Recent developments in estate planning: Part 1

Contributors: Members of the Ernst & Young National Tax Department in Private Tax

This article is the first of two installments providing an annual update on recent developments in estate planning. This first part concerns tax issues of formation and administration of trusts and estate taxation. The second installment, in the November issue, will cover developments in gift and generation-skipping transfer tax, plus inflation adjustments and relevant presidential budget proposals. Both parts cover developments on these topics between August 2022 and June 2023.

Trusts: Estate tax charitable deduction

In Estate of Block,¹ the Tax Court held that an estate was not entitled to a charitable deduction under Sec. 2055 from the value of the gross estate for the transfer of a remainder interest in a trust, finding that the trust did not qualify as a charitable remainder annuity trust (CRAT) and the trustees did not effect a qualified judicial reformation of the trust.

Prior to her death on Oct. 21, 2015, the decedent created a revocable trust and executed a will in which she left her remaining estate to the trust. One of the trust’s provisions created a subtrust that was intended to meet the requirements of a CRAT as defined in Sec. 664.

Under the provisions of the trust, the subtrust was to be created upon the decedent’s death, with the annuity to be paid to the decedent’s sister and then to the sister’s husband, if he should survive her. Upon the death of the later to die of the sister or the sister’s husband, the remainder of the subtrust was to be paid to a public charity eligible for the estate tax charitable deduction pursuant to Sec. 2055. The provisions of the subtrust stated that the decedent’s sister was to be paid an annual amount equal to the greater of: (1) all net income or (2) $50,000. The subtrust provisions further stated that the trust was irrevocable but that the trustees could amend it for the sole purpose of making sure the subtrust met the requirements of Sec. 664. However, the trustees could not change the annuity period, the annuity amount, or the charity.

The estate timely filed its federal estate tax return on or before July 21, 2016, taking an estate tax charitable deduction for the remainder interest in the subtrust going to the charity.

The IRS initiated an examination of the decedent’s estate tax return in August 2017 and issued a notice of deficiency disallowing the charitable deduction, determining that the subtrust did not satisfy the requirements of a CRAT under Sec. 664 because the annuity amount was not a specified amount but the greater of all net income or $50,000.

After issuance of the notice of deficiency, the trustees of the subtrust amended its provisions to provide that the annuity amount was fixed at $50,000 (excluding any reference to the income of the subtrust), making the amendment effective as of the date of the decedent’s death. The IRS continued to disallow the deduction.

Sec. 2055 provides that if a trust fails to satisfy the requirements of a CRAT, the deduction is still allowed if the estate executes a qualified reformation of the trust. A qualified reformation may occur only if the remainder interest is a “reformable interest.”² One of the requirements of a reformable interest is that the annuity payments to the noncharitable beneficiary are expressed in either a specified dollar amount or a fixed percentage. A nonfixed interest is reformable if a judicial proceeding is commenced within 90 days after the due date of the estate tax return and the proceeding results in the trust’s meeting the requirements of a CRAT, retroactive to the date of the decedent’s death.

The Tax Court noted that the initial subtrust provisions did not meet the requirements of a CRAT because the annuity amount was not limited to a specific dollar amount. The court further determined that the judicial reformation provisions in Sec. 2055 also did not apply because: (1) the amendment to the subtrust was executed sometime after August 2017 — beyond the 90-day qualified reformation window — and (2) the amendment was not the result of a judicial proceeding.

The estate made two alternative arguments as to why the deduction should be allowed. First, it argued that it had substantially complied with the judicial reformation requirements. However, citing congressional intent to strictly construe the exception for judicial reformations, the Tax Court determined that the estate had not substantially complied with the requirement.

Second, citing revenue procedures that provide sample terms of a valid CRAT, the estate argued that the trustee of a subtrust could act alone at any time to amend the terms of the subtrust to ensure it met the requirements of a CRAT and retroactively qualified the subtrust for the estate tax charitable deduction.

However, citing certain cautions in the revenue procedures regarding provisions in a CRAT instrument outside those in the sample provisions in the revenue procedures, the court noted that the annuity provision in the subtrust, as originally stated, was a substantive provision outside those sample provisions. Therefore, the court determined, this argument failed.

Character of distributions

In Furrer,³ the Tax Court held that a couple must include the annuity payments from CRATs in income for the years at issue. It further held that the couple was not entitled to claim charitable deductions for contributions of crops they made to the CRATs.

The couple farmed corn and soybeans. Spurred by an ad in a farming magazine, the couple formed CRAT I in July 2015, with their son as trustee. The trust instrument designated the couple as life beneficiaries and listed three charities as remaindermen. Upon forming CRAT I, they transferred 100,000 bushels of corn and 10,000 bushels of soybeans grown on their farm to it. In August 2015, CRAT I sold the crops for $469,003. CRAT I distributed $47,000 to the three charities and used the rest to buy a single-premium immediate annuity (SPIA) from an insurance company. The SPIA then paid annual annuity payments to the couple of $84,368 in 2015 through 2017, reporting each payment on a Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., and listing the annuity payments as gross distributions and only a small amount of interest as taxable.

The couple repeated this pattern in 2016, creating CRAT II, to which they transferred corn and soybeans. CRAT II sold the crops for $691,827, distributed $69,294 to the charitable remaindermen, and used the rest to buy another SPIA, which in turn made $124,921 annual payments to the couple in 2016 and 2017. They reported the transaction in the same manner as they had for CRAT I.

When the couple filed timely joint income tax returns for 2015 through 2017, they did not claim deductions for the remainder interests in the CRATs. They reported income as reported on the Forms 1099-R and did not report the balance of the annuity distributions, which they asserted constituted a nontaxable return of corpus under Sec. 664(b)(4).

The husband filed Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, for 2015 and 2016, reporting (1) the couple’s 2015 contribution to CRAT I of corn and soybeans as having a fair market value (FMV) of $469,003 and a zero cost basis, and (2) their 2016 contribution of crops to CRAT II as having an FMV of nearly $667,000 and a cost basis of zero.

The CRATs’ trustee filed a Form 5227, Split Interest Trust Information Return, and Form 4797, Sales of Business Property, for each pertinent year, reporting the crop sales as follows:

• 2015: $469,003 in proceeds, offset by a $471,000 basis, resulting in a $1,997 loss; and
• 2016: $691,827 in proceeds, offset by a $666,975 basis, resulting in a $24,852 gain.

An IRS audit of the couple’s 2015 through 2017 income tax returns concluded that the couple had improperly characterized the SPIA distributions as nontaxable returns of corpus and that the distributions were proceeds from the sale of the crops and thus taxable to them as ordinary income.

As a result, the IRS increased income on the couple’s Schedule F, Profit or Loss From Farming, by $83,440 in 2015 and $206,967 in 2016 and 2017. While under exam, the couple asserted that they should have claimed noncash charitable contribution deductions for the crops transferred to the two CRATs. They asked the examining agent to allow deductions equal to the proportion of the FMV of the donated crops given to the charitable remaindermen. Although the couple had not obtained an appraisal for either donation, the examination agent agreed to allow charitable contribution deductions of $67,788 for 2015 and $106,413 for 2016.

The IRS issued deficiency notices for 2015 through 2017, and the couple timely petitioned the Tax Court. After the parties settled some issues, the two remaining issues were: (1) whether the couple was entitled to noncash charitable contribution deductions for 2015 and 2016, and (2) whether the annuity distributions were taxable to them as ordinary income for 2015 through 2017. The IRS moved for summary judgment on both issues.

Charitable deduction

The IRS contended that the examining agent had erred in allowing charitable deductions for the crops transferred to the CRATs. As this was a “new matter” before the Tax Court, the IRS bore the burden of proof on it and carried its burden. The court agreed that the deductions were impermissible because the taxpayers had not substantiated the value of the crops by obtaining an appraisal or by maintaining written records substantiating the contribution as required by Sec. 170(f).

Further, the Tax Court determined, even if the taxpayers had substantiated the value of the contributed assets, Sec. 170(e)(1)(A) provides that a deduction for a contribution of property must be reduced by the amount of gain that would not have been long-term capital gain if the taxpayer had sold the property at its FMV. The crops were inventory that the taxpayers primarily held for sale to customers in their business and thus generated exclusively ordinary income. Because the deduction for a contribution of ordinary-income property is limited to the donor’s cost basis in the property, and the couple’s basis for the crops was zero (they had already fully expensed their costs associated with growing them), any charitable deduction would be zero as well.

Annual distributions

The Tax Court explained that a CRAT is a type of charitable remainder trust and thus allows annual distributions to the grantor or other noncharitable beneficiary while retaining an irrevocable remainder interest for at least one Sec. 501(c)(3) charity. The donor typically does not recognize gain when transferring appreciated property to a charitable remainder trust, but income the trust earns is taxable to the income beneficiaries upon distribution. A set of ordering rules in Sec. 664(b) organizes how this income is treated as distributed and thus taxed:

• First, as ordinary income to the extent of the CRAT’s current and previously undistributed ordinary income;
• Second, as capital gain to the extent of current and previously undistributed capital gain;
• Third, as other income to the extent of current and previously undistributed other income; and
• Fourth, as a nontaxable distribution of corpus.

Each class of taxable income must be exhausted before moving on to the next (lower-taxed) class, and the beneficiary may receive a nontaxable distribution of corpus only after all ordinary, capital gain, and other income has been distributed. To ensure compliance with these ordering rules, CRATs must comply with strict reporting requirements.

The Tax Court noted that the husband had conceded in his 2015 and 2016 gift tax returns that the couple’s basis in the crops transferred to the CRATs was zero. The couple did not pay gift tax when they transferred the crops to the CRATs; therefore, the CRATs’ basis in the property received was the same as the couple’s basis.⁴

The CRATs then realized ordinary income ($469,003 and $691,827) when they sold the crops. Because all of this ordinary income must be distributed first, the Tax Court determined that the annuity distributions ($83,440, $206,967, and $206,967) must all be characterized as ordinary income to the couple.

The Tax Court easily dispensed with each of the couple’s arguments, ruling that none had merit. The couple’s contention that the CRATs acquired a stepped-up basis because they sold the crops to the CRATs “does not pass the straight-face test,” the court wrote. As evidenced by the gift tax returns filed by the Furrers, they contributed the crops to the CRATs. “Equally unpersuasive” was the trustee’s reporting on Form 4797 of bases exceeding or nearly equaling the FMV of the crops because the couple provided no support for those numbers, and they were “utterly implausible.” The court also rejected the couple’s assertion that the annuity distributions constituted a nontaxable return of corpus, finding that the Furrers provided no cites to any legal authority supporting this position and that there is none.

Finally, the Tax Court rejected the couple’s contention that distributions from the SPIAs should be taxed under Sec. 72, noting that Sec. 664(b) provides specific rules for annuity distributions from CRATs and that both Code sections allow for income to be excluded only to the extent the taxpayer has an investment in the contract. Because both annuity contracts were purchased with proceeds from the sale of crops with a zero basis, the court concluded the couple had no investment in the contract.

It is somewhat surprising that the examining agent allowed the charitable deductions, because the property was considered inventory to the taxpayers, and they had previously filed returns reporting that their basis in the inventory was zero. Sec. 170(e)(1)(A) is clear on the issue, and the taxpayers had not taken charitable deductions for the remainder interests in the CRATs when they filed their 2015 and 2016 returns. The fact that the charitable deductions were not properly substantiated is irrelevant.

The court noted that the taxpayers initiated the CRAT transactions as the result of an advertisement they saw in a farming magazine. The transactions are similar to those that have been marketed to the public by a firm or firms that were the subject of a previous Office of Chief Counsel memorandum.⁵ The result in other cases where similar transactions have been engaged in will likely be the same as in this case regarding the taxation of the annuity payments.⁶ As with other tax transactions that seem to be “too good to be true” — they generally are.

Estate tax: Basis step-up

In Rev. Rul. 2023-2, the IRS ruled that no adjustment is available under Sec. 1014 to the basis of trust assets on the death of an individual who is the owner of the trust for income tax purposes if the trust assets are not includible in the individual’s gross estate for estate tax purposes.

The decedent had established an irrevocable trust funded with assets that were a completed gift for gift tax purposes. The decedent retained a power over the trust that caused the decedent to be treated as the owner of the trust for income tax purposes under the grantor trust provisions of Secs. 671–679 but did not cause the trust to be included in the decedent’s gross estate for estate tax purposes. At the time of the decedent’s death, the FMV of the trust assets had appreciated. The trust’s liabilities did not exceed the basis of its assets, and neither the trust nor the individual held a note on which the other was the obligor.

Sec. 1014(a)(1) generally considers the basis of property acquired or passed from a decedent to a person that, if it is not sold, exchanged, or otherwise disposed of before the decedent’s death by that person, to be the FMV of the property at the date of the decedent’s death.

Under Sec. 1014(b), seven types of property are considered to have been acquired from or to have passed from the decedent for purposes of Sec. 1014(a): (1) property acquired by bequest, devise or inheritance, or by the decedent’s estate from the decedent;⁷ (2) property transferred in trust during life to pay income for life to, or on the order or direction of, the decedent, where the decedent had, while alive, the power to revoke the trust;⁸ (3) property transferred by the decedent during life to, or on the order of, the decedent, with the decedent’s right to change its enjoyment through exercising a power to amend, alter, or terminate the trust;⁹ (4) property transferred under a testamentary general power of appointment without full and adequate consideration;¹⁰ (5) community property;¹¹ (6) certain property that is included in a decedent’s gross estate under the provisions of Chapter 11;¹² and (7) property included in a surviving spouse’s estate due to a marital deduction allowed in the first-to-die spouse’s estate.¹³

The IRS concluded that the assets in the grantor trust could receive a basis adjustment only if: (1) the property was acquired or passed from a decedent under Sec. 1014(a) and (2) the property fell within one of the seven types listed in Sec. 1014(b).

The IRS first found that the assets were not bequeathed, devised, or inherited within the meaning of Sec. 1014(b)(1) when the decedent died. The IRS based its analysis on previous case law and legislative history and found that the property transferred in trust before the decedent’s death was not bequeathed or inherited because it did not pass by either will or intestacy. The IRS then found that the assets did not fall within any of the remaining types of property listed in Sec. 1014(b). As a result, Sec. 1014(a) did not apply, and the basis of the assets immediately after the decedent’s death was the same as their basis immediately preceding the decedent’s death.

This matter has been on the IRS priority guidance plan since 2015. Many practitioners believe that Sec. 1014(b) applies to preclude a basis adjustment for property that is not includible in a decedent’s estate for estate tax purposes. However, a few practitioners take the position that assets in a “defective grantor trust” (i.e., a trust that is not includible in a decedent’s gross estate) receive a basis step-up under Sec. 1014(b)(9)(C).¹⁴ The argument likely stems from IRS Letter Ruling 201245006, which was issued in 2012 and addressed the application of Sec. 1014 to foreign grantor trusts. Because the taxpayer held the power to appoint the trust property via will or deed at death, the IRS concluded in the letter ruling that the property was received by the taxpayer’s heirs via bequest, devise, or inheritance under Sec. 1014(b)(1). As such, the Sec. 1014(b)(9)(C) exception was met, and the property would receive a basis step-up even though it was not includible in the decedent’s U.S. taxable estate.

In light of this letter ruling, a few practitioners have argued that assets received on account of a decedent’s death, even if not included in the decedent’s gross estate, are eligible for a Sec. 1014(a) basis adjustment. For a defective grantor trust, the argument is that, if the assets passing under the inter vivos trust are deemed to constitute a bequest, as they appear to have been in the letter ruling, then the basis of assets in any irrevocable grantor trust should be adjusted under Sec. 1014(a). Rev. Rul. 2023-2 closes the door on this argument by clarifying that assets in a defective grantor trust are generally not assets eligible for a Sec. 1014(a) basis adjustment because they are not acquired or passed from a decedent within the meaning of Sec. 1014(b).

Valuation

In Connelly,¹⁵ the Eighth Circuit affirmed a district court decision that denied an estate tax refund, holding that life insurance proceeds that a closely held corporation received to redeem shares of one of its owners on his death were includible in the company’s FMV, and a stock purchase agreement did not control how the company should be valued.

Michael and Thomas Connelly were brothers and the only shareholders in Crown C Corp., with Michael owning 385.9 (77.18%) and Thomas owning 114.1 (22.82%) of the corporation’s outstanding shares. To provide for Crown C’s smooth transition of ownership, the brothers and Crown C signed a stock purchase agreement (SPA). The SPA provided that, upon one brother’s death, the surviving brother had the right to buy the decedent’s shares and, if the surviving brother did not do so, Crown C was required to redeem or buy the shares. The brothers always intended that Crown C would redeem a deceased brother’s shares.

The SPA provided two methods for calculating the price at which Crown C would redeem the shares. The primary method required the brothers to execute a new “certificate of agreed value” at the end of every tax year, which set the price per share by mutual agreement. In the event that the brothers failed to execute a certificate of agreed value, they would determine the price per share by securing two or more appraisals. The brothers never signed a certificate of agreed value or obtained appraisals as required by the SPA. To fund its redemption obligation, Crown C purchased $3.5 million in life insurance policies on both brothers.

Michael died in 2013, and, as a result, Crown C received approximately $3.5 million in life insurance proceeds and redeemed Michael’s shares for $3 million. The redemption price was determined pursuant to a larger post-death agreement between Thomas and Michael’s son, Michael Connelly Jr., to resolve estate administration matters. No appraisals were obtained in determining the redemption price.

Thomas, as executor of Michael’s estate, filed an estate tax return valuing Michael’s Crown C shares at $3 million as of the date of Michael’s death and included that amount in the taxable estate.

Afterward, the IRS audited the estate, challenging the $3 million valuation of Michael’s Crown C shares. The IRS determined that, as of Oct. 1, 2013, the FMV of Crown C should have included the $3 million in life insurance proceeds used to redeem the shares, resulting in a higher value for Michael’s Crown C shares than reported on the estate’s return. The IRS issued a notice of deficiency, assessing over $1 million in additional estate taxes. Thomas paid the assessment and filed suit in district court for a refund.

The estate argued that the SPA determined the value of Crown C for estate tax purposes, so the court need not determine Crown C’s FMV. Alternatively, the estate argued that Crown C’s FMV did not include $3 million of the life insurance proceeds because the SPA created an offsetting $3 million obligation for Crown C to redeem Michael’s shares. The IRS argued that the SPA failed to meet the requirements under the applicable authorities to control the valuation of Crown C and that, under applicable law and customary valuation principles, the life insurance proceeds used to redeem Michael’s shares increased Crown C’s FMV by $3 million.

The district court granted summary judgment to the IRS.¹⁶ In making its determination, the Eighth Circuit first analyzed whether the SPA controlled the valuation of Crown C. In doing so, it considered whether the SPA should be respected or disregarded under the principles of Sec. 2703. Sec. 2703(a) states that the FMV of an interest in a company is determined without regard to a buy-sell agreement. However,

Sec. 2703(b) provides an exception to Sec. 2703(a) if the agreement: (1) is a bonafide business arrangement; (2) is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth; and (3) is comparable to similar agreements entered into by persons in an arm’s-length transaction.

The estate argued that the SPA should be respected, as it satisfied the requirements of Sec. 2703(b). The Eighth Circuit disagreed, noting that the SPA did not contain a fixed or determinable price to measure the value of the estate’s shares because the brothers and Crown C did not comply with the SPA’s valuation methods in determining the FMV of Crown C. The court further reasoned that, even if they had complied with the SPA, the agreement fixed no price nor prescribed a formula for arriving at one. Instead, it merely laid out two methods by which the brothers might agree on a price. Because the SPA contained no fixed or determinable price, the court concluded that the requirements of Sec. 2703(b) could not be satisfied, and the SPA could not set the price of the estate’s shares for estate tax purposes.

The Eighth Circuit then considered the FMV of Crown C at Michael’s death, with the key consideration of whether the $3.5 million in insurance proceeds Crown C received upon Michael’s death should be taken into account. The court determined, and the parties agreed, that the issue before the court was the same as one the Eleventh Circuit addressed in Estate of Blount;¹⁷ however, the parties disagreed on whether Blount was correctly decided.

In Blount, the Eleventh Circuit concluded that the redemption agreement had taken into account the life insurance proceeds that a willing buyer and willing seller would take into consideration in determining the FMV of the subject company. The court determined that the life insurance proceeds were an asset that was offset by a liability to redeem the shares and thus had no effect on the FMV of the company.

The Eighth Circuit determined that the Eleventh Circuit’s analysis in Blount was flawed because a company’s obligation to redeem its shares is not a liability “in the ordinary business sense.” The court reasoned that in order for a willing buyer to own Crown C outright at the time of Michael’s death, the willing buyer must obtain all its shares. At that point, the court determined, the willing buyer could extinguish the SPA or redeem the shares from himself. The court opined that such a transaction was simply moving money around, as the willing buyer controlled the life insurance; therefore, there was no liability to be considered. The court concluded that a willing buyer would take into account the life insurance proceeds in determining what to pay for Crown C.

Claims against the estate

In Estate of Spizzirri,¹⁸ the Tax Court held that payments a decedent made to relatives and friends were taxable gifts, that payments his estate was required to make to his stepchildren under a prenuptial agreement were not deductible claims against the estate under Sec. 2053, and that expenses the estate paid to repair a house in Aspen, Colo., that was in the estate were not deductible.

The decedent had been married four times. His first marriage gave the decedent four children. He had three stepchildren as the result of his fourth marriage. Before his fourth marriage, the decedent and his wife-to-be entered into a prenuptial agreement, which was modified several times during their marriage. Among other provisions, the prenuptial agreement, as modified, provided that the decedent’s will would include payments to the surviving spouse and a bequest of $1 million to each of the stepchildren.

Although the decedent’s fourth marriage was never dissolved, he and his wife were estranged for several years before his death. During this estrangement, the decedent had various relationships with other women that resulted in the decedent’s having fathered two more children. The decedent made large payments to a number of these women as well as to various other family members, but he never reported them as gifts or issued a Form 1099-MISC, Miscellaneous Income, to the recipients.

The decedent’s will that was probated had been executed prior to his entering into his fourth marriage and did not contain the provisions he agreed to in the prenuptial agreement regarding payments to his surviving spouse and her children. The will generally provided that the decedent’s estate would go to his children from his first marriage. There were three codicils to this will, all of which specified the rights of his two sons born out of wedlock and one that provided for the payment of the mortgage on, and transfer of his interest in, a condominium he had purchased with one of the women with whom he had a romantic relationship.

During probate, the decedent’s surviving spouse filed claims seeking enforcement of the prenuptial agreement, which were ultimately settled. The surviving spouse’s children also filed claims seeking to enforce the prenuptial agreement regarding the $1 million bequest to each of them. The estate ultimately paid these bequests and sent the Forms 1099-MISC reporting these payments.

After settlement of the claims of the surviving spouse and her children, the estate filed an estate tax return. Among other reported items, the return reported no adjusted taxable gifts, even though the decedent had made payments to various persons in excess of the gift tax annual exclusion. The return also reported the payments to the surviving spouse’s children as claims against the estate that reduced the decedent’s taxable estate. Additionally, the estate claimed as administrative expenses the cost of repairs to property of the estate.

The IRS issued a notice of deficiency and assessed additional tax adjusting the following items: (1) increased adjusted taxable gifts from zero to nearly $200,000; (2) disallowed the deductions for the payments to the surviving spouse’s children; and (3) disallowed administrative expenses for repairs to one of the estate’s properties.

Regarding the transfers made by the decedent during his life, the Tax Court determined that the estate had failed to meet its burden of proof that the transfers were not gifts. The estate argued that the transfers were payments for care and companionship services during the last years of the decedent’s life. The court noted that the decedent made the transfers by checks that contained no indication that they were meant as compensation. In addition, the decedent failed to issue any Forms 1099 or W-2, Wage and Tax Statement, related to these payments, nor did he report them on his personal income tax returns. Finally, the court stated that witness testimony failed to establish that the transfers were anything other than gifts.

Regarding the payments to the surviving spouse’s children, pursuant to Sec. 2053, for an estate to be entitled to a deduction for a claim against it, the claim must be bonafide and contracted for “adequate and full consideration in money or money’s worth” and may not be predicated solely on the fact that the claim is enforceable under state law.¹⁹ Based on these requirements, the Tax Court determined that the claims were not bonafide but were of a donative character, finding that payments to the surviving spouse’s children did not stem from an agreement for the performance of services — they were essentially bequests not contracted for adequate and full consideration in money or money’s worth.

Regarding the administrative expenses for repairs to the house in Aspen, Sec. 2503(a)(2) allows a deduction from the gross estate for administration expenses as permitted by the laws of the state where the estate is administered (in this case, Colorado) but Regs. Sec. 20.2053-3(a) limits deductible administrative expenses to those that are actually and necessarily incurred in the administration of the decedent’s estate. The Tax Court noted that the appraisal report for the Aspen house, on which the house’s claimed FMV was based, stated that the decks on the house that were repaired “may need to be replaced” and that the estate did not provide any corroboration that their replacement was necessary for a sale or to maintain the FMV claimed on its return. Thus, the court determined that the costs paid for the repairs were not deductible expenditures necessary for the house’s preservation and care but rather were nondeductible expenditures for improvements to it.

Agreed-upon settlements

In Estate of Kalikow,²⁰the Tax Court held that an estate was not entitled to reduce the value of trust assets included in the gross estate by the amount of agreed-upon undistributed income, and the estate was not entitled to deduct any part of an agreed-upon settlement payment as administrative expenses under Sec. 2053, except for a commission that the IRS conceded. The decedent resided in New York when she died on Jan. 4, 2006. The decedent’s husband predeceased her in 1990.

The decedent’s husband’s will had created a qualified terminal interest property (QTIP) trust that was funded with the residue of his estate.

The will instructed the trustees to pay the QTIP trust’s net income to the decedent at least quarterly during her lifetime and authorized the trustees to make discretionary principal distributions to her. Upon the decedent’s death, the trust assets were to be paid over to trusts for the benefit of the couple’s two children and their issue. The property that passed to the QTIP trust on the decedent’s husband’s death consisted primarily of interests in 10 income-producing apartment buildings in New York City.

In 1997, the then trustees of the QTIP trust entered into a limited partnership agreement creating a family limited partnership (FLP). The QTIP trust transferred the interests in the apartment buildings to the FLP in exchange for a 98.5% limited partnership interest. At the time of the decedent’s death, the FLP interest, along with $835,000 of cash and marketable securities, constituted the principal property held in the QTIP trust.

Under the decedent’s will, the QTIP trust was responsible for its share of the estate tax arising from the inclusion of the QTIP trust property in the decedent’s estate. After the payment of certain bequests and administration expenses, the residue of the decedent’s estate was bequeathed to a charity the decedent had created during her life.

In November 2009, one of the decedent’s grandchildren petitioned a court to compel a trustee of the QTIP trust to render an account of his proceedings as co-trustee. During these proceedings, the trustee alleged that the FLP had failed to distribute to the QTIP trust all of the income properly due it. The parties litigated the matter for about 10 years, and in March 2019, they settled and agreed that the QTIP trust would pay the estate $9.2 million, $6,572,310 of which was undistributed income earned by the QTIP trust during the decedent’s lifetime.

Pursuant to a decree dated Sept. 18, 2007, a court awarded the QTIP trust’s trustees permanent limited letters of administration for the purposes of filing, supplementing, and defending any audit and/or judicial tax proceeding relating to the portion of the decedent’s estate tax return concerning the QTIP trust. The decree ordered the trustees and the executors of the decedent’s estate to exchange copies of executed estate tax returns. The executors filed the estate’s estate tax return with a statement that the return was made in respect of all assets of the estate other than the decedent’s interest in the QTIP trust. On Schedule F,²¹ the executors listed total “other miscellaneous property” of $31,869,441, including undistributed income due from the QTIP trust of $4,632,489.

The limited administrators (i.e., the trustees of the QTIP trust) prepared on the estate’s behalf a separate estate tax return that incorporated the estate’s assets and deductions as included on the executors’ estate tax return and also included the QTIP trust assets. More particularly, Schedule F incorporated the $31,869,441 of assets (including the $4,632,489 claim for undistributed income from the QTIP trust), as reported on the executors’ estate tax return, and also reported $43,300,000 of QTIP trust assets, made up of the 98.5% limited FLP interest, with a reported value of $42,465,000, and cash and marketable securities of $835,000. In a statement attached to the estate tax return, however, the limited administrators noted that they disputed as having no merit any claim by the executors for amounts due from the QTIP trust.

In the notice of deficiency, the IRS determined, among other things, that the value of the QTIP trust’s 98.5% limited partnership interest in the FLP was $105,664,857 instead of $42,465,000, as reported on the limited administrators’ estate tax return. The IRS also reduced the estate’s Schedule F assets by the $4,632,489 value of the estate’s pending claim against the QTIP trust, as originally reported on the executors’ Schedule F and as incorporated in the estate’s assets reported on the limited administrators’ Schedule F.

In preparation for trial, the parties agreed that the only outstanding matter to be decided relating to the agreed-upon settlement was the payment’s effect on the value of the QTIP trust’s assets included in the decedent’s gross estate. The IRS moved for partial summary judgment that the agreed-upon settlement payment did not reduce the value of the decedent’s gross estate. In their cross-motion for partial summary judgment, the limited administrators asserted that: (1) the value of the QTIP trust assets included in the estate pursuant to Sec. 2044 was properly reduced by the agreed-upon undistributed income amount, and (2) the various components of the agreed-upon settlement payment were deductible from the gross estate as administration expenses under Sec. 2053.

In general, Sec. 2044 includes in a decedent’s estate assets of a QTIP trust created for the benefit of a surviving spouse. Pursuant to Sec. 2044, the decedent’s gross estate included the QTIP trust assets of $55,327,712 (the $54,492,712 limited partnership interest and $835,000 of cash and marketable securities). However, the limited administrators argued that the value of the FLP interest should be reduced by the claim of the decedent’s estate for undistributed income ($6,572,310).

The Tax Court determined that the value of the decedent’s estate’s claim for undistributed income did not reduce the value of the FLP interest included in the decedent’s estate because the liability for the agreed-upon settlement was not a liability of the FLP.

The limited administrators asserted that the inclusion of the undistributed amount in the decedent’s estate would result in an equivalent increased charitable contribution deduction to the estate, and the failure to reduce the value of the QTIP trust’s assets by the same amount would result in double taxation, effectively imposing estate tax on the bequest to the charity. The Tax Court found the argument without merit, determining that the inclusion of the QTIP assets in the decedent’s gross estate would give rise to neither double taxation nor estate tax on any charitable bequest but rather would merely give effect to the provisions of Sec. 2044.

As an alternative to the double-taxation argument, the limited administrators argued that the settlement payment relating to the undistributed income claim was an administrative expense deductible under Sec. 2053, as were the other components of the settlement agreement. The Tax Court noted that the parties devoted much of their arguments to whether the various components of the agreed-upon settlement payment met the limitations on deductibility set forth in the regulations under Sec. 2053. The court then stated that these arguments were misdirected, determining that the limitations on deductibility in the regulations do not apply with respect to claims in favor of the estate that are includible in the decedent’s gross estate under Sec. 2031.

The obligation of the QTIP trust to make the settlement payment to the estate did not give rise to any deduction by the estate. Rather, the estate’s claim against the QTIP trust was itself property to be included in the gross estate. The court determined that, even if it were to assume that the estate actually incurred the fees and commissions specified as components of the agreed-upon settlement payment, reimbursement of these expenses under the settlement agreement would preclude any deduction by the estate.

Estate tax deductions

In a Chief Counsel Advice memorandum, ²² the IRS Office of Chief Counsel determined that a decedent’s estate was not entitled to an estate tax deduction under Sec. 2055 or 2056 for the portion of a unitrust interest that could be distributed either to charity or to the decedent’s spouse at the discretion of a trustee.

The decedent created a testamentary charitable remainder unitrust (CRUT) in which his surviving spouse and a charity were named unitrust beneficiaries. Under the terms of the CRUT, its trustee was required to distribute 25% of the unitrust payment to his surviving spouse, and the remaining 75% of the unitrust payment was to be distributed between the surviving spouse and the charity at the discretion of the trustee. The unitrust payments were to be paid for the life of the surviving spouse, and, upon her death, the remainder interest was to be distributed to the charity.

The issue for the Office of Chief Counsel (OCC) to decide was whether the 75% portion of the unitrust payment qualified for the estate tax marital or charitable deduction.

Sec. 2055(a) allows an estate an estate tax charitable deduction for transfers to charity. However, Sec. 2055(e) (2) generally disallows the deduction where an interest in property is a partial interest and an interest in the same property passes to a noncharity. Sec. 2055(e)(2)(A) provides an exception to this partial-interest rule in the case of a remainder interest if the interest is a CRAT or a CRUT described in Sec. 664 or a pooled income fund described in Sec. 642(c)(5). In the case of any other interest, Sec. 2055(e)(2)(B) provides that no deduction is allowed unless the interest is in the form of a guaranteed annuity or unitrust interest. Regs. Sec. 20.2055-2(a) provides that if a trust is created for both a charitable and a private purpose, a charitable deduction may be taken for the value of the charitable beneficial interest only insofar as that interest is presently ascertainable.

Sec. 2056(a) allows an estate tax marital deduction for transfers to a surviving spouse. However, Sec. 2056(b)(1) provides that, in the case of a terminable interest, no charitable deduction is allowed where on the lapse of time, the occurrence of an event or contingency, or the failure of an event or contingency to occur the interest will terminate or fail. Sec. 2056(b)(8) provides an exception to the terminable-interest rule if the surviving spouse is the only beneficiary of a charitable remainder trust that is not a charitable beneficiary. Regs. Sec. 20.2056(b)-8(a)(1) provides that if the surviving spouse is the only noncharitable beneficiary of a CRUT, the value of the unitrust interest qualifies for an estate tax marital deduction under Sec. 2056, and the value of the remainder interest qualifies for an estate tax charitable deduction under Sec. 2055.

The OCC determined that the remainder interest in the CRUT going to the charity qualified for the estate tax charitable deduction pursuant to Sec. 2055(e)(2)(A) because the CRUT was valid under Sec. 664. However, it also determined that the unitrust interest that could be distributed to the charity did not qualify for the estate tax charitable deduction because it was not in the form of a fixed unitrust amount and no part of the unitrust was ascertainable or severable from the spouse’s noncharitable interest pursuant to Sec. 2055(e)(2)(B).

Regarding the 25% of the unitrust interest designated exclusively for the surviving spouse, the OCC determined that the value of the unitrust interest qualified for the estate tax marital deduction because, pursuant to Sec. 2056(b)(8), the surviving spouse was the only noncharitable beneficiary of the CRUT. To the contrary, however, the OCC determined that the 75% of the unitrust interest of which the trustee of the CRUT had the power to distribute between the surviving spouse and the charity did not qualify for the estate tax marital deduction because the interest passing to the spouse was not ascertainable and, therefore, not treated as passing to the spouse under Sec. 2056(a).

In a footnote, the OCC stated that the same analysis and conclusion would apply under Sec. 2523 (gift tax marital deduction) for a completed gift to a CRUT with similar terms. It further stated that, in prior rulings, the IRS had ruled that taxpayers were entitled to an estate or gift tax marital deduction in similar circumstances.²³ The memo does not revoke these prior rulings but states that they no longer reflect the position of the Chief Counsel’s office.

For example, in IRS Letter Ruling 201845014, the unitrust interest was payable between the spouse and charity after a certain portion was exclusively payable to the spouse. Citing the legislative history of the Economic Recovery Tax Act of 1981,²⁴ the IRS ruled that the unitrust interest qualified for the estate tax marital deduction because the spouse was the only noncharitable beneficiary of the unitrust interest. Letter Ruling 202233014, however, indicates that the amount must still be ascertainable to qualify for the marital deduction.

Footnotes

¹Estate of Block, T.C. Memo. 2023-30.

²Sec. 2055(e)(3)(C).

³Furrer, T.C. Memo. 2022-100.

⁴Per Sec. 1015(a).

⁵IRS Office of Chief Counsel, Generic Legal Advice Memorandum AM 2020-006, released June 26, 2020.

⁶For a case in point, see Gerhardt, 160 T.C. No. 9 (2023).

⁷Sec. 1014(b)(1).

⁸Sec. 1014(b)(2).

⁹Sec. 1014(b)(3).

¹⁰Sec. 1014(b)(4).

¹¹Sec. 1014(b)(6).

¹²Sec. 1014(b)(9).

¹³Sec. 1014(b)(10).

¹⁴“Property described in any other paragraph of this subsection.”

¹⁵Connelly, No. 21-3683 (8th Cir. 6/2/23).

¹⁶Connelly, No. 4:19-cv-01410-SRC (E.D. Mo. 9/21/21).

¹⁷Estate of Blount, 428 F.3d 1338 (11th Cir. 2005).

¹⁸Estate of Spizzirri, T.C. Memo. 2023-25.

¹⁹Citing Estate of Glover, T.C. Memo. 2002-186, and Estate of Carli, 84 T.C. 649 (1985).

²⁰Estate of Kalikow, T.C. Memo. 2023-21.

²¹Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, Schedule F, Other Miscellaneous Property Not Reportable Under Any Other Schedule

²²Chief Counsel Advice memorandum 202233014.

²³IRS Letter Rulings 200813006, 200832017, 201117005, and 201845014.

²⁴Economic Recovery Tax Act of 1981, P.L. 97-34.

Contributor

Justin Ransome, CPA, J.D., MBA, is a partner in the National Tax Department of Ernst & Young LLP in Washington, D.C. He would like to thank members of the firm’s National Tax Department in Private Tax for their contributions to this article, as well as Fran Schafer for her thoughtful comments on the article. The views expressed here are those of the author and do not necessarily reflect the views of Ernst & Young LLP. For more information about this article, contact thetaxadviser@aicpa.org.

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