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Significant Recent Developments in Estate Planning This article examines recent developments in estate, gift and generation-skipping transfer tax planning. Specifically, it highlights legislation, indexing, regulations, cases and rulings and IRS examination issues.
Brian T. Whitlock, J.D.,
LL.M., CPA
Editor’s note: Mr. Whitlock is a member of the AICPA Tax Division’s Trust, Estate and Gift Tax Technical Resource Panel. For more information about this article, please contact Mr. Whitlock at (312) 207-1040 or bwhitlock@bkadvice.com.
Executive Summary
This article focuses on recent developments in estate, gift and generation-skipping transfer (GST) taxes, including legislative developments, indexing, new regulations, cases and rulings and IRS examination developments.
Legislative Developments Federal Estate Tax Reform Washington is quiet these days. Because the Senate did not approve the Economic Growth and Tax Reconciliation Act of 2001 (EGTRRA) with a greater-than-60% majority, all of the EGTRRA's tax-reduction provisions will expire at the end of 2010. Apparently, neither the Democrats nor the Republicans will be able to amass the 60 Senatorial votes needed to remove the EGTRRA's sunset provisions. The latest attempt died in early June 2002; members of Congress are now busy campaigning for November elections. The only noteworthy Federal legislative changes were some provisions specifically geared toward September 11 terrorist attack victims.1 After that date, both the economy and Congress slipped into a waiting mode. Most likely, Congress will not enact significant Federal legislation in the estate tax area before 2005.
State Estate Tax Reform EGTRRA Sections 531 and 532 changed the Federal state death tax credit.2 Beginning in 2002, the credit is reduced 25% each calendar year until it is eliminated. Beginning in 2005, the former credit will change into a Federal deduction. Because many states base their death tax on the state death tax credit, they are being forced to take action to replace lost revenue. In April 2002, Nebraska joined a growing number of states choosing to change how they calculate state tax on estates and/or inherited property; Nebraska will now ask taxpayers to calculate their estate tax liability under a separate state formula. Planning: Today's wealthy individuals have numerous multistate real estate holdings, including homes, vacation properties and residential and commercial rental properties, etc. The proliferation of the number of state estate and inheritance tax statutes that divorce themselves from the Federal credit will add complexity to the estate planning process.3
Gift, Estate and GST Tax Exclusion Indexing The Taxpayer Relief Act of 1997 indexed a number of exclusion items, which began in 1999. This indexing continues even after the EGTRRA and applies to calendar 2002.4
Gift Tax Annual Exclusion For 2002, the Sec. 2503(b) gift tax annual exclusion increased to $11,000 per person. The adjustment is in $1,000 increments as necessary to reflect inflation. Noncitizen spouse: Taxpayers can transfer unlimited property to a U.S. citizen-spouse under the Sec. 2056 marital deduction. However, for a noncitizen spouse, the exclusion was historically limited to $100,000 by Sec. 2523, but increased to $110,000, effective for 2002.
GST Exemption The GST exemption increased to $1.1 million for calendar 2002. Indexing continues under the EGTRRA; however, in 2004, the phased-in increase of the GST exemption to $1.5 million will likely surpass and replace the indexed amount.
Special-Use Valuation Under Sec. 2032A, an executor may elect to value real property used in a farm or business on the basis of actual (rather than highest and best) use. The maximum allowable deduction was $750,000; indexing for 2002 increases it to $820,000.
Tax Deferral for Closely Held Business The Sec. 6166 2% interest rate for the applicable portion of the estate tax payable in installments now applies to tax liabilities of up to $1.1 million.
Receipt of Large Foreign Gifts For tax years beginning in 2002, recipients of gifts from certain foreign persons may have to report them under Sec. 6039F, if the aggregate value of the gifts received in a tax year exceeds $11,642.
Regulatory Developments Treasury changed its fiscal year from December 31 to June 30; as a result, the end of calendar 2001 was uncharacteristically quiet, with no proposed regulations of note. The electing small business trust regulations were finalized, with minor changes. The Sec. 401(a)(9) minimum distribution rules,5 designed to simplify the calculation of required minimum distributions (RMDs) from qualified plans, IRAs, Sec. 457 deferred compensation and similar plans, were also finalized. The final regulations include a new uniform table (based on updated mortality statistics) effective for RMDs for calendar years beginning in 2003. For 2002 RMDs, taxpayers can use the final regulations, the 2001 proposed regulations or the 1987 regulations. Long-awaited proposed regulations were issued on split-dollar life insurance.6 The proposed regulations require an ar-rangement to be taxed under one of two sets of rules, depending on whether the policy owner is the employer or the employee. If the employer owns the policy, its premium payments are treated as providing "economic benefits" to the employee (including the value of the life insurance protection and any other benefits provided the employee under the arrangement). If the employee owns the policy, the employer's premium payments are treated as employee loans; if the employee is not paying market-rate interest on the loan, he or she is taxed on the difference between market-rate interest and the actual interest. The proposed rules apply to arrangements entered into after the regulations become final. Notice 2002-87 revoked Notice 2001-108 and allowed use of the P.S. 58 tables for split-dollar arrangements entered into before Jan. 28, 2002. Until the proposed regulations are final, new split-dollar arrangements should be based on the lower of Notice 2002-8's Table 2001 on an insurer's published premium rates.
Cases and Rulings In the last 12 months, a number of the cases and rulings emphasized the topical overlap that frequently occurs in estate planning. To be successful, estate planners must be attuned to tax implications across multiple chapters of the Code.
Gift or Compensation? Lane9 is a perfect example of the interplay of the gift and income taxes. The decedent felt "fatherly affection" toward his administrative assistant and had a longstanding pattern of making gifts to her and his own family. The transfers were reported on timely filed split gift tax returns. The Lanes' financial adviser could not convince the surviving spouse to file amended gift tax returns and claim the payments made to the assistant as compensation. After the surviving spouse's death, the adviser-cum-executor filed amended income and gift tax returns, claiming that the payments ($798,250) were income-tax-deductible compensation, not gifts. The Fourth Circuit rejected the executor's characterization of the payments as compensation and upheld the characterization as gifts.
Estate and Income Tax In recent years, practitioners have increased their use of irrevocable grantor trusts (under Secs. 671—679) as a planning tool. They use these trusts (commonly referred to as intentionally defective income-only trusts (IDIOTs)) to transfer assets outside of a grantor's taxable estate, while retaining the grantor's obligation to pay income tax. Practitioners have been concerned about a trustee's or trust protector's discretionary power to reimburse the income taxes incurred by the grantor on the "deemed" trust income. In Letter Ruling 200120021,10 the Service stated that such powers are not the retention of a right to receive income or enjoyment under Sec. 2036(a)(1); thus, an IDIOT will not be includible in a grantor's gross estate at death. Qualified joint tenancies: Treasury acquiesced in Hahn,11 hopefully marking the end of a series of cases dating back to Gallenstein,12 in which the IRS challenged the possible double basis step-up on joint tenancy property acquired by spouses before 1977. Under the pre-1977 rule, on the death of the contributing spouse, 100% of the basis of joint tenancy property was stepped up to fair market value (FMV). Over the last 10 years, the Service lost every case it tried in the courts on this issue.
Disclaimers The Eighth Circuit validated a regulation on disclaimed interests. In Walshire,13 the decedent timely filed a disclaimer of a remainder interest in a trust created under his deceased brother's will, but reserved the right to income and use of the property during his life. Sec. 2518(a) states that a transferee may disclaim "any interest in property"; under Sec. 2518(c), "an undivided portion of an interest" may qualify as a disclaimer. In defining "an undivided portion," Regs. Sec. 25.2518-3(b) states, "[a] disclaimer of some specific rights while retaining other rights" is incomplete. Further, disclaiming a remainder interest in a fee simple conveyance of real estate, while retaining a life estate, is not a valid disclaimer. The court held that the regulation was consistent with the statute and invalidated the decedent's disclaimer.
Valuation In the valuation area, the applicability of discounts and premiums to fractional interests continues to be the hottest point of controversy in estate planning. Two major IRS valuation victories were reversed last year. In Est. of Simplot,14 the Ninth Circuit reversed a Tax Court holding allocating a 3% control premium to a decedent's shares. The Ninth Circuit criticized the Tax Court for constructing particular possible purchasers, rather than using a hypothetical willing buyer. Additionally, the court found that the decedent's voting shares did not represent control; thus, a control premium was inappropriate. Finally, the court noted that the Tax Court failed to demonstrate that a controlling block would have had an increased economic advantage. In Est. of Jameson,15 the Fifth Circuit reversed a Tax Court holding on the effect of built-in gain (BIG) on corporate valuations. The decedent owned shares in a corporation that held two parcels of land. The first, 5,400 acres of low-basis Louisiana timberland, had a stipulated $6 million FMV and a current potential $1.9 million BIG tax liability. The second parcel was unimproved land worth $240,000. The Tax Court had opined that the most likely buyer would be an operator that would continue the business and sell 10% of the land each year. Under this approach, the present value of the BIG tax was $872,920. The Fifth Circuit found that the evidence did not support the Tax Court's conclusion that a strategic buyer was the most likely buyer, because the rate of return from continued operations appeared to fall short of such an investor's required rate of return. The court concluded that a typical buyer would not be satisfied with the projected 14% rate of return and would liquidate the timberland much more quickly. No BIG discount had been allowed on the vacant land. The Fifth Circuit reversed and remanded the Tax Court decision, insisting that the latter, in valuing the corporate stock, reconsider the discount on the timberland and allow an additional discount for BIG on the vacant land. To avoid a discount on fractional interests, the IRS will frequently attempt to aggregate the holdings of several different taxpayers and value the combined interests as a single block. Previously, it had lost a number of cases16 in which it tried to aggregate qualified terminable interest property and nonmarital portions of an asset. The IRS reversed this string of defeats recently, when it successfully aggregated a taxpayer's interests with interests held in a general power of appointment (GPA) marital trust for the taxpayer's benefit. In Fontana Est.,17 H and W owned 100% of the stock of a family business as community property. After W's death, the stock was 50% owned by H, 44.069% by a marital trust (over which H was the sole trustee and had a GPA) and 5.931% by a trust for the benefit of the surviving spouse and children (for which H was the sole trustee). The sole issue was whether the stock should be valued as one 94.069% block or as two separate blocks of 50% and 44.069% each. The parties stipulated to a differential of approximately 22%. The Tax Court held that the GPA marital trust is a functional equivalent to outright ownership; thus, for valuation purposes, the decedent's stock interests had to be aggregated.
Lottery Winnings The Tax Court once again ad-dressed how to value a state lottery prize. In Est. of Cook,18 a taxpayer had an informal agreement with a friend to purchase lottery tickets and share any winnings. In 1995, they won $17 million, payable in 20 annual installments. The friends then formalized their agreement by creating a limited partnership (LP); each received a 2% general partnership interest and a 48% LP interest. Shortly after the partnership collected the first payment, the decedent died unexpectedly. The Tax Court held that the installment payments (inside the partnership) had to be valued as an annuity, based on the Sec. 7520 actuarial tables. Planning: Despite the mandate to value the installments as an annuity, the LP structure greatly benefited the taxpayer. The IRS's valuation of the partnership interests permitted the estate discounts for lack of marketability and control and for transfer restrictions that totaled nearly 25%. A potential conflict appears to be developing between a district court's and the Tax Court's interpretation of the use of Sec. 7520 tables in valuing state lottery prizes. In Shackleford,19 the Ninth Circuit upheld a district court view that the tables do not always reflect future lottery payments' FMV. Those courts noted that the tables should not be followed blindly. In Shackleford, California lottery law imposed anti-assignment restrictions on lottery prizes, limiting liquidity. The Ninth Circuit agreed with the district court's assessment that the "use of the annuity tables produces a substantially unrealistic and unreasonable result, because the table does not reflect the discount which must be taken by virtue of the non-liquidity of the prize."
FLPs The tax law demands that the formalities of LPs be respected to claim valuation discounts, just as the common law demands respect for corporate formalities to preserve the shield against shareholder liability. The few victories the IRS has achieved have been limited to situations in which practitioners and clients have failed to follow family limited partnership (FLP) organizational and operational formalities or in which documents have overreached. In Hackl,20 H and W created an Indiana limited liability company (LLC) (funded with Georgia and Florida tree farms and $7.9 million of cash and marketable securities). Under the LLC agreement, the members could not "transfer, assign, convey, sell, encumber, or in any way alienate" their interests without the managing member's prior written consent, which could be "given or withheld, conditioned, or delayed as the Manager may determine in the Manager's sole discretion." Members waived the right to partition any of the company's property and could not withdraw (or demand the receipt of any portion of their) income or capital without the manager's approval. Finally, available cash distributions were solely at the manager's discretion. H was named as managing member for life, although he could be removed by a majority vote of the members. H and W made gifts both directly and indirectly to their adult children, their children's spouses and their grandchildren. The Tax Court held that none of the gifts were present interests. It determined that LLC restrictions failed to give the holder of a membership interest "immediate and unconditional rights to the use, possession, or enjoyment of property or the income from property." Sec. 2503(b) "requires meaningful economic, rather than merely paper, rights." In a second case focusing on the timing of the creation, funding and transfer of assets to an FLP, the Eleventh Circuit affirmed a Tax Court ruling against the taxpayer in Shepherd.21 The courts held that the taxpayer's transfer of land preceded FLP formation by only a few days. The flaw in Shepherd was sloppy creation of the FLP. The courts held that the transfer was a gift of the land, not a gift of an FLP interest. Lack of form over substance cost the taxpayer, whose discount was limited to 15%. TAM 20021200622 repeats the IRS position on the failure to follow organizational formalities. A donor transferred LP interests to his children before the partnership was funded with publicly traded bonds. The taxpayer treated the gift as a transfer of LP interests and claimed a 45% discount, which the IRS disallowed. Shepherd and TAM 200212006 can be contrasted with Church,23 in which Mrs. Church and her children created an FLP two days before her death and assigned ownership of her securities account to it. The LP certificate was filed with the state two days after her death. The corporate general partner was not legally formed, and the brokerage account was not retitled until five months after her death. The Tax Court held (and the Fifth Circuit affirmed) that the written partnership agreement alone constituted an enforceable contract that governed the parties' rights, causing the value to be discounted. Failure to follow FLP operational formalities can be disastrous. In Est. of Harper,24 a decedent created an FLP with two of her children and gifted 60% percent of the LP interests to them. The family failed to apply for a taxpayer identification number for the partnership, allowing the decedent to commingle the partnership funds with her personal assets, and failed to make proportionate distributions. The decedent's failure to follow operational formalities led the Tax Court to conclude that she had retained the economic benefit of assets, thus triggering inclusion of the assets in her estate under Sec. 2036(a).
Reorganized and Refocused IRS Examination Function Audit Figures The IRS released audit statistics for fiscal 1999.25 The level of examinations decreased as compared to fiscal 1998. The number of estate tax attorneys responsible for the examination function in the various district offices continues to decline.
Consolidation Efforts To restructure its current audit effort, the IRS is consolidating the estate and gift tax processing function. Prior to 2002, estate and gift tax returns were filed in each of the 10 regional service centers (Campuses) located throughout the country. The returns were classified and selected for audit by one or more individuals at the Campus. Members of the respective district offices would periodically travel to the Campus to classify returns for their district. As of January 2002, all estate and gift tax returns are now filed only in the Cincinnati Service Center. The individuals employed at the other nine Campuses to review returns were all given the opportunity to transfer to Cincinnati to join the consolidated processing effort, but no one accepted. Cincinnati has over 20 new employees being trained to review estate and gift tax returns. The Cincinnati Service Center examiners perform the first level of classification of estate tax returns there. Examiners from each of the various U.S. district offices are currently traveling to Cincinnati to assist in classifying gift tax returns for districts other than their own. Although this process of cross-district selection ensures impartiality, it loses the benefit of local input. Local input in the selection process allows the Service to focus on both local high-profile taxpayers and known practitioners who are overly aggressive or sloppy. The loss of this experience will further impair the examination process. Practice note: The IRS is making a concentrated effort to find FLP test cases outside of Texas. Nearly all returns outside of Texas with FLP discounts are being sent to district offices for additional review by gift and estate tax examiners. The IRS is desperately trying to find test cases outside of the jurisdiction of the Fifth Circuit, to set up a conflict for appeal to the U.S. Supreme Court. The settlement reigns are being pulled to coordinate FLP discount issues nationally. For example, Chicago District estate tax examination attorneys only have the authority to settle valuation cases of corporations and FLPs with discounts of 25% or less. Discounts over 25% require approval of the issue coordinator. Above some level of discount (perhaps 33%), examiners must consult with district counsel before approving valuation discounts.
Conclusion Estate planning for the balance of 2002 and all of 2003 can rely on the fact that Congress will make few legislative changes; the IRS will issue significant regulations and, as it reorganizes and refocuses its examination processes, focus on valuation discounts of fractional interests. |
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