In what has become an ever eagerly anticipated annual tradition, Ronald Aucutt, a McGuireWoods partner and co-chair of the firm’s private wealth services group, has identified the following as the top ten estate planning and estate tax developments of 2013. Ron is an observer and frequent participant in the formation of tax policy and regulatory and interpretive guidance in Washington, D.C., and is the editor of the Recent Developments materials that are presented each year at the Heckerling Institute on Estate Planning.
Number Ten: Valuation Cases Still Fact-Bound: FLP Furor Is Quieter but Not Silenced: Estate of Koons v. Commissioner, T.C. Memo 2013-94
The fact-specific nature of litigation over the gift and estate tax value of interests in family limited partnerships (FLPs) and LLCs continues to provide both encouragement and warnings to estate planners. This year, for example, Estate of Koons v. Commissioner illustrates the challenges in achieving valuation discounts in the Tax Court for cash-heavy entities. When the decedent died, he owned a total 50.5 percent interest in an LLC, consisting of 46.9 percent of the voting interest and 51.6 percent of the nonvoting interest. (Although the 46.9 percent voting interest was not by itself a controlling interest, it was by far the largest voting interest and could control the LLC when combined with the interests of various trusts, including the 9.9 percent voting interest of a trust over which the decedent held a limited power of appointment.) The LLC, however, had been funded with the proceeds of sale of the decedent’s Pepsi distributorship, significantly not with an operating distributorship itself. It held $322 million in cash (92 percent of its total assets of $351 million), and its debts were only $33 million, leaving a net asset value of $318 million. The estate valued the decedent’s interest at $117 million on the estate tax return but lowered it to $110 million at trial, reflecting a 31.7 percent discount. For its part, the IRS valued the interest at $136 million in its notice of deficiency but raised the value in its amended answer to $148.5 million, reflecting a 7.5 percent discount.
Before his death, the decedent had proposed to use some of the cash in the LLC to redeem the LLC interests of his children. The children, who in the aggregate could not control the LLC anyway, arguably accepted this redemption offer before their father died. The redemption would have increased the estate’s voting interest to 70.4 percent, which was part of the IRS’s justification of a lower discount.
After the redemption did close, increasing the estate’s voting interest to 70.4 percent, the estate borrowed $10.75 million from the LLC to help it pay the estate tax. The note was a “Graegin loan,” prohibiting prepayment as in Estate of Graegin v. Commissioner, T.C. Memo 1988-477, but with the additional unusual feature that the payments to be made over a seven-year period would not start for 18 years, producing total interest payments on the $10.75 million loan of over $71 million, for which the estate claimed a deduction.
The court accepted the IRS’s amended value of $148.5 million and disallowed the deduction of interest on the borrowing, which it found to be “not necessary.”
Both the facts and the outcome of Koons are a contrast to two taxpayer Tax Court successes featured in the 2012 Top Ten list, Estate of Kelly v. Commissioner, T.C. Memo 2012-73 (a partnership owning operating quarries), and Estate of Stone v. Commissioner, T.C. Memo 2012-48 (a partnership owning and managing woodlands). In Kelly, for example, the legitimate asset-protection and risk-management purposes of the partnership had been highlighted by dynamite blasting at quarries on the partnership property, the discovery of bullets in a campfire site on the property, and an incident of a dump truck collision over which the decedent had been sued. The LLC in Koons held mainly cash.
In other developments related to valuation of interests in family-owned entities, when the Administration released its Fiscal Year 2014 Revenue Proposals in April 2013, it omitted its previous calls for Congress to give Treasury greater regulatory authority to create more durable rules for disregarding restrictions under section 2704(b) in valuing such interests. But the Treasury-IRS Priority Guidance Plan for the 12 months beginning July 1, 2013, includes, as it has every year since 2003, a project described as “Regulations under §2704 regarding restrictions on the liquidation of an interest in certain corporations and partnerships” (page 17). The abandonment of the call for more congressional “cover” might signal waning interest in this subject, or it might signal an intention to go ahead and propose regulations under the authority already conferred by section 2704(b)(4). The latter seems most likely.
Number Nine: What Is Happening in State Will and Trust Law?
This Top Ten list typically focuses on federal tax law developments that obviously have a wide impact, even though every year also brings many legislative and judicial developments among the states that are sure to have a local impact and often also represent trends spreading across the nation. But in 2013, an unusually large number of interesting developments involving state law issues or mixed federal-state law issues have attracted attention to trends that bear watching.
Asset Protection. In re Huber , 201 B.R. 685 (Bankr. W.D. Wash.), set aside an Alaska asset-protection trust created by a lifelong Washington resident and funded with interests in an Alaska LLC created for that purpose to which the debtor had transferred substantially all of his assets, all located in Washington except for one $10,000 certificate of deposit in Alaska. To be sure, the court found the debtor’s transfers to have been “fraudulent,” within the meaning of the federal Bankruptcy Code, when they were made. The decision therefore does not necessarily imply the general ineffectiveness of asset-protection trusts created by citizens of one state in other states, even though the court employed the Ninth Circuit’s known choice of federal conflict of laws rules in following Washington law. But it gives pause, particularly because the facts seem somewhat more favorable to the debtor than the previous relevant case of Mortensen v. Battley, 2011 WL 5025288 (Bankr. D. Alas. 2011). Meanwhile, Ohio’s domestic asset protection law, which had been enacted in December 2012, took effect on March 27, 2013, but no state enacted domestic asset protection trust legislation in 2013.
Arbitration. Courts continue to ponder the implications of provisions in trust instruments that might diminish the power of courts to resolve claims of trust beneficiaries or discourage those beneficiaries from seeking help from the courts. The most dramatic context may be the requirement in a trust instrument of binding arbitration, generally disfavored by courts in the absence of an explicit state statute (found only in Arizona and Florida), until Rachal v. Reitz, 403 S.W.3d 840 (Tex. 2013), in which the Texas Supreme Court labored to allow mandatory arbitration under a Texas statute applicable generically to “agreements.” In extending that statute to trust beneficiaries, the court “found assent by nonsignatories to arbitration provisions when a party has obtained or is seeking substantial benefits under an agreement under the doctrine of direct benefits estoppel,” which it viewed as “a type of equitable estoppel.”
In Terrorem Clauses. Another context for courts to be protective of their power is the applicability of harsh “in terrorem” clauses. Callaway v. Willard, 739 S.E.2d 533 (Ga. Ct. App. 2013), refused to apply an in terrorem clause to a challenge to trust administration and fiduciary conduct because such clauses “are not favored in the law” and “cannot be construed so as to immunize fiduciaries from Georgia law governing the actions of such fiduciaries.” Hamel v. Hamel, 299 P.3d 278 (Kan. 2013), applied Kansas law that presumed no contest clauses to be valid unless probable cause existed and then found probable cause in that case.
“Superwills.” Eyebrows were raised by Manary v. Anderson, 292 P.3d 96 (Wash. 2013), which affirmed the use of “superwills” or “blockbuster wills” that are allowed to dispose of non-probate assets, as authorized by state law (RCW §11.11). The court allowed a will to redirect the disposition of real estate held in a previously revocable joint trust that had become irrevocable when the testator’s spouse predeceased him. The will described the real estate but did not mention the trust.
Decanting. Morse v. Kraft , 992 N.E.2d 1021 (Mass. 2013), held that, even in the absence of a decanting statute, a trustee had the authority to “decant” trust assets to new trusts similar to the existing trusts but adding the settlors’ sons as trustees. Massachusetts thus becomes the first state since the enactment of the federal generation-skipping transfer tax to join Florida and New Jersey in recognizing that trustees have “decanting” powers where trust instruments give the trustees broad distribution powers. Phipps v. Palm Beach Trust Co., 142 Fla. 782 (1940); Wiedenmayer v. Johnson, 106 N.J. Super. 161, 164-65 (App. Div.), aff’d sub nom. Wiedenmayer v. Villanueva, 55 N.J. 81 (1969). The GST tax, which the Morse court specifically acknowledged, is important because under Reg. §26.2601-1(b)(4)(i)(A)(1)(ii) a distribution of a GST tax-exempt trust to a new trust (that is, decanting) will not jeopardize the exempt status of the trusts if “at the time the exempt trust became irrevocable, state law authorized distributions to the new trust or retention of principal in the continuing trust, without the consent or approval of any beneficiary or court,” even if the new trust extends the term of the trust, as long as it is not extended beyond lives in being at the creation of the old trust plus 21 years. Because such GST tax-exempt trusts were necessarily irrevocable on September 25, 1985, a state decanting statute enacted since 1985 cannot by itself satisfy this precondition as effectively as a declaration of the state’s common law. But it is significant that three states, South Carolina (effective January 1, 2014), Texas (effective September 1, 2013), and Wyoming (effective July 1, 2013), enacted decanting legislation in 2013.
Number Eight: Paths Opened for Giving Business Interests to Charity: PLRs 201303021 and 201311035
Owners of successful closely held businesses often want to share the profits and growth of the businesses with charity in a manner that preserves family involvement in both the business and the charity. A gift of an interest in the business to a private foundation or a donor advised fund (treated as a private foundation under section 4943(e)) will provide this opportunity, but only if the donee divests the interest within five years under section 4943(c)(6) or, if the gift is of nonvoting stock, only if all disqualified persons, including family members, hold no more than 20 percent of the voting stock under section 4943(c)(2)(A). Thus, the “family” character of supporting charity threatens the “family” character of running the business whose success the family wants to share.
Two letter rulings issued by the IRS in 2012 but released to the public in 2013 offer possible solutions. Letter Ruling 201303021 (Oct. 22, 2012) permitted nonvoting stock to be held indefinitely by a private foundation where the voting shares are dispersed among several trusts, no one of which owns more than 20 percent of the voting shares, with the remainders going to public charities. Letter Ruling 201311035 (Dec. 18, 2012) permitted nonvoting stock to be held indefinitely by a donor advised fund where at least 80 percent of the voting shares are held in a voting trust for the benefit of a public charity.
The keys to these rulings were the rule of Reg. §53.4943-8(b) that voting shares owned by a trust are deemed constructively owned “by its remainder beneficiaries” (so that the trusts were not disqualified persons and therefore disqualified persons did not own more than 20 percent of the voting stock) and the rule of Reg. §53.4946-1(a)(5) that “combined voting power” of a corporation “does not include voting rights held only as a director or trustee” (so that family members could serve as trustees of the trusts in Letter Ruling 201303021 or as the voting trustee in Letter Ruling 201311035).
Number Seven: Confusion About Basis and the Duty of Consistency: Van Alen v. Commissioner, T.C. Memo 2013-235
In Van Alen v. Commissioner, a brother and sister had inherited a cattle ranch from their father in 1994, with a low “special use” estate tax value under section 2032A. They were not executors; their stepmother was. The heirs sold a conservation easement on the land in 2007 and argued that their basis for determining capital gain should be higher than the estate tax value. The court held their basis to the low estate tax value.
A key to the outcome was that section 1014(a)(3) describes the basis of property acquired from a decedent as “in the case of an election under section 2032A, its value determined under such section.” This is in contrast to the general rule of section 1014(a)(1), which describes the basis as merely “the fair market value of the property at the date of the decedent’s death,” which arguably opens up the opportunity for a non-executor heir to argue that the value “determined” for estate tax purposes was simply too low. In addition, the court pointed to the special use valuation agreement, which the two heirs (one, a minor, by his mother as his guardian ad litem) had signed. Consistently with this rationale for its holding, the court cited Rev. Rul. 54-97, 1954-1 C.B. 113 (“the value of the property as determined for the purpose of the Federal estate tax … is not conclusive but is a presumptive value which may be rebutted by clear and convincing evidence”), and observed that “it might be reasonable for taxpayers to rely on this revenue ruling if they were calculating their basis under section 1014(a)(1).”
Surprisingly, however, the court also seemed to view heirs who were not executors as bound by a “duty of consistency” to use the value determined for estate tax purposes as their basis for income tax purposes. The court spoke of a “sufficient identity of interests” between the heirs and the executor and concluded that “[w]e rest our holding on the unequivocal language of section 1014(a)(3).… And we rest it as well on a duty of consistency that is by now a background principle of tax law.”
While “consistency” is superficially an appealing objective, the notion that it might apply generally to the basis of an heir who was not an executor may be more novel and more troubling than the court assumed. The court acknowledged that “[t]here are lots of cases that hold that the duty of consistency binds an estate’s beneficiary to a representation made on an estate-tax return if that beneficiary was a fiduciary of the estate.” But the court then went on to say: “But the cases don’t limit us to that situation and instead say that the question of whether there is sufficient identity of interests between the parties making the first and second representation depends on the facts and circumstances of each case.” The problem is that the court cited the same three cases for both propositions, and all three cases involved the basis of an heir who was a co-executor. Thus, Van Alen appears to stand alone for applying a duty of consistency to the basis of an heir who was not an executor, although the Van Alen holding does have the alternative ground of the word “determined” in section 1014(a)(3), applicable only in special use valuation cases.
Moreover, the Van Alen opinion itself reveals how mischievous a “consistency” requirement might be in this context. The court describes how the audit “went back and forth” and the low value of the ranch could have been a trade for higher values of three other properties. Indeed, the court said: “The bottom line was that the IRS got an increase in the total taxable value of the estate … and an increase in the estate tax” (although later the court said, with specific reference to the ranch, that “[b]oth Shana and Brett [the heirs], and their father’s estate, benefited from a reduced estate tax.” If the heirs benefited from the special use valuation, it was a coincidental detail that is affected by tax apportionment rules and other factors and may not be present in every estate. And, as Van Alen illustrates, executors often settle estate tax audits by trade-offs and for strategic reasons that could have nothing to do with an effort to find the “true” “fair market value” for purposes of section 1014(a)(1). To bind heirs who do not participate in that audit seems quite unfair, and to give the heirs a role in the audit would be monstrously impractical.
The Administration’s budget proposals, including its Fiscal Year 2014 Revenue Proposals (pages 140-41), have included a proposal to “require basis to be based on transfer tax values.” Congress has shown no interest so far in picking up that idea, and lawmakers might think twice about it if they read the description of how the audit of Mr. Van Alen’s estate “went back and forth.”
Number Six: Modest Treasury Legislative and Administrative Guidance Goal
Those Fiscal Year 2014 Revenue Proposals, by the way, include just one new proposal this year under the heading “Modify Estate and Gift Tax Provisions.” The new proposal is described as “Clarify Generation-Skipping Transfer (GST) Tax Treatment of Health and Education Exclusion Trusts (HEETs)” (page 148). A “health and education exclusion trust” builds on the rule of section 2611(b)(1) that distributions from a trust directly for a beneficiary’s school tuition or medical care or insurance are not generation-skipping transfers, no matter what generation the beneficiary is in. Sometimes, by including charities as permissible beneficiaries, the designers of such trusts hope that a non-skip person (the charity) will always have an interest in the trust within the meaning of section 2612(a)(1)(A), and thereby the trust will avoid a GST tax on the taxable termination that would otherwise occur as interests in trusts pass from one generation to another. With an urgency suited to abusive tax shelters (the proposal would be effective on the date of introduction, not the date of enactment), this Treasury proposal would limit the exemption of direct payments of tuition and medical expenses from GST tax to payments made by individuals, not distributions from trusts. But if anything is “abusive” about the use of HEETs, it is more likely the exploitation of a modest charitable interest to avoid taxable terminations, which the proposal would not address. The proposal is widely viewed as misdirected.
Last year’s Fiscal Year 2013 Revenue Proposals also included just one new proposal, described as “Coordinate Certain Income and Transfer Tax Rules Applicable to Grantor Trusts” (page 83), which basically would have included the value of all grantor trusts in the grantor’s gross estate (or subject to gift tax distributions or terminations of grantor trust status during the grantor’s life). That proposal also seemed misdirected and overbroad, and, sure enough, in this year’s Fiscal Year 2014 Revenue Proposals (pages 145-46) it is reworded to subject to estate tax (or gift tax) only the value of property (including accumulated income, appreciation, and reinvestments) received in a sale or similar transaction that is disregarded for income tax purposes under the grantor trust rules. But this year’s proposal, which disregards, for example, the adequacy of any consideration received in such a transaction, has been criticized almost as severely. It would be odd if a simple installment sale to a grantor trust, which is a sale and not a gift, is subjected to harsher gift (and estate) tax treatment than the funding of a GRAT, which actually is a gift. The proposal somewhat helpfully calls for regulatory authority, including specifically “the ability to create exceptions to this provision.” Indeed, this may well be the heart of the proposal, but the specter of a gap between enactment and the publication of the contemplated exceptions is chilling.
In short, at least over the last couple of years, the Treasury estate tax legislative initiatives that have seen the light of day are modest and perplexing.
In addition to legislative proposals, Treasury, in conjunction with the IRS, also publishes an annual “Priority Guidance Plan,” setting forth, as in this year’s Plan, “priorities for allocation of the resources of our offices during the twelve-month period from July 2013 through June 2014 (the plan year).” This year’s Plan, released on August 9, 2013, and updated on November 20, 2013, includes 11 projects under the heading of “Gifts and Estates and Trusts.” But only one of those is new: “Revenue Procedure under §2010(c) regarding the validity of a QTIP election on an estate tax return filed only to elect portability.” Likewise, there was only one new project last year: “Regulations under §2642 regarding the allocation of GST exemption to a pour-over trust at the end of an ETIP.” Unlike the most recent legislative proposals, these projects are not particularly controversial, but, like the legislative proposals, the idea of just one new project per year, when everyone knows there are other subjects that could use some administrative guidance, has become noticeable.
To be sure, policymakers and rulemakers have had their share of distractions – the very unusual estate tax gap year of 2010, the suspense at the end of 2012 and the beginning of 2013, the demands of portability and the Affordable Care Act, and the need to respond to federal recognition of same-sex marriages mandated by the Supreme Court. And it takes a considerable amount of work and several levels of review to place a proposal on one of these lists. Capping the “second five” of the Top Ten in this way is not meant so much as a criticism as it is a simple observation, especially with respect to the Priority Guidance Plan, that there are going to be uncertainties that affect estate planning.
Number Five: Gray Box (Not Quite Black Box) “Salegifts”: Estate of Kite v. Commissioner, T.C. Memo 2013-43; Estate of Davidson v. Commissioner, T.C. Docket No. 13748-13
With the reminder that installment sales to grantor trusts are the subject of Administration scrutiny and may someday be limited by legislation or regulations comes the realization that creative variations on the sale theme have produced some interesting casesover the years. This year, we had one such case, Estate of Kite v. Commissioner, with a surprising conclusion in February and an even more surprising encore in October, and another such case, Estate of Davidson v. Commissioner, that is just getting started but promises to make interesting law if it is not settled.
Kite. In 1995, Mrs. Kite, from an Oklahoma banking family, created a QTIP trust, which continued as a QTIP trust for her benefit after her husband died just one week later and the value of the trust was included in his gross estate. Mr. Kite’s own estate was left in a second QTIP trust, a general-power-of-appointment marital trust, and a credit shelter trust. In March 2001, many transactions later, the QTIP trusts and marital trust held interests in a Texas general partnership (Kite Family Investment Co., or “KIC”). Mrs. Kite exercised her power to replace the trustees with her children, and the children terminated the trusts by a distribution of all of the trust assets – the KIC interests – to Mrs. Kite’s revocable trust. (Mr. Kite’s trusts allowed the trustees to terminate them “when, in the judgment of the trustee, the trust estate is too small to justify management as a trust [likely not the case], or the trust otherwise should be terminated.” The opinion provides no similar information about the termination of the QTIP trust originally created by Mrs. Kite, and the court stated merely that “without more information regarding the Kite children’s decision to terminate the trusts, the Court is reluctant to question the Kite children’s decision.”)
Mrs. Kite, through her revocable trust, then sold the KIC interests to her children for deferred private annuities, with the first payment due 10 years later, in 2001. Mrs. Kite was almost 75, a physician opined that she had at least a 50 percent chance of surviving for 18 months or longer, and her actuarial life expectancy was 12½ years, but she died three years later without receiving any payment from the deferred annuities.
In consolidated gift and estate tax cases, the Tax Court found that the deferred annuities had been adequate and full consideration for the KIC interests. “Indeed [the court added], if Mrs. Kite lived to her life expectancy as determined by IRS actuarial tables, she would have received approximately $800,000 more in annuity payments than the value of her KIC interests.” Then, after noting that all the previous transactions had “preserved the integrity of the QTIP election” because either gift tax was paid or Mrs. Kite retained an income interest, the court held that “[t]he  liquidation of the QTIP trusts and subsequent sale of Mrs. Kite’s interests in KIC, however, disregarded the QTIP rules” and “are treated as a single transaction for purposes of section 2519.” The February 7, 2013, opinion concluded with the familiar “Decision will be entered under Rule 155,” and commentators (including this one) heralded the finding on the deferred annuities as a taxpayer victory.
Tax Court Rule 155 states in part:
Where the Court has filed or stated its opinion or issued a dispositive order determining the issues in a case, it may withhold entry of its decision for the purpose of permitting the parties to submit computations pursuant to the Court’s determination of the issues, showing the correct amount to be included in the decision.… If the parties are not in agreement as to the amount to be included in the decision in accordance with the findings and conclusions of the Court, then each party shall file with the Court a computation of the amount believed by such party to be in accordance with the Court’s findings and conclusions…. [T]he parties may, at the Court’s discretion, be afforded an opportunity to be heard in argument thereon and the Court will determine the correct amount and will enter its decision accordingly…. This Rule is not to be regarded as affording an opportunity for retrial or reconsideration.
Rule 155 proceedings are sometimes contentious, but rarely make interesting contributions to the legal landscape. Kite was different. On October 25, 2013, the court entered an unpublished Order and Decision to resolve an unagreed computation in the gift tax case (Docket No. 6772-08) under Rule 155. Beginning with the trust terminations and sales “as a single transaction,” as it had said in February, the court viewed the transaction as the disposition of an income interest under section 2519, which meant that Mrs. Kite must be “treated as making a gift” under Reg. §25.2519-1(a). “In fact [the court added], a deemed transfer of a remainder interest under section 2519 cannot be made for adequate and full consideration or for any consideration.” Thus the value of the remainder interest was a gift, and the court ruled that the gift tax due for 2001 was $816,206.
On October 28, 2013, the court issued a brief conforming Order and Decision in the estate tax case (Docket No. 6773-08), holding that there was no estate tax deficiency, but an estate tax overpayment in the amount of $304,605.
The idea that the transfer of property that once, even recently, had been in a QTIP trust can never be offset by consideration to the extent the transfer is attributable to what had been the remainder interest in that trust is surprising, to say the least, and creates confusion about the proper role and application of section 2519. Mrs. Kite did not dispose of her income interest; she received a terminating distribution of trust property that then in her hands was free of any income or remainder distinctions. Perhaps concerned about Mrs. Kite’s transfer of significant wealth without actually receiving any consideration at all as it turned out – a result that does have somewhat a too-good-to-be-true element – the court offered the following:
As discussed above, section 2519(a) treats the disposition of a qualifying income interest as a deemed transfer of the remainder interest. In other words, “the donee spouse is treated as making a gift under section 2519 of the entire trust less the qualifying income interest” (emphasis added [by the court]). Sec. 25.2519-1(a), Gift Tax Regs. The term “gift” is not an accident. The remainder interest is a future interest held by the remainderman and not the donee spouse. Accordingly, the donee spouse cannot receive full and adequate consideration, or indeed any consideration, in exchange for the remainder interest.
Section 2519(a) does not use the word “gift”; it uses only the word “transfer” with reference to trust interests other than the qualifying income interest. Reg. §25.2519-1(a) generally also uses the word “transfer”; only in the one sentence quoted by the court does it use the word “gift.” For context, here is the entire regulation up to and including that sentence (emphasis added):
If a donee spouse makes a disposition of all or part of a qualifying income interest for life in any property for which a deduction was allowed under section 2056(b)(7) or section 2523(f) for the transfer creating the qualifying income interest, the donee spouse is treated for purposes of chapters 11 and 12 of subtitle B of the Internal Revenue Code as transferring all interests in property other than the qualifying income interest. For example, if the donee spouse makes a disposition of part of a qualifying income interest for life in trust corpus, the spouse is treated under section 2519 as making a transfer subject to chapters 11 and 12 of the entire trust other than the qualifying income interest for life. Therefore, the donee spouse is treated as making a gift under section 2519 of the entire trust less the qualifying income interest, and is treated for purposes of section 2036 as having transferred the entire trust corpus, including that portion of the trust corpus from which the retained income interest is payable.
Thus, in context, the general rule is that a spouse who disposes of all or part of an income interest in a QTIP trust is treated “as transferring” “all interests … other that the qualifying income interest” – i.e., the remainder interest. The regulation then poses an “example” in which the spouse has disposed of “part” of a qualifying income interest and has “retained” the balance, but is still treated as making “a transfer” of the entire remainder interest. “Therefore,” the regulation states – i.e., in that “example” – the spouse “is treated as making a gift.” Although, as the court states, there is no reason to treat the use of the term “gift” as “an accident,” neither does there appear to be any reason to treat this context as irrelevant. If, as in Kite, the donee spouse ends up transferring for gift tax purposes more than the value of the qualifying income interest, it seems fair to conclude that the regulation, and indeed section 2519 itself, does not address that transfer at all but rather leaves it to be tested by generally applicable gift tax rules, as the court’s analysis of the annuity transaction in its February opinion seemed to do. While Mrs. Kite could not, or at least should not, receive consideration for what belonged to the remainder beneficiaries, the entire KIC interests were in her hands, not the trust’s hands or the remainder beneficiaries’ hands, when she sold them. Although the court’s February opinion treated the trust terminations and the sale “as a single transaction,” the court chose not to second-guess the trustees’ terminations of the trusts, and it analyzed the deferred annuity transaction with reference to “the value of her KIC interests,” not just the value of what had been her income interest.
In sum, while Rule 155 orders are not considered precedential and they are not “published” (although the Kite order was posted on the Tax Court’s website for a few weeks after it was issued), this particular Rule 155 order will inevitably affect the way the original Kite opinion is read and interpreted, and it will leave for another day the clarification of the application of section 2519 in cases like this.
Davidson. Meanwhile, in December 2008 and January 2009, William M. Davidson, the former owner of the Detroit Pistons and the president, chairman, CEO, and owner of 78 percent of the common stock of Guardian Industries Corp., one of the world’s largest manufacturers of glass, automotive, and building products, was engaging in transactions of his own, including gifts, substitutions, a five-year GRAT, and sales that, like Mrs. Kite’s, eventually paid him no consideration at all. He was 86, and his actuarial life expectancy was about five years. He lived for 50 days after making the last transfer and died on March 13, 2009.
The consideration for some of Mr. Davidson’s sales included five-year balloon unconditional notes at the applicable federal rate, five-year balloon self-canceling installment notes (“SCINs”) at the section 7520 rate with an 88 percent principal premium, and five-year balloon SCINs at the section 7520 rate with a 13.43 percent interest rate premium. Addressing Mr. Davidson’s sales both in Chief Counsel Advice 201330033 (Feb. 24, 2012) and in its answer in the Tax Court, the IRS believed the notes should be valued, not under section 7520, but under a willing buyer-willing seller standard that took account of Mr. Davidson’s health. Even though four medical consultants, two chosen by the executors and two chosen by the IRS, all agreed on the basis of Mr. Davidson’s medical records that he had had at least a 50 percent probability of living at least a year in January 2009, the IRS saw the notes as significantly overvalued because of his health, and the difference as a gift. Combined gift and estate tax deficiencies, with some acknowledged double counting, are about $2.6 billion.
The Davidson Estate filed its Tax Court petition on June 14, 2013 (Docket No 13748-13),and the IRS filed its answer on August 9. Trial was set by the court for April 14, 2014, but the parties jointly moved to continue it. In an Order on December 4, 2013, that motion was granted, jurisdiction was retained by Judge David Gustafson, and the parties were ordered to file joint status reports on September 14, 2014, and every three months thereafter. If the case is not settled, Judge Gustafson’s opinion will be interesting.
Number Four: Section 501(c)(4) Issues: Proposed Reg. §1.501(c)(4)-1(a)(2)(iii) (REG-134417-13)
For the remaining top four developments of 2013, there is much that could be written, but not as much that needs to be written, because these developments are so well known and widely analyzed. In fact, 2013 has been unusual for the number of developments with a significant effect on estate planning that have been shaped not by tax policy or technical tax analysis, but by politics or broader public policy dialogues.
On May 3, 2013, an IRS official clumsily admitted delays and other problems with exemption applications for section 501(c)(4) “social welfare” organizations, including new “conservative” organizations directly or loosely emerging from the surge of interest in so-called “Tea Party” causes. Both uninformed charges and uninformed defenses and countercharges have ensued. The IRS conduct in question, whether itself misguided or just misunderstood, surely was not confined to a few “rogue agents” in Cincinnati, which had been an early narrative. Nor is it likely to have been an orchestrated crackdown by political appointees or political campaigns, although it is possible that some of at least the appearance of partiality was, at the margin, subtly influenced by the known political leanings of the Administration or – perhaps even more importantly, but still only at the margin – by the leanings or information sources of a few individual IRS employees.
In any event, the drama has taken a toll on IRS employee morale, on public confidence in IRS employees, on suspicion of the tax collectors and the tax system by some members of Congress (although it has more likely been just an occasion to voice suspicions that were latent anyway), and in the same way on reductions in the IRS budget, especially the training budget. The morale and training of IRS personnel affect the ability, responsiveness, and decisiveness of the persons we must deal with to achieve workable tax guidance and resolution of inevitable tax issues. That is hugely significant.
Despite the political overtones, there are technical tax components of this development, including the long-standing tension between the standards of “operated exclusively for the promotion of social welfare” and “primarily engaged in promoting in some way the common good and general welfare of the people of the community” in Reg. §1.501(c)(4)-1(a)(2)(i). On November 26, 2013, the IRS proposed amendments of the regulations that would change “direct or indirect participation or intervention in political campaigns on behalf of or in opposition to any candidate for public office” in Reg. §1.501(c)(4)-1(a)(2)(ii) to “direct or indirect candidate-related political activity” and would add a new Reg. §1.501(c)(4)-1(a)(2)(iii), defining “candidate-related political activity” to include such things as communications that clearly support or oppose a candidate of a political party or use “advocacy” words like “vote,” “support,” “elect,” “defeat,” or “reject”; communications that refer to a candidate, or events at which a candidate appears as part of the program, within 60 days of a general election or within 30 days of a primary election; communications the expenditures for which must be reported to the FEC; political contributions; voter registration or “get-out-the-vote” drives; distribution of campaign material; and preparation or distribution of a “voter guide” that refers to one or more clearly identified candidates.
At the political level, the proposed rulemaking has been criticized as an attempt to deflect attention from accountability for past actions and as a perpetuation of bias by excluding, for example, section 501(c)(5) labor unions. In a more technical vein, it is possible to raise questions about the scope that includes even nonpartisan activities and, yes, about the need to expand such guidance to labor unions as well as section 501(c)(6) business leagues, chambers of commerce, and boards of trade. Ultimately it might be hoped that a dialogue like this can freely and constructively address not just the imprecision of Reg. §1.501(c)(4)-1(a)(2)(ii) but also the “exclusively”-“primarily” tension in Reg. §1.501(c)(4)-1(a)(2)(i) and perhaps even more fundamental questions about the role of tax exemption and of the IRS in overseeing such collective efforts of citizens in the first place.
Number Three: The 3.8 Percent “Medicare” Tax of Section 1411: TAM 201317010; Reg. §1.1411-3
Enacted in conjunction with the Affordable Care Act in 2010 and effective for taxable years beginning in 2013 or later, the new 3.8 percent tax on “undistributed net investment income” of trusts and estates has been vexing for both tax administration and trust administration. The tax applies to trusts where the top 39.6 percent income tax bracket begins – $11,950 for 2013 and $12,150 for 2014 – producing a combined rate of 43.4 percent at that level.
The tax does not apply to income from a trade or business that is not a “passive activity,” which means that the taxpayer must “materially participate.” Mattie K. Carter Trust v. United States, 256 F. Supp. 2d 536 (N.D. Tex. 2003), applied this to a trust’s employees and agents, not just the trustees, but that seems to go too far. Technical Advice Memoranda 200733023 (released Aug. 17, 2007) and 201317010 (Jan. 18, 2013) reject the Mattie K. Carter Trust approach, but probably apply too narrow a test.
In Technical Advice Memorandum 201317010, the issue was an alternative minimum tax exception for certain research and experimental expenditures under section 56(b)(2)(D), which cross-references the material participation rule of section 469(h). A “special trustee” was also the president of one of the companies owned by the trust and the other shareholder of the company, as well as a beneficiary of the trust. The TAM concluded that he acted in the company only as an employee of the company and not as a trustee. The TAM conceded that as a “special trustee” he was a fiduciary, but only as to his time spent voting the stock or considering sales of the stock (although it’s hard to tell what else a trustee does with stock or how any trustee could leave fiduciary duties behind when running a company).
Frank Aragona Trust v. Commissioner, Tax Court Docket No. 015392-11, involves a trust and section 469 itself. It was tried before Judge Morrison in May 2012, and briefing was completed in October 2012.
The underlying problem is that section 1411(c)(2)(A) (enacted in 2010) refers to section 469 (enacted in 1986). Regulations on the passive activity loss rules of section 469 began to be issued within a couple years, but Reg. §1.469-8, entitled “Application of section 469 to trust [sic], estates, and their beneficiaries,” is “reserved,” and Reg. §1.469-5T(g), entitled “Material participation of trusts and estates,” is also “reserved.” Because section 469 was designed to disallow losses, which arise only infrequently, trusts got along without guidance, and, as a practical matter, CPAs and other return preparers developed conventions and best practices that worked as well as formal guidance. Now that the section 469 definitions affect the taxation of income, informal approaches do not work, and formal guidance is now suddenly necessary or even crucial. Reg. §1.1411-3, proposed on December 5, 2012, and finalized with only a few changes on November 26, 2013, addresses some important issues, but still leaves Treasury and the IRS a quarter-century behind in addressing the issue of “material participation” in the context of a trust or estate. Indeed, the Preamble to the final regulations is quite candid about Treasury’s sympathy with the issues, concluding:
The Treasury Department and the IRS believe that the commentators have raised valid concerns. The Treasury Department and the IRS considered whether the scope of these regulations should be broadened to include guidance on material participation of estates and trusts. The Treasury Department and the IRS, however, believe that this guidance would be addressed more appropriately in the section 469 regulations. Further, because the issues inherent in drafting administrable rules under section 469 regarding the material participation of estates and trusts are very complex, the Treasury Department and the IRS believe that addressing material participation of trusts and estates at this time would significantly delay the finalization of these regulations. However, the issue of material participation of estates and trusts is currently under study by the Treasury Department and the IRS and may be addressed in a separate guidance project issued under section 469 at a later date. The Treasury Department and the IRS welcome any comments concerning this issue, including recommendations on the scope of any such guidance and on specific approaches to the issue.
But administrative guidance cannot change the fact that a combined 43.4 percent tax rate at the low trust level of $11,950 in 2013 and $12,150 in 2014 will be burdensome and will present some awkward challenges for fiduciaries. For example, distributions to trust beneficiaries in lower tax brackets can save from 4.6 percent to 33.4 percent in the tax rate, possibly more when state tax rates are taken into account. These are not new phenomena; the 39.6% rate and new 3.8% tax only increase the stakes. And this mismatch between tax rates is most dramatic in the case of modest trusts for families of modest means, an ironic effect for a tax aimed at “high income taxpayers.”
An obvious solution, which will probably occur to many beneficiaries, is to increase trust distributions to beneficiaries in lower brackets. But while a distribution can save up to 43.4 percent in current income tax, it comes at a cost of removing 100 percent of the distribution from the trust. Most trusts were created for a reason, and therefore fiduciary duties to present and future beneficiaries must be carefully balanced, the applicable distribution standards must be observed, and the way the trust instrument is drafted can matter. But the issues are not and will not be easy.
Number Two: The Treatment of Same-Sex Married Couples: United States v. Windsor, 133 S. Ct. 2675 (2013); Hollingsworth v. Perry, 133 S. Ct. 2652 (2013); Rev. Rul. 2013-17, 2013-38 I.R.B. 201
On June 26, 2013, in United States v. Windsor, the Supreme Court held that the federal government cannot withhold recognition of a marriage a state has chosen to recognize and that the uniform definition in Section 3 of the Defense of Marriage Act (DOMA) to the contrary is unconstitutional. On the same day, in Hollingsworth v. Perry, a lower court’s ruling that California’s Proposition 8 amending the California Constitution to prohibit same-sex marriage violates the U.S. Constitution was upheld for lack of standing to challenge it. Perry is therefore not a precedent in any other state, and there is certain to be further litigation.
The IRS acted quickly to respond to Windsor, and on August 29 released Rev. Rul. 2013-17, 2013-38 I.R.B. 201, adopting a “place of celebration” rule to facilitate more uniform administration of federal tax law, applicable only to legal marriages, not domestic partnerships, civil unions, and similar recognized formal relationships. Secretary of the Treasury Jacob J. Lew released a statement that:
Today’s ruling provides certainty and clear, coherent tax filing guidance for all legally married same-sex couples nationwide. It provides access to benefits, responsibilities and protections under federal tax law that all Americans deserve. This ruling also assures legally married same-sex couples that they can move freely throughout the country knowing that their federal filing status will not change.
Rev. Rul. 2013-17 applies “prospectively as of September 16, 2013,” but it “may” be relied on for any open year for the purpose of filing original returns, amended returns, adjusted returns, or claims for credit or refund for any overpayment of tax. Each of those documents must be consistent; all items must reflect married status. Reinforcing the point that as a matter of administrative forbearance this look-back to prior open years is optional with the taxpayer, IR-2013-72, which announced Rev. Proc. 2013-17, stated: “Individuals who were in same-sex marriages may, but are not required to, file original or amended returns choosing to be treated as married for federal tax purposes for one or more prior tax years still open under the statute of limitations.” It may take litigation to determine whether same-sex married couples have the same opportunity to revisit their tax treatment even in years that are ostensibly closed by the statute of limitations. Although many point out that if section 3 of DOMA was unconstitutional in June 2013 it was also unconstitutional in 1996 when it was enacted, we should not be surprised if the repose objective of the statute of limitations – section 6511 of the Internal Revenue Code for federal tax purposes – is respected, just as it would be respected in the case of any other mistake discovered on a closed return.
Marital status confers a number of tax advantages, including gift-splitting (sections 2513(a) and 2652(a)(2)), the marital deduction (sections 2056 and 2523), portability of the estate and gift tax unified credit (section 2010(c)), per se same generation assignment (section 2651(c)) and reverse-QTIP elections (section 2652(a)(3)) for GST tax purposes, the availability of disclaimers even if the property passes for the disclaimant’s benefit (section 2518(b)(4)(A)), a personal exemption (section 151(b)), the nonrecognition of gain on transfers between spouses (section 1041(a)), expanded eligibility to exclude gain from the sale of a principal residence (section 121(b)(2)(A)), and treatment of spouses as one shareholder of an S corporation (section 1361(c)(1)).
Marriage also presents some potential tax disadvantages, such as treatment of a spouse as a member of the family under chapter 14 (sections 2701(e)(1) and 2704(c)(2)) (which would prevent the use of a GRIT, for example), disallowance of losses (sections 267(c)(4) and 707(b), disallowance of a stepped-up basis in certain cases (section 1014(e)(1)(B)), attribution of stock ownership (section 318(a)(1)), and status as a disqualified person under the private foundation rules (section 4946(d)).
Other tax attributes that attach to marriage can be good or bad, depending on the circumstances. This includes the filing of a joint income tax return itself (section 6013), which can be a benefit when one spouse has all or most of the income, but can produce a “marriage penalty” when both have significant income, and married persons in such cases cannot elect the more advantageous filing as single taxpayers. Similarly, married status can make it easier to qualify a trust as a grantor trust (sections 672(e) and 677(a)(1)), whether that is desirable or undesirable.
A number of state law issues now arise, especially in states that do not recognize same-sex marriage. A same-sex married couple who file joint federal income tax returns may have to file separate state returns, which may require the preparation of separate pro forma federal returns to which the state “conforms.”
There will be construction issues in trust instruments governed by the law of a non-recognition state, such as whether a discretionary power to distribute income or principal to a spouse or a power to appoint to a spouse includes a legally married same-sex spouse. Ultimately, litigation may be needed to address such issues, as well as to strike the balance between testamentary freedom and public policy in the case of grantors and testators who may still prefer a more restrictive approach.
Number One: The American Taxpayer Relief Act of 2012
In last year’s “Top Ten Estate Planning and Estate Tax Developments of 2012,” Number One was “reserved” in case Congress acted before the end of the year to clarify the estate and gift tax law. Congress, always capable of surprising us, did not act before the end of the year, but it acted before the expiration of the 112th Congress at noon on January 3 – hence the passage by Congress on January 1 and the signature of the President on January 2 of the American Taxpayer Relief Act of 2012. As a result, this legislation earns the Number One spot for the second year in a row.
The American Taxpayer Relief Act of 2012 is significant to estate planners primarily because it made the estate and gift tax law permanent. While of course Congress can always change the law, and doubtless will, this is the first time in 12 years that we have not faced the uncertainty of sunsets, cliffs, and “as if … had never been enacted.” That is huge, as everyone who has lived through any part of the previous 12 years knows. Moreover, there appears to be little appetite to change the transfer tax law further, except possibly for stand-alone revenue raisers, occasional technical corrections, and things of that nature. There is still a strong constituency in Congress for total and permanent repeal of the estate tax, but there is also reluctance to open a dialogue that might jeopardize the historic high and indexed exemption. There is a smaller constituency that would favor a more robust estate tax and are especially impatient with indexing, but they know that when it has taken up the subject in recent years Congress itself has enacted larger increases than decades of indexing will accomplish. The Fiscal Year 2014 Revenue Proposals, released in April 2013, repeated (pages 138-39) the Administration’s proposal from the last four years to return to the exemptions and rates in effect in 2009, but this time not until 2018, which is beyond the term of the current Administration. Even the current discussion of “tax reform,” with an uncertain future of its own, is focused on businesses, could affect the taxation of individuals only slightly or indirectly, and does not have a transfer tax component at all.
The January 1 legislation was also an example – albeit a clumsy one – of how Congress actually can compromise, at least with a limited set of subjects, despite posturing about what is “non-negotiable.” The Act did restore the top income tax rate of 39.6 percent, but at taxable income levels of $450,000 for joint filers and $400,000 for single filers, not the $250,000 that had been so publically discussed during the presidential campaign. The rate on long-term capital gains was raised from 15 percent to 20 percent, but the rate on qualified dividends was raised only to 20 percent, not 39.6 percent. Itemized deductions are again phased out, but at a level of $300,000 for joint filers and $250,000 for single filers, not the approximately $180,000 to which the previous phase-out law would have increased under its inflation adjustments. Most “extenders” were extended for two years, 2012 and 2013, and now are becoming a bone of contention again, but popular “middle class” extenders – the American Opportunity Tax Credit, the Child Tax Credit, and the Earned Income Tax Credit – were extended for five years. Democrats were not able to extend the payroll tax reduction as they had wished, but they were able to extend the unemployment benefits many Republicans had opposed. Even the estate tax rate, the only substantive change in the estate tax, was compromised at 40 percent, the midpoint between the 35 percent rate in 2012 law many wanted to keep and the 45 percent rate in 2009 law to which many wanted to return. And so it went.
A similar ability to compromise was reflected in the budget deal reached and enacted this week. Although the deal doesn’t seem to completely satisfy anyone, and it doesn’t go nearly as far as some would have preferred, it is encouraging that at least some in Congress can agree after they have declared agreement impossible, or even appear to have made agreement impossible.
The deal averts another government shutdown on January 15, 2014. And it substitutes two years of following a budget for the blunt instrument of across-the-board “sequester” cuts, although to some that is the abandonment of a necessary fiscal discipline. Under the deal that reopened the federal government on October 16, 2013, the next deadline is the debt limit deadline of February 7, 2014. Limited compromises at the beginning and end of 2013 furnish some encouragement as we enter the New Year, even as a new crescendo of political rhetoric makes another compromise sound impossible – again.
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