Significant recent developments in estate planning.

EXECUTIVE SUMMARY

* The Hubert proposed regulations appear to be more restrictive than the Supreme Court's holding.

* The IRSRRA '98 clarified the QFOBI provisions enacted by the TRA '97.

* The much-celebrated Alaska self-settled spendthrift trust may have passed its first major test last year.

This article--the first of two parts--examines recent developments in estate, gift and generation-skipping transfer (GST) tax planning. Specifically, the article discusses, among other items, the Hubert proposed regulations; the Sec. 6501 (c)(9) "adequate disclosure" proposed regulations; the Sec. 2057 "qualified family owned business interest" deduction; the indexing of the GST tax for inflation; and recent rulings on deathbed planning, family limited partnerships, Alaska creditor protection trusts and the annual gift tax exclusion.

During the period from May 1998--May 1999, there were many interesting (and in some cases, dramatic) estate planning developments. For example, Congress, in key tax legislation, made certain significant statutory changes (including amendments to the Sec. 2033A qualified family-owned business interest (QFOBI) exclusion included in the IRS Restructuring and Reform Act of 1998 (IRSRRA '98) and the permanent extension of Sec. 170(e)(5)). The IRS released several key regulatory projects (including Hubert proposed regulations, Sec. 6501(c)(9) "adequate disclosure" proposed regulations and charitable remainder trust final regulations). In addition, the Service and the courts issued some important rulings (including a Tax Court decision allowing a valuation discount for built-in capital gains tax liability and an IRS ruling invoking a novel "gift on formation" argument to impose gift tax on the routine creation of a family limited partnership (FLP)).

Because a detailed analysis of all of these important estate planning developments is beyond the scope of this article, the discussion below focuses only on the most influential statutory changes, regulations, cases and rulings from the period covered. The first part of this two-part article, below, examines recent developments in estate, gift and generation-skipping transfer (GST) tax planning. The second part, in the September issue, will focus on income tax planning, valuation issues and proposed legislation.

Estate Tax Planning

Although recent estate tax developments pale in comparison to those made by the Taxpayer Relief Act of 1997 (TRA '97), the period covered witnessed some important regulations and rulings, as outlined below.

Hubert Prop. Regs.

In response to its loss in the Supreme Court's decision in Est. of Hubert,(1) which sought to interpret the definition of "material limitation" in Regs. Sec. 20.2056(b)-4(a), the Service issued proposed regulations.(2) The Court in Hubert was confronted with whether an executor's use of estate income attributable to marital property to pay administration expenses was a "material limitation" on the surviving spouse's right to the income, and thus, reduced the marital deduction. The Court found that the regulations failed to define material limitation and that the Service failed to present sufficient evidence of one. A divided Court concluded that the marital and charitable deductions would not be reduced, despite the fact that the estate administration expenses were paid from income derived from the property passing to the spouse and charity. A concurring opinion suggested that the IRS publish regulations on this issue.

The Service and Treasury gave careful consideration in establishing a rule to define material limitation that could be administered in the context of the Court's directive. After reviewing practitioner comments, the Service concluded that the definition of "materiality" was not workable given the cost and administrative burden associated with such a test; thus, it abandoned the concept of materiality and substituted two new concepts: estate "transmission" and "management" expenses, which, according to the Service, will have uniform application to all estates, be simple to administer and reflect the realities of estate administration.(3)

Estate transmission expenses are defined by Prop. Regs. Sec. 20.2056(b)-4(e) (1) as all estate administration expenses that are not estate management expenses, including expenses incurred in collecting the decedent's assets, paying debts and death taxes and distributing the decedent's property to those entitled to receive it. These types of expenses, whether charged to income or principal under state law or the governing instrument, reduce the marital and charitable deductions. Estate management expenses are defined by Prop. Regs. Sec. 20.2056(b)-4(e)(2)(i) as those expenses incurred in connection with the investment of the estate assets and with their preservation and maintenance during the administration period. These expenses do not reduce the marital or charitable deductions in most circumstances, although the Service has proposed adopting a special rule that will reduce the marital deduction for estate management expenses deducted on the Federal estate tax return.

Observation: The Service and Treasury deserve praise for their efforts to develop a simplified approach to defining material limitation, a term with no statutory meaning. However, the proposed regulations fail to provide an immediate solution. Although the preamble indicates that the proposed regulations simplify estate administration, it is uncertain whether that objective has been achieved, because the special new administration expense classification serves to create a "Federal tax/fiduciary accounting law" disparity that will complicate estate administration. The concepts introduced by the proposed regulations will lead to disputes with Service field examiners and Appeals officers, based on differing interpretations. Further, the proposed regulations appear to be more restrictive than the Supreme Court's holding in Hubert, because their effect is the same as the IRS's position in that case, which a plurality of the Court rejected.

QFOBIs

IRSRRA '98 Section 6007(b) replaced Sec. 2033A, which had been added by TRA '97 Section 502, with new Sec. 2057. As originally enacted, Sec. 2033A allowed an estate an exclusion for the lesser of (1) the adjusted value of the decedent's QFOBIs or (2) the excess of $1.3 million over the applicable exclusion amount of the estate's unified credit. The IRSRRA '98 converted this benefit from an exclusion to a deduction, and made the following other technical changes:

* Better coordination with the applicable exclusion amount. Prior to the IRSRRA '98, the QFOBI exclusion decreased as the applicable exclusion amount increased; their combined benefit never exceeded $1.3 million. New Sec. 2057(a)(3) coordinates the increase in the applicable exclusion amount through 2006 by calculating the estate tax as if the estate was allowed a $675,000 maximum QFOBI deduction and a $625,000 applicable exclusion amount.

* Added a requirement under Sec. 2057(b)(2) that the deducted QFOBI pass to a qualified heir or a trust,(4) all of the beneficiaries of which are qualified heirs.

* Clarified (in Sec. 2057(e)) that an individual's interest in property used in a trade or business may qualify for the QFOBI deduction as long as such property is used in a trade or business by the individual or a member of his family. In addition, property leased on a cash-lease basis between family members will not be treated as a passive asset or reduce the amount of the business interest eligible for QFOBI treatment.

* Clarified that the QFOBI deduction is not available for GST tax purposes.

* Clarified (in Sec. 2057(f)(2)) the calculations needed to compute the recapture tax on a disposition event that occurs within 10 years of the decedent's death and before the qualified heir's death.

Observation: The IRSRRA '98 corrections are much-welcomed, because they removed much of the ambiguity in QFOBI planning. QFOBI owners should now seriously consider redrafting their wills to take advantage of this deduction.

Final QTIP Regulations

In March 1994, the Service published final Regs. Sec. 20.2056(b)7(d)(3), which provided that an income interest (or life estate) contingent on the executor making a qualified terminable interest property (QTIP) election Sec. 2056(b)(7)(B)(v) was not a qualifying income interest for life. Thus, no marital deduction was allowed, even if the executor made a QTIP election for such property. After litigating and losing on this issue,(5) in February 1997 the IRS issued temporary regulations to amend its position.(6)

In August 1998, final regulations(7) were issued that follow the temporary regulations. Thus, an interest in property is eligible for QTIP treatment even if the income interest is contingent on the executor's election; the portion of the property for which no election is made will pass to or for the benefit of beneficiaries other than the surviving spouse. In addition, as a result of such discretionary power, the executor will not be considered to have a power to appoint any part of the property to any person other than the surviving spouse.

Deathbed Planning

There were several developments in the area of deathbed planning in the period covered. In Est. of Newman,(8) the decedent's son, acting under a general power of attorney, wrote six checks from her checking account to various family members shortly before her death. It appears that the checks were deposited by the various donees before the decedent's death, but were neither accepted nor paid by the bank until after death. The executor argued that the checks represented completed gifts by the decedent before death, and thus were excludible from her estate. Alternatively, he argued that such checks were incomplete gifts, but that the relation-back doctrine should apply (i.e., that the checks, having been honored in the ordinary course of business, related back to the date of delivery, and thus, were excludible from the estate).

The Tax Court dismissed the completed-gift argument, ruling that the decedent's stop payment power caused her to have dominion and control over the checks until her death. Despite the executor's arguments that Est. of Metzger(9)--in which checks delivered to noncharitable beneficiaries in December, but not paid by the bank until the following year, were treated as completed gifts when delivered--should apply, the Tax Court ruled that the checks were includible in the estate. The court reasoned that the relation-back doctrine did not extend to the estate taxation of noncharitable gifts.

Observation: Based on the Tax Court's decision, it appears that inter vivos gifts to charitable and noncharitable donees that are given in one year, but cashed in the next, may relate back if the donor is alive when the checks are cashed. However, in the case of noncharitable transfers, if the donor dies before the checks are cashed, the amounts transferred will be included in the decedent's estate. In contrast, charitable gifts are deemed completed regardless of whether the donor is alive or deceased when the check is cashed. This is an interesting result, given the supposed unified nature of the estate and gift tax scheme.

In Letter Ruling 9839018,(10) a taxpayer's conservators sought to continue his 30-year history of making annual exclusion gifts. The conservators petitioned a local court to approve such gifts. State (Virginia) law provided that, in the order appointing a conservator (or in a separate proceeding brought on petition), a court could authorize a conservator to make gifts of the ward's property as long as it was (1) not needed for the ward's maintenance and (2) gifted to persons to whom the incapacitated person would, in the court's judgment, have made gifts had he been of sound mind. In determining the amounts, recipients and proportions of such gifts, the court had to consider the estate's size and composition; the nature and probable duration of the ward's incapacity; the effect of such gifts on the estate's financial ability to meet the ward's foreseeable health, medical care and maintenance needs; the ward's estate plan; prior gifting patterns; taxes; the effect on the establishment of or retention of medical services; and any other relevant factors. The IRS ruled that, under these circumstances, the gifts made by the conservators were complete for income and estate tax purposes.

Observation: Other states (e.g., Florida and Alabama) have statutes similar to the Virginia law outlined above. These state laws can be very useful when an incapacitated person has not executed a general power of attorney or when it is silent as to the designated agent's ability to make gifts. Generally, these state laws, with a court's approval, enable a conservator to make gifts to family members and to otherwise enter into gift and estate planning in the incapacitated person's behalf. However, as outlined above, the court must consider many factors when deciding whether to approve such distributions or planning.(11)

Gift Tax Planning

In addition to the above-described developments in the estate tax area, there were several important gift tax developments in the period covered.

"Adequate Disclosure" Prop. Regs.

A significant development was the Service's release of proposed regulations(12) on gift tax "adequate disclosure" for statute of limitations (SOL) purposes. These draft rules, which have attracted much controversy and comment, are intended to illuminate new Secs. 2001(f), 2504(c) and 6501(c)(9).(13)

Certain changes enacted by the TRA '97 and the IRSRRA '98 purported to offer greater certainty in gift tax valuation. Sec. 2504(c) (as amended by TRA '97 Section 506(d) and IRSRRA '98 Section 6007(e)(2)(B)), and Sec. 2001(f) (as amended by TRA '97 Section 506(a) and IRS-RRA '98 Section 6007(e)(2)(B)), bar the IRS from revaluing gifts made in prior years in calculating subsequent gift or estate tax liability (effective for gifts made after Aug. 5,1997).

The point of the new provisions is to lend a certain finality to the values assigned to gifts from prior years. However, Secs. 2504(c) and 2001(f) require that, for the Service to be barred from revaluing old gifts, the applicable SOL has to have run on such gifts. New Sec. 6501(c)(9) (as amended by TRA '97 Section 506(b)) provides that for the gift tax SOL to begin running on any gift, the gift has to have been "adequately disclosed" to the Service. The preamble to the proposed rules provides:

... the draft rules provide a list of information that, if applicable to a transaction, must be reported on a gift tax return, or a statement attached thereto, in order for the transaction to be considered adequately disclosed to cause the period for assessment to commence. The required information must completely and accurately describe the transaction and include: the nature of the transferred property; the parties involved; the value of the transferred property; and how the value was determined, including any discounts or adjustments used in valuing the transferred property. Specific rules are provided in the case of transfers of entities that are not actively traded that own interests in other nonactively traded entities. In addition, the return must disclose the facts affecting the gift tax treatment of the transaction in a manner that reasonably may be expected to apprise the Service of the nature of any potential controversy regarding the gift tax treatment of the transfer. In lieu of this statement, the taxpayer may provide a statement of any legal issue presented by the facts. Finally, the taxpayer must also provide a statement of any position taken by the taxpayer that is contrary to any temporary or final Treasury regulation or any revenue ruling.(14)

Prop. Regs. Sec. 301.6501(c)-1(f)(3) provides adequate disclosure rules for nongift transactions as well. Prop. Regs. Sec. 301.6501(c)-1(f)(4) provides that adequate disclosure of a transfer reported as a completed gift on a gift tax return will commence the running of the SOL under Sec. 6501(c)(9) even if the transfer is ultimately to be an incomplete gift. Conversely, if a donor initially reports a transfer as an incomplete gift, even if the transfer is adequately disclosed, the SOL will not begin to run until the donor reports the transfer as a completed gift. The Service has three years from the date of filing of the subsequent gift tax return disclosing the completed gift to make an assessment.

In addition to interpreting Sec. 6501(c) (9) adequate disclosure, Prop. Regs. Secs. 20.2001-1 and 25.2504-2 attempt to delineate the boundaries of Secs. 2504(c) and 2001(f), respectively. For example, Prop. Regs. Secs. 25.2504-2(b) and 20.2001-1(b) assert that the bar on the Service's ability to revalue gifts (when subsequently computing gift or estate tax liability) only applies to "adjustments related to the value of the gift." Thus, the Service is not precluded from making adjustments not related to value, such as the erroneous inclusion or exclusion of property for gift tax purposes.

Observation: Written comments (and live testimony at an IRS hearing) on the proposed rules have been quite critical. For instance, some observers have argued that the proposed definition of "adequate disclosure" is susceptible to subjective interpretation, open to inconsistent enforcement and unnecessarily broad and burdensome. In addition, certain commentators have argued that once the SOL has run on a gift, the IRS should be barred not only from revisiting valuation issues, but also from revisiting any issue related to the gift.

Gift on Formation of FLP

Perhaps the most important gift tax development in the period covered was the release of Letter Ruling (TAM) 9842003.(15) The decedent and two of her children established a New York FLP in June 1995, approximately four months before her death. The decedent contributed cash in return for a 99% limited partnership interest; the two children contributed cash in exchange for 0.5% general partnership interests each. In the six-week period before the decedent died, she transferred to the partnership $1.7 million in marketable securities, a $145,000 money market fund account, two parcels of real estate (including her personal residence) and nearly $90,000 in cash. Thus, over 98% of the value of all the partnership assets at the decedent's death were transferred by her to the partnership in the six weeks before her death.

The estate claimed a 40% lack of marketability discount for the decedent's limited partnership interest. As in similar previous rulings,(16) the Service attacked this discount, and the FLP itself. The IRs ruled, in familiar arguments, alternatively that (1) under Est. of Murphy,(17) the partnership's existence should be disregarded for estate tax valuation purposes, and the transfer of the assets to the partnership should be regarded as a single testamentary transaction occurring at the decedent's death; (2) the property passing from the decedent is the underlying partnership assets, subject to the partnership agreement, the value of which should be determined without regard to the partnership agreement (in accordance with Sec. 2703(a)(2)); and (3) any restrictions on the decedent's ability to liquidate her interest should be disregarded in valuing the decedent's limited partnership interest (under Sec. 2704(b)(2)).

These arguments have all been used by the Service in previous "sham TAMs." What makes TAM 9842003 unique, however, is that the Service applied a new "gift on partnership formation" argument. In TAM 9842003, the IRS asserted that, assuming that a 40% discount was appropriate, the decedent must have made a gift (ostensibly to the other partners) on the transfer of assets to the partnership. According to the Service, if a donor transfers property to a limited partnership lacking a bona fide business purpose, and takes back an interest in the partnership worth less than the value of the underlying property just transferred (i.e., if the value of the partnership interest the transferor received in the exchange is reduced to reflect lack of marketability and/or lack of control discounts), gift tax should be imposed on the transferor. The IRS's theory is that the very existence of the discount claimed is evidence that there was a transfer of property for less than adequate and full consideration--the classic opportunity for imposition of gift tax. The amount of the gift should be the fair market value (FMV) of the assets transferred to the partnership less the FMV of the decedent's partnership interest after the transfers.

Observation: In so ruling, the Service rejected the notion that the disparity in value between the underlying assets transferred and the partnership interest received "disappeared" as a natural consequence of the partnership form. The IRS argued that this difference in value was transferred to the decedent's children, because the entire transaction (i.e., the creation of the partnership, the decedent's death and the passage of the partnership interest to her children) was an integrated donative plan designed to transfer the alleged "disappearing value" to the decedent's beneficiaries. This position--and the gift on formation argument in general--will no doubt prove highly controversial, and will most certainly be litigated. In the meantime, practitioners should be familiar with TAM 9842003 and aware that this new attack could potentially apply.

Present Interest Exclusion

The period covered witnessed a number of important rulings on more traditional gift tax issues. For instance, Est. of Stinson(18) addressed the fundamental issue of the applicability of the Sec. 2503(b) annual exclusion to gifts to corporations. The taxpayer had sold real estate to a closely held corporation owned by her five children and two grandchildren. She took back a mortgage for part of the purchase price; over the next few years, she forgave a significant portion of the purchase price owed to her by the corporation. The IRS determined that the forgiveness of debt was a gift to the corporation that did not qualify for the $10,000 annual exclusion, because it was not a gift of a present interest to the individual shareholders.

The Stinson court determined that the shareholders would have an immediate right to use, possess or enjoy the property gifted only after (1) a corporate liquidation or (2) declaration of dividends; the former would require approval by a shareholder majority, while the latter would require approval of a director majority. Because no one shareholder could immediately personally use, possess or enjoy the property gifted, there could be no present interest gift on the forgiveness of debt; thus, the annual exclusion was unavailable.

Observation: Stinson can be contrasted with Letter Ruling 9818042,(19) in which a Sec. 501(c)(7) social club owned a facility that included a library, dining rooms, banquet facilities, squash courts, a swimming pool, exercise facilities and guest rooms. The club members planned to conduct a drive to raise funds to make improvements to the facilities. The taxpayer wanted to make a cash contribution to the club that would qualify for the gift tax annual exclusion. The IRS, ruling affirmatively, acknowledged the general rule of Regs. Sec. 25.2511-1(h)(1), that a transfer of property by a donor to a corporation generally represents a gift to the individual shareholders to the extent of their proportionate interests in the corporation.

The IRS noted that an exception under Regs. Sec. 25.2511-1(h)(1) provides that a transfer made by an individual to a charitable, public, political or similar organization may constitute a gift to the organization as a single entity, depending on the facts and circumstances. Because the organization at issue in Letter Ruling 9818042 was a Sec. 501(c)(7) tax-exempt social club operated solely for noncharitable purposes, none of the earnings of which inured to the benefit of any individual, the Service ruled that the exception applied; thus, the taxpayer's transfer to the club was a gift to the dub as a single entity (not a gift to its individual members). In addition, and in contrast to Stinson and Rev. Rul. 71-443,(20) the IRS ruled the gift was one of a present interest, entitling the taxpayer to a Sec. 2503(b) annual exclusion.

Creditor Protection

The much-celebrated Alaska self-settled spendthrift trust may have passed its first major test last year. In Letter Ruling 9837007,(21) a taxpayer created an irrevocable trust, apparently under Alaska law. The taxpayer named an independent party as trustee; no Sec. 672(c) "related or subordinate party" could ever serve as successor trustee. Under the trust's terms, the trustee was to pay to the taxpayer or her living descendants, during her life, any or all of the trust income and/or principal in the trustee's sole and absolute discretion. The taxpayer represented that there was no express or implied agreement between her and the trustee as to how the trustee should exercise this discretionary distribution power.

The trust contained a spendthrift restriction apparently structured to satisfy Alaska's new creditor protection provisions. In general, those provisions would now protect even self-settled spendthrift trusts (traditionally invalid in most American jurisdictions). The taxpayer established the irrevocable trust to protect her assets from creditors and to exclude the trust property from her estate. Accordingly, the taxpayer requested a ruling that the transfer to the Alaska trust was a completed gift for Federal transfer tax purposes. After reviewing Regs. Sec. 25.2511-2(b) and Rev. Rul. 77-378(22) (in which the IRS ruled, on somewhat similar facts, that there was a completed gift), the Service stressed that there was no express or implied agreement between the taxpayer and the trustee concerning the trustee's discretionary distribution of trust income and principal. The IRS also emphasized that the grantor's creditors would be precluded from satisfying claims out of the grantor's interest in the trust. The IRS concluded that the gift to the Alaska trust would be a completed one for Federal tax purposes.

Observation: The Service declined to rule on whether the trust assets would be included in the taxpayer's gross estate (possibly under Sec. 2036 or 2038). Presumably, under available precedent, this should not be the case.

QTIP Trusts 

In Letter Ruling 9908033,(23) a decedent created a QTIP trust on his death. The terms entitled the surviving spouse to all trust income during her life; at her death, the principal was to pass to another trust, the beneficiaries of which were their children. Thus, the children were the ultimate remainder interest holders of the QTIP trust.

The surviving spouse, the trustee of the QTIP trust, the trustee of the trust to be created on the surviving spouse's death and the children intended to petition the local probate court to terminate the QTIP trust and to distribute the entire corpus to the surviving spouse. The petition was to be filed under a state statute permitting the termination of a trust when, owing to circumstances unforeseen by the settlor, continuation would impair or defeat the settlor's intentions in establishing the trust. In anticipation of obtaining the local court ruling, the taxpayer (one of the children) sought a ruling that the termination of the QTIP trust would not constitute a gift by the children to the surviving spouse of their QTIP remainder interest.

In arguing that there should be no gift on the termination of the QTIP trust, the taxpayer relied on Rev. Rul. 98-8,(24) in which a surviving spouse purchased, from the trust remainder interest holder, the remainder interest in a QTIP trust for an amount equal to its actuarial value. As a result of the transaction, the trust terminated and the entire trust corpus was paid to the surviving spouse. The spouse then paid the purchase price to the remainder interest holder from the proceeds of the trust corpus.

Rev. Rul. 98-8 concluded that the surviving spouse had made a gift of property equal to the value of the remainder interest in the QTIP trust. The IRS reasoned that the surviving spouse had essentially acquired an asset (the QTIP remainder) already subject to inclusion in her transfer tax base under Sec. 2044. According to the Service, the receipt of an asset that would not effectively increase the value of the recipient's potential gross estate would not constitute adequate consideration for estate and gift tax purposes. Thus, because the surviving spouse did not receive adequate consideration for the QTIP remainder purchase, she would be deemed to have made a gift equal to the purchase price.

In Letter Ruling 9908033, the taxpayer argued that, under Rev. Rul. 99-8, a remainder interest in a QTIP trust is accorded a value of zero when it is received by the surviving spouse (or when it is already treated as owned by the surviving spouse for gift and estate tax purposes). Thus, the children's transfer of their QTIP remainder interest should not be subject to gift tax.

The IRS disagreed. It ruled that the taxpayer was proposing to transfer a valuable property interest to the surviving spouse without consideration. Under the authority of Sec. 2512(b), the IRS held, such a transfer for less than full and adequate consideration constituted a gift. Moreover, the taxpayer's reliance on Rev. Rul. 98-8 was misplaced. That ruling, the IRS noted, focused on what constitutes adequate consideration for transfer tax purposes and concluded that the receipt of the remainder interest by the spouse would not constitute adequate consideration for the spouse's transfer to the remainder interest holder. It did not follow that the remainder interest should be valued at zero (or the transfer of the interest should not constitute a gift) when the remainder interest holder (i.e., the taxpayer) transfers the interest to the spouse and receives no consideration in exchange. Rather, the taxpayer proposed to make a transfer for less than adequate consideration that would deplete his potential taxable estate. If the taxpayer were to transfer the remainder interest to a third party other than the spouse, the transfer would dearly be a gift; the result should be the same if the donee is the surviving spouse. The IRS ruled that the fact that the receipt of the remainder interest by the spouse will not increase the value of her potential taxable estate is not pertinent to the determination of the Federal gift tax consequences to the taxpayer on the proposed transfer. Accordingly, the taxpayer's proposed transfer would constitute a gift for gift tax purposes.

Observation: The taxpayer's reading of Rev. Rul. 98-8 seemed strained at best, and the result reached in Letter Ruling 9908033 seems a sound one. Thus, unless there is a substantial nontransfer tax reason to do so, terminating a QTIP trust in this manner may make little sense (at least on facts similar to those in Letter Ruling 9908033). If the termination of the QTIP trust (and the accompanying distribution of trust funds to the surviving spouse, free of trust) would enable the surviving spouse to "spend down" the QTIP principal in a manner impossible without the termination, such a termination may make transfer tax sense. The termination would be reasonable, for instance, if the trustee of the QTIP trust had no power to appoint QTIP principal to the surviving spouse (and thus, could not make trust corpus available to the surviving spouse to spend or give away).

Roth IRA Final Regs.

The IRS issued final regulations (in question and answer format) on Roth individual retirement accounts (IRAs).(25) Generally, the final regulations adopt the substance and approach of the proposed rules issued in September 1998, but contain several important changes and clarifications.

While a detailed analysis of the final regulations is beyond the scope of this article, they do address the "gifting" of Roth IRAs. Regs. Sec. 1.408A-6, Q&A-19 discusses the Federal income tax consequences of the transfer of a Roth IRA by gift. A Roth IRA owner's transfer of his account to another individual by gift constitutes an assignment of the owner's rights under the Roth IRA. At the time of the gift, the Roth IRA assets are deemed to be distributed to the owner and, thus, treated as no longer held in a Roth IRA.

Observation: However, for gifts of Roth IRAs made before Oct. 1, 1998, if the entire interest in the Roth IRA was reconveyed to the owner before 1999, the Service will treat the gift and reconveyance as never having occurred for estate, gift and GST tax purposes.

GST Tax Planning

There were several important, recent GST tax-related developments in the period covered.

Inflation Indexing

First, IRSRRA '98 Section 6007(a)(1) clarified that Sec. 2631(c) indexing (for inflation) of the GST tax $1 million exemption is effective for all GSTs (i.e., direct skips, taxable terminations and taxable distributions) made after 1998. (TRA '97 Section 501(d) had provided only that the GST exemption adjustment applied to individuals dying after 1998.) However, under Sec. 2631(c)(2), as amended, any increase in the GST tax exemption amount for any given calendar year will apply only to GSTs made during or after the calendar year for which the adjustment is made; no increase for calendar years after the one in which the transferor dies will apply to transfers made by that transferor.

The IRSRRA '98 legislative history(26) also clarified that, for existing trusts, transferors can make a late allocation of any GST exemption amount attributable to indexing adjustments under the rules applicable to late allocations under Secs. 2632 and 2642 (and the regulations thereunder).

Example: X transferred $2,000,000 to a trust in 1995, and allocated his entire $1,000,000 GST tax exemption to the trust (resulting in an inclusion ratio of 0.50). In 2001, the GST tax exemption has increased to $1,100,000 via indexing; the value of the trust assets is now $3,000,000. If X is alive in 2001, he can make a late allocation of $100,000 of GST exemption to the trust, resulting in a new inclusion ratio of 0.467 [1 -- (($1,500,000 + 100,000)/$3,000,000)].

Observation: Rev. Proc. 98-6127 announced that for calendar year 1999, the GST tax exemption under amended Sec. 2631 (to be used in computing the inclusion ratio defined in Sec. 2642) is $1,010,000.

Election to Treat Revocable Trust as Part of Estate

TRA '97 Section 1305(a) added Sec. 646 (redesignated as Sec. 645 by IRS-RRA '98 Section 6013(a)(1)), allowing an irrevocable election to treat a qualified revocable trust as part of an estate for Federal income tax purposes. TRA '97 Section 1305(b) added Sec. 2652(b)(1), to provide that this election would cause the trust to be considered part of the estate for GST tax purposes, as well as income tax purposes. The IRSRRA '98 clarified, through amendments to Secs. 2652 and 2654, that the election to treat a revocable trust as part of a decedent's estate under Sec. 645 applies for GST tax purposes only with respect to the application of Sec. 2654(b) (which describes when a single trust may be treated as two or more trusts). The election has no other effect for GST tax purposes.(28)

Observation: This clarification is an important one; unlike direct skips, taxable terminations under Sec. 2612(a) and taxable distributions under Sec. 2612(b) can occur only if a "trust" is involved.

Conclusion

In the September issue, part two of this article will focus on income tax planning, valuation issues and estate planning proposed legislation.

(1) Est. of Otis C. Hubert, 520 US 93 (1997)(79 AFTR 2d 97-1394, 1997-1 USTC [paragraph] 60,261).

(2) REG-114663-97 (12/15/98).

(3) See News Notes, "Estate Administration Expenses," 30 The Tax Adviser 72 (February 1999).

(4) See S. Rep't No. 105-174, 105th Cong., 2d Sess. (1998), p. 181.

(5) See Est. of Arthur M. Clayton, Jr., 976 F2d 1486 (5th Cir. 1992)(70 AFTR 2d 92-6262, 92-2 USTC [paragraph] 60,121), rev'g 97 TC 327 (1991); Est. of Willard E. Robertson, 15 F3d 779 (8th Cir. 1994) (73 AFTR2d 94-2329, 94-1 USTC [paragraph] 60,153), rev'g 98 TC 678 (1992); Est. of John D. Spencer, 43 F3d 226 (6th Cir. 1995)(75 AFTR2d 9.5-563, 95-1 USTC [paragraph] 60,188), rev'g TC Memo 1992-579; and Est. of Willis Edward Clack, 106 TC 131 (1996).

(6) See TD 8714 (2/14/97).

(7) TD 8779 (8/18/98).

(8) Est. of Sarah H. Newman, 111 TC 81 (1998).

(9) Est. of John F. Metzger, 100 TC 204 (1993), aff'd, 38 F3d 118 (4th Cir. 1994)(74 AFTR2d 94-6184, 94-2 USTC [paragraph] 60,179).

(10) IRS Letter Ruling 9839018 (6/25/98).

(11) But see IRS Letter Ruling (TAM) 9731003 (3/31/97) (ruling that gifts were includible in the estate when state law (Maryland) was not explicit).

(12) REG-106177-98 (12/22/98).

(13) For more information see Vail, Tax Clinic, "Transfer Tax Valuation Finality and Prop. Regs on the `Adequate Disclosure' of Gifts," 30 The Tax Adviser 388 (June 1999).

(14) See Prop. Kegs. Sec. 1.6501(c)-(f)(2).

(15) IRS Letter Ruling (TAM) 9842003 (7/2/98).

(16) See, e.g., IRS Letter Rulings (TAMs) 9719006 (1/14/97), 9723009 (2/24/97), 9725002 (3/3/97), 9730004 (4/3/97), 9735003 (5/8/97) and 9736004 (6/6/97).

(17) Est. of Elizabeth B. Mushy, TC Memo 1990-472.

(18) Est. of Lavonna J. Stinson, ND Ind., 10/2/98 (82 AFTR 2d 98-6944, 98-2 USTC [paragraph] 60,330).

(19) IRS Letter Ruling 9818042 (1/28/98).

(20) Rev. Rul. 71-443, 1971-2 CB 337.

(21) IRS Letter Ruling 9837007 (6/10/98).

(22) Rev. Rul. 77-378, 1977-2 CB 348.

(23) IRS Letter Ruling 9908033 (11/30/98).

(24) Rev. Rul. 98-8, IRB 1998-7, 24.

(25) TD 8816 (2/3/99).

(26) See Joint Comm. on Tax'n, General Explanation of Tax Legislation Enacted in 1998 (JCS-6-98) (hereinafter, "Blue Book"), p. 16

(27) Rev. Proc. 98-61, IRB 1998-52, 18.

(28) See Blue Book, note 26, p. 210.

Nicholas I. Pye, CPA Senior Manager Washington National Tax-Personal Financial Planning Practice KPMG LLP Washington, DC

Daniel T. Vail, J.D., LL.M. Manager Washington National Tax-Personal Financial Planning Practice KPMG LLP Washington, DC

For more information about this article, contact Mr. Pye at [phone] or Mr. Vail at [phone].