Significant recent developments in estate planning.

Cases and Rulings on the Charitable Deduction, Generation-Skipping Tax and Miscellaneous Income Tax Developments

Parts I through III of this article, published in September, October and November, discussed recent developments in insurance, powers of appointment, retained interests, valuation, gift tax, administration expenses and claims, disclaimers, marital deduction, and miscellaneous estate and trust issues. This final installment covers developments in the areas of the charitable deduction, the generation-skipping tax and miscellaneous income tax issues. Note: Since this issue of The Tax Adviser contains an article on the new Chapter 14 special valuation rules and related proposed regulations (see "The Progeny of Sec. 2036(c)" on page 767), the authors have not discussed these developments herein.

Charitable Giving

The following developments occurred with respect to charitable giving.

* The IRS ruled that a grantor of a charitable remainder trust may act as a trustee.

* The postdeath reformation of defective provisions permitted charitable remainder trust qualification. * A set-aside deduction was allowed for income passing to charity on conclusion of a will contest.

* Replacement of trustee does not disqualify charitable remainder trust In IRS Letter Ruling 9048049,(139) GI and G2 (grantors) executed a charitable remainder unitrust naming P as trustee. For 20 years, the trust pays an amount equal to 8% of the annually redetermined net fair market value (FMV) of its assets to the grantors jointly, then to the surviving grantor and finally to the then-living issue of the grantors until the expiration of the trust term. The grantors and P sought to remove P as the sole trustee and thereafter appoint both P and G1 as co-trustees. The IRS concluded that the intended action would not result in disqualification of the trust's charitable remainder status.

Critique: Regs. Sec. 1.664-1(a)(4) provides that a trust must meet the definition of, and function exclusively as, a charitable remainder trust from inception in order to qualify for that status. The section further provides that, solely for purposes of Sec. 664, the trust will be deemed created at the earliest time that neither the grantor nor any other person is treated as the owner of the entire trust under subpart E, part 1 of subchapter J. Neither the grantor nor the grantor's spouse will be treated as the owner of the trust merely because they are named as a recipient.

Sec. 674(a) directs that a grantor will be treated as the owner of any portion of a trust for which he or she has a power of disposition with respect to the beneficial enjoyment of the corpus or income of the trust if the power is exercisable either by the grantor or a nonadverse party, or both, without the approval and consent of an adverse party. Sec. 674(b)(4) states that this rule does not apply to the extent that the power relates to income or corpus that is irrevocably payable for a charitable purpose specified in Sec. 170(c).

In Letter Ruling 9048049, the IRS concluded that the planned action would not result in a disqualification of the unitrust, since the unitrust amount payable to the noncharitable beneficiaries was fixed by the trust terms and the trustee had no authority to alter or amend the payments. The trustee's ability to select various charitable remaindermen was deemed to come within the exception of Sec. 674(b)(4).

* Reformation saves charitable remainder trust In IRS Letter Ruling (TAM) 9050005,(140) the decedent's will created a trust directing that income be payable to his sister for life, with the remainder held to establish teaching fellowships at designated universities. The sister was granted "the unlimited power to govern [the] trust as to buying, selling, collecting or disposing of any of the assets of [the] estate." Before filing the federal estate tax return, the decedent's estate reformed the testamentary trust by creating two separate trusts: one trust was a noncharitable trust and the other a charitable remainder unitrust. The IRS concluded that the reformation was valid and a qualified remainder trust resulted.

Critique: Sec. 2055(e)(3) allows a deduction with respect to any qualified reformation of an intended charitable remainder trust. Sec. 2055(e)(3)(B) defines a "qualified reformation" as a change of a governing instrument by reformation that changes a reformable interest into a qualified interest, but only if

--any difference between the actuarial value of the qualified interest and the actuarial value of the reformable interest does not exceed 5% of the actuarial value of the reformable interest, and --in the case of a charitable remainder interest, the non-remainder interest (before and after the qualified reformation) terminates at the same time, and the changes are effective as of the date of the decedent's death.

The IRS found that the conversion of the sister's life income interest to a unitrust amount would constitute a reformable interest within this definition.

Further, elimination of the sister's power over buying, selling, collecting or disposing of the trust assets, which under local law was equivalent to a power of invasion, constituted a qualified disclaimer of such power. The fact that the termination of the sister's invasion power occurred as part of the same instrument that reformed the trust was considered inconsequential by the IRS.

* Charitable income tax deduction for escrowed funds In IRS Letter Ruling (TAM) 9037004,(141) on the decedent's death, the estate's executor brought a court action to reacquire various assets that were conveyed by the decedent during his lifetime. In the event such lifetime conveyances were deemed void, the assets would pass under the decedent's will to various charitable beneficiaries. Pending the ultimate resolution of the litigation, the assets were conveyed to an escrow agent. Approximately six years after litigation was initiated, a court order directed that the assets be distributed to the various charities. The IRS ruled that a Sec. 642(c) charitable set-aside deduction was available for the accumulated income distributed from the escrow accounts to the charities.

Critique: Sec. 642(c) states that an estate may claim a charitable deduction for set-aside amounts, provided such set-asides had, in fact, occurred and were made under the terms of the governing instrument. In Letter Ruling 9037004, the settlement agreement directed the residue of the decedent's estate to be distributed to the charities, but did not specifically provide for the disposition of the income earned by the estate. However, under local law, the residuary beneficiary is entitled to the income earned on the residue because such income was not expressly bequeathed to another party. The IRS allowed the set-aside deduction based on the settlement agreement, even though the amount was uncertain until the settlement was reached.

The IRS noted that the escrow was established before the enactment of Sec. 468B(g). As such, the income earned on the disputed amounts placed in escrow was not subject to current taxation, but was taxable in a lump sum to the ultimate recipient of the property and accumulated income on resolution of the dispute. (This treatment is no longer appropriate for transfers in escrow made after Aug. 15, 1986.)

As such, the recipient of the escrowed property was required to include the full amount of accumulated income in its tax return for the year of receipt. Since such property, together with accumulated income, was distributable to charitable beneficiaries identified under the will, the IRS concluded that the income accumulated in the escrow account was deemed set aside within the meaning of Sec. 642(c) and a charitable deduction was available to the estate for amounts passing to charity.

Generation Skipping

The IRS issued a number of letter rulings on the generation-skipping tax (GST), including the following.

* Several rulings allowed the partition or consolidation of trusts without affecting grandfathered status. * The addition of beneficiaries as co-trustees did not affect grandfather status due to their limited powers. * The IRS permitted the division of various QTIP trusts into separate trusts for purposes of making reverse QTIP elections.

* Partition of trust does not affect grandfather from GST In IRS Letter Ruling 9033016,(142) the taxpayer established a trust in 1973 for the benefit of his five children. His adult children were named co-trustees along with an independent party. The remaining children became co-trustees as they attained age 18. The trust was funded with shares of closely held corporate stock.

Trust income and principal may be distributed to the children and descendants for health, support, education and maintenance until five years after the death of the grantor's spouse. At that time, the trust is to be divided into as many trusts as there are living children and deceased children survived by descendants. These resulting trusts will remain in existence for the lives of the living children, while trusts for the descendants of deceased children distribute outright to such descendants. Each living child has a limited power of appointment in favor of his descendants or siblings.

The IRS ruled that a proposal to accelerate partitioning of the initial trust does not adversely affect grandfathering from the GST.

Critique: The IRS noted that for purposes of allocating income and corpus distributions, the five partitioned trusts would be treated in precisely the same manner as if the trusts had remained together. Under the proposal, distributions to a beneficiary would have to be made on a pro rata basis from each of the partitioned trusts, irrespective of the fact that a separate trust had nominally been established for each of the five children. This feature was considered critical in ascertaining whether a substantial modification or change had occurred with respect to the interests of the various beneficiaries. Further, after the partition, the duration and term of each trust would continue in exactly the same manner as if a partition had not occurred.

The IRS noted that "[t]he mere partitioning of a trust that does not otherwise change the quality, value, or timing of any of the powers, beneficial interests, rights, or expectancies originally provided for under the terms of the trust will not prevent the resulting trust interests from being treated as a trust in existence on the date of the original trust instrument for purposes of Chapter 13...."

A similar result occurred in Letter Ruling 9033047,(143) in which the IRS allowed the partition of two simple trusts holding closely held stock into multiple trusts, one for each of the grantor's children. The object of the partition was to enable each trust to qualify as a holder of S corporation stock. As in Letter Ruling 9033016, the facts indicated that a simple partition would not change the quality, value or timing of any of the beneficial interest rights or expectancies.

Finally, in Letter Ruling 9109022,(144) the IRS ruled that a consolidation of eight trusts into four trusts--so that there would be only one trust for each of four specific beneficiaries--did not adversely affect the grandfathered status of these trusts. The two existing trusts for each beneficiary were virtually identical.

* Change of trustees does not affect grandfather status In IRS Letter Ruling 9038037,(145) the grantor established five trusts, one for each of his children, and named a bank as the independent trustee. Each trust was to accumulate income and corpus until the named beneficiary achieved age 35. Thereafter, all income was to be distributed currently. On the death of the named child beneficiary, corpus was distributable to his descendants.

The IRS ruled that the planned appointment of each child as an additional trustee of his trust did not adversely affect the grandfather status of the trust for purposes of the GST. In this ruling, the trustee's powers were extremely limited and there was no discretion with respect to the distribution of income or principal throughout the trust term. As such, the addition, substitution or deletion of trustees would have no impact on the beneficial interest or enjoyment of the trusts' beneficiaries.

* Division of trust accommodates reverse QTIP election In IRS Letter Ruling 9101013,(146) the decedent's will provided a bequest to a qualified terminable interest property (QTIP) trust of a specific sum for the benefit of his surviving spouse. The residue of the decedent's estate passed to the same trust. The decedent's estate sought to create two identical QTIP trusts as described in the will: Trust One would be funded with the specific bequest and Trust Two with the residue. Once the split is effected, the executor intends to make a reverse QTIP election with respect to one of the trusts. The IRS agreed that this technique was valid. Critique: Sec. 2631(a) provides a $1 million GST exemption that may be allocated to any property of which the individual is a "transferor" within the meaning of the statute. In the case of any property subject to federal estate tax, Sec. 2652(a)(1) defines the "transferor" as the decedent.

Notwithstanding the above, Sec. 2056(b)(7) provides an election to treat certain qualified terminable interest property as passing from the decedent to the surviving spouse for purposes of the marital deduction. Under Sec. 2044(a), the value of property in a QTIP trust is included in the surviving spouse's gross estate. As such, for generation-skipping transfer tax purposes, the surviving spouse is the "transferor" of a QTIP trust.

In light of the above, when a decedent causes most or all of his estate to pass to his surviving spouse in a QTIP, the surviving spouse, rather than the decedent, is the transferor for GST purposes, and the decedent, without affirmative action, could lose his $1 million GST exemption.

To help ameliorate this problem, Sec. 2652(a)(3) allows the decedent's estate to elect to treat all of the property in a trust for which a QTIP election is made as if no QTIP election had been made. The effect of this so-called "reverse QTIP" election is to cause the decedent, rather than the surviving spouse, to be treated as the transferor of the QTIP property for GST purposes. The usefulness of this election is somewhat blunted, however, by the statutory requirement that it must be made with reference to the entire QTIP, rather than on a fractional basis.

In Letter Ruling 9101013, the taxpayer sought to preserve both the decedent's and the surviving spouse's GST exemption by having two identical QTIP trusts, rather than a single trust, established under the will. In allowing this technique, the IRS noted that the Senate Report to the Technical Corrections Bill of 1988 stated that "the executor's indication on a Federal estate tax return that separate QTIP trusts will be established will suffice to permit such trusts to be treated as separate trusts for purposes of [the reverse QTIP election under Sec. 2652(a)(3)]." As such, the IRS noted that it was sufficient to notify the Service, on the federal estate tax return, that either two trusts have been established for purposes of funding separate bequests under the will or that a single trust under the will has been split into two identical trusts. Presumably, the notification required on the federal estate tax return would be effective assuming either the instrument or local law would permit, in fact, the establishment of two identical trusts or the division of a single trust within the context of the instrument.

A similar result occurred in IRS Letter Ruling 9050022,(147) in which the executor sought to create two identical trusts out of a single trust established for a residuary marital bequest. The will permitted the fiduciary to divide the trust into two or more separate shares. This ruling differed from Letter Ruling 9101013 in that there was only a single source of funding with respect to the trust created in the instrument. The IRS concluded that such a division was appropriate, provided that the two trusts were identical in all respects with the single trust prior to division and that property transferred to the trusts would be fairly representative of the net appreciation and depreciation in the value of the property occurring between the date of death and the date of allocation.

Planning hints: These rulings provide ideal planning opportunities for the use of the reverse QTIP election when only a single QTIP trust has been established under the instrument. Estate planners should attempted to optimize the use of both spouses' $1 million GST exemption. These letter rulings indicate that the IRS will grant considerable latitude in the establishment of a specific QTIP-type trust that would hold sufficient assets to absorb the decedent's $1 million exemption.

Miscellaneous

The following miscellaneous income tax developments occurred.

* A grantor was taxable on trust income derived from the funds loaned to the trust by the grantor. * Predeath deferred gain was taxable to the decedent's estate because the will cancelled the installment obligation. * A direction to charge mortgage principal payments against accounting income was ignored in allocating a trust's depreciation deduction. * Tax on a second-tier partnership's potential gain under an executory contract was eliminated by Sec. 754 basis step-up elections.

* Trust funded by demand note held grantor trust In Kushner,(148) in 1981, the taxpayer established a trust for his children and conveyed $100 to it as corpus. During 1981, 1982 and 1983, the trustee entered into a series of transactions in which it borrowed substantial sums of money from the grantor in exchange for demand notes. Each year, the borrowed funds were invested by the trustee and the resulting interest accrued to the benefit of the income beneficiaries. At the end of each year, the principal amount was repaid and the demand note retired. During the three years, interest was reported on the trust returns and taxes paid. The Tax Court concluded that the trusts were grantor trusts and that the entire income was taxable to the grantor.

Critique: Sec. 674(a) provides that a grantor will be treated as the owner of any portion of a trust over which he or a nonadverse party possesses an independent power of disposition over the beneficial enjoyment of the corpus or income. The IRS argued, and the Tax Court agreed, that the taxpayer's demand note was equivalent to a power of disposition over the trust. Simply by exercising his right to demand payment, the grantor could remove from the trust virtually all of its assets, rendering it a virtual nullity. This ability to demand payment constituted direct dominion and control over the benecifical enjoyment of the trust corpus.

The Tax Court refused to entertain the taxpayer's assertion that LaFargue(149) should control. In LaFargue, the Ninth Circuit found that a grantor may also be a creditor of a trust, without grantor trust status being imposed. The court found that LaFargue was irrelevant since it addressed only whether amounts could be includible in the grantor's gross income by applying Sec. 677(a) and did not address the issue of dominion and control under Sec. 674(a).

Finally, the Tax Court concluded that substantial authority did not exist with respect to the taxpayer's assertion that the income of the trust should be taxable to the trust, rather than to the grantor. As such, a Sec. 6661(a) addition to tax was assessed.

The Tax Court's language in Kushner has a very acrimonious ring to it. Clearly, the court felt that the series of transactions were purely tax avoidance devices. In distinguishing the taxpayer's position as a creditor from that of the taxpayer in LaFargue, the court noted that the Ninth Circuit had modified the Tax Court's decision in LaFargue, which was in the IRS's favor. It was clear from the Tax Court's opinion in Kushner that it remains unconvinced of the Ninth Circuit's position and was happy to find a distinguishing feature.

* IRD resulting from note cancellation taxable to estate In IRS Letter Ruling 9108027,(150) at the time of the decedent's death, two promissory notes relating to the installment sale of a farm were outstanding. The gain on the sale was deferred under Sec. 453.

Under the decedent's will, both notes were to be cancelled and returned to the obligor as paid in full. The IRS ruled that taxable income resulted from the cancellation and that such income was taxable to the estate.

Critique: Sec. 691(a)(1) provides that items of income in respect of a decedent (IRD) will be taxable when received by (1) the decedent's estate, (2) a person who acquires the right to receive such property, provided such right is not first acquired by the decedent's estate or (3) the legatee or devisee who acquires it through a distribution from the decedent's estate. All other transfers of IRD property (i.e., sales, exchanges, gifts and other dispositions) will result in the triggering of the deferred income.

Sec. 691(a)(5)(A) further provides that deferred income will be triggered with respect to outstanding installment obligations when gain has been deferred under Sec. 453 or 453A, and the obligation is either cancelled or becomes unenforceable by reason of the death of the holder of the obligation. In Letter Ruling 9108027, the provision in the decedent's will cancelling the outstanding installment notes fell within the ambit of Sec. 691(a)(5)(A) and income was realized to the extent of the difference between their FMVs (or face amounts, if greater) and the decedent's remaining bases.

Sec. 661(a) specifies when deductions are available to an estate for distributions to a beneficiary. In general, amounts either required to be distributed or properly paid or credited to a beneficiary will be treated as a deduction by the trust and includible in the income of the beneficiary. However, Sec. 663(a) expressly provides that Sec. 661(a) will not apply to any amounts that are paid or credited as a gift or bequest of a specific sum of money or of specific property. The IRS concluded that the cancellation of the notes constituted a specific bequest within the meaning of Sec. 663(a). The estate realized income to the extent of deferred gain, but was not entitled to a distribution deduction. As a result, the residuary legatees bore the tax cost of the debt cancellation. This may or may not have been intended by the decedent.

* Trust instrument disregarded for purposes of depreciation allocation In Rev. Rul. 90-82,(151) the grantor established a trust and empowered the trustee to invest in real estate. Under the trust instrument, all income was distributable annually to the income beneficiary. However, both interest and principal payments on any real estate mortgage indebtedness were required to be treated as an income charge.

The trustee acquired real estate and incurred a mortgage. In its first full year of operation, the trust realized rental income of $140x and made interest and principal payments of $130x ($30x representing principal). The depreciation deduction for the first year was $40x. The IRS ruled that three-quarters of the depreciation should be allocated to the trust and one-quarter to the beneficiary.

Critique: Sec. 167(h) provides that, when a trustee does not maintain a depreciation reserve, annual depreciation is allocated between the trust and beneficiaries in the same proportion that trust income is allocated to each. Under this directive, it would initially appear that 100% of the depreciation is allocable to the income beneficiary.

However, the general rule of Sec. 167(h) is subject to the limiting provisions of Regs. Sec. 1.643(b)-1, which states that trust provisions that depart fundamentally from the concepts of local law in determining trust income are not recognized for federal income tax purposes. The regulation provides an example in which interest and dividends are allocable to principal. Under such circumstances, the trust is an accumulation trust for federal income tax purposes and is not to be treated as one requiring current distributions of income. In effect, the regulation provides that the required allocation of interest and dividends to principal is, for federal income tax purposes, equivalent to a mandatory direction that the trustee accumulate portions of taxable income.

As in the case of the above example, the IRS concluded that a similar treatment should be accorded a real estate mortgage when principal is required to be charged against trust accounting income. In that circumstance, rental income to the extent of principal payments is required to be reallocated away from the income beneficiary and accumulated for the benefit of the remainderman. This type of allocation is fundamentally at variance with the provisions contained in the Uniform Income and Principal Act and normal trust accounting rules. As such, for federal income tax purposes, the provision is merely deemed to be a mandatory accumulation of income.

In light of the above, for federal income tax purposes, the income of the trust would be determined as follows.

             Rental income      $140x
             Interest expense    100x
             Net trust income   $ 40x

Since only $10x of the $40x income for the year is distributed, the IRS concluded that one-quarter of the depreciation deduction should be allocable to the income beneficiary and the remaining three-quarters to the trust.

* Sec. 754 election available to second-tier partnership In IRS Letter Ruling 9102018,(152) the decedent was a partner in partnership GP1, which in turn was a partner in partnership GP2. Before the decedent's death, GP2 entered into an agreement for the sale of real estate. However, this sale was subject to various substantial conditions that remained outstanding as of the date of death. Shortly after death, most of the conditions were fulfilled and the sale was consummated.

The IRS ruled that the decedent's interest in the gain resulting from the sale of real property by GP2 was not IRD and that a Sec. 754 basis step-up was available with respect to GP2's underlying property.

Critique: Under the agreement, the sale closing was conditional on GP2's fulfilling certain conditions, including obtaining a permit from the Department of Environmental Protection of the appropriate state. On the date of the decedent's death, a number of conditions remained unfulfilled. After the death, the terms and conditions of the contract were satisfied and the sale was consummated.

Citing Sec. 706(c)(1), the IRS stated that, except in the case of a termination, a partnership's tax year does not close for federal income tax purposes as a result of a partner's death, the entry of a new partner or the liquidation of a partner's interest in the partnership. As such, the decedent's successor in interest would be required to pick up any income of GP2 occurring within the calendar year in which the decedent died. Further, Regs. Sec. 1.7061(c)(3)(v) indicates that a decedent's distributive share of partnership income required to be included in the gross income of a successor in interest will constitute IRD within the meaning of Sec. 691.

However, with very little discussion, the IRS concluded that the gain attributable to the sale was not sufficiently vested as of the date of death so as to constitute IRD. In fact, the executory contract for the sale had languished for a number of months and the inability of the partnership to satisfy certain significant restrictions had caused the agreement to temporarily lapse on one occasion. As such, the IRS ruled that the gain realized after the decedent's death did not represent IRD even though the sale occurred within the same calendar year in which the decedent died.

Finally, the IRS concluded that the decedent's estate received a Sec. 1014(a) basis step-up in its interest in GP1 and that a Sec. 754 election could be made with respect to the decedent's interest in GP1's underlying assets. Further, under Rev. Rul. 87-115,(153) the IRS ruled that the decedent's estate may request GP2, the lower-tier partnership, to elect under Sec. 754, in accordance with Regs. Sec. 1.754-1, to step up the basis of the real property held by that lower-tier partnership in the manner provided in Sec. 743. As a result, not only was the gain not IRD, but the Sec. 754 election could be made to eliminate any taxable gain on the sale, both with respect to the decedent and his estate.

(139)IRS Letter Ruling 9048049 (9/4/90). (140)IRS Letter Ruling (TAM) 9050005 (8/31/90). See also IRS Letter Ruling 9101027 (10/10/90). (141)IRS Letter Ruling (TAM) 9037004 (6/5/90). (142)IRS Letter Ruling 9033016 (5/18/90). (143)IRS Letter Ruling 9033047 (5/22/90). See also IRS Letter Ruling 9108013 (11/21/90). (144)IRS Letter Ruling 9109022 (11/30/90). (145)IRS Letter Ruling 9038037 (6/26/90). See also IRS Letter Ruling 9034031 (5/24/90). (146)IRS Letter Ruling 9101013 (10/5/90). (147)IRS Letter Ruling 9050022 (9/14/90). See also IRS Letter Ruling 9028005 (3/30/90). (148)Jack Kushner, TC Memo 1991-26. (149)Esther LaFargue, 689 F2d 845 (9th Cir. 1982)(50 AFTR2d 82-5944, 82-2 USTC [P] 9622). (150)IRS Letter Ruling 9108027 (11/26/90). (151)Rev. Rul. 90-82, 1990-2 CB 44. (152)IRS Letter Ruling 9102018 (10/12/90). (153)Rev. Rul. 87-115, 1987-2 CB 163.