Alternate valuation: the silver living to the cloud over the market.

The Silver Lining to the Cloud Over the Market?

The alternate valuation election is a valuable post-mortem tax planning technique that is often overlooked, especially in a bull market. This article discusses the election and reminds practitioners that when the stock market declines subsequent to a decedent's date of death, the election can result in a significant amount of estate tax savings.

The world heard a collective groan in the late summer and early fall of 1998 when the stock market declined significantly for the first time in recent memory. At the time of the plunge, most investors were too distressed over their own potential losses to consider whether anything good could actually come out of such a disaster. Potential estate tax savings via an alternate valuation election on an estate tax return may be the one positive "gain" from the negative market. The purpose of this article is to summarize the requirements and various considerations of alternate valuation and remind practitioners that all is not lost during the inevitable periods of market decline.

Consider the following: The Dow Jones industrial average closed on April 1, 1998, at 9,162.27. Six months later, on October 1, the industrial average closed at 7,632.53, a decline of more than 1,200 points, or approximately 14 percent. If the value of the assets of a decedent who died on April 1,1998, decreased by 14 percent six months later, the estate tax liability would also decrease significantly. For example, if the value of a decedent's assets on April 1 (date of death) were $5,000,000, the estate tax liability would be $2,188,750. If the value of the assets were $4,300,000 on October 1 (the alternate valuation date) and an alternate valuation election was made, the estate tax liability would be $1,803,750. This represents an estate tax reduction of $385,000.

Generally, the value of a decedent's gross estate is the fair market value of all of the decedent's property as of the date of his or her death,[1] unless the "alternate valuation method" under [sections] 2032 is elected.[2] Alternate valuation "permit[s] a reduction in the amount of tax that would otherwise be payable if the gross estate has suffered a shrinkage in its aggregate value in the six months following the decedent's death."[3] If elected,[4] [sections] 2032(a) provides that the gross estate is valued as of the date which is six months after the decedent's date of death,[5] except:

1) With respect to the decedent's property that is distributed, sold, exchanged, or otherwise disposed of within six months after date of death, such property is valued as of the date of such distribution, sale, exchange, or other disposition,[6] and

2) With respect to any interest in the decedent's estate which is affected "by mere lapse of time," such interest is valued as of the decedent's date of death with adjustments for any valuation differences not due to mere lapse of time as of the appropriate alternate valuation date.[7]

Distributions, Sales, Exchanges....

The phrase "distributed, sold, exchanged, or otherwise disposed of" includes all possible ways by which property ceases to be part of a decedent's gross estate, but does not include "transactions which are mere changes in form."[8] In Revenue Ruling 57-495, the IRS concluded that the division of a trust into "two equal parts" in order to facilitate the payment of income to the life beneficiaries was not a "distribution" within the meaning of [sections] 2032(a) because the trust "[did] not cease to form a part of the decedent's gross estate by reason of the division of the assets of the trust."[9] In Revenue Ruling 73-97, the IRS distinguished Revenue Ruling 57-495 and ruled that the division of a trust into "separate trusts" for each of the decedent's children was a distribution within the meaning of [sections] 2032(a) because "the trust that formed a part of the decedent's gross estate ceased to exist when the terms of the trust instrument were implemented and the corpus of the original trust was transferred ... and delivered to the trustee of the successor trusts."[10]

The regulations provide who may distribute, sell, exchange, or otherwise dispose of property, and when such distribution, sale, exchange, or other disposition is considered complete.[11] The personal representative or trustee of property included in the gross estate may distribute property; such a distribution is considered to have occurred upon the earlier of 1) an order or decree of distribution, if such order/decree subsequently becomes final; 2) the segregation of the property from the estate/trust so that it becomes unqualifiedly subject to the demand of the distributee; or 3) the actual delivery of the property to the distributee.[12] The sale, exchange, or other disposition of property can be completed by the personal representative, the trustee, an heir or devisee to whom title of the property passes directly under local law, a surviving joint tenant or tenant by the entirety, or any other person. Moreover, the sale, exchange, or other disposition is considered to have occurred as of the effective date of the contract, unless such contract is not subsequently executed in accordance with its terms.[13]

"Mere Lapse of Time"

The alternate value must be reduced by the "mere lapse of time."[14] Property interests that may be affected by a mere lapse of time include "patents, estates for the life of a person other than the decedent, remainders, reversions, and other like properties, interests or estates."[15] The use of alternate valuation in these cases would not reflect the shrinkage in value unrelated to market conditions. Life estates, remainders, and other similar interests are valued for alternate valuation purposes using 1) the age of the person whose life may affect the value of the interest as of the decedent's date of death, and 2) the value of the property as of the alternate valuation date,[16] so that the mere passage of time does not affect the value of the interest.

Deductions

If alternate valuation is elected, deductions will not be allowed with respect to an asset to the extent that such deductions are already taken into account in determining the alternate value of that asset.[17] Additionally, charitable and/or marital deduction(s) are valued as of the decedent's date of death and are adjusted for any differences in value (other than changes due to mere lapse of time) as of the earlier of the date of disposition or six months after date of death.[18]

"Included Property" versus "Excluded Property"

If alternate valuation is elected, all property includable in a decedent's gross estate as of his or her date of death is subject to alternate valuation. These property interests are referred to as "included property," and continue to be classified as such regardless of any change in form during the alternate valuation period.[19] Property earned or accrued subsequent to the date of death and during the alternate valuation period which is not "included property" is considered "excluded property."[20] For example, interest on a bond or note that had accrued at the date of death is included property; interest that accrues after the date of death and before the alternate valuation date is excluded property.[21]

An advance payment of interest made during the alternate valuation period that has the effect of reducing the value of the principal obligation will be included in the gross estate and valued as of the date of payment.[22] To the extent that dividends declared post-date of death cause the shares of stock on the alternate valuation date to "not reasonably represent" the same "included property" as of the date of death, such dividends will be considered "included property" as of the alternate valuation date, except to the extent such dividends are paid out of the corporation's post-date of death earnings and profits.[23]

The Election

The fiduciary must properly elect the alternate valuation method in order for it to apply.[24] The election must be made on the estate tax return,[25] and can only be made if such return is required to be filed.[26] If the appropriate election is not designated on the estate tax return, but the values for the assets are shown on the appropriate schedules under the heading "Alternate Value," the election will be treated as having been made.[27] Furthermore, the Tax Court has held that a protective alternate valuation election may be made, regardless of the lack of statutory or regulatory authority for such a protective election.[28]

The election cannot be made if the estate tax return is filed more than one year after the filing date for such return, including extensions.[29] If elected, alternate valuation applies to all of the decedent's property included in the gross estate; the alternate valuation method cannot be selectively applied to a portion of the individual assets included in the gross estate.[30] Once made, the election is irrevocable.[31]

Alternate valuation may be elected only if the value of the gross estate and the aggregate of the estate taxes and generation-skipping transfer taxes imposed with respect to the decedent's estate will be reduced.[32] The caveat regarding the reduction of estate taxes was added to [sections] 2032 by the Tax Reform Act of 1984 to discourage the election of alternate valuation solely for the purpose of saving income taxes, which was not consistent with the underlying purpose of the alternate valuation method to reduce estate taxes.[33]

Effects on Other Code Sections

Use of alternate valuation may affect the use of [subsections] 303, 6166, and 2057.[34] Under [sections] 303, if the value of the stock of a closely-held corporation included in the decedent's gross estate constitutes more than 35 percent of the gross estate (reduced by debts, funeral expenses, administration expenses, and losses), to a certain extent the redemption of corporate shares of stock held by the estate may be eligible for capital asset treatment, rather than treatment as ordinary income. Under [sections] 6166, if the 35 percent test is met with regard to a closely-held business, the fiduciary can elect to pay the estate tax attributable to such business in installments beginning several years after the date of the estate tax return. Under [sections] 2057, if the 50 percent test is satisfied, all or a portion of the value of the family-owned business can be deducted from the gross estate. Electing alternate valuation may help the estate to qualify for these special provisions or, alternatively, may prevent the estate from qualifying.

The election also will affect the income tax basis of the assets under [sections] 1014 for determining gain or loss on the subsequent sale of the assets. In addition, the basis will impact future depreciation, amortization, and depletion of the assets because the cost basis is used as a starting point to compute these types of expenses.

Alternate Valuation and Marital Deduction Planning

Alternate valuation does not necessarily only apply upon the second death of a married couple, although typically it is upon the second death that estate taxes will be paid. There may be a potential advantage to electing alternate valuation upon the first death and paying tax at that time. For example, the personal representative or trustee may elect to "split the brackets" by paying some estate tax on the first death, resulting in lower combined estate taxes in both estates. Additionally, the surviving spouse may be in a position to plan for the use of the previously taxed property credit[35] (commonly known as the PTP or TPT credit), a planning technique that seems to be overlooked all too frequently.[36]

Alternate valuation cannot be elected unless the aggregate of the estate taxes and generation-skipping transfer taxes payable will be reduced.[37] It may be impossible to meet this requirement if a testamentary document includes an optimum marital deduction formula that automatically results in zero estate tax payable. Post-mortem planning may provide solutions to this problem. For example, if the dispositive provisions of a testamentary document include a credit shelter trust (CST) and an outright marital bequest, the surviving spouse could disclaim a portion or all of the outright distribution to trigger some estate tax.[38] Alternatively, if the dispositive provisions include a CST and a qualified terminable interest property[39] (QTIP) trust, the personal representative or trustee of the first dying spouse's estate may choose not to make a QTIP election for a portion or all of the property in order to trigger some estate tax.

The choice of whether to elect alternate valuation on the first death will depend in part upon the type of formula clause used to fund the CST and the marital bequest upon the first death: preresiduary marital versus preresiduary CST. For example, assume a "true worth"[40] preresiduary marital formula clause is used and that upon the decedent's date of death, the value of his or her gross estate is $2,500,0004[41] and that the alternate value of the gross estate is $2,200,000. Also assume that the value of the assets of the gross estate on the date of funding or distribution is $2,000,000. If alternate valuation is not elected, the marital bequest would be funded first with $1,850,000 ($2,500,000 less $650,000), and the CST would be funded with the remaining balance of $150,000.[42] Accordingly, a significant portion of the decedent's applicable credit amount would be wasted, not to mention the detriment to the CST beneficiaries. On the other hand, if the alternate valuation method is elected, the marital bequest would be funded with $1,550,000 ($2,200,000 less $650,000) and the CST would be funded with $450,000 (less the small amount of tax paid).

Alternatively, assume under the same facts that a true worth preresiduary CST is used. Again, assuming that alternate valuation is not elected, the CST would be funded first with $650,000, and the marital bequest would be funded with the remaining balance of $1,350,000. Again, assuming that the alternate valuation election was made, the same values would be used for funding purposes; however, the assets distributed to the CST and as part of the marital bequest would lose some of their basis step-up and the corresponding losses that otherwise could have been carried forward to future tax years of the estate.[43]

Conclusion

In the aftermath of the market's decline, the benefits of alternate valuation are seen more clearly. As the market corrects and then hits new highs, do not forget the alternate valuation option and the potential tax savings it may bring.

[1] I.R.C. [sections] 2031(a) (1998).

[2] Treas. Reg. [sections] 20.2031-1(b); see I.R.C. [sections] 82032.

[3] Treas. Reg. [sections] 2032-1(b)(1).

[4] I.R.C. [sections] 2032(a) and (d).

[5] I.R.C. [sections] 2032(a)(2). See also Rev. Rul. 74-260, 1974-1 C.B. 275 ("[w]here there is no day in the sixth month following the decedent's date of death, the correct alternate valuation date under [S]ection 2032(a)(2) ... is the last day of the sixth month.").

[6] I.R.C. [sections] 2032(a)(1). See also Rev. Rul. 77-180, 1977-1 C.B. 270, in which the decedent's will directed the executor to sell a certain estate asset for $10,000 if paid for within three months of date of death. The date of death value of the asset was $50,000, and the fair market value of the asset on the date of sale was $45,000. Alternate valuation was elected. The Service held that the option granted to purchase the property for less than its value "is an indirect testamentary gift of property" equal to the excess of the fair market value of the property on the date of sale over the purchase price. The proper alternate value for the asset was $45,000, not $10,000.

[7] I.R.C. [sections] 2032(a)(3).

[8] Treas. Reg. [sections] 20.2032-1(c)(1). The decedent's cash which is used to pay funeral expenses or is invested after date of death is considered to be "otherwise disposed of." This term also includes the surrender of a stock certificate for corporate assets in a complete or partial liquidation of the corporation. Examples of transactions which are "mere changes in form" are a 8351 transfer of assets to a corporation in exchange for its stock and the exchange of stock in a corporation for stock in the same corporation in a merger, recapitalization, reorganization, or other transaction in which no gain or loss is recognized.

[9] Rev. Rul. 57-495, 1957-2 C.B. 616.

[10] Rev. Rul. 73-97, 1973-1 C.B. 404.

[11] Treas. Reg. [sections] 20.2032-1(c)(2) and (3).

[12] Treas. Reg. [sections] 20.2032-1(c)(2).

[13] Treas. Reg. [sections] 20.2032-1(c)(3).

[14] Treas. Reg. [sections] 20.2032-1(f).

[15] Id.

[16] Treas. Reg. [sections] 20.2032-1(f)(1).

[17] I.R.C. [sections] 2032(b); see also Treas. Reg. [sections] 20.2032-1(g).

[18] Id.

[19] Treas. Reg. [sections] 20.2032-1(d).

[20] Id.

[21] Treas. Reg. [sections] 20.2032-1(d)(1). Similar rules apply to rental payments due with regard to leased property and dividends on corporate stock. Treas. Reg. [sections] 20.2032-1(d)(2) and (4). See Maass v. Higgins, 312 U.S. 443 (1941) (rents, royalties, interest, or dividends received by an estate post date of death are not included in the decedent's gross estate for alternate valuation purposes.)

[22] Treas. Reg. [sections] 20.2032-1(d)(1). Again, a similar rule applies with regard to advance payments of rent. Treas. Reg. [sections] 20.2032-1(d)(2).

[23] Treas. Reg. [sections] 20.2032-1(d)(4).

[24] Supra notes 2 and 4 and accompanying text.

[25] I.R.C. [sections] 2032(d)(1); see I.R.C. [sections] 6018 and Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, Rev. July 1998, page 2, item 1.

[26] Treas. Reg. [sections] 20.2032-1(b)(1).

[27] Rev. Rul. 61-128, 1961-2 C.B. 150.

[28] Estate of Mapes v. Comm'r, 99 T.C. 511, 529-31 (1992).

[29] I.R.C. [sections] 2032(d)(2); see I.R.C. [sections] 6075(a) and I.R.C. [sections] 6081(a). Note that although the alternate valuation method may be elected on a late-filed estate tax return, this does not eliminate the potential interest and penalties that may be imposed nor the loss of the ability to elect to pay the estate tax in installments. See I.R.C. [sections] 6166(d) (requiring that the election for estate tax deferral be made no later than filing date of the estate tax return, including extensions).

[30] Treas. Reg. [sections] 20.2032-1(b)(2).

[31] I.R.C. 2032(d)(1).

[32] I.R.C. [sections] 2032(c).

[33] General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 (H.R. Rep. 4170, 98th Cong.; Pub. L. No. 98-369), prepared by the Joint Committee on Taxation (December 31, 1984). Prior to the change in the law, Where property appreciated in value after a decedent's date of death, it was possible to elect alternate valuation to increase the income tax basis of the property, even though no additional estate tax resulted. Supra note 3 and accompanying text. The requirement that the net estate and generation-skipping transfer taxes are reduced is applicable to generation-skipping transfers occurring after October 22, 1986. See Pub. L. No. 99-514, [sections] 1432(c)(1).

[34] A full discussion of [subsections] 303, 6166, and 2057 is beyond the scope of this article.

[35] I.R.C. [sections] 2013.

[36] For an in-depth look at maximizing the PTP credit, see Robert J. Stommel & Lester B. Law, Planning to Maximize the [sections] 2013 Credit, 72 FLA. B.J. 66 (Jan. 1998).

[37] See supra notes 32-33 and accompanying text.

[38] If a surviving spouse is making such a disclaimer, but wants to benefit from the disclaimed assets, the will or revocable trust should provide that upon a disclaimer of the outright marital bequest, any disclaimed assets shall be administered in the CST (which presumably will benefit the surviving spouse).

[39] I.R.C. [sections] 2056(b)(7).

[40] Under a "true worth" formula clause, assets are distributed in kind are distributed at their date of distribution values, regardless of date of death value or alternate value.

[41] Assume that the surviving spouse will either disclaim a portion or all of his or her marital bequest or will not make a QTIP election in order to trigget the payment of estate tax.

[42] For all purposes of this article, it is assumed that the applicable credit amount is $650,000. Under the Taxpayer Relief Act of 1997, Pub. L. No. 105-34, [sections] 501(a)(1)(B) (1997), the applicable credit amount in 1999 is $650,000; it will gradually increase to $1,000,000 by the year 2006. This example also assumes that the decedent did not use any of his or her applicable credit amount during his or her lifetime.

[43] I.R.C. [sections] 1014(b); I.R.C. [sections] 1212(a)(1)(B).

David Pratt, P.A., is a partner in the law firm of Morris & Pratt, a Partnership of Professional Associations with offices in Boca Raton, West Palm Beach, Aventura, and Ft. Lauderdale. Mr. Pratt is Florida board certified in tax and wills, trusts and estates and has an LL.M. degree, in taxation, from New York University.

Lisa Z. Hauser is an associate with the West Palm Beach law firm of Jones, Foster, Johnston & Stubbs, P.A. She has an LL.M. degree, in taxation, from the University of Florida.

This article is submitted on behalf of the Tax Law Section, J. Bob Humphries, chair, and Michael D. Miller and Lester B. Law, editors.