Significant recent developments in estate planning.
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: gifts, disclaimers, debts, claims and administration expenses, powers of appointment, retained interests and charitable deductions.
In general, no developments occurring after Mar. 31, 1994 are included within this review, except when a case or ruling has been issued affecting a development included in the text of this article.
Recent developments involving gifts included the following.
* The exercise of a limited power of appointment creating a new trust was not a taxable gift.
* The exercise of a limited power of appointment in favor of family members resulted in a taxable gift.
* When considered together, the issuance of an employment agreement and voting stock constituted a gift.
* Funds transferred after death from a brokerage account were not completed gifts.
* Transfers made under a durable power of attorney were incomplete gifts.
* Exercise of power of appointment creating new trust not a gift
In Letter Ruling 9352005,(1) a trust was created in the taxpayer's spouse's will. Under its terms, the trustee could accumulate or pay income to the taxpayer and/or her son. Principal could not be distributed. Two individuals were named as trustees and a bank was designated the successor trustee. The son received a limited power of appointment over corpus that could be exercised among a class of individuals, including the taxpayer.
The son proposed to exercise his limited power in favor of the taxpayer, subject to an agreement under which the taxpayer would immediately retransfer the principal to a new, identical trust in which the taxpayer and son were co-trustees and there was no limited power of appointment. These transactions were designed solely to avoid the old trust's corporate trustee expenses. The IRS ruled that neither a sale nor a gift resulted from the proposed transaction, and that the taxpayer would not be deemed to possess an includible power over the trust within the meaning of Secs. 2036, 2038, 2041 and 2043.
Critique: Citing the Seventh Circuit's decision in Silverstein,(2) the IRS stated that no sale had occurred within the meaning of Sec. 1001, because the effect of the transaction was to leave the taxpayer in the same economic condition, with the same level of benefits, as she possessed before it. Regarding the gift issue, the IRS similarly concluded that the transaction had an economically neutral impact with respect to all parties, as if the old trust were still in force. Thus, the principal transfer to the new trust was not a gift by the taxpayer, nor was she the trust grantor under Secs. 671 through 677.
A similar result occurred in Letter Ruling 9344016,(3) in which the taxpayer proposed exercising a general power of appointment in favor of one of her daughters, subject to a prior agreement under which the daughter would convey the principal to a new trust with identical terms. The taxpayer was dissatisfied with the manner in which the existing corporate trustee administered the trust, but the existing document did not allow for trustee substitution. The proposed new trust corrected this deficiency.
Planning hints: A limited power of appointment can create flexibility for beneficiaries to change trustees, especially if a replacement power is not otherwise provided. In some cases, it may even allow beneficiaries to recast the trust terms without adverse tax consequences.
* Exercise of limited power treated as general power
In Letter Ruling (TAM) 9419007,(4) a settlor created 11 separate trusts for the benefit of family members. During the first 15 years of each trust, income would be accumulated, followed by five years of income payout to a designated older-generation family member. Thereafter, the trust would benefit a designated grandchild until that grandchild attained age 30, at which time the trust would terminate. Between the expiration of the initial 20-year term and the grandchild's attaining age 30, income would be paid to that grandchild. If a grandchild died before attaining age 30, the accumulated income and principal would be paid to his issue or, if none, to other younger-generation family members.
The trust instrument provided each grandchild a limited power of appointment over his trust that could be exercised in favor of certain family members. The grandchildren were expressly prohibited from exercising the power in favor of themselves, their estates, their creditors or creditors of their estates. After the expiration of the 20-year initial term, but prior to attaining age 30, a grandchild exercised the limited power of appointment in favor of certain family members. The IRS ruled that a taxable gift occurred by reason of the exercise.
Critique: In asserting that no taxable gift had occurred, the taxpayer relied on Self.(5) There, the Court of Claims held that the relinquishment of a power holder's income interest through the exercise of a limited power of appointment did not result in a gift. In reaching its conclusion, the court found support in Walston,(6) in which the Fourth Circuit expressly disagreed with the predecessor to Regs. Sec. 25.2514-1(b)(2). It was this regulation that the IRS relied on in asserting the gift in Self. In Letter Ruling 9419007, the IRS noted that it had previously announced its decision not to follow Self in Rev. Rul. 79-327.(7)
The IRS argued that characterizing the grandchild's relinquishment as a "limited power of appointment" did not change the economic substance of the transaction. The grandchild was the beneficial owner of the income and contingent interests and had gratuitously transferred them.
The IRS drew considerable support from the Supreme Court's decision in Jewett,(8) which principally dealt with a disclaimer's timeliness under pre-Sec. 2518 law. However, the IRS noted that there, the taxpayer asserted that his disclaimer was the equivalent of the exercise of a limited power of appointment, since it could benefit only a limited class of beneficiaries, which excluded the disclaimant, his estate and creditors. The Supreme Court in Jewett disposed of this argument, stating that "a disclaimant's control over property more closely resembles a general power of appointment, the exercise of which is a taxable transfer ... Unlike the holder of a special power ... a disclaimant may decide to retain the interest himself."(9) (Emphasis in original.) In light of the above, the IRS stated that the interests and powers held by the taxpayer in Jewett were identical to those possessed by the taxpayer in Letter Ruling 9419007. As such, the IRS concluded that Jewett effectively eliminated whatever precedential value Self may previously have had.
The IRS clearly dislikes possessors of lifetime limited powers of appointment effecting at any time tax-favored transfers of their interests when the same cannot be achieved through a disclaimer. However, the IRS has sought to "correct this abuse" through the questionable technique of an administrative pronouncement. The authors believe that the IRS's interpretation of the Supreme Court's decision in Jeweet is at best misleading, and at worst disingenuous. In fact, the Supreme Court never opined on the gift tax impact of an exercise of a limited power of appointment. It simply stated that the disclaimer made by Jewett could not be recharacterized as a limited power. The Supreme Court analogized the disclaimer to a general power, because of the taxpayer's ability to wait out the life tenancy and receive a remainder interest. However, this analogy does not mean that the Court would find a clearly expressed limited power of appointment to be the same as a general power whenever the power holder possessed a contingent remainder interest. It is difficult to speculate where the IRS is going in Letter Ruling 9419007. Is it possible that it is setting the groundwork for denying the existence of all limited powers for transfer tax purposes?
Planning hints: The IRS has aggressively "thrown down the gauntlet" on this issue. It is clear that it will not follow Self and will challenge the tax-free status of exercised limited powers of appointment, particularly when the power holder possesses a current income interest and/or a contingent remainder. Estate planners should inform clients of the potential consequences of such exercise. Hopefully, this issue will reach the courts and be ruled on definitively.
* Receipt of voting shares and employment contract a gift
In Letter Ruling (TAM) 9352001,(10) the taxpayer owned the following assets: $1.661 million of stocks and bonds; $906,000 of bank deposits and Treasury bills; 1,829.5 acres of ranch land, plus cattle and equipment with a total value of $643,000; and 500 shares of a shell corporation. In 1990, the taxpayer's daughter, under a power of attorney, recapitalized the corporation, authorizing the issuance of 10,000 shares each of voting and nonvoting common stock. Shortly thereafter, the taxpayer's 500 voting shares were exchanged for 500 nonvoting shares and the balance of his assets were conveyed to the corporation in exchange for the remaining 9,500 nonvoting shares.
A few days later, an employment contract was entered into between the daughter's spouse and the taxpayer (acting through the daughter's power of attorney). Under this contract, the spouse was engaged to "reestablish, expand and maintain a cattle ranching business" at an annual salary of $60,000, plus immediate receipt of two shares of voting common. Subsequent to the contract's execution, the spouse held the only outstanding voting shares. The IRS ruled that a taxable gift occurred both with respect to the salary and to the control premium attaching to the voting shares.
Critique: The IRS concluded that the corporate recapitalization, the asset conveyance to the corporation, the transfer of voting shares to the daughter's spouse and the execution of the employment agreement were part of a single prearranged transaction. Further, it concluded that the transaction's purpose was to enrich the spouse through the employment agreement and voting control, and that such enrichment was achieved without adequate consideration.
The IRS reached this determination after a detailed analysis of the surrounding facts. In particular, the IRS stressed that the daughter and her spouse had no knowledge of ranching operations, nor had they lived where the ranch was located for several years. In fact, the spouse had engaged in a teaching career for the majority of his life and had entertained "entering ranching" only after making a decision to retire from teaching. Further, the spouse's ranching inexperience was amply demonstrated by the fact that he immediately engaged an outside contractor to perform these duties once he had entered into the employment agreement.
The IRS also pointed out that the prevailing salary level for experienced ranch managers was significantly below that paid to the spouse under the agreement. As a result, the IRS ruled that the entire $60,000 annual salary was a gratuitous transfer not supported by consideration. It also determined that the issuance of the two voting shares represented a gift of a controlling interest in the corporation.
The facts in Letter Ruling 9352001 are incredibly bad. It is not clear from the ruling how the daughter obtained the power of attorney over her father's affairs, or whether the father was competent when the transaction occurred. Notwithstanding, there does appear a clear purpose to obtain effective control over the taxpayer's entire wealth and redirect at least some of the benefits to the daughter and her spouse. The "construction" of a business purpose for the transaction, while appearing clever at the time, was utterly insupportable after a review of the facts.
* Postdeath transfers from brokerage account not completed gifts
In Cummins,(11) at 3:46 p.m., the decedent executed an "Irrevocable Letter of Instructions" directing his broker to make cash transfers of $10,000 each to 20 relatives. At execution, the decedent's account had insufficient funds to effect these transfers. Thus, the letter directed that sufficient investments be liquidated to (1) complete the transfers and (2) ensure that $50,000 cash on hand remained in the account after the donative transfers. The letter of instructions was given to the decedent's attorney, who delivered it to the broker by 4:30 p.m. The broker accepted it and agreed to its terms. At 4:40 p.m. the same day, the decedent died.
The next day, the attorney informed the broker of the decedent's death. By that afternoon, the broker had liquidated various securities. The following day it sent a $10,000 check, drawn on its own account, to each of the beneficiaries listed in the letter. Immediately after issuing these checks, it debited the decedent's brokerage account for the aggregate transfers. The Tax Court held that no gift had occurred and the cash transfers were includible in the decedent's gross estate.
Critique: The sole issue in Cummins was whether the decedent's execution of the "Irrevocable Letter of Instructions" was sufficient to effect the intended donative transfers. The decedent's estate noted that the letter expressly stated that "the gifts herein shall be complete and irrevocable as of the time I sign this letter." In effect, the estate asserted that the letter's execution created a trust relationship between the decedent and the broker, so that effective delivery to the broker occurred before death.
The IRS disagreed. It argued that the relationship between the decedent and the broker was more accurately characterized as that of principal and agent. Further, "[a]n agency is generally revocable at any time by the principal. The power to revoke at any time is not affected by the fact that there is a contract between the principal and agent that the agency is irrevocable."(12) In addition, the IRS asserted, and the Tax Court agreed that, as a general rule, "[a]n agency that is not coupled with an interest... terminates as of the date the agent has knowledge of the principal's death."(13)
The Tax Court also concluded that the nature of the letter's directions reinforced the IRS's argument that an immediate delivery of, and concomitant cessation of dominion over, the assets was not contemplated by the decedent. The letter explicitly authorized the broker to make the transfers only after sufficient assets had been liquidated to ensure that $50,000 cash remained in the account after the transfers. At the time of the letter's execution, insufficient cash was in the account to achieve this result. As such, the decedent's directions could only be achieved by actions taken by the broker subsequent to its knowledge of the decedent's death.
Planning hints: The adverse result in Cummins can be attributed to at least one apparent mistake: conditioning the transfers on the creation of a minimum cash reserve in the account. That mistake seems almost nonsensical. The decedent-donor was obviously in extremis, as he died within one hour of executing the letter. As such, the retention of a minimum cash balance in the account appears pointless. Further, if the broker could have immediately drawn checks on its account and debited the brokerage account, instead of fulfilling the letter's terms the next day, the result might have been different. The cutting of checks on the broker's own account, if done prior to knowledge of the decedent's death, probably would have effected a valid gift and resulted in the exclusion of the amount from the decedent's gross estate.
* Transfers made under a durable power of attorney not valid gifts
In Letter Ruling 9410028,(14) in 1986, the decedent executed a durable power of attorney naming an individual as attorney-in-fact. Under the power, the attorney-in-fact was directed to make "payment of expenses necessary for my health care, payment of my household maintenance expenses, and all matters required in the management of my financial assets...."
Beginning in 1986, the decedent adopted an annual gift program. As various certificates of deposit (CDs) matured, she transferred the proceeds to her children and grandchildren. In 1992, the decedent followed the same practice, executing seven checks totaling $40,499. Shortly there-after, she became incapacitated. These checks were not mailed and eventually were lost.
Six weeks prior to the decedent's death, her attorney-in-fact executed and delivered to the various beneficiaries six duplicate checks, to replace those which had been lost, and seven new checks totaling $58,999. The IRS ruled that neither set of checks was a completed gift.
Critique: The IRS stated that "[i]t is a general rule that a power of attorney must be strictly construed...." As such, the instrument can be interpreted as conferring only those powers expressly stated within it. Within this context, the Fourth Circuit, in Casey,(15) held that a durable power of attorney under Virginia law will not confer the power to make gifts unless the instrument expressly grants that power.
The highest court in the decedent's jurisdiction (Colorado) had not specifically addressed whether a durable power implicitly granted the attorney-in-fact a power to make gifts. However, the IRS concluded that such court would have followed the preponderance of case law and found no such power. In addition, the IRS noted that the durable power granted in Letter Ruling 9410028 was narrow in application. It limited the attorney-in-fact's authority solely to paying medical, household and investment management expenses. None of these authorized expenditures could be extended to gifts, regardless of the decdent's past gift-giving history.
Planning hints: Many states' laws do not specifically address whether a durable power of attorney grants a gift-giving power. Therefore, drafters must consider a specific reference to this authority in every durable power they draft. The power may exceed the authority desired by the power holder but, in most cases, it will provide a means to accomplish the principal's desires and avoid the difficulties encountered in this ruling.
Some of the recent developments in the disclaimer area included the following.
* Proposed disclaimers of jointly owned CDs qualified under Sec. 2518.
* Proposed pecuniary disclaimer resulting in full unified credit usage qualified under Sec. 2518.
* Disclaimer of GRIT resulted in marital deduction of trust assets.
* Disclaimer of a remainder interest valid under state law was ruled untimely by the Supreme Court, resulting in a taxable gift.
* Disclaimer of various jointly owned CDs qualified under Sec. 2518
In Letter Ruling 9336011,(16) the decedent held CDs in four different ways: outright; in joint tenancy with right of survivorship with his spouse and three daughters; payable on death (POD) to his surviving spouse; and in joint tenancy with his spouse, payable to his three daughters after the second spouse's death.
The surviving spouse proposed to disclaim her contractual survivorship interest in the jointly owned and POD certificates, as well as her right to the CDs she owned outright under her husband's will. The IRS ruled that the proposed transaction was a qualified disclaimer.
Critique: One of the Sec. 2518(b) requirements is that the disclaimer be filed within nine months after the transfer that created the disclaimant's interest. At issue in Letter Ruling 9336011 was whether the spouse's interests in the jointly owned and POD certificates were created at the decedent's death or at the time they were titled in this manner. In ruling for the taxpayer, the IRS stated that, for purposes of Sec. 2518, CDs are treated similarly to savings accounts. Since the decedent was the sole contributor to each CD and could have withdrawn funds from all of them at will, no completed transfer was deemed to occur until his death, when the survivorship rights matured. As such, a disclaimable interest was not created until the decedent's death. A different result would have occurred to the extent that the CDs were comprised of funds contributed by both the decedent and the surviving spouse.
* Qualified disclaimer maximizes unified credit usage
In Letter Ruling 9338010,(17) the decedent died intestate. Under his state's intestacy laws, the surviving spouse received $20,000, plus one-half of the remaining intestate estate. The other onehalf, which was distributable to his child, was insufficient to absorb the decedent's unified credit. The IRS concluded that the spouse's proposed disclaimer of a pecuniary amount that achieved full use of the unified credit, when added to the amount distributed to her child by intestacy, was qualified under Sec. 2518.
Planning hints: One of the most commonly overlooked estate planning techniques is the disclaimer. It can achieve significant tax and family benefits in a relatively simple and risk-free manner. To achieve optimum flexibility, both prior and postmortem planning is necessary. Prior to death, proper shaping of the will or revocable trust agreement ensures that disclaimed property passes to the intended beneficiaries. After death, there must be proper analysis of the economic and family consequences attendant to the disclaimer and satisfaction of the detailed requirements of Sec. 2518. The "tailoring" of a decedent's dispositive program to meet family and/or tax objectives, as described in Letter Ruling 9338010, as well as Letter Rulings 9350032(18) and 9350033,(19) reflects the benefits that can be derived from correct usage of a disclaimer.
* Disclaimer of GRIT results in marital deduction
In Letter Ruling 9340052,(20) prior to his death, the decedent established a grantor retained income trust (GRIT) in which he retained an income interest for six years. On termination, assuming the settlor was still living, the trust corpus was to pass to named beneficiaries. If, however, the settlor died prior to the income term expiration, the undistributed income and remaining principal were to be paid to such persons, including the decedent's estate, as appointed under his will. In default of appointment, the undistributed income was payable to his estate, with the corpus distributable to his two children or, if deceased, to their respective estates.
The decedent died prior to the income interest expiration and he did not execute his testamentary power of appointment. The decedent's children and grandchildren proposed to disclaim their interests so that, under South Carolina intestacy law, the entire corpus would pass to the decedent's surviving spouse. The IRS ruled that the disclaimers would meet Sec. 2518 and that the disclaimed amounts would qualify for the marital deduction.
Critique: The primary issue concerned the disclaimers' timeliness. The decedent had created the GRIT approximately five years before his death and the proposed disclaimers were to be filed within nine months after death. Sec. 2518 states that a qualified disclaimer must be filed no later than nine months after the transfer creating the disclaimant's interest was created. In most instances, this means nine months from the date a trust is established or, in the case of a will, from the date of death.
Special treatment is accorded when a general power of appointment is involved. Regs. Sec. 25.2518-2(c)(5), Example (2), clearly states that the taker under an executed testamentary general power of appointment, as well as the taker in default of the power's exercise, may execute qualified disclaimers within a period ending not later than nine months after the power holder's death. This position is logical since, until that death, the alternate takers' interests are contingent.
In the ruling, for purposes of the marital deduction, the qualified disclaimers allowed the disclaimants to be treated as if they had predeceased the decedent. In consequence, the trust corpus passing to the surviving spouse under the intestacy statute was considered to have passed directly from the decedent.
Planning hints: The fact pattern in Letter Ruling 9340052 offers estate planners some significant opportunities. The "tolling" of the disclaimer period when general powers of appointment are involved provides great flexibility in tailoring dispositive transfers involving long-term trusts. In many instances, the power holder may live for decades. It is not unlikely that, at the time of death, alternative dispositive schemes not contemplated by the original settlor may make better family and economic sense than those outlined in the instrument. In some cases, the alternatives may be achieved through disclaimers. It is important to note that this tolling does not occur with respect to limited powers of appointment. Of course, the trade-off is estate inclusion induced by the general power if the trust terms do not otherwise intend such inclusion.(21)
* Supreme Court rules disclaimer of a remainder interest untimely
In Irvine,(22) in 1917, prior to the enactment of the gift tax, the settlor established an inter vivos irrevocable trust naming his spouse and children as concurrent primary beneficiaries. On the last primary beneficiary's death, the trust principal was distributable to the settlor's grandchildren per stirpes. In 1979, a child disclaimed a fraction of her interest in the trust principal. The disclaimer was valid under Minnesota law, even though the disclaimant had been aware of her interest since at least 1931 and had been receiving annual income distributions since that date. Unlike Ordway,(23) its companion case, involving a sibling, in which the Supreme Court denied certiorari, the Irvine court concluded that the disclaimer was not timely and that a taxable gift resulted.
Critique: Irvine arose with respect to a 1987 claim for refund of $16 million in tax and interest filed by the disclaimant's estate, which, in turn, was based on a deficiency assessment made in conjunction with an IRS audit of the disclaimant's 1979 gift tax return. The IRS, relying on the Supreme Court's decision in Jewett,(24) asserted that the disclaimer had not been filed within a reasonable time after the disclaimant's knowledge of the (earlier) transfer. This argument hinged on a regulation promulgated in 1958 that related to disclaimers made prior to the enactment of Sec. 2518. The taxpayer, on the other hand, argued that Jewett should not control because (1) the trust was created prior to enactment of the gift tax and (2) the "reasonable time" limitation imposed by the regulation did not apply, because the preenactment transfer creating the trust was not a "taxable transfer."
The Irvine Court began by stating that the disclaimer was not timely under Jewett. Thus, the sole issue was whether the requirements of Regs. Sec. 25.2511-1(c) extended to pregift tax transfers in trust. The Court then addressed the underlying rationale for the enactment of the gift tax, i.e., to capture into the tax system lifetime transfers falling outside of the purview of the estate tax. It pointed out that the regulation generally subjecting disclaimers to the gift tax was consistent with this objective, as a disclaimer acts to reduce the expected size of the disclaimant's taxable estate and to confer a gratuitous benefit on the objects of his bounty. Further, the gift tax exception accorded disclaimers made within a reasonable time after the transfer offered a recipient ample opportunity to reject the transfer and allow it to pass to others without tax.
In light of the above, the Court held that nothing existed in the statute to exempt pregift tax transfers from the "reasonable time" requirements set for tax-free disclaimers under the 1958 version of Regs. Sec. 25.2511-1(c). In reaching this decision, the Court reiterated that the disclaimer in Irvine was made 48 years after the disclaimant had reached majority and that she had received benefits from the trust throughout that period.
Debts, Claims and Administration Expenses
Recent developments involving debts, claims and administration expenses included the following.
* Promissory notes preceded by gifts were not a deductible claim against the estate.
* Payment made in settlement of will contest was not deductible under Sec. 2053.
* A postdeath payment under a lease guaranty agreement was a deductible claim.
* Costs of the sale of a decedent's personal residence were deductible as administration expenses.
* Donees' loans tied to gifts not a deductible claim
In Flandreau,(25) the decedent made gifts to various donees in 1970, 1971 and 1972 totaling $102,000, in the form of noninterest-bearing, unsecured promissory notes. At the same time, the donees made loans of identical amounts to the decedent. The notes were payable in 1995, or, if earlier, on the decedent's death. The Second Circuit held that Sec. 2053(c)(1) barred an estate tax deduction for these promissory notes.
Critique: The court noted that it had consistently rejected taxpayer attempts to use gifts to family members, followed by loans back, as a means to avoid Federal taxes that would otherwise be imposed.(26) The court cited the Tax Court's conclusion that such "debts" were "merely circular transfers of money from decedent to her children and back to decedent." The economic effect was to leave the decedent in the same position with respect to the transferred funds as before the gifts. Substantively, the donor never really lost dominion over the funds.
In Flandreau, the court based its decision against the estate on the following factors: (1) the gifts and loans were contemporaneous transactions; (2) the gift and loan amounts were identical; (3) the promissory note terms were such that the decedent was practically relieved of repayment obligations during life; and (4) nothing existed to demonstrate full and adequate consideration for the loans. In fact, the transactions clearly demonstrated that the loans were the expected, and almost certainly required, quid pro quo for the gifts.
Planning hints: Flandreau was a clear loser. The contemporaneous nature of the gifts and loans was clearly part of a single transaction. Query whether a different result would have occurred had the gifts and loans been materially separated in time, or of different amounts. One thing is certain, however: the paper trail would not have been as obvious.
* Will settlement payments held not deductible claims
In Huntington,(27) the decedent's husband had executed a will in 1978 that made $25,000 bequests to each of his three children. The balance of his estate went to his wife (the decedent) in trust, with the remainder passing equally to his children. In 1979, the husband executed a new will that left his entire estate to his wife outright. External evidence existed demonstrating that the revised will was based on an understanding that the wife would execute a reciprocal will that left her estate equally to the children.
Subsequent to their father's death, and prodded by the decedent's inaction, his two sons (children of their father's prior marriage) entered into a settlement with her. She agreed to execute a will that left each of them 20% of her estate at her death. Notwithstanding this agreement, she died intestate. The sons filed a claim against her estate and initiated a lawsuit to enforce the settlement. Subsequently, the sons entered into a settlement agreement with the wife's estate, pursuant to which each received a 20% share. The estate deducted these payments (i.e., 40% of the wife's estate) as a claim. The First Circuit denied the deduction.
Critique: At issue was whether the payments made pursuant to the settlement agreement were in satisfaction of a bona fide debt with respect to which full and adequate consideration in money or money's worth was received. The estate asserted that both settlement agreements arose in conjunction with the purported legal obligation of the decedent to execute a "reciprocal" will in favor of the children. This obligation, in turn, was attributed to an oral agreement existing between the decedent and the children's father that triggered his 1979 will revision. Finally, the estate argued that adequate consideration was received when the sons "compromised" their purported two-thirds interest in the spouse's estate for a combined 40% interest.
The First Circuit disagreed. It stated that the enforceability, under local law, of an oral agreement to execute a reciprocal will did not necessarily create a bona fide debt within the meaning of Sec. 2053(c)(1). In fact, the court noted that the father's intent with regard to the reciprocal will was inherently testamentary. His objective was to ensure that a share of his estate passed to his children from a prior marriage. Surrounding facts indicated that the husband and wife, at best, entered into a collaborative effort to pass family assets to all of the children.
Within this context, the court stated that "[s]uch a purely voluntary, testamentary arrangement is not the product of a bona fide contract...." The court also noted that no evidence existed suggesting that the 1979 will revision was anything more than an attempt to provide the wife with a greater measure of economic security while furthering the husband's testamentary objectives regarding his children. Finally, the court concluded that allowing a Sec. 2053(a)(3) deduction would undermine the section's purposes. It would allow a significant portion of the decedent's estate to pass under a testamentary scheme free of estate tax.
* Postdeath payment under lease guaranty resulted in estate deduction
In Letter Ruling (TAM) 9321004,(28) the decedent was guarantor of his company's lease. Under the guaranty, the landlord could enforce against the decedent any claim it could enforce against the corporation without first enforcing its claim against the corporation. At the time of his death, the decedent's corporation was solvent and meeting its lease obligations. Notwithstanding, the landlord filed a contingent creditor's claim in the amount of the lease obligation against the decedent's estate.
Approximately 11 months after the decedent's death, the corporation defaulted on the lease and payment under the guaranty was sought against the estate. Fourteen months after the decedent's death, his estate made payments under the guaranty and claimed a deduction, which the IRS allowed.
Critique: Generally, deductible debts must be matured obligations enforceable against the decedent's estate. Typically, postdeath events affecting the obligation have negligible relevance.
An exception to this rule applies to contingent obligations, such as a personal guaranty of the decedent. As indicated in Hagmann,(29) when the decedent is a guarantor of the debts of another, events occurring after the decedent's death that affect the liability are considered by the courts.
In Letter Ruling 9321004, the guaranty entered into with the corporation's landlord was incurred pursuant to a bona fide arm's-length contractual arrangement. The IRS expressly pointed out that the landlord was not related to the decedent and that the guaranty was a condition precedent to the landlord accepting the lease.
Maturation of a contingent liability under a personal guaranty is not alone sufficient to assure deductibility. Both the initial debt obligation, as well as the personal guaranty, must meet the statutory test of being bona fide and contracted for adequate and full consideration in money or money's worth.
* Personal residence selling expense deductible by estate
In Letter Ruling (TAM) 9342002,(30) the decedent died leaving a probate estate, of which his adult child was sole heir, valued at approximately $420,000. It consisted of a personal residence and publicly traded stocks and mutual funds. In addition, he held bank and brokerage accounts worth $400,000 in joint tenancy with his child. The decedent was the sole contributor to these joint accounts. The child, acting as executor, sold the personal residence to raise cash to pay the decedent's debts, the costs of administration, and Federal and state transfer taxes. The IRS ruled that the expenses of sale were deductible as administrative expenses under Sec. 2053(a).
Critique: In Letter Ruling 9342002, the principal issue was whether the sale of the residence was necessary to estate administration when sufficient cash was on hand in the various joint bank accounts to pay debts, expenses and taxes. The IRS concluded that the sale was appropriate and that the expenses were deductible. The ruling was based on the fact that local law charged the probate estate with payment of estate costs and taxes. As such, the joint bank accounts, which were not part of the probate estate, were statutorily exempted from these obligations. The IRS then noted that to rule otherwise would be effectively to require the surviving tenant to lend cash. Such a result would be clearly contrary to the local probate statute, even though the sole heir, joint tenant and executor were the same person.
Planning hints: The deductibility of selling costs as an administration expense continues to be an area of dispute with the IRS. The language of Letter Ruling 9342002 is not as "gratuitous" as it may first appear. There is a clear implication that a different result may have occurred had the bank accounts been part of the probate estate. In fact, however, there are several legitimate reasons underlying an executor's decision to sell estate assets during the administration period. Raising cash to pay debts and taxes is only one of them. For example, it may be very prudent to sell common stocks and bonds in a volatile market, diversify estate assets or simply take advantage of an opportunity to sell an asset at its peak value. Each of these reasons falls within the administrator's charge to preserve and maintain the value of the estate, and each exists independently of the cash reserves available to the estate.
Advisers should be prepared to respond to IRS challenge in many of these instances. In such cases, the best defense is to demonstrate why the sale was prudent and why it was not practical (or wise) to defer the sale until after distribution of the asset.
Powers of Appointment
Significant developments in the area of powers of appointment included the following.
* Decedent's incapacity to exercise general power of appointment did not prevent the property's includibility under Sec. 2041.
* Following state law, decedent's use of life estate was construed as a limited, not general, power of appointment.
* General power of appointment restricted by prior contingency resulted in estate inclusion of 5% of family trust.
* Trustee removal power was not a general power of appointment.
* Power holder's incapacity does not prevent Sec. 2041 application
In Letter Ruling (TAM) 9344004,(31) a husband and wife created a revocable trust comprised of their community and respective separate property. On the wife's death in 1989, three trusts were funded from the revocable trust: Trust D, comprised of the husband's share of community property and his separate property, Trust E, funded with the wife's separate property and one-half community interest, and Trust C, funded with an amount equal to the wife's unused unified credit. The document provided for an independent decision-making group with authority to remove a trustee due to incompetence. The husband was named initial trustee, but was removed by the group prior to his wife's death and a year before his death in 1990.
Under the instrument, the trustee was authorized to distribute Trust C income and principal as necessary to provide for the survivor's "health, maintenance, support, comfort and welfare at the standard of living to which he had become accustomed" as of his wife's death. The IRS ruled that the decedent had a general power of appointment over the trust, even though he was legally incapacitated at the time of his death.
Critique: In Letter Ruling 9344004, the trust instrument authorized the decedent, as trustee, to make principal distributions to himself to promote his "comfort and welfare." Citing Rev. Rul. 77-60(32) and Lehman,(33) the IRS noted that such standards were not ascertainable within the meaning of Sec. 2041. As such, absent extenuating circumstances, the trust was includible in the decedent's estate.
The estate asserted that the husband's removal as trustee barred his ability to exercise the trustee's powers. In ruling for inclusion, the IRS noted that the provision creating the decision-making group was not a prior contingency imposed on the decedent's possession of the power. Rather, it became effective only on the occurrence of subsequent events and, by its terms, was reversible if the conditions triggering its application ceased to exist. Citing Gilchrist,(34) the IRS noted that property is includible in an estate unless it can show that the general power could not be exercised at all on the owner's behalf by any person in any capacity. That court held that adjudication of the holder's incompetence is irrelevant because possession of a general power, rather than the ability to exercise it, triggers taxation.
Planning hints: The result in Letter Ruling 9344004 was clearly unintended, since Trust C was designed to take advantage of the predeceasing spouse's unified credit. The drafting mistake was providing the trustee with broad invasion powers in favor of the surviving spouse and then naming that spouse as trustee. While the decedent may have wanted the resulting discretion, it is the estate planner's responsibility to counsel that such contradictory objectives often lead to estate tax disasters. The situation could have been salvaged if either the invasion standard had been ascertainable within the meaning of Sec. 2041 (i.e., limited to "health, education, support and maintenace") or an independent trustee had been named.
* Right to consume Kentucky life estate not a general power
In Duvall,(35) a life estate in property was bequeathed to the decedent by her spouse. The spouse's will, probated in 1959, specified that "the life estate was given to [the] decedent 'to do as she pleases without bond as long as she lives and after her death the balance to be divided among designated beneficiaries.'" The Tax Court concluded that the decedent did not possess a general power of appointment over the life estate at the time of her death.
Critique: In excluding the life estate's value from the gross estate, the executors relied on a previous district court disallowance of the marital deduction to the decedent's husband's estate.(36) That court held that the wife did not possess the requisite general power of appointment. The IRS argued that the prior decision was not controlling because a subsequent state law case, Melton,(37) had effectively retroactively overruled the district court's decision.
In holding for the taxpayer, the Tax Court chose to analyze whether the Melton decision had, in fact, negated the holding in the first Duvall case. The court concluded that the state court had not overturned the legal rationale on which the first Duvall case was decided. Rather, it sought to eliminate inconsistencies evident in prior decisions. It did this by holding that a general power of appointment existed whenever the instrument creating a life estate clearly and unambiguously reflected an intent to grant to the life tenant unlimited power over the property subject to the life estate. However, the Tax Court found that the decision in the first Duvall case was consistent with Melton. Although the decedent was given broad discretion in the possession and use of the property subject to the life estate, the decedent's power to dispose of such property was limited to her needs relating to health, education, support and maintenance.
Since the Tax Court determined that the first Duvall case would have been unaffected by the later Melton decision, it held that the decedent possessed no general power over the life estate and that no inclusion was mandated under Sec. 2041.
Planning hints: Duvall resulted from sloppy drafting. This, in turn, could have resulted in a tax disaster, i.e., denial of the marital deduction and inclusion of the property in the surviving spouse's estate. Secs. 2056 and 2041 do not act in concert. Better drafting would have avoided the risk and the cost of going to court twice to achieve what was clearly the testator's intent.
* General power subject to prior contingency triggers estate inclusion
In Kurz,(38) the decedent's spouse's will had created marital and family trusts of approximately equal value. The decedent was the income beneficiary of both trusts and possessed an unlimited invasion power over the marital trust principal. The decedent also had a right to withdraw from the family trust the greater of $5,000 or 5% of trust corpus value, but only after the marital trust principal had been completely exhausted. As of the decedent's death, the marital trust principal was intact. The Tax Court held that 5% of the family trust was includible in the decedent's gross estate under Sec. 2041.
Critique: The IRS asserted that 5% of the family trust was includible because it was subject to a general power of appointment. The taxpayer countered that the decedent's ability to exercise the 5% and $5,000 power was restricted by a prior contingency that had not occurred as of the date of death. The taxpayer based its argument on Regs. Sec. 20.2041-3(b), which states that "a power which by its terms is exercisable only upon the occurrence during the decedent's lifetime of an event or a contigency which did not in fact take place or occur during such time is not a power in existence on the date of the decedent's death."
The IRS asserted that the presence of marital trust corpus did not constitute that type of prior contingency, because the decedent's ability to exhaust the marital trust was totally within her sole control up to the time of death. She could have perfected her right to invade the family trust at any time, simply by exercising her right to withdraw all of the marital trust principal.
The Tax Court adopted a midway position. First, it stated that the mere fact that a general power's exercise is subject to a prior contingency is not alone sufficient to avoid Sec. 2041. However, the court refused to accede to the IRS's argument that any prior contingency subject to the control of the power holder must be disregarded. In deciding Kurz, the Tax Court used a test based on "independent nontax significance." Thus, a prior contingency within the control of the power holder can avoid Sec. 2041, if its occurrence has consequences of independent nontax significance. The court gave examples of a general power arising due to a future adoption, birth or divorce.
The court concluded that the decedent's decision to withdraw marital trust principal would not involve consequences of independent significance. As such, the 5% and $5,000 power over the family trust was not subject to a prior contingency within the meaning of Sec. 2041.
Planning hints: The decision in Kurz resulted in approximately $169,000 in additional value being added to the decedent's gross estate. It is unlikely that this was intended either by the taxpayer or its adviser. These adverse consequences could have been avoided if the decedent's marital trust invasion power had been limited to a 5% and $5,000 power or was based on an ascertainable standard. Of course, in such cases, the economic position of the surviving spouse would have been, at least theoretically, different. However, the importance of the unlimited power of invasion against the marital trust is suspect. After all, the decedent felt no need to exercise any withdrawal right over either trust during her lifetime.
* Beneficiary's power to remove trustee not deemed a general power
In Letter Ruling 9351016,(39) trusts were established for the benefit of named beneficiaries. Each trust provided for income accumulation until the named beneficiary attained age 21, with net income being paid out after age 25. The trustee had discretion to distribute income after age 21. The trusts authorized income and principal distributions in the event of "illness or other emergency." The income beneficiary had been given the power to remove the trustee and replace it with a trust company or bank, if and when a specified individual was no longer associated with the institution appointed as trustee, or if the residences of a majority of the beneficiaries changed such that it became inconvenient for the designated trustee to continue trust administration. On a technical point, the IRS ruled that the trustee substitution power did not confer on the beneficiary a general power of appointment.
Critique: The IRS noted that the trustee's principal invasion powers were not subject to a Sec. 2041 ascertainable standard. Thus, if those powers were held directly by the beneficiary, the trust's principal would have been includible in the beneficiary's estate.
The IRS cited Rev. Rul. 79-353(40) as authority for the position that a "decedent's retention of the unrestricted power to remove and replace the corporate trustee was tantamount to the reservation of the trustee's powers." On this basis, the IRS inferred that, in the absence of other mitigating circumstances, the beneficiary in Letter Ruling 9351016 would be deemed to "stand in the shoes" of the independent trustee because of the removal power and, thereby, treated as possessing a general power of appointment. However, this result was not imposed by virtue of Rev. Rul. 81-51,(41) which stated that Rev. Rul. 79-353 generally will not apply to a trust that was irrevocable on Oct. 28, 1979.
Letter Ruling 9351016 is interesting on two counts: First, the removal power was not unrestricted, but limited to sound business reasons; second, because the IRS's position flies directly in the face of the Tax Court's decision in Wall(42) (discussed under "Retained Interests," infra), in which the court rejected Rev. Rul. 79-353 because it ignored the fiduciary's legal obligations.
An ambiguity exists. In Wall, the removal power was held by the trustor and the issue was estate inclusion under Sec. 2036 or 2038. The Tax Court held for the taxpayer because trustees owe their fiduciary obligation to the beneficiaries, not the settlor. In Letter Ruling 9351016, however, the beneficiary held the removal power and the issue was inclusion under Sec. 2041. Since a trustee has fiduciary obligations to both current and future beneficiaries, the Wall rationale should apply equally to a power held by a beneficiary when there are future remainder interest holders or collateral takers.
Planning hints: While the Tax Court's decision in Wall was handed down after the issuance of Letter Ruling 9351016, estate planners should continue to approach with caution the estate tax consequences under Secs. 2036(a) and 2041 of unrestricted trustee removal powers. Hopefully, this entire issue will be resolved in the manner outlined by the court in Wall. A trustee removal power provides a businesslike approach to resolving nontaxrelated issues and is not likely to result in meaningful abuse.
Recent developments involving retained interests included the following.
* Only the portion of an irrevocable trust needed to fund a support obligation was includible in decedent's gross estate.
* Grantor's release of a power to appoint hereself as successor trustee resulted in trusts' exclusion from estates.
* Decedent's retained power to substitute successor corporate trustees did not trigger estate inclusion of irrevocable trusts.
* Differing results in cases and rulings involving gifts from revocable trusts within three years of decedent's death.
* Support obligation triggers partial estate inclusion of a trust
In Sullivan,(43) in 1967, the decedent established an irrevocable inter vivos trust that was required to distribute in quarterly installments its entire net income to his wife for life. In addition, the trustees were directed to distribute so much of the principal as they, in their discretion, deemed necessary to provide for her "care, support, maintenance and health, taking into consideration her needs and the other sources of financial assistance ...." A subsequent provision authorized the trustees to distribute funds either directly for the wife's support or to another person responsible for her care in the event that she should no longer be capable of handling her own financial affairs. The decedent and a close friend were co-trustees. The Tax Court held that the portion of the trust corpus required to fund the "support" obligation was includible in the decedent's estate under Sec. 2036(a)(1).
Critique: The IRS sought estate inclusion of income and corpus on two grounds. First, the income interest granted to the spouse was in satisfaction of a support obligation and, therefore, represented a retained interest within the meaning of Sec. 2036(a)(1). Second, the authorization to pay income or principal directly for the wife's support or maintenance subjected the entire trust to the decedent's legal support obligation. The Tax Court rejected both arguments.
Citing Colonial-American National Bank,(44) the Tax Court stated that "[i]t is well established that one spouse may make a gift to the other spouse without affecting their duty of support, and there is no presumption that such a gift is in discharge of the donor's marital duty."(45) It noted, however, that such a gift can be equated with a discharge of the legal obligation of support provided it is clear from the trust instrument that such was the intent of the settlor.(46) After reviewing the document in Sullivan, the Tax Court found the language clear and unambiguous in its intent to convey an unconditional gift of the income to the settlor's spouse.
With respect to the clause authorizing the trustee to disburse trust income directly for the wife's support in the case of incapacity, the Tax Court concluded that it did not constitute a condition or qualification on the use of trust income. It was, rather, more appropriately interpreted" as an administrative provision due to its relative position within the trust instrument." This interpretation was supported by the Minnesota Trustees' Powers Act, which contains a similar provision as a means of facilitating payment.
The Tax Court then distinguished this rationale with respect to principal. The trust instrument clearly authorized the trustees to distribute principal to meet the wife's support needs. Further, due to the co-trustee's virtual lack of involvement, the settlor was the sole effective trustee. Thus, the decedent-settlor had the lifetime power to direct a portion of the principal to satisfy his legal support obligation. The court then concluded that the decedent's power extended only to the portion likely to be distributed, based on his wife's needs and known financial resources. Using the tables in Regs. Sec. 20.2031-7, this amount was determined to be $200,000 (i.e., approximately 20% of the trust corpus).
Planning hints: The settlor retained excessive powers over the distributions of the trust that resulted in partial inclusion in his gross estate. The estate inclusion could have been avoided if the trust document required a trustee other than the settlor to exercise the discretion to distribute principal for the wife's support and other needs.
* Release of power to name oneself trustee avoids estate inclusion
In Letter Ruling 9340014,(47) the decedent created two irrevocable inter vivos trusts for the benefit of various persons. The trustee possessed powers over income distribution and accumulation that would have triggered estate inclusion under Sec. 2036(a)(1) had the settlor retained them. The trusts had independent trustees, but the settlordecedent retained the right to name new trustees, including herself, in the event that the present trustee ceased to serve. The settlor did not retain the right to remove the original trustee.
Four years after the trusts' creation, and more than three years before her death, the grantor released her power to appoint herself as successor trustee. The IRS concluded that the trusts were not includible in her gross estate.
Critique: A power to control trust income distributions constitutes a prohibited power under Sec. 2036(a)(1). Under roughly comparable facts, Rev. Rul. 73-21(48) concluded that such powers granted to an independent trustee will be attributed to the grantor if she has retained, either expressly or by operation of state law, the ability to appoint herself successor trustee (and thereby obtain the ability to exercise those powers). Further, it was immaterial whether the settlor actually exercised the prohibited powers or whether her exercise was subject to the occurrence of a contingency beyond her power to control. In Letter Ruling 9340014, the IRS stated that, absent the release, the trust would have been includible in her estate. However, her release, more than three years before her death, of the power to appoint herself successor trustee avoided estate inclusion.
The more-than-three-year period separating the release and the decedent's death was critical to the IRS's finding for the estate, since Sec. 2035(a) and (d)(2) expressly direct that a release or relinquishment occurring within three years of death mandates application of Sec. 2036(a)(1).
Planning hints: Letter Ruling 9340014 once again illustrates how an otherwise innocuous "administrative" power can have catastrophic tax consequences. The settlor probably viewed her contingent power to appoint a successor trustee to be of little importance and the probability of exercising that power to be remote. Yet, had she not timely released the power, the entire trust would have been includible in her estate. It is incumbent on estate planners to advise their clients of the tax consequences regarding the retention of powers over transferred property. Normally, if these consequences are clearly explained, most taxpayers will choose to forgo the power. When such powers are granted in existing documents, power holders should consider relinquishing them as soon as possible.
* Power to remove and replace corporate trustee will not trigger inclusion
In Wall,(49) the decedent created three separate trusts for the benefit of her daughter and two grandchildren. With respect to each trust, the trustee had various powers over income distributions that would have triggered Sec. 2036(a) inclusion had they been possessed by the settlor. An independent corporate trustee was appointed for each trust and the settlor retained the right to substitute a successor corporate trustee. She was expressly prohibited from appointing as successor trustee either herself or an entity in which she possessed any interest. The Tax Court held that the decedent's power to substitute successor corporate trustees did not result in estate inclusion under Sec. 2036(a).
Critique: The issue in Wall was whether the independent trustee's powers over trust income distributions could be attributed to the settlor-decedent, for purposes of Sec. 2036(a), solely by virtue of her unconditional right to substitute independent corporate trustees. In reaching its decision, the Tax Court was required to address the IRS's highly controversial position Rev. Rul. 79-353.(50)
In Rev. Rul. 79-353, the IRS concluded that a retained unrestricted right to substitute corporate trustees resulted in attribution of the trustee's powers to the settlor. It based this position on the underlying assumption that a corporate trustee could be compelled to follow the bidding of a settlor who had the power to remove it. The leverage to fire an uncooperative trustee and "shop" for a more accommodating replacement resulted in the de facto ability to exercise the trustee's powers. In support of this position, the IRS cited earlier revenue rulings(51) and two cases, O'Malley(52) and Corning.(53)
In Wall, the Tax Court noted that the rulings and O'Malley considered only the settlors' retained powers to appoint themselves as successor trustees, a fact pattern with respect to which little controversy exists. It then found Corning inapplicable because (1) it involved an income, rather than estate, tax matter and (2) while the instrument prohibited the settlor from naming himself as successor trustee, it did not prevent the appointment of a settlor-controlled corporation.
Affter dismantling the technical support purportedly underlying Rev. Rul. 79-353, the Tax Court then addressed the merits of the IRS's other arguments. First, it noted that both lower courts in Byrum(54) expressly addressed the decedent's retention of the right to substitute corporate trustees. Each concluded that such a right does not cause estate inclusion. On review, the Supreme Court noted, without further discussion, the retained right's existence. It also stated that the retained "right" contemplated by Sec. 2036(a)(2) "must be given its normal and customary meaning. It connnotes an ascertainable and legally enforceable power."(55)
In Wall, the Tax Court found this statement extremely important given the IRS's argument that the substitution is equivalent in law to the right to control distribution of trust assets--a right possessed under the instrument exclusively by the corporate trustee. In assessing the validity of the IRS's position, the Tax Court analyzed trust and fiduciary law.
Within this context, the Tax Court noted that it is a clear principal of law that "[i]n irrevocable trusts such as those under scrutiny, the trustee is accountable only to the beneficiaries, not to the settlor, and any right of action for breach of fiduciary duty lies in the benficiaries, not in the settlor." Further, "[t]he trustee has a duty to administer the trust in the sole interest of the beneficiary, to act impartially if there are multiple beneficiaries, and to exercise powers exclusively for the benefit of the beneficiaries." As such, a corporate trustee could not subordinate its judgment to that of a settlor, regardless of whether that settlor possessed a substitution power, without breaching its fiduciary duty. Accordingly, the Tax Court held that the power of trustee substitution possessed by the decedent-settlor does not trigger estate inclusion.
Almost 15 years have passed since the IRS issued Rev. Rul. 79-353. At the time, the ruling was highly controversial and throughout its life, most commentators have considered its position to be erroneous. Finally, there is a well-reasoned decision analyzing its merits. A reserved right to remove a corporate trustee makes considerable business sense. It allows the settlor flexibility to address issues and problems unforeseen at the trust's creation (e.g., beneficiaries moving to distant locations, making contact difficult, trustees of an out-of-state bank having a very different character, poor investment results, etc.). Most of these situations do not lend themselves to a specific formula or standard that can be incorporated in the agreement. It should be noted that the appeal period for Wall has expired. However, the repeal of the Wall doctrine is now on the IRS's legislative "wish list."
* Gifts from revocable trust and the three-year rule
Since last year's article,(56) there have been a number of developments relating to estate inclusion of gifts from revocable tursts within three years of death.
In Letter Ruling (TAM) 9343003,(57) a revocable trust instrument directed the trustee to pay income to the settlor quarterly, and principal to the settlor pursuant to his written request. In the event of incapacity, the trustee was authorized to pay income and principal to the settlor and his dependents. While competent, the decedent wrote a letter authorizing the trustee to issue $10,000 gifts to each of nine beneficiaries. The letter was given to his financial adviser for delivery to the trustee. Without his knowledge, the settlor's mother directed the adviser to delay delivering the letter. The settlor's physical condition suddenly deteriorated. The mother directed the adviser to deliver the letter and the checks were mailed about two hours before the settlor died. The IRS ruled that the funds were not includible in the settlor's estate.
In McNeely,(58) the Eighth Circuit reversed a lower court and declined to include gifts made from a revocable turst even though the trustee could distribute principal to either the trustor or third parties. In this case, the trust document required the prior written authorization of the settlor.
The taxpayer also prevailed in Barton.(59) There, the trust document required the trustee to distribute income or principal " ... to the Grantor or as she may from time to time otherwise direct in writing...." Within three years of her death, and on three separate occasions, she directed the trustees to transfer stock to various individuals. The Tax Court decided that her retained powers were similar to those it had favored in Jalkut.(60)
These favorable developments should be contrasted with Letter Ruling (TAM) 9343004.(61) Under the revocable trust document there, the trustees (the decedent's sons) had the power to make discretionary distributions to the trustor or such other persons as the decedent would designate. During any period of incapacity, the trustees could "make lifetime gifts of tax-saving nature in accordance with any program of lifetime gift giving of the trustor of which the trustees are aware." After the decedent bacame incapacitated, the trustees issued checks to themselves and their spouses. The decedent died two years later. The IRS ruled that the gifts within three years of her death were includible in her estate.
Critique: The IRS wants to include gifts from revocable trusts in all instances in which the trustee has authority to distribute to anyone other than the trustor. The favorable result in Letter Ruling 9343003 was due to the IRS's recognition that the trustees were authorized to distribute only to the settlor during periods of legal capacity. The trustees' improper delay until after the settlor's incapacity was deemed noncontrolling.
McNeely is a breath of fresh air on this issue, which truly regales form over substance. The Eighth Circuit decided to focus on the requirement for trustor authorization to distribute to third parties, as opposed to the existence of others in the class of potential beneficiaries. However, as Letter Ruling 9343004 indicates, distributions in the trustee's discretion will cause inclusion.
Planning hints: Until the courts definitively resolve the many fine points that can arise based on subtleties of document language and trustor capacity, estate planners should remain wary of distributions from revocable trusts to third parties. Drafters should avoid authorizing distributions other than to the grantor. Even third-party distributions requiring trustor authorization should be approached with caution, particularly for taxpayers in jurisdictions other than the Eighth Circuit.
Although it is administratively burdensome, the preferred approach is for the trustee to distribute cash or property to the grantor. The grantor then may use the distributed property in a gift program.
The charitable deduction area included the following development.
* Disclaimers triggering distribution of disclaimed assets to private foundation were qualified under Sec. 2518(b).
* Disclaimer favoring private foundation is qualified under Sec. 2518
In Letter Ruling 9350032,(62) the decedent bequeathed his estate to a trust and named his two children as co-trustees. Pursuant to the instrument, the corpus was divisible into two equal shares--one for each child. Each of these shares was divided into three "distributable" portions, from which the named beneficiary was entitled to income for life. However, separate provisions contemplated different dispositions of each child's portion in the event of disclaimer. Specifically, with respect to portion A, which represented 25% of the total share, a disclaimer would trigger a distribution of the disclaimed assets to that child's previously established private foundation. Any undisclaimed portions would continue in trust for that child's issue.
Each child intended to disclaim a fixed percentage of his one-half share in the trust. Under the turst instrument, this disclaimed percentage would be allocated ratably among the three distributable portions of that share. Thus, approximately 25% of the disclaimed amount would pass to the respective foundations. The IRS ruled that a qualified disclaimer resulted, provided the disclaimant had resigned as trustee of the private foundation prior to filing the disclaimer.
Critique: Regs. Sec. 25.2518-2(d)(2) states that "[i]f a beneficiary who disclaims an interest in property is also a fiduciary ... [the] fiduciary ... cannot retain a wholly discretionary power to direct the enjoyment of the disclaimed interest." In Letter Ruling 9350032, each child was a trustee of his respective foundation. Since the trustees had the power to allocate income and principal among a class of charitable beneficiaries, the proposed disclaimer would not meet all of the requirements of Sec. 2518 if the child continued to act as trustee. To solve this problem, one child proposed substituting her daughter as trustee, while the second proposed naming her adult sons and her husband as substitute trustees. The IRS ruled that it was irrelevant that the substitute trustees were close relatives of the disclaimant.
A similar result was achieved, by somewhat different means, in Letter Ruling 9350033.(63) There, the taxpayer proposed (1) expanding the number of foundation trustees, (2) providing for a separate foundation fund to specifically hold the disclaimed assets and (3) changing the foundation documents to prevent the disclaimant-trustee from participating in any decisions concerning the separate fund. The IRS accepted these actions, provided the increased number of foundation trustees and the required modifications to the foundation documents occurred prior to the execution of the disclaimer.
Planning hints: While Letter Ruling 9350033 is silent on the point, it can be inferred that the foundation either was funded, or was likely to be funded, with significant assets other than those disclaimed. The disclaimant did not wish to completely disassociate herself from its operations. The proposed modifications to the foundation documents allowed her continued involvement, at least to the extent of funds not derived from the proposed disclaimer. The different approaches reflected in Letter Rulings 9350032 and 9350033 illustrate that there are often several ways to achieve a desired tax result, and that often they can be tailored to the taxpayer's express wishes.
(1)IRS Letter Ruling 9352005 (9/27/93).
(2)H.M. Silverstein, 419 F2d 999 (7th Cir. 1969)(24 AFTR2d 69-5972, 70-1 USTC [paragraph] 9109).
(3)IRS Letter Ruling 9344016 (8/5/93).
(4)IRS Letter Ruling (TAM) 9419007 (2/3/94).
(5)James C. Self, Jr., 142 F Supp 939 (Ct. Cl. 1956)(49 AFTR 1913, 56-2 USTC [paragraph] 11,613).
(6)Florence E. Walston, 168 F2d 211 (4th Cir. 1948)(36 AFTR 1020, 48-1 USTC [paragraph] 10,619).
(7)Rev. Rul. 79-327, 1979-2 CB 342.
(8)George F. Jewett, 455 US 305 (1982)(49 AFTR2d 82-1470, 82-1 USTC [paragraph] 13,453).
(9)Id., at 82-1 USTC 84,261.
(10)IRS Letter Ruling (TAM) 9352001 (9/3/93).
(11)Est. of Larch M. Cummins, TC Memo 1993-518.
(12)Id., at 93-2737.
(14)IRS Letter Ruling 9410028 (12/10/93).
(15)Est. Of Olive D. Casey, 948 F2d 895 (4th Cir. 1991)(68 AFTR2d 91-6060, 91-2 USTC [paragraph] 60,091).
(16)IRS Letter Ruling 9336011 (6/8/93).
(17)IRS Letter Ruling 9338010 (6/21/93).
(18)IRS Letter Ruling 9350032 (9/22/93).
(19)IRS Letter Ruling 9350033 (9/22/93).
(20)LRS Letter Ruling 9340052 (7/12/93).
(21)Regs. Sec. 25.2518-2(c)(5), Example (1).
(22)John O. Irvine and First Trust National Association, Sup. Ct., 1994 (73 AFTR2d 94-1323, 94-1 USTC [paragraph] 60,163), rev'g 981 F2d 991 (8th Cir. 1992)(71 AFTR2d 93-2145, 93-1 USTC [paragraph] 60,126), aff'g DC Minn., 1989 (89-2 USTC [paragraph] 13,818).
(23)John G. Ordway, Jr., 908 F2d 890 (11th Cir. 1990)(66 AFTR2d 90-5998, 90-2 USTC [paragraph] 60,035), cert. denied.
(24)Jewett, note 8.
(25)Est. of Lulu K. Flandreau, 2d Cir., 1993 (72 AFTR2d [paragraph] 149,095, 93-1 USTC [paragraph] 60,137), aff'g TC Memo 1992-173.
(26)See F. Coit Johnson, 86 F2d 710 (2d Cir. 1936)(18 AFTR 650, 37-1 USTR [paragraph] 9007); Guarantee Trust Co. of New York, 98 F2d 62 (2d Cir. 1938)(21 AFTR 649, 38-2 USTC [paragraph] 9416); and Peter E.C. Muserlian, 932 F2d 109 (2d Cir. 1991)(67 AFTR2d 91-912, 91-1 USTC [paragraph] 50,204).
(27)Est. of Elizabeth G. Huntington, 16 F3d 462 (1st Cir. 1994)(73 AFTR2d 94-1164, 94-1 USTC [paragraph] 60,157), aff'g 100 TC 313 (1993).
(28)IRS Letter Ruling (TAM) 9321004 (2/16/93).
(29)Est. of Frank G. Hagmann, 60 TC 465 (1973).
(30)IRS Letter Ruling (TAM) 9342002 (6/15/93).
(31)IRS Letter Ruling (TAM) 9344004 (7/13/93).
(32)Rev. Rul. 77-60, 1977-1 CB 282.
(33)Herbert H. Lehman, 448 F2d 1318 (5th Cir. 1971)(28 AFTR2d 71-6257, 71-2 USTC [paragraph] 12,806).
(34)Est. of Anna Lora Gilchrist, 630 F2d 340 (5th Cir. 1980)(47 AFTR2d 81-1568, 80-2 USTC [paragraph] 13,378).
(35)Est. of Jane H. Duvall, TC Memo 1993-319.
(36)Jane Duvall, 246 F Supp 378 (E.D. Ky. 1965)(16 AFTR2d 6175, 65-2 USTC [paragraph] 12,342).
(37)Melton v. Wyatt, 517 SW2d 242 (Ky. 1974).
(38)Est. of Ethel H. Kurz, 101 TC 44 (1993).
(39)IRS Letter Ruling 9351016 (9/24/93).
(40)Rev. Rul. 79-353, 1979-2 CB 325.
(41)Rev. Rul. 81-51, 1981-1 CB 458.
(42)Est. of Helen S. Wall, 101 TC 300 (1993).
(43)Est. of Virgil C. Sullivan, TC Memo 1993-531.
(44)The Colonial-American National Bank of Roanoke, 243 F2d 312 (4th Cir. 1957)(51 AFTR 80, 57-1 USTC [paragraph] 11,689).
(45)Sullivan, note 43, at 93-2847.
(46)Est. of Arthur S. Dwight, 205 F2d 298 (2d Cir. 1953)(44 AFTR 48, 53-1 USTC [paragraph] 10,903).
(47)IRS Letter Ruling 9340014 (6/30/93).
(48)Rev. Rul. 73-21, 1973-1 CB 405.
(49)Wall, note 42.
(50)Rev. Rul. 79-353, note 40.
(51)Rev. Ruls. 73-142, 1973-1 CB 405, and 77-182, 1977-1 CB 273.
(52)Charles E.. O'Malley, 383 US 627 (1966)(17 AFTR2d 1393, 66-1 USTC [paragraph] 12,388).
(53)Warren H. Corning, 24 TC 907 (1955).
(54)Marian A. Byrum, 311 F Supp 892 (S.D. Ohio 1970)(26 AFTR2d 70-5967, 70-2 USTC [paragraph] 12,692), aff'd, 440 F2d 949 (6th Cir. 1971)(27 AFTR2d 71-1744, 71-1 USTC [paragraph] 12,763), aff'd, 408 US 125 (1972)(30 AFTR2d 72-5811, 72-2 USTC [paragraph] 12,859).
(55)Wall, note 42, quoting from Byrum, id., Sup. Ct., at 72-2 USTC 85,971.
(56)Nager, Abbin and Carlson, "Significant Recent Developments in Estate Planning (Part I)," 24 The Tax Adviser 755 (Dec. 1993), at 766-767.
(57)IRS Letter Ruling (TAM) 9343003 (6/30/93).
(58)Harry G. McNeely, 8th Cir., 1994 (73 AFTR2d [paragraph] 94-587, 94-1 USTC [paragraph] 60,155), rev'g and rem'g unreported DC Minn. decision.
(59)Est. of Eleanor P. Barton, TC Memo 1993-583.
(60)Est. of Lee D. Jalkut, 96 TC 675 (1991), acq. 1991-2 CB 1.
(61)IRS Letter Ruling (TAM) 9343004 (6/30/93).
(62)IRS Letter Ruling 9350032 (9/22/93).
(63)IRS Letter Ruling 9350033 (9/22/93).
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|Title Annotation:||part 1|
|Author:||Carlson, David K.|
|Publication:||The Tax Adviser|
|Date:||Oct 1, 1994|
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