Increased IRS scrutiny on transfer taxes.

The IRS is sharpening its focus in the transfer tax area. It has released a business plan with a host of projects in this area, has increased the emphasis on gift tax examinations in its examination plan, and has aggressively pursued issues in ongoing examinations, particularly in the area of discounted family limited partnerships (FLPs) and grantor retained annuity trusts (GRATs). In addition, recent technical advice memoranda (TAMs) have been issued by the IRS National Office, providing increased fuel for examination challenges to FLPs and GRATs. This increased IRS scrutiny may not only result in challenges to past transactions, but also must be considered in future planning.

IRS Business Plan

The Service released its "1997 Priorities for Tax Regulations and Other Administrative Guidance" at the end of February 1997. The list of priorities in the trusts, gifts and estates area included a number of carryover items from 1996, and several new items. The major carryover item from 1996 is a regulations project providing guidance on charitable remainder trusts. The IRS has issued proposed regulations (REG-209823-96), as well as Rev. Proc. 97-23, dealing with charitable remainder trusts. The impetus for the project was the high-income charitable remainder unitrust (CRUT) capital gains tax avoidance transaction that was the subject of Notice 94-78. The proposed regulations address this transaction by requiring that the payment of the annuity or unitrust amount in a fixed percentage charitable remainder trust be made by the end of the tax year.

Additional areas addressed by the proposed regulations include allowing a unitrust to "flip" to a fixed percentage method from a net income method in certain circumstances; providing that the donor can be a trustee in connection with unmarketable assets if a qualified appraisal is obtained; applying the rules of Sec. 2702 to certain charitable remainder trusts with multiple noncharitable beneficiaries; and prohibiting the allocation of pre-contribution gain to income in connection with net income with make-up charitable remainder trusts (NIMCRUTs). The proposed regulations and Rev. Proc. 97-23 indicate that no rulings will be issued and the IRS will study whether investing the assets of a NIMCRUT for deferral purposes causes the trust to fail to meet the requirements for a charitable remainder trust.

The other controversial item carried over from last year that should be finalized "soon" involves final regulations on qualified personal residence trusts (QPRTs). Proposed regulations were issued on Apr. 16, 1996, and introduced the requirement that, in order for a trust to qualify as a QPRT, it must prohibit the grantor, the grantor's spouse or an entity controlled by either, from purchasing the residence from the trust, both during the retained term and after such term has expired. Practitioners expect this position to be adopted in the final regulations; although inclusion of a hardship exception was being debated between Treasury and the IRS, no significant t relief from this new requirement is expected.

Another item carried over from last year is the finalization of regulations relating to the generation-skipping transfer tax dealing with the exercise of a nongeneral power of appointment. (For background information, see "Proposed Amendments of Regulations" (PS-22-96), Federal Register (6/12/96).) An additional final regulations project on the list of priorities addresses conforming the disclaimer regulations to court decisions that have held the current regulations invalid with respect to disclaimers of certain joint interests in property. (For background information, see "Proposed Amendments of Regulations" (REG208215-91), Federal Register (8/21/96).)

New items on the business plan include the following:

* Guidance on the transfer of compensatory stock options for less than full consideration.

* Guidance on the purchase of a remainder interest in trust.

* Proposed regulations under Chapter 14 on technical corrections enacted during 1996.

* Proposed regulations under Sec. 7701(a)(30) and (31), clarifying the definition of domestic and foreign trusts.

* Proposed regulations dealing with contingent qualified terminable interest property.

* Proposed regulations on widely held fixed investment trusts.

The Service has begun to issue guidance in connection with legislative changes made last year and plans to continue placing a high priority on the issuance of such guidance, particularly in the international area.

IRS Examination Focus

The IRS has begun its anticipated attack on discounts, particularly in connection with FLPs. The IRS 1997 examination plan provides that, in the estate and gift tax area, special emphasis will be placed on the valuation of FLPs and on the valuation of other "fractured" entities. This examination focus has already begun with a vengeance. The current IRS examination tactic with respect to discounted FLPs is to argue that the transaction was a sham transaction that lacked economic substance; and, in the alternative, to rely on Sec. 2703 to ignore the partnership completely, thereby disallowing the claimed discount in total. Obviously, this is an unacceptable position that is an unwarranted extension of Sec. 2703.

In a yet-unnumbered TAM, the IRS National Office has ruled in a case with extreme facts (terminally ill woman established an FLP after being removed from life support and transferred limited interests to children; a 48% discount was claimed for the remaining limited interests for estate tax purposes) that the existence of a partnership could be disregarded for estate tax valuation purposes. This adverse guidance from the IRS National Office analyzed the transaction as lacking economic substance and, alternatively, as being subject to Sec. 2703(a)(3). This TAM will only aggravate the current examination dilemma. (A second TAM with similarly bad facts should be released shortly.) Thus, the Service's audit activity in this area has increased and it appears that the initial IRS examination position may well be to disallow or to propose a substantial reduction in any discounts.

Another area in which the IRS has demonstrated an increased examination interest is in connection with short-term GRATs (i.e., of two to five years). Recent TAM 9707001 (dealing with revocable spousal annuities) is one of the items expected to be raised in examinations of GRAT transactions. In addition, the Service is rumored to be taking the position in some of these examinations that short-term GRATs do not meet the requirements of Sec. 2702. It is difficult to discern why the IRS would take this position, unless it is merely expressing an inherent dislike of effective planning techniques.

The Service's increased emphasis on gift tax examinations is just beginning. The 1997 IRS Examination Plan provides that special emphasis is to be placed on the classification and examination of filed gift tax returns. This is not a study; it is a directive to every IRS District to include gift tax returns in its examination plans, and not to use them solely as supplemental information for estate tax examinations. In addition, the most recent release of Form 709 (rev. December 1996), United States Gift (and Generation-Skipping transfer) Tax Return, contains a new question on Schedule A, inquiring whether the value of any item listed on the schedule reflects a valuation discount. The related instructions provide as follows:

If the value of any gift you report in either Part 1 or Part 2 of Schedule A reflects a discount for lack of marketability, a minority interest, a fractional interest in real estate, blockage, market absorption, or for any other reason, answer "Yes" to the question at the top of Schedule A. Also, attach an explanation giving the factual basis for the claimed discounts and the amount of the discounts taken.

Consequently, the existence of discount transactions reported on gift tax returns will be highlighted.

In light of these IRS trends and developments, taxpayers should be advised to obtain appraisals, compile good documentation and develop "good" facts in current and future transactions, to proactively establish a strong defense to aggressive IRS exam positions.

From John H. Gardner, J.D., Washington, D.C.