Top 10 Revenue Rulings Every Estate Practitioner Should Know. ABA Tax Section May Meeting. May 8, 2015

Transcription

1 Top 10 Revenue Rulings Every Estate Practitioner Should Know ABA Tax Section May Meeting May 8, 2015 A. Christopher Sega, Esq Taylor P. Bechel, Esq Katherine E. Ward, Esq

2 Top 10 Revenue Rulings Every Estate Practitioner Should Know A) Introduction B) Grantor Trusts Transactions with Grantor Trusts Settlor s Substitution Power Reimbursing a Settlor for Trust Taxes C) Common Problems Removal and Replacement of Trustees Retaining Occupancy of Transferred Residence Settlor Serving as Trustee Under Ascertainable Standards Completed Gifts and the Relation Back Doctrine QTIPing an IRA D) Gifting of Minority Business Interests Valuation of Closely Held Business Interests Gifts of Voting and Non-Voting Interests

3 REV. RUL Issue: Will a trust from which the settlor borrows the entire trust corpus be treated as a grantor trust with respect to the settlor? To what extent are a settlor and her grantor trust treated as the same person for income tax purposes so that transfers between the settlor and the trust are not recognized as sales? Facts: A settled an irrevocable trust for the benefit of A s child. A s spouse served as sole trustee of the trust. Neither A nor any other person retained a power over the trust that would cause the trust to be treated as a grantor trust with respect to A. One year later, A borrowed the entire trust corpus, which had appreciated in value, in exchange for a promissory note, bearing appropriate interest. A sought to treat the borrowing as a sale or exchange, resulting in an increased tax basis in the trust corpus that A had borrowed. A sought the increased tax basis in order to reduce A s gain on a subsequent sale. At the time, A s tax rates were higher than the trust s, resulting in a combined net tax savings if the trust were recognized as a separate taxpayer. Decision: A sale or exchange between a settlor and her grantor trust are disregarded. The Internal Revenue Service will not follow the Second Circuit s decision in Rothstein v. U.S. 735 F.2d 704 (2d. Cir. 1984). Reasoning: Congress could not have intended that the grantor trust rules under I.R.C. 671 et seq. would require a settlor to include items of income, deduction, and credit attributable to the trust in computing the settlor s taxable income and credits while allowing the trust to remain a separate taxpayer. Implications: Settlors may engage in transactions with their grantor trusts without such transactions triggering gains or losses and generally without having any income tax consequences. Strategies: Rev. Rul has become the cornerstone of modern estate planning. It has provided the basis for planning with ILITs, GRATs, Installment Sales, CLATs, and other estate planning transactions where the settlor wants to preserve the ability to engage in transactions with the trust without triggering adverse income tax consequences. Planners rely on Rev. Rul for a broad range of transactions. These include transfers of life insurance policies between a settlor and her grantor trust, as well as between grantor trusts without fear of triggering the transfer for value rules. Similarly, a purchase of an appreciating asset from a grantor trust allows the settlor to place a cap on the growth of the asset in the trust. The revenue ruling is the authority for disregarding the rent paid to a terminating Qualified Personal Residence Trust ( QPRT ). Moreover, transfers between trusts that are grantor trusts of each spouse will qualify for the same nonrecognition treatment under I.R.C afforded transfers between the spouses directly. Planners must remain cautious in selecting grantor trust powers, just as they must exercise caution to avoid inadvertent gain when grantor trust status terminates. 2

4 REV. RUL Issue: Does a retained substitution power make a trust includible in the settlor s estate under either I.R.C. 2036(a) or 2038(a)? Facts: A established an irrevocable trust for the benefit of his descendants. A was prohibited from serving as trustee of the trust under the terms of the trust. However, A retained the power, exercisable at any time, to acquire any property held in trust by substituting other properties of equivalent value. Such substitution did not require the consent of the trustee, but did require A to certify in writing that the substituted property and the trust property for which it is being exchanged are of equivalent value. Under local law, the trustee has a fiduciary obligation to ensure that the properties being exchanged are of equivalent value. Additionally, the trustee has a duty, under local law to act impartially towards all beneficiaries in investing and managing the trust assets. Decision: The value of the trust was not includible in A s estate under I.R.C. 2036(a) or 2038(a). Reasoning: The substitution power is not a retained power triggering estate inclusion under I.R.C. 2036(a) or 2038(a) so long as: 1) the power is subject to a fiduciary obligation to ensure that the substitutions are actually equivalent in value and 2) the substitution power does not create the ability to shift benefits between beneficiaries. Although A was not himself subject to either of these limitations, the power was so subject because the trustee had a fiduciary obligation under local law to ensure that the properties acquired and substituted were of equal value. In addition, the trustee had a fiduciary obligation to the beneficiaries to manage and invest the substituted property in a manner that benefited all of the beneficiaries equally. This prevented A from attempting to use the substituted property to benefit a particular beneficiary. Implications: This ruling confirms the idea from Estate of Jordahl v. Commissioner, 65 T.C. 92 (1975), that a retained power of substitution does not trigger estate inclusion as long as the power cannot be used to alter the value of the trust or shift the benefits among beneficiaries. Therefore, the substitution power is an effective tool for creating a grantor trust without triggering estate tax inclusion. Although in this case, the Settlor and Trustee were not the same person, many practitioners agree, especially when looked at in combination with Jordahl, it does not create a requirement that they be separate people. Therefore, the Settlor may retain the power of substitution and act as the trustee, without risking the grantor trust categorization or estate tax inclusion. Strategies: This ruling is very favorable for the taxpayer and provides many opportunities for clients. However, it is important to make sure the client understands that if he/she wishes to exercise this power to retrieve property contributed to the trust, he/she must substitute property of equal value. **Note: Rev. Rul is modified by Announcement , but that merely corrects a mistaken citation to Restatement (Third) of Trusts from I.R.C. 183 and 232 to I.R.C

5 REV. RUL Issue: Does the settlor of a grantor trust make a taxable gift when she pays the income taxes attributed to the settlor as a result of the trust s grantor trust status? What are the gift and estate estate tax consequences if, pursuant to the governing instrument or applicable local law, the settlor either may or must be reimbursed by the trust for the tax so paid? Facts: A settles an irrevocable grantor trust to which transfers qualify as completed gifts. A does not retain any powers over the trust that would cause inclusion in the A s estate. The facts of the revenue ruling presented three separate situations. In Situation 1, neither state law nor the trust s governing instrument contained provisions either requiring or permitting the trustee to reimburse A for A s grantor trust income tax liability. In Situation 2, the governing trust instrument required the trustee to reimburse A for this tax liability. In Situation 3, the trust agreement gave the trustee the discretion to reimburse A for the tax liability. Decision: A s payment of her own tax liability due with respect to the grantor trust income does not constitute a gift to the trust. Nor was the reimbursement a gift by the trust beneficiaries. The reimbursement would cause the trust assets to be includible in A s estate if (1) the reimbursement was required, (2) there existed an understanding that the reimbursement would be made, or (3) the possibility of the reimbursement would cause the trust assets to be subject to the claims of A s creditors. Reasoning: In none of the situations would A s use of her own funds to pay the tax she owed on the grantor trust income constitute a taxable gift to the trust. She simply paid her own liability, not someone else s. Nor would the trustee s reimbursement of A s tax payment constitute a gift by the trust beneficiaries, whether required or discretionary. The beneficiaries had no control over this reimbursement decision and a gift could not occur absent such control. In Situation 2, the trustee s required reimbursement would result in trust assets being includible in A s estate under I.R.C. 2036(a)(1). This result obtains because A was using trust assets to discharge her own liability. By so doing, A had retained the possession or enjoyment of, or the right to the income from the trust assets within the meaning of I.R.C. 2036(a)(1). In Situation 3, where the tax reimbursement was discretionary in the trustee, neither the right to reimbursement nor the actual reimbursement would cause the trust corpus to be includible in A s estate. However, the trust corpus would be so includible if an understanding existed between A and the trust, if A could remove the trustee and appoint herself as trustee, or if state law would subject trust assets to the claims of A s creditors. Implications: Practitioners must be careful in drafting reimbursement clauses to expressly waive them (including any state reimbursement right) if they wish to avoid the possibility of estate inclusion. If waiver is not desirable, then clients must not enter into any understanding that the reimbursement will occur at times of the settlor s choosing. Strategies: A settlor s payment of the taxes due on a grantor trust s income allows the trust income to grow tax free. It offers incredible leverage. Settlors might consider toggling off grantor trust status prior to realizing a grantor trust s tax burden that the settlor cannot afford. 4

6 REV. RUL Issue: Does a settlor s reservation of a power to remove a trustee and appoint a new trustee cause (i) inclusion of the trust property in the settlor s estate under I.R.C or 2038 or (ii) a gift to the trust to be incomplete for gift tax purposes? Facts: In Estate of Wall v. Commissioner, 101 T.C. 300 (1993), the decedent had created a trust for the benefit of others and designated an independent corporate fiduciary as the trustee. The trustee possessed broad discretionary powers of distribution. The decedent reserved the right to remove and replace the corporate trustee with another independent corporate trustee. The court concluded that the decedent s retained power was not equivalent to a power to affect the beneficial enjoyment of the trust property as contemplated by I.R.C and In Estate of Vak v. Commissioner, 973 F.2d 1409 (8th Cir. 1992), the decedent had created a trust and appointed a family member as the trustee with discretionary powers of distribution. The decedent reserved the right to remove and replace the trustee with successor trustees who were not related or subordinate to the decedent. The issue considered in Estate of Vak was whether the decedent s gift in trust was complete when the decedent created the trust and transferred the property to it. The court concluded that the decedent had not retained dominion and control over the transferred assets by reason of his removal and replacement power. Accordingly, the court held that the gift was complete under Treas. Reg (c). Decision: A settlor s reservation of an unqualified power to remove a trustee and to appoint an individual or corporate successor trustee that is not the settlor or someone who is related or subordinate to the settlor within the meaning of I.R.C. 672(c) is not considered a reservation by the settlor of the trustee s discretionary powers of distribution over the property transferred by the settlor to the trust. Accordingly, the trust corpus is not included in the decedent s gross estate under I.R.C or The settlor s reservation of such a power is also not equivalent to the retention of dominion and control over property gifted to the trust and thus does not affect the completed nature of a gift to the trust. Reasoning: The power to remove a trustee and replace it with another independent trustee is not the type of power that would affect the enjoyment of the trust contemplated by I.R.C. 2036(a)(2) or 2038(a)(1). A settlor s retention of the right to remove and replace the trustees does not constitute retention of dominion and control over the trust. Implications: A settlor s retained power to remove and replace the trustee does not cause estate inclusion so long as the new trustee who may be appointed is not the settlor and is not related or subordinate within the meaning of I.R.C. 672(c) to the settlor. Beneficiaries, as well as other individuals, may also possess the power to remove and replace trustees who are not related or subordinate to the appointing individual without adverse tax consequences. Strategies: When defining a power to remove and replace trustees, it s beneficial to mirror the language of Rev. Rul specifically referencing I.R.C. 672(c) to define related or subordinate. Also, note that related or subordinate parties to the settlor may be initially named as trustees or successor trustees in the trust agreement; these persons just cannot be permissible appointees by an individual exercising a removal or replacement power. 5

7 REV. RUL Issue: Does continued enjoyment of the benefits of transferred property make such property includible in the transferor s estate? Facts: A transferred title of his residence to his son and daughter-in-law. There was an understanding at the time of the transfer that A would continue to live in the residence until his death, which he did. Neither the son nor daughter-in-law occupied the property, and A did not pay them any rent. Decision: The full fair market value of the property is includible in A s estate. Reasoning: Under I.R.C. 2036(a)(1), the value of the gross estate includes the value of all of the property that the decedent has transferred but has retained possession or enjoyment of the property for his life. Continued, rent-free occupancy of the transferred residence is as much an economic benefit as if he had rented the property and obtained the income therefrom. Implications: A taxpayer cannot expect to be treated as giving up an asset and avoiding estate tax inclusion if the taxpayer has retained all of the benefits of the assets. This is true if the retention of benefits is the result of a merely implied agreement, as opposed to explicit in the terms of the transfer. Strategies: Be careful when advising clients about gifting to remember to cut all of the strings. For example, if a client wishes to remove his residence from his gross estate, like in this case, he cannot transfer it and continue to live there rent free. Instead, he should transfer it, and then make fair-market monthly rent payments to the transferee. This will serve the dual purpose of cutting the strings on the transfer of the residence, thereby excluding it from the gross estate, as well as gradually removing additional sums from the gross estate through rent payments. 6

8 REV. RUL Issue: Does the settlor s power, acting as trustee, to invade the trust corpus for the benefit of the beneficiary make the trust includible in the settlor/trustee s estate under I.R.C. 2038? Facts: During his life, A created a trust for each of his son and daughter and appointed himself as the trustee of both trusts. The terms of the trusts provided that income was payable to the beneficiary for life, the remainder to be distributed outright to the beneficiary s children at the time of the beneficiary s death. Each trust also included language allowing for the trustee, in the event of a special need as determined in the trustee s sole discretion, to make distributions of principal from the trust to the beneficiary. The daughter s trust limited such distributions to those advisable for her support and education. The son s trust did not have this additional requirement. Decision: The son s trust was included in the estate. The daughter s trust was excluded. Reasoning: A retained power to invade the corpus of a trust for the benefit of the beneficiary does not constitute the power to alter, amend, or revoke the trust if the retained power is limited by an ascertainable standard. The terms in the son s trust, in the event of a special need as shall seem to [the trustee] advisable is not sufficiently limited, but the daughter s trust, adding additional limiting language that it be advisable for her support and education is sufficiently limited as to meet the ascertainable standard requirement. The ascertainable standard makes the difference because it creates the ability for the beneficiaries to go to court and compel a distribution. Thus, the trustee becomes a mere lieutenant subject to the direction of the general in the form of the court and therefore does not truly retain the kind of power which trigger inclusion even though it may appear that he does retain sufficient powers upon first look. Implications: Nondiscretionary powers, which are those limited by an ascertainable standard, to vary the beneficial interests of a trust held by a settlor-trustee do not render the trust property includible in his gross estate. More broadly, it supports the position taken in Jennings v. Smith, 161 F.2d 74 (2d Cir. 1947), that a settlor serving as trustee does not necessarily trigger estate tax inclusion, and provides clarification on the ascertainable standard in that case. Strategies: This revenue ruling is a good reminder of the importance of careful drafting. It is unclear whether this ruling is based on actual facts or a hypothetical put forward by the IRS, but in either case, a mere five words ( for her support and education ) made the difference between inclusion and exclusion from the estate. Omitting five words from the end of a sentence could easily have been a very costly scrivener s error. Another example of the importance of small words making big differences is the choice between as the Trustee shall deem advisable and in the Trustee s sole discretion. Although in everyday practice we often view these terms interchangeably, the second option could be read to suggest that the Trustee is not subject to court oversight.* That reading would undermine the effectiveness of any ascertainable standard and cause estate inclusion. Therefore, best practices suggest using the as the Trustee shall deem advisable language. *Note that in this case the sole discretion language was used. However, this ruling specifically does not address inclusion under I.R.C Therefore, it cannot be relied upon to support a claim that sole discretion language does not undercut the ascertainable standard principal for all estate tax exclusion purposes. 7

9 REV. RUL Issue: When is the delivery of a check to a noncharitable donee considered to be a completed gift? Facts: In Rev. Rul , the donor transferred a gift check on December 25 to a noncharitable donee, but the donee held the check until January 2 of the following year when it was cashed by the drawee s bank. Rev. Rul concluded that the gift was not complete until January 2 because, prior to the check s payment, the donor had not relinquished dominion and control over the funds. In Estate of Metzger v. Commissioner, 100 T.C. 204 (1993), the Tax Court applied the relation-back doctrine to annual exclusion gift checks drawn on December 14 and deposited on December 31. The checks did not clear the bank until January 2. The court stated that it would apply the relation-back doctrine to noncharitable gifts where the taxpayer is able to establish the donor s intent to make a gift, unconditional delivery of a check, and presentment of the check in the year for which favorable tax treatment is sought and within a reasonable time of issuance. Decision: The delivery of a check to a noncharitable donee is deemed to be a completed gift on the earlier of (1) the date on which the donor has so parted with dominion and control under local law and to leave in the donor no power to change its disposition, or (2) the date on which the donee deposits the check (or cashes the check against available funds of the donor) or presents the check for payment, if it is established that: (i) the check was paid by the drawee s bank when first presented to the drawee s bank for payment, (ii) the donor was alive when the check was paid by the drawee s bank, (iii) the donor intended to make a gift, (iv) delivery of the check by the donor was unconditional, and (v) the check was deposited, cashed, or presented in the calendar year for which completed gift treatment is sought and within a reasonable time of issuance. Reasoning: In view of the Fourth Circuit s decision in Metzger, the IRS modified Rev. Rul to hold as described above. Implications: The relation-back doctrine will preserve the annual exclusion for a check that is not paid before the end of the calendar year, provided the donor is alive when the check is paid, delivery of the check is unconditional, and the check is deposited in the calendar year for which completed gift treatment is sought and within a reasonable time of its issuance. Strategies: Ideally, gifts should be completed by year end without having to rely upon the relation-back doctrine. To avoid any problems, consider using wire transfers to facilitate last-minute gifts. Elderly or seriously ill taxpayers, in particular, should not procrastinate in making annual exclusion gifts, and donees should deposit checks promptly. 8

10 REV. RUL Issue: Can an IRA name a marital trust as the beneficiary without compromising the QTIP election? Facts: A died in 1999 at the age of 55 and was survived by a spouse, B, age 50. A had established an IRA prior to death. The IRA invested only in productive assets. A designated the trustee of a testamentary trust as the beneficiary of the entire death benefit payable from the IRA. A copy of the testamentary trust and a list of its beneficiaries were given to the IRA custodian within nine months of A s death. At the time of his death, the trust was valid and irrevocable under state law. Under the terms of the testamentary trust, B was entitled to all of the income payable annually and was the only permissible beneficiary of trust principal during her lifetime. A s children, all of whom were younger than B, were the remainder beneficiaries. B had the power, exercisable annually, to require the trustee to withdraw from the IRA an amount equal to the income earned in the IRA during the year. If B did not exercise this power, the trustee would need to withdraw only the minimum required distribution. The IRA agreement contained no prohibition on withdrawing amounts exceeding the annual required minimum distribution. Decision: An executor may elect to treat an IRA and a trust as QTIP when the trustee of the trust is the named beneficiary of the IRA, the surviving spouse can compel the trustee to withdraw from the IRA an amount equal to all the income earned on the IRA assets at least annually and to distribute that amount to the spouse, and no person has a power to appoint any part of the trust property to any person other than the spouse. Reasoning: Surviving spouse s ability to compel trustee s withdrawal and payment meets the standard requiring the surviving spouse to be entitled to income for life to meet QTIP standards. Since the trust is a conduit for payments equal to income, the executor must make a QTIP election for both the IRA and trust. Implications: An IRA owner who wants to designate a QTIP as a beneficiary may qualify both the QTIP instrument and the IRA for the estate tax marital deduction by complying with the following rules: (1) name the QTIP as the beneficiary in the designated beneficiary form, (2) include in the QTIP instrument all standard provisions, (3) include in the QTIP instrument a provision that gives the surviving spouse the power to compel the trustee to withdraw an amount equal to the income earned on the assets held in the IRA and to distribute that amount to the spouse through the trust, and (4) elect QTIP treatment for both the QTIP and the IRA. Strategies: Investors and their advisors should review the IRA agreement along with the designated beneficiary form to ensure that the trustee will not be prohibited from withdrawing more than the required minimum distribution from the IRA. Other Notes: Rev. Rul was modified by Rev. Rul to deal with the definition of income in jurisdictions that have adopted the Uniform Principal and Income Act, a permitted unitrust conversion, or otherwise control a trustee s discretion in determining what constitutes trust income. 9

11 REV. RUL Issue: How is the fair market value of stock of closely held corporations determined for estate and gift tax purposes? Facts: The stated purpose of Rev. Rul is to outline and review in general the approach, methods, and factors to be considered in valuing shares of closely held corporations or other business entities for which market quotations are either unavailable or are of such scarcity that they do not reflect the fair market value. Decision: All available financial data, as well as all relevant factors affecting the fair market value, should be considered. The following factors, although not all-inclusive, are fundamental and require careful analysis in each case: (1) the nature of the business and the history of the enterprise from its inception, (2) the economic outlook in general and the condition and outlook of the specific industry in particular, (3) the book value of the stock and financial condition of the business, (4) the earning capacity of the company, (5) the dividend-paying capacity, (6) whether or not the enterprise has goodwill or other intangible value, (7) sales of the stock and the size of the block of stock to be valued, and (8) the market price of stocks of corporations engaged in the same or similar line of business having their stocks actively traded. For companies that sell products or services to the public, earnings are the primary test of value. For investment or real estate holding companies, the greatest weight is given to the market value of the underlying assets of the company. Reasoning: A determination of value, being a question of fact, will depend upon the circumstances in each case. No formula can be devised that will be generally applicable to the multitude of different valuation issues arising in estate and gift tax cases. Often, an appraiser will find wide differences of opinion as to the fair market value. Valuation is not an exact science. A sound valuation will be based upon all the relevant facts, but the elements of common sense, informed judgment, and reasonableness must enter into the process of weighing those facts and determining their aggregate significance. Implications: Although published over 55 years ago, Rev. Rul still provides the basic guidelines used by the valuation community and the IRS alike for the valuation of closely held business interests for gift and estate tax purposes. Strategies: Selection of an experienced appraiser is crucial. A qualified appraisal prepared by a qualified appraiser is always the safest route. For example, for gift tax purposes, the statute of limitations does not begin to run until the gift was adequately disclosed on federal gift tax return. If you attach a qualified appraisal prepared by a qualified appraiser to the gift tax return, the valuation requirement of adequate disclosure is automatically met. See Treas. Reg (c)-1(f)(3) for the requirements of a qualified appraiser and qualified appraisal. Always review the appraisal to ensure that Rev. Rul was mentioned and it includes a discussion of the factors listed above. 10

12 REV. RUL Issue: Will the transfer of stock with respect to which the transferor never held any voting rights result in the transferred stock being includible in the transferor s estate. Facts: Rev. Rul dealt with the impact of the Supreme Court s decision in United States v. Byrum, 408 U.S. 125 (1972) on prior Rev. Rul In Rev. Rul , the decedent transferred assets to a corporation that issued 10 shares of voting and 990 shares of nonvoting common stock. The decedent transferred the 990 shares of non-voting stock in trust for the benefit of his children. The trust owned the 990 shares at the date of decedent's death. Rev. Rul concluded that the decedent had retained control of the corporate dividend policy through retention of the voting stock and, thus, had retained the right to determine the income from the nonvoting stock. The ruling held that the decedent's retention of the right to control income amounted to a transfer whereby the decedent had retained the right to designate the persons who shall enjoy the transferred property or income therefrom. As a result, the property was includible in decedent's gross estate under I.R.C. 2036(a)(2). The Byrum decision held that the legal theory underlying the holding in Rev. Rul was invalid. Congress subsequently enacted I.R.C. 2036(b) to do legislatively what the IRS sought to do through its revenue ruling. The issue then became whether the invalidating effect of Byrum on Rev. Rul was itself reversed by the enactment of I.R.C. 2036(b). Decision: The IRS revoked Rev. Rul based on the legislative history of I.R.C. 2036(b). Reasoning: Although many consider I.R.C. 2036(b) as Congress s effort to overturn Byrum, Congress made it clear that the new statutory provision was not intended to address certain transactions. The Senate Finance Committee Report relating to section 2036(b)(1) provides as follows: The rule would not apply to the transfer of stock in a controlled corporation where the decedent could not vote the transferred stock.... For example, where the decedent owned both voting and nonvoting stock and transferred the nonvoting stock to another person, the rule does not apply to the nonvoting stock simply because of the decedent's ownership of the voting stock. S. Rep. No , 95th Cong., 2d Sess. 91 (1978). Accordingly, the legislative history of I.R.C. 2036(b) demonstrates that the effect of Byrum on Rev. Rul was not changed by the enactment of section 2036(b) of the Code. Implications: I.R.C. 2036(b) does not apply where the transferred interest was non-voting stock, even if the transferor retains voting stock in the same entity. Strategies: A voting/nonvoting recapitalization, followed by the transfer of the non-voting stock is an appealing transaction for clients wishing to retain control of a closely held corporation while still removing significant value from their estates. Moreover, because non-voting stock traditionally carries a lower value, the transaction permits the transfer of significant wealth at a discount. 11