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Significant Recent Developments in Estate Planning
This article examines recent developments in estate and gift tax planning and compliance. It highlights legislative developments, administrative and procedural changes and significant recent cases and rulings.
Roby B. Sawyers,
Ph.D., CPA
Brian T. Whitlock, J.D.,
LL.M., CPA For more information about this article, contact Dr. Sawyers at roby_sawyers@ncsu.edu or Mr. Whitlock at bwhitlock@blackmankallick.com.
Executive Summary
This article examines
recent developments in estate and gift tax planning and compliance. It
highlights legislative developments over the last year, Economic Growth and Tax
Relief Reconciliation Act of 2001
(EGTRRA)
changes that take place in 2005, annual inflation adjustments affecting the
estate and gift tax and changes in the administrative procedure for requesting
extensions for filing gift tax returns. It also covers recent cases and rulings
on family limited partnerships
(FLPs),
general valuation, deductibility of estate administration expenses, the marital
deduction, spousal disclaimers and guidance on spousal election rights and
charitable remainder trusts (CRTs). Legislative Developments The House of Representatives voted on April 13, 2005, to permanently and immediately repeal the estate tax.1 Along with repeal, the bill would replace the current basis step-up rules with a modified carryover basis. However, the Senate has not been able to muster the votes needed for permanent repeal. Many observers expect significant estate tax legislation in the next year. As a result of the Senate’s stalemate, as of July 15, 2005, the estate and gift tax remains legislatively unchanged as the EGTRRA continues to phase in. Under current law, all of the EGTRRA tax reduction provisions will expire at the end of 2010. If the law is not changed, the applicable exclusion amount will revert to $1 million on Jan. 1, 2010, with a maximum tax rate of 55% (before the 5% surtax). EGTRRA Changes for 2005 While the estate tax exclusion remains unchanged at $1.5 million for 2005, the top estate and gift tax rates continue to decrease. For individuals dying (or making gifts) in 2005, the top marginal tax rate is reduced to 47%. Federal State Death Tax Credit In 2005, the Sec. 2011 state death tax credit disappeared completely and was replaced by a deduction for death taxes paid to the states. Decoupling from the Federal Estate Tax States continue to decouple from the Federal estate tax. Washington state’s Supreme Court invalidated the state’s former estate tax in Hemphill.2 The Washington estate tax was a “pick-up” tax that was completely phased out after 2004. The state legislature adopted a new tax independent of the Federal credit, effective May 17, 2005; it applies to estates valued in excess of $1.5 million in 2005 and $2 million in 2006 and thereafter. The tax rates range between 10% and 19%, depending on the size of the taxable estate.3 On June 30, 2005, significant changes in Connecticut’s gift and estate taxes were made, replacing the succession tax with a new transfer tax on taxable gifts and estates exceeding $2 million.4
Planning: Florida
and California are attracting unmarried retired persons, because these states do
not have an estate tax and have prohibitions against such a tax in the future.
Annual Inflation Adjustments The Tax Reform Act of 1997 amended the Code to provide that for transfers made in any calendar year after 1998, certain provisions of the estate and gift tax law would be indexed for inflation. Rev. Proc. 2004-715 contains the adjustments for 2005. Gift Tax Annual Exclusion The annual exclusion for gifts remains at $11,000 for 2005. The adjustment is in $1,000 increments and is likely to increase to $12,000 in 2006. Exclusion for Transfers to Noncitizen Spouses Noncitizen spouses are ineligible to receive unlimited property transfers under either Sec. 2523 or 2056—the gift and estate tax marital deduction provisions. However, they are eligible for an annual gift tax exclusion that differs from that for spouses who are U.S. citizens. In 2005, the annual exclusion for gifts to noncitizen spouses rose from $114,000 to $117,000. Receipt of Large Foreign Gifts For tax years beginning in 2005, gifts in excess of $12,375 from certain foreign persons need to be reported by the recipient under Sec. 6039F. Special-Use Valuation Under Sec. 2032A, an executor may elect to value qualified real property used in a farm or business on the basis of actual, rather than highest and best, use. For an estate of a decedent dying in calendar-year 2005, if the executor elects to use special-use valuation, the aggregate decrease in the value of qualified real property cannot exceed $870,000. Tax Deferral for Closely Held Business
The Sec. 6166 amount
eligible for the 2% interest rate rose from $1.14 million in 2004 to $1.17
million in 2005. Procedure and Administration New Form 8892—Extension of Gift Tax The IRS has issued a new, separate form for requesting an extension to file Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. The April 15th due date for gift tax returns can be extended by filing: 1. Form 4868, Application for Automatic Extension of Time To File U.S. Individual Income Tax Return, which automatically extends Forms 1040 and 709 until August 15. This form is appropriate when no gift tax payment is due. 2. Form 2688, Application for Additional Extension of Time To File U.S. Individual Income Tax Return, which is appropriate if Form 4868 was filed and additional time is needed (until October 15) to file Form 1040, as well as Form 709.
3. Form 8892, Payment of
Gift/GST Tax and/or Application for Extension of Time To File Form 709, which is
appropriate when
a gift tax payment is
due or
when an additional extension of time is needed and Form 1040 has already been
filed. This extension runs for six months. Form 8892 should be mailed directly
to the address indicated on the form, not to the IRS Service Center that
processes Forms 1040 (similar to Form 709). Significant Cases and Rulings Although numerous cases and rulings were decided last year, this section focuses on FLPs, general valuation, deductibility of estate administration expenses, the marital deduction, spousal disclaimers and guidance on spousal election rights and CRTs. FLPs In the last few years, the IRS has successfully challenged FLP cases using Sec. 2036(a). These cases have generally had one or more of the following “bad facts”:
In addition, the taxpayer was frequently old and in bad health, and formed the partnership shortly before death, without evidence of business or investment motivations.6 In 2004, however, there were two taxpayer victories, in Kimbell7 and Stone.8 In Kimbell, the Fifth Circuit reversed a district court’s decision and held that the transfer met Sec. 2036’s bona fide sale exception. Likewise, in Stone, the Tax Court held that none of the assets transferred to a FLP were includible in the taxpayers’ estates, because the transfers were bona fide sales for full and adequate consideration. Bigelow: In the first half of 2005, the pendulum appears to have swung back toward the middle, with several IRS victories. The Tax Court held, in Bigelow,9 that rental real estate transferred from a decedent’s revocable trust to a FLP had to be included in her gross estate under Sec. 2036(a), because she had retained, for her life, the right to the property’s rental income and its economic benefit under an implied agreement. The court found that the transfer “wasn’t a bona fide good faith sale for adequate consideration where it effectively left the decedent insolvent.” Turner: Likewise, in Turner,10 the Third Circuit upheld the Tax Court and found that marketable securities transferred by a decedent to FLPs, which the estate discounted for lack of control and marketability, were includible in his estate, because an implied agreement existed between him and his family that he would retain enjoyment and economic benefit from the transferred property. The court concluded that the decedent’s transfers to the FLP were a mere recycling of value and did not constitute “bona fide sales” within the meaning of Sec. 2036(a), because the decedent did not replenish his estate with other assets of equal value. It also held that although a “bona fide sale” does not necessarily require an arm’s-length transaction between the transferor and an unrelated third party, it still must be made in good faith. A “good faith” transfer to a FLP must provide the transferor some potential for benefit other than estate tax advantages resulting from holding assets in a partnership. The court noted:
Korby: In a set of related cases, Est. of Austin Korby11 and Est. of Edna Korby,12 the Tax Court held that the fair market value (FMV) of assets transferred by a husband and wife to a FLP were includible in their respective estates; the facts surrounding the transfers and the parties’ subsequent actions pointed to an implied agreement to retain enjoyment of the income from the property. Austin and Edna Korby, an elderly couple, formed Korby Properties, A Limited Partnership (KPLP), around the time that Edna was diagnosed with Alzheimer’s-related dementia. A living trust was KPLP’s sole general partner (GP) from its formation until 1999. The Korbys transferred substantially all of their assets to the partnership, except for their personal residence and a few other assets. Consequently, their Social Security benefits were insufficient to cover their living expenses. The difference was made up in purported management fees paid to the living trust as the GP. However, the Tax Court concluded that the payments were actually intended to pay living expenses and it included the assets in their estates under Sec. 2036(a)(1), holding that “all these facts, taken together, show that Austin and Edna had an implied agreement with their sons that Austin and Edna were entitled to the income from the assets they transferred to KPLP.” The court noted the bona fide sale exception was inapplicable, due to the taxpayers (1) standing on all sides of the FLP’s formation without negotiation or input from the limited partners; and (2) use of the FLP’s income for basic living expenses. Abraham: In Abraham,13 three pieces of commercial property were transferred to FLPs as part of the decedent’s estate plan. The decedent’s interests in the FLPs were later transferred to her children and their families. The Tax Court found that it was understood that the decedent was entitled to any and all funds generated from the partnerships. Further, the sales of FLP interests to her children were not bona fide, because the estate did not provide evidence as to the adequacy of the consideration paid by the children. In agreeing with the Tax Court, the First Circuit held that the decedent transferred an interest in property to her children by gift and purchase, but the purchases were not bona fide sales for adequate and full consideration and the decedent retained income rights to the property. Bongard: In Bongard,14 the decedent and an irrevocable family trust contributed stock in a closely held company to a limited liability holding company (LLC), in return for voting and nonvoting units, as part of a plan to raise capital for the corporation. The next day, the decedent and the trust formed a FLP. The decedent contributed all of his nonvoting LLC units for a nonvoting LP interest; the trust contributed some of its nonvoting LLC units for a voting GP interest. The decedent transferred some of the LP interests to his spouse, children and grandchildren over the next year and died unexpectedly, just before the two-year anniversary of the LLC’s formation. The Tax Court allowed the bona fide sale exception for the LLC’s formation, because the decedent possessed a “legitimate and significant” nontax reason for the transfer and received LLC interests proportionate to the transferred property’s value. However, it found no exception for the FLP’s formation, holding that Sec. 2036(a)(1) applied because of an implied agreement allowing the decedent to control the benefit of the LLC units transferred to the FLP. Senda: In Senda,15 the Tax Court ruled that transfers of stock by a taxpayer and his wife to a FLP, coupled with transfers of the FLP interests to trusts for the benefit of their children, were indirect gifts to the trusts under Sec. 2511. The stock, rather than the FLP interests, were valued for gift tax purposes; as a result, no valuation discounts were available. The Tax Court followed the reasoning in Shepard,16 which similarly disregarded the entity when the formalities of transfer were not cleanly respected. Planning: CPAs should structure new FLPs and review existing ones to guard against the application of Sec. 2036. In general, this means that (1) the transfer should meet the bona fide sale exception or (2) there is no express or implied agreement that the client will retain certain rights as to the possession of, enjoyment of, or income from the property transferred to the FLP. The cases discussed above point out that clients should not commingle assets, personally use FLP property, receive improperly planned distributions, etc.17 General Valuation Issues In Dunia,18 a large parcel of real estate was valued based on a comparable sale four months earlier, with adjustments for superior location, topographical advantages, access and improvements. An actual sale of part of the decedent’s property three years later, plus alleged offers, were given little weight. In Noble,19 the decedent died in September 1996 owning an 11.6% stock interest in a bank. The stock was sold in October 1997 for $1.1 million. It was appraised for the return at $903,988. At trial, the estate’s expert revalued the shares at $841,000. The IRS’s expert valued the stock at $1.1 million, using 15% minority and 30% marketability discounts. The Tax Court valued the stock at $1,067,000. In True,20 the Tenth Circuit affirmed the Tax Court and ignored buy-sell agreements in establishing the FMV of the taxpayer’s closely held corporations. The courts found that the agreements were reached in an arbitrary manner without professional guidance or consultation, and were testamentary substitutes intended to pass on the decedent’s interests for less than full and adequate consideration. The appeals court noted that a buy-sell agreement “must be entered into for a legitimate business purpose” and “cannot be a testamentary device.” Administrative Expenses In Letter Ruling (TAM) 200513028,21 the Service disallowed an up-front interest deduction on a loan to pay estate taxes. The estate at issue owned a FLP with significant liquid assets. The Service ruled that the loan was not needed to administer the estate. It held that the FLP could have easily distributed cash, which would have relieved the estate from borrowing from a third-party lender. The ruling flies in the face of Graegin,22 which permitted an estate to borrow money from an unrelated third party and to deduct it on the estate tax return in advance of its actual payment, when the loan was necessary for administration and there were interest prepayment penalties. In Gilman,23 an estate could deduct interest on a loan to obtain funds to pay estate taxes and proper administration expenses, plus $1.8 million for necessary services, including legal fees. Interest to pay salaries and for periods after the payment of taxes, plus consulting fees for the business, were nondeductible. The factor determining deductibility was whether the amount and the duration of the loan were needed for proper estate administration. Marital Deduction In Davis,24 the decedent left property in trust to his spouse. The trust gave her income for “health, education, support, maintenance, comfort and welfare” in accordance with her “accustomed manner of living.” Because this language prevented her from having complete control over the trust income and did not satisfy any of the exceptions to the terminable interest rule, the estate was not allowed to claim the marital deduction under Sec. 2056(b)(7). Spousal Disclaimer In Katz,25 the Tax Court held that when a surviving spouse disclaimed an interest in property, the property passed to a credit shelter trust, thereby incurring estate tax. At issue was the interpretation of trust terms as to funding and formula. The estate plan directed that the credit shelter trust was to be funded with an amount equal to the “aggregate Federal estate tax exemption equivalent.” The document further provided that such amount “shall not be reduced on account of any disclaimer by my wife.” The estate argued that the trust was to be funded with an amount equal to the “aggregate Federal estate tax exemption equivalent” and no more, and that the court “should interpret the decedent’s will in such a manner as to effectuate decedent’s probable intent to this end,” emphasizing that the overall intent was to minimize taxes. The court held otherwise, noting that while the decedent’s intent may have been to minimize taxes, it was thwarted by the surviving spouse’s disclaimer. Spousal Election Rights and CRTs Rev. Proc. 2005-2426 requires, in certain circumstances, a grantor’s spouse to waive the right to claim a portion of a CRT as part of the spouse’s statutory share of the grantor’s estate. A number of states grant a surviving spouse the right to take an elective share of the decendent spouse’s estate. While many states limit the elective share to the probate estate, others permit the spouse to extend the election to include the “augmented estate,” which could include irrevocable trusts created by the decedent during life for the benefit of others. This definition would include CRTs. Technically, the mere possibility that a CRT’s assets could be used to satisfy a spouse’s elective share would disqualify it. The IRS will disregard the right of election if the spouse irrevocably waives that right in the manner set forth in the procedure. The signed waiver is not filed with the IRS, but is retained by the trustee with the trust’s permanent records. The AICPA believes that Rev. Proc. 2005-24 creates several potential traps and has written to the IRS with suggestions and recommendations.27
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