Significant recent developments in estate planning.

EXECUTIVE SUMMARY

* The current phase-in and indexing of prior EGTRRA provisions will continue to affect estate planning,

* FLPs continue to be a hotbed of controversy--tax advisers need to assist clients in FLP management.

* The marital deduction may be protected by clearly stating the intent to qualify for it and including a savings clause in the trust document.

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This article examines recent developments in estate, trust and gift tax planning. It highlights recent cases and rulings on valuation, family limited partnerships, deductibility of administration expenses and qualified marital deduction trusts.

This article examines recent developments in estate, trust, gift and generation-skipping transfer taxes. It focuses on the current indexing and phase-in of prior-year legislative changes, court battles and rulings in significant areas (e.g., valuation, family limited partnerships (FLPs) and the marital deduction) and on other IRS guidance.

Legislative Developments

The estate and gift tax remains legislatively unchanged as the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) continues to phase in. All of the EGTRRA tax reduction provisions will expire at the end of 2010, because the Senate has been unable get the 60% vote needed to approve a permanent repeal. Little is likely to be done in this current election year, as the parties campaign. Most likely, the first year of the new presidential term will bring broad legislative changes.

EGTRRA Changes Taking Effect in 2004

QFOBI Deduction Disappears

The deduction for qualified family owned business interests (QFOBI) under Sec. 2057 was prospectively repealed, effective Jan 1. 2004.

Estate Tax Credit Decouples from Gift Tax

The estate tax credit equivalent increased to $1.5 million. However, the gift tax credit equivalent remains at $1 million. Although the tax tables are unified, the credits are not.

Estate and Gift Tax Rates

The estate and gift tax rates continue to "flatten out." The top marginal tax rate for both of these taxes was reduced for individuals dying in 2003 to 48%. Effectively, there are four brackets for the gift tax and two brackets for the estate tax:

Threshold amount     Rate
$1,000,000            41%
$1,250,000            43%
$1,500,000            45%
$2,000,000 or more    48%

Federal SDTC

The Federal state death tax credit (SDTC) was reduced from 50% to 25%. In 2005, it will disappear completely, and a deduction for death taxes paid to the state will replace it.

States Decouple from the Estate Tax

Prior to the EGTRRA, over 40 states based their death tax on the Federal SDTC. As the Federal phase-out of the SDTC leaves these states without a death tax, 19 jurisdictions had, by October 2003, either decoupled their "pick-up" tax from the SDTC or fixed their estate tax at a level to avoid the phase--out. The jurisdictions include: Illinois, Kansas, Maine, Maryland, Massachusetts, Minnesota, Nebraska, New Jersey, New York, North Carolina, Oregon, Pennsylvania, Rhode Island, Vermont, Virginia, Washington, West Virginia, Wisconsin and the District of Columbia. (1)

Today's wealthy individuals have numerous multistate real estate holdings (e.g., homes, vacation properties, residential and commercial rental properties, etc). The proliferation of separate state taxes will add complexity to the estate planning process.

Annual Inflation Adjustments

Each year since 1997, the IRS has been required to adjust various income, gift and estate tax exclusions and brackets for inflation. Rev. Proc. 2003-85 (2) contains the adjustments for 2004. Among the items of interest to advisers focusing on estate and gift taxes are the following.

Gift Tax Annual Exclusion

The Sec. 2503(b) gift tax annual exclusion remains at $11,000 per person per year for 2004. The adjustment is in $1,000 increments as needed to reflect inflation.

Exclusion for Transfers to Noncitizen Spouses

Noncitizen spouses are ineligible to receive unlimited property transfers under either Sec. 2523 or 2056--the gift and estate tax marital deduction provisions. They are eligible for an annual gift exclusion historically limited to $100,000, under Sec. 2523 (i). Effective Jan. 1, 2004, that exclusion increased to $114,000.

GST Exemption

The GST exemption increased to $1.5 million in 2004, surpassing and replacing the indexed amount.

Special--Use Valuation

Under Sec. 2032A, an executor may elect to value real property used in a farm or business on the basis of actual, rather than highest and best, use. The maximum allowable deduction was set at $750,000; indexing for 2004 increased it to $850,000. (3)

Tax Deferral for Closely Held Business

The applicable portion of the estate tax payable in installments and subject to the Sec. 6601(j) 2% interest rate increased to $1.140 million.

Receipt of Large Foreign Gifts

For tax years beginning in 2004, recipients of gifts from certain foreign persons may have to report them under Sec. 6039F if the aggregate value of the gifts received in a tax year exceeds $12,097.

Significant Rulings and Cases

Although numerous cases were decided during last year, this article focuses on four significant areas: valuation, FLPs, deductibility of estate administration expenses and qualification of trusts for the marital deduction.

Valuation

The valuation of closely held stock and state lottery payments continues to be controversial.

Stock: Discounts are generally available when valuing the stock of closely held companies, but which events may be considered in the valuation? In Okerlund, (4) the taxpayers--the four children of the founder of a $2 billion ice cream manufacturer and frozen foods producer--attempted to factor various industrial risks into a valuation. The founder died unexpectedly and left his stock to a charitable foundation. The corporation had a redemption agreement that allowed it to purchase shares from the foundation. The children created trusts for the benefit of the founder's grandchildren and funded them with gifts of stock they owned. The stock was valued at a 45% discount; based on this valuation, each child paid less than $300 of gift tax. The Service challenged the valuation, because it reflected industrial risk factors (i.e., for possible salmonella contamination). The Federal Circuit refused to allow the market risks and subsequent events, stating that they lacked "relevance." As a result, each child paid only $3,000 of additional tax.

The case is interesting from two perspectives. First, the risk of salmonella contamination that the valuation expert reflected in its appraisal coincidentally later struck the taxpayer's business. Second, the fact that the controversy centered on such modest gifts is curious--it is surprising this case was not settled before trial.

Lottery payments: The valuation of lottery payments similar to commercial annuities continues to be a strange source of controversy. In Cook, (5) the Fifth Circuit affirmed the Tax Court's ruling that a decedent's right to receive lottery payments was a private annuity and, thus, should be valued under the Sec. 7520 tables. The decision was based on the court's conclusion that marketability restrictions, per se, did not justify departure from valuation under the tables; rather, the value produced under such tables was not so unreasonable or unrealistic as to warrant a different valuation method. This decision sets up a controversy that could move up to the Supreme Court, because it is in direct opposition to prior decisions of the Second Circuit in Gribauskas (6) and the Ninth Circuit in Shackleford. (7)

In Gribauskas, the Second Circuit reversed and remanded a Tax Court decision, finding that the remaining installments of a state lottery prize were subject to transferability restrictions and should be valued in the estate of a deceased winner without regard to the actuarial tables for valuation of annuities, when the restrictions resulted in a lower market value. According to the Second Circuit, "[t]he governing principle is that a departure is allowed if the tables produce a substantially unrealistic and unreasonable result." In reversing the Tax Court, the court held that nonassignable lottery winnings for estate tax purposes need not be valued solely by reference to the Sec. 7520 tables; rather, the valuation may he reduced due to lack of marketability.

Further, in Shackleford, the Ninth Circuit previously affirmed the holding of a California district court, in which departure from the Sec. 7520 tables to value lottery winnings for estate tax purposes was warranted, because state law prohibited assignment of lottery payments. The Ninth Circuit allowed a lack of marketability discount in valuing such payments. By holding in Cook that the payments should be valued under the Sec. 7520 tables, the Fifth Circuit did not follow the Second and Ninth Circuits.

FLPs

After years of trying to advance numerous unsuccessful strategies, the IRS's challenge of FLPs seems to firmly center on Sec. 2036(a). Several cases decided in 2003, including Kimbell (8) and Strangi, (9) applied that provision to FLPs. (10)

However, 2004 brings an apparent taxpayer victory. On May 20, 2004, the Fifth Circuit reversed (11) the district court's decision in Kimbell that FLP assets were includible in the taxpayer's estate under Sec. 2036, by holding that the full and adequate consideration exception in Sec. 2036(a) may be applicable to family situations. The Tax Court had summarily rejected the notion that family members could enter into a bona fide sale. The court of appeals, in reaching its decision, focused on "objective facts," which looked at the FLP's business purpose and operational aspects. In Strangi, the parties also appealed to the Fifth Circuit. However, they postponed oral argument until the court handed down its decision in Kimbell.

In Stone, (12) another taxpayer victory on Sec. 2036, the Tax Court held that none of the petitioners' assets transferred to FLPs were includible in the taxpayers' estates under Sec. 2036(a)(1), because the transfers were bona fide sales for adequate and full consideration. The court distinguished the case from previous Sec. 2036 cases, because the transfers were primarily motivated by business and investment issues relating to the petitioners during their lives, as well as by a desire to resolve their children's litigation. The taxpayers' children actively participated in the FLPs during their parents' lives, the transfers were part of active negotiations between the generations and the taxpayers retained sufficient assets to maintain their lifestyle. In addition, the transfers were in exchange for a pro-rata FLP interest, not gifts, and were motivated by investment, business and management concerns. As a result, the court found no recycling of value and determined that the transfers were bona fide sales.

Two additional Tax Court memorandum decisions, Hillgren (13) and Abraham, (14) were handed down in 2004, but neither added much to the debate. Both involved bad facts in which the IRS easily argued that the FLPs were testamentary vehicles created shortly before death with substantially all of the decedent's assets.

Planning: Where does that leave tax advisers? There are at least three possible scenarios. First, if the "full and adequate consideration" exception is available to avoid Sec. 2036, proper structuring at inception should preserve FLPs' usefulness. Second, if the battleground is Sec. 2036(a)(2), then the legal community will need to prove that the FLP (and closely held business entities in general) can withstand IRS attack. Due to the implications for other closely held business entities, it would appear to be a stretch for the IRS to prevail under that section.

Finally, if Sec. 2036(a)(1) is the battleground, then tax advisers will be caught in the crossfire. Sec. 2036(a)(1) involves a facts-and-circumstances determination. Clearly, as seen in Strangi, last-minute measures will not save a poorly conceived and/or operated FLP. Nonetheless, the message seems to be clear--"watch the formalities."

The Chair of the FLP Operations Checklist Working Group of the AICPA Tax Division's Trust, Estate, and Gift Tax TRP prepared a "checklist of issues to consider in yearly administration of family limited partnerships." (15) See Exhibit 1 at right for some specific Do's and Don'ts.

Exhibit 1: Do's and Don'ts of FLP
Administration

DO:

* Maintain a business purpose.

* Respect all fiduciary duties.

* Try to hold business assets, such as real estate.

* Maintain adequate business records, such as a
general ledger.

* Consider having regular meetings, with minutes.

* Pay fair market value far the use of any
partnership assets.

* Make all regular distributions called for by the
agreement.

DON'T:

* Commingle partnership and personal assets.

* Hold personal-use assets in the partnership.

* Make distributions that benefit the transferor
more than the other partners.

Administration Expenses

Interest incurred by an executor during FLP administration may generally be deducted on either the estate tax return, Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, or the fiduciary income tax return, Form 1041, U.S. Income Tax Return for Estates and Trusts. Because the estate tax rate is usually higher, the executor may choose between the two, but the IRS can challenge the determination.

Two recent cases addressed the deductibility of interest incurred during estate administration. In Turner, (16) a will directed an executor to pay a large bequest to a charity; however, the executor insisted that the organization prove its exempt status before making the distribution. State law required that interest be paid on any deferred payment of a bequest. The Service challenged the estate tax deductibility of interest, insisting that the taxpayer should have deducted the interest on the income tax return. The district court stated that it was reasonable for the executor to get proof before payment; it deemed the expense reasonable and necessary.

An estate tax return is due within nine months of a decedent's death. Because of timing problems, interest incurred on loans likely to be out standing for long periods may be suspect. Thus, the Service hesitates to allow estate tax deductions for the present value of interest that may never be paid. A state court case (17) provides an excellent example of how to structure acceptable loans. A decedent's estate was worth more than $300 million; the estate tax liability was more than $200 million. The trustee of the living trust needed to borrow $49 million from a third party to pay the tax. The loan was zero--coupon, bearing interest at 8.75% and due in 2027. Prepayment of the loan was prohibited. The trustee disclosed in state court that it had successfully negotiated an estate tax deduction with the IRS for the interest to be paid over the life of the loan.

Marital Deduction

The deduction for interests passing to a spouse can be relatively complicated. A couple of recent rulings shed some light on potential issues and problems in dealing with trusts attempting to qualify for this deduction.

QTIP election: In a letter ruling, (18) the Service held that an extension to file a qualified terminable interest property (QTIP) election for later-discovered assets is not necessary when those assets pass to a marital trust for which the election had previously been made. A decedent and his spouse each created a trust for each is own benefit; the decedent transferred one of two parcels of real estate to his wife's trust. The parcel remaining in the decedent's name was not discovered or transferred until after his estate tax return was fried. The funding formula in the decedent's will and trust distributed the newly discovered parcel to a marital trust. Because the executor elected under Sec. 2056(b)(7) to treat the marital trust assets as QTIP, the later-discovered asset, which passed through the decedent's will to the marital trust, was also considered QTIP property and, accordingly, was also subject to Sec. 2044 in the surviving spouse's estate. The Service held that it was not necessary to seek Sec. 9100 relief for a late QTIP election, because the election made on the timely filed return applied to all assets owned at death and passing to the marital trust.

The ruling is indicative of file IRS's and the courts' willingness generally to allow a marital deduction when a taxpayer clearly attempted to comply. In a recent Tax Court case, (19) the taxpayer hired "expert counsel" to create an estate plan with a QTIP marital trust. The document stated that the marital trust portion was intended to qualify for the marital deduction. The tax adviser, however, included a provision that would have allowed the trustee to accumulate income during any period in which the surviving spouse was disabled. The accumulation power would violate the provision of Sec. 2056 that "requires" income to be distributed. The court acknowledged the trust's conflicting terms and ignored the restriction.

Savings clauses: The marital deduction generally applies to trusts that hold income-producing assets and requires the trustee to distribute all of the income each year. Unproductive (non-income-producing) assets can be problematic. The Service will generally permit unproductive assets to be held as part of a marital trust if the spouse can force the trustee to sell such assets and convert the proceeds into income-producing property. Attorneys usually attempt to cover this situation by including a "savings clause" in the marital trust language.

For example, in another ruling, (20) the estate planning documents contained a marital savings clause that allowed a trustee to retain an otherwise non-income-producing asset as long as the spouse was given the ability to make the asset income-producing. The decedent's estate plan created a marital trust funded in part with stock that, to date, had never paid a dividend. The trust included a clause that the decedent intended to retain the stock, and that disposition was authorized only under very limited circumstances. The Service looked to Regs. Sec. 20.2056(b)-5(f)(4), which provides that a trustee's power to retain unproductive property will not disqualify a spouse's life income interest if a trust's administrative provisions permit the spouse to require the trustee to either make the property productive or convert it into productive property within a reasonable time.

The ruling differs from the facts of two recent Tax Court memorandum decisions, (21) in which a spouse did riot have the right to all of the income. In Aronson, (22) the Tax Court denied the estate a marital deduction for a testamentary trust, because the widow was only entitled to "as much income from such assets as she needs," as opposed to "all of the income from the property," as required by the statute. Moreover, she was not the sole individual beneficiary for life, as required by the Sec. 2056(b)(7) QTIP provisions, and, there was no evidence in the will that the decedent intended the trust to quality for the marital deduction. The court refused to give effect to a 1998 surrogate court decision to reform the will so that it would qualify for the marital deduction, because that decision (1) was based on incorrect information supplied by the decedent's grandson, (2) made substantial changes in the decedent's 1993 will and (3) was rendered by consent.

Similarly, in Davis, (23) the Tax Court held that a widow's right to income from a trust was limited under the trust terms (i.e., "usual and customary standard of living" is much more restrictive than "best interests"). The court held that the widow had nothing equivalent to an ownership right to an income interest in the trust. Perhaps most damning, the trust agreement did not refer to the marital deduction or to Sec. 2056. The usual and customary standard might have been sufficient had the widow been the only named trustee, but she was not. Thus, the decedent's transfer did not qualify for the Sec. 2056(b)(5) marital deduction. Because the surviving spouse's income interest failed under Sec. 205600) (5), it likewise failed to qualify under Sec. 2056(b)(7). (24)

Conclusion

Estate planning for the balance of 2004 promises more of the same. No legislative changes are expected in the Federal arena, while more and more states will surely decouple the pick-up tax.

Housekeeping should be the major focus of estate planners who deal with FLPs. Practitioners should interject themselves into the FLP recordkeeping process. Clients need to be encouraged to consult with tax advisers before making partnership distributions and before paying extra ordinary or personal expenses out of a partnership. If unmarried elderly clients own or control the general partnership interest of a FLP, consideration should be given to terminating the FLP or transferring the general partnership interest more than three years before death. Holding a controlling general partnership interest at death could lead to a successful IRS challenge under Sec. 2036 and cause all of the partnership assets to be included without valuation discounts.

(1) For a complete list and discussion, see Godfrey, "The Phaseout of the Federal State Death Tax Credit (Part II)," 34 The Tax Adviser 148 (March 2004).

(2) Rev. Proc. 2003-85, IRB 2003-49, 1184.

(3) For details on Sec. 2032A, see Zupanc, Guamnitz and Guamnitz, "The Intricacies of Special-Use Valuation," 34 The Tax Adviser 434 (July 2004).

(4) Jeffrey Okerlund, 365 F3d 1044 (Fed. Cir. 2004).

(5) Gladys J. Cook, 349 F3d 850 (5th Cir. 2003).

(6) Est. of Paul C. Gribauskas, 342 F3d 85 (2d Cir. 2003).

(7) Rosa Shackleford, 262 F3d 1028 (9th Cir. 2001).

(8) David A. Kimbell, 244 FSupp2d 700 (ND TX 2003), rev'd, 5th Cir., 5/20/04.

(9) Est. of Albert Strangi, TC Memo 2003 145.

(10) See Whitlock "Significant Recent Developments in Estate Planning," 34 The Tax Adviser 548 (September 2003).

(11) Kimbell, note 8, supra,

(12) Est. of Eugene Stone, TC Memo 2003-309.

(13) Est. of Lea Hillgren, TC Memo 2004-46.

(14) Est. of Ida Abraham, TC Memo 2004-39.

(15) The Checklist is available at www.cpa2biz.com/ResourceCenters/Tax/ Estate%2c+ Gift%2c+Trust%2c+Fiduciary/default.htm.

(16) Betsy Turner, 306 FSupp2d 668 (ND TX 2004).

(17) Conrad Klein v. Alexander Hughes, CA Court of App., 1st App. Dist., Div. 3, Case A103940 (4/20/04).

(18) IRS Letter Ruling 200336014 (9/5/03).

(19) Est. of Merle Whiting, TC Memo 2004-68.

(20) IRS Letter Ruling (TAM) 200339003 (5/7/03).

(21) Est. of Charles Aronson, TC Memo 2003-189 and Est. of Ralph Davis, TC Memo 2003-55.

(22) Est. of Charles Aronson, note 21 supra.

(23) Est. of Ralph Davis, note 21 supra.

(24) See Regs. Sec. 20.2056(b)-7(d)(2).

For more information about this article, contact Mr. Whitlock at [phone] or [e-mail].