Significant recent developments in estate planning.
Once again, we have prepared our annual review of significant recent court decisions and IRS rulings. The results, contained in this issue and in the January 1994 issue, concern estate planning developments during the period Apr. 1, 1992 through Mar. 31, 1993. The summaries of developments will be supplemented by editorial comments (i.e., "Critiques" or "Planning hints") as they occur to us.
As a general note of caution, the estate planner should determine the current status of a reported development, particularly if the IRS has appealed or otherwise indicated that it will not follow a court decision. In such cases, the estate planner should emphasize to clients that the recommended plan, although supported by a court decision, may lead to litigation in which the IRS may prevail.
Part I, below, will discuss the following topics: disclaimers, debts, claims and administration expenses, gifts, life insurance, marital deduction, powers of appointment and retained interests.
In general, no developments occurring after Mar. 31, 1993 are included within this review, except when a court case or ruling has been issued affecting a development included in the text of this article.
Recent developments involving disclaimers included the following.
* Nine-month disclaimer period begins with date of death, not date will is probated.
* Dividend deposited unknowingly in disclaimant's account does not constitute acceptance.
* Qualified disclaimer by children and grandchildren of their residual interests increased the marital share.
* Nine-month disclaimer period begins
with date of death
In Fleming,(1) the decedent's husband died during September 1983 and bequeathed his residuary estate to his wife. In January 1984, his will was admitted to probate. The decedent died in May 1984. In August 1984, the decedent's executor filed a petition to disclaim her estate's interest in the husband's assets. The Seventh Circuit held that the disclaimer was not timely under Sec. 2518.
Critique: In general, Sec. 2518 requires that a disclaimer be filed in writing within nine months of the day on which the transfer creating the interest is made. The taxpayer argued that, under Illinois law, an interest in a decedent's property is not created until the will is submitted for probate. As such, the disclaimer was timely, since it was filed within nine months of that date.
The Seventh Circuit disagreed. It noted that the Illinois statute did not clearly and unambiguously state that a testator's assets are transferred only after a will is submitted to probate. Notwithstanding local law, however, the court noted that the underlying purpose for enacting Sec. 2518 was to establish a uniform standard "for determining the time within which a disclaimer must be made."(2) Looking to varying state law to determine when a transfer is made would defeat the congressional goal of uniformity. Further, Regs. Sec. 25.2518-2(c)(3) indicates that the date of death should be treated as the beginning of the disclaimer period within the meaning of the statute.
Planning hints: The taxpayer in Fleming pursued a lost cause from the outset. Both the regulations and the applicable committee reports clearly indicate that the date of death is the beginning of the disclaimer period. Further, Congress's clear intent was to remove local law considerations when determining a disclaimer's gift tax implications.
Unfortunately, the facts in Fleming placed a burden of urgency on the executor. The decedent died eight months after her husband. Further, it is unlikely that a disclaimer would have been made had she lived. Thus, the executor had only a month to get his planning house in order. However, the pressures imposed by the decedent's death eight months into the disclaimer period did not absolve the executor from taking the requisite action within the statutory period.
* Dividend deposited unknowingly in
disclaimant's account is not acceptance
In IRS Letter Ruling 9243024,(3) the decedent died holding 449.25 shares of an S corporation, which passed to the taxpayer by intestacy. A few months after the date of death, these shares paid a dividend to the estate. The decedent's administrator deposited it into a joint account of which the taxpayer was the surviving tenant. The taxpayer was at all times unaware of this dividend.
Within the period specified in Sec. 2518, the taxpayer sought to disclaim 55.65% of the shares (i.e., 250). The IRS found that the planned disclaimer conformed to the statutory requirements.
Critique: One of the criteria detailed in Sec. 2518 for a qualified disclaimer is that the disclaimant not accept any benefits from the property. Regs. Sec. 25.2518-2(d)(1) states that a prohibited acceptance of benefits includes accepting interest, dividends or rents or directing others to act with respect to the property. In Letter Ruling 9243024, the taxpayer was unaware of the dividend paid into her joint account and had not appropriated funds from that account. Further, she was neither a director of the corporation nor had she attended any shareholder meetings.
The IRS also stated that the disclaimer was not barred simply by the fact that bare title to the shares passed to her under the local intestacy law. Acceptance presupposes the receipt of more substantive benefits than temporary possession of legal ownership. Finally, the disclaimer of 250 shares was considered a valid "fractional disclaimer" within the meaning of Sec. 2518.
Planning hints: A disclaimer can be one of the most useful tools in postmortem planning. The Sec. 2518 rules are not onerous, but they must be complied with precisely. An untimely election and the inadvertent acceptance of benefits are the two most common reasons that disclaimers fail. Estate advisers should act carefully to maintain the option to use the disclaimer provisions. Depositing the dividend check to the taxpayer's account would have been fatal had she known of the transaction and not taken immediate steps to reverse it.
* Disclaimer by children and grandchildren
Increased marital share
In IRS Letter Ruling 9310020,(4) the decedent, a California resident, provided a "widow's election" bequest in his will. If the spouse so elected, the decedent's separate property, together with both his and his spouse's interests in community property, would be transferred to a marital deduction trust in which the surviving spouse had a right to income for life. Absent consent, the spouse would receive only her one-half community property interest under California law. The decedent's separate property and his share of community property would pass in trust for the benefit of his children, with the remainder passing outright to his grandchildren.
The surviving spouse executed the requisite consent. However, shortly thereafter, she revoked this document. Her children and grandchildren then proposed to disclaim their residual interests except to the extent of certain private company shares equal to a stated value. The IRS ruled that the disclaimers would be "qualified" under Sec. 2518 and that any amounts passing to the spouse by intestacy would qualify for the marital deduction.
Critique: The widow presumably made the election to qualify the entire estate for the marital deduction and maximize the total assets available for her support. Working in conjunction with her descendants, the consent's revocation dramatically changed the estate plan and tax consequences. The revocation redirected the decedent's estate to the descendants' trusts. At first blush, that action substantially increased the estate tax liability and eliminated all but the widow's community interest from the property available for her support.
The disclaimers shifted a substantial portion of the property back to her. Their effectiveness rested on the children's ability to remove all but the stock from the various trusts. Generally, a disclaimer will not qualify if a beneficiary merely disclaims income from specific property held in trust, while continuing to receive income from the remaining properties held in the same trust. Since the grandchildren received trust residue outright on the children's deaths, the disclaimers removed the property from the trusts. Consequently, the children did not retain a continuing interest. In light of the above, the IRS ruled that the disclaimers were timely under the statute and met the requirements of a fractional-interest disclaimer, as the shares retained from the residuary estate were severable property within the meaning of Regs. Sec. 25.2518-3(a)(1)(iii).
Similarly, in IRS Letter Ruling 9228004,(5) a series of disclaimers was executed by the decedent's children and grandchildren to secure a marital deduction. in that ruling, the testator's share of community property was bequeathed to a trust that did not qualify for the marital deduction. Once again, the result was dependent on the cooperation of willing and acquiescent second and third generation family members.
Planning hints: The effect of the disclaimers in Letter Ruling 9310020 was substantial. First, they greatly increased the amount of assets that the surviving spouse would otherwise have received by taking against the will. Second, they dramatically changed the nature of her interest in these assets. Under the will, she would have received merely a life estate in all of the decedent's property, while under the present arrangement she obtained an outright interest in a significant portion of these assets. Third, the estate was relieved of a substantial transfer tax cost. Fourth, when the children and grandchildren disclaimed, they retained closely held stock. Presumably that retention would avoid later inclusion in the widow's estate of that stock's substantial appreciation potential.
Finally, all this was accomplished without incurring gift tax. It is interesting to note, however, that the distribution plan implemented postmortem is likely very different from the one that the testator intended-or desired.
Debts, Claims and Administration Expenses
Some of the recent developments in the deductibility of debts, claims and administration expenses included the following.
* IRS is not bound by probate court decree in determining Sec. 2053 deductibility of expenditures.
* The deduction of the value of trees planted on leased property as a claim against the estate was disallowed.
* A probate court decree, by itself,
does not justify Sec. 2053 deductibility
In IRS Letter Ruling (TAM) 9246008,(6) the decedent's will named an unrelated third party as both attorney and executor of his estate and expressly stated that the individual was "entitled to receive a fee in both capacities." Both fees were paid and, subsequent to payment, the probate court issued a decree authorizing the expenditures.
One of the estate's five beneficiaries initially challenged a portion of these expenditures. However, the remaining four beneficiaries signed affidavits consenting to them. These affidavits were never filed with the probate court. The fifth beneficiary subsequently signed a statement declining to further pursue her protest. The IRS concluded that it is not bound by the probate court's decree in determining whether all of the expenditures were deductible under Sec. 2053.
Critique: See. 2053(a)(2) permits a deduction from the gross estate for amounts paid as administration expenses if they are allowable under the law of the jurisdiction under which the estate is administered. While the authorization granted by Sec. 2053 appears quite broad, its application is limited by the regulations. Regs. Sec. 20.2053-1(b)(2) limits deductibility to those expenditures that would be found by the highest court of the jurisdiction to have been properly paid in conjunction with estate administration. Further, while a lower court decree normally will be accepted in this area, it must be demonstrated that the decree was issued after passing on the merits of the claim. However, "[t]he decree will not be accepted if it is at variance with the law of the State; as, for example, an allowance made to an executor in excess of that prescribed by statute." (Emphasis supplied by the IRS.)
The IRS also cited the Fifth Circuit's decision in Pitner, which held that deductibility was conditional on the expenditure being "an |administration expense' within the meaning of that term as it is used in the statute, and that the amount sought to be deducted be reasonable under the circumstances."(7)
The IRS, in Letter Ruling 9246008, noted that the probate court had routinely approved the fees without qualitative review of their reasonableness since no formal protest had been filed by any party to the estate. As a result, the court decree did not meet the guidelines for acceptance in Regs. Sec. 20.2053-1(b)(2). Since there had been no review of the claim's merits under applicable state law, the IRS ruled that the statute, Pitner and the Supreme Court's holding in Bosch(8) permitted it to evaluate the expenditure's merits within the meaning of Sec. 2053 and state law.
Planning hints: On various occasions, the IRS has issued private letter rulings concerning its ability to "second guess" probate court decrees authorizing expenditures as administration expenses. It has had varied success in having this position stand up in litigation. In Letter Ruling 9246008, the IRS was clearly concerned about the double up of executor and attorney fees in a single person. It should be noted, however, that the ruling does not rule on the availability of a deduction in this instance. It only expresses the IRS's right to evaluate the claim within the context of local law and Sec. 2053. It remains uncertain how a court would decide the issue if the estate litigates an adverse holding.
* The value of fruit trees planted on
leased property not deductible as a claim
In Gettysburg National Bank,(9) the decedent leased real estate to a family corporation engaged in orchard operations. Under its terms, the lease was renewable automatically on a year-to-year basis and the tenant owned all fruit trees planted after the original lease date. In a claim for refund of Federal estate taxes, the decedent's estate deducted the value of the trees owned by the tenant as a claim against the estate under Sec. 2053(a). A district court disallowed the deduction.
Critique: Sec. 2053(a) provides for a deduction from a decedent's gross estate of amounts paid for funeral expenses, administration expenses and claims against the estate. To be deductible, a claim must be enforceable under local law at the time of death and the local law's technical requirements for the perfection of claims must be met.
In Gettysburg, the court wrestled with the question of whether the tenant's interest in the fruit trees constituted a claim within the meaning of local law. The court did not question the lease agreement's provisions governing ownership of the trees. However, the critical issue was the nature of the remedy possessed by the tenant with respect to the trees if the lease was terminated.
The court concluded that the trees constituted trade chattels under Pennsylvania law, since they were property used in the tenant's trade or business, affixed to the leased property by the tenant, and capable of being removed without permanent harm to the real estate. It then noted that the tenant's remedy, in the event of lease termination, was limited to physical removal of the trees. The remedy could not be converted to a right to cash damages. As such, local law did not establish an enforceable claim equal to the value of the trees that could be deducted under Sec. 2053(a). Further, the court indicated that a future reduction of the gross estate, equal to the value of the removed trees, might be justified, but only after such trees had been removed from the property.
Planning hints: While the estate's arguments in Gettysburg can be viewed as a "stretch," the case does demonstrate local law's importance in determining whether a debt or claim may be deducted from the gross estate. The case facts did not indicate where the value of the trees was actually included in the decedent's estate. The decedent was the owner of both the leased real estate and the family corporation that was its lessee. Presumably, the fruit trees owned by the corporation were included in its Federal estate tax value. Yet, the court also indicated that a reduction of the Federal estate tax value of the real estate might be appropriate if, and when, the trees are removed. Does this mean that the tenant's trees were also included when valuing the real estate? If so, the executor may have inadvertently caused a double inclusion in the estate.
In the gift tax area, the following developments occurred.
* An agreement to acknowledge adopted children as qualified beneficiaries triggered taxable gifts.
* A continuing taxable gift occurred when a preferred shareholder failed to raise the dividend yield.
* A retroactive adjustment clause was deemed ineffective for gift tax purposes.
* Agreement to include adopted children
in a beneficiary class deemed a gift
In IRS Letter Ruling 9308032,(10) the decedent died in 1956 and his will provided a testamentary trust for each of his two daughters. Under the will, each daughter received income for life and the remainder was distributable to her children per stirpes. The will was silent as to whether adopted children were qualified beneficiaries.
Both daughters had children, but one daughter's children were adopted. In order to protect her children's interests, that daughter entered into a series of agreements in 1982 with her sister and her sister's children that acknowledged her adopted children's remainder interest rights. These agreements, which were approved by the probate court, were purportedly executed to avoid the significant litigation costs that otherwise would result. The IRS ruled that the second daughter's children made a gift of their contingent remainder interests to their aunt's adopted children.
Critique: Relying on Bosch,(11) the IRS noted that a state trial court's characterization of property rights did not conclusively bind a Federal court or agency in an estate tax controversy. In such instances, the highest court of the jurisdiction is the best authority on the underlying substantive rule to be applied in the Federal matter.
In 1956, Connecticut followed the common law, which raised a presumption that an adopted child is not within "the intended bounty" of a settlor or testator. As such, in the absence of clear evidence to the contrary, the decedent's testamentary trusts were deemed to exclude the daughter's adopted children from the remainder bequest. She testified that the decedent had orally expressed his belief that natural and adopted children should be treated the same. However, these comments were made prior to any adoptions occurring and were unsupported by any language in the decedent's will. The IRS viewed these comments as not controlling. In 1959, Connecticut passed a statute that overturned the common-law rule and treated adopted children on a parity with natural children. The IRS ruled this statute irrelevant since it was expressly limited to wills of individuals dying after Oct. 1, 1959.
Finally, in 1991, the Connecticut statute was revised to extend the application of the 1959 law to the estates of decedents dying before Oct. 1, 1959. The IRS ruled that this statute had no effect on the children who had executed the 1982 agreements. As such, they were deemed to have made a gift of a contingent remainder interest as of that date. However, with respect to those children who were minors and did not sign the agreement, the 1991 statute expunged their contingent remainder interest and no gift was deemed made by them.
Planning hints: The facts of Letter Ruling 9308032 are obviously unusual. However, the ruling does demonstrate how inattention to local law can result in unintended results that can have adverse consequences to almost all of the involved parties. Clearly, in the instant situation, both daughters obviously believed the decedent intended adopted and natural children to benefit from the trusts. Omissions in the will defeated this intent. However, a good-faith attempt to "right" the problem triggered unanticipated taxable gifts. All of this could have been avoided had adopted children been included in the beneficiary class from the outset.
* Continuing gift found when preferred shareholder
did not raise amount of dividend
In IRS Letter Ruling (TAM) 9301001,(12) in 1981, the taxpayer established a new corporation and transferred to it assets having a total value of $4.29 million. In exchange, he received 244 shares of common stock and 5,430 shares of voting preferred. The preferred stock had a liquidation right of $790 per share and a noncumulative annual dividend right of $3. Two weeks later, he transferred all of the common shares to his children.
Subsequently, the new corporation had substantial annual income. Throughout this period, the $3 noncumulative dividend was paid regularly. The IRS ruled that a continuing taxable gift occurred each year to the extent of the difference between the hypothetical preferred return that could reasonably have been secured on the taxpayer's investment and the $3 per share actually paid.
Critique: The IRS first noted that, at the time of the corporation's formation, the average yield on newly issued, publicly held preferred shares was 11.55%. The $3 dividend equated to a return of only 0.0038%. After the transaction, the taxpayer "presumably" had sufficient voting control to either liquidate the corporation or revise upward the dividend yield on his preferred holdings. The IRS stated that the taxpayer's failure to do either resulted in a substantial windfall to the common shareholders, as virtually all of the corporation's income inured to their benefit.
The ruling rested on the IRS's interpretation of the Tax Court's decisions in Anderson(13) and Snyder.(14) In Anderson, the Tax Court held that the decedent's voting preferred shares should have been valued with the recognition that his voting control permitted him to liquidate the corporation at any time. As such, the court concluded that the taxpayer could have recovered the value of his stock at any time.
In Snyder, the taxpayer's 7% noncumulative Class A preferred could be converted at any time, and without penalty, into 7% cumulative Class B shares having an additional 5% noncumulative option. The Tax Court argued that no business reason prevented the taxpayer from making a "free" conversion election that was clearly to her economic advantage. Further, since unpaid noncumulative dividends indirectly inured to the benefit of the common shareholders (i.e., the taxpayer's children), her annual failure to convert was deemed a donative act.
The IRS's reliance on both cases is faulty. In Snyder, the taxpayer possessed a conversion right that was legally inherent in her preferred stock. No recapitalization or other extraordinary action was required to convert. Further, both the Class A and Class B preferred were identical in every way, except for the enhanced dividend feature of the Class B shares. As a result, the Tax Court could see no economic disincentive to the taxpayer from conversion. She would be in the same position as before, except for the substitution of a 7% cumulative dividend for a 7% noncumulative one. In fact, the sole beneficiaries of a failure to convert were the common shareholders.
In Anderson, the court noted that the preferred shareholder's ability to liquidate the corporation must be considered when valuing his stock interest. This is a far cry from saying that a comparable power in the instant case required the taxpayer to force a distribution of assets and that those assets could have been readily invested at an 11.55% return. In fact, the corporation in Letter Ruling 9301001 held various assets, most of which were illiquid and not readily marketable. As to a controlling shareholder's fiduciary obligations to minority owners, the IRS simply stated that the taxpayer could and should have used that control to correct a dividend rate that was "grossly unfair" to himself.
Planning hints: The IRS obviously continues to be troubled by aspects of some freeze transactions that occurred before Chapter 14's enactment. Interestingly, unlike some prior attempts to assert a gift for taxpayers' failures to act,(15) the IRS did not raise Dickman(16) as support, presumably due to the Tax Court's Snyder decision. Perhaps a gift did occur, but it was not a continuing gift as expressed in the ruling. Rather, at the date of formation, the preferred shares may have had a fair market value (FMV) significantly less than their stated value. If so, a one-time gift tax could have been assessed on the common stock gift. Note that this desired result is behind the legislative "cure" to these freeze transactions. Chapter 14 would cause an automatic front-end gift if this transaction had occurred after Oct. 8, 1990.
* A retroactive adjustment is ignored
for gift tax purposes
In IRS Letter Ruling (TAM) 9309001,(17) the donor transferred real property to a limited partnership in exchange for a 1% general partnership interest and a 98.98678% limited partnership interest. The remaining limited interests were acquired by her two children for a nominal amount. On the same day, a total of 88.72141% of the limited partnership interests were transferred by gift to the donor's children and grandchildren.
For each transfer, the donor executed a document purporting to limit each donee's gift to a specified dollar amount. It provided that the donor would be deemed to reacquire a fractional portion of each gift to the extent a settlement agreement or court decree determined that the value exceeded the intended gift amount. The IRS ruled that the retroactive adjustment clause was ineffective for gift tax purposes.
Critique: The donor asserted that the transfer in excess of the "specified amount" was incomplete within the meaning of Regs. Sec. 25.2511-2(b), since she had not parted with the requisite dominion and control of the property. The IRS disagreed. Citing Procter,(18) it stated that retroactive adjustment clauses are against public policy for three reasons:
1. They discourage tax collection since the only effect of a tax enforcement effort is to defeat the gift.
2. They obstruct the administration of justice by requiring courts to pass on a moot case.
3. They neutralize the effect of a final judgment at the time the judgment is rendered.
The IRS stated that mandating a partial reacquisition in the event of a settlement agreement does not remove the clause from the application of the Procter rule. It could identify no bona fide situation, other than an IRS challenge, where a settlement would arise. In addition, parties acting at arm's length would never enter into such an agreement, as the actual amount of the transfer would be indeterminate for several years.
In the area of the taxation of life insurance, the following development occurred.
* A transfer for value to a partnership does not forfeit Federal income tax exemption of insurance proceeds.
* Transfer for value to partnership
does not forfeit income tax exclusion
In IRS Letter Ruling 9309021,(19) A and B were shareholders of two closely held corporations. Each corporation held insurance policies on the lives of both individuals. These policies were to be used in conjunction with a stock purchase agreement among the shareholders and the corporations.
A and B propose to form a general partnership. They intend to have the partnership purchase the life insurance policies from the corporations at their interpolated terminal reserve values. On their deaths, the proceeds would be paid in retirement of their partnership interests. The IRS ruled that the insurance proceeds would not lose their Federal income tax exemption as a result of the transaction.
Critique: Sec. 101(a)(1) provides that gross income will not include amounts received under a life insurance contract, provided that they are paid by reason of the insured's death. Sec. 101(a][2) modifies this general rule if the life insurance contract has been transferred to another for valuable consideration. In such circumstances, the income tax exclusion is limited to the consideration paid, plus the amount of premiums or other payments made by the transferee with respect to the policy.
The "transfer-for-value" rule does not apply if the transfer is made to the insured, a partner of the insured, a partnership of which the insured is a partner, or a corporation of which the insured is a shareholder.(20) Since A and B were shareholders of the transferor corporations and partners of the transferee partnership, the IRS concluded that the Federal income tax exclusion was not forfeited.
Further, the IRS stated that, on an insured's death, the proceeds are reflected in that partner's distributive share as tax-exempt income under Sec. 702. The result is a positive basis adjustment under Sec. 705(a)(1)(B). Finally, distribution of the proceeds to the partner would be income tax free, except to the extent cash distributions exceed the partner's basis in the partnership.(21)
In a somewhat similar transaction, the Sec. 101(a)(1) exclusion was not lost when corporate-owned insurance was purchased at FMV from the corporation by an irrevocable trust created by the insured. The critical fact in IRS Letter Ruling 9235029(22) was that the insured and the irrevocable trust were partners in a partnership, which apparently was not involved in the transaction. As such, all parties were permissible transferees within the meaning of Sec. 101(a)(2)(B).
Similarly, in IRS Letter Ruling 9239033,(23) B, a shareholder of Y Corporation, acquired for value a life insurance policy on A, who was also a shareholder of the same corporation. As in Letter Ruling 9235029, the proceeds' income tax exclusion rested on the fact that A, B and the corporation were general partners in the same partnership.
Planning hints: Many estate plans, particularly those involving a closely held business, rely on some insurance to help fund Federal estate taxes and buyout agreements. In today's dynamic and uncertain economic climate, however, there is no certainty that the business entities in place when a plan is initially implemented will continue unchanged for the balance of a taxpayer's lifetime. New partnerships and corporations may be established to pursue new product lines or geographical markets. In many instances, the older entity holding the insurance may shrink in value or be sold, while newer ones are created and grow. Estate planners sometimes overlook the adverse consequences that may result when life insurance, particularly that intended for use in a buyout, is located in the wrong entity. Secs. 101(a)(1) and 101[a)(2)(B) provide taxpayers with considerable flexibility in addressing this problem, as the above letter rulings clearly demonstrate.
The approach in Letter Ruling 9235029 removes the insurance from risks associated with corporate ownership and simplifies the use of the insurance proceeds through partnership ownership. Advisers must consider the valuation and estate inclusion issues inherent in an insured-owned entity holding the insurance policy.
Developments relating to the marital deduction included the following.
* QTIP trusts did not qualify for the marital deduction when the assets were redirected in the event of nonelection.
* A QTIP was deemed valid even though the trustee possessed an "accumulation" right.
* The gift of six works of fine art qualified for QTIP status.
* A gift of a limited partnership interest qualified for the marital deduction.
* QTIPs fail due to alternate beneficiaries
in event of nonelection
In Robertson,(24) the decedent bequeathed most of his residuary estate to three separate marital trusts. The balance passed to a family trust for the exclusive benefit of his descendants. Two of the marital trusts were intended to be qualified terminable interest property trusts (QTIPs); however, the will directed assets to be reallocated to the family trust to the extent not covered by a valid QTIP election. The Tax Court held that the two QTIP trusts did not qualify for the marital deduction even though valid QTIP elections were filed.
Critique: Agreeing with the position previously asserted by the IRS, the Tax Court denied the marital deduction because the amount passing to the surviving spouse was indeterminate at the date of the decedent's death, having been subject to a power of divestiture in the executor.
The Tax Court stated that two crucial requirements for a QTIP marital deduction were missing in the testamentary bequest. First, the assets in the two trusts did not "pass from the decedent" since the bequest was merely conditional. Vesting did not occur until the executor, not the decedent, undertook a positive act, i.e., a QTIP election. Further, in the absence of that act, the trust assets were irrevocably redirected away from the surviving spouse. As a result, the marital trusts were deemed to be derived from the actions of the executor, rather than passing under the decedent's will.
Second, the bequest violated the Sec. 2056(b)(7)(B)(ii)(I) requirement that the surviving spouse be entitled to all of the income from the property for the remainder of her life. The executor's powers in Robertson were deemed to be equivalent to a power of appointment in favor of a third party exercisable during the spouse's life. In support of its decision, the Tax Court cited its holding in Clayton,(25) which dealt with a similar fact pattern.
Notwithstanding the fact that the Tax Court's decisions in Robertson and Clayton conformed with the long-held views of the IRS and of most commentators, the Fifth Circuit has now introduced a considerable measure of uncertainty. On appeal, it reversed the Tax Court's decision in Clayton, holding that the QTIP election was valid with respect to the elected assets, even though the nonelected assets passed under the will to other trusts in which the surviving spouse did not possess a qualified income interest.
In its decision, the Fifth Circuit summarily disposed of the question of whether the QTIP assets "passed from the decedent" under the will. it simply said that they did and that there was no disagreement on this issue among the parties. As such, it found that the sole issue for resolution was whether the surviving spouse possessed a qualified income interest in the QTIP property from the date of death.
The IRS asserted that this qualified income interest must, under the statute, extend to all potential QTIP property and that the reallocation clause defeated this right by empowering the executor to "appoint" a portion of the property (and its income) to the family trust. The Fifth Circuit disagreed. It argued that there was significance in Congress's awarding the elective right to the executor, rather than the surviving spouse, in that the estate was an extension of the decedent. In effect, the election, and the right to make a partial election, provided the decedent's surrogate with the ability to modify the dispositive scheme within the election period. As long as this modification was within the parameters outlined in the will, the court could not find that a passing from the decedent did not occur.
Secondly, the court noted that all estate tax elections, including the QTIP, are deemed made at the time of death. As such, the executor's election had the legal effect of establishing the QTIP status and perfecting the surviving spouse's rights in the elected property as of the date of death. Further, since none of the trusts were funded from the estate until an election was made (or not made), the surviving spouse was legally deemed to have a qualified income interest in the entire trust property covered by the election in conformity with the requirements of the statute.
The Fifth Circuit was troubled by the apparent inequity of denying a marital deduction in Clayton because granting the deduction would not have defeated the overall statutory scheme underlying the marital deduction. As the court noted, the assets assigned to the QTIP trust would be taxed at the surviving spouse's death and the property not covered by the election would be taxed immediately in the decedent's estate. As such, "Congress clearly could not care less about the post-mortem disposition of that portion of the residue of the testator's estate for which the QTIP election was not made, because every dollar's worth of that property was taxed currently in the estate of the Testator ...."(26) (Emphasis added.) Planning hints: The Fifth Circuit's opinion in Clayton is well-reasoned and conforms to the economic realities of the situation. If it is followed by other circuits, it can provide a far greater degree of flexibility in the use of partial QTIP elections than is presently the case. However, the IRS is not likely to acquiesce and is probably now seeking to test the issue in another circuit.
In view of the plethora of letter rulings, technical advice memoranda and cases involving fiduciary powers affecting QTIP qualification, drafters should exercise extreme caution. Seldom does the extra flexibility resulting from these powers appear to offset the risk of significant tax dollars due to the potential loss of the marital deduction.
* QTIP valid even though trustee possessed
In Ellingson,(27) the decedent and his spouse created an inter vivos revocable trust as part of their "comprehensive estate plan." On the decedent's death, a portion of the trust assets, including the family farm, was allocated to a marital trust. Under its terms, the marital trust directed the trustees to distribute the "entire net income" to the surviving spouse at least annually. However, another provision authorized income accumulation if the income exceeded the surviving spouse's needs, "best interests and welfare." The Ninth Circuit held that the trust qualified for the marital deduction.
Critique: The sole issue was whether the accumulation provision prevented the surviving spouse from having a qualified income interest within the meaning of Sec. 2056(b)(7)(B)(ii). Citing Prop. Regs. Sec. 20.2056(b)-7(c)(1), the Ninth Circuit stated that a qualified income interest is one that entitles the surviving spouse to all of the income from the property, payable at least annually.
The court noted that the trust instrument did present some ambiguities. It appeared to provide the requisite interest, only to take it away in a subsequent provision. Because of this ambiguity, it concluded that an additional effort must be made to glean the grantor's intent. Further, this intent was to be derived from a reading of the instrument, plus a review of the facts surrounding its creation. In pursuing this exercise, the court was bound by Arizona law.
In concluding that the grantors intended that all income be annually distributed, the court relied on two factors: First, the agreement contained language indicating the intention that the assets allocated to the marital trust "may" qualify for the marital deduction and "may" be the subject of a QTIP election. The court disagreed with the IRS's contention that the word "may" was a weak direction and not equivalent to a mandate. Rather, it took the position that the word "may" was consistent with the grantors' intentions if QTIP status was not elected, i.e., accumulation could be appropriate if there was no longer a statutory requirement that income be currently distributed.
Second, the court noted that income could be accumulated only to the extent it exceeded the surviving spouse's "best interests." The court interpreted the "best interests" provision as mandating that all income be distributed currently, since it was in the spouse's best interests that taxes not be paid on the marital bequest property. The court noted that the imposition of such a tax would have forced a sale of the family farm and a significant reduction in the spouse's income. The court noted that the accumulation standard applied to the same trust after the spouse's death did not include the "best interests" of the alternative takers. In support of this reading, the court cited Todd.(28) In Todd, the Tax Court ignored an accumulation provision that directed the trustee to expend income necessary to "accomplish the purposes of this trust." The Tax Court concluded that the instrument clearly expressed a purpose that the trust qualify for the marital deduction.
Planning hints: The holding in Ellingson, like that in Clayton, should be relied on only with caution. The Ninth Circuit was clearly bothered by the fact that denying the marital deduction would have increased the taxable estate by $8 million and forced the sale of the family farm. Further, the court's explaining away the use of the word "may" (as distinguished from "shall") in the critical trust provision raises more questions than it answers.
Most significantly, this decision seems to put the Ninth Circuit in agreement with the Fifth Circuit's decision in Clayton. If the accumulation right becomes effective only in the absence of a QTIP election, the elective trust's dispositive provisions differ from the provisions in the absence of the election.
Another question concerns whether local law interpretation of the "best interests" phrase would bar the executor from nonelection of QTIP status. This seems to be what the Ninth Circuit is asserting, but the opinion offers no guidance on this issue. To be logical, the court should have followed the Fifth Circuit's approach and held that the election, once made, was retroactive to the date of death and that the "best interests" language, when viewed in conjunction with the positive election, required a distribution of all income. Notwithstanding, the court's arguments are weak and should be viewed as an attempt to remedy an otherwise poorly drafted instrument.
* Fine art gift qualifies for QTIP
In IRS Letter Ruling 9242006,(29) the donor transferred to his spouse a legal life estate in six pieces of fine art. Under the deed of gift, the spouse was entitled to full use of the property during her life, including the right to license photographs and reproductions of the pieces, as well as to sell her life interest (but not the artwork itself). She was not required to insure the pieces, nor did she bear any risk of loss. The IRS ruled that a valid QTIP election could be made.
Critique: Sec. 2523(f) allows a gift tax marital deduction for a QTIP, provided the property has passed from the donor, the donee spouse has a qualified income interest for life and a QTIP election is made. Regs. Secs. 20.2056(b)5(f)(4) and 20.2056(b)-5(f)(5) clarify that a life interest in a residence or other nonproductive property, in trust or otherwise, qualifies for QTIP status unless the trust's or life estate's primary purpose is to safeguard the property without providing the spouse with full beneficial enjoyment for life.
In Lettcr Ruling 9242006, the IRS found that the spouse's unrestricted use of the artwork during her lifetime, coupled with her right to license reproductions and photographs, provided her with the requisite beneficial enjoyment. Further, since the spouse was not required to insure the property and was not liable for any loss, "it cannot be said that safeguarding the artwork is a primary purpose of the arrangement ...."
* Gift of limited partnership interest
qualifies for marital deduction
In IRS Letter Ruling 9310039,(30) in 1992, the donor and his spouse formed a limited investment partnership. The donor transferred $990,000 in exchange for a 1% general and 98% limited interest and his spouse transferred $10,000 for a1% limited interest. Shortly thereafter, the donor made a gift of his entire limited partnership interest to his spouse. The IRS ruled that the gift qualified for the marital deduction and that the transferred interest would not subsequently be includible in the donor's gross estate under Secs. 2036 and 2038.
Critique: In order for a gift to qualify for the gift tax marital deduction, it must not be a terminable interest. Under Sec. 2523(b), a terminable interest is one that will fail or terminate with the passage of time, the occurrence of an event or contingency, or on the failure of an event or contingency to occur. In the ruling, the donor, as general partner, retained broad powers over the management of partnership assets. The limited partners had no defined rights to interim distributions from the partnership prior to its scheduled termination. However, the IRS concluded that the partnership interest was not terminable within the meaning of Sec. 2523(b).
The IRS found that the management and interim distribution rights held by the donor, in his capacity as general partner, were circumscribed by local partnership law. The general partner, in exercising his authority, was bound by a fiduciary duty to act in the best interests of all partners. Because of this, and the fact that the limited partner's rights to partnership capital and undistributed income could not be changed, the IRS cited Byrum(31) in concluding that the donor did not have a retained right to control enjoyment within the meaning of Sec. 2036(a) or a power to revoke, modify or amend the transfer under Sec. 2038.
Powers of Appointment
In the powers of appointment area the following development occurred.
* "Comfort" is not considered an ascertainable standard in "reciprocal" trusts within the meaning of See. 2041.
* "Comfort" is not ascertainable standard
in "reciprocal" trusts
In IRS Letter Ruling 9235025,(32) the decedent's will created two identical trusts for his children's benefit. Each trust authorized the trustees to distribute principal to the primary beneficiary under a standard of "support, maintenance, comfort, emergencies and serious illness." While both children were named as co-trustees of each trust, local law prohibited a beneficiary-trustee from making discretionary distributions on his own behalf.
The IRS concluded that "comfort" is not an ascertainable standard within the meaning of Sec. 2041. The IRS then deemed each child to have a general power of appointment by asserting the reciprocal trust doctrine.
Critique: The IRS noted that Regs. Sec. 20.2041-1(c)(2) defines an ascertainable standard as one that is reasonably measurable in terms of "health, education, or support (or any combination of them)." It also cited Rev. Rul. 77-194,(33) Penner(34) and Sowell(35) in support of the contention that "comfort" and "emergencies" have been long recognized as providing a trustee with a far broader standard than is contemplated under Sec. 2041.
The IRS then addressed whether a beneficiary-trustee could be deemed to possess distributive powers over his trust, even though local law prohibited him from exercising discretion on his own behalf. The ruling rested on the "reciprocal trust doctrine" first established in Grace.(36) In Grace, two individuals each established an identical trust for the benefit of the other. Each grantor retained broad discretionary powers over distributions in favor of the primary beneficiary. The Supreme Court held that the reciprocal nature of the powers created an objective inference that each would exercise the distributive powers on a reciprocal basis.
Grace did not deal with powers of appointment in trusts created by a third party. Extending the "reciprocal trust" doctrine to the testamentary trusts in Letter Ruling 9235025 seems somewhat of a "stretch." In Grace, the Supreme Court was clearly addressing an abusive situation. The taxpayers had consciously created reciprocal trusts so as to achieve an indirect economic interest, yet avoid estate inclusion under the retained interest rules in effect at that time. No such abuse existed in Letter Ruling 9235025. Further, the IRS rested its conclusion on a New York Surrogate Court ruling in Spear(37) that general powers of appointment, under New York law, were deemed to exist in each primary beneficiary under roughly comparable facts.
Planning hints: Aside from the merits of applying the "reciprocal trust" doctrine, the ruling once again demonstrates the folly of varying from the language of the statute and regulations when enumerating "ascertainable" distribution standards in a trust instrument when the beneficiary is also trustee. Since this estate planning series was first published over two decades ago, the authors have cautioned estate planners about the adverse consequences of supplementing the standards of health, maintenance, education and support with such words as "comfort," "well-being" and "emergencies." Those who continue to "stretch" for the perceived flexibility will continue to have trouble in technical advice requests and in the courts.
Recent developments relating to retained interests included the following.
* The court recharacterized a "sale" of a residence as a gift with a retained interest.
* The FMV of certificates transferred to a revocable trust was includible in the decedent's gross estate under Sec. 2038.
* Sale of residence deemed a gift
with retained interest
In Maxwell,(38) in March 1984, the decedent "sold" her personal residence to her son and daughter-in-law for $270,000. At the time of sale she forgave $20,000 of the purchase price and received an interest-bearing mortgage note in the amount of $250,000. She also executed a five-year lease on the property at an $1,800 per month rental.
The decedent forgave an additional $20,000 of mortgage principal in each of 1985 and 1986. She also revised her will to reflect a testamentary forgiveness of any remaining unpaid balance that was owed at the time of her death. Between the dates of sale and decedent's death in 1986, both the interest on the note and the monthly rental were regularly paid. The decedent was living in the residence at the time of her death. The Tax Court held that the residence's full value was includible in the decedent's estate under Sec. 2036 and the Second Circuit recently affirmed that decision.
Critique: The Tax Court concluded that the series of transactions occurring in Maxwell represented, in substance, a transfer subject to an implied retained lifetime interest. Several reasons were given supporting this conclusion. First, the decedent's practice of annually forgiving a portion of the note, coupled with her testamentary forgiveness of the unpaid balance, led the court to believe that none of the parties ever contemplated making cash payments against principal. Second, the difference between the annual interest and rental payments was less than $1,500. Since these payments were exchanged between a parent and child, the court found them lacking in economic substance. Finally, at the time of the sale and leaseback, the decedent was 82 years old and suffering from cancer. As such, the Tax Court asserted that all parties recognized that the lease term probably extended beyond her true life expectancy.
In reaching its decision, the court stated: "Taken singly, none of these facts may be determinative of the parties' intent .... But viewed as a whole, they leave the unmistakable impression that regardless of how long the decedent lived ..., the entire principal balance ... would be forgiven, and the Maxwells would not be required to pay any of such principal."(39)
The holding in Maxwell should be contrasted with that in Powell.(40) In the latter case, the decedent, in 1983, began transferring to her children undivided fractional interests in her residence. At the time of her death, the children owned a 60% undivided interest in the property as tenants in common with their mother. The key difference between Maxwell and Powell involved the decedent's continued occupancy of the residence once the gift program was initiated. In Powell, the decedent's ill health required that she move to a managed care facility. The Tax Court noted that, once the decedent left her home, no evidence was presented indicating she had any intention of returning. Further, it was not considered relevant that the donees failed to use the property as their principal residence.
Planning hints: The adverse decision in Maxwell rested largely on the court's recharacterization of the "sale" as a gift. The decedent's advisers failed to take note of the "substance over form" doctrine that applies to such transactions. The overall facts simply did not pass the Tax Court's smell test. The "sale" was structured from the outset as a poorly disguised gift. This was evident from the immediate forgiveness of $20,000 on the date of sale, followed by annually forgiving like amounts. It would have been wiser to have required the purchasers to make some principal payments on the note. In fact, while the court did not address the issue, it could be argued that the entire gift of the property occurred on the date of original conveyance, less the actuarial value of the decedent's retained life estate.
* Gifts from revocable trust
may be includible under Sec. 2038
In IRS Letter Ruling (TAM) 9226007,(41) the decedent transferred voting trust certificates to a revocable trust. The trust instrument directed the trustee to distribute income or principal to the decedent or as otherwise directed. Between 1986 and 1988, a period ending within three years of the decedent's death, certificates having an estimated FMV of approximately $950,000 were distributed to various donees. The IRS ruled that the FMV of the transferred certificates was includible in the gross estate under Secs. 2035(a) and (d)(2) and 2038.
Critique: Sec. 2038(a)(1) provides that the value of previously transferred property will be included in the transferor's gross estate if it is either subject to a retained power of revocation, modification or amendment or if such a power was relinquished during the three-year period ending with the decedent's date of death. In addition, Sec. 2035(d)(2) requires the inclusion of property transferred within three years of death if, prior to the transfer, the property would have been included under Sec. 2036, 2037, 2038 or 2042.
Citing Jalkut,(42) the IRS noted that the trust agreement expressly authorized the trustee to make distributions of property to third parties at the grantor's request. Under such circumstances, the conveyance of the property out of the trust removed it from the scope of the decedent's retained power of revocation. This removal was deemed to be equivalent to a relinquishment of that power. Further, within the context of Sec. 2035(d)(2), had the conveyance not been made, the property would have remained in the trust and, thereby, been includible under Sec. 2038.
A different result occurred in IRS Letter Ruling (TAM) 9309003.(43) However, the IRS distinguished the two rulings by noting that, in the latter, the trust agreement permitted distributions only to, or on behalf of, the grantor. As such, the distributions to third parties in Letter Ruling 9309003 could legally be accomplished only if property was withdrawn from the trust and, thereafter, transferred by the grantor to the donees. A withdrawal is not considered a relinquishment within the meaning of Sec. 2038 and once the property was reacquired by the grantor, its future includibility is governed by Sec. 2033. Transfers within three years of death of property that would be includible under Sec. 2033 do not fall within the purview of Sec. 2035(d)(2).
Planning hints: During the past few years, a number of taxpayer disasters have arisen under the position reflected in Letter Ruling 9226007. However, both the IRS and the courts have agreed that third-party gifts from a revocable trust will result in inclusion under Sec. 2038 when the transfers occur within three years of the grantor's death and the instrument authorizes such transfers. The cost of ignoring this rule can be substantial, since inclusion extends to the FMV of the property at the date of death and not simply the value at the time of conveyance.
Tax planners are urged to draft new documents to avoid this trap and, when current gifts are contemplated, review existing documents to be sure that a risk of inclusion does not exist. When it does, the easy answer is to first withdraw the property from the trust and then reconvey it to the intended donees. Obviously, form is paramount here; it favors the government, and drafters have generated disasters by ignoring the decisions, technical advice memoranda and letter rulings delineating the distinctions to be applied.(44)
(1) Est. of Jennie Fleming, 974 F2d 894 (7th Cir. 1992)(70 AFTR2d 92-6226, 92-2 USTC [paragraph] 60,113), aff'g TC Memo 1989-675. (2) H. Rep. No. 1380, 94th Cong., 2d Sess. 66-67 (1976). (3) IRS Letter Ruling 9243024 (7/23/92). (4) IRS Letter Ruling 9310020 (12/14/92). (5) IRS Letter Ruling (TAM) 9228004 (3/31/92). (6) IRS Letter Ruling (TAM) 9246008 (7/31/92). (7) Moselle Silvey Pitner, 388 F2d 651 (5th Cir. 1967)(21 AFTR2d 1571, 68-1 USTC [paragraph] 12,499). (8) Est. of Herman J. Bosch, 387 US 456 (1967)(19 AFTR2d 1891, 67-2 USTC [paragraph] 12,472). (9) Gettysburg National Bank, M.D. Pa., 1992 (70 AFTR2d 92-6229, 92-2 USTC [paragraph] 60,108). (10) IRS Letter Ruling 9308032 (11/30/92). (11) Bosch, note 8. (12) IRS Letter Ruling (TAM) 9301001 (6/30/92). (13) Est. of James W. Anderson, TC Memo 1988-511. (14) Elizabeth W. Snyder, 93 TC 529 (1989). (15) See, e.g., IRS Letter Rulings (TAMs) 8723007 (2/18/87), 8726005 (3/13/87) and 8610011 (11/15/85). (16) Esther C. Dickman, 465 US 330 (1984)(53 AFTR2d 84-1608, 84-1 USTC [paragraph] 9240). (17) IRS Letter Ruling (TAM) 9309001 (9/30/92). (18) Frederic W. Procter, 142 F2d 824 (4th Cir. 1944)(32 AFTR 750, 44-1 USTC [paragraph] 10, 123). (19) IRS Letter Ruling 9309021 (12/3/92). (20) Sec. 101(a)(2)(b). (21) Sec. 731. (22) IRS Letter Ruling 9235029 (5/29/92). (23) IRS Letter Ruling 9239033 (6/30./92). (24) Est. of Willard E. Robertson, 98 TC 678 (1992). (25) Est. of Arthur M. Clayton, Jr., 976 F2d 1486 (5th Cir. 1992)(70 AFTR2d 92-6262, 92-2 USTC [paragraph] 60,121), rev'g and rem'g 97 TC 327 (1991). (26) Id., 5th Cir., at 92-2 USTC 86,286. (27) Est. of George D. Ellingson, 964 F2d 959 (9th Cir. 1992)(69 AFTR2d 92-1475, 92-1 USTC [paragraph] 60,101), rev'g 96 to 760 (1991). (28) Est. of James S. Todd, Jr., 57 TC 288 (1971). (29) IRS Letter Ruling 9242006 (7/15/92). (30) IRS Letter Ruling 9310039 (12/16/92). (31) Marian A. Byrum, 408 US 125 (1972)(30 AFTR2d 72-5811, 72-2 USTC [paragraph] 12,859). (32) IRS Letter Ruling 9235025 (5/29/92). (33) Rev. Rul. 77-194, 1977-1 CB 283. (34) Est. of Alice B. Penner, 67 TC 864 (1977). (35) Est. of Ida Maude Sowell, 74 TC 1001 (1980). (36) Est. of Joseph P. Grace, 395 US 316 (1969)(23 AFTR2d 69-1954, 69-1 USTC [paragraph] 12,609). (37) Matter of Est. of Nathaniel Spear, Jr., 553 N.Y.S.2d 985 (Sur. 1990). (38) Est. of Lydia G. Maxwell, 2d Cir., 1993 (72 AFTR2d [paragraph] 149, 100, 93-2 USTC [paragraph] 60,145), aff'g 98 TC 594 (1992). (39) Id., TC, at 604-605. See also Minnie E. Deal, 29 TC 730 (1958). (40) Est. of Marion I. Powell, TC Memo 1992-367. (41) IRS Letter Ruling (TAM) 9226007 (2/28/92). (42) Est. of Lee D. Jalkut, 96 TC 675 (1991), acq. 1991-2 CB 1. (43) IRS Letter Ruling (TAM) 9309003 (11/13/92). (44) See Abbin, Carlson and Nager, "Significant Recent Developments in Estate Planning (Part I)," 23 The Tax Adviser 676 (Oct. 1992), at 687.
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|Title Annotation:||part 1|
|Author:||Carlson, David K.|
|Publication:||The Tax Adviser|
|Date:||Dec 1, 1993|
|Previous Article:||Investment interest expense and capital gain income.|
|Next Article:||The new $150,000 limit on qualified plan compensation.|