Significant recent developments in estate planning.

Part I of this article, published in October, covered gifts; disclaimers; debts, claims and administration expenses; powers of appointment; retained interests; and charitable deductions. Part II, below, addresses valuation, special use valuation and the marital deduction. The final installment will be published in the December issue.

Valuation

Amendments to family partnership agreements reduced partnership interests' transfer tax value.

No gift resulted from a corporate recapitalization in which the exchanged stock was undervalued by the IRS.

Estate could discount decedent's undivided one-half real estate interest only to the extent of the cost of partitioning the property.

Testamentary division of control block of stock resulted in a single controlling interest for estate tax purposes, but shares passing to surviving spouse were a separate minority interest block for purposes of computing the marital deduction.

On remand from the Tenth Circuit, Tax Court held that alternate valuation considers both time value of money and a reasonable adjustment for oil and gas production risks.

Discount in value of decedent's residence and farmland disallowed for agreement to pay children from proceeds of ex-wife's transfer to decedent of her one-half community interest in fee simple.

Taxpayer could not rely on Sec. 483 safe harbor interest rate on transfer of stock to trust in exchange for promissory notes.

Valuation of father's gifts of fractional interests to children reflected bad economy and local rent stabilization laws.

IRS's expert, not estate's, correctly used net asset value for decedent's nonoperating, closely held company stock.

* Amendments to partnership agreement reduce transfer tax value

In McLendon,(64) the decedent, who had cancer, held general partnership interests in two family partnerships. In May and August of 1985, he and his son (the other general partner) amended the partnership agreements to (1) eliminate provisions mandating liquidation on the decedent's death and (2) give the son sole management control over the partnerships and authorization to expel any partner contesting his managerial decisions.

On Mar. 5, 1986, the decedent established a trust for the benefit of his three daughters and named his son trustee. On the same day, the decedent, as annuitant, entered into a private annuity agreement with his son (individually) and the trust, under which the decedent sold a 25% remainder interest in his general partnership interests to the son outright and a 75% remainder interest to the trust. The initial annuity payment was $250,000. In setting the annuity, it was assumed that the decedent's remaining life expectancy under Regs. Sec. 25.2512-5(f) (Table A) was 15 years. The decedent died in September 1986.

The IRS asserted a gift tax deficiency of $31,142,507, plus interest and penalties, arguing that the private annuity transaction was really a part gift/part sale. The deficiency was based on the stipulated partnership liquidation value, less the value of the retained life estate (which the IRS calculated based on an estimated life expectancy of 0.65 years) and the $250,000 payment.

The Tax Court held that the annuity payment was substantially less than the value of the remainder interest, resulting in a gift. However, the court disagreed with the IRS's contention that the 1985 amendments should be ignored and that the partnership interests should be valued at net liquidation value.

Critique: In determining whether a gift occurred, the Tax Court focused on the value of the partnership interests, i.e., the bona fides of the annuity calculation. The court concluded that liquidation value was not an appropriate measure. Instead, the court found that the fair market value (FMV) of the partnership interests, rather than the aggregate value of the underlying assets, was the appropriate measure for transfer tax purposes. The parties stipulated this value to be between approximately one-third and one-half of liquidation value. Essential to the court's finding was the determination that the 1985 amendments were not driven solely by testamentary motives. The decedent wanted the businesses to continue after his death and was convinced that only his son could manage them. Further, in the absence of the amendments, the decedent was afraid that his daughters would seek dissolution.

The court held that the annuity was purely a testamentary device unsupported by economic substance. First, it noted that the general partnership interests were undervalued by almost $5 million for annuity calculation purposes. Second, the $250,000 initial payment bore no relationship to the actual annuity value, either under the court's or the decedent's asset value estimates. The court also noted that, other than the $250,000, no annual annuity payment was set out in the agreement. Finally, the Tax Court found that the decedent's reliance on the Regs. Sec. 25.2512-5(f) tables was misplaced, because his medical condition was such that he was not expected to survive more than one year beyond the transaction date. The court therefore held that the annuity should have been valued using a 0.65-year, rather than a 15-year, life expectancy.

Planning hints: The McLendon facts are extremely unfortunate. The decedent's health, together with the loose terms of the annuity agreement, clearly demonstrated that neither party perceived the private annuity to be anything more than an estate tax saving device. In fact, no attempt was even made to meet the formal requirements of an annuity. The $250,000 payment was more than $500,000 less than the payment required under a 15-year life expectancy.

However, it is comforting that the court rejected the concept of "partnership amendment in contemplation of death" and respected the independent significance of the amendments. Query whether such an act, accomplished contemporaneously with the creation of the private annuity, would have been treated differently. Because of its significance to business continuity, the six-month gap between the amendments and the annuity should not be viewed as significant. Finally, the amendments to the partnership agreements predated Sec. 2704, which can require valuation of a partnership interest without regard to certain restrictions on liquidation.

* Corporate recapitalization does not result in gift

In Hutchens,(65) in 1982, the decedent owned 86.79% of the voting common stock and 75.42% of the nonvoting common stock of his family business. The remaining shares were owned by his spouse and three sons. In September 1982, he implemented a preferred stock recapitalization under which he and his spouse exchanged their voting and nonvoting common for Class A and Class B voting preferred. His eldest son received voting common and the other sons received nonvoting common.

The Class A and Class B preferred were entitled to a noncumulative variable dividend based on a designated bank's prime rate. The dividends became cumulative to the extent of $3 per share on the later of the eldest son's thirty-fifth birthday or the decedent's death. On liquidation, the proceeds were first payable to the preferred shareholders at $100 per share, plus any declared but unpaid dividends. Finally, the Class A preferred's voting rights lapsed on the later of the eldest son's fortieth birthday or the decedent's death, but were restored solely to vote on payment of the dividends if the corporation was in arrears on dividend payments. Between the recapitalization date and the decedent's death, no dividends were declared.

In conjunction with the recapitalization, the decedent obtained an appraisal of the corporation and the preferred shares. The preferred shares' value roughly equaled the common shares' value surrendered in the exchange. Subsequent to the decedent's death, however, the IRS challenged this conclusion, asserting that a gift to the sons resulted from the recapitalization. The asserted undervaluation ranged from almost $15 million (in the deficiency notice) to almost $4.9 million (in the trial pleadings). The Tax Court held that no gift had occurred.

Critique: In valuing the preferred shares, the taxpayer's expert used four alternative approaches: the Black-Scholes option pricing formula (which the court rejected); a comparable pricing method; a discounted cash flow analysis; and an asset liquidation analysis. Under the latter two approaches, the expert argued that favorable economic events affecting the corporation's industry (e.g., increased demand for the company's product, a recent history of record earnings and the near-resolution of a product liability suit) enhanced the likelihood that the noncumulative dividends would be paid. The expert also argued that a sale of the business would result in net proceeds at least equal to the liquidation preference accorded the preferred stock.

The IRS's expert, on the other hand, stated that a willing buyer would purchase the shares only with a view toward liquidation and that he would discount the estimated liquidation proceeds by approximately 35% to account for financial and legal risks of the transaction.

In holding for the taxpayer that no gift had occurred, the Tax Court noted that business conditions supported the likelihood of future dividend payments. It concluded that a willing buyer would purchase the stock at par in anticipation of receiving such dividends, particularly when the going concern value of the business more than supported the liquidation preference.

The IRS also argued that the company's failure to declare noncumulative dividends constituted an ongoing gift to the common shareholders. The court noted that only the board of directors is vested with the power to declare dividends. The business's cyclic nature, the failure of a new product line and the pending product liability suit all were factors constituting an adequate basis for the company to retain cash in the business, rather than pay dividends.

Planning hints: Hutchens is a significant taxpayer victory. Assuming it is not reversed on appeal, it reassures taxpayers who undertook well-constructed asset value freezes prior to the enactment of Chapter 14. Moreover, the case should be viewed as a victory for the taxpayer's valuation expert. The Tax Court simply accorded more credibility to him than it did to the IRS's expert.

However, an expert's credibility is not guaranteed. In Ford,(66) the Tax Court rejected the testimony of a taxpayer's expert, finding him technically unqualified as a business appraiser, his report replete with errors and his testimony sloppy and unconvincing. As the authors have previously noted, the courts are no longer inclined to simply "split the difference" on valuation issues.(67) Technical credentials and the thoroughness of a valuation expert's approach are now often the determinants of complete victory or loss.

* Discount of real estate undivided interest limited to partitioning cost

In Letter Ruling (TAM) 9336002,(68) the decedent's estate included an undivided one-half interest in real estate. The other half was owned by unrelated third parties. The IRS ruled that the estate was entitled to discount the decedent's one-half interest only by his share of the estimated cost of partitioning the property.

Critique: In ruling against the taxpayer, the IRS stated that FMV contemplates that a willing buyer and willing seller will choose to act in their own best economic interests. Thus, where undivided interests in property exist, the undiscounted values can be realized by all parties if they simply act in concert. Where concerted action is not possible, the party wishing to sell can achieve a sale by partition. In such cases, the only cost borne by the seller is the cost of partition.

Obviously, the IRS's argument is specious, for many reasons. For example, concerted action by undivided interest owners often is not easily achieved. What may seem a fair price to one interest holder may seem ridiculously low to another. One owner may wish to hold the property indefinitely as an investment, while the other may be strapped for cash.

More importantly, partition proceedings present significant uncertainties as to outcome. Not all acres are the same, due to differences in improvements, access, water and mineral rights, etc. A willing buyer faces potentially protracted litigation with no assurance as to whether the proceedings will result in a satisfactory split. Further-more, the sum of the value of the parts often does not equal the value of the whole. A 100-acre tract may be more valuable than the two tracts into which it may be divided in a partition proceeding. The IRS will lose when challenged in court. Many taxpayer victories (such as LeFrak,(69) discussed below) demonstrate that a fractional interest discount extends beyond just the cost of partitioning.

* Testamentary division of control block reduces marital deduction

In Letter Ruling (TAM) 9403005,(70) another discount situation, the decedent owned a controlling block of stock. The will divided the stock into two interests, one eligible for the marital deduction and one to use the unified credit. The two bequests divided the block such that each bequest constituted a noncontrolling interest.

The IRS ruled that a control block of corporate shares must be valued as a single controlling interest for estate tax purposes, even though the will divided the stock into two noncontrolling blocks. However, relying on Chenoweth(71) and Ahmanson Foundation,(72) the IRS also ruled that a minority discount had to be applied to the shares passing to the marital trust in computing the marital deduction.

Planning hints: Advisers should exercise caution when planning for estates that may split a controlling interest between deductible and nondeductible bequests. Taking Letter Ruling 9403005 to the extreme, estate tax could result if only charities and the surviving spouse were estate beneficiaries and the bequest funding divided controlling into noncontrolling interests. Conversely, if the estate includes a control block, the ruling's rationale might permit a greater-than-proportionate number of noncontrolling shares to fund a credit shelter bequest, assuming a control block funds the marital share.

* Alternate value includes interim oil and gas sales

In Holl,(73) the decedent owned substantial oil and gas reserves, which his estate valued at $9 million. The estate, which elected Sec. 2032 alternate valuation, received $980,000 net income from oil and gas sold between the date of death and the alternate valuation date. On the estate tax return, the estate reported a $683,000 in-place value for the interim production. The IRS determined a deficiency, asserting that a risk discount from sales proceeds was inappropriate. The Tax Court agreed, but the Tenth Circuit did not. The appeals court ruled that the alternate valuation should not reflect postdeath changes in the reserves' condition. On remand, the Tax Court concluded that the most appropriate valuation considered both the time value of money and a reasonable adjustment for production risks.

Critique: On remand, each party presented further evidence relating to the alternate valuation of the reserves. The estate contended that the value on the alternate valuation date was either $583,765 or $373,664, whereas the IRS alleged the value was either $931,664 or $869,606. The Tax Court valued the produced reserves at $869,600. Citing Maass(74) and Johnston,(75) the court concluded that the risk discount should be determined by reference to the risks associated with near-term production, rather than the increased risks associated with the reserves' entire producing life.

* Discount disallowed for agreement to pay proceeds to children

In Climer,(76) in 1954, the decedent owned farmland and a residence as community property with his spouse. Pursuant to a divorce agreement, the spouse conveyed her one-half community interest in fee simple to her husband, subject to his agreement to pay to his children one-half of any sales proceeds on such property received during his lifetime. Between the divorce and his death, the decedent sold most of the real estate and transferred one-half of the proceeds to the children. The executor included in the estate tax return only one-half of the value of the remaining real estate. The Tax Court held that the full real estate value was includible in his estate.

Critique: The Tax Court held that the nature of the decedent's interest was governed by local law (Texas). In that state, extrinsic evidence is pertinent to the interpretation of a deed only if the instrument's language is ambiguous. Further, "[a] deed is ambiguous only if, after the application of pertinent rules of interpretation ... it is uncertain which of two or more meanings is the proper meaning."(77) In Climer, the court found that the deed was clear and not subject to conditions. As a result, it held that the decedent's promise to pay one-half of the sales proceeds to the children was an independent contractual arrangement. In case of default, the children's recourse was under contract law.

Since the deed did not expressly condition the decedent's ownership on his compliance with the divorce agreement, neither a constructive trust nor other ownership interest of the children was imposed on the property. Thus, no discount or exclusion from the decedent's gross estate was proper.

* Sec. 483 safe harbor not controlling for transfer tax purposes

In Schusterman,(78) the taxpayer created irrevocable trusts for the benefit of his descendants. He then sold his shares of a family business to the trusts for 6% installment notes of over $7.9 million. At the time, the market rate on gift loans was 11.5%.(79) The district court, agreeing with the IRS, held that a gift resulted of the difference between the FMV of the stock transferred to the trusts and the present value of the notes using an 11.5% discount rate.

Critique: The taxpayer argued that loans meeting the 6% test rate contained in then Regs. Sec. 1.483-1(d)(1)(ii)(B) could not be recharacterized as something other than principal under any Code provision. The court disagreed, relying on the Tax Court's decision in Krabbenhoft: "The section merely characterizes payments as principal or interest, while gift tax valuation is concerned with the value of all payments, whether principal or interest. The character of a payment does not affect its value for gift tax purposes."(80)

Planning hints: Schusterman is another example of the disastrous results that can occur when planners erroneously act on the assumption that the income and transfer tax rules operate in concert with one another. Similar difficulties arise when it is assumed that the Sec. 671 grantor trust rules and the asset inclusion rules of Secs. 2036-2038 are compatible and internally consistent.

* Value of gifts reflected bad economy and fractional interest

In LeFrak,(81) the taxpayer owned numerous rental properties in New York City. In 1976, he formed 20 partnerships with his four children or their trustees, and conveyed his rental properties to the partnerships. Each of his children received a 7.5% interest in each of the properties, either outright or in trust, so that the decedent owned a 70% interest. The taxpayer contributed cash to the partnerships in advance of the transfers so that no property's value was less than its mortgage. The buildings, less the $25 million aggregate mortgage debt, were valued at $225,000 and the total gifts at $59,925 (30% of $225,000, less a minority discount). The IRS asserted an FMV of $34.8 million before debt, and gifts of over $2.6 million.

Critique: The Tax Court determined that LeFrak gave his children fractional interests in real estate, rather than partnership interests, as the taxpayer contended. Although both parties' experts agreed that the properties should be valued based on their income-generating capabilities, the Tax Court rejected the IRS's contention that the net income would increase in the future. Instead, it relied on the taxpayer's evidence concerning a downward trend in the New York City economy and the effect of rent stabilization laws.

With respect to the minority discount, the court noted that a fractional interest holder has the power to compel partition of the property, which adds cost and delay. It rejected the IRS's argument that no minority discount is appropriate when all the owners are members of the same family, and granted a 20% minority discount. Finally, the court determined that an additional 10% discount for lack of marketability was proper, accepting the IRS's expert's determination.

* Net asset method used to value nonoperating company stock

In Ford,(82) the Tax Court held that the IRS's expert correctly used the net asset value approach in valuing the decedent's nonoperating, closely held company stock. That methodology generally is given greatest weight for nonoperating companies holding real estate or other investments.

The court also concluded that the estate was entitled to a 20% minority discount for its stock in some of the companies. Further, a 10% lack of marketability discount was applied to all corporations, including those in which the decedent held a controlling interest. The court rejected the historic book value approach employed by the taxpayer, noting that book value often does not accurately reflect true value, since unadjusted book value bears little relation to an asset's FMV at the date of valuation.

Special Use Valuation

* Cash lease of ranch land by qualified heirs to their brother triggered Sec. 2032A recapture.

* Surviving spouse's disclaimer of interest in insurance policy preserved Sec. 2032A benefits of property placed in trust.

* Taxpayer continued to farm foreclosed property, avoiding Sec. 2032A recapture.

* Recapture agreement deemed incomplete because qualified heirs signed in their capacity as individuals and not as directors and officers of the farming corporation.

* Response to IRS questionnaire, disclosing cash rental agreement of qualified real property, constituted notice of cessation of qualified use.

* Cash lease to qualified heirs' sibling triggers recapture

In Fisher,(83) the decedent devised an undivided one-sixth interest in Kansas ranch land to each of her six children. From the date of her death, the land was continuously committed to her son's cattle-raising operation. His activities constituted material participation and special use valuation was elected. Shortly after the election, the children exchanged their undivided interests for separate interests in the property. After the exchange, five of the children entered into a cash lease arrangement with their brother. The Tax Court held that the ranch land had ceased qualified use by the five children, resulting in Sec. 2032A recapture.

Critique: The Tax Court noted that the issue raised in Fisher had been resolved against the taxpayer in both Williamson(84) and Shaw.(85) However, the court chose to revisit those decisions in light of one Ninth Circuit judge's strong dissent in Williamson.

The Tax Court concluded that Sec. 2032A(c)(1)(B) clearly requires a "qualified heir" to put the property to a "qualified use." Further, it found no provision "permitting the qualified heir to cash rent the property to anyone else, even to a family member, without incurring recapture tax."(86) Thus, even though all of the children were qualified heirs, and one of the children materially participated in the cattle-raising operation, the court concluded that the five other siblings' cash rental agreement converted their holdings to passive interests. This interpretation was supported by the Revenue Bill of 1992,(87) which contained a provision (not enacted) that would have reversed Williamson.

Conversely, in Minter,(88) special use treatment was allowed when the decedent's children, like their deceased parent, leased farmland under a cash rental arrangement to a family farming corporation of which they were shareholders. The court noted that the shareholders were qualified heirs and that concurrent ownership of the farmland and the corporate shares meant they were subject to the economic risks of production. The Eighth Circuit clearly distinguished between a third-party cash rental agreement and a similar arrangement with a partially lessor-owned entity. The court applied the "substantial-dependence-on-production" test to determine whether the qualified heir put the farmland to a qualified use.

Planning hints: As was apparent from the dissent in Williamson, current law tends toward unfairness to qualifying property held by some inactive qualifying heirs. A fixed cash rental's relative certainty is preferable to the vagaries of a crop rental arrangement. In these circumstances, the law's spirit seemingly is achieved because the property remains within the family.

However, notwithstanding Minter's favorable holding, until remedial legislation is passed, planners must recognize that the execution of a cash lease will almost certainly result in IRS challenge and possible Sec. 2032A recapture.

* Disclaimer preserves Sec. 2032A election

In Letter Ruling 9407015,(89) the decedent's gross estate included ranch land held in a revocable trust and an insurance policy on the surviving spouse's life. At death, the revocable trust became irrevocable and its corpus allocable between a general power of appointment marital trust (which expressly could not be funded with unmatured life insurance policies) and a residuary trust. The surviving spouse had a general power of appointment over the marital trust and was the sole income beneficiary of the residuary trust. On the surviving spouse's death, the residuary trust's corpus was payable as follows: $5,000 to a named charity; $55,000 to certain children; and the balance to the decedent's other children.

Shortly after the decedent's death, the insurance policy was transferred to the residuary trust and the surviving spouse disclaimed his interest in the policy within nine months. Due to the disclaimer, the residuary trust was deemed terminated. The trust borrowed $60,000 against the cash surrender value of the policy to satisfy the specific bequests. The policy, subject to the loan, was then conveyed to the residuary trust's remainder interest holders. The IRS ruled that the ranch land qualified for Sec. 2032A treatment.

Critique: When potential Sec. 2032A property is placed in a trust with successive interests, Regs. Sec. 20.2032A-8(a)(2) disallows special use treatment unless all of the successive interests pass to the decedent's qualified heirs and the election includes all of those heirs' interests. While qualified heirs were the sole beneficiaries of the marital trust's remainder interest, a charity was granted a specific bequest from the residuary trust's remainder. Since property passing to a charity fails special use treatment,(90) the absence of further action would have denied Sec. 2032A benefits. However, the surviving spouse's disclaimer saved such benefits.

A disclaimant is treated as if he predeceased the decedent. In Letter Ruling 9407015, the transfer of the policy to the residuary trust, followed by the disclaimer, resulted in the trust being deemed terminated from inception, because the intervening life estate never matured. The satisfaction of the specific bequests with policy loans was treated as coming from estate assets other than the ranch land. Thus, the entire ranch property conveyed to the marital trust qualified for special use treatment.

Planning hints: Letter Ruling 9407015 is a fine example of a disclaimer used to achieve an estate planning result otherwise barred by statute. Perhaps a simpler technique would have been to direct the specific bequest to be paid immediately after the decedent's death expressly from property not qualifying under Sec. 2032A.

* Farmland foreclosure proceeding did not cause recapture

In Letter Ruling (TAM) 9333002,(91) the taxpayer materially participated in the operation of two mortgaged farms inherited from his parent. Two years after taking possession, the taxpayer defaulted on one mortgage and foreclosure proceedings were initiated. The taxpayer allowed the statutory redemption period to expire, but repurchased the farmland pursuant to his statutory right of first refusal. Throughout the proceedings, the taxpayer continuously farmed the property himself or under a crop-share arrangement with a third party. The IRS concluded that the farmland was continuously committed to a qualified use, so there was no recapture.

Critique: The IRS first noted that neither the initiation nor implementation of a foreclosure action constituted an involuntary conversion. Consequently, Sec. 2032A(h)(1)(A) did not apply, and a perfected third-party sale pursuant to foreclosure proceedings would trigger recapture. The taxpayer could not mitigate this result by acquiring another property for an amount equal to the sales proceeds.

Next, the IRS stated that the taxpayer's rights regarding the farmland were defined under local law, which provided both a right to redeem the property prior to a foreclosure sale and a right of first refusal once the property was sold. Further, the taxpayer's equitable interest was not extinguished until his rights under both statutory provisions expired. Therefore, since the taxpayer continued to farm the land throughout the foreclosure period and perfected his interest through the exercise of his right of first refusal, no Sec. 2032A recapture occurred. The IRS noted, however, that a different result might have occurred had the taxpayer been removed from the land under an action for unlawful detainer by the mortgagee during the foreclosure proceedings. In such circumstances, qualified use would have ceased.

In another situation, the IRS ruled that the sale to a qualified heir of a five-acre tract in a 120-acre farm did not trigger Sec. 2032A recapture. In Letter Ruling 9340035,(92) the five-acre tract included a residence and other buildings used for storing farm equipment. The purchaser was a qualified heir who would materially participate in farm operations and receive a 25% net income share. The acquisition of the tract for the purpose of making improvements was a qualified use under Sec. 2032A(e)(3).

* Recapture agreement incomplete

In Letter Ruling (TAM) 9346003,(93) a special use valuation recapture agreement with respect to farming corporation stock was incomplete because the qualified heirs signed it in their individual capacities, not as corporate directors and officers. However, the IRS ruled that the recapture agreement as originally filed substantially complied with Regs. Sec. 20.2032A-8 because, under applicable state law (Arizona), a corporation is legally bound by the knowledge of its director. Thus, the estate's representative had 90 days after notification to perfect the agreement and provide the appropriate signatures.

* Answer to IRS questionnaire constituted notice of cessation of qualified use

In Stovall,(94) a case of first impression, the Tax Court held that disclosure of a cash rental arrangement in response to an IRS questionnaire constituted notification of cessation of qualified use. The disclosure commenced the Sec. 2032A(f) three-year statute of limitations on assessment and collection of recapture. The court rejected the argument that the rental arrangement was not a passive fixed cash rental because the heir participated in farming operations, and concluded that the heir was not obligated to file Form 706-A, United States Additional Estate Tax Return (To report dispositions or cessations of qualified use under section 2032A of the Internal Revenue Code), to achieve disclosure. Rather, response to the questionnaire was sufficient.

Marital Deduction

* QTIP election based on a formula resulted in maximum marital deduction.

* Holographic will's unclear language establishing trust denied marital deduction.

* Marital and ESOP deduction of same stock partially disallowed as a double deduction.

* Settlement of will contest permitted marital deduction.

* QTIP election allowed for passthrough trusts holding lottery winnings.

* Trustee's ability to restrict beneficiary's interest denied marital deduction.

* Marital deduction based on net book value of assets was not a formula that permitted increased deduction.

* Disposition of assets in case of failure to make QTIP election did not preclude marital deduction.

* Assets passing to pooled income fund qualified for QTIP election.

* Loan guarantees did not preclude marital deduction.

* QTIP election reduces outright bequest to achieve maximum marital deduction

In Letter Ruling 9343008,(95) the decedent's will divided his estate into two equal shares. Under Article Fifth, one-half of his estate, less amounts deemed to have passed under other articles of the will, went outright to his wife. Under Article Sixth, the balance went to a residuary trust in which the wife was the sole income beneficiary. A qualified terminable interest property (QTIP) election was made with respect to the residuary trust for a fractional share of the "total trust estate" that resulted in the largest marital deduction necessary to avoid estate tax, after considering any available credits. The executor treated the entire estate as passing into the residuary trust and computed the marital deduction for the QTIP to be 98.44852% of that trust. The IRS ruled that the claimed amount qualified for the marital deduction.

Critique: In the absence of the QTIP election, one-half of the decedent's estate would have passed outright to the surviving spouse. However, the fractional share language qualified virtually all assets passing to the residuary trust for the marital deduction. Since the outright bequest was net of all other amounts deemed passing to her under other articles of the will, the language acted to divert all assets to the residuary trust, thereby leaving the Article Fifth bequest unfunded.

In Montgomery,(96) the Tax Court held that (under a clause similar to that in Article Fifth) a $300,000 QTIP election reduced dollar-for-dollar the amount of the initial outright bequest. Thus, the marital deduction was limited to $300,000, plus the value of property passing under the initial bequest, less the value of assets subject to the QTIP election. The IRS, however, distinguished Letter Ruling 9343008 from Montgomery, noting that the election in the letter ruling was based on a formula, not a specific amount. Thus, the diversion of estate assets to the residuary, coupled with the formula election, resulted in a maximum arital deduction.

Planning hints: The result in Letter Ruling 9343008 arose either from careful planning or sheer luck. Nonetheless, the structure of the decedent's will afforded at least three separate postmortem planning options: First, the will could stand as written, with the surviving spouse receiving one-half of the estate outright. Second, a partial QTIP election could have been made to reduce the outright bequest and divert some of the marital deduction property to the residuary trust. Third, a maximum marital deduction in trust could be achieved, as in Letter Ruling 9343008.

One intended result may have been forestalled, however. The executors could not allow the outright bequest to stand and elect QTIP treatment for the residuary trust, because the Article Fifth bequest was reduced both by assets passing and deemed to pass to the surviving spouse under other articles of the will.

* Agreement to ignore trust and distribute assets failed marital deduction

In Carpenter,(97) the decedent executed a holographic will in which he left most of his estate to his surviving spouse. He had had only a vague understanding of the requirements of a trust and simply indicated that the assets bequeathed to his wife were to be placed in trust to protect her from undue influences. He then stated that his spouse was to have free use of the property so that she could enjoy the remainder of her life free of financial concerns. Anything left in the trust after his wife's death passed to his daughter. The will failed to expressly indicate the extent of the spouse's income interest or her specific rights to principal vis-a-vis the remainder interest holder. Further, it did not designate an executor or trustee, but authorized the spouse to select them.

Various banks refused to accept trusteeship unless the spousal and remainder rights were clearly determined. Legal counsel advised the spouse and daughter not to establish the trust due to the instrument's ambiguities and potential conflicts of interest. On further advice of counsel, the spouse and daughter entered into a settlement agreement under which the trust was ignored and the estate's assets were equally distributed outright to each. The Tax Court held that the amounts distributed to the spouse did not quality for the marital deduction.

Critique: To qualify for the marital deduction, the surviving spouse's interest under the will must be nonterminable and must pass from the decedent. The amount distributed to the spouse under the settlement agreement failed both tests. Based on North Carolina law, the court concluded that the surviving spouse's interest was a terminable interest, plus a broad right to consume principal to maintain her lifestyle. Although the invasion right could result in complete consumption of trust assets, the right was not equivalent to a life estate with a general power of appointment under local law. The court equated a general power with one enabling the spouse to withdraw assets from the trust and convey them in fee simple to others. As such, the trust was deemed a terminable interest within the meaning of Sec. 2056.

The outright distribution did not cure the terminable interest issue, since that distribution resulted from a side agreement, rather than from the will's dispositive provision. As such, the interest did not "pass" from the decedent within the meaning of Sec. 2056. Under North Carolina law, the only rights created were a life estate and limited power of invasion for her exclusive benefit. The combination of these two interests did not justify their conversion into a fee interest,(98) which was the effect of the settlement agreement.

Planning hints: It is amazing that some individuals with relatively large estates choose to adopt a "self-help" approach to estate planning. If the decedent drafted his own will simply to save money, his decision clearly was catastrophic.

Unfortunately, it is difficult to identify postmortem action that could have saved the situation. The trust was hopelessly muddled in terms of the spouse's and daughter's rights. The banks' refusals to accept trusteeship left the parties in a considerable bind. Document reformation by a probate court proceeding might have been possible. However, it remains unclear whether the IRS would have been bound by such a proceeding. Clearly, the decedent left his heirs a lose-lose situation.

* Marital and ESOP deductions are mutually exclusive

In Reeves,(99) the decedent died in December 1986, leaving a gross estate in excess of $20 million. His will provided a number of specific bequests, with the estate residue passing to a QTIP trust. The estate included 511, 116 shares of a closely held business with a date-of-death value of $10 per share. Since these shares were not specifically bequeathed, they were included in the residue.

The estate tax return claimed a marital deduction of $11,583,568, computed by including the stock's full date-of-death value in the marital residue. Subsequent to his death, the 511,116 shares were sold to an employee stock ownership plan (ESOP) for $2,555,580. The estate claimed a Sec. 2057 deduction of $1,277,790. The Tax Court disallowed the double deduction and reduced the marital deduction by the Sec. 2057 deduction.

Critique: Sec. 2057 provides an estate tax deduction equal to one-half of the proceeds of a qualified sale of employer securities to an ESOP. Sec. 2056(b)(9) provides that the value of any interest in property cannot be deducted more than once either under Sec. 2056 or any other estate tax provision. In Reeves, the IRS asserted that including the shares' full value in the marital deduction and claiming a Sec. 2057 deduction violated Sec. 2056(b)(9).

The taxpayer argued that Sec. 2056(b)(9) did not apply, because the related committee reports(100) limited its application to claiming a double charitable and marital deduction for charitable remainder interests. The Tax Court disagreed. Citing Huntsberry,(101) it stated that "where a statute is clear on its face, we require unequivocal evidence of legislative purpose before construing the statute so as to override the plain meaning of the words used therein." It then noted that Sec. 2056(b)(9)'s language is clear and unambiguous. Further, the cited committee report was not intended to be definitive. The reference to charitable remainder interests merely was one of the section's applications.

Planning hints: Sec. 2056(b)(9) applied because the shares sold were included in the marital residue. Language in the opinion seems to support a different result if the will had expressly directed that Federal taxes and expenses be paid first from the proceeds of the sale of such shares.

* Will contest settlement qualifies for marital deduction

IN Hubert,(102) in 1977, the decedent executed a will creating a maximum marital deduction general power of appointement trust. In 1982, a new will created a marital trust to be funded with the estate residue. This trust differed from the 1977 trust in that the remainder interest passed to charity on the surviving spouse's failure to exercise her general power. A codicil to the 1982 will eliminated the surviving spouse's general power of appointment.

After the decedent's death, the spouse and other parties initiated a will contest. It was asserted that the 1982 will and codicils were invalid due to undue influence exerted by certain charities. The Georgia Department of Revenue and Georgia's attorney general participated in settlement discussions on behalf of the charities. A settlement agreement was executed and approved by the superior court.

Under the agreement, the residue was divided into (1) a general power of appointment trust for the spouse's benefit, (2) a QTIP trust and (3) an outright distribution to charities. The marital deduction was claimed based on the settlement agreement. The IRS disallowed approximately $12.65 million of the marital deduction, arguing that it had to be based on the 1982 will and codicils, rather than the settlement agreement. The Tax Court held for the taxpayer.

Critique: In ignoring the settlement agreement, the IRS cited Regs. Sec. 20.2056(e)-2(d)(2), which provides that an assignment or surrender of property "pursuant to a decree rendered by consent, or pursuant to an agreement not to contest a will..." need not necessarily be accepted as a bona fide evaluation of the spouse's rights. However, while the Tax Court was not bound by the agreement, it concluded that in this case, it should not be ignored. The agreement resulted from bona fide adversarial proceedings. The surviving spouse ultimately received an amount substantially equivalent to what she would have received had the 1982 will and codicils been set aside in the will contest. Thus, the settlement did not deprive the IRS of revenues it would have received had the 1982 instruments not been executed.

* Trust funded with lottery winnings qualifies for marital deduction

In Letter Ruling 9352015,(103) the taxpayer and his spouse jointly owned a winning lottery ticket. Under the lottery rules, gross winnings were payable in 20 equal annual installments. The taxpayer and spouse transferred their rights to a revocable trust (the "lottery trust") that would collect the annual payments and immediately convey one-half to the taxpayer's and his spouse's individual revocable trusts.

During the settlors' lifetimes, the individual trusts would distribute net income at least quarterly. Each settlor could withdraw all principal from his or her respective trust at any time. Postdeath income was payable monthly to the surviving spouse. The trust was required to pay to the survivor for life each lottery installment received after the other settlor's death. The IRS ruled that a QTIP election could be made.

Critique: In Letter Ruling 9352015, the IRS made clear that an essential qualification element was the complete passthrough to the surviving spouse of the trust's annual lottery installment. Sec. 2056(b)(7)(C) provides an automatic marital deduction only if annuity payments are receivable directly by the survivor.

* Trustee's authorization to modify beneficiary's interest defeats marital deduction

In Letter Ruling (TAM) 9325002,(104) a marital trust was established under the decedent's revocable trust agreement. Net income was payable to the surviving spouse at least annually and any undistributed income was payable to her estate. In addition, the trustee was authorized, in the face of "changed circumstances or a change in law," to petition a court of competent jurisdiction to amend the trust terms to "restrict or remove any of the pwoers, duties, rights and privileges of the trustee, the beneficiaries, or any other person...." The IRS ruled that the latter provision rendered the surviving spouse's life interest uncertain and disallowed the marital deduction.

Critique: To be a QTIP, the surviving spouse's interest must be a qualified income interest. However, the amendment clause authorized the trustee to petition a court to "scale back" the surviving spouse's income interest based on changed circumstnaces, e.g., a lowered standard of living, incompetence, etc. Since the spouse did not have an absolute right to all trust income for life, the IRS denied the marital deduction.

The IRS rejected the taxpayer's argument that the amendment clause was inoperative given other document language expressing the decedent's desire to obtain the marital deduction. It stated that the trust instrument was clear and unambiguous until read as contradicting the stated intent of obtaining a marital deduction. The language indicated only an intent to obtain a marital deduction, rather than an intent to provide an interest of such nature and duration as to qualify for the marital deduction. Thus, the intent language was relevant only for Federal tax purposes. Relying on Procter,(105) the IRS ruled that a savings clause having the limited application present in Letter Ruling 9325002 is ineffective for Federal transfer tax purposes.

Planning hints: The disallowance in Letter Ruling 9325002 should not have occurred. It is one more instance of extraneous language inserted in an instrument, causing catastrophic consequences. There is no practical reason for including an authorization to petition the court to modify the powers and rights of the trustee or beneficiary. In fact, one wonders what the testator (or more likely, the drafter) had in mind.

* Marital deduction based on buy/sell agreement value fails

In Letter Ruling (TAM) 9327005,(106) the decedent's will left his estate, which consisted primarily of family corporation stock, in trust. The executor was authorized to make a partial QTIP election with respect to said trust. The shares were valued pursuant to a buy/sell agreement under which the executor was obligated to sell the stock back to the corporation at net book value. A QTIP election was made with respect to "$67,542 of the total amount transferred to the trust (10.35%)...." On audit, the corporate shares were revalued upward. The IRS ruled that the marital deduction was limited to the original amount reflected on the Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return.

Critique: The relatively small marital deduction was based on the estate's modest size (as reflected in the estate tax return) and a desire to maximize use of the unified credit. The IRS audit substantially increased the value of the gross estate and the amount subject to transfer tax.

The IRS refused to modify the marital deduction to reflect the increased value of the gross estate, on two grounds. First, the marital deduction is limited to the actual amount passing to the surviving spouse. In Letter Ruling 9327005, the estate was obligated to sell the shares at a fixed price--net book value. The IRS's adjustment to the value of those shares did not affect the estate's contractual rights under the buy/sell agreement. Thus, regardless of the eventual estate tax value of the shares, the amount realizable by the executor on sale, as well as the amount passing to the trust, was limited to net book value.

Second, the election was not expressed as a formula, but as a percentage and set dollar amount. The election did not indicate the derivation of the 10.35% figure reflected on the Form 706. The election also failed to indicate the percentage to be applied to any amount other than that stated in the original return.

Planning hints: Letter Ruling 9327005 is a good example of how the use of a buy/sell agreement as an aggressive estate valuation technique can backfire. The IRS was not bound to accept the buy/sell price, and the resulting deficiency significantly eroded the estate remaining to provide for the surviving spouse. This could have been avoided had the agreement contained a clause requiring the buyer to pay additional amounts to the extent that the Federal estate tax value exceeded the initial contract price. Such a clause would have pumped more proceeds into the estate that could have funded the maritial trust.

A change in the buy/sell agreement, however, was not enough. The executor should have couched the election as a formula of the estate as finally determined for estate tax purposes. The formula should have been expressed so that the entire residue, after setting aside the amount necessary to absorb available credits, would be covered by the QTIP election.

Letter Ruling 9327005 leaves the taxpayer with the worst of all worlds--a de minimis marital deduction, a substantial estate tax and the diversion of assets intended to support the surviving spouse to the payment of taxes.

* Asset disposition in default of QTIP election does not defeat marital deduction

In Robertson,(107) the decedent's will created four trusts: a family trust with income payable to a class of beneficiaries that did not include the surviving spouse; a general power of appointment marital trust; and two additional trusts with net income only payable to the surviving spouse for life. The will also stated that, if the executor did not make a QTIP election, the latter two trusts' assets were to be distributed to the family trust. All parties agreed that the family trust failed the QTIP requirements.

The executor made a QTIP election for the two trusts, which the IRS disallowed. The Eighth Circuit, overruling the Tax Court, held for the taxpayer.

Critique: Consistent with its prior pronouncements, the IRS disallowed the marital deduction, arguing that the surviving spouse's "qualified income interest" was defeasible during her lifetime through the actions of a third party--i.e., the executor. The executor's ability not to elect QTIP status constituted a power of appointment in favor of other persons, since the family trust, which was the named recipient of nonelected assets, did not qualify for a QTIP election.

The Eighth Circuit disagreed. It noted that Sec. 2056(b)(7)(B)(i)(III) clearly makes the executor's election essential to QTIP treatment. The court concluded that it was irrelevant what happened with respect to property not covered by the election. When QTIP status is not elected, there is immediate taxation. Tax revenues are unaffected by whether the spouse has, or does not have, a lifetime income interest in nonelected assets. As such, following the Fifth Circuit's reasoning in Clayton,(108) the Eighth Circuit held that QTIP status cannot be denied simply because non-QTIP assets pass to a trust in which the surviving spouse lacks a qualified income interest.

Planning hints: Robertson and Clayton are significant victories for the taxpayer, particularly since they reverse a long-standing IRS position. If supported by other circuits, they dramatically enhance estate planning flexibility by allowing the executor to forgo QTIP status and, at the same time, open up the class of permitted beneficiaries with respect to the nonelected property. Whether estate planners outside the Fifth and Eighth Circuits should draft their documents accordingly is problematic. Until the IRS acquiesces to the above cases, or additional circuits concur with them, challenge remains possible. The Tax Court's continued agreement with the IRS position may require recourse to other appellate courts.

* Income interest in pooled income fund qualifies as QTIP

In Letter Ruling 9406013,(109) the IRS ruled that QTIP status could be elected for assets passing to a pooled income fund maintained by a charity. Under its governing instrument, the pooled income fund was required to pay to the surviving spouse all of its income in monthly installments and no one had the power, during the life of such spouse, to distribute any portion of the income or principal to a third party, including the charity.

* Gratuitous loan guarantee does not risk marital deduction

In Letter Ruling 9113009,(110) the IRS ruled that gratuitous loan guarantees disqualify a marital trust for QTIP treatment. The rationale was that the potential satisfaction of such guarantees from QTIP property is equivalent to a prohibited power of appointment in favor of someone other than the spouse. It also ruled that an estate trust funded solely by the face value of all loans guaranteed by the decedent fails to qualify for the marital deduction.

In Letter Ruling 9409018,(111) the IRS withdrew the prior ruling. The IRS stated that "the mere presence of a loan guarantee as an encumbrance on assets passing from the taxpayer at death would not ordinarily cause the complete disallowance of the marital deduction that would otherwise be allowable for the bequest to the Estate Trust or the Marital Trust."

Abbreviations Commonly Used in The Tax Adviser

TTA          The Tax Adviser
aff'g        affirming
AFTR2d       American Federal Tax Reports, second
             series (Research Institute of America)
Ann.         IRS Announcement
CB           Cumulative Bulletin
Cir.         Court of Appeals
Cl. Ct.      Claims Court
COBRA        Consolidated Omnibus Budget
             Reconciliation Act of 1985
Cong. Rec.   Congressional Record
DC           District Court
DRA          Deficit Reduction Act of 1984
ERISA        Employee Retirement Income
             Security Act of 1974
ERTA         Economic Recovery Tax Act of 1981
Fed. Reg.    Federal Register
F2d          Federal Reports, second series
F3d          Federal Reports, third series
F Supp       Federal Supplement
GCM          General Counsel Memorandum
H. Rep.      House Ways and Means Committee
             Report
IR           Internal Revenue News Release
IRB          Internal Revenue Bulletin
PL           Public Law
Regs. Sec.   Treasury Regulation
Rev. Proc.   Revenue Procedure
Rev. Rul.    Revenue Ruling
rev'g        reversing
RRA          Revenue Reconciliation Act of 1993
Sec.         Section (refers to the Internal
             Revenue Code of 1986 unless
             otherwise indicated)
S. Rep.      Senate Finance Committee Report
SSRA         Subchapter S Revision Act of 1982
Sup. Ct.     Supreme Court
TAM          Technical Advice Memorandum
TAMRA        Technical and Miscellaneous
             Revenue Act of 1988
TC           Tax Court (regular decision)
TC Memo      Tax Court (memorandum decision)
TD           Treasury Decision
TEFRA        Tax Equity and Fiscal
             Responsibility Act of 1982
TRA          Tax Reform Act of 1986
USTC         United States Tax Cases
             (Commerce Clearing House)

(64)Est. of Gordon B. McLendon, TC Memo 1993-459.

(65)Lewis G. Hutchens Non-Marital Trust, TC Memo 1993-600.

(66)Est. of Ray A. Ford, TC Memo 1993-580.

(67)See Nager, Abbin and Carlson, "Significant Recent Developments in Estate Planning (Part II)," 25 The Tax Adviser 3 (Jan. 1994), at 4; and Abbin, Carlson and Nager, "Significant Recent Developments in Estate Planning (Part I)," 22 The Tax Adviser 590 (Sept. 1991), at 599.

(68)IRS Letter Ruling (TAM) 9336002 (5/28/93).

(69)Samuel J. LeFrak, TC Memo 1993-526.

(70)IRS Letter Ruling (TAM) 9403005 (10/14/93).

(71)Est. of Dean A. Chenoweth, 88 TC 1577 (1987).

(72)The Ahmanson Foundation, 764 F2d 761 (9th Cir. 1981)(48 AFTR2d 81-6317, 81-2 USTC [paragraph]13,438).

(73)Est. of F.G. Holl, 95 TC 566 (1990), rev'd and rem'd, 967 F2d 1437 (10th Cir. 1992)(70 AFTR2d 92-6191, 92-2 USTC [paragraph]60,104), on remand, 101 TC 455 (1993).

(74)Herbert H. Maass v. Higgins, 312 US 443 (1941)(25 AFTR 1177, 41-1 USTC [paragraph]10,032).

(75)Est. of Nellie S. Johnston, 779 F2d 1123 (5th Cir. 1986)(57 AFTR2d 86-1502, 86-1 USTC [paragraph]13,655).

(75)Est. of Nellie S. Johnston, 779 F2d 1123 (5th Cir. 1986)(57 AFTR2d 86-1502, 86-1 USTC [paragraph]13,655).

(76)Est. of Glen Climer, TC Memo 1994-29.

(77)Universal C.I.T. Credit Corp. v. Daniel, 243 S.W.2d 154, 157 (Tex. 1951), cited in Climer, id., at 94-114.

(78)Charles Schusterman, N.D. Okla., 1994 (73 AFTR2d [paragraph]94-666, 94-1 USTC [paragraph]60,161).

(79)IR-84-60 (5/11/84), reprinted in Rev. Proc. 85-46. 1985-2 CB 507.

(80)Lester H. Krabbenhoft, 939 F2d 529 (8th Cir 1991)(68 AFTR2d 91-6021, 91-2 USTC [paragraph]60,080), aff'g 94 TC 887 (1990), at 890, cited in Schusterman, note 78, at 94-1 USTC 18,285.

(81)LeFrak, note 69.

(82)Ford, note 66.

(83)Jack Fisher, TC Memo 1993-139.

(84)Beryl P. Williamson, 93 TC 242 (1989), aff'd, 974 F2d 1525 (9th Cir. 1992)(70 AFTR2d 92-6244, 92-2 USTC [paragraph]60,115).

(85)Lavona Pauline Shaw, TC Memo 1991-372.

(86)Fisher, note 83, at 93-626, citing Williamson, note 84, TC, at 247.

(87)HR 11, 102d Cong., 2d Sess. (1992), Statement of Managers and Conference Bill, at 419.

(88)Marilyn Minter, 19 F3d 426 (8th Cir. 1994)(73 AFTR2d [paragraph]94-803, 94-1 USTC [paragraph]60,160).

(89)IRS Letter Ruling 9407015 (11/18/93).

(90)Rev. Rul. 81-220, 1981-2 CB 175.

(91)IRS Letter Ruling (TAM) 9333002 (4/20/93).

(92)IRS Letter Ruling 9340035 (7/7/93).

(93)IRS Letter Ruling (TAM) 9346003 (8/9/93).

(94)Mary Eileen Stovall, 101 TC 140 (1993).

(95)IRS Letter Ruling 9343008 (7/20/93).

(96)Est. of Melvin M. Montgomery, TC Memo 1988-457.

(97)Est. of Stanley M. Carpenter, TC Memo 1994-108.

(98)Keener v. Horn, 46 N.C. App. 214 (1980).

(99)Est. of Hazard E. Reeves, 100 TC 427 (1993).

(100)Staff of Joint Committee on Taxation, Description of HR 6056, Technical Corrections Act of 1982 (J. Comm. Print, 1982), at 12.

(101)Howard Y. Huntsberry, 83 TC 742, 747 (1984).

(102)Est. of Otis C. Hubert, 101 TC 314 (1993).

(103)IRS Letter Ruling 9352015 (9/30/93).

(104)IRS Letter Ruling (TAM) 9325002 (2/26/93).

(105)Fred W. Procter, 142 F2d 824 (4th Cir. 1994)(32 AFTR 750, 44-1 USTC [paragraph]10,123), cert. denied.

(106)IRS Letter Ruling (TAM) 9327002 (2/25/93).

(107)Est. of willard E. Robertson, 8th Cir., 1994 (73 AFTR2d [paragraph]94-524, 94-1 USTC [paragraph]60,153), rev'g 98 TC 678 (1992).

(108)Est. of Arthur M. Clayton, Jr., 976 F2d 1486 (5th Cir. 1992)(70 AFTR2d 92-6262, 92-2 USTC [paragraph]60,121).

(109)IRS Letter Ruling 9406013 (11/10/93).

(110)IRS Letter Ruling 9113009 (12/21/90).

(111)IRS Letter Ruling 9409018 (12/1/93).