Significant recent developments in estate planning.

The estate planning area continues to be a "hotbed" of IRS activity. During the period Sept. 1, 1996 through Apr. 30, 1997, significant developments occurred in the areas of charitable gifts, Chapter 14, entity discounts and deduction of estate administration expenses.

This article is presented to assist estate planning professionals attempting to stay abreast of these and other controversial developments in the estate planning area. The article begins by examining the period's most significant items, followed by highlights of additional court decisions and IRS rulings, regulatory developments and other authoritative pronouncements.

Highlights

The period's highlights included:

* The release of proposed regulations terminating the viability of the short-term charitable remainder trust (CRT) as a capital gains elimination technique, and publication of the IRS's position on built-in gains on assets contributed to a CRT.(1) However, the proposed regulations now allow "flip" CRTs that meet imposed requirements.

* A technical advice memorandum (TAM) officially reversed the IRS's previous ruling that a spouse's revocable interest in a grantor retained annuity trust (GRAT) is not a "qualified interest."

* The Supreme Court issued a long-awaited, pro-taxpayer decision on administration expenses that guarantees additional litigation.

* A TAM set forth the IRS's position on the availability of discounts for interests in family limited partnerships (FLPs).

CRT Prop. Regs.

Generally, a CRT provides for a specified periodic distribution to one or more noncharitable beneficiaries for life or a term of years, coupled with an irrevocable remainder interest held for the benefit of charity. If the CRT has no unrelated business taxable income (UBTI), it is exempt from income tax.

Sec. 664(d) specifies two types of CRTs: a charitable remainder annuity trust (CRAT) pays a sum certain at least annually to one or more noncharitable beneficiaries; a charitable remainder unitrust (CRUT) pays a fixed percentage of the net fair market value (FMV) of the trust's assets valued annually (the fixed percentage method) to one or more noncharitable beneficiaries. Alternatively, a CRUT may be structured to pay the lesser of (1) the fixed percentage method amount or (2) the trust's net income (the net income method). The unitrust amount could also be the amount determined under the fixed percentage method, plus (to the extent trust income exceeds the current year's fixed percentage), the unitrust amount can be increased to "make up" for any shortfall in distributions from prior years when trust income was less than the fixed percentage amount (the net income with makeup charitable remainder trust (NIMCRUT) method).

The proposed regulations attempt to clarify issues and halt use of various techniques deemed abusive. The proposed regulations address (1) flip CRUTs; (2) the timing of the CRAT or CRUT payment; (3) appraisals for "unmarketable assets" (i.e., assets that are not cash, cash equivalents or marketable securities); (4) the application of Sec. 2702; and (5) the allocation of an asset's precontribution gain between CRT principal and income.

Flip CRUTs: Prop. Regs. Sec. 1.664-3(c) sanctions the use of "flip" CRUTs under certain conditions. A flip CRUT is a CRUT initially structured as a NIMCRUT, but that later becomes a fixed percentage method CRUT. Prop. Regs. Secs. 1.664-3(c)(1)-(4) allow donors to use flip CRUTs, if all of the following are met: 1. At least 90% of the FMV of the assets held in the trust immediately after the initial contribution (or any subsequent contribution) consists of "unmarketable assets." 2. The governing instrument provides that the change in method will be triggered on the earlier of (a) the sale or exchange of a specified unmarketable asset or group of assets initially contributed to the CRUT or (b) the sale or exchange of unmarketable assets if, immediately after the sale or exchange, the FMV of remaining CRUT assets is 50% or less of the FMV of all CRUT assets. 3. After flipping, the CRUT will use only the fixed percentage method of calculating all remaining unitrust payments. 4. Any remaining makeup amount (as described in Sec. 664(d)(3)(B)) will be forfeited as of the beginning of the next trust year.

An amendment procedure is provided for flip trust agreements that do not contain these provisions. According to Prop. Regs. Sec. 1.664-3(f)(iv)(b), these rules are effective for CRUTs created on or after the date final regulations are published in the Federal Register.

Timing of CRAt/CRUT payment: Under Regs. Secs. 1.664-2 and -3, for administrative convenience, a trustee must pay a CRUT or CRAT amount within a reasonable period following the close of the trust's tax year. Prop. Regs. Secs. 1.664-2(a)(1)(i) and -3(a)(1)(i) require that such amount determined under the fixed percentage method be paid by the close of the tax year in which due. These rules are proposed to be effective for tax years ending after Apr. 18, 1997. Nevertheless, the IRS will continue to challenge the purported tax consequences of accelerated CRUTs, as described in Notice 94-78.(2)

The requirement that payment be made by the end of the CRT's tax year effectively eliminates the viability of the accelerated, CRT technique. Under the income ordering rules, if highly appreciated property is transferred to a CRT in year 1 and sold at the beginning of year 2, a payment to the donor in year 2 in satisfaction of the CRT's first-year obligation does not consist of any capital gain generated by the sale of the asset (because the capital gain did not occur until year 2). Thus, if the payout percentage is set at an extremely high level (e.g., 90%), and the trust term is short (e.g., two years), the vast majority of capital gain realized on the CRT's sale of an appreciated asset will never be recognized. This planning opportunity is eliminated by Prop. Regs. Secs. 1.664-2(a)(1)(i)`s and -3(a)(1)(i)'s requirement that the payment be made by the close of the tax year in which due.

Although the new timing requirement is an effective method of ensuring that a CRT donor is taxed on the trust's capital gains, it is administratively unworkable. The preamble to the proposed regulations states that "[t]hese proposed amendments should not require the amendment or reformation of governing instruments of existing [CRTs]...[t]he trustees of such trusts can comply with the proposed regulations by actually paying the annuity or unitrust amount within the time permitted by the proposed amendments." In the case of many CRUTs, this statement is naive. If a CRUT's valuation date is the last business day of its year, as a practical matter, it is impossible for the trustee to pay the CRUT amount prior to the end of the year. Thus, the IRS and Treasury will be forced to reconsider this requirement, or to provide a reformation procedure for existing CRUTs with year-end valuation dates.

Appraising unmarketable assets: Prop. Pegs. Sec. 1.664-1 (a)(7) provides that if a CRT holds unmarketable assets and the trustee is the CRT's grantor, a noncharitable beneficiary, or a related or subordinate party to the grantor or the noncharitable beneficiary, the trustee must use a current qualified appraisal from a qualified appraiser to value those assets. Arguably, this rule is supported by congressional intent as indicated in the legislative history accompanying Sec. 664.(3) The provision is proposed to be effective for trusts created on or after the date final regulations are published in the Federal Register.

Application of Sec. 2702: Currently, Sec. 2702 does not apply to CRUTs or CRATs. Sec. 2702 provides special rules to determine the value of a gift when an individual makes a transfer in trust to or for the benefit of a family member, and the donor or donee retains an interest in the trust.(4) Prop. Regs. Sec. 25.2702-1 (a)(3)(i) provides that the unitrust interest in a NIMCRUT retained by the donor or any applicable family member will be valued at zero if someone other than the donor and/or the donor's spouse is a noncharitable beneficiary of the trust.

As a result, if someone other than the donor or the donor's spouse receives a unitrust interest in the NIMCRUT, the value of such interest received (i.e., the donor's gift to the interest holder) will be the FMV of all the property transferred to the CRUT, less the value of the remainder interest that will be transferred to charity. Thus, for gift tax purposes, the value of the interest retained by the donor or his spouse is zero. This provision is proposed to be effective for transfers in trust made on or after May 19, 1997.

No allocation of precontribution gain to trust income: Prop. Regs. Sec. 1.664-3(a)(1)(i)(b)(3) clarifies that the proceeds from the sale or exchange of assets contributed to a NIMCRUT by the donor must be allocated to principal and not to trust income, at least to the extent of the FMV of those assets on the date of contribution. In addition, the preamble to the proposed regulations indicates that, for sales and exchanges occurring prior to the effective date (Apr. 18, 1997), the IRS will continue to challenge any attempt to allocate precontribution gain to trust income as being fundamentally inconsistent with applicable local law and with the charitable deduction claimed.

However, the proposed regulations do not explicitly require that a NIMCRUT's contingent liability generated by previously unpaid unitrust amounts (because trust income was less than the required unitrust payment) be taken into account when calculating a unitrust amount. In previous rulings,(5) the Service had required the liability to be taken into account in performing the calculation.

Spouse's Revocable GRAT Interest

The Service ruled in Letter Ruling (TAM) 9707001(6) that a spouse's revocable contingent right to receive annuity payments in a GRAT is not a qualified interest for Sec. 2702(b) purposes; thus, the interest is valued at zero in determining the gift to the remainder beneficiaries. TAM 9707001 appears to mark a change in the Service's previous position on valuing revocable contingent spousal interests.

In the TAM, a grantor created a trust funded with cash. For each of five years, the trustees were to pay to the grantor an annuity equal to a specified percentage of the initial FMV of the property transferred to the trust; if the grantor died within the five-year term, the remaining annuity payments were to be made to his spouse. The grantor retained the right to revoke the spouse's interest.

In the event of such revocation, or if the spouse predeceased the grantor or survived him but died prior to the expiration of the trust term, any remaining annuity payments were to be paid to the grantor's estate for the balance of the five-year term. At the end of the trust term, the remaining trust principal would be distributed to individual trusts for the benefit of the grantor's descendants.

The Service ruled that the spouse's contingent right to receive annuity payments, commencing only if the grantor died prior to the expiration of the five-year term, is the same as the contingent interest considered in Regs. Sec. 25.2702-3(e), Examples 5 and 6. Accordingly, the Service held in TAM 9707001 that the spouse's revocable contingent interest was not a qualified interest for Sec. 2702(b) purposes, because it was unclear at the time the GRAT was established if the spouse's interest would ever take effect. As a result, the Service valued the contingent interest at zero in determining the value of the gift generated when the GRAT was established.

From 1993 through October 1994, the Service issued several favorable letter rulings dealing with irrevocable contingent spousal interests.(7) These rulings generally involved GRATs that provided the grantor's spouse with a revocable contingent right to an annuity payment (because it took effect only if the grantor died during the trust term). In each case, the Service ruled such an interest to be a qualified annuity interest. As a result, the taxpayers could use the two-life tables in valuing the GRAT retained interest. In late 1994, the Service suspended the issuance of further rulings pending the completion of a study on the issue. The Service has not yet revoked or modified the outstanding rulings.

Regs. Sec. 25.2512-5(d)(2) provides that when a donor transfers property in trust and retains an interest therein, the gift is the value of the property transferred less the value of the donor's retained interest. However, if the transfer is made to or for the benefit of a family member, the gifts value is determined under Sec. 2702. Under Sec. 2702(a)(2)(A), if a retained interest is not a "qualified interest," its value is zero. As a result, the gift to the family member is the entire value of the transferred property, despite the donor's retained interest.

Regs. Sec. 25.2702-2(a)(5) provides that the transferor's retention of a power to revoke his spouse's qualified annuity (or unitrust) interest is treated as the transferor's retention of such interest. Implicitly, then, if a grantor's spouse is given a revocable qualified annuity interest and the grantor retains the right to revoke, the value of the interest should be taken into account in determining the gift when the GRAT is funded. Support for this conclusion is contained in Regs. Sec. 25.2702-2(d), Examples 6 and 7, in addition to the rulings cited above.

In Regs. Sec. 25.2702-2(d), Example 6, a grantor retains a 10-year income interest in a trust, and grants his spouse a revocable 10-year income interest in the trust after his death. The facts are the same in Example 7, except that both the term interest retained by the grantor and the revocable interest transferred to the spouse are qualified annuity or unitrust interests. The amount of the gift in each example is the FMV of the property transferred to the trust, reduced by the value of both the grantor's qualified interest and the value of the qualified interest transferred to the spouse (subject to the grantor's power to revoke).

Clearly, the implication of these examples and of Regs. Sec. 25.2512-5(d)(2) is that an annuity interest in a GRAT granted to the transferor's spouse after the transferor's death and subject to revocation by the transferor can be a qualified annuity interest for Sec. 2702 purposes. (If not, Example 7's conclusion that the grantor's power to revoke is a qualified interest cannot be correct.) The only distinction between the facts in TAM 9707001 and Regs. Sec. 25.2702-2(d), Examples 6 and 7, is that in the latter, the spouse's interest is subsequent to, rather than concurrent with, the grantor's.

The Service's position in TAM 9707001 is that because the spouse's right to the annuity payment is contingent on the grantor dying prior to the end of the trust term, the annuity interest is not "fixed and ascertainable"; consequently, it is not a qualified annuity interest and so is valued at zero. In addition, while not directly stating, the Service appears to be basing its decision on the fact that the spouse's annuity interest is not for a fixed term. Because the spouse's right to an annuity payment begins only if the grantor dies during the trust term, there is no guaranteed starting point for the annuity; in fact, the spouse will not receive any annuity payments if the grantor survives the trust term. Basing the ruling on the fact that the annuity term is not fixed appears to have some merit; however, the Service's position does not comport with the Sec. 2702 regulations.

The regulations do not address a revocable spousal interest that is not subsequent to the grantor's retained term.(8) However, as was discussed, Regs. Sec. 25.2702-2(a)(5) states that a power to revoke a qualified annuity (or unitrust) interest of the transferor's spouse is treated as the retention of such interest; this implies that the spouse's interest must meet the definition of a qualified interest, even though it is a contingent interest (because it is revocable). Thus, the Service's objection to the interest examined in TAM 9707001 cannot be because it is contingent.

While the length of the spouse's annuity interest is fixed in the examples, it is still contingent on the spouse surviving, the grantor and his retained trust term. Nevertheless, Regs. Sec. 25.2702-2(d)(2), Example 7, concludes that the spouse's revocable interest is a qualified interest. Thus, the examples provide continued support for the position that the term does not have to be fixed in the case of revocable spousal interests; as a result, such interests should continue to be qualified annuity interests under the regulations, regardless of the Service's position in TAM 9707001.

Hubert

In a muddled plurality (4-3-2) opinion that settles little, the Supreme Court affirmed the Tax Court's and Eleventh Circuit's decisions in Est. of Hubert.(9) The Court held that the estate did not have to reduce its marital or charitable deduction by the administrative expenses paid from income generated by assets allocated to those bequests. However, the issue is far from settled for future taxpayers.

In Hubert the executors used the date-of-death valuation for property included in the gross estate. The marital (Sec. 2056) and charitable (Sec. 2055) deductions are allowed only to the extent of "value." The Supreme Court considered whether the executors were required, for valuation purposes, to take into account the fact that income generated during estate administration by assets allocated to the marital and charitable bequests was expected to be used to pay administration expenses.

A divided Tax Court had ruled in favor of the estate, holding that the marital and charitable deductions. need not be reduced by the administration expenses allocated to income, and the Eleventh Circuit affirmed.

The Supreme Court noted first that the only question before it was one of valuation. In the Court's view, only "material limitations" on the right to receive income are taken into account when valuing the property interest passing to the surviving spouse; under Regs. Sec. 20.2056(b)-4(a), a provision requiring or allowing administration expenses to be paid from income "may" be deemed a "material limitation" on the spouse's right to income.

A plurality (Rehnquist, Kennedy, Stevens and Ginsburg) agreed that, based on the facts presented, the trustee's discretion under state law (Georgia) to pay administration expenses out of income was not a material limitation on the right to receive income. Based on the legislative history and regulations, Kennedy wrote that, "[w]hen income is used, consistent with state law and the will, to pay administrative expenses, this does not require that the estate tax deductions be diminished." However, the plurality decision is ripe for a revisit if and when the Service revises its litigation strategy.

In a concurrence, Justice O'Connor admitted her "reluctance" in finding that a $1.5 million diminution in postmortem income was immaterial. She was willing to join the plurality decision only because she found that the Tax Court was "effectively preempted from making [a finding that the limitation was material] by the Commissioner's litigation strategy," because "the Commissioner elected to marshall all her resources behind the proposition that any diversion of postmortem income was material, and never presented any evidence or argued that $1.5 million was quantitatively material." (Emphasis in original.) Given the Service's burden to prove materiality(10) and its failure to press that issue, Justice O'Connor found the Tax Court's hands had been tied.

Taxpayers should be wary of finding comfort in Hubert, given the fragility of the coalition that adopted the opinion, the scathing dissent written by Justice Scalia,(11) Justice O'Connor's concurrence, and the Service's likelihood of adopting the litigation blueprint set forth therein.

Service Attacks FLP Discounts

In Letter Ruling (TAM) 9719006,(12) the Service ruled that a FLP should be ignored f(;r estate tax valuation purposes and that related partnership transactions should be regarded as a single testamentary transfer. The Service used the extremely bad facts of the TAM to support alternative taxpayer-unfavorable positions with respect to discounts. While the TAM's facts are extreme, its conclusion requires every practitioner to reevaluate the risk inherent in implementing a FLP as part of a client's estate plan.

In the TAM, the decedent held assets in a revocable trust and was the beneficiary of a marital trust in which she had a general power of appointment. One or more of the decedent's children were trustees of these trusts. The assets in both trusts consisted of marketable securities and real estate. Under the terms of each trust, the decedent's two children would each receive one-half of the assets at her death.

Two days before the decedent's death, a FLP was formed, with each of the children contributing cash in exchange for a 1% general partnership interest; the two trusts contributed marketable securities and land in exchange for limited partnership interests. The marital trust then transferred two 30% limited partnership interests (one to each of the decedent's children) for $10,000 cash and a 30-year, interest-bearing promissory note. After the decedent's death, the estate contended that while the two trusts had contributed assets valued at over $2.2 million to the FLP, their partnership interests should be valued for estate tax purposes, only two days after the FLP was formed, at $1.7 million (a 48% discount). The Service set forth two alternate positions in disallowing the discounts.

Relying on Est. of Murphy,(13) the Service ruled that the entire transaction lacked economic substance and should be viewed as a single testamentary transaction occurring at the decedent's death. Accordingly, the Service disregarded the decrease in value of the trust-held assets resulting from the creation of the partnership. Alternatively, the Service stated that Sec. 2703(a)(2) applied; as a result, the partnership was treated as created at the decedent's death, with the property passing from the decedent viewed as the underlying partnership assets, subject to the partnership agreement. Consequently, the Service ruled that the assets' value should be determined without regard to the partnership agreement.

In Murphy, prior to death the decedent held a controlling interest in a closely held corporation through a marital trust; the interest was subject to the decedent's general power of appointment. The decedent exercised the power of appointment 18 days before her death and transferred enough stock to her children to leave a minority interest in the trust. The decedent's estate claimed a minority discount in valuing the trust assets. The Tax Court refused to allow the discount, concluding that the sole purpose of the inter vivos transfer was to reduce estate tax and that the transaction lacked economic substance. The court noted that nothing had changed regarding the management of the company and that control had remained with the decedent's family. Accordingly, for valuation purposes, the court treated the two transfers as a single testamentary transfer.

Relying on Murphy in TAM 9719006, the Service ruled that the only discernible purpose for the FLP was to depress the value of the partnership assets as they passed through the gross estate, stating that "[t]he arrangement merely operated to convey the assets to the individuals (the decedent's children) who would have received the assets in any event under the testamentary instruments"; thus, the transaction lacked economic substance. Likewise, the Service ruled that the sale of the partnership interests to the decedent's children in exchange for notes was similarly devoid of substance; the debt was merely a "disguise for the gratuitous testamentary transfer" created solely for the purpose of tax avoidance.

Alternatively, the Service noted Sec. 2703(a)(2), which provides that for estate, gift and generation-skipping transfer (GST) tax purposes, the value of any property shall be determined without regard to any restriction on the right to sell or use such property. An exception is provided by Sec. 2703(b); the restriction will not be disregarded in valuing the property when (1) it is a bona fide business arrangement, (2) it is not a device to transfer such property to members of the decedent's family for less than full and adequate consideration in money or money's worth and (3) its terms are comparable to similar arrangements entered into by persons in an arms'-length transaction.

The taxpayer's position was that the property transferred was the partnership interest, not the underlying partnership assets. Because there were no restrictions in the partnership agreement on the transferees' ability to sell, transfer or use the partnership interests, they could not be disregarded under Sec. 2703(a)(2). However, citing Murphy and Est. of Cidulka,(14) the Service applied the step-transaction doctrine to collapse the transactions into a single integrated transaction -- the transfer at the decedent's death of the underlying partnership assets. Thus, the Service viewed the partnership assets as the subject matter of the transfer; any restriction had to be disregarded under Sec. 2703(a)(2) in valuing the transfer. The Service held that the partnership agreement was a restriction to be disregarded.

The Service next ruled that the transaction lacked a bona fide business purpose. The Service pointed out that transactions within a family group are subject to special scrutiny, and a presumption applies that such a transfer is not at arms' length. The Service also observed that the children, acting in their representative capacities, essentially were dealing with themselves on behalf of the trusts and decedent. Rather than maximizing the value of the trust, they structured the transaction to achieve the opposite result. In the Service's view, it was inconceivable that the decedent would have accepted, if dealing at arms' length, a partnership interest purportedly worth only a fraction of the value of the assets she transferred.

The Service summarily dismissed the fact that, arguably, there was some legitimate business purpose for the transaction (e.g., creditor protection, centralized management of family assets, etc.). Instead, the Service ruled that the "facts evidence that the transaction, including the formation of the limited partnership, was contrived primarily (if not exclusively) for the purpose of artificially reducing the value of the decedent's gross estate in order to reduce the estate tax liability. Accordingly, the partnership was a device to transfer property to members of the decedent's family for less than adequate consideration."

Finally, the Service ruled that even if the transactional steps were not collapsed, and the partnership interest recognized as the subject matter of the transfer, Sec. 2703(a)(2) would still apply. The partnership agreement or state law imposed several impediments on a transferee's ability to sell or use the property that would normally be taken into account in determining FMV. "Clearly, these restrictions constitute restrictions on the limited partner's right to use the partnership interest and impede the partner's ability to sell the interest." Therefore, the Service ruled that no discount would be available (except for a discount to reflect the fractional interest in the real estate).

Informal conversations with the Service indicate that it will probably continue to challenge FLPs based on the sham transaction doctrine. It was also indicated that the Service is currently concerned with its image. Given all of the recently proposed legislation to lessen the impact of transfer taxes on family businesses and farms, the Service is concerned that if it takes an outright position against FLPs based on Sec. 2703, such position may have an effect on legitimate partnerships that hold family businesses and farms, thereby causing the IRS additional bad publicity.

Gift Tax Matters

The following significant developments occurred during the period:

* The Service again loses on annual exclusion availability for Crummey interests.

* The timing of a gift by check to a noncharitable beneficiary was revisited,

* Intent to gift-split was unclear.

Service Loses Crummey Challenge

In Est. of Kohlsaat,(15) the Tax Court rejected the Service's argument that a donor was not entitled to Sec. 2503(a) annual exclusions for gifts in trust to beneficiaries holding only contingent remainder interests, coupled with a Crummey(16) withdrawal right.

In Kohlsaat, the decedent had made an inter vivos transfer of a commercial building to an irrevocable trust and granted 18 beneficiaries (16 contingent) unrestricted rights to demand immediate distributions of trust property. Each beneficiary received timely notification of the withdrawal right, but chose not to exercise it.

The estate treated the interests of the contingent beneficiaries as qualifying for 16 annual gift tax exclusions, which the IRS disallowed on the grounds that the decedent and the beneficiaries had an understanding that the latter would not exercise their withdrawal rights. The Tax Court held for the estate.

The Service had argued that substance-over-form doctrine should apply; notwithstanding the executed documents, the decedent never intended to transfer an unrestricted, present right to the immediate use, possession or enjoyment of the trust property. The court found the beneficiaries offered several credible reasons as to why they did not exercise their rights and there was no evidence that the contingent beneficiaries believed they would be penalized for exercising their rights to demand distributions of trust property or that the trustees purposefully withheld information from the beneficiaries.

Kohlsaat illustrates the Service's continued hostility toward annual gift tax exclusions for contingent trust beneficiaries' withdrawal rights, even though its litigation track record on this issue is dismal.(17) One has to wonder when the Service will stop challenging the availability of the annual gift tax exclusion in such cases.

Timing of Gift by Check to Noncharitable Beneficiary

In Rev. Rul. 96-56,(18) the Service announced that, in response to Est. of Metzger,(19) delivery of a check to a noncharitable donee will be deemed to be complete when (1) the check is deposited, (2) cashed against the donee's available funds or (3) presented for payment in the calendar year for which gift treatment is sought.

Summary Judgment Denied; Intent to Gift-Split Was Unclear

In Nordstrom,(20) the taxpayer's spouse signed the gift-splitting consent line on the taxpayer's Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, and treated some of his gifts as having been made by her on her Form 709. She also checked "no" consent to gift-split on her return. Nevertheless, the IRS was denied summary judgment, because the taxpayer testified that he intended to gift-split and had completed the gift-splitting information lines on his gift tax return.

The court noted that Regs. Sec. 25.2513-1(b)(5) provides that gift-splitting applies to all gifts if "the consent is effectively signified on either the husband's return or the wife's return." According to the court, if the required consent is present, all gifts will be treated as split even though the couple may have attempted impermissibly to split only some gifts. The court denied the Service's request for summary judgment, stating that "it could not conclude that a reasonable fact-finder would be compelled to find that the [donors] failed to `effectively signify' their consent to split all 1988 gifts between them."

Retained Interest and Powers of Appointment

Current decisions and rulings included:

* Third Circuit upholds viability of sale of a remainder interest.

* TAM holds New York attorney-in-fact had gifting power.

Sale of Remainder Interest

The sale of a remainder interest may still be a viable planning technique, at least in the Third Circuit. In Est. of D'Ambrosio,(21) that court held that a decedent's remainder interest in closely held preferred stock was not includible in her gross estate because she had sold the remainder interest at its FMV. In so ruling, the court refused to follow a string of cases dating back to the 1960s:

At age 80, the decedent had sold her remainder interest in preferred stock for a lifetime annuity actuarially valued at $1.3 million; her estate tax return omitted that stock. The Tax Court upheld the Service's assessment against the estate, agreeing, that it should have included $1.3 million, the date-of-death, FMV of the preferred stock, less the value of the annuity payments received. The Third Circuit reversed.

The Tax Court had relied on a number of factually similar cases that had considered the application of Sec. 2036 to a sale of a remainder interest in property and concluded that "full and adequate consideration" must be measured against the full FMV of a fee interest in the property as of the date of sale, not against the value of a remainder interest.(22) The rationale of these cases is that the policy behind Sec. 2036 can be defeated if a remainder interest can be sold and effectively removed from the seller's estate. The Third Circuit rejected these decisions, finding that if the value of the annuity payments received by a decedent in exchange for the remainder interest is taken into account in combination with the income interest retained in the property, 100% of the asset's value is includible in the estate.

While D'Ambrosio may make the sale of a remainder interest in property a viable (if risky) planning opportunity, the practitioner must keep Sec. 2702 in mind when structuring such sales. For purposes of determining whether a transfer is a gift when property is transferred to a family member, the value of any interest retained by a transferor will be zero unless the retained interest is a "qualified interest" (as defined in the Sec. 2702 regulations).

If a remainder interest is sold to a family member and the retained interest is not a Sec. 2702 qualified interest, for gift tax purposes the transferor will be deemed to have made a gift to the family member equal to the entire value of the transferred property, regardless of the fact that the family member is obligated to make payments in exchange for the purchased remainder interest.

New York Attorney-in-Fact Had Gifting Power

Although the Service generally takes a dim view of gifts by attorneys-in-fact if the empowering document does not specifically authorize gifting,(23) in Letter Ruling (TAM) 9708004,(24) it ruled that an attorney-in-fact, acting under a New York 1987 "statutory short form" power of attorney coupled with a subsequent writing, had the power to make gifts on the decedent's behalf.

The power of attorney granted the decedent's daughter very broad powers, including the power to dispose of all property; write checks; do any act that a principal can do through an agent for the welfare of the principal's family; and a "residual power" to act as an "alter ego of the principal with respect to any and all possible matters and affairs" of the decedent not otherwise explicitly delegated in the power of attorney.

The decedent subsequently delivered to his daughter a written document stating that he intended her to use the power of attorney to make annual exclusion gifts to family members. From 1990 through 1993, the daughter wrote checks to the decedent's family members in amounts falling within the annual exclusion. Although, according to the Service, New York's highest court has not directly ruled on whether the short form power of attorney authorizes an attorney-in-fact to make gifts on the principal's behalf, the Service found that, because of the broad nature of the rights delegated by the power and the explicit writing by the decedent authorizing his daughter to use the power of attorney to make gifts, the gifts were authorized by him. Thus, the transfers were completed gifts, not revocable transfers under Sec. 2038.

Disclaimers

The following decision was rendered:

* Nonwritten disclaimer was not valid.

Invalid Disclaimer

In Est. of Delaune,(25) the decedent's spouse had predeceased her by nine months; the decedent had received his entire estate. Prior to her death, the decedent had met with the attorneys representing her late husband's estate, and discussed renouncing her interest in said estate. She died 12 days after the meeting without executing a formal disclaimer. The decedent's estate passed intestate to her heirs under state (Louisiana) law. The estate representative argued that either his disclaimer on the decedent's behalf was valid or that her oral instruction to draft a disclaimer was an enforceable oral contract between the decedent and her heirs giving rise to an estate tax deduction.(26)

A district court rejected the disclaimer argument, stating that (1) there was "no written irrevocable and unqualified refusal" by the decedent to accept an interest in her spouse's estate, as required by Sec. 2518 for a disclaimer to be valid and (2) Louisiana law did not provide a method for a deceased individual to renounce an inheritance post-mortem. The court also dismissed the argument that there was an oral contract between the intestate beneficiaries and the decedent that gave rise to a Sec. 2053 estate tax deduction.

Debts, Claims and Administrative Expenses

The following decisions were issued:

* State law governs definition of "necessary" expenses.

* Attorney's fees not per se unallowable.

Sixth Circuit Ways State Law Defines "Necessary" Expenses

In Est. of Millikin,(27) the Sixth Circuit affirmed the Tax Court's determination that the maintenance and selling expenses of "Ripplestone," the decedent's personal residence, were not "necessary" estate expenses under Ohio law, and so not deductible under Sec. 2053(b). However, the Sixth Circuit reaffirmed that, contrary to Regs. Sec. 20.2053-3(a) (which is more stringent), an administrative expense need only be allowable under applicable state law to be "necessary."

At the time of the decedent's death, she was a beneficiary of a trust funded with Ripplestone that had been created by her predeceased spouse. Because the decedent had a power of appointment over the trust assets at the time of her death, Ripplestone was included in her estate. When her estate tax return was filed in 1990, Ripplestone had not yet been sold; the estate claimed an estimated administrative expense under Sec. 2053 for $150,000 in estimated selling costs and $213,500 in estimated maintenance costs.

In reviewing the Service's disallowance of the claimed expenses, the court cited Est. of Park,(28) and held that Ohio law governed the meaning of "necessary"; the more stringent requirement in Regs. Sec. 20.2053-3(a) (requiring that the expense be both allowable under state law and "necessary" to estate administration within the meaning of the regulations) was not the Sixth Circuit rule.(29) The court declined the Service's invitation to overrule Park.

However, in analyzing the expenses, the court agreed with the Tax Court's decision that the expense of selling and maintaining Ripplestone after the date the estate tax return was filed was not a necessary administrative expense under Ohio law. In the court's view, there was no reason under Ohio law for the estate to sell Ripplestone and distribute cash rather than directly distribute the property in accordance with the trust document. Moreover, the fact that the Ohio probate court had allowed the expense as an allowable estate administrative expense was not binding; a lower court's opinion is only persuasive, rather than conclusive, proof of state law.

Attorney's Fees Not Per Se Unallowable

In Est. of Baird,(30) the estate retained the law firm that had prepared the decedent's will to provide all legal services associated with administration. The firm charged $386,100, which the estate deducted under Sec. 2053.

The Tax Court noted that, although the fee was reasonable under New York law, it was not fully allowable under Regs. Sec. 20.2053-3(a). The court disallowed the portion of the fee related to the sale of the decedent's residence and the portion representing an advance payment of executors' fees.

Valuation

The IRS decided the following:

* Changes to shareholder agreement not substantial modifications.

De Minimis Changes

Sec. 2703(a) provides that for estate, gift and GST tax purposes, the value of any property is determined without regard to (1) any option, agreement or other right to acquire or use the property at a price less than FMV of the property (without regard to such option, agreement or right) or (2) any restriction on the right to sell or use such property. Under Revenue Reconciliation Act of 1990 Section 11602(e)(1)(A), Sec. 2703 applies to agreements, options, rights or restrictions entered into or granted after Oct. 8, 1990, and to those agreements, options, rights or restrictions in existence before that date that are "substantially modified" thereafter.(31)

In Letter Rulings 9711017,(32) 9652010(33) and 9652009,(34) the Service held that changes to agreements executed prior to Oct. 9, 1990 were only de minimis changes to the quality, value or timing of the parties' rights under the agreements that did not constitute modifications; thus, each agreement continued to be exempt from Sec. 2703.

Charitable Gifts

The following rulings were issued:

* Presence of UBTI renders all charitable trust income taxable.

* Post-contribution gain may be allocated to income.

UBTI Makes CRUT Taxable on Entire Net Income

In Newhall Unitrust,(35) the Ninth Circuit found that a CRUT's receipt of UBTI caused the trust to be taxable on its entire net income in the year the UBTI was received. The CRUT at issue held units in three publicly traded limited partnerships (PTLPs) during its 1988 and 1989 tax years. The Service asserted that the amounts received from the PTLPs during those years were UBTI, and that, under Sec. 664(c) and Regs. Sec. 1.664-1 (c), receipt of UBTI caused the trust to be taxable on all of its income in those years.

The Tax Court ruled for the Service, rejecting the trust's position that it should be taxable (if at all) on only its UBTI, finding Sec. 1.664(c) to be unambiguous and Regs. Sec. 1.664-1(c) to be a reasonable interpretation of the statute.

On appeal, the taxpayer argued that PTLPs are not "partnerships" for Sec. 512(c) purposes, but instead should be treated as corporations. Further, it argued that because its investment in the PTLPs was merely passive, income from the PTLPs should not be treated as UBTI. Finally, the taxpayer reiterated its argument that the receipt of UBTI should cause only that income to be taxable.

The Ninth Circuit rejected the first two arguments, stating that the taxpayer failed to demonstrate that the PTLPs were corporations. The court also found no ambiguity in the Code or regulations.

Under Newhall, if a CRUT receives any UBTI during a tax year, it will be subject to tax for that year on all of its current undistributed income. The CRUT will be treated as a complex trust for that year and receive a distribution deduction for any portion of its distributable net income actually distributed to income beneficiaries. In following years, the CRUT will again be a tax-exempt entity in years it does not receive UBTI.

Post-Contribution Gain May Be Allocated to Income

A and B established a NIMCRUT funded with appreciated securities; each retained a life income interest. The trust agreement provided that the trustee (A), in his fiduciary capacity, could reasonably allocate post-contribution capital gain to trust income; in calculating the unitrust payment, the assets' FMV would be reduced by the deficiency in unitrust payments from prior years, up to the amount of the unrealized post-contribution gain in trust assets as of the valuation date. In Letter Ruling 9711013,(36) the Service held that the trust qualified as a CRUT.

Marital Deduction 

The following development occurred:

* Temp. regs. conform to Tax Court decision.

Regulations Issued

After losing numerous cases, the Service issued temporary regulations conforming to the Tax Court's decision in Est. of Clack.(37) In Clack, the Service had unsuccessfully argued that a property interest did not qualify for the marital deduction if it passed to a surviving spouse contingent on an election by a personal representative.

In July 1996, an acquiescence to Clack was issued in result only.(38) The Service subsequently issued a temporary regulation conforming Regs. Sec. 20.2056(b)-7 to Clack; effective for estate tax returns filed after Feb. 18, 1997, Temp. Regs. Sec. 20.2056(b)-7T(d)(3)(ii) provides that an income interest for life contingent on an executor choosing to make a qualified terminable interest property (QTIP) election will be a Sec. 2056(b)(7) qualifying income interest.

GST Tax Developments

The following decisions were issued:

* Service continues to issue favorable grandfathered rulings.

* Late reverse QTIP elections allowed.

Favorable Grandfathered Rulings

Under Regs. Sec. 26.2601-1(b)(1)(i), trusts that were irrevocable on Sept. 25, 1985 are exempt from GST tax, to the extent that a transfer from the trust is not made from contributions to the trust after that date. Regs. Sec. 26.260 1-1 (b) (1) (iv) provides that, if an addition is made after Sept. 25, 1985 to an irrevocable trust otherwise exempt from Chapter 13 because it is a "grandfathered" trust, a pro rata portion of subsequent distributions from (and terminations of interests in property held in) the trust is subject to Chapter 13.

In general, a modification to a trust that was irrevocable on Sept. 25, 1985 will be treated as a deemed addition to the trust if the modification affects the quality, value or timing of any beneficial interest in the trust and will cause it to lose exempt status. The Service has been generous in its interpretation of modifications that affect the quality, value or timing of a beneficiary's interest. Letter Rulings 9713013,(39) 9709003,(40) 9709004(41) and 9709017(42) are illustrative of fact patterns on trust modifications that do not affect a trust's grandfathered status.

Extensions of Time for Reverse QTIP Elections

The IRS continued to generously,exercise its authority under Regs. Sec. 301.9100-1 (a) to extend the time to make a reverse QTIP election when a filed return improperly indicated the election.(43)

Chapter 14 Special Valuation

The Service rendered the following decision:

* Continued liberal definition of residence for QPRT purposes.

Definition of QPRT "Residence"

The meaning of "residence" for purposes of qualified personal residence trusts (QPRTs) continues to be granted wide berth by the Service.(44) Generally, the Service has favorably defined "residence" for QPRT purposes.

(1.) REG-209823-96 (4/17/97).

(2.) Notice 94-78, 1994-2 CB 555.

(3.) See H. Rep. No. 91-413, 91st Cong., 1st Sess. 60 (1969),1969-3 CB 200, 239.

(4.) Under Sec. 2702(a), the retained interest is valued at zero unless the interest is a "qualified interest."

(5.) See, e.g., IRS Letter Rulings 9711013 (12/10/96) and 9609009 (11/20/95).

(6.) IRS Letter Ruling (TAM) 9707001 (10/25/96).

(7.) See, e.g., IRS Letter Rulings 9451056 (9/26/94), 9449013 (9/9/94), 9449012 (9/9/94), 9416009 (12/30/93) and 9352017 (9/30/93).

(8.) Although Regs. Sec. 25.2702-2(d), Examples 6 and 7, deal with revocable spousal interests, those interests are successive, not concurrent.

(9.) Est. of Otis C. Hubert, 117 Sup. Ct. 1124 (1997), aff'g 63 F3d 1083 (11th Cir. 1995)(76 AFTR2D 95-6448, 95-2 USTC [paragraph] 60,209), aff'g 101 TC 314 (1993); see NewsNotes, "Estate Administration Expenses:" 28 The Tax Adviser 260 (May 1997).

(10.) The original deficiency notice omitted a challenge to claimed administrative expenses.

(11.) Justice Scalia stated that the plurality decision "creates a tax boondoggle never contemplated by Congress, and announces a test of deductibility virtually impossible for taxpayers and the IRS to apply."

(12.) IRS Letter Ruling (TAM) 9719006 (1/14/97).

(13.) Est. of Elizabeth B. Murphy, TC Memo 1990-472. (14) Est. of Joseph Cidulka, TC Memo 1996-149.

(15) ESt. of Lieselotte Kohlsaat, TC Memo 1997-212.

(16) D. Clifford Crummey, 397 F2d 82 (9th Cir. 1968) (22 AFTR2d 6023, 68-2 USTC [paragraph] 12,541), aff'g and rev'g TC Memo 1966-144.

(17) See Schenkel, "Well a Crummey Beneficial Interest Qualify for an Annual Gift Tax Exclusion?," 28 The Tax Adviser 378 (June 1997).

(18) Rev. Rul. 96-56, IRB 1996-50, 7, modifying Rev. Rul. 67-396, 1967-2 CB 351.

(19) Est. of Albert F. Metzger, 38 F3d 118 (4th Cir. 1994) (74 AFTR2d 94-7486, 94-2 USTC [paragraph] 60,179), aff'g 100 TC 204 (1993).

(20) William D. Nordstrom, N.D. Iowa, 1997 (79 AFTR2d 97-612, 97-1 USTC

(21) Est. of Rose D'Ambrosio, 101 F3d 309 (3d Cir. 1996) (78 AFTR2d 96-7347, 96-2 USTC [paragraph] 60,252), rev'g and rem'g 105 TC 252 (1995); see "Tax Clinic: Third Circuit Allows Exclusion of Asset From Gross Estate When Only Remainder Interest Had Been Sold," 28 The Tax Adviser 205 (April 1997).

(22) See, e.g., Curtis Allen, 293 F2d 916 (10th Cir. 1961) (8 AFTR2d 6055, 61-2 USTC [paragraph] 12,032), cert. denied; Est. of Lillian B. Gregory, 39 TC 1012 (1963); Est. of C. Miffin Frothingham, 60 TC 211 (1973); George S. Gradow, 11 Cl. Ct. 808 (1987) (59 AFTR2d 87-1221, 87-1 USTC [paragraph] 13,711).

(23) See Gardner and Zysik, "Significant Recent Developments in Estate Planning," 27 The Tax Adviser 753 (Dec. 1996), p. 757.

(24) IRS Letter Ruling (TAM) 9708004 (10/31/96).

(25) Est. of Sammie Barman Delaune, DC La., 1997 (79 AFTR2d 97-1509, 97-1 USTC [paragraph] 60,266).

(26) Sec. 2053 allows an estate tax deduction for claims against a decedent's estate arising from executory contracts in existence at the time of decedent's death.

(27) Est. of Marguerite S. Millikin, 106 F3d 1263 (6th Cir. 1997) (79 AFTR2d 97-1509, 97-1 USTC [paragraph] 60,258), aff'g TC Memo 1995-288.

(28) Est. of Mary F.C. Park, 475 F2d 673 (6th Cir. 1973) (31 AFTR2d 73-1442, 73-1 USTC [paragraph] 12,913).

(29) The court first found that the distinction between deduction for administrative expenses under Sec. 2053(a) and (b) was not significant, because the expenses at issue had been paid prior to the expiration of the statute of limitations.

(30) Est. of Clara D. Baird, TC Memo 1997-55.

(31) See also Regs. Sec. 25.2703-2.

(32) IRS Letter Ruling 9711017 (12/11/96).

(33) IRS Letter Ruling 9652010 (9/26/96).

(34) IRS Letter Ruling 9652009 (9/9/96).

(35) Leila G. Newhall Unitrust, 105 F3d 482 (9th Cir. 1997) (79 AFTR2d 97-547, 97-1 USTC [paragraph] 50,159), aff'g 104 TC 236 (1995).

(36) IRS Letter Ruling 9711013 (12/10/96).

(37) Est. of Willis Edward Clack, 106 TC 131 (1996); see Gardner and Zysik, Note 23, p. 761.

(38) OAD 1996-011, IRB 1996-29, 4.

(39) IRS Letter Ruling 97113013 (12/24/96).

(40) IRS Letter Ruling 9709003 (11/19/96).

(41) IRS Letter Ruling 9709004 (11/26/96).

(42) IRS Letter Ruling 9709017 (11/26/96).

(43) See, e.g., IRS Letter Rulings 9707007 (11/12/96), 9702005 (9/30/96) and 9701045 (10/7/96).

(44) See, e.g., IRS Letter Rulings 9705017 (11/1/96), 9701046 (10/7/96) and 9645010 (8/2/96).