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Significant Recent Developments in Estate
(Planning (Part II))

Part I of this two-part article, in the last issue, analyzed current developments in estate, gift and generation-skipping tax planning. Part II examines income tax planning developments, including (1) final regulations on charitable remainder trusts, (2) proposed regulations on the separate share rules for estates and (3) final regulations on foreign trusts. The article then reviews certain important rulings and releases on various valuation issues and concludes with a look at proposed legislation.

Nicholas I. Pye, CPA
Senior Manager
Washington National Tax—Personal Financial Planning Practice
KPMG LLP
Washington, DC

Daniel T. Vail, J.D., LL.M.
Manager
Washington National Tax—Personal Financial Planning Practice
KPMG LLP
Washington, DC

For more information about this article, contact Mr. Pye at (202) 467-3935 or Mr. Vail at (202) 739-8965.

Executive Summary

• Final regulations address five basic areas of CRT planning and administration.

• Davis and Eisenberg allowed valuation discounts on closely held stock for built-in capital gains tax liability.

• Congress and the Administration have proposed numerous, significant legislative changes in the estate planning area.

Part II of this two-part article focuses on income tax planning developments, including (1) final regulations on charitable remainder trusts (CRTs), (2) proposed regulations on the separate share rules for estates and (3) final regulations on foreign trusts. The article then reviews certain important rulings and releases on various valuation issues and concludes with proposed legislation. The period covered is May 1998–May 1999.

Income Tax Planning

The past period has produced some very favorable income tax developments, especially for wealthy, charitable donors.

Qualified Appreciated Property

First, Section 1004(a)(1) of the Tax and Trade Relief Extension Act of 1998 made permanent the Sec. 170(e)(5) provision allowing a donor to take a fair market value (FMV) charitable deduction for gifts of qualified appreciated stock (generally, publicly traded stock) to a nonoperating private foundation. This change was effective for gifts made after June 30, 1998.

Observation: Until the passage of this legislation, the qualified appreciated stock provision under Sec. 170(e)(5) was a constant "extender"; thus, it caused much angst amongst wealthy donors over the creation of nonoperating private foundations and the timing of contributions thereto.

CRTs

Another significant development was the issuance of CRT final regulations under Sec. 664 and the Sec. 2702 special valuation rules. The final regulations,²⁹ effective Dec. 10, 1998, adopt, with some revisions, proposed regulations³⁰ issued in 1997. The final regulations address five basic areas of CRT planning and administration, including (1) establishing a "flip charitable remainder unitrust" (Flip CRUT), (2) modifying the timing of year-end annuity payments and unitrust payments for fixed-percentage CRUTs, (3) appraisals of unmarketable assets held by CRTs, (4) modifying the gift tax consequences of transferring unitrust interests in "income exception" CRUTs (e.g., net income makeup CRUTs (NIMCRUTs)) and (5) new rules on the allocation of precontribution gain to principal. Flip CRUTs and the timing of annuity and unitrust payments are discussed below.

Flip CRUTs: A Flip CRUT begins as an income-exception CRUT, but flips to a fixed-percentage CRUT on the occurrence of a "triggering event." In contrast to the proposed regulations (which limited the availability of this planning technique to a fairly small population of taxpayers), the final regulations dramatically expand the availability of this new type of CRUT to all otherwise-eligible CRUT donors and annuitants.

Under Regs. Sec. 1.664-3(d), a CRUT's governing instrument can now provide for a flip on the occurrence of marriage, divorce, death, birth of a child, date certain, achieving a certain age or sale of an unmarketable asset. However, Regs. Sec. 1.664-3(e), Examples 3, 9 and 10, provide that impermissible triggering events include the sale of marketable assets, a determination by the CRUT recipient's financial adviser that the trust should switch methods or a request from the CRUT recipient that the trust convert to the fixed-percentage method. Each of these triggering events is impermissible because, for regulation purposes, it is deemed to be within a person's control.

Observation: Generally, a triggering event is permissible if the date or event is outside the control of the trustee or any other person. Thus, a triggering event not within a person's control should be permissible, regardless of whether it is specified in the final regulations.

Similar to the proposed regulations, Regs. Sec. 1.664-3(c)(2) provides that the flip to the fixed-percentage method occurs at the beginning of the tax year immediately following the one in which the triggering date or event occurs. Regs. Sec. 1.664-3(c)(3) provides that any make-up amount described in Sec. 664(d)(3)(B) is forfeited when the trust converts to the fixed-percentage method.

Observation: Care should be taken not to inadvertently forfeit the make-up amount. In the year the triggering event occurs, the make-up amount should be paid to the annuitant if possible.

According to Regs. Sec. 1.664-3(c), a CRUT may flip only once; the Flip CRUT allowed by the final regulations is the only type of conversion or flip permissible. Thus, a charitable remainder annuity trust (CRAT) cannot convert to a CRUT; a CRUT using the fixed-percentage method cannot flip to an income-exception method without losing its status as a CRUT. The Flip CRUT rules are effective for CRUTs created after Dec. 9, 1998. A window period is available for an income-only CRUT to convert to a Flip CRUT if the trustee initiates legal proceedings to reform the trust by June 30, 2000.³¹

Observation: Despite the government's trend of "tightening the screws" in the area of CRT planning,³² the Flip CRUT provisions appear to provide new planning opportunities (especially in light of the flexibility regarding the triggering event that may cause a conversion). In essence, a permissible triggering event includes all dates or events outside the trustee's or any one else's control. In addition, and unlike the proposed regulations, a Flip CRUT can be used even if the trust is funded with marketable assets.

Timing of annuity and unitrust payments: To curb the planning opportunities associated with the use of accelerated CRTs³³ described in Notice 94-78,³⁴ the proposed amendments to the Sec. 664 regulations provided that the payment of all annuity or unitrust amounts of fixed-percentage CRUTs had to be made by the close of the tax year in which due. Although recent legislative changes³⁵ have significantly reduced the potential tax benefits of accelerated CRTs, according to the preamble to the final regulations, the Service and Treasury continue to be concerned about the potential abuse of the post-year-end grace period to produce a tax-free return of appreciation in the assets contributed to a CRAT or a fixed-percentage CRUT.

Thus, with certain modifications, the final regulations adopt rules similar to those in Notice 97-68.³⁶ Effective for tax years ending after April 18, 1997, Regs. Sec. 1.664-3(a)(1)(i)(g) provides that, for CRATs and fixed-percentage CRUTs, the annuity or unitrust amount may be paid within a reasonable time after the close of the year for which due if (1) the character of the annuity or unitrust amount in the recipient's hands is income under Sec. 664(b)(1), (2) or (3); and/or (2) the trust distributes property (other than cash) it owned as of the close of the tax year to pay the annuity or unitrust amount and the trustee elects on Form 5227, Split-Interest Trust Information Return, to treat any income generated by the distribution as occurring on the last day of the tax year for which the amount is due.

In addition, for CRATs and fixed-percentage CRUTs created before Dec. 10, 1998, the annuity or unitrust amount may be paid within a reasonable time after the close of the tax year for which due if the percentage used to calculate the annuity or unitrust amount is 15% or less, according to Regs. Sec. 1.664-2(a)(1)(i)(b) (for CRATs) and -3(a)(1)(i)(h) (for CRUTs).

Observation: Although the final regulations restrict the timing of annuity payments and unitrust payments from fixed-percentage CRUTs, they are significantly more favorable than the proposed regulations, which required trustees of all CRATs and fixed-percentage CRUTs to pay the annuity or unitrust amount by the close of the tax year in which due. The proposed regulations would have caused much administrative grief at year-end, especially if the CRT had a year-end valuation.

In addition, income-exception CRUTs (e.g., NIMCRUTs) are not subject to these year-end rules; by definition, any distributable amount of such a trust is income to the unitrust recipient. Thus, income-exception CRUTs can continue to use the "administrative period" in making the required unitrust payment.

Separate Share Rules

Under the separate share rules, a beneficiary is taxed only on the amount of income belonging to his separate share. Although trusts have been subject to separate share rules for many years, the Service issued proposed regulations in January 1999 on the separate share rules applicable to estates.³⁷ The rules reflect TRA '97 Section 1307(a), which amended Sec. 663 to extend the separate share rules to estates.

Before this amendment, a distribution to an estate beneficiary in the ordinary course of administration often resulted in his being taxed on a disproportionate share of the estate's income. The preamble to the proposed regulations provides that the extension of the separate share rule to estates promotes fairness by more rationally allocating the income of the estate among the estate and its beneficiaries, thereby reducing the distortion that may occur when a disproportionate distribution of estate assets is made to one or more estate beneficiaries in a year when an estate has distributable net income (DNI). Thus, the proposed regulations provide that substantially separate and independent shares of different beneficiaries are to be treated as separate estates for purposes of computing DNI; further, a surviving spouse's statutory elective share is a separate share. Finally, a revocable trust that elects to be treated as part of a decedent's estate is also a separate share.

Observation: Unlike a trust, in which it is fairly easy to determine the existence of separate shares (e.g., a fraction of the whole), separate shares of estates can be much less distinct. While the proposed regulations provide much more thorough guidance than the single sentence on the issue that was included in TRA '97 Section 1307, the implementation of such rules will cause problems for trust and estate administrators—especially if such rules become effective during the middle of a year.

Foreign Trusts

Section 1907 of the Small Business Job Protection Act of 1996 amended Secs. 7701(a)(30) and (31) to provide a new rule for determining whether a trust is domestic or foreign. Sec. 7701(a)(31)(B) provides that a "foreign trust" is any trust other than a trust that is a "U.S. person." Sec. 7701(a)(30)(E) defines "U.S. person" as any trust if (1) a court within the U.S. can exercise primary supervision over its administration (court test) and (2) one or more U.S. persons can control all its substantial decisions (control test). A trust that does not meet these tests is a foreign trust.

Observation: In addition to imposing different filing requirements, a trust's status as foreign could trigger some very unfavorable tax consequences. For example, Sec. 679(a)(1) generally provides that a U.S. person who transfers property to a foreign trust is treated as the trust owner if there is a U.S. beneficiary. Thus, the foreign trust status may cause an otherwise nongrantor trust to be treated as a grantor trust for Federal income tax purposes. In addition, for a trust to qualify as a CRT under Sec. 664, the trust must not be a grantor trust. Therefore, an otherwise valid CRT would be disqualified if it is deemed to be a foreign trust. Finally, under Sec. 684, the transfer of property by a U.S. person to a foreign trust (or estate) generally is treated as a sale or exchange.

Because the amendments to Sec. 7701(a)(30) and (31) created problems for some trusts, TRA '97 Section 1161(a) permitted eligible trusts that would have been classified as foreign trusts under the new rules to elect to continue being treated as domestic trusts. Notice 98-25³⁸ outlined the election procedures. In February 1999, the Service issued Sec. 7701 final regulations on defining trusts as domestic or foreign.³⁹ The regulations adopt (with certain modifications) proposed regulations issued in June 1997⁴⁰; they were effective Feb. 2, 1999.

The final regulations incorporate the guidance in Notice 98-25, address when the election terminates and provide a safe harbor for determining whether the court test is met. Regs. Sec. 301.7701-7(c)(1) states that a trust meets the safe harbor if (1) the trust instrument does not direct the trust to be administered outside the U.S. and (2) the trust is, in fact, administered exclusively in the U.S. Automatic migration or "flee" clauses will not cause a trust to fail the court test if the trust will migrate from the U.S. only in the case of a foreign invasion of the U.S. or widespread confiscation or nationalization of property in the U.S.

Because the TRA '97 substituted the term "persons" for "fiduciaries" in the control test, Regs. Sec. 301.7701-7(d)(1) counts all persons with any power over substantial decisions of the trust, whether or not acting in a fiduciary capacity. Regs. Sec. 301.7701-7(d)(2) extends, to 12 months from six months, the time a trust has to take corrective action to avoid a change in residency that may result from an inadvertent change in fiduciaries. If the trust fails to correct the problem within the 12-month period, the regulations permit the Service to grant an extension if the failure was due to reasonable cause.

According to Regs. Sec. 301.7701-7(e)(1) and (2), trusts created between Aug. 19, 1996, and April 3, 1999 that satisfy the control test outlined in the proposed regulations (but not the final regulations) may be modified to satisfy the final regulations' control test by Dec. 31, 1999. If the modifications are completed by that date, the trust will be treated as meeting the final regulations' control test for tax years beginning after 1996.

Valuation Issues

Built-in Capital Gains Tax Discounts

Last year's edition of this article⁴¹ discussed discounts for potential capital gains tax in light of the Tax Court's decision in Eisenberg.⁴² In that case, the taxpayer had gifted stock in a closely held corporation that held commercial rental property as its sole asset. For gift tax purposes, the taxpayer reduced the stock's value by 25% for a minority discount and by the capital gains taxes attributable to the built-in gain on the building. Notwithstanding the taxpayer's contention that a hypothetical buyer would consider the built-in capital gains tax liability when establishing a purchase price, the Tax Court embraced the Service's view that no discount should be allowed; it reasoned that a buyer could lease the building without incurring capital gains tax liability and the taxpayer had no liquidation plans.

Observation: In light of the number of prior cases holding similarly, the Tax Court's decision in Eisenberg was not surprising. In an established line of cases,⁴³ the Tax Court had held that built-in capital gains taxes do not reduce the value of closely held stock when liquidation is speculative. The disallowance of discounts for built-in gains taxes seems unwarranted in today's environment; after the Tax Reform Act of 1986's (TRA '86's) repeal of the General Utilities⁴⁴ doctrine, the cost of liquidation is very real when a willing buyer and willing seller are determining the FMV of property.

Since Eisenberg, the Tax Court has continued its stance by disallowing built-in capital gains discounts in Est. of Welch.⁴⁵ At death, the decedent owned minority interests in two closely held corporations. A professional appraiser based the estate tax valuation on the net asset valuation method. However, the appraiser separately valued the real property holdings of the corporations from such valuations; he believed that the properties had been targeted for potential sale to the local city government.

The appraiser applied no discount to reflect either corporations' built-in capital gains tax liability, as he did not consider either of the corporations to be in liquidation. In determining the value to be included on the estate tax return, however, the estate aggregated the values of the real property holdings and the closely held corporations, then applied a 34% discount for built-in capital gains taxes. In concluding that no discount should be allowed for such taxes, the Tax Court stated that it had repeatedly rejected reductions in the value of closely held stock to reflect built-in capital gains tax liability when the evidence failed to establish that a liquidation of the corporation or sale of its assets was likely to occur. As to the pending sales of real property, the Tax Court ruled that the estate failed to show that it was likely that either of the corporations would pay built-in capital gains tax on the sales. The Tax Court's position was buttressed by the fact that both corporations could avoid (and indeed, did avoid) gain recognition under Sec. 1033. Thus, the Tax Court held that the requisite likelihood that capital gains taxes would be incurred was lacking.

Taxpayers later scored their first significant victory in this area when the Tax Court decided Est. of Davis.⁴⁶ In that case, the taxpayer had made gifts to his two children of minority interests in a closely held corporation, the primary asset of which was publicly traded stock. A 37.63% capital gains tax would have been due had the corporation's assets been sold. On the valuation date, however, the corporation had not adopted a formal plan of liquidation; there was no intention by the corporation or the taxpayer to liquidate the corporation or otherwise dispose of its assets.

While they disagreed on the amount, all of the valuation experts (including the Service's) included a discount for the potential built-in capital gains tax liability. While acknowledging that its own expert had included a discount in its valuation report, the Service contended that such a discount would be contrary to Federal tax law. In ruling to the contrary, the Tax Court held that even though no liquidation of the closely held corporation or sale of its assets was planned or contemplated on the valuation date, a hypothetical willing seller and buyer would not have agreed on that date on a price for each of the blocks of stock in question that took no account of the built-in capital gains tax. It found that such a willing seller and buyer of each of the two blocks of stock at issue would have agreed on a price on the valuation date, at which each such block would have changed hands, that was less than the price that they would have agreed on had there been no built-in capital gains tax as of that date.

The Tax Court rejected the Service's argument that the corporation could have avoided all built-in capital gains tax by (1) having the closely held corporation elect S status and (2) prohibiting the S corporation from selling any of its assets for 10 years, because the record did not indicate that such action was practical. The Tax Court determined that the appropriate lack-of-marketability (LOM) discount (without regard to the built-in gains tax) should be $19 million; the total LOM discount (including a $9 million discount for the corporation's built-in capital gains tax) should be $28 million. Thus, while the built-in capital gains discount was not equal to the full amount of the closely held company's potential capital gains tax liability, it was substantial (roughly 34% of the actual liability).

Citing Davis, the Second Circuit revoked and remanded the Tax Court's decision in Eisenberg,⁴⁷ ruling that the taxpayer could discount the FMV of shares she had given to her family by the potential capital gains tax liabilities that might be incurred by the corporation (even though there were no plans for liquidation). The court stated that, because the TRA '86 effectively closed the option to avoid capital gains tax at the corporate level, reliance on cases decided under pre-TRA '86 law should no longer continue. Further, contrary to the Tax Court's opinion, because the General Utilities doctrine was repealed, a tax liability on liquidation or sale for built-in capital gains is not too speculative; an adjustment for potential capital gains tax liabilities could be taken into account in valuing the stock at issue. The court remanded the case to the Tax Court for a determination of the appropriate discount.

Observation: Whether the tide has turned in this area remains to be seen. Certainly, Davis and Eisenberg are valuable to taxpayers who transfer interests in closely held corporations. Whether these cases set a new precedent is uncertain, however.

Securities Restrictions Discounts

Another case in the valuation discounts area was Est. of McClatchy.⁴⁸ The decedent had owned a substantial number of unregistered Class B shares of McClatchy Newspapers, Inc., a company in which he had been the chief executive officer, chairman of the board and an editor. The Class B shares were convertible into Class A shares and subject to Rule 144 restrictions due to the decedent's Securities and Exchange Commission "affiliate" status. The shares were not subject to such restrictions in the hands of the estate's personal representatives. The Service and the estate agreed that, taking into account the restrictions, the shares were worth $12.3375 each; without the restrictions, the shares were worth $15.56 each.

The Tax Court held that the stock should be valued for estate tax purposes based on its value in the personal representatives' hands; thus, its unrestricted FMV was $15.56 per share. The court reasoned that such restrictions did not exist at the moment of the decedent's death. The Ninth Circuit reversed; it determined that, while the lapsing of the restrictions increased the stock's value, the triggering event was not the decedent's death, but the transfer of the stock to the estate (a nonaffiliate for Rule 144 purposes). Thus, at the decedent's death, the stock's value had to be discounted due to the restrictions existing at that time.

Chapter 14 Special Valuation

There have been certain significant developments in the Chapter 14 area; for example, two rulings invoked Sec. 2702. In Letter Ruling 9841017,⁴⁹ a husband, wife and son each contributed cash to an irrevocable trust. The husband and wife took back a "joint and survivor" life estate; the son took back the remainder interest. The cash each contributed came from independent sources. The contributions were based on the actuarial value of the parties' respective interests.

The trustee then purchased a personal residence to be held in the trust, to be used by the husband and wife during their lifetimes, with the remainder passing to the son. The Service held that the trust holding the residence was a valid qualified personal residence trust (QPRT) under Regs. Sec. 25.2702-5(c); further, the creation of the trust would not be deemed a taxable gift from the parents to the son, because the son had used independent funds to pay for his actuarial value of the remainder interest. The Service also ruled that the trust assets would not be includible in the husband's or wife's gross estate under Sec. 2039.

Observation: This ruling seems to explicitly sanction a way to prevent the application of the "joint purchase rule" of Sec. 2702(c)(2). Apparently, the rule can be avoided if the joint purchase is of a personal residence (because the personal residence exception of Sec. 2702(a)(3)(A)(ii) negates the operation of the joint purchase rule). This would seem to prevent the payment of gift tax on the joint purchase, and perhaps allow for the term interest holders to remain in the home for life without having the property included in their estates at death. Despite this favorable result, Letter Ruling 9841017 does not address whether Sec. 2036 could apply to a joint-purchase QPRT (because the transaction might be characterized as a transfer with a retained lifetime income interest or right to beneficial enjoyment). Joint purchases between parents and children of homes already owned by the parent, for instance, may heighten such estate tax concerns.⁵⁰

In Letter Ruling (TAM) 9848004,⁵¹ a husband and wife each transferred property to separate grantor retained annuity trusts (GRATs), which paid an annuity to the grantor for seven years. If the grantor were to die within the seven-year term, the annuity payments were to be paid to the grantor's spouse for the balance of the term. The grantor retained the right to revoke the spousal annuity interest.

In determining the taxable gift arising from the creation of the GRATs, each grantor deducted from the amount transferred the present value of the retained annuity interest and the present value of the spouse's revocable annuity interest. The Service disagreed with this approach, ruling that the husband's and wife's rights to receive spousal annuity payments from each other's GRATs were contingent on the grantor's death during the seven-year term. Citing Regs. Sec. 25.2702-3(e), Examples 5 and 6, the Service ruled that the right to receive annuity payments contingent on the grantor's death during his retained term interest is not a qualified interest. Thus, the spousal revocable annuity interests in the GRATs at issue were not qualified interests that could reduce the taxable gift.

The Service also noted that the spousal interest would not satisfy Regs. Sec. 25.2702-3(d)(3), which requires the term of a qualified annuity interest to be for the life of the term holder, for a specified term of years or for the shorter of the two. Under the facts at issue, the spouse's annuity would not be payable for any of these periods; rather, it was payable (if at all) for an unspecified period dependent on whether the grantor died during the GRAT term, and on the GRAT term then remaining. For this reason, the revocable spousal annuity interests were not qualified interests.

Observation: Many observers have questioned the validity of Regs. Sec. 25.2702-3(e), Examples 5 and 6, arguing that there is no statutory authority for the Service's stance that fixed payments made after a GRAT grantor's death must be ignored in valuing a transfer under Sec. 2702. Indeed, it appears that the Service has disregarded Example 5 in its own rulings in this area.⁵²

Sec. 2703 was also affected by certain noteworthy rulings last year. For instance, in Est. of Gloeckner,⁵³ the Second Circuit analyzed the phrase "natural objects of the decedent's bounty"—a concept important to Sec. 2703 analysis. In Gloeckner (a pre-Sec. 2703 case), the decedent (founder of a company that distributed horticultural products) had entered into a redemption buy-sell agreement with the minority shareholder. Under the agreement, at the decedent's death, the corporation was to buy as much of his stock as would be needed to pay estate taxes (the decedent could bequeath the rest of his stock as he saw fit). The decedent named a trusted employee to whom he had made favorable loans in the past as beneficiary of any shares not redeemed by the corporation at his death. This employee was to succeed to the majority control and management of the company after the decedent's death.

The Tax Court ruled that the price contained in the decedent's buy-sell agreement was not valid for estate tax purposes, because it was a testamentary device to pass the decedent's shares to the natural objects of his bounty (the employee) for less than full and adequate consideration. Accordingly, under Regs. Sec. 20.2031-2(h) (the foundation for much of Sec. 2703), the price listed in the buy-sell agreement did not control.

The Second Circuit disagreed. Reversing and remanding the Tax Court, it found that the employee was not a "natural object the decedent's bounty"; thus, the price contained in the buy-sell agreement could fix the estate tax value of the decedent's shares. The court noted that "natural object of decedent's bounty" was a somewhat elusive concept not admitting of one clear definition, and had to be interpreted on a case-by-case basis. The court conceded that an intended beneficiary need not be a relative (in the commonly understood sense of the word) to qualify as a natural object of a decedent's bounty, but the person must "have enjoyed a relationship with the decedent in which he was considered as though he were in some manner related to the decedent." Thus, there must be sufficient evidence to suggest than an unrelated party shares a relationship with the decedent such as to be effectively considered a member of his family if the buy-sell agreement is to be prevented from fixing estate tax values. Because no evidence suggested that the relationship between the decedent and the trusted employee was other than a business one, the Second Circuit ruled that the estate tax value fixed in the buy-sell agreement controlled.

Observation: Although this case dealt with pre-Sec. 2703 law, it is important for its insight into the "natural objects of the decedent's bounty" definition. The court's reasoning would presumably be persuasive in any subsequent analysis of the Sec. 2703(b)(2) device test, and of Regs. Sec. 25.2703-1(b)(1)(ii) (illuminating the device test and stating that the general rule of Sec. 2703(a) does not apply to any right or restriction if, in part, it is not a device to transfer property to the natural objects of the transferor's bounty for less than full and adequate consideration).⁵⁴

Revised Actuarial Tables

The Service published temporary and proposed regulations⁵⁵ under Sec. 7520 that revise the actuarial tables for valuing annuities, interests for life or a term of years and remainder or reversionary interests. The revised tables take into account the most recent mortality experience available (which is based on the 1990 census). The regulations affect the valuation of inter vivos and testamentary transfers of interests dependent on one or more measuring lives.

The temporary and proposed regulations were generally effective May 1, 1999; transition rules help mitigate adverse consequences that might result from this regulatory change. According to the preamble, for gift tax purposes, if the valuation date of a transfer is after April 30, 1999 but before July 1, 1999, the donor has the option of determining the value of the gift (and/or any applicable charitable deduction) under tables based on either Life Table 80CNSMT (i.e., the old tables) or Table 90CM (i.e., the new tables). Similarly, for estate tax purposes, if the decedent dies after April 30, 1999 but before July 1, 1999, the value of any interest (and/or any applicable charitable deduction) may be determined under tables based on either Table 80CNSMT or Table 90CM, at the executor's option.

In cases involving a charitable deduction, if the valuation date occurs after April 30, 1999 and before July 1, 1999, and the executor or donor elects under Sec. 7520(a) to use the Sec. 7520 rate for March 1999 or April 1999, Table 80CNSMT must be used. If the executor or donor uses the Sec. 7520 rate for May 1999 or June 1999, either Table 80CNSMT or Table 90CM may be used. If the valuation date occurs after June 30, 1999, the executor or donor must use Table 90CM, even if a prior-month interest rate election under Sec. 7520(a) is made.

Observation: The preamble to the new tables notes that for estate tax purposes, the estate of a mentally incompetent decedent may elect to value the property interest included in the gross estate under the mortality table and interest rate in effect at the time the decedent became mentally incompetent or the mortality table and interest rate in effect on the decedent's date of death, if the decedent (1) was under a mental incapacity that existed on May 1, 1999 and continued uninterrupted until death or (2) died within 90 days of regaining competency after April 30, 1999.

Proposed Legislation

The preceding discussion (and Part I of this article⁵⁶) have endeavored to digest and distill the most important developments in estate planning from May 1998 through May 1999. What about the next 12 months? What notable proposals can tax advisers expect to see from Congress, the President and the Service that might affect estate planning?

Congressional Concerns

A plethora of proposals has been introduced in Congress this legislative session to significantly alter the present transfer tax scheme. Continued cries that gift and estate taxes are unfair and unwarranted have pressed many members of Congress to call for (1) dramatic changes to the way these taxes are currently imposed and applied or (2) outright repeal.

For example, several bills would accelerate the phase-in of the applicable credit amount so that the $1 million applicable exclusion amount (available in 2006) would be available for estates of decedents dying and gifts made after 1999.⁵⁷ Others have clamored for more dramatic changes to the current estate tax scheme and would enact a capital gains tax on assets transferred at death (via elimination of the Sec. 1014 stepped-up basis rules). Finally, and most radically, some members of Congress would repeal the current transfer tax regime, and not replace it.⁵⁸

Observation: Given our ever-expanding economy, these reform proposals may now be somewhat more legislatively viable. In the past, many have attacked this reformist cause, arguing that any abolition or amendment of the transfer tax would dangerously undermine much-needed fiscal discipline, only to benefit the rich. Given ballooning budget surpluses, however, this criticism has been somewhat blunted. Thus, some strain of this "kill the death tax" sentiment may now stand a greater (if still slim) chance of actual passage by Congress.

If gift and estate tax reform will not pass this year, however, some measure of "charitable giving" reform may. Indeed, perhaps the most notable proposal emerging from the current legislative session is one attempting to curb perceived excesses involving charitable split-dollar insurance arrangements. These transactions are characterized by a transfer of money by a taxpayer to a charity, and the subsequent payment by the charity of premiums for life insurance on the life of the donor (or a member of his family). Because the taxpayer has "gifted" money to a charity, he claims a charitable deduction, even though some of the gifted proceeds are used to purchase life insurance benefiting the donor (and despite the fact that no deduction would be allowed if the taxpayer paid for the premiums directly).

House Ways and Means Committee Chairman Bill Archer (R-Tex.) and Rep. Charles Rangel (D-NY) believe that these types of arrangements are an abuse of the charitable deduction; they introduced H.R. 630 to deny such a deduction for any "gift" associated with such an arrangement. According to Archer, the bill ostensibly clarifies present law by providing that no charitable deduction will be allowed for a transfer to (or for the use of) an organization described in Sec. 170(c), if in connection with the transfer (1) the organization directly or indirectly pays (or has previously paid) any premium on any "personal benefit contract" for the transferor or (2) there is an understanding or expectation that any person will directly or indirectly pay any premium on any personal benefit contract for the transferor. A personal benefit contract would be any life insurance, annuity or endowment contract, if any direct or indirect beneficiary under the contract is the transferor, a member of his family or any other person (other than a Sec. 170(c) organization) designated by the transferor.⁵⁹

Sec. 170(c) organizations would be subject to an excise tax of 100% of the premiums paid on any life insurance, annuity or endowment contract, if the payment of such premiums is made in connection with a transfer for which a deduction is not allowed under the bill. (The excise tax would not apply, however, if all of the direct and indirect beneficiaries under the personal benefit contract are Sec. 170(c) organizations.) The bill also requires Sec. 170(c) organizations to report annually the amount of premiums it paid during the year that are subject to the excise tax, the name and taxpayer identification number of each beneficiary under the personal benefit contract to which the premiums relate and other information mandated by the Service. If enacted, the bill would have a retroactive effective date of Feb. 8, 1999.

Observation: William Roth (R-Del.), Senate Finance Committee Chairman, recently proposed a similar provision in the Senate. It thus appears as though some version of this legislation will likely pass Congress this session. In addition, in Notice 99-36,⁶⁰ the IRS announced its official position on charitable split-dollar arrangements. The Service stated that such arrangements will not result in a charitable deduction; moreover, participating individuals and charities could be liable for various excise taxes and penalties for entering into these types of transactions.

President's Budget Proposals

President Clinton's budget proposals for fiscal year 2000,⁶¹ released in February 1999, include many provisions that would affect transfer tax planning. Specifically, the administration seeks to:

• Increase the applicability of the 5% transfer tax "surtax," to restore its pre-TRA '97 purpose of phasing out the benefits of the graduated transfer tax brackets and the unified credit. Currently, the benefit of the graduated rates is phased out.

• Require persons taking a basis in property under Sec. 1014 to use the FMV of the property reported on the estate tax return as the basis of the property for income tax purposes. Currently, there is no such "duty of consistency."

• Conform basis allocation in part-gift, part-sale transactions to the Sec. 1011 rule applied to bargain sales to charity (under which the basis of bargain-sale property is allocated ratably between the gift portion and the sale portion, based on the FMV on the date of transfer and the consideration paid). Currently, the donor and donee may take inconsistent positions on the basis of bargain-sale property; consequently, basis can sometimes be lost or created.

• Eliminate basis step-up under Sec. 1014(b)(6) in the part of community property owned by a surviving spouse before the decedent spouse's death. Currently, in community property states, surviving spouses are entitled to a stepped-up basis in the portion of the community property owned by the surviving spouse, as well as in the portion owned by the decedent (even though surviving spouses in non-community property states receive a stepped-up basis only in the decedent spouse's half).

• Amend Sec. 2044 to provide that if a marital deduction is allowed for qualified terminable interest property (QTIP) under Sec. 2523(f) or 2056(b)(7), inclusion is automatically required in the beneficiary spouse's estate under Sec. 2044. Currently, in some situations, taxpayers have attempted to "whipsaw" the Service by (1) claiming the marital deduction for QTIP property on the death of the first spouse and (2) arguing, after the statute of limitations on assessing estate tax has run on the first estate, that a technical flaw in QTIP eligibility or election militates against inclusion under Sec. 2044 in the second estate.

• Amend the Sec. 2518 disclaimer rules to (1) clarify that disclaimers are effective for income tax (as well as transfer tax) purposes; (2) provide that, in the case of a Sec. 2518(c)(3) "transfer-type" disclaimer, partial disclaimers are allowed; and (3) allow a spouse to make a disclaimer effective for gift tax purposes even when the disclaimed property passes to a trust in which the surviving spouse has an income interest. Currently, it is somewhat unclear whether "transfer-type" disclaimers should be treated the same as non-transfer-type disclaimers, and whether qualified disclaimers generally are effective for income tax purposes.

• Eliminate valuation discounts in family limited partnerships. Currently, many clients fund such partnerships with marketable assets, then claim significant minority and LOM discounts (when valuing interests in the entity for transfer tax purposes). The Administration believes such discounts are warranted only on the transfer of interests in active businesses.

• Repeal the current personal residence exception of Sec. 2702(a)(3)(A)(ii) and replace it with a "residence-GRAT" or "residence-grantor retained unitrust" (in which the trust would be required to pay out the required annuity or unitrust amount, even if the residence is the property contributed to the trust). Currently, regular personal residence trusts and QPRTs may be established, allowing the contributor of the residence to continue living in it without requiring the trust to pay him an annuity or unitrust amount.

Observation: The last two proposals were included in last year's Administration budget, as was a provision that would have overruled Crummey.⁶² The "anti-Crummey" proposal was left out of the President's budget this year.

IRS Business Plan

Presently, the prospects of passage for any of the President's proposals appear dim. A more certain bet for actual action may be some of the Service's own guidance projects scheduled for the short term. In March 1999, the Service and Treasury released the 1999 "Priority Guidance Plan,"⁶³ which lists the regulations and other administrative guidance the government expects to publish by the end of the year.

The list includes many estate planning projects, including finalizing the proposed regulations discussed above and, among other items:

• Proposing regulations regarding the estate tax exclusion for certain qualified family-owned business interests under Sec. 2057.⁶⁴

• Offering guidance on the income tax treatment of transfers by U.S. persons to foreign trusts with U.S. beneficiaries.

• Providing guidance on the qualification of distributions from an individual retirement account as QTIP property under Sec. 2056(b)(7).

• Issuing guidance on the operation of Sec. 645 (on the election by certain revocable trusts to be treated as part of an estate).

• Offering guidance under Sec. 2601 on modifications to trusts qualifying for a grandfather exception to the generation-skipping transfer tax.

• Providing guidance under Sec. 1361 on electing small business trusts.

©1999 AICPA