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Significant recent developments in estate planning.

The past year has produced a number of key estate planning developments, including some long-anticipated legislative changes. This article will examine court decisions, IRS rulings and regulations, and changes in the tax law significantly affecting estate planning that occurred between Apr. 1, 1995 and Aug. 31, 1996. The article begins by examining the period's most prominent and controversial developments, including new statutory provisions important to estate planners followed by a discussion of other developments, organized by topic.


The past year's highlights included:

* Controversial proposed regulations were issued requiring trust agreements to prohibit certain individuals and entities from purchasing a residence held in a qualified personal residence trust (QPRT).

* The IRS attacked the use of notes to satisfy annuity payments from a grantor retained annuity trust (GRAT).

* Final regulations barred "zeroed-out" GRATs.

* The IRS restricted the allocation of precontribution capital gains to trust accounting income (TAI) of a charitable remainder unitrust (CRUT).

* The IRS attacked the use of Crummey powers to create present interests.

* New legislation was enacted.

QPRT Prop. Regs.

The IRS issued proposed regulations amending Regs. Secs. 25.2702-5 and -7, dealing with QPRTs.(1) Under Prop. Regs. Secs. 25.2702-1(b)(1), (c)(9) and -7, for trusts created after May 16, 1996, a QPRT's governing instrument must prohibit the grantor, his spouse or an entity controlled by either from purchasing the residence from the trust both during and after the retained term. While the proposed regulations will not apply retroactively, if the facts and circumstances indicate a preplanned purchase, the IRS may challenge pre-effective date QPRTs.

Prop. Regs. Sec. 25.2702-5(a)(2) addresses reformation of QPRT documents. A QPRT that does not include the provision discussed above is deemed to comply if the trust is reformed judicially or nonjudicially (if effective under state law) within a prescribed time period.

The IRS justification for the repurchase prohibition is to prevent a grantor from "baiting and switching," so that at the end of the trust term, beneficiaries receive assets other than the residence, while the requirements for a GRAT or grantor retained unitrust (GRUT) are avoided.

Under Rev. Rul. 85-13,(2) if a QPRT is structured to remain as a grantor trust after the term holder's interest expires, and the grantor purchases the residence from the trust at that time, no gain is recognized. If the grantor subsequently the owning the residence (or a residence with a substituted basis), the beneficiaries receive the residence with a stepped-up basis; gain on the residence thus escapes taxation in the grantor's generation. (This is not a valuation issue properly the subject of the Sec. 2702 regulations.) In addition, the repurchase of a residence from a QPRT is not always the result of a prearranged plan; rather, it is an option that grantors are typically very concerned with, due to the possibility of changed circumstances (e.g., the death of a remainder beneficiary).

Use of Notes to Make GRAT Payments Rejected

Letter Ruling (TAM) 9604005(3) held that a GRAT did not meet the requirements of Sec. 2702 because, from its inception, there was a plan to satisfy the annuity payments with notes.

In the TAM, each of 25 trusts was funded with class A voting stock in Company, a closely held corporation that had no history of paying cash dividends on such stock; thus, the GRATs would lack sufficient cash flow to make the required annuity payments. If, as an alternative, payments were made in kind, frequent appraisals of the stock would be necessary. To avoid the need for frequent appraisals, the donors devised the following plan:

* Separate "administrative trusts" would be established to coordinate the GRAT payments.

* The donors would loan the respective administrative trust an amount necessary to make the annuity payments.

* The trustee of the administrative trust would execute a separate promissory note for each GRAT.

* The proceeds of each loan would be used to satisfy each required annuity payment.

The trustee was required to pay each promissory note no later than Dec. 31, 2004, the last day of the year in which the longest GRAT terminated. The notes initially carried zero interest, paying interest only after a trust with respect to which the note was issued ceased to be a grantor trust.

Although the GRATs' express terms satisfied the technical requirements of Sec. 2702 and the regulations thereunder, the IRS concluded that the trusts did not qualify as GRATs because the retained interests were not qualified annuity interests. The IRS found that, based on the company's dividend-paying history, the GRATs would generate insufficient cash flow to pay the annuities. Further, the trustee would never willingly distribute stock in satisfaction of the annuity payments, because such a distribution would clearly defeat the purpose of creating the GRATs.

TAM 9604005, in combination with Letter Ruling 9515039,(4) illustrates the Service's hostility toward the use of notes to satisfy a GRAT's required annuity payments. Thus, while after these things, it may be possible for a GRAT to continue using notes to satisfy annuity payments, taxpayers should be wary of such arrangements, particularly when the notes are noninterest-bearing and the GRAT property is not likely to produce sufficient income to fund the payments. Also, if the IRS were to conclude on audit that the use of notes to satisfy annuity payments caused the GRAT to fail to meet Sec. 2702, the full value of the transferred property would be a taxable gift.

"Zeroed-out" GRAT Prohibited

Final Regs. Sec. 25.7520-3(b)(2)(i)(5) adopts the IRS position set forth in Rev. Rul. 77-454,(6) that a GRAT may not be valued using a standard Sec. 7520 annuity factor if the annuity is expected to exhaust the trust before the last payment date; the Tax Court rejected this position in Shapiro.(7) In light of the regulations, taxpayers wishing to rely on Shapiro have the burden of proving those rules are unreasonable, a burden that did not exist with respect to Rev. Rul. 77-454.

Precontribution Capital Gain Not Allocable to

CRUT's Income

In Letter Ruling 9609009,(8) the taxpayer sought to establish a CRUT funded with common stock. The taxpayer and another person would be the trust's lifetime income beneficiaries. The trust was established as a net-income only CRUT with a make-up provision. The trust instrument provided that any gain realized on the disposition of the specific assets contributed to the trust was to be treated as principal, but all other capital gain would be allocated to TAI. In addition, when calculating the CRUT's payments each year, the fair market value (FMV) of the assets was to be reduced by any deficiency in payments for prior years.

The IRS ruled that the trust was a valid CRUT because it allocated certain capital gains from post-contribution assets to income and treated the unitrust deficiency as a liability in valuing the trust's assets. Letter Ruling 9609009, along with recent statements by IRS personnel (discussed below), demonstrates the new IRS position that precontribution capital gain cannot be allocated to a CRUT's TAI. This is contrary to previous rulings; Letter Rulings 9511007(9) and 9511029(10) held that the allocation of precontribution capital gain to TAI does not violate the CRUT requirements, provided that applicable local law allows allocation of capital gain to TAI.

In an attempt to prevent manipulation of TAI, Regs. Sec. 1.643(b)-1 states that trust provisions that depart fundamentally from the concepts of local law in the determination of what constitutes income are not recognized. A possible interpretation of this regulation is that capital gain may not be allocated to TAI unless applicable local law so provides; however, state principal and income acts generally allow a trust instrument to control allocation of receipts between income and principal.(11) Consequently, because the states allow capital gain to be relocated to TAI if specified in the trust document, such a provision in the trust instrument should not depart fundamentally from local law concepts; thus, the Service's position in Letter Ruling 9609009, that precontribution capital gain cannot be allocated to TAI, appears inconsistent with Regs. Sec. 1.643-1.

Unfortunately, the IRS has signaled its intent to rule contrary to the regulation. Frances Schaefer, Senior Technical Reviewer in Branch 4, Office of Assistant Chief Counsel and the drafter of Letter Ruling 9609009), indicated during a telecast sponsored by the American Law Institute and the American Bar Association that the IRS will not allow income-only CRUTs to allocate precontribution appreciation to income for trust accounting purposes.(12) MS. Schaefer indicated that the Service's business plan for 1996 includes the issuance of guidance on CRUTs, particularly those that limit the annuity payment to TAI and have a make-up provision. The IRS has also indicated that a regulations project had been opened on income-only CRUTs.(13)

Purported Withdrawal Powers Did Not Create

Present Interests

The IRS continued its attack on Crummey(14) powers in its acquiescence in result only(15) to Cristofani(16) and its issuance of Letter Ruling (TAM) 9628004.(17) In Cristofani, an individual created an irrevocable inter vivos trust, and made annual contributions to the trust in the year of death and the immediately preceding year. The decedent's two adult children were the primary beneficiaries; her five minor grandchildren were contingent remainder beneficiaries.

The trust contained a Crummey withdrawal power, granting each of the two primary and five secondary beneficiaries an unrestricted right to withdraw up to $10,000 for 15 days after a contribution. While allowing the donor's Sec. 2503(b) annual gift tax exclusions attributable to the children, the IRS disallowed the exclusions attributable to the grandchildren, finding what the grandchildren's withdrawal rights were not present interests. The Tax Court relied on Crummey in holding for the estate.

In acquiescing in the result, the IRS stated that it "does not contest annual gift tax exclusions for Crummey powers where the trust instrument gives the power holders a bona fide unrestricted legal rights to demand immediate possession and enjoyment of trust income or corpus." However, the IRS intends to deny "the exclusions for Crummey powers, regardless of the power holders' other interests in the trust, where the withdrawal rights are not in substance what they purport to be in form."(18)

The IRS also said it "will continue to litigate cases whose facts indicate that the substance of the transfers was merely to obtain annul exclusions and that no bonafide gift of a present interest was intended." This reasoning which denied annual exclusions with respect to trust beneficiaries holding solely powers of withdrawal in the trust. The IRS stated that because there was no logical reason these beneficiaries would fail to exercise their withdrawal rights, there had to have been a prearranged understanding between the donor and the beneficiaries.

Taxpayers making contributions to trusts with multiple contingent beneficiaries having Crummey powers (or with individuals having only Crummey powers and no other trust interests) can expect IRS scrutiny.

New Legislation Passed

In August 1996, the tax legislation logjam burst with the enactment of the Small Business Job Protection Act of 1996 (SBJPA) and the Health Insurance Portability and Accountability Act of 1996 (HIPAA). Of most interest to estate planners are the SBJPA provisions affecting S corporations(19) and foreign trusts(20); the HIPAA affects U.S. citizens and long-term residents relinquishing, respectively, U.S. citizenship and residency.

SBJPA Provisions

Number and types of shareholders: SBJPA Section 1301 expanded the maximum number of S shareholders to 75; SBJPA Section 1302 increased estate planning opportunities S shareholders by creating a new type of shareholder, an "electing small business trust" (ESBT). Only individuals or estates that are eligible S shareholders may be ESBT beneficiaries. An ESBT beneficiary cannot have acquired its trust interest by purchase. Charitable organizations may hold contingent reminder interests in ESBTs. SBJPA Section 1303 extends the period during which testamentary trusts can be eligible S shareholders from 60 days to two years.

Charitable deductions: SBJPA Section 1206(a) reinstated an expired provision allowing a charitable deduction for the full FMV of gifts of qualified appreciated stock to certain private foundations. The reinstated provision applies to contributions made after June 30, 1996 and before June 1, 1997.

Foreign grantor and nongrantor trusts: Planning opportunities using inbound and outbound foreign grantor trusts are curtailed. Under SBJPA Section 1904, with respect to inbound trusts, beginning Aug. 20, 1996, the grantor trust rules generally no longer apply, subject to certain exceptions, if the result is to deem any foreign person as the trust owner.

Under SBJPA Section t903, effective for transfers of property after Feb. 6, 1995, tightened outbound rides extend grantor trust treatment to trusts with U.S. beneficiaries that receive property from U.S. persons (and prospective U.S. persons).

Foreign nongrantor trusts are also negatively affected. According to SBJPA Section 1906(a), the Sec. 668(a) interest charge applicable to accumulation distributions from a foreign trust made after Aug. 20, 1996 (for accumulations deemed to occur after 1995) will be based on compound interest at the Sec. 6621 underpayment rate; the interest charge on pre-1996 accumulations continues at a 6% simple rate. Under SBJPA Section 1906(c), loans of cash or marketable securities after Sept. 19, 1995 by a foreign trust to a U.S. grantor or U.S. beneficiary (or a U.S. person related to such grantor or beneficiary) are treated as distributions to the grantor or beneficiary. For this purpose, "cash" includes foreign currency and cash equivalents.

SBJPA Sections 1902 and 1907(b) apply Sec. 1491's provisions to trusts that change situs from U.S. to foreign. On the date situs changes, a deemed transfer to a foreign this occurs, triggering a 35% excise tax. Informal discussions with joint Tax Committee staff indicate that the Sec. 1491 excise tax should not be imposed when the situs of a U.S. grantor trust changes to foreign, provided the trust remains a grantor trust after the change.(21)

A number of additional provisions affecting foreign transaction are included in the SBJPA. For the first time, there is a statutory test fixing a trust's residency (Sec. 7701(a)(30)(E) and (31)(B), as amended by SBJPA Section 1907(a)). Effective for amounts received after Aug. 20, 1996, gifts and bequests from foreign sources to U.S. persons must be reported if the aggregate value of such transfers exceeds $10,000 (indexed for inflation after 1996). For this purpose, "qualified transfers" defined in Sec. 2503(e)(2) are not foreign-source gifts. Failure to file a required report may result in a penalty of up to 25% of the value of the transfer; the IRS is granted authority to treat the amount received. (but unreported) as taxable income (Sec. 6039F, as added by SBJPA Section 1905).

Reporting requirements are now imposed on grantors of, transferors to or executors of ("responsible parties") foreign trusts. Effective after Aug. 20, 1996, a responsible party must file an information return with Treasury within 90 days of the occurrence of a "reportable event": generally, (1) creation of a foreign trust by a U.S. person, (2) direct and indirect transfers of money or property to a foreign trust (including due to death) or (3) the death of a U.S. citizen or resident, if any portion of a foreign trust is includible in the decedent's gross estate (Sec. 6048, as amended by SBJPA Section 1901(a)).

For tax years beginning after 1995, a U.S. person treated as the owner of any portion of a foreign trust generally is required to ensure that the trust file an annual return providing a full accounting of the trust's activities for the tax year. Failure to ensure compliance may result in a penalty of 5% of the reportable amount. In addition, after Aug. 20, 1996, any U.S. person receiving (directly or indirectly) a distribution from a foreign trust generally must file a return reporting the name of the trust, the aggregate distributions received and other prescribed information. Persons failing to provide the required notice or return with respect to the transfer of property to a foreign trust (or a distribution by a foreign trust) are subject to penalties, initially equal to 35% of the gross reportable amount; a reasonable cause exception is available (Secs. 6048 and 6677, as amended by SBJPA Section 1901(a) and (b)).

HIPAA Provisions

Departure tax: Effective for persons relinquishing U.S. citizenship and departing "long-term, residents"(22) relinquishing residency after Feb. 5, 1995, the Secs. 877 and 2107 expatriation provisions are expanded, and the classes of persons eligible to claim nontax-motivated expatriations are restricted. An individual's explanation is deemed tax motivated if his (1) average annual net Federal income tax ability exceeds $100,000 for the five tax years prior to expatriation or (2) net worth expatriation equals or exceeds $500,000. (Both figures are indexed for inflation after 1996.) In the case of U.S. citizens deemed to have expatriated for tax-motivated reasons, Sec. 877(c)(1)(B) provides that a ruling that the explanation was not tax motivated may be obtained if certain requirements are met; in general, the ruling request must be submitted granted the authority to issue regulations addressing deemed tax-motivated exceptions in the case of long-term residents (Sec. 877, as amended by HIPAA Section 511(a)).

If an expatriate's change in status was tax motivated, gains on U.S.-situs property and on stock or debt obligations issued by U.S. persons will continue to be treated as U.S.-source income. Capital gain and dividend income associated with stock in a foreign corporation will also be sourced to the U.S. in certain cases. In most cases, income will be re-sourced to the U.S. for a 10-year period beginning with the date of expatriation (or loss of residency.


* Under new proposed regulations, the governing instrument of a QPRT created after May 16, 1996 must prohibit the grantor, his spouse or an entity controlled by either from purchasing the residence from the trust both during and after the retained; term the IRS may challenge a pre-effective date QPRT if the facts and circumstances indicate a preplanned purchase.

* Rev. Rul. 95-58 provides that a decedent-grantor's reservation of the power to remove a trustee and appoint a new individual or corporate trustee does not cause the trust property to be includible in his estate.

* The Tax Court stated in Clack that its decisions in Robertson, Clayton and Spencer, all of which were reversed on appeal, will no longer be followed; thus, income interests contingent on an executor's election may qualify for QTIP treatment (see Regs. Sec. 20.2056(b)-7(d)(3)).

(1) PS-4-96(4/16/96). (2) Rev. Rul. 85-13, 1985-1 CB 184. (3) IRS Letter Ruling (TAM) 9604005 (10/17/95). (4) In IRS Letter Ruling 9515039 (1/17/95), the IRS, although allowing the use of notes to satisfy annuity payments (provided the remainder interest holder guaranteed the payment of the note and had sufficient independent wealth to satisfy the obligation), ruled that if the payment of the notes was satisfiable solely, out of the underlying trust property and earnings, the notes represented only a cumulative right of withdrawal of trust assets, which is not a qualified annuity interest under Regs. Sec. 25.2702-3(b). (5) TD 8630 (12/12/95). (6) Rev. Rul. 77-454, 1977-2 CB 351. (7) Est. of Benjamin Shapiro, TC Memo 1993-483. (8) IRS Letter Ruling 9609009 (11/20/95). (9) IRS Letter Ruling 9511007 (12/12/94). (10) IRS Letter Ruling 9511029 (12/16/94). (11) Generally, based on the Uniform Principal and Income Act or the Revised Uniform Principal and Income Act. (12) See 96 Tax Notes Today 63-8 (3/28/96). (13) See 96 Tax Notes Today 90-15 (5/7/96). (14) D. Clifford Crummey, 397 F2d 82 (9th Cir. 1968)(22 AFTR2d 6023, 68-2 USTC [paragrah]12,541), rev'g TC Memo 1966-144. (15) AOD CC-1996-010 (16) Est. of Maria Cristofani, 97 TC 74 (1996). (17) IRS Letter Ruling (TAM) 9628004 (4/1/96). (18) See 96 Tax Notes Today 137-21 (7/15/96). (19) See Karlinsky, "S Corporations: Current Developments," 27 The Tax Adviser 614 (Oct. 1996). (20) see Lifson and Guadiana, "Recent Legislation Imposes New Compliance and Tax Burdens on Individuals With Foreign Connections," 27 The Tax Adviser 676 (Nov. 1996). (21) See Rev. Rul. 87-16, 1987-2 CB 219. (22) A long-term resident is defined in Sec. 877(e)(2) as any lawful permanent resident (i.e., a green card holder) for at least eight tax years during the 15-year period ending with the tax year residency is lost. Under this definition, a foreign citizen who has held a green card for as little as six years and two days may be a long-term resident.

Editor's note: Mr. Gardner chairs the AICPA Tax Division Trust, Estate and Gift Taxation Committee.

The estate and gift tax expatriation provisions now apply to departing long-term residents for a 10-year period beginning with the date residency is relinquished.(23) Sec. 2107 was modified by HIPAA Section 511(e) to include in a decedent expatriate's Federal taxable estate a pro rata share of his interests in every foreign corporation holding US.-situs property, provided the decedent (1) owned (directly or indirectly) 10% or more (by vote) of the corporation's stock and (2) owned (directly, indirectly or constructively) more than 50% (by vote or value) of the corporation's stock. (There was no 50% of value test prior to the HIPAA.) Under Sec. 6039G, as added by HIPAA Section 512, an expatriate must file an information return providing: (1) a taxpayer identification number; (2) the mailing address of his principal foreign residence; (3) the foreign country in which he is residing; (4) the foreign country of which he is a citizen; (5) information detailing the expatriate's assets and liabilities (if net worth exceeds $500,000 on the date of expatriation); and (6) such other information as Treasury may prescribe.(24) The State Department is required to share information with Treasury regarding expatriation cases, md the Federal Register will publish expatriates' names.

Under HIPAA Section 511(g)(3), expatriates who performed certain acts of expatriation after Feb. 5, 1994, and prior to Feb. 6, 1995, but who failed to furnish a signed statement of voluntary relinquishment of US. nationality by the latter date, may be subject to the new provisions.

Gift Tax Matters

The following significant developments occurred:

* The Tax Court held that loans were not bona fide. * Gifts under powers of attorney were includible in estate. * The Sec. 483 safe harbor rate did not apply for gift tax purposes. * Transfers to a trust for insufficient consideration were gifts. * The waiver of notice of a withdrawal power negated the creation of a present interest.

Loans Were Really Gifts

In Miller,(25) the Tax Court sustained the IRS's position that a mother's transfer of $100,000 to each of her two sons constituted gifts rather than loans. The court held that the taxpayer failed to establish that a bona fide debtor-creditor relationship was entered into at the time of the transfers.

The taxpayer wrote two $50,000 checks to one son in 1982 on which she noted "loan" on the click stub and in her check register. In September 1982, the son executed a noninterest-bearing $100,000 note requiring him to repay the funds on the earlier of demand or approximately three years from the date of signing. TWO months later, the son repaid $15,000, but made no other payments. When the son failed to repay the money within the three-year period, the taxpayer did not demand payment, institute legal proceedings or take my other steps to enforce repayment. The taxpayer then wrote a letter to her son approximately once per year reducing the principal by the stated amount.

The taxpayer also gave a $100,000 check to her second son in October 1982 in the same manner as the funds given to the first son (i.e., notation on check stub and register, and execution of the same type of noninterest-bearing note). After this son made no payments during the thee-year period, the taxpayer wrote him the same series of annual forgiveness letters.

The fact that the one son actually made one $15,000 payment did not persuade the Tax Court that the transactions were loans; rather, the court concluded that the taxpayer never intended for her sons to repay her, noting that neither son earned enough to possibly repay her within a three-year time frame and that she made no attempt to collect the notes when the time limits expired.

No Gift-Making Power Granted

In Letter Ruling 9634004,(26) the IRS held that gifts made by a decedent's attorney-in-fact under three powers of attorney (POAS) that lacked explict grants of power to make gifts were revocable transfers includible in the decedent's estate.

The POAs contained very broad powers that were to be exercised for the decedent's use and benefit; in addition, they contained a "residual clause" granting the attorney-in-fact full power and authority to do all acts the decedent could perform.

The IRS rejected the estate's argument that the broad grants of power contained in the residual clauses conferred on the attorney-in-fact the power to make gifts; instead, it ruled that the clauses were meant to facilitate management of the decedent's assets and provide the attorney-in-fact with the flexibility needed to preserve those assets.

Use of Sec. 483 Safe Harbor Rate Rejected

The Tenth Circuit held in Schusterman(27) that the Sec. 483 safe harbor rate does not apply for gift tax valuation purposes. In 1980 (prior to enactment of the Sec. 7872 imputed interest rules), the taxpayer transferred stock to five irrevocable trusts in exchange for promissory notes with 6% stated interest, the Sec. 483 safe harbor rate. (The then-prevailing market interest rate was 11.5%.) The IRS notified the taxpayer that gift tax was due on the transfer of the stock to the trusts, to the extent of the difference in the value of the stock and the value of the notes using the 11.5% market interest rate. The IRS asserted that the use of the Sec. 483 safe-harbor rate did not bar the assessment of gift tax on the transfer based on the market interest rate then in effect.

The district court, and ultimately, the Tenth Circuit, held that Sec. 483 applies for income tax purposes, not for gift tax purposes; thus, there was a gift of the difference between the FMV of the stock and the present value of the promissory notes discounted at 11.5%.

Gift Occurred on Entity Formation

Trenchard(28) illustrates the need for careful planning when entities are used in gift tax planning. Parents, their daughter and her children transferred farm property to a newly formed family corporation in exchange for stock and debt. The IRS asserted that the parents made gifts to the daughter and grandchildren, because the value of the property the parents transferred exceeded the value of the stock and debt received. The Tax Court agreed, holding that the value of such gifts was the difference between the FMV of the property transferred to the corporation and the FMV of the stock and debentures received. This result should be avoided if the parents transfer property in exchange for interests in an entity and then gift those interests.

Waiver of Withdrawal Notice Negated Present


The IRS ruled in Letter Ruling (TAM) 9532001(29) that transfers to an inter vivos trust in which the beneficiaries had Crummey withdrawal rights did not create present interests under Sec. 2503(b), because the beneficiaries waived their right to be notified of the transfers.

When the trust was created, each beneficiary signed a statement waiving further notice of withdrawal rights in connection with future gifts. Citing Fondren,(30) the IRS noted that a donee must have current notice of any gift in order for that gift to be a transfer of a present interest. Because the grandchildren waived their rights to be notified of additions to the trust, all transfers to the trust after the initial transfer created future interests.

Retained interests and Powers of Appointment

The IPS ruled as follows:

* Power to replace trustee does not trigger estate inclusion. * Scrivener's error did not cause estate inclusion.

Estate Inclusion Not Triggered by Power to

Replace Trustee

In Rev. Rul. 95-58,(31) the IRS revoked Rev. Rul. 79-353(32) and ruled that a decedent-grantor's reservation of the power to remove a trustee and appoint a new individual or corporate trustee not related or subordinate to the decedent does not cause the trust property to be includible in his estate under Sec. 2036 or 2038. The IRS based its change in position on Wall(33) and Vak.(34)

Scrivener's Error Did Not Trigger Estate Inclusion

In Letter Ruling 9623043,(35) a will established a trust benefiting the decedent's daughter. Under the trust's terms, the trustee could distribute income and principal to the daughter during her life; the daughter also could appoint trust property during her lifetime and at death "to or among any one or more of my lineal descendants." The taxpayer represented that the word "my" was included in the power to appoint rather than the word "her" as the result of a scrivener's error.

The IRS ruled that, provided that the taxpayer received a binding court order stating that the power was not a general power of appointment (i.e., not exercisable in favor of the taxpayer, her creditors or her estate), the power would not be regarded as a general power of appointment for estate and gift tax purposes.


Rulings and other developments included:

* New proposed regulations addressed disclaimers of joint interests. * Formula disclaimers were approved.

Disclaimer Regulations Modified

The IRS issued proposed regulations(36) that conform to recent court decisions invalidating portions of the present regulations on disclaimers of joint interests in property. The proposed rules also clarify the meaning of "taxable transfer."

Prop. Regs. Sec. 25.2518-2(c)(3)(i) provides that the nine-month disclaimer period in Sec. 2518 does not depend on the actual imposition of a transfer tax at the time the interest to be disclaimed is created. In addition, if a joint tenancy is unilaterally severable by either party under applicable state law, the surviving joint tenant can disclaim the one-half survivorship interest surviving nine months of the death of the first joint tenant. In the case of a tenancy that cannot be unilaterally severed (with limited exceptions concerning interests covered by former Sec. 2515), the proposed regulations continue to require that the interest be disclaimed within nine months of creation. Also proposed are rules governing the treatment of joint bank accounts and joint brokerage accounts.

Formula Disclaimers Approved

While disclaimers add tremendous flexibility to an estate plan, the amount of property to be disclaimed is not always evident at the the a document is drafted. The IPS continues to look favorably on formula disclaimers; a recent example is Letter Ruling 9623064.(37)

Debts, Claims and Administrative Expenses

Current decisions and rulings included:

* The Tax Court allowed an interest deduction for funds borrowed to pay estate tax. * The amount paid a surviving spouse under a prenuptial agreement was not a deductible claim against the estate. * State-mandated interest payments on bequests were not deductible.

Estate Properly Deducted Interest

on Borrowed Funds

In McKee,(38) an estate held stock subject to restriction agreements. Under the agreements, a deceased shareholder's estate qualifying to make a Sec. 6166 election could (1) make the election and offer the decedent's shares to the company or (2) not make the election and offer all shares to the company within 30 days after the Federal estate tax was due.

The executors chose not to make a Sec. 6166 election; rather, funds to pay the estate tax were provided via a disclaimer by the decedent's husband and a loan from the company. The estate did not seek the state probate court's permission to borrow the funds or to take subsequent loans. The estate claimed as an adminisrative expense the interest paid on various notes on its timely filed Form 706, United States Estate (and Generation-skipping Transfer) Tax Return. The IRS denied the interest expense deduction, contending that the executors' actions were unauthorized and should not be charged to the estate.

The Tax Court found that nothing in the with limited the executors' power to borrow funds; on the contrary, the will explicitly incorporated provisions of the state probate code, including the power to borrow. The court rejected the IRS's argument that the structure of the will, when viewed together with the stock restriction agreements, was a binding indirect instruction to the executors to make a Sec. 6166 election.

Payment Under Prenuptial agreement Was Not

Claim Against Estate

In Herrmann,(39) the decedent and his surviving spouse had a prenuptial agreement under which each spouse waived claims for property distribution from the other, except that the surviving spouse was entitled to a life interest in a cooperative apartment on the decedent's death. The IRS disallowed the executors' deduction of the FMV of the apartment as a claim against the estate; the Tax Court agreed that the spouse's claim was not the result of an arm's-length, bona fide sale for adequate and full consideration court held that the prenuptial waiver did not qualify as consideration under Sec. 2053(c)(1)(a), so that the value of the life interest was includible in the estate. On appeal, the Second Circuit affirmed that the surviving spouse's relinquishment of marital equitable distribution rights was not adequate and full consideration, but declined to rule as a matter of law that a waiver of equitable distribution rights can never serve as consideration by reason of Sec. 2043(b)(1).(40)

Statutory Interest on Bequests Was Nondeductible

The IRS ruled in TAM 9604002(41) that interest paid under Pennsylvania law on the delayed distribution of a pecuniary bequest was not a deductible administration expense under Sec. 2053. Pennsylvania law provided that when a sum of money was directed to be set aside at a specified time as a separate trust, it had to bear 5% interest from the date it was to be set aside until the date actually set aside. The IRS reasoned that the statutory interest was merely a mechanism for allocating estate income among the beneficiaries to compensate the pecuniary legatees for a delay during estate administration.


The courts decided as follows:

* QTIP interest was not combined with other fractional interests. * SEC restrictions could be disregarded in valuing a decedent's stock. * Marketability discount was impermissible, because the stock's value was not determined by reference to listed stock. * Some valuation discounts were valid.

QTIP and NON-QTIP Interests Did Not Merge

In Bonner,(42) the decedent died owning undivided fractional interests in two parcels of real estate and a boat; the remaining fractional interests were held by a qualified terminable interest property (QTIP) trust created by the taxpayer's predeceased spouse. A 45% fractional interest discount on the assets was taken on the decedent's estate tax return. The IRS contended that the fractional interests the decedent owned outright merged with those in the QTIP trust at the time of his death. The district court agreed and held that for estate tax purposes, the separate interests merged at the decedent's death, resulting in a 100% fee ownership in the decedent at death, negating any discount.

On appeal, the Fifth Circuit explained that, although under Sec. 2044 the QTIP is treated as having passed from the decedent for estate tax purposes, it does not require that, in so passing, the QTIP assets merge with the other assets. According to the court, the QTIP assets could have been left to any beneficiary by the decedent's spouse, and neither the decedent nor his estate had control over their ultimate disposition. Accordingly, the estate tax valuation should "reflect the reality" that at the time of the taxpayer's death, the hypothetical "willing seller" for Sec. 2031 valuation purposes (i.e., the decedent's estate) could not be presumed able to negotiate as if free of the QTIP trust's separate interests. Letter Rulings (TAMS) 9608001(43) and 9550002(44) are directly on point and hold contrary to Bonner; thus, it is likely that the IRS will continue to litigate this issue.

SEC Restrictions Ignored in Valuing Stock in


In McClatchy,(45) the decedent owned over two million shares of a company's class B common stock md had been an "affiliate" of the company for securities law purposes; thus, his stock was unregistered and restricted under Rule 144 of the Securities Act of 1933 (SEC Rule 144). His estate reported the shares at a per-share value of $12.3375; the IRS asserted the shares had a higher value. In Tax Court, the parties stipulated that if the SEC Rule 144 restrictions were taken into account, the value of the stock was the value reported.

The Tax Court agreed with the IRS that the stock should be valued without regard to the restrictions. Citing Ahmanson Foundation,(46) in which the Ninth Circuit held that stock must be valued at the precise moment of death, taking into account any transformations of the property that are logically prior to its distribution to the beneficiaries, the Tax Court ruled that because at death, SEC Rule 144 no longer applies, the shares had to be valued without the restrictions.

Marketability Discount Denied

In Cloutier,(47) the decedent owned all of the stock of a closely held corporation; prior to trial, the parties stipulated to the value of the stock without a marketability discount. In reaching said value, both sides relied on appraisers whose opinions were based primarily on transactional md financial data and without reference to the price of a comparable stock on a public exchange. The Tax Court held that a marketability discount did not apply, because the value of the underlying stock did not represent its freely traded value.

Some Discounts Recognized

Partial interests in property and entities can be worth significantly less than a pro rata share of the value of the property as a whole. With regard to interests in entities (e.g., partnerships, corporations, etc.), discounts are most often recognized for lack of marketability and for minority interests; the courts have generally continued to recognize the economic substance of such discounts. A review of the cases(48) in this area reveals that the thoroughness and credibility of a party's expert is the determinative factor in defending the discounts claimed.

Charitable Planning

New developments included:

* FMV deduction was reinstated for stock contributions to private foundations. * Charitable gift annuities were exempted from antitrust and registration requirements. * A gift of a partnership interest to a CRUT was not self-dealing.

Stock Gifts to Foundations

As mentioned previously, SBJPA Section 1206(a) restored Sec. 170(e)(5)(d), allowing a charitable deduction for the full FMV of gifts of qualified appreciated stock to certain private foundations made after June 30, 1996 and before June 1, 1997.

Exemption of Charitable Gift Annuities

In December 1995, Congress enacted two laws affecting charitable gift annuities: the Charitable Gift Annuity Antitrust Relief Act of 1995 permits charities to agree to use the same rates for charitable gift annuities (as set by the Committee on Gift Annuities) without violating Federal and state antitrust laws; the Philanthropy Protection Act of 1995 exempts charitable gift annuities from Federal md state securities registration requirements.

Gift of Partnership Interest to CRUT

Not Self-Dealing

In Letter Ruling 9533014,(49) an individual planned to contribute a portion of a partnership interest to a CRUT; he was to be the CRUT's grantor and trustee. The partnerships sole asset was an apartment complex subject to a nonrecourse mortgage entered into more than 10 years before the transfer. All of the income generated by the partnership was rent that was not unrelated business taxable income. None of the partners were personally liable on the debt, and the donor would indemnify and hold the CRUT harmless from and against all expenses, losses, payments or obligations arising from the CRUT's ownership of the partnership interest.

The IRS ruled that the transfer of the partnership interest to a CRUT would not violate Regs. Sec. 1.664-1(a)(3) and-3 (a) (4), relating to restrictions on investments and to nonqualified payments from a CRUT; would not constitute an act of self-dealing under Sec. 4941; and would not generate unrelated debt-financed income for 10 years following the gift.

Marital Deduction

Decisions and rulings included:

* Eleventh Circuit reversed Tax Court ruling on stub income. * IRS acquiesced in result of elective QTIP case. * Final QDOT regulations were issued. * Supreme Court heard argument on expenses paid from estate income. * Surviving spouse's QDOT could receive an IRA rollover.

Tax Court Reversed on QTIP Stub Income Issue

In Shelfer,(50) a surviving spouse received quarterly income distributions from her deceased husband's TIP trust. The Tax held that the QTIP was not includible in her estate, because the QTIP trust did not provide that she was entitled to all the income"; rather, the will provided that, at the surviving spouse's death, any income not distributed between the last distribution date and her date of death ("stub income") was to be paid to the QTIP's residuary beneficiaries. Because the statute of limitations had expired with regard to the predeceased spouse's estate, the government was whipsawed. On appeal, the Eleventh Circuit, joining the Ninth Circuit,51 overturned the Tax Court. For decedents dying after Mar. 1, 1994, Regs. Sec. 20.2056(b)-7(d)(4) reaches the same result. IRS Acquiesced in Result in Executor QTIP Election Case

To provide flexibility, a will sometimes gives an executor the power to decide whether to make a QTIP election. The IRS has successfully argued in Tax Court that income interests contingent on such an election are disqualified from QTIP treatment. However, in three of these cases,52 the Tax Court was subsequently reversed; consequently, in Clack,(53) it stated that those cases win no longer be followed.

Accordingly, the IRS has acquiesced in Clack in result only,(54) and only with respect to decedents dying prior to the effective date of Pegs. Sec. 20.2056(b)-7(d)(3) (decedents dying after Feb. 28, 1994). Given the rejection of its position by the Fifth, Sixth and Eighth Circuits and now the Tax Court, it is questionable whether that regulation (which incorporated the IRS's litigating position) with withstand judicial scrutiny,

QDOT Final Regs. Issued

The IRS issued final regulations55 governing the income, gift and estate tax consequences of qualified domestic trusts (QDOT's). The final rules largely follow the proposed regulations issued in january 1993, except for the addition of QDOT qualification requirements proposed to ensure the connection of the Sec. 2056A tax. The final regulations apply to decedents dying, and gifts made, after Aug. 22, 1995. Allocating Estate Expenses to Marital Share

Inter vivos trusts often provide that administrative expenses of the grantor's estate may be paid from trust income earned after the grantor's death. The IRS has argued that when part of the trust is to be distributed to a surviving spouse and would qualify for the marital deduction, the deduction must be reduced by the post-mortem income used to pay estate administrative expenses, a position it reiterated in Letter Ruling (TAM) 9617003.(56) To settle a conflict among the circuits on this issue, the Supreme Court recently heard oral argument in Hubert.(57)

Noncitizen Spouse's IRA Rollover


Can a surviving non-U.S. citizen spouse roll over a decedent spouse's individual retirement account (IRA) and qualify for the income tax deferral under Sec. 408(d)(3)(A) and (D)? The IRS ruled m the affirmative in Letter Ruling 9623063,(58) in which the surviving spouse, who was the primary beneificiary of the decedent's IRAs, timely rolled over the decedent's interest in the IRA to her own IRA, and irrevocably entered into a QDOT agreement with respect to her IRA. The IRS also held that the spouse was the account holder under Sec. 401(a)(9) for purposes of required distribution.

Generation Skipping

The following developments occurred:

* Final regulations were issued. * Extensions were granted for late reverse QTIP elections. * Spouse with general power of appointment was deemed a transferor for GSTT purposes.

GSTT Final Regs. Released

The IRS issued final generation-skipping transfer tax (GSTT) regulations(59) at the end of last year that are a step back from the highly controversial application of the GSTT to transfers by nonresident aliens. The proposed regulations subjected property not situated in the U.S. under the estate and gift tax rules to the GSTT based on the status of the skip person and the status of the person in the skipped generation; the final regulations provide that the GSTT applies only when an estate or gift tax is imposed on the transfer of property.

In connection with lifetime allocations of the GSTT $1 million exemption, Regs. Sec. 26.2632-1 provides that the automatic allocation of GSTT exemption to direct skips occurs whether or not a gift tax return is filed. Under Regs. Sec. 26.2632-1(b)(2)(i), a timely allocation of GSTT exemption does not become irrevocable until after the due date of the return. Late allocations are deemed to precede in time any taxable events occurring on the date the late allocation is made; a late allocation may be made on a gift tax return reporting another transfer, according to Regs. Sec. 26.2632-1(b)(2)(ii)(A). The proposed rule, that allocations in excess of the amount of the property transferred are void, has been expanded to void any allocation to a trust that has no GSTT potential at the time the allocation is made.

The final regulations adopt the position of the proposed regulations with respect to the separate share rule; accordingly, under Regs. Sec. 26.2654-1(a)(1)(i), a portion of a trust is not a separate share unless such share exists from and at afl times after the trust's creation. For example, a trust provides income to a child for life, but when a grandchild reaches age 30, a separate trust is to be established for the child, the grandchild and the grandchild's issue; the separate shares will not be recognized as separate trusts for GSTT purposes because they did not exist from and at all times after the trust's creation.

The final regulations also provide some clarification of the rules in connection with an estate tax inclusion period (ETIP). If the GSTT exemption is allocated to the trust during an ETIP, the allocation may not be revoked even though the ETIP rules provide that the allocation is not effective until the termination of the ETIP with respect to a am. For example, a 10-year GRAT is established with a grandchild as a remainder beneficiary. No GSTT allocation is effective until the income portion of the mt ends. For this reason, grandchildren are rarely named as GRAT beneficiaries.

Proposed regulations(60) would delete Regs. Sec. 26.2654-1(a)(4), dealing with the application of the GSTT to the exercise of a special power of appointment in a manner that would extend vesting in violation of the rule against perpetuities; Regs. Sec. 26.2652-1(a)(6), Examples 9 and 10 (dealing with the same issue), would also be deleted.

Time Extended to Make Reverse QTIP Elections

As in previous years, the IRS continued to generously exercise its authority under Regs. Sec. 301.91 00-1 (a) to grant an extension of time to make a reverse QTIP election when a return was filed without properly indicating the election.(61)

Failure to Exercise General Power of Appointment

Was Addition to Grandfathered Trust

In Letter Ruling (TAM) 9630003,(62) a surviving spouse held a testamentary general power of appointment over a testamentary trust established by the decedent. The trust, established in 1966, was a GSTT grandfathered trust (i.e., it was irrevocable on Sept. 25, 1985). At her death, the surviving spouse exercised her general power of appointment, and the trust was distributed to her eight granddaughters. The spouse's estate's position was that no constructive additions were made to the trust after 1985, so that the GSTT should not apply.

The IRS held that because the trust was includible in the spouse's gross estate under Sec. 2044, the spouse became the transferor of the trust corpus for GSTT purposes; because the to the grandchildren were direct skips from the spouse to the grandchildren, they were subject to GSTT. In reaching its decision, the IRS noted that the GSTT grandfathering provisions were enacted to protect individuals whose executed documents could not be changed. Here, the spouse could have changed the tax consequences of the executed documents by appointing the am property to non-skip persons. The IRS analogized the situation to that found in Regs. Sec. 26.2601-(1)(b)(1)(v)(D), Example 1, and ruled that there was no distinction between the situation presented and that examined in Peterson Marital Trust.(63)

Chapter 14 Special Valuation

Developments included:

* "Residence" defined for QPRT purposes. * Technical corrections enacted.

Definition of "Residence"

for QPRTs

The meaning of "residence" for QPRT purposes continues to be expanded in letter rulings. Generally, the IRS has a history of issuing favorable rulings regarding what constitutes a residence for QPRT purposes. In Letter Ruling 9609015,(64) a 4,000-square foot home containing a 500-square foot residential unit was referred to a trust that required all trust income to be paid annually to the grantor. The IRS ruled that the trust qualified as a QPRT.

The IRS held in Letter Ruling 9606003(65) that trusts to which a couple transferred property that was divided into two tracts by a right-of-way, and that consisted of their undivided interest in a personal residence and a separate garage that housed inventory from a small corporation they owned, would be QPRTS. The IRS concluded that the property qualified as a personal residence because the appurtenant structures were used by the couple for residential purposes and because the adjacent land did not exceed that which was reasonably appropriate given the residence's size and location.

Technical Corrections Enacted

SBJPA Section 1702(f) amended the Sec. 2701 estate freeze rules to include (1) a grant of regulatory authority to the IRS to treat a partnership interest with rights junior either as to income or capital as a junior equity interest; (2) the replacement of the junior equity interest exception with an exception for a right under an interest that is junior to the rights of the transferred interest, (3) a change in the rules for electing in or out of qualified payment treatment; and (4) a grant of regulatory authority for double taxation relief when required qualified payments are not made.

(23) See generally, Secs. 2503(a)(3) and 2107. Although perhaps an unusual case, a long-term resident not domiciled in the U.S. may be able to avoid the intended effect of Sec. 2503(a)(3) by transferring intangible property prior to relinquishing residency. (24) Sec. 6039G(f) provides the long-term residents relinquishing residency must supply the required information with their last-required Federal income tax return. (25) Elizabeth B. Miller, TC Memo 1996-3. (26) IRS Letter Ruling 9634004 (5/2/96). (27) Charles Schusterman, 63 F3d 986 (10th Cir. 1995)(75 AFTR2d 95-6316, 95-2 USTC [paragraph]60,206), aff'g N.D. Okla. 1994 (73 AFTR2d 94-2349, 94-1 USTC [paragraph]60,161). (28) Est. of Helen M. Trenchard, TC Memo 1995-121. (29) IRS Letter Ruling (TAM) 9532001 (4/12/95). (30) Ella F. Fondren, 324 US 18 (1945)(33 AFTR 302, 45-1 USTC [paragraph]10,164). (31) Rev. Rul. 95-58, 1995-2 CB 191, revoking Rev. Ruls. 79-353, 1979-2 CB 325, and 81-51, 1981-1 CB 458, and modifying Rev. Rul. 77-182, 1977-1 CB 273. (32) Rev. Rul. (33) Est. of Helen S. Wall, 101 TC 300 (1993). (34) Est. of Joseph A. Vak, 973 F2d 1409 (8th Cir. 1992)(70 AFTR2d 92-6239, 92-2 USTC [paragraph]60,110), rev'g TC Memo 1991-503. (35) IRS Letter Ruling 9623043 (3/11/96). (36) REG-208215-91 (8/21/96). (37) IRS Letter Ruling 9623064 (3/14/96). (38) O.D. McKee, TC Memo 1996-362. (39) Est. of Herbert R. Herrmann, 85 F3d 1032 (2d Cir. 1996)(77 AFTR2d 96-2500, 96-1 USTC [paragraph]60,232), aff'g TC Memo 1995-90. (40) Sec. 2043(b)(1) generally provides that relinquishment of "other marital rights in the decendent's property or estate" is not consideration. (41) IRS Letter Ruling (TAM) 9604002 (10/6/95). (42) Est. of Louis F. Bonner, Sr., 84 F3d 196 (5th Cir. 1996)(77 AFTR2d 96-23569, 96-2 USTC [paragraph]60,237). (43) IRS Letter Ruling (TAM) 9608001 (8/18/95). (44) IRS Letter Ruling (TAM) 955002 (8/31/95). (45) Est. of Charles K. McClatchy, 106 TC 206 (1996). (46) The Ahmanson Foundation, 674-F2d 761 (9th Cir. 1981)(48 AFTR81-6317, 31-2 USTC [paragraph]13,438). (47) Est. of Joseph A. Cloutier, TC Memo 1996-49. (48) See, e.g., Est. of James Barudin, TC Memo 1996-395; Est. of Ross H. Freeman, TC Memo 1996-372; Est. of Arthur Scanlan, TC Memo 1996-331; John Michael Wheeler, W.D. Tex. 1996 (77 AFTR2d 96-1405, 96-1 USTC [paragraph]60,226); Est. of Lucille Marie McCormick, TC Memo 1995-371; Bernard Mandelbaum, TC Memo 1995-255. (49) IRS Letter Ruling 9533014 (5/15/95). (50) Est. of Lucille P. Shelfer, 103 TC 10 (1994), rev'd, 86 F3d 1045 (11th Cir. 1996)(78 AFTR2d 96-5177, 96-2 USTC [paragraph]60,238). (51) Est. of Rose D. Howard, 91 TC 329 (1988), rev'd, 910 F2d 633 (9th Cir. 1990)(66 AFTR2d 90-4993, 90-2 USTC [paragraph]60,033). (52) Est. of Willard E. Robertson, 98 TC 678 (1992), rev'd 15 F3d 779 (8th Cir. 1994(73 AFTR2d 94-2329, 94-1 USTC [paragraph]60,153); Est. of Arthur M. Clayton, Jr., 97 TC 327 (1991), rev'd, 976 F2d 1486 (5th Cir. 1992)(70 AFTR2d 92-6262, 92-2 USTC [paragraph]60,121); Est. of John D. Spencer, TC Memo 1992-579, rev'd, 43 F3d 226 (6th Cir. 1995)(75 AFTR2d 95-563, 95-1 USTC [paragraph]60,188). (53) Est. of Willis Edward Clack, 106 TC 131 (1996). (54) AOD CC-1996-011; see 96 Tax Notes Today 137-22 (7/15/96). (55) TD 8612 (8/21/95). (56) IRS Letter Ruling (TAM) 9617003 (1/4/96). (57) Est. of Otis. C. Hubert, 101 TC 314 (1993), aff'd, 63 1083 (11th Cir. 1995)(76 AFTR2d 95-6448, 95-2 USTC [paragraph]60,209); see News Notes, "Court Decisions: Administration Expenses," 27 The Tax Adviser 324 (June 1996); Strobel and Strobel, "The Proper Treatment of Administrative Expenses," 26 The Tax Adviser 228 (Apr. 1995). (58) IRS Letter Ruling 9623063 (3/13/96). (59) TD 8644 (12/26/95). (60) PS-22-96 (6/11/96). (61) See IRS Letter Rulings 9633026 (5/17/96), 9616011 (1/4/96), 9613008 (12/22/95) and 9608008 (11/8/95). (62) IRS Letter Ruling (TAM) 9630003 (4/16/96). (63) E. Norman Peterson Marital Trust, 102 TC 790 (1994), aff'd, 2d Cir., 1996 (77 AFTR2d 96-1184, 96-1 USTC [paragraph]60,225). (64) IRS Letter Ruling 9609015 (11/22/95). (65) IRS Letter Ruling 9606003 (11/7/95).
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Author:Zysik, Jeffrey C.
Publication:The Tax Adviser
Date:Dec 1, 1996
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