to the Class A partner would not be treated as guaranteed payments under section 707(c) in years when the net profits of the partnership exceed the guaranteed preferred return.
4. Estate entitled to equitable recoupment for beneficiary's tax overpayment
The Ninth Circuit, in Estate of Frank Branson, 88 AFTR 2d Par. 2001-5272, held that the doctrine of equitable recoupment entitled the decedent's estate to a credit for income tax overpayment by a legatee on capital gains recognized on the sale of inherited stock. The decedent's estate included stock in two banks that were sold during the course of administration. The estate reported a gain on the sale based upon the difference between the sale price and the price reported for Federal estate tax purposes. The estate passed the long term capital gain through to its beneficiary who reported the gain on his personal return and paid the tax. After the Service audited the estate tax return asserting a higher value for the bank stock, the tax court determined the correct value to be higher than the amount reported on the estate tax return, but less than the amount asserted by the IRS. The tax court determination was made after the running of the statute of limitations for obtaining a refund of income tax paid by the beneficiary.
The estate argued that it was entitled to an equitable recoupment of the tax paid by the beneficiary because the statute of limitations had expired. A claim for equitable recoupment requires the presence of four elements. First, the claim for refund of income tax must be time-barred. Second, the time-barred offset must arise out of the same transaction as the estate tax deficiency. Third, the transaction must have been treated inconsistently, and finally, there must be an identity of interest between the estate and the beneficiary who paid the income tax. The court rejected the Service's argued difference between tax court and district court jurisdiction. The court also rejected the Service's argument that section 6214 (a) limited the tax court's jurisdiction. The court concluded that no provision of the Code prevented the tax court from exercising jurisdiction and granting the estate a recoupment of the time-barred overpayment.
5. Extension of time to elect special use valuation allowed
The Service, in Letter Ruling 200143014, ruled that an estate was entitled to an extension of time to file a special use valuation election under section 2032A with respect to ranch property owned by a decedent where the executor acted reasonably and in good faith reliance upon a tax professional's advice. The executor, who was the decedent's child, hired an attorney to prepare the Federal Estate tax return. The attorney, after interviewing the executor and reviewing documents presented by him, determined that the executor, and not the decedent, was the owner of the ranch property in question on the date of death. The ranch was not included as an asset of the decedent's gross estate. The child subsequently instituted a quiet title proceeding which resulted in an order concluding that the child held the ranch in a constructive trust for the decedent's estate. Although the attorney was aware of the state court litigation, he did not believe that the court's determination required an amendment to the Federal estate tax return to include the ranch as an asset of the estate, and therefore did not advise the executor to amend the estate tax return.
Upon audit of the decedent's estate tax return, the Service determined that the ranch should have been included in the decedent's estate. A second attorney was hired to represent the estate in connection with the Service's audit. The second attorney filed a petition with the tax court for a redetermination of the Federal Estate tax. The Service was successful in a motion for summary judgment, arguing that the executor was collaterally estopped from litigating the issue of ownership of the ranch. The executor then submitted a request for an extension of time to make the special use valuation election under section 2032A. The Service granted the extension request on the basis that the executor acted reasonably and in good faith and that granting the relief would not prejudice the interests of the government. The Service found that under regulation sections 301.9100-3(b)(1)(iii) and (v), the taxpayer failed to make the election, after exercising reasonable diligence, because he was unaware of the necessity for the election and reasonably relied upon a qualified tax professional who failed to make, or advise the executor to make, the election.
6. Retroactive estate tax rate increase upheld as constitutional
The Federal Circuit has upheld the retroactive increase in the maximum estate tax rate imposed by the Omnibus Budget Reconciliation Act of 1993. The decedent died in 1993 and her executor filed an estate tax return paying estate taxes determined by using the then applicable 50 percent estate tax rate. The maximum rate had been 55 percent, but had defaulted down to a 50 percent rate as a result of congressional inaction. In August 1993, OBRA increased the estate tax rate for taxable estates in excess of $3,000,000, retroactive to January 1, 1993. The executor paid the difference and then filed a claim for a refund arguing that the retroactive increase was unconstitutional.
The court of Federal Claims upheld the retroactive increase. It rejected arguments that the increase violated the separation of powers, finding that nothing in the Constitution prevents Congress from reenacting defeated legislation, including that which was previously rejected by a pocket veto. The court also found that the increase in the tax rate was neither a direct tax, nor a new tax and therefore did not violate either the Due Process Clause or the Apportionment Clause. The court also rejected arguments that the retroactive increase was a taking under the Fifth Amendment, and violated equal protection principles, since it related to a legitimate governmental purpose. The Federal Circuit upheld the court of Claims. Nationsbank of Texas, 88 AFTR 2d Par. 2001-5278.
7. Annuity tables not required for valuing lottery payments
In Schackleford v. U.S., 88 AFTR2d Par. 2001-5250, the Ninth Circuit court of Appeals affirmed a district court holding, finding that an estate was not required to value a decedent's interest in a lottery award under Regulation section 20.2031-7 because the tables did not consider marketability restrictions. The decedent had won a $10.2 million jackpot which was payable in 20 annual payments. He died three years later, after receiving only three of the payments. The estate initially valued the interest in the lottery payments at $4,000,000 dollars, but subsequently filed supplemental information asserting the remaining value of the lottery payments at zero and seeking a refund. The Service denied the refund claim arguing that the decedent's interest in the payments was a term of years annuity includible in the decedent's estate which should be valued using tables under regulation section 20.2031-7. The estate, in addition to arguing for the exclusion of the annuity as an asset under section 2039, maintained that it should be valued using sales of comparable contracts.
The district court had concluded that the interest in the lottery payments was includible in the estate but that the estate was entitled to a refund because the payments were improperly valued under section 20.2031-7. The court reached this conclusion because the tables failed to consider the marketability restrictions in valuing the annuity. The appellate court found that, while the general rule requires the use of the tables, an exception should be made when the tables do not reasonably approximate the value of the asset. The court found that the tables produced an unrealistic result because it did not reflect the discount that should be applied as a result of the non-liquidity of the asset. It stated that fairness required it to use an alternate method to value the property. court rejected the Service's argument that consideration of the lack of marketability would undercut the regulatory certainty established by the use of the tables, observing that the departure is permitted only when a party has proved a more realistic value can be determined through another valuation method.
8. Gifts of limited partnership properly discounted
In Elma M. Dailey, TC Memo. 2001-263, the tax court sustained a 40 percent aggregate minority and marketability discount for gifts of limited partnership interests. The decedent had created a family limited partnership prior to her death and funded it primarily with securities. She subsequently gifted approximately 60 percent of her limited partnership interest to her son and his wife on December 8, 1992, with the balance being transferred to her revocable trust. The gifts were not timely reported. Subsequent to the decedent's death, on January 10, 1997, gift tax returns for the transfers to the son and his wife were filed reporting the discount for minority interest and lack of marketability.
The only issue before the court was the appropriateness of the discounts claimed for the gifts. The parties agreed that the Service had the burden of proof on the valuation issue. The estate's experts used published data to substantiate the claimed discount of 40 percent for lack of marketability, control and liquidity. The Service's expert relied in part on an unpublished study which he co-authored and gave testimony which was contradictory and unsupported regarding the amount of the discount. Although the court noted that neither expert was extraordinary, it concluded that the estate's expert was more convincing and sustained the claimed lack of marketability and minority interest discounts claimed.
9. Life insurance not includible in gross estate
The Service, in Letter Ruling 200147039, found that life insurance proceeds payable to an irrevocable insurance trust were not "receivable by the executor" and therefore not includible in the insured's gross estate. The taxpayers in the ruling were husband and wife who created an irrevocable life insurance trust funded by a policy insuring their joint lives. The insurance trust provided that the Trustee was not required to pay any amounts to either the husband or wife's estate in satisfaction of debts or liabilities of any kind. However, it provided that the Trustee could, in the Trustee's sole discretion, pay estate, inheritance or other tax expenses arising as a result of either spouse's death, but was not required to do so. The taxpayers had also created a joint revocable trust which had primary responsibility for payment of expenses of final illness, funeral and taxes.
The Service found that under section 2042, the value of the gross estate includes all property to the extent receivable by the executor as insurance under policies on the life of the decedent. Under regulation section 20.2042-1(b), life insurance proceeds are considered "receivable by the executor," if they are received by another beneficiary but subject to an obligation which is legally binding on that beneficiary to pay taxes, debts and other charges enforceable against the estate. The Service concluded that because the Trustee of the insurance trust was not required to use the proceeds to pay the obligations of the surviving spouse's estate, the fact that it had discretion to use the proceeds for such purposes did not cause the payments to be "receivable by the executor." Therefore, the proceeds were properly excludable from the surviving spouse's estate.
10. Conservation easement generates estate and income tax deduction
In Letter Ruling 200143011, the Service concluded that a decedent's estate could deduct the value of conservation easement property includible in the gross estate, even though the decedent's heirs claimed income tax charitable deductions related to their own interests in the same property. The decedent and her husband had established a real estate trust to hold the property. After the husband's death, his interest in the real estate trust passed to a marital deduction trust for the benefit of his spouse, who had a testamentary general power of appointment over the trust. After the wife's death, but prior to filing her estate tax return, the Trustees of the realty trust conveyed a conservation easement on the trust property. The decedent's executor included her personal interest in the property and that of the marital trust as a part of her gross estate. The executor claimed a section 2031(c) exclusion for the conservation easement, as well as a charitable deduction under section 2055(f). The decedent's children claimed income tax charitable deductions under section 170(h) for the portions of the conservation easement attributable to their personal interest in the realty trust property.
The Service ruled that the decedent's estate could claim an estate tax charitable deduction for the conservation easement value attributable to the realty trust property interest includable in the estate even though the children had claimed income tax charitable deductions for the value of their interest in the same property. The Service construed section 2031(c)(9) as disallowing an estate tax charitable deduction only if an income tax deduction was claimed for the same portion of the easement interest which was includable in the gross estate. The Service found that since the children claimed their income tax deductions only with respect to their own interests in the easement property, their claim did not preclude the estate's claim to an estate tax charitable deduction for that portion of the interest includable in the gross estate.
By James M. Lestikow
Introduction
After all the rhetoric in Congress, and by the President, on the need to do away with "death taxes," the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) was enacted. Estate and GST tax are repealed in 2010, but prior to then, they are phased out and minimized through larger exemptions and steadily declining maximum rates. Many of the provisions do not come into play for several years, but other aspects are currently in effect, and would apply to a person dying in 2002. To further complicate the planning process, EGTRRA is subject to the sunset provisions mandated for certain Congressional Acts affected by the "Byrd Rule" (section 313 of the Congressional Budget Act of 1974, sponsored by Senator Robert Byrd). That means the entire package would disappear in 2011 unless a future Congress reenacts it with the requisite 60 votes in the Senate. A sunset of the law would reinstate the $1 million applicable credit amount and the current marginal rates.
This article will provide a summary of EGTRRA provisions that currently affect planning strategies. It is meant as a checklist to stimulate further detailed analysis in a specific factual setting, not as a full discussion of each provision, and provisions which do not come into play for some time, such as carry-over basis, are not covered.
GST tax planning
GST exemption vs. estate tax credit shelter amount. The GST tax exemption will cause problems for drafters of wills and trusts until 2004. The GST tax exemption is indexed for inflation, and the estate tax exemption is not. For 2002, it is $1.1 million versus the $1 million estate tax exemption. In 2004, the increase in estate tax exemption will erase the discrepancy. Until then, a transfer pursuant to a provision in a will, pegged to the maximum GST tax exemption, will exceed the maximum estate tax exemption and trigger some estate tax at the death of the first spouse to die. Also, a marital GST exempt trust will be needed to utilize the $100,000 additional GST tax exemption over and above the credit shelter amount.
Because of the significant increase in GST amounts, estate plans with three trusts may need to be reviewed to make sure the GST exempt trust which will receive the maximum unused GST exempt amount is not over-funded in proportion to assets available for the marital trust. In larger taxable estates, descendants could be significantly benefited by the maximum GST exempt gift if the estate tax phase out never is completed.
Automatic allocations. There are new rules that automatically allocate the GST exemption to gifts made during lifetime. Pre-EGTRRA law allowed the transferor to allocate unused GST tax exemption at any time prior to, or at the time of, the filing of the federal estate tax return, and automatically allocated GST exemption only to direct skips, but now that allocation is extended to indirect skips, (IRC '2632(c)(1) as amended by EGTRRA '561), to produce the lowest possible inclusion ratio. An "indirect skip" is defined to include any transfer to a "GST trust" which is a trust that could result in a generation-skipping transfer unless certain circumstances occur. GST Trusts do not include charitable lead or charitable remainder trusts, or trusts for which more than 25 percent or more of the corpus must be distributed to, or may be withdrawn by (a) one or more non-skip persons before attaining age 46, or (b) by one or more persons who are living at the date of death of another person who is their senior by 10 or more years. They also do not include trusts, any portion of which is includable in the estate of a non-skip person other than the estate of the transferor, if he or she were to have died immediately after the transfer. An election can be made to opt out of the automatic rule by so indicating on a timely filed gift tax return. IRC '2632(c)(5)(A)(i)(I). The new provisions may exhaust the GST exemption in a manner that is not the optimal use for exemption.
It may be necessary to file a gift tax return even for gifts under $10,000 ($11,000 as of January 1, 2002) to opt out of the automatic allocation in situations such as gifts to irrevocable insurance trusts, used to pay premiums. The current tax return will be due April 15, 2002, unless extended.
Separation of trusts. New rules will make it easier for a Trustee to separate a trust that would have a fractional inclusion ratio, to create a trust with a zero ratio and another with a ratio of one. (IRC '2642(a)(3)(A), EGTRRA '562(a)). The old law only allowed such a division if the governing instrument specifically permitted it, or if the trustee's discretion was sufficient to permit it. EGTRRA provides for a "qualified severance" to create trusts that will be treated as separate for GST purposes, provided that the resulting trusts do not change the succession interests from the original trust. This provision was effective in 2001, but drafters should continue to include facilitating language in wills and trusts.
Power of appointment. Have a beneficiary of any existing non-GST tax exempt trusts exercise any available power of appointment through their will to direct that trust distribution to a new trust that has at least one non-skip person as a beneficiary.
Estate tax planning
A major premise in planning for many clients at this juncture, is that flexibility is good. A plan that can be adjusted as needed, to cope with the circumstances in place when the documents are put into action, is a good plan. A plan that tries to cover all eventualities, i.e. provisions which are effective if the testator dies in a certain year, is not going to be effective, or comprehensible by the client and/or personal representatives.
Revise marital deduction formulae. Current marital deduction formulae allocate the maximum amount to the credit shelter trust, or the minimum amount to the marital gift/trust, without incurring an estate tax. The increasing estate tax exemption will cause that amount to rise, finally reaching $3.5 million in 2009. All but a few of very wealthiest clients could see an over-allocation of assets to the credit shelter trust, putting them out of the control of the surviving spouse. Consider limiting the credit shelter gift to a specific dollar amount or a percentage of the estate. This formula would have to be monitored frequently to prevent over funding the marital gift to create a taxable estate at the death of the surviving spouse.
Disclaimers. Provide for an outright gift of the entire estate to the spouse with a contingent credit shelter trust. Such a Will should provide significant written guidance on the concept of disclaimer. The spouse, in a hopefully timely manner, would consider such factors as, current age, health, assets, needs of children, current income, and other pertinent circumstances, including potential estate taxes at his/her death, and make a disclaimer of a portion of the estate which then falls into the credit shelter trust.
There is one important caveat. The credit shelter trust MUST NOT give the spouse any control over the trust, such as a power of appointment over it, even one limited to appointment to the descendants. (See IRC '2518).
A Q-Tip Trust (without power of appointment to the spouse) may be used as an alternative to the outright gift to the spouse.
Power of attorney. Utilize the statutory Power of Attorney for Property, 755 ILCS 45/3, to hedge against a disability which would incapacitate the testator and preclude a timely modification of documents to respond to a change in circumstances, or the phase-in of another level of tax exemption, or against the reluctance to plan for step-up of basis until 2010 or 2011. The Power of Attorney Act authorizes an agent to make certain changes to a will or revocable trust of the principal if authorized by specific authority in the Property Power of Attorney and if specific reference is made to the trust or trusts which may be amended or revoked. 755 ILCS 45/3-4(n). The agent holding such a power should generally be an independent party to avoid adverse estate tax consequences if the power holder dies before the estate tax is repealed. In order to respond to the natural client reluctance to granting a Power of Appointment to a non-family member, use a separate Power for this one provision, and appoint the family member agent in the traditional Power of Attorney for Property.
Trust protector. Utilize a "trust protector" for all revocable or irrevocable intervivos trusts, to allow an independent party to amend the non-dispositive provisions in the document to deal with changes in the law or circumstances.
Gift tax planning
The gift tax and the estate tax will cease to be unified on January 1, 2004, when the estate tax exempt amount is increased to $1.5 million but the gift tax exemption remains at $1 million. The maximum gift tax rate will decline at the same pace as the estate tax rate until 2010 when it becomes 35 percent, which is the same as the scheduled maximum individual income tax rate as of that date. Most importantly, the gift tax is not repealed in 2010.
In most instances, avoid voluntarily incurring a gift tax liability over and above the $1 million exempt amount and annual exclusion amounts. With the potential of repeal of the estate tax, and the ongoing $1 million lifetime limit on gifts, many of the traditional techniques for moving significant wealth from an estate during lifetime no longer make sense. If estate tax repeal runs its course, and the property can be passed at death without any transfer tax, there would have been, in effect, a "gift" to the government. Obviously, there will be exceptions, but concentrate on strategies that eliminate or minimize the gift tax.
Loans. One technique that is a viable strategy is a minimum interest (under IRC ' 7872) loan to a family member to allow them to purchase the income producing asset. The income from the property may be sufficient to pay the installments, especially with the low rates currently in effect that can be locked in.
If the lender dies before payoff, the remaining balance of the loan would be includible in the estate of the lender, but if the estate tax is repealed and death is after 2009, or the earlier phase in of a sufficient exemption amount, that will not be of any consequence.
The loan transaction may be augmented or leveraged to better advantage by first contributing the property to a Family Limited Partnership. The loan can then be for the purpose of purchasing a limited partnership interest subject to the discounts for lack of marketability and control.
Grantor retained annuity trusts. The concept of a Grantor Retained Annuity Trust may still be useful if the grantor survives the term of the GRAT but dies while the estate tax is still in place. If a longer term is selected for a GRAT, and the grantor survives, the property passes to the beneficiary without further tax, but so what? The grantor can leave the property to the beneficiary in his or her Will with no tax. Unless we want the beneficiary to have the property during our lifetime, with minimal gift tax, the long term (over 10 years) GRAT makes no sense.