An Introduction To Actuarial Valuations

Transcription

1 An Introduction To Actuarial Valuations Lawrence P. Katzenstein All section references are to the Internal Revenue Code ( Code ), unless otherwise indicated. GRAT refers to grantor retained annuity trust; GRIT, to grantor retained income trust; QPRT, to qualified personal residence trust; QTIP, to qualified terminable interest property; Service, to the Internal Revenue Service; and TAMRA, to the Technical Miscellaneous Revenue Act of A. Actuarial Valuations In General 1. Broad Applications. Actuarial valuations of temporal interests have broad applications in a wide variety of estate-planning circumstances. Common uses include determining the charitable deduction for a gift to a charitable remainder unitrust for a person s life, the value of an annuity for a term of years for estate tax valuation purposes, the value of an income interest in a trust for previously taxed property credit purposes, and so forth in an almost endless list. The widespread use of GRATs, GRITs, QPRTs, and other such planning vehicles has made actuarial calculations a more important part of tax practice than ever before. This outline analyzes section More impor- Lawrence P. Katzenstein is a partner in Thompson Coburn, LLP, St. Louis, Missouri. He is the author of the Tiger Tables Actuarial Software, and is a member of the adjunct faculty of the Graduate Tax Program, Washington University School of Law, and the American College of Trust and Estate Counsel. A complete set of the course materials from which this outline was drawn may be purchased from ALI-ABA. Call CLE-NEWS and ask for Customer Service. Have the order number of the course materials SJ073 handy. 5

2 6 ALI-ABA Estate Planning Course Materials Journal December 2004 tantly, this outline gives you a feeling for what these actuarial factors actually mean and introduces you to some of the mathematics behind the factors. 2. Official Actuarial Tables. Over the years, the Service has published actuarial tables enabling practitioners and tax preparers to calculate the value of certain interests. When we had only one set of tables (assuming a six percent or 10 percent interest rate), tables were included in the Treasury Regulations under section 2031 for a variety of life estate and term interests. Actuarial factors for valuing charitable remainder unitrusts were included in the Treasury Regulations under section 664, and tables for valuing remainder interests in pooled income funds were included in the Treasury Regulations under section Interest Rates. The Service tables, at various times, incorporated different interest rates reflecting current economic conditions. a. The tables at one time assumed a percent discount rate. Later six percent tables were in effect and still later the Service promulgated tables assuming a 10 percent discount rate. b. Wide fluctuations in interest rates made possible numerous schemes to take advantage of table interest rates that either overvalued or undervalued interests based on actual economic conditions. For example, Service tables in effect before December 1, 1983, assumed a six percent rate of return, although the actual rate of return achievable on many fixed-income investments was substantially in excess of that. Because of the inability of the tables to keep up with market interest rates, it became possible to undervalue gifts of life estates and other interests substantially as a result. 4. Mortality Component. The mortality component of the actuarial tables has also been subject to change at various times. Tables in effect from time to time incorporated mortality data based on then-available census information, but the mortality assumptions were not changed frequently or with any consistency for timing. a. For periods before December 1, 1983, the Service prescribed separate mortality tables for male and female lives. For valuations on or after that date, unisex tables are prescribed. b. Unisex tables are appropriate even though males and females have demonstrably different life expectancies, since in no other case do we make

3 Actuarial Valuations 7 socioeconomic distinctions in mortality. For example, the Service does not have separate tables for blacks and whites, for people making more or less than $100,000 a year, or for Mississippians and Minnesotans even though all of these groups also have measurably different mortality experiences. It would be arbitrary to take into account one demographic characteristic but no other. B. Section Overview Of Section Section 7520, which TAMRA added to the Code, attempted to bring regularity and uniformity to the area of actuarial valuations. Section 7520 provides that the value of annuities, interests for life or terms of years, or remainders or reversionary interests, shall be determined under tables prescribed by the Treasury using an interest rate (rounded to the nearest 2/10 of one percent) equal to 120 percent of the federal midterm rate in effect under section 1274(d)(1) for the month in which the valuation date falls. Rates have actually varied from a low of 4.6 percent to a high of 11.6 percent since the effective date of the floating rates in If an income, estate, or gift tax charitable deduction is allowable for any part of the property transferred, the taxpayer may elect to use the 7520 rate for either of the two months preceding the month in which the valuation date falls. Section 7520(b) provides that section 7520 shall not apply for purposes of Part I of Subchapter D of Chapter 1 (pension, profit-sharing, stock bonus plans, and the like) or to the extent specified in the Treasury Regulations. a. Section 7520 did more than change the interest assumptions in the actuarial tables. It directed the Treasury to issue tables reflecting the most recent mortality experience available. The Treasury was to issue these tables no later than December 31, Further, it directed the Treasury to issue new tables at least once every 10 years thereafter that would reflect the most recent mortality experience available at the time of the revision. Finally, section 7520 directed the Treasury to issue tables containing valuation factors for a series of interest-rate categories. b. Section 7520 requires interest rates to be rounded to the nearest 2/10 of a percent for a very practical reason only half as many tables are necessary as rounding to the nearest 1/10 of a percent would require. But the number of tables was increased dramatically by section Instead of a single 10 percent table for each factor, the tables must now encompass a wide range of rates. We went from a pamphlet to a telephone directory.

4 8 ALI-ABA Estate Planning Course Materials Journal December 2004 C. Regulations And Departures From The Tables 1. The history of the Treasury Regulations illustrates some of the issues with which estate planners and the Service had to deal. 2. Proposed Regulations I. Proposed Treasury Regulations were released in two parts. Those issued in October 1992 (PS ) clarified a number of ambiguities and raised others, some of which were dealt with in the final Treasury Regulations. a. The general comments of the proposed Treasury Regulations noted that section 7520 did not apply for purposes of section 72. In response to comments, the final Treasury Regulations excluded charitable gift annuities from this general rule and provided that the section 7520 tables are to be used in valuing charitable gift annuities. This is consistent with the principle adopted in Rev. Rul , C.B Note that for computing the exclusion ratio, the section 72 return multiples use a different set of mortality assumptions (found in Treas. Reg (c)(1)). These assume longer life expectancies, which makes perfect sense: people at death s door don t buy annuities! b. Section 7520 is by its terms mandatory, although section 7520(b) provides that it shall not apply to the extent so specified in Treasury Regulations. The proposed Treasury Regulations did not deal with the question of when use of the tables would be inappropriate. However, Rev. Rul , C.B. 429; Rev. Rul , C.B. 194; Carter v. United States, 921 F.2d 63 (5th Cir. 1991), and numerous other cases did deal with this question. In these cases, the Service asserted, usually successfully, that the use of the published tables was inappropriate. (Note that Rev. Rul. 96-3, C.B. 348, effective Dec. 14, 1995, declared Rev. Ruls and obsolete.) c. Rev. Rul provided that the tables could not be used to value the life of a person afflicted at such time with a fatal and incurable disease in such an advanced stage that he could not survive for more than a short time. In Rev. Rul the Service ruled that standard tables could not be used when death is clearly imminent. Death is not clearly imminent if there is a reasonable possibility of survival for more than a very brief period. Many of the cases (particularly involving the section 2013 credit for previously taxed property) involved simultaneous deaths, typically in airplane crashes.

5 Actuarial Valuations 9 3. Final Regulations I. In response to comments that this subject be dealt with, a second set of proposed Treasury Regulations dealing with the issue of when the tables could not be used was issued on June 9, On the same day, the Service issued final Treasury Regulations dealing with the other issues raised by the 1992 proposed Treasury Regulations. a. The proposed Treasury Regulations suggested changing the method of determining the assumed rate of return for a pooled income fund from the method required by IRS Notice 89-60, C.B That Notice included various formulas for determining some simple actuarial factors and tables for a few basic actuarial factors. It used a method by which the 12 monthly rates prescribed under section 7520 for each of the three preceding taxable years were averaged, with the deemed rate of return being equal to the highest of these average rates less one percentage point. (From 1983 to 1989, the deemed rate of return for new pooled funds was a flat nine percent, which was one percentage point less than the 10 percent used in the tables during that period.) The proposed Treasury Regulations changed from a drop-one-percent to a multiply-by-90-percent approach. In response to comments, the final Treasury Regulations went back to the old drop-by-one percent method. b. Section 7520 provides that in the case of transfers of more than one interest in the same property, the taxpayer shall use the same section 7520 rate with respect to each such interest. Example: Acreates a charitable remainder annuity trust for a donor s child. Section 7520 requires that the donor use the same 7520 rate to value both the charitable gift and the gift to the child for gift tax purposes. The final Treasury Regulations made it clear that a subsequent transfer by the child of her remaining life estate to the charitable remainderman will be valued at the 7520 rate in effect at the time of the subsequent transfer. c. Section 7520 provides for use of either of the two preceding months federal midterm rates if a charitable contribution is allowed for any part of the property transferred. The proposed Treasury Regulations attempted to add a gloss on the statute requiring that the charitable portion be at least five percent of the value of the gift. In response to comments that section 7520 permits a prior month s rate to be used if a charitable deduction is allowed for any portion of the transfer, this proposed five percent test was dropped in the final Treasury Regulations.