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Planning to maximize the s. 2013 credit.

Those of us who toil in the areas of estate planning and estate administration learned early on in our practice about the credit for tax on prior transfers (TPT credit) allowed by [Section]2013 of the Internal Revenue Code.(1) We encounter the credit on the checklists we review when preparing or reviewing a federal estate tax return, and we are mindful of the credit when advising (tactfully) the surviving spouse that we may wish to extend the filing of the federal estate tax return for the estate of the first spouse to die in the event that the surviving spouse may not survive the six-month extension period. However, as more articles appear by commentators extolling the benefits of paying tax in the estate of the first spouse to die,(2) increased attention is being focused on the credit, and deservedly so.

The purpose of this article is to raise the level of consciousness of the TPT credit by reviewing how it works and how practitioners can plan to maximize its potential benefit. An in-depth analysis of the TPT credit is beyond the scope of this article. Our intent is to discuss the credit in enough detail to hopefully spark in the reader/practitioner/planner some ideas for planning (not only in the "post-mortem" administration phase, but in the "pre-mortem" estate planning phase) to use the credit in its usual application.

Overview of the Credit

The TPT credit was once characterized as "the most complex and confusing provision of the estate tax law."(3) Simply put, the purpose of the TPT credit is to prevent property from being diminished by estate taxes imposed on the property in successive estates within a relatively short period of time. For discussion purposes, the person from whom property is transferred is termed the "transferor" and the transferee of the property is termed the "decedent."(4) The TPT credit is the amount of the federal estate tax paid on property transferred to the decedent from the transferor who died within 10 years before, or within two years after, the decedent's death and is allowed as a credit against the federal estate tax imposed on the decedent's estate. If the transferor died within two years of the decedent's death, the full amount of the TPT credit is available to the decedent's estate. If the transferor predeceased the decedent's death by more than two years, the credit is reduced by 20 percent for every two years or portions thereof that the decedent survived the transferor so that the available credit is fully extinguished if the decedent survives the transferor by more than 10 years.

To reiterate, the TPT credit is a credit applied to the federal (and not the state) estate tax liability of the decedent's estate equal to the amount of the federal estate tax deemed paid on property transferred to the decedent from the transferor. To determine the amount of the TPT credit, you must first determine if there is a "transfer" of "property" that can be valued. The regulations broadly define a "transfer" as any passing of property or an interest in property from a transferor that was included in the transferor's gross estate. For instance, the examples cited in the regulations include interests in property held by or devolving upon the decedent: 1) as spouse under dower or curtesy; 2) as surviving tenant of a joint tenancy with survivorship rights; 3) as beneficiary of the proceeds of life insurance; 4) as survivor under an annuity contract; 5) as donee of a general power of appointment; 6) as appointee under the exercise of a general power of appointment; and 7) as remainderman under the release or nonexercise of a power of appointment by reason of which the property is included in the gross estate of the donee of the power.(5) These examples, however, are by no means exhaustive.

The regulations also broadly define "property" as any beneficial interest in property including a general power of appointment and includes annuities, life estates, term interests, vested or contingent remainders, and other future interests. The term does not include an interest in property consisting of bare legal title, such as that of a trustee. Nor does the term include a power of appointment that is not a general power as defined in [Section]2041.(6) Two important aspects of the transfer and property requirements should be noted. First, the property interest need not be included in the decedent's gross estate for it to constitute property. For example, a life estate interest received from a transferor is "property" for purposes of the credit even though it is not includable in the decedent's estate. Second, there is no tracing requirement, that is, there is no requirement that the transferred property be identified in the decedent's estate or even be in existence at the time of the decedent's death. These aspects are what gives the TPT credit significant value. This is important in planning to effectively use the TPT credit, as discussed below.

Valuation Problems

Once you have a transfer of property from the transferor to the decedent, you must determine the value of the property interest. For the purpose of computing the TPT credit, the transferred property must be valued in the decedent's estate at the same amount that the property was valued in the transferor's gross estate. Moreover, that value must be reduced by three important items: 1) death taxes payable out of the property interest transferred to the decedent or which were payable by the decedent as a result of the transfer to him; 2) the amount of any liability on the property or any obligation imposed by the transferor with respect to the property; and, 3) any marital deduction received by the estate of the transferor as a result of the transfer. The third item is the most common item that reduces the amount of the TPT credit. In effect, if property is transferred from the nontaxable estate of the transferor (through the use of a full marital deduction combined with the applicable "Applicable Credit Amount"(7)), there will be no TPT credit in estate of the decedent (i.e., the surviving spouse).

If the property interest may not be valued or has a zero value, there can be no TPT credit. Valuation problems may arise in the situation of simultaneous deaths, and with life estate interests, interests in discretionary trusts, and powers of appointment.

When valuing life estates (or remainders), the value of the interest is determined (as of the date of the transferor's death) on the basis of recognized valuation principles. For persons dying after April 30, 1989, Code [Section]7520 dictates that the valuation be made under tables provided by the Internal Revenue Service (Publications 1457 and 1458) based on an interest rate equal to 120 percent of the federal midterm rate in effect under [Section]1274(d) for the month in which the valuation date falls (the "[Section]7520 rate"). The Service has issued regulations under [Section]7520 effective for transactions after December 13, 1995. These regulations set out exceptions to the use of the standard [Section]7520 tables that address common situations in which valuation problems arise.

The regulations provide that the standard [Section]7520 rate may not be used if the transferor and the individual who is the measuring life of the property interest die as a result of a common accident or other occurrence. These regulations incorporate the Service's position that in common disaster--simultaneous death situations--use of the standard tables would be inappropriate and produce unreasonable results. This result is the same even if it can be proved that the person who is the measuring life survived the transferor.

The regulations also provide that the [Section]7520 rate may not be used if the person who is the measuring life of the property interest is terminally ill at the time of the transferor's death. A person known to have an incurable illness or deteriorating physical condition combined with at least a 60-percent probability that the person will die within one year is considered terminally ill. However, a person who survives the valuation date by 18 months or more is presumed not to have been terminally ill on the valuation date unless the contrary is established by clear and convincing evidence.(8)

Further examples provided by the regulations precluding the use of the [Section]7520 rate are where a fund to provide an annuity for a defined period may be exhausted before the end of the defined period, or where property in which the income interest is held is unproductive.

The point is, you must be mindful when dealing with life estate or annuity interests that the interests not be impaired in a manner that precludes the use of the [Section]7520 rate for their valuation.

While the focus above has been on life estates, remainder interests also may be difficult to value or be incapable of valuation. The regulations provide that the [Section]7520 rate should not be used to value remainder or reversionary interests unless the effect of the administrative and dispositive provisions for the interests that precede the remainder or reversionary interest assures that the property will be adequately preserved and protected from erosion, invasion, depletion, or damage until the remainder or reversionary interest takes effect in possession and enjoyment. The regulations further state that the degree of preservation and protection would be provided only if it was the transferor's intent, as manifested by the provisions of the arrangement and the surrounding circumstances, that the entire disposition provides the remainder or reversionary beneficiary with an undiminished interest in the property transferred. For example, where the life estate holder has the power to consume the property, the remainder interest cannot be valued using the [Section]7520 rate. Thus, as discussed below, careful consideration should be given drafting your client's will or trusts.

As might be expected based on the foregoing discussion of problems in valuing life estates, valuation problems also are present in discretionary trusts. The regulations specifically provide that the [Section]7520 rate may not be used to value a life income interest in a trust if 1) the trust, will, or other governing instrument requires or permits the beneficiary's income or other enjoyment to be withheld, diverted, or accumulated for another person's benefit without the consent of the income beneficiary; or 2) the governing instrument requires or permits trust principal to be withdrawn for another person's benefit without the consent of the income beneficiary during the income beneficiary's term of enjoyment and without accountability to the income beneficiary for such diversion. Thus, once again, much consideration should be given to the proper drafting choices in the pre-mortem or estate planning phase for your clients.

Valuation issues also are present with powers of appointment. Several revenue rulings present interesting analyses of powers of appointments for purposes of the TPT credit. For instance, in one revenue ruling,(9) the Service ruled that where a surviving spouse received both 1) a life annuity interest, and 2) a one-year power of withdrawal over the entire proceeds of an annuity contract that was included in her predeceased spouse's (i.e., the transferor's) gross estate (but which was not subject to a marital deduction), the surviving spouse (i.e., the decedent) had at the time of the transferor's death a general power of appointment (as a result of the one-year power of withdrawal). The Service further stated that the fact she held the general power for only one year is of no consequence, because the TPT credit is concerned only with whether the transferor transferred a "beneficial interest in property" to the surviving spouse at the time of the transferor's death. Even if after the transferor's death the "beneficial interest in property" (here, the general power of appointment) is suddenly transmuted into something that is no longer a beneficial interest in property, it does not defeat the availability of the TPT credit to the decedent's estate.

In another ruling(10) which focused on the "five and five power," the Service held that where the transferor provided in a testamentary trust that the beneficiary A (i.e., the decedent), would be entitled to the income of the trust for his lifetime and would also have the noncumulative five and five power, A's right of withdrawal at the date of the transferor's death was a general power of appointment and it qualified as property for purposes of the TPT credit. The fact that at A's death the value of the power of appointment had lapsed had no consequence on the TPT credit. This reemphasizes the tenet that the transferred property need not be identified in the decedent's gross estate or even be in existence at the decedent's death.

While general powers of appointment may present valuation problems, the regulations are clear on the treatment of special powers of appointment with respect to the TPT credit. A special power of appointment is not treated as "property" for purposes of the credit. Presumably the taker in default of appointment of a special power also would not have an interest capable of being valued as his interest can be terminated by exercise of the power. If this is the case, then no one who receives the property at the death of the life interest holder may claim the TPT credit since the interest was not capable of being valued at the donor's (transferor's) death.(11)

Determining the Credit

Once you have determined that you have a "transfer" for purposes of the TPT credit; and, you have determined that the transfer is of property that qualifies as "property" for purposes of the credit; and, you have determined that such transferred property is capable of being valued; then, and only then, can you proceed to determine the "amount" of the TPT credit. That amount is the lesser of two separately computed amounts referred to as the "first limitation"(12) and the "second limitation,"(13) as follows: 1) the first limitation is the amount of the federal estate tax attributable to the transferred property in the transferor's estate (computed using the "average" or "pro rata" method of tax allocation); 2) the second limitation is the amount of the federal estate tax attributable to the transferred property in the decedent's estate (computed using the "with and without" or "marginal" method of tax allocation). As a general rule, the first limitation applies when the taxable estate of the decedent is greater than the taxable estate of the transferor, as the marginal rate of tax in the decedent's estate should be greater than the average rate of tax in the transferor's estate. Generally, the second limitation will apply where the average rate of tax in the transferor's estate exceeds the marginal rate of tax in the decedent's estate.

The regulations provide an algebraic formula that assists in determining the first limitation. Schedule Q to Form 706 and the worksheet that accompanies the instructions to Schedule Q provide a very helpful tool that assists in computing the amount of the TPT credit. The authors strongly suggest careful review of the instructions to Schedule Q and the schedule and worksheet that accompanies it in determining the amount of the TPT credit.

Planning for the Credit

Most view the TPT credit as an estate administration or "post-mortem" planning tool. Although we agree with the populous, we suggest that this tool also be considered thoroughly in the estate planning or "pre-mortem planning" phase for your clients. This means that in planning for clients who have estates in excess of the applicable exclusion amount, proper drafting must be considered to take advantage of the TPT credit at the respective deaths of the transferor and the decedent.

As stated at the outset of this article, the concept of paying some estate tax in the estate of the first spouse to die (i.e., the transferor) rather than completely exempting the first spouse's estate from taxation is receiving more attention from commentators. Economic analyses show that in certain situations more wealth can be passed to the beneficiaries of a husband and wife by paying estate tax in the estate of the first spouse to die regardless of the number of years in which the surviving spouse survives the death of the first spouse (debunking the time value of money argument associated with the early payment of the estate tax). Part of this benefit is as a result of the TPT credit.(14) Since the majority of planning that we do as practitioners is for married couples, this focuses the attention on the need for planning to utilize the TPT credit along with the marital deduction.(15) This involves creating in the surviving spouse (i.e., the decedent) beneficial interests that qualify as property transferred for purposes of the TPT credit, but which do not require inclusion of those interests in the surviving spouse's gross estate upon her death.

Qualified terminable interest property (QTIP) trusts are commonly used in today's estate plans. As indicated above, the only way to receive the TPT credit is if the transferor's estate pays some estate tax with respect to property deemed transferred to the decedent. One way to pay some estate tax in the transferor's estate is to make a partial QTIP election (or make no QTIP election) with respect to the QTIP trust. The effect of this is that the surviving spouse (i.e., the decedent) will have a life estate interest in the non-QTIP (portion of the) trust that will qualify for the TPT credit. The life estate will qualify as "property transferred" to the surviving spouse at the transferor's death.

Similarly, the applicable exclusion trust (using today's terminology) also should provide for mandatory income distributions exclusively to the spouse to qualify that life estate interest as "transferred property" for the TPT credit.

The addition of a five and five power to each of the applicable exclusion and QTIP trusts will increase the value of the beneficial interests passing to the surviving spouse and thus increase the potential TPT credit.(16)

To augment the beneficial interests created for the surviving spouse, outright property bequests to the surviving spouse disclaimed by the spouse should be directed to the applicable exclusion trust or a separate mandatory income disclaimer trust created for the surviving spouse's benefit if circumstances warrant a separate trust. This will increase the value of the beneficial interest passing to the surviving spouse from either of these trusts, thus increasing the potential amount of the TPT credit.

There are some points to consider regarding this planning. For instance, the client may prefer that the applicable exclusion trust and the non-QTIP (portion of the) trust (assuming a partial QTIP election) have sprinkling provisions for income among beneficiaries other than the surviving spouse. It may be difficult to counsel clients to plan in a manner to maximize the TPT credit, especially considering the fact that the TPT credit evaporates if the surviving spouse survives the transferor by 10 years. To plan for the situation where it appears that the age or health of the surviving spouse will make such spouse's death within 10 years of the transferor unlikely, you should consider drafting a backup disclaimer trust providing for the sprinkling of income or income accumulation to which disclaimed spousal interests in the applicable exclusion or non-QTIP trusts would fall. This provides a degree of flexibility for this situation. Admittedly, reliance on the spouse to disclaim may be a negative factor.

In the post-mortem setting the use of disclaimers is useful in seeking to qualify property interests for maximum use in the TPT credit computation. If the surviving spouse's income interest in the applicable exclusion trust is not susceptible of valuation at the transferor's death because of sprinkling provisions as to income or principal in favor of others than the surviving spouse, or even if it is susceptible of valuation (but at a lower value) because of ascertainable standards surrounding invasion possibilities for others coupled, perhaps, with a clear intent that the income beneficiary be the trust's primary beneficiary, disclaimers by those other beneficiaries as to their income and/or principal interests could either qualify the income interest for the TPT credit, or if it were merely a question of amount, increase the value of the income interest for credit purposes to its full actuarial value. However, if payment of income is entirely within the trustee's discretion, disclaimers by the other income recipients will not result in qualification of the income interest for TPT credit purposes.(17)

Where a life estate with a power of appointment trust is being used as the marital trust and your client desires to pay tax in the transferor's estate, the surviving spouse may disclaim the power of appointment over all or a portion of the trust. The portion of the trust to which the disclaimer applies will not qualify for the marital deduction, but the retained income interest in the trust will qualify as a beneficial interest in property for purposes of the TPT credit.

What if a trustee's administrative powers over a trust are too broad, such that the value of the income (or principal) interest is not susceptible to valuation? For example, the regulations provide that the power to invest in non-income-producing assets generally will render an income interest as not susceptible of being valued. A trustee's disclaimer of the offending provision will allow the income interest to be valued and thus qualify it for TPT credit purposes.

The above examples illustrate how careful thought, taking into consideration the TPT credit, could provide your clients with ways of taking advantage of the credit, while providing the family with flexible estate planning documents.

Admittedly, the TPT credit has been viewed as more of a post-mortem planning tool than as a traditional "pre-mortem" planning device. However, that was in the days of 100 percent deferral of tax upon the death of the first spouse being the norm. Clearly the economic analyses supports the concept that it is sometimes better to pay some estate tax in the estate of the first spouse to die (i.e., the transferor). This very well could become the norm for estates fitting certain parameters. This warrants that closer attention be paid to planning that maximizes the potential use of the TPT credit.

(1) All references will be to the Internal Revenue Code of 1986, unless otherwise indicated. References to Code sections will be referred to as "Code [Section]" or "[Section]."

(2) E.g., Pennell and Williamson, The Economics of Prepaying Wealth Transfer Tax, TR. & EST., June 1997 at 45, July, 1997 at 40, and August, 1997 at 52.

(3) Rudick, The Estate Tax Credit for Tax on Prior Transfers, 13 TAX L. REV. 3 (1957).

(4) Code [Section]2013(a), Treasury Regulations [Section]20.2013-1(a) (hereinafter all references to Treasury Regulations will be referred to as "Treas. Reg. [Section]" or "Reg. [Section]").

(5) See generally, Treas. Reg. [Section]20.20135.

(6) Id.

(7) This is the new term used in [Section]2010 after passage of the Taxpayer Relief Act of 1997 ("1997 Act"). For purposes of this article, all references to the old terminology, "Unified Credit," shall henceforth be referred to as the "Applicable Credit Amount" and to the "Applicable Exclusion Amount" (as such terms apply and as such terms are now defined in Code [Section]2010 after passage of the 1997 Act).

(8) Further prohibitions on the use of the [Section]7520 rate exist where the transfer instrument does not provide the life beneficiary with the degree of beneficial enjoyment that is consistent with the type of property interest the standard tables are designed to measure. Thus an income beneficiary must receive that degree of beneficial enjoyment that the principles of the law of trusts provide to a person who is unqualifiedly designated as the income beneficiary of the trust. Similarly, where a person is given the right to use tangible personal property, that use must coincide with the use, possession, and enjoyment of the property that applicable state law affords to a life tenant. Treas. Reg. [Section]20.7520-3(b)(4).

(9) Rev. Rul. 66-38, 1966-1 C.B. 212.

(10) Rev. Rul. 79-211, 1979-2 C.B. 319. 11 Kessler, Estate Tax Credits and Computations, 844 TAX MGMT. PORTFOLIO, at A-24.

(12) Treas. Reg. [Section]20.2013-2.

(13) Treas. Reg. [Section]20.2013-3.

(14) Typically, in the case of a married couple, the other part of the benefit is as a result of "running up the brackets" in the first spouse's estate. For a detailed analysis, see, Pennell's and Williamson's article, supra note 2. However, please note that the article was written before the 1997 Act, and as such some of the analysis may not be complete with respect to the period from 1998 to 2006 (i.e., the period that the Applicable Exclusion Amount will be increased from its current $600,000 amount to $1 million).

(15) Recall that there is a tension between the utilization of the TPT credit and the marital deduction. In order to receive the benefit of the TPT credit, the property transferred cannot be subject to the marital deduction in the estate of the transferor (i.e., first spouse to die). For an article discussing the optimization of the TPT credit with a partial QTIP election when spouses die in quick succession, see, Bost, The Optimal QTIP Election and the Prior 7) Transfer Credit, PROB. & PROP., May/ June, 1992 at 42.

(16) However, please note that although the five and five power will increase the potential benefit of the TPT credit, it may also increase the value of the surviving spouse's gross estate. Thus, careful analysis should be made before considering utilizing the five and five power. Clearly, if there are nontax reasons for including the five and five power, then the TPT credit would be an added benefit for utilizing the power.

(17) Excerpted from Moore, Recognition and Uses of Federal Estate Tax Credits in Estate Planning and Administration, PHILIP E. HECKERLING INST. ON EST. PLAN., [Section]805.3 (1987).

Robert J. Stommel is a shareholder with the Naples law firm of Myers Krause & Stevens, Chartered. He received his J.D., cum laude, from the Thomas M. Cooley Law School and is board certified in wills, trusts, and estates.

Lester B. Law is an associate with the Naples law firm of Myers Krause & Stevens, Chartered He received his J.D. from the University of North Carolina at Chapel Hill, and his LL.M. in taxation from the University of Florida, where he received the Richard B. Stevens Award. Mr. Law serves as co-editor of the Tax Notes column of The Florida Bar Journal.

This column is submitted on behalf of the Tax Law Section, Lauren Young Detzel, chair, and Michael D. Miller and Lester B. Law, editors.
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Title Annotation:tax on prior transfers
Author:Stommel, Robert J.; Law, Lester B.
Publication:Florida Bar Journal
Date:Jan 1, 1998
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