Recent developments in estate planning: Part 1

This article is the first part of an annual update on recent developments in estate planning. It covers trust and gift tax issues. The second part, in the November issue, will focus on estate tax developments. The update below discusses deductions available to a trust or estate, how California taxes trusts' income, qualified terminable interest property trusts, and other matters. The period covered is from July 2020 through June 2021.

Trusts

Expense deduction

In final regulations issued in October 2020,¹ Treasury and the IRS addressed deductions available to a trust or estate. The regulations clarify that deductions allowed to an estate or nongrantor trust under Sec. 67(e) are not miscellaneous itemized deductions and thus are unaffected by suspension of the deductibility of miscellaneous itemized deductions. Sec. 67(e) deductions are:

• Estate or trust administration costs that would not have been incurred if the property were not held in the estate or trust;
• The personal exemption of an estate or nongrantor trust; and
• Deductions for distributions of income to beneficiaries of the estate or trust.

The regulations also provide guidance for beneficiaries succeeding to the property of a terminating estate or trust when that entity has expenses in excess of income in the year of termination.

Background: Sec. 67(g), added by the law known as the Tax Cuts and Jobs Act (TCJA),² suspends the deduction of miscellaneous itemized deductions for tax years 2018 through 2025. For purposes of Sec. 67, miscellaneous itemized deductions are itemized deductions other than those listed in Secs. 67(b)(1) through (12).

The adjusted gross income (AGI) of an estate or trust generally is computed for Sec. 67 purposes in the same manner as AGI for an individual, but the Sec. 67(e) deductions are also allowed in computing AGI.

With respect to excess deductions on the termination of an estate or trust, Sec. 642(h) allows beneficiaries succeeding to the property of the estate or trust to deduct (1) a Sec. 172 net operating loss (NOL) carryover and a Sec. 1212 capital loss carryover of the terminating estate or trust; and (2) certain deductions that exceed gross income for its last year (excess deductions). In the past, the excess deductions were treated in the hands of the beneficiary as a single miscellaneous itemized deduction that was subject to the 2% floor for deductibility and potentially to disallowance under Sec. 67(g).

In July 2018, the IRS issued Notice 2018-61 announcing its intention to issue regulations clarifying the effect of Sec. 67(g) on the deductibility of expenses described in Secs. 67(b) and (e) that are incurred by estates and nongrantor trusts. In the same notice, the IRS also asked for comments on how Sec. 67(g) affects the ability of the beneficiary to deduct amounts comprising the Sec. 642(h)(2) excess deduction on the termination of an estate or trust.

In May 2020, Treasury and the IRS issued proposed regulations³ addressing these matters.

Final regulations: The final regulations issued in October 2020 adopt the proposed regulations with some modifications. Consistent with the proposed regulations, the final regulations clarify that items described in Sec. 67(e) remain deductible in determining the AGI of an estate or nongrantor trust during the tax years in which Sec. 67(g) applies, which are 2018 through 2025 (Regs. Sec. 1.67-4). The final regulations in this section adopt the proposed rules without modification.

With respect to excess deductions, the final regulations also adopt the general rule included in the proposed regulations. Under this rule, if an estate or trust, on termination, has deductions for its last tax year in excess of gross income — not counting the deductions allowed under Sec. 642(b) (personal exemption) or Sec. 642(c) (charitable deduction) — the excess deductions are allowed as items of deduction to the beneficiaries succeeding to the property of the terminated estate or trust (Regs. Sec. 1.642(h)-2(a)).

Rather than treating all excess deductions as miscellaneous itemized deductions, the regulations assign the deductions to three categories:

1. Deductions allowable in calculating AGI under Secs. 62 and 67(e);
2. Itemized deductions under Sec. 63(d) that are allowed in calculating taxable income; and
3. Miscellaneous itemized deductions (which are temporarily disallowed under the TCJA).

For example, tax preparation fees that would be deductible by a trust or estate in computing AGI are deductible by the beneficiary in computing the beneficiary's AGI (rather than as a miscellaneous itemized deduction under prior law).

The final regulations in this section include some modifications in response to comments, described below.

First, for purposes of determining the character and amount of the excess deductions under Sec. 642(h)(2), the provisions of Regs. Sec. 1.652(b)-3 are used to allocate each item of deduction among the classes of income in the year of termination of a trust (see Regs. Sec. 1.642(h)-2(b)(2) of the final regulations). In response to a comment, the final regulations clarify that beneficiaries may claim all or part of the excess deductions under Sec. 642(h)(2) before, after, or together with deductions of the same character that are separately allowable to the beneficiary under the Code.

Example 2 in Regs. Sec. 1.642(h)-5(b) of the final regulations illustrates computations under Sec. 642(h)(2). Various commenters pointed out that the example in the proposed regulations, which included rental real estate taxes as an expense, could raise several issues beyond what the example aims to illustrate. To remedy this, the final regulations adopt a suggestion to modify the example to avoid these issues by having rental real estate expenses entirely offset rental income with no unused deduction. In addition, in response to comments, Example 2 in the final regulations was further revised to include personal property tax paid by the trust rather than taxes attributable to rental real estate. Finally, Example 2 was also modified to illustrate the application of trustee discretion as found in Regs. Secs. 1.652(b)-3(b) and (d).

Regarding Example 1 in Regs. Sec. 1.642(h)-5, a couple of commenters requested that it be revised to take into account the amendments to Sec. 172(b)(1)(D) under the Coronavirus Aid, Relief, and Economic Security (CARES) Act⁴ by allowing a beneficiary to carry back (five years) the NOL carryover the beneficiary succeeds to under Sec. 642(h)(1) for tax years after Dec. 31, 2017, and before Jan. 1, 2021. The final regulations did not adopt these comments. The preamble notes that the phrase in Sec. 642(h)(1) "the estate or trust has a net operating loss carryover" means that the estate or trust incurred an NOL and either already carried it back to the earliest allowable year under Sec. 172 or elected to waive it under Sec. 172(b)(3) and now is limited to carrying over the remaining NOL. Because the NOL is a carryover for the estate or trust, the beneficiary succeeding to that NOL may, under Sec. 642(h)(1), only carry it forward.

California taxation of trusts

In Steuer v. Franchise Tax Board,⁵ the California Court of Appeal held that all of a trust's California-source income was subject to California tax, regardless of the residency of the trust's fiduciaries. Additionally, the court held that the California resident beneficiary's interest in the trust was contingent because the terms of the trust instrument gave the trustees complete discretion to determine when (or if) to make distributions.

The Paula Trust had two individual trustees: (1) a California resident; and (2) a Maryland resident. The sole beneficiary was a California resident. In 2007, the trust's underlying assets realized capital gain. On its original 2007 tax return, the trust apportioned all its income (i.e., the gain) to California. In 2012, the trust filed an amended tax return requesting a refund on the ground that only half its income should be apportioned to California because only one of its two trustees resided in California.

When the trust's refund was denied, the trustees filed an administrative appeal with the California State Board of Equalization (board). The board rejected the trust's refund request, and the trust filed a tax refund suit. The trial court granted the trust's motion for summary judgment, holding that: (1) the trust's California taxable income (both California and non-California source) should be determined using an apportionment percentage based on trustee residence; and (2) the beneficiary's interest in the trust was contingent. The California Franchise Tax Board filed an appeal.

On appeal the trust argued, as it had in the trial court, that California's rules for determining a nonresident's income from California sources do not apply to trusts because the term "resident," as used in the statute, refers only to "individuals" or "natural persons." The trust also contended that its California taxable income must be determined by California Rev. & Tax. Code Section 17743, which states in relevant part: "Where the taxability of income under this chapter depends on the residence of the fiduciary and there are two or more fiduciaries . . . , the income taxable under Cal. Rev. & Tax. Code Section 17742 shall be apportioned according to the number of fiduciaries resident in this state."

The California Court of Appeal, First Appellate District, began its review of the case by examining Section 17743 and other applicable California statutes:

• Cal. Rev. & Tax. Code Section 17731: Requires a California trust to compute its taxable income in the same manner as an individual for federal tax purposes.
• Cal. Rev. & Tax. Code Section 17041(e): Requires a California trust to pay taxes equal to the amount computed under subdivision (a) of Cal. Rev. & Tax. Code Section 17041 for an individual having the same amount of taxable income.
• Cal. Rev. & Tax. Code Section 17742: California tax applies to the entire taxable income of a trust if the fiduciary or beneficiary (other than a contingent beneficiary) is a resident.

The Court of Appeal, after reviewing the plain language of the statutes, found the trust's argument unpersuasive. The court held that a trust's California-source income is always taxable by California because: (1) a trust computes its taxable income in the same manner as an individual; and (2) the taxable income of an individual (whether a resident or nonresident) always includes California-source income. In other words, because California-source income in the hands of an individual is taxable in all events, the same is true for a trust. Accordingly, the court found that the Franchise Tax Board's long-standing regulations validly direct trusts to pay tax on California-source income in all events and to apportion only the non-California-source income.

The Court of Appeal also addressed the trust's argument that Section 17743, by virtue of its reference to the income taxable under Section 17742, required the apportionment of the trust's entire taxable income (i.e., both its California-source and non-California-source income) and that to the extent the regulation provided otherwise, it was invalid.

The court rejected the trust's argument, noting that the plain language of the statute required the taxing of California-source income and apportionment of only non-California-source income according to the number of resident fiduciaries. The court reasoned that California's ability to tax California-source income never depends on the residence of the fiduciary because California-source income is always taxable on a source basis. Furthermore, the court reasoned that Section 17743 only applies in the limited circumstance where a trust has non-California-source income and two or more fiduciaries.

Finally, the Court of Appeal affirmed the trial court's holding that the trust's sole beneficiary was a contingent beneficiary. In analyzing this issue, the court reviewed the trust document and determined that the trustees were authorized, but not required, to distribute trust income and principal as the trustees deemed to be in the beneficiary's interest. Under California law, a beneficiary holds a contingent interest in a trust if the trustee has absolute discretion to determine if or when to make distributions of trust income and principal to the beneficiary. Here, the court found that the trustees had complete discretion to decide if or when to make distributions, and, thus, the sole beneficiary was a contingent beneficiary. Therefore, the trust would not be taxable on all of its income based on the beneficiary's California residence, and the trust's non-California-source income is apportionable.

Gift tax

Commutation of QTIP interests

In CCA 202118008, the Office of Chief Counsel of the IRS advised that the commutation of a qualified terminable interest property (QTIP) trust was a disposition of the surviving spouse's qualifying income interest that was subject to Sec. 2519. The Office of Chief Counsel further held that the commutation of the trust and the distribution of all of the trust property to the surviving spouse did not result in offsetting reciprocal gifts between the surviving spouse and the remainder beneficiaries.

The decedent died testate, survived by his spouse and children. Pursuant to the decedent's will, three trusts were created. The trust at issue was funded with the residue of the estate. The trust directs all income to be distributed to the spouse at least annually and authorizes principal distributions for the spouse's health, maintenance, and support in the spouse's accustomed manner of living if the income is insufficient for such purposes. The trust also grants the spouse a testamentary limited power of appointment in favor of the decedent's descendants. In the absence of the spouse's exercise of the testamentary limited power of appointment, the trust directs the remainder to be distributed outright to the children.

On its timely filed estate tax return, the estate made an election to treat the trust property as qualified terminable interest property under Sec. 2056(b)(7). Subsequently, the spouse and children entered into an agreement providing that the trust was commuted and all of its property was to be distributed to the spouse. The spouse and children had agreed that the spouse would be better served if she held the trust assets outright. The parties also acknowledged that the spouse's testamentary limited power of appointment was not operative.

Furthermore, the agreement provided that: (1) the commutation of the trust results in a deemed gift of the remainder interest in the trust assets from the spouse to the children under Sec. 2519; (2) by virtue of the distribution of all of the trust assets to the spouse, the commutation of the trust does not result in a deemed gift of the spouse's income interest in the trust under Sec. 2511; and (3) by signing the agreement and by virtue of the distribution of all of the trust assets to the spouse, the commutation of the trust results in a gift of the remainder interest in the trust from the children to the spouse. Essentially, the agreement determined that the deemed gift of the remainder interest from the spouse to the children and the gift from the children to the spouse resulted in a reciprocal gift transfer. After the commutation and the children's gifts of their remainder interests to the spouse, the spouse owned all the trust property outright.

The spouse and children each filed a gift tax return reporting the commutation and distribution of the trust property from the spouse to the children to be deemed to be the same value as the property transferred from the children to the spouse and asserted that the amounts of the gifts were zero.

Commutation of QTIP trust: Under Sec. 2519(a), any disposition of a qualifying income interest for life in any property to which Sec. 2519 applies is treated as a transfer of all interests in such property other than the qualifying income interest. Sec. 2519(b) provides that Sec. 2519(a) applies to any property if a deduction was allowed with respect to the transfer of such property to the donor under Sec. 2056(b)(7).

Under Regs. Sec. 25.2519-1(a), if a donee spouse makes a disposition of all or part of a qualifying income interest for life in any property for which a deduction was allowed under Sec. 2056(b)(7) for the transfer creating the qualifying income interest, the donee spouse is treated as transferring all interests in property other than the qualifying income interest. A transfer of the income interest of the spouse is a transfer by the spouse under Sec. 2511. Under Regs. Sec. 25.2519-1(f), the sale of the qualified terminable interest property, followed by the payment to the donee spouse of a portion of the proceeds equal to the value of the donee spouse's income interest, is considered a disposition of the qualifying income interest.

The IRS noted that in the instant case, the deceased spouse's estate made an election under Sec. 2056(b)(7) to treat the trust as a QTIP trust and claimed an estate tax marital deduction for the value of the trust. Next, the spouse and children entered into the agreement that effected the commutation of the trust. The IRS stated that in a commutation, the trustee makes terminating distributions to the holders of the beneficial interests in the trust equal to the actuarial value of the interests. Each beneficiary gives up his or her respective beneficial interest in exchange for a lump-sum payment, in what is essentially a sale transaction. The commutation terminates any relationship between the beneficiary and the trust, and if all interests are commuted, the trust terminates.

Accordingly, the IRS advised that the commutation of the trust constituted a disposition by the spouse of her qualifying income interest within the meaning of Sec. 2519(a). Thus, for gift tax purposes, the spouse was treated as transferring by gift all interests in the trust other than the qualifying income interest.

Reciprocal exchange: The IRS first discussed the issue of contractual "consideration" for purposes of Sec. 2512(b) and reciprocal transfers. The IRS reviewed the Supreme Court cases Wemyss⁶ and Merrill v. Fahs,⁷ in which the Supreme Court considered the gift tax meaning of the term "adequate and full consideration in money or money's worth" in the context of antenuptial contracts.

In Wemyss, the donor transferred assets to his fiancée to compensate her for the loss of an income interest that would terminate upon her marriage to him. There was no dispute that both a promise of marriage and detriment to a contracting party constituted valuable consideration for purposes of the law of contracts. The Supreme Court explained that valuable contractual consideration in the hands of the donor is not sufficient; adequate and full consideration is that which replenishes, or augments, the donor's taxable estate. In Merrill, the donor transferred property to the donor's then-spouse in exchange for the spouse's relinquishment of marital rights in the donor's remaining property. The Supreme Court held that the spouse's relinquishment of the marital rights did not constitute adequate and full consideration for the donor's transfer because the assets subject to the marital rights were already includible in the donor's gross estate.

After reviewing these Supreme Court cases, the IRS then discussed Rev. Rul. 69-505, which involved a transfer to a trust of joint-tenancy property that was treated as a reciprocal exchange for consideration in money or money's worth. The two joint tenants could each unilaterally sever the joint tenancy, and if not severed, the property would pass to the survivor upon the death of the other joint tenant. Together they transferred the property to a trust, reserving the right to receive one-half of the income therefrom for their joint lives, with all to the survivor for life and the remainder to a third party. The revenue ruling held that the transfers were treated as a reciprocal exchange for consideration in money or money's worth. Thus, neither tenant made a gift to the other to the extent that the transfers were of equal value.

After discussing these authorities, the IRS noted that the parties in the present case had stated in their written agreement that the "deemed gift of the remainder interest" under Sec. 2519(a) and the gift from the children to the spouse under Sec. 2511 would result in a "reciprocal gift transfer." This statement in the agreement, however, was not supported by the economics of the transaction or the gift tax meaning of what constitutes "adequate and full consideration." Absent entering into the agreement, the spouse had no right to the remainder under the terms of the trust or local law. Therefore, from an economic perspective, the transaction resulted in a one-sided gift transfer from the children to the spouse. Unlike in Rev. Rul. 69-505, the spouse's deemed transfer under Sec. 2519(a) and the children's transfers of their remainder interests under Sec. 2511 did not constitute offsetting exchanges of consideration. The IRS determined that the spouse received no consideration for the deemed transfer to the children under Sec. 2519(a).

The IRS determined this analysis was also consistent with the QTIP statutory scheme and legislative history. The QTIP provisions (Secs. 2056(b)(7), 2044, and 2519) were enacted in 1981, at the same time as the unlimited marital deduction. Sec. 2056(b)(7) was enacted to provide an alternative to an outright transfer of property to the surviving spouse that would qualify for the unlimited marital deduction. Given that an income interest that terminates at death generally is not includible in a decedent's gross estate, Secs. 2044 and 2519 were added to ensure that the estate tax deferred by Sec. 2056(b)(7) becomes subject to tax, either on the surviving spouse's death or upon a lifetime disposition of the spouse's qualifying income interest.

Thus, the IRS noted that the QTIP statutory scheme was consistent with the policy underlying the marital deduction, that is, to allow property to pass to the surviving spouse without the decedent-spouse's estate paying tax on its value, but only until such time as the surviving spouse either dies or makes a lifetime disposition of the property. Under either circumstance, the transfer tax is ultimately paid.

The IRS determined that here the QTIP statutory scheme and the legislative history support the view that Rev. Rul. 69-505 has no application and the separate transfers by the spouse and children would not be offset by consideration for gift tax purposes. The decedent's estate received the benefit of deferral of the estate tax liability allocable to the property of the trust as a result of making the QTIP election for such property under Sec. 2056(b)(7). Because the commutation constitutes a taxable disposition by the spouse within the meaning of Sec. 2519(a), it marks the end of the deferral of the tax.

The IRS concluded that the commutation of the trust and the distribution of all trust property to the spouse results in separate gift transfers by the children under Sec. 2511 and by the spouse under Sec. 2519(a) that do not offset each other.

The IRS ruling is consistent with the Code and existing precedent. The spouse and children sought to equate the effect of the tax imposed under Sec. 2519(a) on the spouse on the termination of the QTIP trust as being the transfer by the spouse to the children of the remainder interest in the trust. However, the spouse never actually owned the remainder interest in the qualified terminable interest property. The transfer of the remainder interest in the qualified terminable interest property occurred when the deceased spouse died. Estate tax would have been paid regarding that transfer, but the estate elected to defer the tax until the surviving spouse's later death or prior termination of the QTIP trust. Thus, the transfer of the remainder interest by the children to the spouse was not an offsetting transaction because the spouse provided no consideration.

Dissolution of a foreign trust

In CCA 202045011, the Office of Chief Counsel determined that the beneficiary of a foreign trust became subject to U.S. federal gift tax when he indirectly transferred assets from the dissolution of the trust to someone else's bank account.

The taxpayer, a U.S. resident, was the primary beneficiary of a foreign foundation (a "stiftung," organized under the laws of a foreign country and essentially a trust for U.S. tax purposes) that had been established for the benefit of the taxpayer and his family. The decision was eventually made by the foundation's counsel to dissolve the foundation and to distribute the assets to the taxpayer. However, the taxpayer directed the distribution of the foundation's assets to be made to a bank account not owned by the taxpayer (i.e., the taxpayer never had signature authority over the bank account or control of or access to the bank account's assets).

The first issue the IRS considered was whether the taxpayer should be treated as having received the distribution from the foundation and then having subsequently transferred the assets via gift to the owner of the bank account, thereby making a gift. The Service noted that Sec. 2501(a)(1) and corresponding regulations impose a gift tax on the transfer of property by gift by a U.S. citizen or resident. Sec. 2511(a) provides that the tax imposed under Sec. 2501 applies whether the gift is direct or indirect.

Regs. Sec. 25.2511-2(b) states that a gift is considered complete when the donor releases "dominion and control" over property or an interest in property. The IRS determined here that the transfer to the bank account was made at the taxpayer's request. When the foundation's assets were transferred to the bank account, the taxpayer relinquished dominion and control over them and, thus, made a gift to the owner of the bank account.

The IRS also considered whether the taxpayer's direction of the assets to the bank account constituted a "qualified disclaimer." A qualified disclaimer is an irrevocable and unqualified refusal by a person to accept an interest in property. Pursuant to Sec. 2518(a), if the taxpayer made a qualified disclaimer, he would not be treated as having received the assets from the foundation and thus would have made no gift for gift tax purposes.

Pursuant to Sec. 2518(b), a qualified disclaimer is only valid if:

1. The person's refusal to accept the property interest is in writing;
2. The writing is received by the transferor of the interest, his or her legal representative, or the holder of the legal title to the property to which the interest relates, not later than the date that is nine months after the later of: (a) the date on which the transfer creating the interest in the person is made; or (b) the day on which the person attains age 21;
3. The person has not accepted the interest or any of its benefits; and
4. As a result of the refusal to accept the property interest, the interest passes without any direction on the part of the person making the disclaimer and passes either: (a) to the spouse of the decedent; or (b) to a person other than the person making the disclaimer.

The IRS concluded here that there was no qualified disclaimer because the transfer was made at the direction of the taxpayer and thus failed to satisfy the requirement that the transfer must be made "without any direction" on the part of the person making the disclaimer.

In sum, by directing the dissolved foundation's assets to a bank account over which he had no ownership or control, the taxpayer made a gift for gift tax purposes.

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

Footnotes

¹T.D. 9918.

²P.L. 115-97.

³REG-113295-18.

⁴Coronavirus Aid, Relief, and Economic Security Act, P.L. 116-136.

⁵Steuer v. Franchise Tax Board, 51 Cal. App. 5th 417 (Cal. Ct. App. 2020).

⁶Wemyss, 324 U.S. 303 (1945).

⁷Merrill v. Fahs, 324 U.S. 308 (1945).