent’s children in the form of the $500,000 transfer to the irrevocable trust earlier that year. The IRS issued a notice of deficiency to the estate determining a deficiency of nearly $6.4 million. Additionally, the IRS issued a notice of deficiency determining a gift tax liability of more than $1.3 million for the 2005 tax year.

Among other issues, the Tax Court identified and addressed the following important questions:

1. Should the value of the farm be included in the decedent’s gross estate, despite its sale by the FLP?
2. Can the decedent’s estate deduct the $2 million loan from the FLP to the living trust?
3. Were the $500,000 transfers to each of the decedent’s children bona fide loans?

Inclusion of farm in decedent’s gross estate: The Tax Court first addressed whether the value of the farm should be included in the gross estate under Sec. 2036. Generally, Sec. 2036(a) functions as a catchall designed to prevent taxpayers from avoiding estate tax simply by transferring all their assets out of their estates before they die. Specifically, Sec. 2036(a) recaptures the value of certain assets transferred by a decedent during life where the decedent has retained benefits or has the right to determine who will benefit from the transferred assets.

Citing Estate of Bongard,⁷ the Tax Court noted that it has developed a three-part test to determine whether Sec. 2036(a)(1) pulls property back into a decedent’s estate. A transfer is not respected if: (1) the decedent made a transfer of property during life; (2) the transfer was not a bona fide sale for adequate and full consideration; and (3) the decedent retained an interest or right in the transferred property. While part one of the test was easily dispelled, the court addressed parts two and three in detail.

Under part two of the test, a transfer is subject to Sec. 2036(a) if the transfer is not a bona fide sale for adequate and full consideration. Under Bongard, a sale is bona fide only if the record establishes the existence of a legitimate and significant nontax reason for the creation of the FLP and the transfer of assets to it. And while the decedent’s estate argued that the principal reasons for forming the FLP were to encourage family unity and provide creditor protection, the Tax Court, based on the record before it, found these reasons did not establish a legitimate and significant nontax reason for creating the FLP and transferring assets to it.

The court noted that (generally) in instances where it found transfers were motivated by genuine nontax purposes, the transferred businesses required active management. In the present case, there was no business to run because the decedent had sold the farm days after transferring it to the FLP. Moreover, the only assets remaining in the FLP for the decedent’s children to manage were liquid, and the children did not actually manage the assets. Regarding the creditor protection argument, the court highlighted that this argument could never meet the bona fide sale exception (i.e., could not be considered a significant nontax reason), and based on the record, the decedent had no legitimate concern with creditor claims. Further, the court noted that the FLP was planned when death was imminent, as part of an attempt to avoid federal gift and estate taxes. Not only was the entire plan implemented unilaterally by the decedent, but the court also noted it would not ignore the testamentary essence of the plan as a whole.

Under part three, a transfer will be subject to Sec. 2036(a) if a decedent retained an interest or right in the transferred property. The Tax Court found that the decedent had, at the very least, an implied agreement to retain possession or enjoyment of the farm property upon the transfer of four-fifths of the farm to the FLP, and even after the sale of the entire farm. Buttressing this conclusion was the fact that the decedent continued to occupy the property after transfer and used other FLP assets as if they were his own (paying personal expenses, making loans to children, and paying estate planning fees).

Accordingly, because the decedent retained possession or enjoyment of the farm, and because his transfer of part ownership to the FLP lacked a substantial nontax purpose, the Tax Court concluded that the value of the farm was included in the decedent’s gross estate under Sec. 2036(a)(1).

Next, the Tax Court moved to an analysis of Sec. 2043(a) (regarding transfers for insufficient consideration) to determine the amount of the farm’s value to include in the decedent’s gross estate. The court noted that, generally, if Sec. 2036 applies, then Sec. 2043(a) provides that the decedent’s gross estate includes only the excess of the fair market value (FMV) over the value of the consideration received, citing Estate of Powell.⁸ The court noted that the general formula for the Sec. 2043(a) calculation is as follows: Value included in (or added to) gross estate = Consideration (date-of-death value) included under Sec. 2033 + FMV (date-of-death value) of Sec. 2036 transfer — Consideration received by the decedent at the time of the transfer.

Although the decedent’s estate valued the decedent’s 95% limited interests in the FLP at $5.3 million, and the IRS valued the interest at $8.5 million, the Tax Court noted that the net value included in the estate did not depend on whether the estate or the IRS was correct, because the value of the interest did not change in the short period between the sale and decedent’s death. Thus, the date-of-transfer and date-of-death amounts netted out in the formula. Through a series of examples, applying the facts presented, and further simplifying the equation, the court determined the following equation would allow the estate and the IRS to calculate the final inclusion amount under Rule 155: Value included in (or added to) gross estate = Value of the farm at date of death — Money that left the estate between the time of the sale and the date of death.

Loan by FLP to living trust: The Tax Court turned next to the deductibility of the $2 million loan between the living trust and the FLP. Although the estate tax return reported the estate as owing $2 million to the FLP as a result of the loan from the FLP to the living trust, the Tax Court found no evidence that the transfer was a loan. There was no promissory note, no interest charged or paid, no collateral, no maturity date, no payments made, and no demand for payments.

Transfers to children: Lastly, the Tax Court reviewed whether the $500,000 transfers to each of the children were loans or gifts. The decedent directed the FLP to transfer $500,000 to each of his four children in return for a five-year note bearing interest at a rate of 3.6%. The IRS asserted that these transfers were gifts and not loans because they lacked a legitimate debtor/creditor relationship. Even though the children had signed notes, the court found it was more likely than not that these were gifts, based on a variety of factors, such as:

• The notes had no fixed payment schedule;
• The children never made required interest payments;
• The FLP never demanded repayment;
• There was no evidence the children had the resources to repay the loans;
• The notes were not secured;
• Comparable funding from a third-party lender was unlikely; and
• The decedent listed a desire that each of his children receive $500,000 as one of his estate planning goals, and the attorney who assisted the decedent with his estate plan testified that the payments needed to be loans for tax purposes because having the payments as gifts would not be the best use of the tax laws.

Accordingly, the Tax Court concluded that the transfers from the FLP to the children, totaling $2 million, were treated as gifts, and the additional resulting gift tax was included in the gross estate under Sec. 2035(b) because the gifts had been made within three years of death.

Regarding the issues addressed by the Tax Court in this case, the fact that the Tax Court ruled against the decedent’s estate on each of them is, once again, attributed to bad facts — the decedent’s not abiding by the formalities of the FLP arrangement. The Sec. 2043 analysis is interesting because it goes further than Powell in exploring the amount includible in an estate when Sec. 2036 is deemed to apply — particularly when the property transferred has been sold by the FLP.

GRAT includible in decedent’s estate

In Badgley,⁹ the Ninth Circuit affirmed the District Court’s summary judgment in the IRS’s favor, that a grantor retained annuity trust (GRAT) was properly included in the decedent’s estate.

The decedent’s husband held a 50% partnership interest in Y&Y Co., a family-run general partnership and property development company in California. After the husband’s death, the decedent became a 50% partner in Y&Y Co. On Feb. 1, 1998, the decedent created the GRAT and funded it with her partnership interest in Y&Y Co. The GRAT provided that the decedent was to receive annual annuity payments for the lesser of 15 years or her earlier death (paid quarterly) equal to 12.5% of the date-of-gift value of the property transferred to the GRAT. Under the GRAT, the Y&Y Co. interest was to pass to the decedent’s two daughters on the expiration of the decedent’s annuity payments. From 2002 to 2012, the GRAT made quarterly annuity payments to the decedent. The decedent died shortly before the 15-year annuity period expired.

The decedent’s estate included the value of the GRAT in its gross estate and subsequently filed a claim seeking a refund from the IRS in the amount of the estate tax it overpaid as a result of the inclusion of all the assets of the GRAT in the decedent’s estate. The IRS did not act on the refund claim, and the decedent’s estate filed a refund action in district court.

The district court denied the estate’s motion and granted the IRS’s cross motion, holding that the decedent’s interest in the GRAT was includible in the decedent’s gross estate because she retained a right to income from, and continued enjoyment of, the property the GRAT held. The district court also held that Regs. Sec. 20.2036-1(c)(2) (which included the calculation of the amount of the GRAT that was includible in the decedent’s estate under Sec. 2036) was a valid interpretation of Sec. 2036.

Under Sec. 2036(a)(1), an individual’s gross estate includes property she transferred during her life if she retained the right to possess the property, to enjoy the property, or to receive income from the property. Thus, the Ninth Circuit examined whether the annuity from the GRAT is a right included under Sec. 2036(a)(1). The court noted that it is well-settled law that the terms “enjoy” and “enjoyment” for estate tax purposes connote substantial present economic benefit rather than technical vesting of titles or estates.

The Ninth Circuit determined that the decedent’s annuity payment from the GRAT was a “substantial present economic benefit” and required inclusion of the value of the GRAT at the time of her death. Moreover, the annuity stemmed from the partnership interest contributed to the GRAT because no other property was contributed to the GRAT. Thus, the partnership interest was not transferred to the beneficiaries of the GRAT because the GRAT had yet to terminate. Therefore, the court affirmed the district court’s holding that the GRAT was includible in the decedent’s estate.

The Ninth Circuit refused to answer the question of whether Regs. Sec. 20.2036-1(c)(2) was a valid regulation because the decedent’s estate had failed to make a sufficient or compelling argument regarding its validity.

GST tax

Modification

In Letter Ruling 201947004, the IRS ruled that the modification of a trust would not cause the trust to lose its grandfathered status as exempt from GST tax, even when the period of trust is extended beyond its original termination date.

The trust was for the primary benefit of the grantor’s son and the son’s issue. Article II of the trust agreement provided that upon the death of the son, the trust would be split into as many shares as necessary to allocate one share to each child of the son who is then living and one share to each deceased child of the son who has left issue then living. Article II further provides for the mandatory distribution of net income in quarterly installments to the child for whom the share was created. Upon that child’s attaining the age of 21, the share held for that child is to be distributed to the child free of any trust. If any of the surviving issue die prior to reaching the age of 21, the trust or share of the trust held for that child is distributed to the child’s estate.

Under the state law governing the trust, the grantor and all of the current and contingent beneficiaries of the trust proposed to modify the trust instrument by executing an agreement signifying consent to modify Article II of the trust instrument (and also a trustee provision that is not relevant to this article).

Article II as modified would provide that any share of a deceased child leaving issue surviving will be further divided into shares for the then-living issue of that deceased child on a per stirpes basis. Each child’s share and per stirpes share of a child’s share in the case of a deceased child leaving issue surviving shall be held in a separate trust. The original Article II did not provide for what was to be done with the deceased child’s share.

Article II was also to be modified to direct the trustee to make lifetime distributions of income and principal from each separate trust to the beneficiary for whom the trust was created, for that beneficiary’s support, maintenance, health, and education, in the absolute discretion of the trustee. Upon the death of the beneficiary for whom the trust was created, the beneficiary would be granted a testamentary general power to appoint the remaining trust property including undistributed trust income. To the extent not effectively appointed by that beneficiary, the trust would be divided into per stirpes shares for the then-living issue of that beneficiary, and if none, the then-living issue of the son. Article II, prior to modification, provided for the trust to terminate when the beneficiary turned 21. Under the modification, the term of the trust would be extended for the life of the beneficiary with a testamentary general power of appointment.

One of the rulings requested was that the proposed modification would not cause the trust or any separate trust subsequently created under the terms of the trust to lose its grandfathered GST status.

The IRS began its analysis by reciting regulations under Sec. 2601 regarding when the modification of a trust may cause it to lose its grandfathered status. Regs. Sec. 26.2601-1(b)(4)(i)(D)(1) provides that a modification of the governing instrument of a grandfathered trust by judicial reformation, or nonjudicial reformation that is valid under applicable state law, will not cause a grandfathered trust to be subject to GST tax if the modification does not shift a beneficial interest in the trust to any beneficiary who occupies a lower generation (as defined in Sec. 2651) than the person or persons who held the beneficial interest prior to the modification, and the modification does not extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original trust.

Regs. Sec. 26.2601-1(b)(4)(i)(D)(2) provides that for purposes of Regs. Sec. 26.2601-1, a modification of an exempt trust will result in a shift in beneficial interest to a lower generation beneficiary if the modification can result in either an increase in the amount of a GST or the creation of a new GST. To determine whether a trust modification will shift a beneficial interest to a beneficiary who occupies a lower generation, the effect of the instrument on the date of the modification is measured against the effect of the instrument in existence immediately before the modification. If the effect of the modification cannot be immediately determined, it is deemed to shift a beneficial interest in the trust to a beneficiary who occupies a lower generation than the person or persons who held the beneficial interest prior to the modification.

The IRS noted that under the proposed modification of Article II, the trust property is divided upon the son’s death into the same trust shares as under the original governing instrument of the trust. Each share will be held in a separate trust for the lifetime benefit of the beneficiary for whom it is created, and any remaining trust property including undistributed income will be subject to that beneficiary’s general power of appointment at his or her death. Therefore, the IRS ruled that the value of that property will be included in the beneficiary’s gross estate under Sec. 2041(a)(2) and the beneficiary will be treated as the transferor of that property for GST tax purposes under Sec. 2652(a)(1).

The IRS concluded that the proposed modification of Article II of the trust agreement would not shift a beneficial interest in the trust to any beneficiary occupying a lower generation than the person who held the beneficial interest prior to the modification, and the modification would not extend the time for vesting of any beneficial interest in the trust beyond the period provided for in the original governing instrument of the trust. Accordingly, the IRS concluded that the modification of the trust would not cause the trust or any separate trust subsequently created under the terms of the trust to lose its status as exempt from GST tax.

The key to not losing grandfathered GST status in this case was the testamentary general power of appointment. Had the power of appointment been limited, the same result would not have occurred. This case illustrates that merely extending the life of a trust does not cause the trust to lose its grandfathered GST status — not altering the generations who receive the trust’s assets by modification of the trust is the determining factor.

Trust reformation

In Letter Ruling 201941023, the IRS allowed the reformation of six trusts reforming a beneficiary’s withdrawal power from a trust to be applied retroactively because the specific provisions of the trust did not comply with the taxpayer’s intent at the time the trusts were created. In addition, it ruled on the consequences of the reformation and certain mistakes made on gift tax returns reflecting the transfers to the trusts.

The taxpayer executed an irrevocable trust for the benefit of his six children and their descendants. The taxpayer’s wife served as trustee. Under the trust agreement, six separate trusts were established with each child being the primary beneficiary of his or her trust.

The taxpayer made transfers to the children’s trusts in four consecutive years. The taxpayer timely filed a gift tax return for each year. The taxpayer and the spouse treated all the gifts as having been made one-half by each spouse. On the gift tax return filed for years 1—3, the gifts to each child’s trust were incorrectly reported on Schedule A, Computation of Taxable Gifts, Part 1, “Gifts Subject Only to Gift Tax,” instead of Schedule A, Part 3, “Indirect Skips and Other Transfers in Trust,” of Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. No affirmative allocation of GST exemption was made to the transfers to each child’s trust. Furthermore, the automatic allocation of the GST exemption was not reported on Schedule C, Computation of Generation-Skipping Transfer Tax (now Schedule D).

The taxpayer’s father also made transfers to the trusts in years 1 and 2. The father timely filed gift tax returns for each year he made transfers to the trusts. The taxpayer’s father and mother treated all the gifts as having been made one-half by each spouse. On the gift tax returns filed for years 1 and 2, the gifts to the trusts were incorrectly reported on Schedule A, Part 1, instead of Schedule A, Part 2, “Direct Skips.” No affirmative allocation of GST exemption was made to the transfers to the trusts. Furthermore, the accountant failed to fill out the GST tax portion of the gift tax return (Schedule C at the time the gifts were made, now Schedule D).

The trusts were created and funded based on the attorney’s advice. The taxpayer created the trusts to provide for his descendants of all generations and to reduce the overall transfer taxes payable on the trusts’ assets by ensuring that the assets held in the trusts would not be includible in any of the children’s gross estates upon their death, and to minimize the amount subject to GST tax by using the taxpayer’s and his spouse’s GST exemption. The taxpayer also intended to ensure that the six children would avoid incurring federal gift and estate tax in connection with the taxpayer’s transfer to the trust.

The withdrawal provision of the trust agreement contained a drafting error. Each primary beneficiary’s withdrawal right over the assets contributed to a child’s trust in any given year was not limited to the greater of $5,000 or 5% of the value of the trust assets. Accordingly, any lapse of a primary beneficiary’s withdrawal right would be treated as a taxable transfer by that primary beneficiary under Sec. 2514(e) to the extent that the property that could have been withdrawn exceeds in value the greater of $5,000 or 5% of the aggregate value of the assets subject to withdrawal.

Moreover, each primary beneficiary would become a transferor to his or her child’s trust for GST tax purposes with respect to the portion of the child’s trust constituting a gift by the child, thereby preventing (1) an effective deemed allocation of GST exemption under Sec. 2632(c) by the taxpayer and the taxpayer’s spouse with respect to the taxpayer’s transfers to that child’s trust for each of years 1-4; and (2) an effective deemed allocation of GST exemption under Sec. 2632(b) by the taxpayer’s father and mother with respect to the taxpayer’s father’s transfer to that child’s trust for years 1 and 2. In addition, the portion of each child’s trust relating to the lapsed withdrawal right in excess of $5,000 or 5% of the value of the trust assets would be included in the primary beneficiary’s gross estate for estate tax purposes.

The error was discovered by a new estate planning counsel the taxpayer engaged. The taxpayer was informed of the drafting error that defeated the intent of the taxpayer in establishing the trusts. The trustee of the trusts subsequently filed a petition in state court requesting judicial reformation of the erroneous provision, effective as of the date the trusts were originally created. The state court issued an order reforming the trust agreement to eliminate the scrivener’s error retroactive to the date of the trusts’ creations. The trust agreement was reformed to limit the annual lapse of each primary beneficiary’s withdrawal right to the greater of $5,000 or 5% of the value of the trust assets.

The taxpayer requested the following rulings from the IRS: (1) As a result of the reformation, no child will be deemed to have released a general power of appointment by reason of the lapse of any right of withdrawal held by the child with respect to any transfers to his or her trust; accordingly, no child will be deemed to have made a taxable gift to his or her trust and no part of his or her trust will be included in his or her gross estate; (2) as a result of the reformation, the only transferors to each trust for GST tax purposes are the taxpayer, the taxpayer’s spouse, and the taxpayer’s father and mother; and (3) as a result of the reformation, each of the taxpayer’s and his spouse’s GST exemption is automatically allocated to one-half of the transfers by the taxpayer to each child’s trust, and each of the taxpayer’s father’s and mother’s GST exemption is automatically allocated to one-half of the transfers by the taxpayer’s father to each child’s trust.

Ruling 1: The IRS began its analysis citing Estate of Bosch,¹⁰ as the standard as to whether to give a state court’s reformation of a trust retroactive effect for federal tax purposes. In Bosch, the Supreme Court considered whether a state trial court’s characterization of property rights conclusively binds a federal court or agency in a federal estate tax controversy. The Court concluded that the decision of a state trial court as to an underlying issue of state law should not be controlling when applied to a federal statute. Rather, the highest court of the state is the best authority on the underlying substantive rule of state law to be applied in the federal matter. If there is no decision by that court, then the federal authority must apply what it finds to be state law after giving “proper regard” to the state trial court’s determination and to relevant rulings of other courts of the state. In this respect, the federal agency may be said, in effect, to be sitting as a state court.

Under the applicable state law, a proceeding to approve or disapprove a proposed modification or termination of a trust may be commenced by a trustee or a beneficiary, and the state court may reform the terms of a trust, even if unambiguous, to conform the terms to the taxpayer’s intention if it is proved by clear and convincing evidence that the taxpayer’s intent or the terms of the trust were affected by a mistake of fact or law.

The IRS determined that in the present case, the original terms of the trust agreement, resulting from a scrivener’s error, were contrary to the taxpayer’s intent. The purpose of the reformation was to correct the scrivener’s error, not to alter or modify the trust instrument. The IRS concluded that as a result of the reformation, no child will be deemed to have released a general power of appointment by reason of the lapse of any right of withdrawal held by the child with respect to any transfers to his or her trust. Accordingly, no child would be deemed to have made a taxable gift to his or her trust, and no part of his or her trust would be included in his or her gross estate.

Rulings 2 and 3: The IRS began its analysis by noting that Sec. 2513(a)(1) provides, generally, that a gift made by one spouse to any person other than the donor’s spouse is considered for purposes of the gift tax as made one-half by the donor and one-half by the donor’s spouse. Regs. Sec. 25.2513-1(b)(4) provides that the consent is effective only if both spouses signify their consent to treat all gifts made to third parties during that calendar period by both spouses while married to each other as having been made one-half by each spouse. If the consent is effectively signified on either the husband’s return or the wife’s return, all gifts made by the spouses to third parties during the calendar period are treated as having been made one-half by each spouse.

Sec. 2652(a)(2) provides that if, under Sec. 2513, one-half of a gift is treated as made by an individual and one-half of the gift is treated as made by the individual’s spouse, the gift shall be so treated for GST tax purposes.

Sec. 2632(a)(1) provides that any allocation by an individual of his or her GST exemption under Sec. 2631(a) may be made at any time on or before the date prescribed for filing the estate tax return for that individual’s estate (determined with regard to extensions), regardless of whether a return is required to be filed. Under Sec. 2632(b)(1), if an individual makes a direct skip transfer during his or her lifetime, any unused portion of that individual’s GST exemption is automatically allocated to the property transferred to the extent necessary to make the inclusion ratio zero. Under Sec. 2612(c)(1), the term “direct skip” means a transfer subject to gift or estate tax of an interest in property to a skip person. Regs. Sec. 26.2632-1(b)(1)(ii) provides, in part, that an automatic allocation of GST exemption is effective as of the date of the transfer to which it relates. A gift tax return need not be filed to report an automatic allocation.

Sec. 2632(c)(1) provides that if any individual makes an indirect skip during that individual’s lifetime, any unused portion of that individual’s GST exemption shall be allocated to the property transferred to the extent necessary to make the inclusion ratio for that property zero. Sec. 2632(c)(3)(A) provides that for purposes of Sec. 2632(c), the term “indirect skip” means any transfer of property (other than a direct skip) subject to the tax imposed by Chapter 12 made to a GST trust. Sec. 2632(c)(3)(B) provides, in part, that the term “GST trust” means a trust that could have a generation-skipping transfer with respect to the transferor unless the exceptions enumerated in Secs. 2632(c)(3)(B)(i) through (vi) apply.

The IRS determined that each child’s trust was a GST trust for purposes of Sec. 2632(c). Since the taxpayer and his spouse timely filed gift tax returns for years 1-4 and elected to split the gifts under Sec. 2513, the taxpayer and his spouse were treated as the transferor of one-half of the value of the entire property transferred to each child’s trust in years 1-4 under Sec. 2652(a)(2). The IRS ruled that the automatic allocation rules under Sec. 2632(c)(1) apply to allocate the taxpayer’s and his spouse’s GST exemption to one-half of the transfers of property made to each child’s trust in each of years 1-4. Similarly, since the taxpayer’s father and mother timely filed Forms 709 for years 1 and 2 and elected to split the gifts under Sec. 2513, the taxpayer’s father and mother were treated as the transferor of one-half of the value of the entire property transferred to each child’s trust in years 1 and 2 under Sec. 2652(a)(2).

The IRS ruled that the automatic allocation rules under Sec. 2632(b)(1) applied to allocate the taxpayer’s father’s and mother’s GST exemption to one-half of the transfers of property made to each child’s trust in each of year 1 and year 2. This was true even though all the taxpayers filed gift tax returns reporting their gifts in the wrong sections of their returns.

Inflation adjustments

Rev. Proc. 2019-44 sets forth inflation adjustments for various tax items for 2020. The following may be of interest to estate planning professionals:

• Unified credit against estate tax:The basic exclusion amount is $11,580,000 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 resulting from electing to use Sec. 2032A for purposes of the estate tax cannot exceed $1,180,000.
• 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 $157,000.
• Interest on a certain portion of estate tax payable in installments:The dollar amount used to determine the “2-percent portion” (for purposes of calculating interest under Sec. 6601(j)) of the estate tax extended as provided in Sec. 6166 is $1,570,000.

The views expressed in this article are those of the author and do not necessarily reflect the views of Ernst & Young LLP, or the global EY organization or its member firms.

Footnotes

¹T.D. 9884, 84 Fed. Reg. 64995.

²P.L. 115-97.

³Notice 2017-15 (regarding the application of Windsor, 570 U.S. 744 (2013), as it relates to certain gifts, bequests, and generation-skipping transfers by (or to) same-sex spouses and their remaining applicable exclusion amount and remaining GST tax exemption to the extent an allocation of that exclusion or exemption was made to certain transfers made while the taxpayer was married to a person of the same sex).

⁴REG-106706-18, 83 Fed. Reg. 59343.

⁵Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16.

⁶Estate of Moore, T.C. Memo. 2020-40.

⁷Estate of Bongard, 124 T.C. 95 (2005).

⁸See Estate of Powell, 148 T.C. 392 (2017).

⁹Badgley, No. 18-16053 (9th Cir. 4/28/20), aff’g No. 4:17-cv-00877 (N.D. Cal. 5/17/18).

¹⁰Estate of Bosch, 387 U.S. 456 (1967).