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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, recent cases and rulings and administrative and procedural changes.
Roby B. Sawyers, Ph.D., CPA
Vinu Satchit, CPA
For more information about this article, contact Prof. Sawyers at (919) 515–4443 or roby_sawyers@ncsu.edu or Mr. Satchit at (336) 821–1409 or vsatchit@bdo.com.
Executive Summary
This article examines recent developments in estate and gift tax planning and compliance. It highlights legislative developments over the last year, and examines recent cases and rulings. It also discusses the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) changes taking place in 2006, and annual inflation adjustments affecting the estate and gift tax. Legislative Developments While the House voted for full repeal of the estate tax in April 2005, the Senate continues to lack the needed votes. On June 8, 2006, it failed to overcome a procedural hurdle that would have allowed a vote on permanent repeal. The most likely outcome will probably be a compromise that preserves the estate tax, but with a substantially higher exclusion amount. HR 5638, approved by the House in late June 2006, would increase the estate tax exemption amount to $5 million per person ($10 million for couples) effective Jan. 1, 2010, and would index these amounts for inflation. Estates under $25 million would be taxed at the capital gain rate, with larger estates paying tax at twice that rate. However, at press time, it is uncertain whether Senate Majority Leader Bill Frist (R-TN) can come up with the 60 votes needed to avoid a filibuster. Consequently, estate planners and taxpayers remain in limbo and face the possibility of a one-year estate tax repeal in 2010. Significant Cases and Rulings Although numerous rulings and cases were decided in the last year, this article focuses on those dealing with family limited partnerships (FLPs) and a variety of valuation issues, including discounts, the tax on built-in gains (BIGs), lottery winnings, fractional interests in real estate and buy-sell agreements. It also discusses cases and rulings on administrative expense deductibility, the qualified terminable interest property (QTIP) election, disclaimers, spousal election rights, charitable remainder trusts (CRTs) and income in respect of a decedent (IRD). FLPs
The IRS has
successfully argued for including assets transferred to FLPs in Abraham: During 2005, various appeals courts agreed with the IRS. For example, in Abraham,1 the First Circuit sided with the Service in a case involving an incapacitated woman who transferred assets to a FLP, but had an implicit arrangement with her children that entitled her to “any and all funds generated from the partnerships for her support.” The Supreme Court declined to review this case on June 5, 2006. Its decision is not surprising, given that there is no split in the circuits on how to apply Sec. 2036(a)(1) to partnerships. Strangi: The Fifth Circuit’s much-awaited ruling in Strangi2 was handed down in August 2005. In noting that (1) numerous FLP distributions were used to pay personal expenses; (2) asset transfers consisted of 98% of the transferor’s wealth and left him without any meaningful liquid assets; and (3) the transferor continued to live in the residence transferred to the FLP until death without paying rent, the Fifth Circuit affirmed the Tax Court’s decision to apply Sec. 2036(a)(1). Much to the disappointment of practitioners, it did not rule on the Tax Court’s conclusion that Sec. 2036(a)(2) also applied, because the decedent’s position on the corporate general partner’s board of directors was a prohibited power to designate the property’s beneficiaries. That finding was extremely controversial, as it is well-settled law that powers exercisable only in a fiduciary capacity do not typically cause estate-tax inclusion. The fallout from Strangi caused by the Fifth Circuit’s refusal to rule on the Sec. 2036(a)(2) issue may not be as extensive as many estate planners fear, because the case’s unique facts allowed the Tax Court to diverge from Byrum.3 In noting the extensive amount of disproportionate distributions actually made, the Tax Court stated that following Byrum in Strangi “ignore(s) factual realities,” as the “facts of this case belie the existence of any genuine fiduciary impediments to decedent’s rights.” Schutt: Bolstered by its many successes, the IRS has attempted to expand the application of Sec. 2036(a) to instances in which there is no objective evidence of the retention of a valuable economic benefit. For example, in Schutt,4 the Tax Court held that the value of stock transferred by the decedent to two Delaware business trusts was not includible in his estate under Sec. 2036 or 2038, because the transfers were bona-fide sales for full and adequate consideration. According to the court, the trusts were formed primarily for nontax reasons (although tax reasons, including discounts, were also considered), the decedent retained sufficient assets outside of the trusts to maintain his lifestyle, other family members contributed their own funds for their interests, funds were not commingled and proportionate interests were received in exchange for the transfer. Keller: The fact that the Sec. 2036(a) inquiry is largely a factual one for objective evidence of the retention of prohibited rights was reemphasized in Keller.5 A Texas district court declined the IRS’s motion for summary judgment, stating that the factual nature of the inquiry made it inappropriate. Senda: Sec. 2036(a) is not the only IRS weapon against FLPs. The Service has also attacked certain FLPs using the indirect-gift theory, arguing that the transfers of partnership interests were actually indirect gifts of the underlying assets transferred to the partnership (which results in zero or substantially reduced discounts), because the partnership interests were technically transferred before the transfer of assets to the partnership. In Senda,6 the Eighth Circuit affirmed the Tax Court’s decision that stock transfers to two partnerships were indirect gifts of the stock to the taxpayer’s children (and hence, were valued with no discount), because the transferor failed to follow the procedural formalities in forming and funding the partnership. Valuation BIG Tax While the courts and the IRS have agreed that BIG taxes on a corporation’s appreciated assets should be taken into account in valuing its stock using the asset-based approach, they have not agreed on the proper method for quantifying the discount. The Fifth Circuit held that an asset-based approach includes the assumption that the assets were sold on the valuation date, regardless of whether the company was contemplating liquidation; thus, the stock’s value (as determined under the asset-based approach) was to be reduced by 100% of the potential BIG taxes.7 In Jelke,8 the decedent owned a 6.44% interest in a closely held corporation whose assets consisted primarily of appreciated securities valued at $178 million as of the date of death. In using the asset-based approach, the estate argued that the entire BIG tax liability should be allowed against the FMV of the securities; the IRS argued that such liability should be offset, because the taxpayer would incur the tax in the future, rather than immediately. In noting that the company “had performed well and kept up with the S&P 500,” which made liquidation unlikely, the Tax Court held the IRS expert’s method of discounting the BIG tax liability over a 16-year period to be reasonable. If appealed, this case will allow the Eleventh Circuit to rule on the issue for the first time. A discount for BIG tax is not allowed for partnership interests. In Temple,9 a Texas district court denied the discount, stating that a willing buyer could avoid such gain by making a Sec. 754 election. Sec. 7520 Tables What is the proper method for valuing, for estate tax purposes, the remaining installment payments of lottery winnings after a decedent’s death? The IRS’s position—which has been accepted by the Fifth Circuit and the Tax Court—considers lottery payments to be an annuity to be valued using the Sec. 7520 valuation tables. Taxpayers have argued successfully, before the Second10 and Ninth Circuits,11 for a departure from the tables, and a reduction of the present value of the future installments for illiquidity and lack of marketability, because state law restricts (in most cases) the assignment or transfer of lottery winnings. On April 26, 2005, a district court agreed with the Service that a departure from the IRS tables was not justified in valuing nonassignable lottery payments.12 Yet another district court has entered the fray. In Davis,13 it discounted unpaid, nonassignable lottery winnings to reflect the lack of marketability. The ultimate resolution of this issue may have to come from the Supreme Court. The issue at hand—whether nontransferability provisions will justify a departure from the use of the Service’s valuation tables—is important, because it will apply not just to lottery payments, but to all types of interests that require valuation by the tables. The IRS does require a departure from the use of the tables in valuing interests related to terminally ill donors. For example, it ruled14 that the general actuarial tables under Sec. 7520 cannot be used to value life estates given away by a donor who was terminally ill at the time of the gifts and who had no more than a 50% likelihood of surviving one year. Fractional Real Estate Interests In Baird,15 the IRS sought to limit the discount for undivided ownership interests in real estate to the pro-rata share of the estimated costs of partitioning the property. In noting that its previous decisions and those of other courts have routinely held that partition costs are only one of the expenses to consider in determining appropriate discounts, the Fifth Circuit not only rejected the Service’s argument, but also awarded attorneys’ fees, because the government’s position lacked merit. Buy-Sell Agreements Since the enactment of Sec. 2703, taxpayers have unsuccessfully tried to argue that buy-sell agreements set the value of stock for estate tax purposes. In Amlie,16 the Tax Court agreed with the taxpayer that the agreement met the Sec. 2703 requirements—namely, it was (1) binding during life and after death, (2) entered into for bona-fide business reasons, (3) was not a substitute for a testamentary disposition and (4) its terms were comparable to those of similar arrangements entered into at arm’s length. IRAs In Kahn,17 the Tax Court held the value of two IRAs to be the fair market value of the underlying securities in the accounts, as of the date of death, without a discount for anticipated income tax liabilities. The estate argued for discounts of approximately 22% for the anticipated income tax liabilities (and for lack of transferability). However, according to the court, a willing buyer of the underlying securities would not take income taxes into consideration, because he or she would receive the underlying securities free and clear of any tax liability. The decision is consistent with that of the Fifth Circuit in Smith.18 Deducting Administration Expenses Investment Advisory Fees Whether investment advisory fees paid to outside advisers are fully deductible by a trust, or deductible only to the extent they exceed 2% of the trust’s adjusted gross income (2% floor), has created a split in the various circuits. Reversing the Tax Court, the Sixth Circuit (in O’Neill19) ruled that the fees were fully deductible, while the Federal Circuit (in Mellon Bank20) and the Fourth Circuit (Scott21) ruled them subject to the 2% floor. The courts differ in their interpretation of Sec. 67(e)(1), which states that expenses that must be incurred in the administration of the trust or estate, and that “would not have been incurred if the property were not held in such trust or estate” are fully deductible. The Sixth Circuit interpreted the statute to apply to expenses that must necessarily be incurred by a trustee to meet fiduciary obligations under state law, while the Federal and Fourth Circuits, focusing on the plain and unambiguous meaning of the statute, stated that it applied only to “trust-related expenses that are unique to the administration of a trust and not customarily incurred outside of trusts.”22 Rudkin23 involved an individual trustee (a Connecticut resident) who paid approximately $22,000 to an outside investment adviser and took a full deduction for such expenses on the trust’s 2000 tax return. The trust’s argument relied heavily on the fiduciary’s obligation under state law to consult such advisers. After reviewing its original interpretation of Sec. 67(e) in O’Neill and the subsequent decisions in Scott and Mellon Bank, the Tax Court concluded that investment advisory fees were indeed subject to the 2% floor. Rudkin has been appealed to the Second Circuit. The ultimate resolution of this issue may have to come from the Supreme Court. Interest The IRS stated in technical advice24 that interest paid by an estate on a 10-year interest-bearing promissory note to a partnership (in which the estate held a 99% assignee interest) was not deductible as an administrative expense under Sec. 2053(a). Interest is generally deductible as an administrative expense if the loan was reasonably and necessarily incurred in estate administration. In the instant case, the Service stated that the loan was not a bona-fide debt arrangement, because the (1) partnership could have made distributions (in lieu of a loan) to the estate to allow it to pay its taxes; and (2) transaction appeared to have no economic purpose other than to generate deductible interest payments. The conclusion is troubling, because the loan terms suggested an arm’s-length transaction, the partnership was a bona-fide entity, and the estate, which had only an assignee interest in the partnership, lacked the ability to unilaterally control the partnership’s actions. QTIP Election The IRS ruled25 that a QTIP made on an estate tax return could be extended to assets discovered after the original return was filed. QTIP elections are made on Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, by listing the QTIP on Schedule M, Bequests, etc., to Surviving Spouse, and deducting its value. In this case, the estate’s personal representative discovered a promissory note that had not been included in the original estate tax return. The Service ruled that the estate could file a supplemental estate tax return to report this value in the gross estate as an asset of the marital trust and that the QTIP election could be extended to the newly discovered asset. However, in another ruling,26 a QTIP election was effective only for those assets actually listed on Schedule M, at the time the election was made. The decedent’s spouse disclaimed certain assets that would have passed to her through a marital trust. The disclaimed property was not listed on Schedule M of the estate tax return and, accordingly, the QTIP election did not include such property. After the estate tax return was filed, the disclaimer was found to be invalid. The estate requested a ruling on whether it had made a QTIP election for all the property passing to the marital trust, including the property originally disclaimed. The IRS ruled that the election applied only to the property specifically listed in Schedule M. Disclaimers The use of disclaimers has long been an effective tool in estate and gift tax planning. Sec. 2518 provides that if a person makes a “qualified disclaimer” of an interest in property received by a gift or bequest, the interest is treated as not being transferred to the individual for estate or gift tax purposes. However, a qualified disclaimer requires the person not to accept the interest or any of its benefits. According to Rev. Rul. 2005-36,27 a qualified disclaimer of an IRA can be made after the beneficiary has taken a required minimum distribution (RMD). However, the distribution itself and the income allocable to it cannot be disclaimed. Example: A, an individual, died in 2004 with an IRA worth $2 million. A was already receiving RMDs, but had not yet taken one for 2004. Under the IRA’s terms, A’s spouse, B, was designated the IRA’s sole beneficiary; A’s daughter was the beneficiary if B predeceased A. Three months after A’s death, the IRA custodian paid $100,000 to B, which was the RMD for 2004. Seven months after A’s death, B disclaimed $600,000 of the IRA, along with the income attributable to the $600,000 earned after death. A’s daughter was subsequently paid the $600,000, plus the income thereon. While B could not disclaim the $100,000 already received, the IRS ruled she could validly disclaim the $600,000 and the income thereon. Spousal Election Rights and CRTs After being bombarded with negative comments, the IRS and Treasury are reconsidering the approach taken in Rev. Proc. 2005-24.28 In Notice 2006-15,29 the IRS extended the June 28, 2005 grandfather date originally provided in Rev. Proc 2005-24. The procedure requires spouses, in certain circumstances, to waive the right to claim a portion of a CRT as part of their statutory share of the grantor’s estate, for the trust to qualify for the charitable deduction. Originally, the Service had stated that waivers were necessary for trusts created after June 27, 2005. Commentators (including the AICPA30) asserted that Rev. Proc. 2005-24 created potential traps and placed an undue burden on taxpayers and trustees seeking to comply with the rule. Until further guidance is issued, the IRS will disregard the effect of the spousal right of election on a trust’s qualification as a charitable remainder annuity trust or charitable remainder unitrust. However, trusts will continue to be disqualified if the surviving spouse actually exercises the right of election. IRD IRD continues to be litigated in the courts and clarified in administrative rulings. Income earned by an individual before death that is not included in his or her final return—typically, because it was not received—is IRD. IRD items are includible in the decedent’s gross estate and includible in income by the estate or beneficiary when the amounts are received. In Rev. Rul. 2005-30,31 the IRS clarified and expanded on Rev. Rul. 79-335,32 on the treatment of amounts received by a beneficiary under a deferred annuity contract. In this situation, the owner of a deferred annuity contract died before the annuity starting date; the beneficiary received a death benefit under the contract that exceeded the owner’s investment. The excess amount was ruled to be IRD and, thus, includible in the beneficiary’s income when received. In Eberly,33 the court ruled that a lump-sum distribution from a retirement plan, paid to a decedent’s beneficiaries, was not IRD. The plan allowed participants to receive a lump-sum benefit. In this case, the taxpayer’s father requested a lump-sum distribution one week before his death. The lump-sum payment was properly distributed to the decedent’s three beneficiaries. However, the taxpayer did not include his one-third share of the distribution in income. The IRS claimed that the payment was a death benefit and should be treated as IRD. However, the Tax Court ruled that the lump-sum distribution was income to the decedent and not IRD, which would have required the taxpayer to include the income in his return. In Cronk,34 the taxpayer was not allowed to file a late return on behalf of his mother to make a Sec. 454 election to pick up accrued interest on U.S. savings bonds as income on her final return. The taxpayer’s mother died in 1999; she did not have sufficient income to file a tax return. In 2001, the taxpayer discovered $30,000 of series E bonds that had been owned by his mother and cashed them in as the named beneficiary, receiving $31,980 interest. The taxpayer attempt-ed to file a 2001 Federal return for his mother to report and pay tax on the $31,980. However, the return was rejected. At trial, the Tax Court ruled that because an election was not made under Sec. 454 on the mother’s final return, the interest was taxable to the taxpayer when received in 2001. Planning The taxpayer might have been successful in having the income taxed on his mother’s final return if he had requested a retroactive filing extension for that return. He could then have made a valid election under Sec. 454 to include the income from the bonds in his mother’s final return. Miscellaneous Sec. 2503(e) provides an exclusion from taxable gifts for amounts paid on behalf of an individual as tuition to an educational institution. In one ruling,35 a grandmother prepaid tuition through grade 12 for six grandchildren attending a private school. The payments were made directly to the school and were nonrefundable. The IRS ruled that the entire amount of the tuition prepayments were excluded from gift tax under Sec. 2503(e) and were not generation-skipping transfers. Planning Tax advisers should note that this example is different from that provided in Regs. Sec. 25.2503-6(c). In that situation, funds were transferred to a trust that required the trustee to pay tuition expenses for the transferor’s grandchildren. However, because the funds were not paid directly to an educational organization for tuition costs of a designated individual, they did not qualify for the Sec. 2503(e) exclusion. Procedure and Administration The IRS released a revised Schedule K-1, Beneficiary’s Share of Income, Deductions, Credits, etc., for estates and trusts for 2005 returns. The intent of the revision was to simplify the form to reduce common errors and the time for completion. The new schedule uses codes to identify common reportable items. In addition, the new K-1 can be scanned by the Service, which should reduce the risk of errors in transcribing information. EGTRRA Changes Taking Effect in 2006 Estate and Gift Tax Rates The estate tax exclusion amount increased to $2 million for taxpayers dying in 2006. Under current law, it is scheduled to remain in effect through 2008. The top estate and gift tax rates continue to be reduced. For individuals dying (or making gifts) in 2006, the top marginal tax rate is reduced to 46%. In 2007, the rate is reduced to 45%. 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. 2005-7036 contains the adjustments for 2006. Annual Gift Tax Annual Exclusion The annual exclusion for gifts increased to $12,000 for 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 different from that for spouses who are U.S. citizens. In 2006, the annual exclusion for gifts to noncitizen spouses rose from $117,000 to $120,000. Receipt of Large Foreign Gifts For tax years beginning in 2006, gifts in excess of $12,760 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 2006, if the executor elects special-use valuation, the aggregate decrease in the value of qualified real property cannot exceed $900,000. Tax Deferral for Closely Held Business The Sec. 6166 amount eligible for the 2% interest rate rose from $1.17 million in 2005 to $1.2 million in 2006. |
