Recent Developments Affecting Estate Planning
Stanley M. Johanson
University Distinguished Teaching Professor andJames A. Elkins Centennial Chair in LawThe University of Texas School of Law
Austin, Texas
Probate, Trust and Estate SectionDallas Bar Association
Dallas, TexasMay 23, 2017
TABLE OF CONTENTS
I. The Federal Estate Tax—What Happens Now?A. The one constant with respect to transfer taxes has been constant change.............................1B. Will the estate tax be repealed?...............................................................................................1C. What about the gift tax?..........................................................................................................1D. And what about the “new basis at death” rule?.......................................................................2E. What do we (and our clients) do in the meantime?.................................................................2F. Trusts will remain the linchpin in estate planning..................................................................3G. Account transcript in lieu of estate tax closing letters............................................................5
II. Section 401—Qualified Plans and IRAsA. Inherited retirement benefits: Five-year payout limit except for spouses?.............................6B. Community property IRA—beneficiary is someone other than spouse ................................6C. Testamentary trust was a valid look-through trust..................................................................7D. No look-through trust here; court order did not cure financial advisor’s error.......................8E. Waiver of 60-day rollover requirement: Treasury makes it easier.........................................9F. Waiver of 60-day rollover requirement granted to W but not to H........................................9G. Penalty waived for underpaid tax on early IRA distributions.................................................9
III. Section 671—Grantor Trust RulesA. Grantor trust modified to add reimbursement clause............................................................10B. GRATs modified to add missing language...........................................................................10
IV. Section 1014—Basis of Property Acquired From a DecedentA. Proposed regulations answer some questions and raise others.............................................10B. New focus: Income tax planning...........................................................................................11
V. Section 2033—Property In Which Decedent Had an InterestA. Estate expert’s lowball valuation dismissed--conflict of interest.........................................13
VI. Section 2053—Administration Expense DeductionA. Graegin loan: $71.4 million deduction for $10.7 million loan? No way! ............................14B. After settlement with IRS, no increase in Section 2053 deduction. .....................................15
VII. Section 2055—Charitable DeductionA. Syndicated conservation easement transactions are “listed transactions”............................15B. Post-death redemption plan reduced amount passing to charity...........................................16
VIII. Section 2056—Marital DeductionA. QTIP election in connection with portability election—how do you spell relief?!!.............16B. Extension of time to make portability election granted. ......................................................18C. Marital deduction for same-sex couples...............................................................................18
IX. Section 2704—Lapsing Rights and RestrictionsA. Long-awaited proposed regulations published, but where do they stand now?....................19
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X. Texas Legislative DevelopmentsA. Overview...............................................................................................................................20B. Uniform Power of Attorney Act...........................................................................................20C. Partition of Tenancy in Common—Uniform Partition of Heirs’ Property Act....................22D. Miscellaneous probate matters..............................................................................................22E. Trust Code.............................................................................................................................23F. Rule Against Perpetuities: Life in Being Plus 300 Years??? No way!.................................23G. Guardianship—the term “ward” would disappear...............................................................23 H. Reporting financial abuse of elderly persons........................................................................23I. Multiple-Party Accounts.......................................................................................................23J. New forms for Anatomical Gifts and Medical Power of Attorney.......................................24
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I. The Federal Estate Tax—What Happens Now?
A. The one constant with respect to transfer taxes has been constant change. It all began with the Tax Reform Act of 1976, which “unified” the federal estate tax and gift taxes, increased the estate tax exemption from $60,000 to $175,625, introduced the first (mercifully short-lived) version of the generation-skipping transfer tax, repealed (for a few years) the “new basis at death” rule, and made other significant changes (and some insignificant changes—remember the orphan’s deduction?). ERTA 1981 increased the estate tax exemption to $600,000, introduced the unlimited marital deduction, and gave us QTIP trusts. The Tax Reform Act of 1986 increased the exemption, reduced the maximum estate & gift tax rate, and gave us the current version of the generation-skipping transfer tax. In 1990, we were introduced to the Special Valuation Rules of Chapter 14. EGTRRA 2001 (the “Bush Tax Act”) repealed the estate tax under the Budget Reconciliation procedure’s “sunset” rule—a slow-burning fuse. After an estate-tax-free year in 2010, in 2012 Congress made the exemption “permanent” at $5,000,000 (with annual CPI adjustments).
1. And those are just the highlights! These same Acts, and sundry statutes in between, made more-than-tinkering changes to our transfer tax laws on an almost annual basis.
2. And here we are again—maybe!
B. Will the estate tax be repealed? The Trump administration released its tax reform plan on April 26, 2017—a one-page summary. The plan calls for repeal of the estate tax. In a briefing on the plan, Economic Council Director Gary Cohn clarified that repeal of the estate tax would be effective immediately, rather than being phased out.
1, Well… even with the Republicans holding both houses of Congress, they have only 52 senators, and it would tax 60 votes to override a likely Senate filibuster. (On the other hand, several Democrat senators will be up for reelection in states that went for President Trump.) A filibuster could be avoided if Republicans took the Budget Reconciliation route (as with the Bush Tax Act in 2001), producing a “repeal” that (thanks to the “Byrd rule” in the Senate) would expire in ten years.
2. State estate tax laws can be a concern even for Texans regardless of what happens at the federal level. New Jersey has repealed its estate tax (effective in 2018), but 20 states and the District of Columbia have estate or inheritance taxes. (In Oregon, for example, the estate tax exemption is $1,000,000, and progressive tax rates begin at 10 percent. And don’t smugly assume that those state death taxes are of no concern to us Texans. The situs rule raises a concern for any Texan who holds an interest in real property in one of those states. In most of these states, for real property owned by a nonresident the exemption is prorated. This means that absent planning, a vacation property in Oregon or some other state can produce a substantial estate tax.
C. What about the gift tax? Repeal of the estate tax would no doubt include repeal of the generation-skipping transfer tax. But would the federal gift tax also be repealed? The summary plan made no reference to the gift tax.
1. As important as the gift tax is as an adjunct to the estate tax, it may be even more important as a means of shoring up the progressive structure of the income tax. Recall the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), which via Senate's budget
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reconciliation procedure was structured to repeal the estate tax effective January 1, 2010 (for one year!). The Joint Committee on Taxation persuaded Congress that repeal of the gift tax would lead to substantial downward adjustments of income tax revenue. As a result, while EGTRRA gradually increased the estate tax exemption to $3,500,000 (in 2009), the gift tax exemption was capped at $1,000,000.
2. Some examples that might arise in a world with no gift tax (and no gift tax returns to report transactions).
a. Client owns Acme common stock with a cash basis of $10,000 that is now valued at $100,000. If Client sells the stock, he incurs capital gain of $90,000 which (under the current rate of 23.8 percent) would generate $21,420 in income tax. Client instead gives the stock to Mother, who has modest income aside from social security. Mother sells the stock, incurs capital gain of $90,000, but pays little or no income tax thereon.
b. Client gives income-producing assets, generating income of $40,000/year, to 22-year-old Daughter. The income is taken off the top of Client's income tax base (currently taxed at 39.6 percent—not to mention state income tax in many states) and is taxed to Daughter at much lower rates. Five (old and cold) years later, when Daughter has begun earning substantial income, she gives the assets back to Client.
(1) At least in the Clifford Trust days (10-year-and-a-day trusts—remember those?—repealed in 1986), Client had to wait 10 years to get the property back.
3. This subject is discussed at length (and with concern) in Soled, The $250 Billion Price Tag Associated With Gift Tax Repeal, 154 Tax Notes 429 (Jan. 23, 2017). As the title of Professor Soled's article suggests, repeal of the gift tax would have a whopping adverse effect on income tax revenues.
D. And what about the “new basis at death” rule? A Trump administration is hardly likely to repeal the “new basis at death” rule—at least for most Americans. However, on the campaign trail Trump proposed a capital gain tax for assets held at death and valued at more than $10 million. How in the heck would that work? Would there be a step-up in basis for the first $10 million—and if so, how would assets be selected for the step-up? We of course have no clue, and neither does anybody else.
E. What do we (and our clients) do in the meantime? Daily Tax Reports (12-28-16) had a choice quote from Cynda Ottaway, president of ACTEC: “You’ve got to say, ‘keep your plan in place and stay healthy,’ because you don’t know what’s going to happen.” Digging further into history, also helpful is a quotation attributable to Oliver Cromwell, the 17th Century British revolutionary: “put your trust in God; but keep your powder dry." Bottom line: wait and see. If planning decisions must be made in the interim, it will be important to build as much flexibility into the plan as possible.
1. Did Benjamin Franklin have it wrong? It was Benjamin Franklin, in a 1789 letter, who wrote that “Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.” Death, yes; income taxes, yes; but death taxes can hardly be said to be certain.
a. The annual Short Course on Estate Planning given by the Center for American and International Law (formerly the Southwestern Legal Foundation) in Dallas, at which I have lectured for 50 years, was scheduled this year for the first week in February. We
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decided to postpone the course because none of the speakers had a clue as to whether anything we might say would have any relevance six months later.
2. For the short run (and possibly for the long run—we just don’t know), clients assuredly should shelve plans for that proposed installment sale to a defective grantor trust or any other sophisticated planning transaction. (And this is yet another reason to not text while driving.)
3. Should you consider changing your practice to another area? Not to worry! There is a good likelihood that, whatever Congress does, you will be busier than you are now! Think back on all of the changes that I mentioned at the beginning of this outline, and how they affected your practice. Virtually every time Congress has made changes in the transfer tax area—especially when the rules are “simplified,” things tend to get more complicated, meaning more work for estate planners in revising existing wills and trusts (and doing it again a couple of years later).
F. One thing that won’t change: Trusts will remain the linchpin in estate planning.
1. Trusts for spouses remain important. A “bypass” trust that gives the spouse a life income interest and limited invasion powers over trust principal will continue to be important even if there are not going to be any estate taxes to bypass. It must be conceded that clients really like two page “I love you” wills: "to my [spouse] if he survives me, otherwise to my children in equal shares"—or perhaps “to my descendants per stirpes.”
a. One concern is that if the spouse later becomes incapacitated, the result will be a costly and cumbersome guardianship administration. If instead the estate was left in trust—with the spouse serving as trustee for as long as he or she is able and so inclined—a guardianship administration will be avoided.
b. Another concern is the risk of financial abuse. In Financial Abuse: the Silent Epidemic, Barron’s (Nov. 12, 2016), it was estimated that one out of five older citizens has been financially exploited, and that in 70 percent of the cases a child was the suspected perpetrator. Settling assets in a trust shields the assets from being exploited—unless, of course, that bad-apple child is the trustee!
c. A trust settlement assures that the remainder interest on the spouse’s death will pass to the children, rather than to that dreaded second husband, that trophy second wife, or that too-solicitous caretaker.
(1) As for caretakers, c.f. Texas Family Code §123.102 (triggered by alleged instances in which Caretaker whisked Patient to a justice of the peace, married him, disappeared, and then reappeared after his death wearing black—she’s a widow, after all), authorizing a suit to challenge a marriage on the ground that the decedent lacked sufficient mental capacity to enter into the marriage if (1) the marriage occurred within three years of death and (2) the action is filed within one year after death.
d. A trust can (and should!) give the spouse a special testamentary power of appointment, the power to appoint the trust property (e.g.,) “outright or in further trust to such one or more of my descendants as survive me.” Professor Ed Halbach (University of California) has noted that a power to appoint also gives the power to disappoint, and tends to insure filial devotion: If an elderly mother or grandmother has a special
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testamentary power to appoint assets worth $2 million, how likely is it that she will be alone at Thanksgiving?
2. Trusts for children and other descendants. Another problem with that two-page will: If the children may succeed to more than a modest amount, there are very real advantages in creating trusts for the children's benefit rather than giving them outright ownership. Moreover, each child can be the trustee of his or her own trust, giving the child the power to make management and investment decisions (just as an outright owner would make) while also giving various advantages.
a. Covering the contingency of divorce. In today’s world, over one-half of all marriages end in divorce. In Texas, only community property is subject to equitable ("just and right") division in a divorce proceeding. The judge cannot divest one spouse of title to his or her separate property and award it to the other spouse. Granted, if property is bequeathed outright to a child, it is the child's separate property because acquired by gift, devise or descent. However, under Texas law all property on hand at the time of divorce (or death) is presumptively community property. To keep its separate property status, the property cannot be commingled with community property, and good records must be kept; otherwise it may not be possible to establish separate ownership so as to overcome the community presumption by the required clear and convincing evidence.
A trust (even a trust with the child as trustee) is a useful vehicle for segregating inherited property and keeping it separate.
b. Creditor protection. If the child is in a profession or line of work in which malpractice actions are a concern (and, in today's litigious society, that includes just about everybody!), property left to a child in a trust can be given spendthrift protection, meaning that no creditors can reach the child's interest in the trust—even if the child declares bankruptcy.
c. In-law protection. Even if the child’s marriage is solid and the likelihood of divorce is remote, parents may be concerned that the child’s spouse might take some action that puts the child’s inheritance at risk. (Several Texas lawyers have told me that, in explaining the pros and cons of trusts for clients’ children, this is the scenario that catches the clients’ attention.)
Example 1: Donna, having inherited $750,000 from her parent’s estate, carefully places the inherited funds in a Paine Webber investment account. Donna has the account titled in her name as her “sole and separate property,” to segregate the assets from her and her husband Steve’s other assets. Donna and Steve have been married five years, their marriage is solid, and they have a young child. Steve has decided to start a business, and has negotiated a $575,000 loan from First State Bank. Steve tells Donna that the bank won’t make the loan unless Donna co-signs the note (or, perhaps, unless the loan is secured by Donna’s Paine Webber account), and Steve asks her to co-sign.
Stop the camcorder! What is Donna going to tell Steve? “Sorry, Steve; I know this is important to you, but I’m not going to help you out by signing the note”? It’s fair to say that Donna is in a rather dicey situation—as is her inheritance.
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Need I continue the story? Donna co-signs the note. A year later, Steve’s business folds after the borrowed funds have been expended in leasing an office and purchasing supplies. Donna, having co-signed the note, is personally liable. There goes Donna’s inheritance.
Example 2: Same facts, except that the $750,000 that Donna inherited was left in a trust of which Donna is the trustee. The trust contains a spendthrift clause. Again, Donna co-signs Steve’s note. She is personally liable on the obligation, but the trust assets cannot be reached because of the spendthrift clause.
Example 3: Same facts as in Example 2, except that Steve, instead of attempting to borrow money from the bank, asks Donna, as trustee, to either (i) loan the funds to Steve or (ii) invest trust funds in his business. Here, Donna has no choice but to point out that, in view of her fiduciary duties as a trustee, (i) a loan to a relative would constitute impermissible self-dealing, and (ii) investing trust funds in a start-up company would be an imprudent investment not within the “prudent investor” standard.
d. Avoids guardianship should the beneficiary, years from now, lose her capacity.
e. Bypasses child’s estate for tax purposes if (i) there is still an estate tax and (ii) the child’s estate exceeds her exemption equivalent in the year of her death. (On the other hand, in retrospect it may turn out to have been appropriate to give the child a general testamentary power of appointment, securing a basis step-up for assets in the trust.)
G. Account transcript as substitute for estate tax closing letter. Until June 2015, the Service issued estate tax closing letters for every estate tax return filed. In a June 16, 2015 update to its “Frequently Asked Questions and Answers” website (an unusual way to announce a more-than-modest change in procedure), the Service announced that for estate tax returns filed after June 1, 2015, closing letters would be issued only on request of the taxpayer. The reason given for the change was that “[t]he volume of estate tax returns filed solely to make the portability election continues to increase tying up limited resources.” The announcement advised that practitioners should wait at least four months after filing the return to request a closing letter. The premise of the change of procedure was that the IRS believed that it would issue fewer closing letters if taxpayers had to ask for one. This is questionable, as many executors want to have a closing letter before terminating the administration and distributing the estate.
1. In response to concerns raised by the AICPA and tax practitioners, on December 4, 2015, the Service announced on its “Office of Information and Regulatory Affairs” website that a new procedure could be used by tax professionals to determine that the Service’s review of an estate tax return is closed. The announcement advised that account transcripts, which reflect transactions including acceptance of the Form 706 and completion of an examination, may be an acceptable substitute for the estate tax closing letter. At least at the outset, more than a few practitioners had frustrating experiences in obtaining account transcripts from the IRS, and got a satisfactory resolution only by phoning the IRS and requesting a closing letter.
2. Notice 2012-17, published January 6, 2017, announced that “an account transcript issued by the Internal Revenue Service (IRS) can substitute for an estate tax closing letter…. An account transcript that includes transaction code ‘421’ and the explanation ‘Closed examination of tax return’ indicates that the IRS’s examination of the estate tax return has been completed and that the IRS examination is closed…. Accordingly, an account transcript
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showing a transaction code of ‘421’ can serve as the functional equivalent of an estate tax closing letter.” This formal conformation of the procedure will, it is hoped, make the account transcript an effective substitute for closing letters in situations where third parties have insisted in closing letters (e.g., brokerage firms which sometimes have insisted on a closing letter before releasing funds to beneficiaries).
a. Estates and their authorized representatives can request an account transcript by filing Form 4506-T, Request for Transcript of Tax Return no earlier than four months after the filing of the estate tax return. The Form 4506-T can be filed via mail of fax. The Notice advised that although account transcripts are not currently available through the Service’s online transcript Delivery Service, an automated method should become operational in the future.
b. The Notice advises for those who wish to receive a closing letter, a request may be made by calling the IRS at (866) 699-4083, no earlier than four months after filing the estate tax return.
II. Section 401—Qualified Plans and IRAs
A. Inherited retirement benefits: Five-year payout limit for beneficiaries other than spouses, minor children? Beginning in 2014, the Obama administration’s annual Fiscal Year Budget Proposals included proposals that would apply the five-year rule to distributions from qualified plans and individual retirement accounts (including Roth IRAs). Beneficiaries could no longer stretch out required minimum distributions over their life expectancy—except for spouses (who could continue to make spousal rollovers), minor children, disabled or chronically ill beneficiaries, and beneficiaries less than ten years younger than the participant.
1. Interest in this proposal did not come to an end with the Obama presidency. On September 21, 2016, the Senate Finance Committee unanimously approved the Retirement Enhancement and Savings Bill of 2016. The bill includes a number of changes to qualified plans and IRAs—including the five-year rule (and exceptions thereto) as outlined above. Stay tuned on this one!
B. What are the consequences if a community property IRA names someone other than the surviving spouse as beneficiary? That was the situation in Ltr. Rul. 201623001. H and W were married and had a child C. H named C as beneficiary of three IRAs. After H’s death, W filed a claim against H’s estate for her one-half interest in community property. W and C negotiated a settlement under which W’s community property interest in the estate was determined. A state court approved the settlement, and ordered that the IRA custodians assign Amount of the inherited IRA for C to A “as a spousal rollover IRA.”
The family dynamics must have been interesting. The ruling did not concern the “usual” pattern of a divided family, involving a second spouse and children by a first marriage. C was the child of H and W, and H named the child rather than his spouse as IRA beneficiary. Interesting!
1. State law governs spouse’s interest in community property IRA. W made four ruling requests. In request 1), W asked that Amount of the IRAs naming C as sole beneficiary be classified as W’s community property interest. The Service declined to issue the requested ruling. “Whether an amount of the inherited IRA for [C] is classified as [W’s] community property interest is a matter of state property law and not a matter of federal tax law.”
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2. Under federal tax law, spouse’s interest does not qualify for spousal rollover. In the other ruling requests, W asked 2) that W be treated as payee of the inherited IRA, 3) that the custodian can distribute Amount to W in the form of a surviving spouse rollover IRA, and 4) that the distribution of Amount from C to W will not be considered a taxable event.
a. The Service declined to grant these ruling requests. C was beneficiary of the inherited IRAs. “Section 408(g) provides that section 408 shall be applied without regard to any community property laws, and, therefore, section 408(d)’s distribution rules must be applied without regard to any community property laws.” Because W was not the named beneficiary of the IRAs, she cannot be treated as a payee and cannot rollover any amounts from C’s inherited IRAs, “and therefore any contributions of such amounts by [W] to an IRA for [W] will be subject to the contribution limits governing IRAs.”
b. Additionally, because Child is the named beneficiary of the IRAs “and because we disregard [W’s] community property interest, any ‘assignment’ of an interest in the inherited IRA for [C] to [W] will be treated as a taxable distribution to [W]. Therefore, the order of the state court cannot be accomplished under state law.”
3. Ruling applies only to federal tax consequences. The ruling concludes by noting that “[t]his ruling expresses no opinion on the property rights of the parties under state law, and only provides a ruling on the federal tax law impact of the specific facts presented.”
a. The ruling does not identify the state in which H and W resided. As far as W’s rights are concerned, this would be important. In California and Washington, except for de minimus gifts one spouse cannot make a donative transfer of community property without the other spouse’s consent or acquiescence. In Texas and Louisiana, a spouse can make “reasonable” gifts of community property so long as the gifts are not so excessive as to constitute a “fraud on the other spouse’s community rights.” A number of factors are to be considered in determining whether a gift is reasonable or excessive. Because an IRA involves a nontestamentary transfer, as with life insurance policy designations the beneficiary designation is subject to the “fraud on the spouse” doctrine, and not the “widow’s election will” doctrine.
4. Federal law does control if the nonparticipant spouse under a qualified plan predeceases. In Boggs v. Boggs, 520 U.S. 833 (1997), the Supreme Court ruled that if the nonparticipant spouse (“NPS”) under a qualified plan predeceases the participant, the NPS does not have a devisable interest in her community share of the plan. The court concluded that it would be contrary to ERISA’s purpose to permit testamentary beneficiaries to acquire an interest in pension benefits at the expense of the plan participant and his beneficiaries. Dorothy’s testamentary transfer was a prohibited “assignment or alienation” as far as ERISA is concerned.
a. Boggs v. Boggs was a 5-4 decision. The dissenting opinion pointed out that if W had divorced H, her community property interest would be recognized, and she could have obtained a Qualified Domestic Relations Order. “That being so, it would be anomalous to find a congressional purpose in ERISA that would in effect deprive Dorothy of her interest because, instead of divorcing Isaac, she ‘stayed with him till her last breath.’".
C. Testamentary trust was a valid look-through trust. As a general rule, only individuals may be considered designated beneficiaries for purposes of stretching out required minimum distributions. If an IRA names a trust as beneficiary and the IRA owner dies before her required beginning date,
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the IRA fund must be distributed under the five-year rule—by December 31 of the fifth year following the owner’s death. However, the trust can qualify as a “look-through” trust, and the life expectancy of the oldest trust beneficiary can be used in computing required minimum distributions if the following test is met: (1) the trust must be a valid trust under state law, (2) the trust is irrevocable, (3) the beneficiaries are identifiable from the trust instrument, and (4) certain documentation must be provided to the plan administrator within a specified period. If this test is satisfied, the five-year rule does not apply, and the life expectancy of the oldest trust beneficiary can be used in calculating required minimum distributions.
1. This test was satisfied in Ltr. Rul 201633025—and the facts on which the ruling is based provide a useful model as to how such a trust might be drafted. D named a testamentary trust as beneficiary of three IRAs. The trust provided for payment of all trust income to Child, and gave the trustee discretion to distribute principal to Child or Child’s issue for health, education, support or maintenance. Child had three children. “Since Decedent’s death, Trust has taken distributions … that comply with the minimum distribution requirements that would apply if the applicable distribution period is based on [Child’s] life expectancy.” The trust is to terminate when Child attains age 50, at which time the trust estate is to be distributed to Child. If Child before age 50, the trust estate is to be distributed to Child’s issue (with any share to be held in trust until age 21 if a distributee is under that age). If none of Child’s issue is then living, the trust estate is to be distributed to D’s two siblings.
a. The concern raised by these facts is that if the siblings as remainder beneficiaries are considered contingent beneficiaries, the period for required minimum distributions would be much shorter because the siblings would be in the same age range as D. Far more basic, if the charity’s contingent remainder interest is to be considered, the five-year rule would apply because only individuals can be designated beneficiaries, and a charity is not an individual.
3. Under Reg. §1.401(a)(9)-5, Q&A-7(b), a contingent beneficiary who might take upon the participant’s death—even on a remote contingency—is to be considered for purposes of determining the designated beneficiary and determining whether an entity rather than an individual is a beneficiary. However, the cited regulation states that a person will not be considered a beneficiary merely because that person could become the successor to the interest of one of the beneficiaries after the beneficiary’s death.
a. That was the situation here, said the Service. When D died, the beneficiaries—and thus the designated beneficiaries—were Child and his issue. “All other potential recipients of the funds in the Trust are mere successor beneficiaries within the meaning of the regulations.” Therefore, the life expectancy of Child, as the oldest beneficiary, is to be considered in making required minimum distributions.
D. No look-through trust here; court order did not cure financial advisor’s error. In Ltr. Rul. 201628004, D maintained two IRAs with Custodian A and worked with a financial advisor employed by Custodian A. D named three trusts, all in compliance with the “look-through” provisions of the regulations, as the IRA beneficiaries. The financial advisor moved to another firm, and D transferred the IRA assets to a new IRA with Custodian B. The financial advisor provided a beneficiary designation form, which D signed, that named D’s estate as beneficiary. Oops! After D’s death, the trustees brought a declaratory judgment action and secured a court order that named the trusts as beneficiaries, with the order retroactive to the date D signed the new beneficiary designation form.
1. That doesn’t work, said the Service. “[A]though the Court order changed the beneficiary of IRA X under State law, the order cannot create a ‘designated beneficiary’ for purposes of section 401(a)(9).” Citing and quoting from Van Den Wymelenberg v. United States, 397
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F.2d 443 (7th Cir. 1968), and several Tax Court cases, “Courts have held that the retroactive reformation of an instrument is not effective to change the tax consequences of a completed transaction.” D had named his estate as beneficiary, and an estate cannot be a designated beneficiary for purposes of calculating required minimum distributions. As D had not named a designated beneficiary and died after his required beginning date, required minimum distributions must be computed on the basis of D’s life expectancy (determined on the basis of D’s age in the year of his death).
E. Waiver of 60-day rollover requirement: Treasury makes it easier. Until recently, if a plan participant or IRA account owner missed the 60-day deadline for making a rollover, to request an extension from the IRS it was necessary to apply for a private letter ruling, with all of the attendant costs and complications. Rev. Proc. 2003-16, 2003-4 I.R.B. 59. No longer. Effective August 24, 2016, Rev. Proc. 2016-47, IRB 2016-37, provides for a self-certification procedure (subject to verification on audit) that may be used to claim an extension. Plan administrators and IRA custodians and trustees can rely on the self-certification, which must satisfy one of eleven listed conditions, including financial institution error, misplaced and uncashed check, distribution deposited in non-plan or non-IRA account, severe damage to taxpayer’s residence, a death in the family, serious illness of taxpayer or family member, and postal error.
1. Contribution to the plan or IRA must be made “as soon as practicable,” a requirement that is deemed to be satisfied if the contribution is made within 30 days after the reason for the delay no longer prevents the taxpayer from making the contribution.
2. The Revenue Procedure includes a model “Certification of Late Rollover Contribution” form.
F. Waiver of 60-day rollover requirement granted to W but not to H. In Ltr. Rul. 201612017, H and W each owned SEP-IRA accounts at the same financial institution. They instructed the financial institution to wire distributions from the accounts to new accounts at a different financial institution, to receive better protection in the FDIC-insured accounts. However, the new accounts were non-IRA accounts. W did not make any withdrawals from her new account, but for several months H withdrew funds from his account to pay living expenses. When they became aware of the error in preparing their income tax return, they transferred their funds to new IRA accounts. They requested a waiver of the 60-day rollover requirement (the full balance as to W’s account and the balance after living expense distributions as to H’s account).
1. Applying the test set out in the since-modified Rev. Proc. 2003-16, 2003-4 I.R.B. 359, the Service determined that none of the factors set out in the Rev. Proc. applied to H, and thus the full amount distributed from the SEP-IRA account was includible in H’s gross income for the year of the distribution. Because H had used the account as a checking account for living expenses, he had not established that he intended to roll over the SEP-IRA account to a new IRA account. H’s lack of knowledge of the 60-day rollover requirement was not an acceptable excuse. (Significantly, no assertion of financial institution error was made.) The Service determined, however, that the Rev. Proc. factors supported W’s request, and that she had relied on H’s financial decisions.
2. A number of recent ruling requests for an extension were successful: e.g., Ltr. Rul. 201629013 (financial institution error), 201629014 (Alzheimer’s), 201629015 (mental condition impaired ability to process information and read printed material), 201634030 (cancer surgery), and 201635012 (financial institution error).
G. Penalty waived for underpaid tax on early IRA distributions. In Cheves v. Commissioner, T.C. Memo. 2017-22, Cheves lost his job in 2010 and was unemployed for 18 months. (A footnote in the opinion notes that Mrs. Cleves also lost her job and later found employment at a lower salary.) To meet family living expenses after depleting his personal savings, Cheves made periodic
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withdrawals from his individual retirement accounts, with the honest but mistaken assumption that later payments to his insurance agent would mitigate the early withdrawals. The court ruled that, in addition to income tax liability, Cheves was liable for the 10 percent tax on early withdrawals under §72(t) because the statute “makes no exception to that tax for economic hardship.” The court ruled, however, that “in light of all the facts and circumstances, including the experience, knowledge, and education of the taxpayer,” Cheves was not liable for the penalty under §6662(a).
III. Section 671—Grantor Trust Rules
A. Grantor trust modified to add tax reimbursement clause. In Ltr. Rul. 201647001, Grantors had created irrevocable trusts for the benefit of their children. The trusts contained substitution power provisions, authorizing Grantors, acting in a non-fiduciary capacity, to reacquire trust assets by substituting assets of an equivalent value. Thus, the trusts were grantor trusts for income tax purposes, making Grantors liable for income taxes on trust income—and in effect transferring additional property to the children with no gift tax consequences. The ruling advises that due to unforeseen circumstances, Grantors’ payment of the trusts’ income taxes had become unduly burdensome. Grantor’s obtained a judicial modification, contingent on passing IRS muster, that added a provision authorizing the trustee, in his discretion, to reimburse Grantors for that income tax liability. The Service ruled that because the clause to be added was consistent with Rev. Rul. 2004-64 (which deals with the reimbursement issue), the modification was administrative in nature, and did not result in a deemed transfer of property to the trusts. As a consequence, there were no adverse gift tax or estate tax consequences.
B. GRATs reformed to add missing language. In PLR 201652002, G’s attorney drafted several trusts intended to qualify as GRATs. The attorney failed to include language prohibiting the trustees from issuing a note, other debt instrument, option or other similar financial arrangement in satisfaction of the annuity obligation, as required by Reg. §25.2702-3(d)(6). However, each trust gave the trustees “the power to amend the Trust Indenture in any manner that may be required for the purpose of ensuring that the Grantor’s retained interest in the Trust qualifies and continues to qualify as a ‘qualified interest.’ The Service gave its approval to a judicial reformation that added the missing language, with the modifications effective retroactively to the dates the trusts were created.
IV. Section 1014—Basis of Property Acquired From a Decedent
A. Proposed regulations answer some questions and raise others. Proposed basis consistency regulations under §§ 1014 and 6035 were published in T.D. 9757 on March 3, 2016. The proposed regulations give workable answers to some issues, but raise vexing problems on other issues.
1. Return filed to make portability election—no requirement for basis reporting. The proposed regulations make it clear that the valuation statement requirement does not apply to an estate tax return filed only for the purposes of making a portability election. The basis consistency reporting rules apply only to property that increases the federal estate tax liability, and property that qualifies for the charitable or marital deduction isn’t subject to these rules.
2. Reporting requirement on beneficiary who transfers inherited property. The proposed regulations impose a new reporting requirement imposed on a beneficiary who transfers the inherited property to a related recipient—a member of the beneficiary’s family, an entity controlled by the beneficiary, or a grantor trust. The transferee takes the basis of the original beneficiary, of course—but the beneficiary has a duty to file an information statement with
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the Service and the related recipient within 30 days of the transfer. There is no explicit (or even implicit) language in §6035 to support this requirement, which considerably expands the reporting requirements by imposing a duty on not just executors but also beneficiaries. Of course, §6035(b) provides that “The Secretary shall prescribe such regulations as necessary to carry out this section.”
a. If a beneficiary disposes of property before its value is finally determined, the beneficiary must provide the executor with the information, and the executor will send the recipient the supplemental statement once the value is finally determined.
3. Zero basis for unreported assets? Suppose that property is discovered after the federal estate tax return was filed, or was omitted from the return for some other reason? If the executor reports that property before expiration of the assessment period, the basis of the property will be the estate tax value as finally determined. If, however, the property is not reported before the limitations period on assessment expires, property’s basis is zero.
a. To say that this is an interesting “interpretation” of §1014(f) is … a stretch. Put simply, there is nothing in the statute to support what amounts to a rewriting of the statute. The statutory language does not impose a “zero basis” rule in any circumstance.
b. If valid, this rule would have extraordinarily negative tax consequences to the property’s beneficiaries, which in some cases could be recouped by suing the executor if the situation arguably was of the executor’s action or inaction.
4. These items need not be reported. Under the proposed regulations, the following items need not be included on an information statement: cash, income in respect of a decedent, tangible property (unless an appraisal is required because an item’s value exceeds $3,000), and property sold or otherwise disposed of by the estate. If, however, an executor is not sure what property will be used to satisfy a beneficiary’s interest, the executor must list all of the properties that could possibly be used.
5. Supplemental statements. Supplemental statements are required for discovery of property not reported on a return, a change in value due to an audit or litigation, or a change in the identity of the beneficiary due to death or disclaimer.
6. Status of proposed regulations. Daily Tax Reports (3/16/2017) reported that Theresa Melchiorre, of the IRS Office of Associate Chief Counsel, speaking March 3 at the Federal Bar Association Tax Law Conference, stated that “[w]e don’t know exactly when the final regulations are going to be released.” Because top positions such as the assistant secretary for tax policy were not yet filled, “we don’t have the people in place to actually issue regulations at this point.”
B. New focus: Income tax planning. For the vast majority of our clients, estate and gift taxes are no longer an area of primary concern—or any concern at all. Instead, for many of our clients (and their advisers) the focus will shift to income tax planning—and, in particular, planning to secure a step-up in basis for the client’s successors who acquire property from the decedent.
1. Look what has happened to bypass trusts! This was brought home to me in my Wills & Estates course last fall, when we were covering Estate of Vissering v. Commissioner, 990 F.2d 578 (10th Cir. 1993). Vissering was the beneficiary and a co-trustee (along with the bank) of a trust that gave the trustees a discretionary power to distribute principal “as may be required for the continued comfort, support, maintenance, or education of said beneficiary.” The Court of Appeals opinion was written by Jim Logan, a visiting professor at Harvard
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(where I was a Teaching Fellow at the time), the dean at the University of Kansas, a judge on the Tenth Circuit—and the co-author of a casebook in Estate Planning. Judge Logan somehow found that because the distribution power was required for the continued comfort etc. of the beneficiary, this was close enough to “standard of living” phraseology in the Treasury Regulations to be within the HEMS ascertainable standard. Thus, Vissering did not hold a general power of appointment. The result was a $708,000 estate tax saving, because the trust bypassed Vissering’s estate.
a. As I tell my students, my sense is that Professor-Dean-Judge Logan, who had spent his career looking at issues from taxpayers’ perspectives, was looking for a way to rule for the taxpayer, and that “required for the continued comfort” have him all the opening he needed.
b. But if the case arose today, the “bypass” feature of the trust would mean no step-up in basis for the trust’s assets. In today’s world (depending on the size of the estate, of course), the estate would likely argue that this was a general power of appointment, and it would be the Service arguing that the distribution power was within the ascertainable standard.
c. For over 50 years I have taught my students that “health, education, maintenance and support”—the terms you have employed in countless wills and trusts you have drafted—are good words, and that “comfort,” “benefit” and “well-being” are bad words that should be avoided at all cost.
d. Well, then; how should we now be drafting bypass trusts? Should the beneficiary (e.g., spouse or descendant) be given the power to appoint for her “comfort” and “benefit”? The problem is that if the beneficiary is given a general power of appointment, there goes creditor protection (it would seem).
2. And look what has happened to valuation discounts! In Estate of Williams v. Commissioner, T. C. Memo. 1998-59 (1998), in 1980 and 1983 W gave her nephew undivided one-half interests in a total of 8,700 acres of Florida land, valued at $3 million. Simple arithmetic would suggest that the total amount of the gifts was one-half of $3 million, or $1.5 million. However, the Tax Court upheld the taxpayer's expert witness testimony that a 44 percent discount should be granted due to lack of marketability (there is no ready market for fractional interests in real estate, and sale of the real estate in that particular market at that time would encounter delays), lack of control (a tenant in common cannot unilaterally decide how to manage the property), and the necessity of resorting to a partition action and related costs to liquidate one's interest in a tenancy in common. The result was a $660,000 discount, reducing the value for gift tax purposes from $1.5 million to $880,000. Taken from a 50% transfer tax bracket, the tax saving from the fractional interest gift was $330,000.
a. W and the nephew later sold the two tracts, so W's retained one-half interest in the land was not in her estate at death. However, W owned an undivided one-half interest in yet another tract (whose full value was $630,000), which she devised to the nephew. Again, simple arithmetic would suggest that the value of W's one-half interest for estate tax purposes was $315,000. Once again, however, the Tax Court applied a 44 percent discount, reducing the gross estate inclusion to $175,000.
b. It must be noted that a 44 percent fractional interest discount is much higher than the discounts usually recognized in such cases (which typically range from 20 to 30 percent). The high discount was largely the result of a tactical error made by the government in trying the case before the Tax Court. The government went to the mat in contending that any discount should be limited to the cost of a partition action, and did
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not present testimony on what the discount might be if the court granted a valuation discount.
c. What would be the income tax consequences of these transactions in today’s world? W had inherited the land from her husband, who died in 1962. We aren’t told what W’s income tax basis was in the properties, but it must have been very low when she made the gifts, meaning that under the carryover basis rule of §1015 the donee nephew succeeded to that very low basis. W died in 1992 leaving an $870,000 gross estate, meaning that under §1014 W’s retained one-half interest was given a new income tax basis at a discounted value.
d. Going back to the 1980s when all of this occurred and the tax savings were realized, in this one case the lawyer or CPA who planned and implemented this gift and estate tax strategy should have earned his or her way into the Estate Planning Hall of Fame!
In today’s world, a lawyer or CPA who recommended and implemented this gift and estate tax strategy would likely be a defendant in a malpractice action.
3. Planning to secure a step-up in basis. While the ink is not yet dry on suggested planning steps that might be taken to secure a step-up in basis, here is a brief list of techniques that are being discussed.
a. Give the trustee (not a beneficiary-trustee) a discretionary power to distribute assets out of the trust to the beneficiary.
b. Give an independent party the power to grant a general power of appointment to the beneficiary. Jason Flaherty (Brink Bennett Flaherty, Austin) has suggested this clause:
“The Independent Trustee may grant the beneficiary of a trust a testamentary power to appoint all or part of the trust or trust share to the creditors of the beneficiary’s estate. Any testamentary power of appointment granted by the Independent Trustee must be in (le writing and may be revoked at any time during the lifetime of the beneficiary to whom the power was given. I suggest that the Independent Trustee consider exercising this authority when it may reduce generation-skipping transfer taxes or so that, upon the beneficiary’s death, his or her estate may utilize the basis increase allowed under Internal Revenue Code Section 1014.”
c. The Delaware Tax Trap, leading to a gross estate inclusion if the holder of a special testamentary power of appointment exercises the power by giving the appointee a presently exercisable general power of appointment.
V. Section 2033—Property In Which the Decedent Had an Interest
A. Estate expert’s lowball valuation of “Old Master” paintings dismissed due to conflict of interest. In Estate of Kollsman v. Commissioner, T.C. Memo. 2017-40, Hyland, who was also the estate’s executor, inherited two 17th-century “Old Master” paintings. The first, by Pieter Brueghel, was titled “Village Kermesse, Dance Around the Maypole”. The second, by Jan Brueghel, was titled “Orpheus Charming the Animals.” Shortly before K’s death in August 2005, Wachter, a vice president of Sotheby’s, sent Hyland a letter proposing a consignment arrangement. The letter stated that the value of the Maypole painting was $500,000 and the value of the Orpheus painting was $100,000. Those values were used in filing the estate tax return.
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1. The Tax Court concluded that Wachter’s expert report was unreliable because “Mr. Wachter, on behalf of his firm, had a direct financial incentive to curry favor with Mr. Hyland by providing fair market value estimates that benefited his interests as the estate’s residual beneficiary—that is to say, ‘lowball’ estimates that would lessen the Federal estate tax burden borne by the estate.” Wachter’s report exaggerated the dirtiness of the paintings on the valuation date and the risks involved in cleaning them. In contrast to Wachter, the government’s valuation expert offered comparables to support his valuations.
2. The court, having determined that the government’s valuation expert was more reliable, ruled that the date-of-death value of the Maypole painting was $2.1 million and the value of the Orpheus painting was $375,000.
VI. Section 2053—Administration Expense Deduction
A. This was not a Graegin loan; projected future interest ($71.4 million interest on a $10.7 million loan!) was not deductible. Laying a predicate: The use of a Graegin loan to pay estate taxes, inspired by Estate of Graegin v. Commissioner, T.C. Memo. 1988-477, was dramatically illustrated in Estate of Duncan v. Commissioner, T.C. Memo. 2011-255. To pay federal and state estate taxes, debts and expenses, D’s revocable trust borrowed $6.5 million from an irrevocable trust (of which D’s father was grantor) that was established by D’s exercise of a testamentary power of appointment. The loan was evidenced by a 15-year balloon note that prohibited repayment. The estate claimed a $10.7 million deduction for the interest that would be paid at the end of the 15-year term of the loan, which the Tax Court (following Estate of Graegin) allowed in full. Although the lender and borrower trusts had the same trustees and the same beneficiaries, this was a bona fide debt between two separate entities. The loans were actually and reasonably necessary, because the revocable trust could not meet its obligations without selling assets at discounted prices. On the facts presented, the 15-year term of the trust and the interest rate were reasonable, and the court refused to second-guess the trustees’ decision in making the loan.
1. This strategy was unsuccessful in Estate of Koons v. Commissioner, T.C. Memo. 2013-94, aff’d, 2017 BL 139095 (11th Cir. 2017) (unpub. op.), involving the estate of a former Pepsi soft drinks distributor. To pay estate tax liabilities, the trustee of Koons’ revocable trust borrowed $10.75 million from an LLC in which (as discussed below) the trust held a majority interest. Under the terms of the loan, the interest and principal payments were to be deferred for over 18 years. This deferral resulted in $71.4 million in projected interest payments. The court concluded that the estate was not entitled to a deduction for the projected interest expense. With a 70.42 percent voting interest in the LLC, the trust could have forced the LLC to distribute apportion of its $200 million in liquid assets. Thus, it was unnecessary for the trust to have borrowed the money from the LLC in order to pay the estate tax.
a. Unlike the Tax Court in Estate of Duncan, where the court refused to second-guess the trustees’ decision in making the loan, the Court of Appeals rejected the estate’s argument that the court should defer to an expert’s business judgment in all cases. “If courts were required to defer to the executor’s business judgment, executors would have blanket authority to establish that a deduction was proper without judicial oversight.”
2. Valuation issues resolved in favor of the government. The LLC had presented Koons’ four children with an offer to redeem their LLC interests, which they had accepted two weeks
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before Koons’ death. Following his death, the children’s redemption increased the trust’s voting interest to 70.42 percent. The Court of Appeals agreed with the Tax Court’s acceptance of the government’s valuation expert, who took the children’s redemption into account when he calculated the value of the trust’s ownership in the LLC, as the children were legally bound under Ohio law to redeem their interests at the time of Koons’ death. The court adopted the government expert’s allowance of a 7.5 percent lack of marketability discount, rather than the estate’s proposed 37.7 percent discount.
B. After estate had settled with the IRS, an increase in debt obligation did not warrant an increase in the Section 2053 deduction. In Billhartz v. Commissioner, No. 14-1216 (7th Cir. 2015), B had entered into a court-approved divorce settlement under which the couple’s four children (three daughters and a son) would receive one-half of B’s estate at his death. After B died, the four children entered into a settlement agreement with B’s second wife, under which the children received $20 million. On the estate tax return, the estate claimed a $14 million deduction under §2053(a)(3), which permits a deduction for an indebtedness founded upon a promise or agreement. (The opinion notes that it is unclear why the estate claimed a $14 million rather than a $20 million deduction.) The IRS issued a notice of deficiency that disallowed the deduction in full. In a settlement reached two weeks before the Tax Court trial date, the parties agreed to a deduction of 52.5 percent of the claimed $14 million. Two months later, B’s three daughters brought suit against the estate, contending that their settlement with the estate was procured by fraud. The parties reached a court-approved settlement under which each daughter received an additional $1.45 million.
1. Seeking an increase in the amount of the §2053 deduction, the estate filed a motion to have the case restored to the Tax Court’s general docket, which the court denied. On appeal, the Court of Appeals for the Seventh Circuit ruled that the Tax Court did not abuse its discretion by refusing to set aside the settlement agreement. The court rejected the estate’s argument that there was a mutual mistake of fact. The estate’s failure to foresee the daughters’ lawsuit did not involve a fact about which the parties were mistaken at the time they reached the settlement. Moreover, the $14 million claim was the basis for the Service’s settlement offer, not the amount actually paid to the children. Also, said the court, the fact that the settlement was calculated as a percentage made no difference; “all monetary settlement amounts can be expressed as a percentage of the amount claimed by the plaintiff.”
2. Finally, “the Estate’s argument is contrary to the very nature of settlements…. Settlements are meant to substitute certainty for risk, but that does not make them risk free. By settling, parties close the door to new information; that’s risky because they do not know whether new information will be helpful or harmful.”
VII. Section 2055—Charitable Deduction
A. Syndicated conservation easement transactions are “listed transactions.” In Notice 2017-10, 2017-4 IRB, the Service announced that a syndicated conservation easement transaction being offered by some promoters, a tax avoidance transaction, is a listed transaction. (A working synonym for “listed transaction” is “audit.”) The Notice “also alerts persons involved with these transactions that certain responsibilities may arise from their involvement…. The IRS intends to challenge the purported tax benefits from this transaction based on the overvaluation of the conservation easement. The IRS may also challenge the purported tax benefits from this transaction based on the partnership anti-abuse rule, economic substance, or other rules or doctrines.”
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1. The Notice describes such a transaction as follows: “An investor receives promotional materials that offer prospective investors in a pass-through entity the possibility of a charitable contribution deduction that equals or exceeds an amount that is two and one-half times the amount of the investor’s investment. The promotional materials may be oral or written…. The investor purchases an interest, directly or indirectly (through one or more tiers of pass-through entities), in the pass-through entity that holds real property. The pass-through entity that holds the real property contributes a conservation easement encumbering the property to a tax-exempt entity and allocates, directly or through one or more tiers of pass-through entities, a charitable contribution deduction to the investor. Following that contribution, the investor reports on his or her federal income tax return a charitable contribution deduction with respect to the conservation easement.”
2. “Transactions entered into on or after January 1, 2010, that are the same as, or substantially similar to, the transaction described in section 2 of this notice are identified as listed transactions’…. Persons entering into these transactions on or after January 1, 2010, must disclose the transactions as described in § 1.6011-4 for each taxable year in which the taxpayer participated in the transactions, provided that the period of limitations for assessment of tax has not ended on or before December 23, 2016.”
B. Charitable deduction reduced where post-death redemption plan reduced the amount passing to charity. In Estate of Dieringer v. Commissioner, 146 T.C. No. 8 (2016), the Tax Court upheld a $4.125 million estate tax deficiency and an $825,000 accurately-related penalty. D was the majority shareholder in DPI, a closely held C corporation real property management company in Portland, Oregon. D’s will left her entire estate to Trust which, after making several charitable bequests, left the bulk of her estate to Foundation. In early 2009, the DPI directors discussed the possibility of redeeming some of the DPI shares, in part because of the declining real estate market. However, the plan was not implemented before D’s unexpected death in April 2009. In November 2009, DPI elected S Corporation status, primarily to avoid a §1374 tax on built-in gains on corporate assets, and also to avoid Foundation being subject to unrelated business income tax. D’s sons implemented a plan taking steps to have DPI redeem some of Foundation’s shares and subscribe for the purchase of other shares. Valuation of the redeemed and subscribed shares included a 50 percent minority discount for D’s substantial majority interest.
1. The estate tax return claimed a charitable deduction based on the date-of-death value of D’s majority interest. Not surprisingly, the court agreed with the Commissioner that the charitable deduction must be limited by the amount that actually passed to Foundation. While there were valid business reasons for the redemption and subscription by D’s sons, the record did not support the redemption valuation. There was no valid business reason for redeeming the shares at a reduced value. The sons thwarted D’s testamentary plan by altering the date-of-death value of her intended donation.
2. Accuracy-related penalty imposed despite reliance on an attorney. The court sustained an accuracy-related penalty under §6662(a) despite the estate’s contention that reliance was made on the advice of DPI’s seasoned attorney. The “lawyer’s advice regarding the charitable contribution deduction was based on an errant appraisal. The date-of-death appraisal and the redemption appraisal—performed only seven months apart—differed substantially in value. The estate knew that a significant percentage of the value” of the bequeathed shares did not pass to Foundation and that the sons were acquiring a majority interest DPI at a discount.
VIII. Section 2056—Marital Deduction
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A. QTIP election in connection with a portability election—how do you spell relief?!! Rev. Proc. 2016-49, published on September 27, 2016, gave a favorable answer to an issue that has been buzzing around for quite some time: What is the effect of a QTIP election if the election is made, not to secure a marital deduction (which is not needed), but to secure portability of the deceased spouse’s unused exemption? Can a QTIP election be made if no estate would be due without the election, or is the QTIP election to be disregarded pursuant to the earlier Rev. Proc. 2001-38, 2001-24 IRB 1355?
1. Here’s the background. When the marital deduction was introduced in 1948, a deduction could be secured by giving property outright to the spouse or by creating a trust that either gave the spouse a general power of appointment or gave the remainder interest to the spouse’s estate. Granting the spouse the power to control the property’s devolution was considered an acceptable price to pay in order to defer tax on roughly one-half of the estate to the death of the surviving spouse. (Community property did not qualify for a marital deduction because it was already “split” for estate tax purposes.)
2. The QTIP trust and QTIP elections. In ERTA 1981, which gave us the unlimited marital deduction under which an entire estate could qualify for the deduction, Congress concluded that granting the spouse the power to control the property’s devolution was too high a price to pay for securing the deduction. Accordingly, if a trust gives the spouse a life income interest and the executor makes an election on the decedent’s estate tax return, the disposition qualifies for the deduction even the spouse was given a “terminable interest.” The price to pay for securing a deduction is that the trust property is includible in the spouse’s gross estate at her death under §2044 even though the spouse was given a terminable interest that had no value at her death. Thus was born the QTIP trust, for “Qualified Terminable Interest Property.”
a. In more than a few cases, however, executors made QTIP elections on the estate tax return even though it turned out that no marital deduction was needed to eliminate tax—where the value of the taxable estate, before allowance of the marital deduction, was less than the applicable exclusion amount. This would result in a §2044 inclusion in the spouse’s gross estate with no benefit to the first decedent’s estate. This led to a spate of private letter rulings in which taxpayers sought relief for mistaken QTIP election.
b. Treasury resolved this problem in Rev. Proc. 2001-38, 2001-24 IRB 1335, under which the Service would treat a QTIP election as a nullity if the election was not necessary to reduce the estate tax liability to zero. This provided relief to the spouse of a decedent whose estate had received no benefit from the unnecessary QTIP election.
3. The portability election. Along came the Tax Relief Act of 2010, which gave us the portability election. By making an election on the estate tax return, the deceased spouse’s unused exemption (DSUE) can benefit the surviving spouse. A portability election allows the spouse to apply the DSUE amount to the spouse’s subsequent transfers during life or at death.
a. The smaller the decedent’s taxable estate, the greater the benefit of the DSUE portability election. Consider an $8 million community property estate (and an oversimplified example!). D dies leaving his one-half community property interest to a trust that gives his spouse an income interest for life. If no QTIP election is made but D’s executor files an estate tax return that makes the portability election, the DSUE amount will be [$5,490,000 basic exclusion amount -$4,000,000 taxable estate =] $1,490,000. If, however, the executor makes a QTIP election for the trust, thanks to the marital deduction D’s taxable estate would be zero, and the DSUE amount would be $5,490,000.
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b. The problem was that Rev. Proc. 2001-38 stated that “in the case of a QTIP election within the scope of this revenue procedure, the Service will disregard the election and treat it as null and void.” How can a QTIP election increase the DSUE amount if the QTIP election is null and void?
4. Revenue Procedure 2016-49. Rev. Proc. 2016-49, published on September 26, 2016, modifies and supersedes Rev. Proc. 2001-38 in a favorable way: “Rev. Proc. 2001-38 was premised on the belief that an executor would never purposely elect QTIP treatment for property if the election was not necessary to reduce the decedent’s estate tax liability. With the amendment … to provide for portability elections, an executor of a deceased spouse’s estate may wish to elect QTIP treatment for property even where the election is not necessary to reduce the estate tax liability. A QTIP election would reduce the amount of the taxable estate …, resulting in less use of the decedent’s applicable credit amount and producing a greater DSUE amount than would exist if no QTIP election was made for the property….”
“In view of the foregoing, the Treasury Department and the IRS have determined that it is appropriate to continue to provide procedures by which the IRS will disregard an unnecessary QTIP election and treat such election as null and void, but only for estates in which the executor neither made nor was considered to have made the portability election. In estates in which the executor made the portability election, QTIP elections will not be treated as void.”
a. Rev. Proc. 2016-49 goes on to address the procedures to be followed if the executor was not making a portability election and wants the QTIP election to be disregarded and treated as null and void.
B. Extension of time to make portability election granted. In Ltr. Rul. 201706012, D-1 died on Date 1, survived by D-2 (who died on Date 2). No timely-filed return making a portability election was made by D-1’s personal representative—who was also D-2’s personal representative. After discovering that a portability election had not been made for D-1’s estate, “Personal Representative, as executor of Decedent 1's and Decedent 2's estate, represents that the value of Decedent 1's gross estate is less than the basic exclusion amount in the year of the Decedent 1's death and that during her lifetime, Decedent 1 made no taxable gifts. As executor, Personal Representative requests an extension of time pursuant to § 301.9100-3 to elect portability of Decedent 1's DSUE amount.” The request was granted. “Under these facts, the Commissioner has discretionary authority under § 301.9100-3 to grant to Decedent 1's estate an extension of time to elect portability. Based on the facts submitted and the representations made, we conclude that the requirements of § 301.9100-3 have been satisfied.”
1. The ruling gives no discussion as why no portability election was made by D-1’s estate—just oversight? It appears that the “oops” was discovered after D-2 died, and that it was then determined that utilization of the DSUE amount would be beneficial to D-2’s estate. Also, the ruling gives no real discussion in support of the Service’s decision other than as summarized above. The central point—I guess—is that it was determined that the government’s interest was not prejudiced.
2. The facts of the ruling are of course redacted, meaning that we don’t know how much time elapsed between D-1’s death on Date 1 and D-2’s death on Date 2. Apparently, D-1’s estate was still “open.” What if D-2 died three years after D-1 and the administration of D-1’s estate had been closed, and the personal representative had been discharged?
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C. Marital deduction for same-sex couples—transfers before United States v. Windsor was decided. Notice 2017-15 gives guidance relating to transfers to same-sex spouses made before the decision in United States v. Windsor, 133 S. Ct. 2675(2013), and the ruling in Rev. Rul. 2013-17, 2013-38 IRB 201. The Notice provides that taxpayers can establish that the transfers qualified for the marital deduction even if the limitations period for claiming a credit or refund has expired, and sets out procedures for recalculating the applicable exclusion amount and any remaining GST exemption,
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IX. Section 2704—Lapsing Rights and Restrictions
A. Proposed regulations were published in August, but where do they stand now?
1. The background: Section 2704. Section 2704 was enacted in 1990, as one of four Special Valuation rules designed to rein in certain planning strategies that Treasury perceived as having too many cake-and-eat it elements. The objective of §2704 was to limit valuation discounts for family partnership and LLC interests transferred to family members, where the family continued to control the entity after the transfers. Under §2704(a), a lapse of voting or liquidation rights in a corporation or partnership is to be treated as a taxable transfer if members of the transferor’s family hold control of the entity both before or after the lapse. Under §2704(b), certain specified “applicable restrictions” on liquidation are disregarded in determining the value of the transferred interest. However, §2704(b)(3) states that an “applicable restriction” does not include “any restriction imposed, or required to be imposed, by any Federal or State laws.” As many states have a default rule limiting the ability of a limited partner or member of an LLC to withdraw, this in Treasury’s view provided too easy a path to plan around the §2704 restrictions and undercut the statute’s purpose.
a. In the Obama administration’s Fiscal Year 2010 Budget Proposal (and also the budget proposals for Fiscal Years 2011, 2012 and 2013), a proposal was made to amend §2704, but no bills were ever introduced to enact the proposal. The administration stopped working on a legislative solution, and dropped the proposed amendments in the Budget Proposals beginning with Fiscal Year 2014.
b. Meanwhile, the §2704(b) regulation project was listed in every annual Treasury-IRS Priority Guidance Plan. Treasury was working on proposed regulations that would implement the administration’s recommended amendments. Section 2704(b)(4) gives the Secretary authority to promulgate regulations to “provide that other restrictions shall be disregarded … if such restriction has the effect of reducing the value of the transferred interest … but does not ultimately reduce the value of such interest in the transferee.” For several years, Treasury officials advised professional groups that “we are working on the regulations,” which will be published “soon,” or “any day now.” As for reasons for the delay, one reason may have been that Treasury was waiting—and waiting—to see whether the administration’s proposed amendments would be enacted by Congress. Another reason for the delay was that the issues to be addressed—as with the proposed regulations—are quite complex.
2. Proposed regulations were promulgated on August 2, 2016. The proposed regulations, if and when finalized, would dramatically reduce if not eliminate lack-of-control valuation discounts in intra-family transfers of interests in entities. The proposed regulations defy easy summary, and I’m not going to try. (The internet already has a goodly number of good and detailed analyses of the proposed regulations.) Just a few highlights:
a. Three-year-year-of death rule. The lapse of liquidation rights with respect to transfers within three years of death (shades of the old §2035 “in contemplation of death” rule!) would be treated as additional transfers, requiring inclusion of the liquidation value in the transferor’s gross estate—a phantom value—that would not qualify for a marital or charitable deduction.
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b. State law default rule restrictions on liquidation are to be disregarded in valuing a transferred interest if they are not mandated by state law.
c. Disregarded restrictions. The proposed regulations create a new category of “disregarded restrictions.” The interests of unrelated parties (e.g., a charity) are not to be considered in determining whether the family can remove disregarded restrictions unless an impossible-to-meet test is satisfied.
d. Assignees. Transfers to mere assignees will be subject to the “disregarded restrictions” rules.
3. What will happen next? A day-long hearing on the proposed regulations was held on December 1, 2016, at which a number of the speakers said that the proposed regulations were too broad, particularly as they applied to closely held businesses. Speaking at the January 20, 2017 mid-year meeting of the American Bar Association Taxation Section, Cathy Hughes, attorney-adviser in Treasury’s Office of Tax Policy, said that the final regulations might exempt closely held businesses from the new rules, but that one of the issues that would have to be addressed would be how to define a closely held business for this purpose.
a. In the meantime—actually, several weeks before—we had an election. At the confirmation hearing of Treasury Secretary Steven Mnuchin, Mnuchin said that he would consider dropping the proposed §2704 regulations.
b. Daily Tax Reports (1/18/2017) reported that the AICPA has asked Treasury to pull the proposed regulations, and that Sen. Mark Rubio (R. Fla.) and Rep. Warren Davidson (R. Ohio) have introduced bills that would kill off the regulations. Daily Tax Reports (3/16/2017) reported that House Ways and Means Chairman Kevin Brady (R. Texas) has asked President Trump and Treasury Secretary Mnuchin to pull the proposed regulations. DTR also reported that the status of the proposed regulations was uncertain because top Treasury posts had not yet been filled.
c. On April 21, 2017, President Trump signed an executive order instating an immediate review of “all significant tax regulations” issued since January 1, 2016. An interim report to be due in 60 days is to identify regulations that “impose an undue burden” on taxpayers, “add undue complexity,” or “exceed the statutory authority of the Internal Revenue Service.”
X. Texas Legislative Developments
A. Overview. Bills introduced during the 2017 legislative session include the following. None have yet been enacted. Except where otherwise noted, citations are to the Texas Estates Code. This summary is based on reports prepared by Bill Parmagan (Austin), Craig Hopper (Austin), and Barbara (Johanson) Klitch, who monitors all bills relating to these areas on behalf of the Real Estate, Probate and Trust Law Section of the State Bar. Don’t assume that these bills (even the noncontroversial ones) will become Texas law. As occurred last year, some issue may erupt during the last two or so weeks of the session, bringing everything to a halt.
B. Uniform Power of Attorney Act. Previous attempts to enact the Uniform Power of Attorney Act were met with opposition from several groups. After negotiations with what Parmagan calls “stakeholders” (Texas Land Title Association, Texas Business Law Foundation, Texas Hospital
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Association and other groups), the REPTL Financial Power of Attorney bill would make a number of changes relating to durable powers of attorney. The bill adopts nearly all of the UPOAA promulgated by the Commissioners on Uniform State Laws in 2006 (and modified several times since then)—with some Texas twists. The result is that the official Commentary to the Uniform Act’s provisions will be important in construing and applying the Texas statutes. Distinctive features of the new law—should this become the law—are as follows:
1. Third party acceptance of durable power required. Pargaman reported that “[t]his subchapter [§751.201 et seq.] generated the most concern (and the most negotiation) among stakeholders.” Unless one or more grounds for refusal exist, a person presented with and asked to accept a power of attorney must either accept the power or request either a certification or an attorney’s opinion within 7 days. An action can be brought to require the third party’s acceptance of the power, with the award of costs and attorney’s fees. The statute contains a detailed list of the grounds upon which a person may refuse to accept the power of attorney.
a. This is the primary issue on which the “stakeholders” are concerned. At a House Committee hearing on April 4, several “stakeholder” representatives had harsh words about the UPOAA in general and this provision in particular. A Texas Bankers Association representative suggested that the bill would be almost as disastrous to banks as the Dodd-Frank Act. Rep. Wray (R. Texarkana) hosted a post-hearing discussion among the parties, and expressed confidence that a compromise could be worked out.
3. Oversight over agent—civil remedies. Suppose that Mother has given a durable power of attorney to trusted Daughter (who lives in the same city). Son, who lives in California, consults you. He is concerned that Daughter is abusing the power of attorney, and is appropriating Mother’s assets for her personal benefit. Does Son have standing to seek an accounting from Daughter, or take any action seeking to determine whether Daughter is acting improperly?
a. Under current Texas law, the answer is No. During Mother’s lifetime, Son has no interest in Mother’s property. Only Mother herself, or the holder of her durable power or her duly appointed guardian has standing to challenge any transaction concerning Mother’s property. In order to have standing, Son would have to be appointed guardian of Mother’s estate—and if Mother has named Daughter in a Designation of Guardian Before Need Arises, Son will have a further obstacle to overcome.
b. A new §751.251 would address this problem by permitting actions to construe a power of attorney or review the agent’s conduct brought by (i) the principal or agent, (ii) a guardian or fiduciary of the principal, (iii) a person named as beneficiary to receive the property on the principal’s death, (iv) a government agent, or (v) any other person who demonstrates to the court sufficient interest in the principal’s welfare or estate.
4. “Hot” powers. The following actions (which are not included in the Statutory Durable Power of Attorney form) can be taken only if expressly granted: (1) create, amend or revoke a trust, (2) make gifts, (3) create or change survivorship provisions, or (4) create or change beneficiary designations on bank accounts, P.O.D. designations, and other nonprobate transfers. §751.031.
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a. If the agent is given a power to make gifts, gifts are limited to amounts within the annual exclusion unless spouses are involved, in which both annual exclusions may be considered. §751.032.
5. Co-agents. A principal may name two or more co-agents, each with the authority to act independently of the other unless otherwise provided. §751.021.
6. Successor agents. In addition to naming a successor agent (no change there) a principal may delegate to his agent the authority to name a successor agent. §751.023.
7. Compensation. Unless the power provides otherwise, an agent is entitled to reimbursement for expenses and reasonable compensation. §751.024.
8. Non-Texas powers. Various changes would be made with respect to powers executed outside of Texas, including recognition of photocopies or electronically transmitted copies. §751.0023.
9. Goodbye to “attorney in fact.” The statutes would no longer refer to “attorney in fact or agent,” but instead would refer to “agent.”
10. Statutory durable power of attorney. The statute would make a number of changes to the statutory form—let me just leave it at that.
C. Partition of tenancy in common—Uniform Partition of Heirs’ Property Act. This Uniform Act would address the problem faced by low- and middle-income families who inherit property as tenants in common. The Act would place a limit on the ability of a tenant in common to seek a court-ordered partition action with its attendant costs. The Act would provide for notice and appraisal, and give each cotenant a right of first refusal to purchase the property. If no cotenant exercises the right to purchase, the court will order a partition in kind or, if not feasible, a commercially feasible sale followed by a proportional distribution of the sale proceeds. §751.024.
D. Miscellaneous probate matters.
1. Small estate administration by affidavit would be available for estates with nonexempt property not exceeding $75,000 (increased from $50,000). §205.001.
2. Publication of notice to creditors. Section 308.051 currently requires publication of notice of administration in a newspaper printed in the county in which the letters are issued. Oops! The Austin American-Statesman is now printed in Houston or San Antonio, and the Austin Business Journal is printed in Dallas. That leaves Travis County with the Austin Chronicle. Many smaller counties have no newspaper printed in the county. The amendment would call for publication in a newspaper of general circulation in the county, regardless of where the newspaper is printed.
3. Do you still call it a Last Will and Testament? That phraseology appears at several places in the Estates Code, and would be replaced with, simply, “will.” Pargaman suggests that it is not really appropriate to refer to your drafting product as “Last Will,” because the client may write later wills before he or she leaves the scene. Pointing out that it would be more apt but awkward to refer to “Latest Will,” Parmagan suggests “Will.”
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4. Digital assets. The Revised Uniform Fiduciary Access to Digital Assets Act (RUFADAA) would give (in very great detail) the power to plan for the management and disposition of their digital assets.
5. No-contest clauses. Section §112.038 would make clear what several Texas cases have ruled: A forfeiture provision does not apply to a judicial construction suit, or to an action to compel a fiduciary to perform his duties or seek redress for breach of such duties.
6. Beneficiary designation to transfer title to motor vehicle. Transportation Code §501.0315 would permit the owner of a motor vehicle to transfer title to a sole beneficiary on the owner’s death. The current statute (§501.031) provides for including a right of survivorship, but that’s it.
E. Trust Code—Waiting for Governor’s signature
1. Decanting. Several fine-tuning changes would be made to Property Code §§ 112.071 et seq., dealing with decanting of assets from one trust to a second trust.
2. Delegation of real property powers to agent. The statutory authority of a trustee to employ agents would be expanded to authorize the delegation of authority to engage in a laundry list of real property transactions. Property Code §113.018.
3. Powers of appointment. Property Code §181.083 would be amended to authorize a power-holder to give the appointee a presently exercisable general power of appointment. This would permit triggering the “Delaware tax trap,” resulting in an inclusion in the beneficiary’s gross estate and thereby obtaining a new income tax basis for the trust’s assets.
4. Venue rules for single or multiple non-corporate trustees would be changed.
F. Rule Against Perpetuities: Life in Being Plus 300 Years? No way!As in the past three or four sessions, a bill that would increase the perpetuities period to 300 years didn’t get out of committee.
G. Guardianship—the term “ward” would disappear. At the last legislative session, several citizen groups (most notably, WINGS—Texas Working Interdisciplinary Network of Guardianship Stakeholders) pressed for restrictions on guardianship proceedings and on the judges who supervise them. That session produced a ward’s bill of rights and a long list of alternatives to a guardianship that must be considered by the court. These groups see the term “ward” as demeaning. The bill would, throughout the Estates Code, replace “proposed ward” with “alleged incapacitated person,” and “ward” with “person with a guardian.”
1. Demand for accounting from agent. Section 151.104 would authorize a guardian to demand an accounting from an agent acting under a durable power of attorney.
H. Reporting financial abuse of elderly persons. Several essentially competing bills would amend the Finance Code and Human Resources Code to impose a reporting requirement on an employee of a financial institution who has a good faith belief that financial abuse of an elderly person has occurred or is incurring. The employee would be required to submit a report to Adult Protective Services and a local law enforcement agency. “Financial abuse” is defined to include misuse of a financial power of attorney and abuse of guardianship powers. Failure to make such a report could
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result in a monetary penalty. Another bill would amend the Penal Code to elevate the criminal penalty for such financial abuse from a Class A misdemeanor to a 1st degree felony.
I. Multiple-party accounts
1. Statutory account form would be modified to include acknowledgment by the customer that he or she has read each paragraph, received an explanation of the ownership rights of each type of account, and has placed his or her initials next to the type of account desired.
2. “Trust Account” would be removed from Multiple-Party Account statutes. As with many states, Texas has long recognized “A, trustee for B” accounts. §113.004. This can at best be described as an accident of history, because (i) such an account is not at all different from a P.O.D. account (“A, pay on death to B”), and (ii) the label is misleading. A is not really a trustee and owes no fiduciary duties to B, and such an account has no relation either to a lawyer’s trust account or to a bank account opened by a trustee.
a. Trust account provisions would be removed from the statute, which also would remove “convenience account” from the Definitions section. However, the statute would still permit one or more “convenience signers” on single-party and multiple-party accounts, with payments to such signers “for the convenience of the parties.”
J. New forms for Anatomical Gifts and Medical Power of Attorney. If these provisions are enacted, you will want to replace the forms currently on your word processer.
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