Alongstanding, if curious, feature

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1 Toggling Gross Estate Inclusion On and Off: A Powerful Strategy Creative planning increases the opportunity to balance estate tax savings of excluding property from an estate with income tax savings of estate inclusion. AUSTIN W. BRAMWELL AND ELISABETH O. MADDEN Alongstanding, if curious, feature of the U.S. gift and estate tax system lately celebrating its 100 th anniversary 1 is that the same property whose transfer was subject to gift tax during lifetime may be subject to estate tax at the transferor s death. To take a classic example, suppose that a father irrevocably transfers to his daughter a remainder interest in his residence, but retains a life estate for himself. The father thereby makes a taxable gift of the remainder, and will be liable for any gift tax that may be due. 2 In addition, at the father s death, the residence will be included in his gross estate for estate tax purposes under Section 2036(a)(1). Fortunately, the estate tax computation procedures, by effectively purging the gift from the transfer tax base and allowing a credit for gift taxes payable, 3 prevent double taxation of the same gift. That said, gross estate inclusion does cause the residence to be taxed at its date-of-death value rather than its value at the time of the gift. Revaluation rather than double taxation, in other words, is the consequence when property transferred during lifetime is pulled back into the donor s gross estate at death. As most property tends to appreciate in value, wealthy taxpayers typically plan to avoid gross estate inclusion of lifetime property transfers. Suppose, for example, that the father AUSTIN W. BRAMWELL is a partner in the Trusts & Estates Group of Milbank, Tweed, Hadley & McCloy LLP and an adjunct professor of law at New York University School of Law, where he teaches income taxation of trusts and estates. He is a Fellow of the American College of Trusts and Estates Counsel. ELISABETH O. MADDEN is a vice president of Rockefeller Trust Company, N.A., where she focuses on the administration of trusts and estates for private clients. The authors acknowledge with gratitude the comments of Prof. David Herzig, Jerry Hesch, Elizabeth Munson, and Sean R. Weissbart. The views expressed herein are the authors own; have been provided for informational purposes only; and are not intended as legal, tax, estate planning, or other professional advice. Copyright 2017, Austin W. Bramwell and Elisabeth O. Madden. 3 owns shares of stock that will appreciate in value from $1 million to $5 million by the time of his death. If the father makes a gift of the stock to his daughter when it is worth $1 million, and the stock passes outside of his gross estate, he will be subject to gift tax on only $1 million. But if instead the stock is pulled back into the father s gross estate at death, an estate tax will be imposed on $5 million. Lifetime gifts that escape estate tax at death, in short, freeze value as of the time of the gifts. For that very reason, however, taxpayers sometimes prefer to have property transferred during lifetime included in their gross estates at death. Suppose, for example, that the father makes a gift in trust of stock worth $5 million at the time of the gift. In this scenario, by the time of the father s death, the stock happens to decline in value to $1 million. If the stock is included in the father s gross estate at death, estate tax will be imposed on the $1 million value, and the $5 mil-

2 4 lion gift will effectively be purged from the wealth transfer tax base. Gross estate inclusion in this case is more efficient than having the property pass free of estate tax. 4 Including property transferred during lifetime in the decedent s gross estate may or may not be tax efficient, depending on the value of the property at death and its cost basis. Another reason that taxpayers may prefer gifts made during lifetime to become subject to estate tax at death is that the income tax savings from gross estate inclusion, thanks to the step up in basis at death for property acquired from a decedent, may exceed any estate tax savings achieved from setting a fixed value. 5 Suppose that the father owns 100 ABC Corp shares having a value of $5 million but a cost basis of $0. If the father simply holds onto the shares, they will qualify for a stepup in basis at his death. Assuming (for simplicity) a flat capital gains tax rate of 23.8% and that the value of the shares remains $5 million, the basis step-up saves $1,190,000 of income tax, if the shares are sold after the father s death. But suppose instead that the father makes a gift of the shares to his daughter during his lifetime. If the shares appreciate after the date of the gift, the daughter receives the benefit of the appreciation free of any further gift or estate tax. At a 40% estate tax rate, the savings from each $1 million of post-gift appreciation is $400,000. Notice, however, that $400,000 of estate tax savings is less than half of the $1,190,000 income tax savings that could be achieved simply by having the father hold onto the shares during his lifetime. For the estate tax savings from the father s gift to exceed the income tax cost of losing the step-up in basis, the shares must appreciate approximately %, or from a value of $5 million to a value of $12,345, If that appreciation fails to occur, it would be preferable, assuming that the shares will be sold, to have the shares pulled back into the father s gross estate at death. In short, including property transferred during lifetime in the decedent s gross estate may or may not be tax efficient, depending on the value of the property at death and its cost basis. Ideally, taxpayers would be able to monitor their past gifts and decide whether to trigger gross estate inclusion or not. Put another way, taxpayers would like to toggle gross estate inclusion on and off, depending on which result is preferable. Strangely, however, there is very little literature on toggling strategies. 7 This article explores the strategies that taxpayers might wish to consider in order to turn gross estate inclusion on and off. 1 For historical retrospectives, see McCaffrey and McCaffrey, Our Wealth Transfer Tax System: A View From the 100th Year, 41 ACTEC L. J. 1 (Spring 2015); Christerson, The Estate Tax at 100, 42 Estate Planning Review 165 (2016); and Kaufman On the Centennial Anniversary of the Estate Tax, 43 ETPL 38 (September 2016). 2 Under the special valuation rules of Section 2702, the value of the gift is deemed to be equal to the entire value of the property. 3 Any gift tax payable on the gift of the remainder is effectively restored in the form of a credit under Section 2001(b)(2). Any unified credit used up by the gift is likewise effectively restored, as the gift is not treated as a adjusted taxable gift as defined in the flush language of Section 2001(b). 4 An interesting question is whether the same result applies if the decline in value is caused by distributions rather than negative investment returns. For example, suppose that the father makes a completed gift in trust of $5 million, of which all but $1,000 is distributed to beneficiaries during his lifetime. At his death, the remaining $1,000 is included in the father s gross estate under Section 2038(a). Logically and as a matter of policy, it would seem that only the portion of the trust that was not distributed during lifetime should be purged from the wealth transfer tax base at death; the balance of the $5 million gift should be added to the computation of estate tax as an adjusted taxable gift as defined in Section 2001(b). 5 Section 1014(a) generally provides (subject to exceptions, such as for income in respect of a decedent under Section 1014(c)) that the basis of property inherited or acquired from a decedent is equal to its fair market value at death, or its value on the alternate valuation date, if an alternate valuation date election is made under Section By Section 1014(b)(9), most property that is included in a decedent s gross estate for estate tax purposes is deemed to have been acquired from a decedent and qualifies for the change in basis under Section 1014(a). The change in basis does not necessarily result in an increase or step up. As most property tends to appreciate in value, however, the change in basis is commonly referred to, including in this article, as a step up in basis. 6 This computation ignores, for simplicity, the effect of the gift tax annual exclusion under Section For one example of an article advocating toggling, see Weissbart, Estate Planning Strategies for the Young and Wealthy, 41 ETPL 28 (February 2014). See also McCaffrey, Tax Tuning the Estate Plan by Formula, 33 U. of Miami Law Center s Philip E. Heckerling Institute on Estate Planning 403 (1999) (proposing a formula strategy, discussed below in the text); Blattmachr and Zeydel, Regretting Recent Estate Tax Planning Arrangements?, 42 ETPL 3 (October 2015). 8 For an example of a failed toggling strategy, see Estate of Sommers, TCM (rejecting taxpayer s argument that assignments during lifetime were incomplete for gift tax purposes until blanks were filled in). 9 Reg (b); see also Sanford s Estate, 308 U.S. 39, 23 AFTR 756 (1939). 10 Reg (g). 11 As the Supreme Court pointed out in Sanford s Estate, supra note 9, a gift s being incomplete for gift tax purpose does not prevent the government from ever taxing the transfer of the property, for, if transfers are not taxed as gifts they remain subject to death taxes... and the Government gets its due. 12 Reg (d). 13 See Estate of Alexander, 81 TC 757 (1983), aff d in unpub. op. (CA-4, 1985); Reg (a); Lober, 346 U.S. 335, 44 AFTR 467 (1953). 14 Rifkind, 5 Cl. Ct. 362, 54 AFTR2d (1984). 15 Estate of Halbach, 71 TC 141 (1978) (holding that a disclaimer of an interest is equivalent to a transfer or relinquishment). 16 Section 2038(a) has its own, separately stated three-year look-back rule, which applies if taxable powers are renounced within three years of and in contemplation of death. 17 A renunciation or other elimination of a taxable power could itself be a taxable gift. For example, suppose the father makes a gift of property to an irrevocable trust, and retains the power to determine which of his descendants will receive the income of the property. The father s gift is incomplete as to income (although the income interest will be valued at zero under Section 2702). A renunciation of the power to determine who will receive the income of the trust will complete the gift of the income interest. (If Section 2702 applied to the original gift in trust, a special rule prevents double taxation of the gift of the income.) 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3 5 Obstacles to toggling If toggling gross estate inclusion on and off is possible at all, it is not easy. 8 For one thing, the opportunity to pull transferred property back into a donor s gross estate arises only if the donor makes a completed gift for gift tax purposes. A donor does not make a completed gift, however, unless the donor, in the words of Treasury regulations, has so parted with dominion and control as to leave him no power to change its disposition. 9 The relinquishment of dominion and control eliminates many (although not all) of the possible ways in which the transferred property can be included in the donor s gross estate. For example, suppose that the father transfers property in trust but retains the power, as trustee, to decide who, out of the class of trust beneficiaries, will receive distributions of income or principal. Such a retained power over distributions, if not limited by an ascertainable standard, 10 prevents a completed taxable gift from occurring. In addition, the trust property will be included in the father s gross estate at death under Sections 2036(a)(2) and 2038(a)(1). As the property would have been included in the father s gross estate had he not made the transfer at all, the transfer in trust does not create an opportunity to avoid gross estate inclusion. 11 Suppose instead that the father appoints an independent trustee who has the power to make distribution decisions. The father s gift in that case is complete for gift tax purposes. But this time the opposite problem arises: Although the property, without further planning, will pass outside of the father s gross estate at death, that may not, as discussed above, always produce the optimal result. Without some possible gross estate inclusion trigger, the property will pass outside the father s gross estate, even if the father and his family would prefer the property to be subject to estate tax. As discussed in further detail below, it is possible for the donor to retain (or to possess at death) powers that will cause gross estate inclusion yet not prevent a completed gift. Broadly speaking, these powers come in three types: 1. Retained or reserved powers, or powers held by the donor at the time of the transfer. 2. Automatically triggered powers, or powers that automatically spring into being at death in order to cause gross estate inclusion, if that is the right result. 3. Conferred powers, or powers that could be given to the donor by the time of his death in order to cause gross estate inclusion under Section 2038(a). These three types of powers, and the challenges of using them to toggle gross estate inclusion on and off, are discussed below. Toggling inclusion on and off with retained powers As discussed, a donor may make a completed gift, yet still retain powers that will cause the property to be pulled back into his or her gross estate at death. For example, suppose that a father creates an irrevocable trust for the sole benefit of his daughter, but retains the ability to distribute income and principal to the daughter at such time as the father determines. The father s gift, despite the retained power over the timing of the daughter s enjoyment, is complete for gift tax purposes. 12 Nevertheless, his retained power will cause gross estate inclusion at his death under Sections 2036(a)(2) and 2038(a). 13 Once a gift is made in a manner that, without further planning, will cause the transferred property to be included in the donor s gross estate, the only way to avoid gross estate inclusion is to eliminate the retained taxable rights and powers. For example, a donor could relinquish the powers that would otherwise cause gross estate inclusion, such as by resigning from office 14 or disclaiming the taxable power. 15 An effective relinquishment would eliminate the taxable retained powers. But that may be a hollow victory: Section 2035(a) provides that, if an interest or power causing gross estate inclusion under Sections 2036, 2037, 2038, or 2042 is transferred or relinquished within three years of death, the property will still be included in the decedent s gross estate. 16 A relinquishment, therefore, will cause the trust property to pass outside of the gross estate only if the donor survives three years from the time of the relinquishment. 17 That three-year restriction makes renunciation of retained pow- M A R C H V O L 4 4 / N O 3 T O G G L I N G I N C L U S I O N

4 6 ers an inflexible tool for toggling off gross estate inclusion. 18 That said, it may be possible, through careful planning, to avoid the three-year rule of Section 2035(a). It seems that a transfer or relinquishment under Section 2035(a) does not occur without some affirmative or voluntary act by the individual whose power is transferred or relinquished. 19 Thus, as the IRS has acknowledged in non-binding rulings, 20 termination of a right to property in accordance with its terms, such as a right that automatically terminates after a fixed period of years, does not trigger a three-year gross estate inclusion period under Section 2035(a). Likewise, the termination of a power as a result of events outside the transferor s control should not be viewed as a transfer or relinquishment within the meaning of Section 2035(a). 21 Thus, even if the transferor does retain a taxable power under Section 2036(a)(2) or 2038(a), it may be possible to avoid the three-year rule of Section 2035(a) (and the separately stated three-year rule of Section 2038(a)) if the power could be eliminated by a third party. For example, the donor could give an independent party the power to eliminate the transferor s distribution powers. The three-year inclusion rule of Section 2035(a) may in that case not be triggered if the donor s power is eliminated, even if within three years of the donor s death. As yet, it remains unclear whether this position will prevail. 22 Furthermore, even if it is true, in principle, that Section 2035(a) is not triggered where a power is expunged rather than relinquished, the IRS could argue that the decedent relinquished the power in substance, based on circumstances suggesting that the power would be eliminated at the request (even if non-binding) of the decedent. 23 For that reason, an attempt to avoid the relinquishment requirement of Section 2035(a) by having an independent party eliminate the donor s retained powers is not certain to work. Retained powers that trigger gross estate inclusion are unattractive for other reasons as well. First, if the donor retains such a power, the donor will be prevented under Section 2642(f) from allocating generation-skipping transfer (GST) exemption to the transfer for GST tax purposes. Second, thanks to a technical defect in Section 2001(e), if the donor and the donor s spouse elect to split their gifts for the year under Section 2513, the donor s spouse s gift tax exclusion amount may be wasted if it turns out that the property is included in the donor s gross estate. 24 Thus, retained powers should not be used as a toggling 18 The donor or a family member could acquire life insurance in order to shift the risk that the father will die within three years. At a minimum, however, such insurance, even if available, will add to the costs and complexity of attempting to turn off gross estate inclusion by renunciation. 19 Cf. Estate of dimarco, 87 TC 653 (1986) ( [T]here can be no act of transfer unless the act is voluntary and the transferor has some awareness that he is in fact making a transfer of property, that is, he must intend to do so ); Harris, 340 U.S. 106 (1950) (requiring that a transfer be voluntary for gift tax to apply). 20 Ltr. Ruls and Under Section 6110(k), private letter rulings may not be cited as precedent. 21 Ltr. Rul In TAM , a grantor s interest in a grantor-retained income trust was commuted by the trustee, who terminated the grantor s retained interest by paying out to the grantor cash in an amount equal to the actuarial value of the grantor s interest. The IRS rejected the estate s argument that Section 2035(a) did not apply to the commutation. According to the IRS, although the Decedent did not formally initiate the commutation, the exercise of the power by the trustee was consistent with Decedent s intent and was authorized, if not implicitly directed, by the Decedent. Consequently, the commutation was a voluntary transfer by the grantor, and Section 2035(a) applied. 23 Cf. TAM (ruling that a commutation of the decedent s interest was a transfer within the meaning of the Section 2035(a) in part on the grounds that the purpose of the commutation was to avoid gross estate inclusion). The concept of a right existing based on an understanding between the transferor of property and another is found in the regulations under Section 2036(a)(1). Reg (c)(1)(i). See, e.g., Estate of Linderme, 52 TC 305 (1969); Paxton, 86 TC 785 (1986). The concept also applies, in the IRS s view, to the power to vote stock of a controlled corporation under Section 2036(b). See Rev. Rul , CB 271; Prop. Reg (c). Finally, in the case of transfers made on or before 6/22/1936, a right is considered to have been retained by the decedent if there was an understanding, express or implied, that the power would be conferred on the decedent. Reg (c). As yet, it is unclear whether the concept applies in the Section 2035 context. 24 Section 2001(e) of the Code provides that, if property transferred by a decedent s spouse is included in a decedent s spouse s gross estate under Section 2035, and the decedent elected to split gifts with the decedent s spouse, the decedent s deemed gift is not considered an adjusted taxable gift; thus, it is effectively purged from the gift and estate tax base. If the property is included in the decedent s spouse s gross estate under another section, however, no similar relief is available. Even if property is included in the decedent s spouse s gross estate under Section 2035, the relief of Section 2001(e) is not available if the decedent dies first and the adjusted taxable gifts of the decedent become finally determined for estate tax purposes before there is a chance to invoke Section 2001(e). Cf. Rev. Rul , CB For more on this technique, see McCaffrey, Tax Tuning the Estate Plan by Formula, 33 U. of Miami Law Center s Philip E. Heckerling Institute on Estate Planning 403 (1999). 26 Reg (b). 27 Reg (b)(3). 28 Reg (b)(3). 29 Authority interpreting the scope of the regulation exception is scarce. 30 Another problem, perhaps, is that the formula inclusion strategy relies on a regulation, Reg (b)(3), whose viability remains untested. The rule stated in that regulation that Section 2036(a)(2) does not apply to powers which do not affect the enjoyment of property during the decedent s lifetime is arguably at odds with the words of the statute, which do not contain a limitation to powers that can affect only the enjoyment of income during the decedent s lifetime. (On the other hand, perhaps the rule is based on the statutory condition that Section 2036(a) applies only if a taxable power or right is retained for life, for a period that does not in fact end before death, or for a period not ascertainable without reference to the transferor s death. The regulation s view may be that if a power does not become exercisable until death, then it does not fall within the time frames specified by the statute; rather, it occurs only after the requisite time frames have ended.) Conceivably, the IRS could attempt to disavow the rule in a litigation. Burke, 504 U.S. 299, 69 AFTR2d (1992) (Scalia, J. concurring) ( [W]hile agencies are bound by those regulations that are issued within the scope of their lawful discretion... they cannot be bound by regulations that are contrary to law. ). 31 McCaffrey, Tax Tuning the Estate Plan by Formula, 33 U. of Miami Law Center s Philip E. Heckerling Institute on Estate Planning 403 (1999). The reason for caution is that a power of sale could be deemed a Section 2038(a) power in the context of the formula inclusion strategy. E S T A T E P L A N N I N G M A R C H V O L 4 4 / N O 3

5 7 strategy if the donor and the donor s spouse wish to split gifts. Triggering inclusion automatically by formula Another technique for triggering gross estate inclusion, if desirable, is for the donor to transfer property to an irrevocable trust, but retain control over only so much principal as will lead to an optimal tax result. 25 Example. A father makes a gift in trust for his descendants of $5 million worth of ABC stock having a basis of zero. The trust provides that, at the father s death, the trust will pay over the shares to the father s estate, unless the value of the shares exceeds a threshold amount. The threshold amount is exceeded, according to a formula set forth in the trust instrument, only if the estate tax savings from avoiding gross estate inclusion exceeds the income tax cost to the beneficiaries of losing the step-up in basis. If the shares fail to appreciate, the estate tax savings of avoiding gross estate inclusion will be zero, and the shares, in accordance with the formula, would be paid over to the father s estate at death (and thereby qualify for a step-up in basis). By contrast, if the shares (for instance) quadruple in value, the estate tax savings of passing the appreciation free of 32 Id. 33 Even the timing of estate tax payment may not be possible to predict in advance. For example, the executor may obtain an extension of time to pay estate tax under Section 6161 or Although interest will be charged on deferred tax payments, the value of deferral may still exceed the interest cost. If interest is charged under Section 6161, the interest so charged will normally be deductible for estate tax purposes. These and other complications make it virtually impossible to get the formula inclusion exactly right in advance. 34 Section 2642(f). estate tax would exceed the cost of losing the step-up in basis. Thus, none of the shares would be paid over to the father s estate. Consequently, Section 2038(a)(1) would not cause gross estate inclusion, as that section does not apply to contingent powers not actually possessed at death. 26 Section 2036(a)(2), in contrast to Section 2038(a), does cause gross estate inclusion if the decedent retained a contingent right to determine who will enjoy the income from property transferred during lifetime. 27 Treasury regulations, however, take the position that the Section does not apply to a power over the property which does not affect the enjoyment of income during the decedent s lifetime. 28 Powers exercisable only at death, evidently, 29 do not cause gross estate inclusion under Section 2036(a)(2). As the possible return of transferred property to the transferor s estate does not affect the enjoyment of income during the transferor s lifetime, Section 2036(a)(2) will not trigger gross estate inclusion. Formula clause drawbacks. Triggering a certain amount of gross estate inclusion by formula is an ingenious strategy. Nevertheless, it has limitations. One limitation may be simply that it is not well understood. 30 Another is that, as the architects of the strategy acknowledge, out of caution, the donor should not retain investment powers. 31 Most importantly, the strategy is inflexible. Formula gross estate inclusion is not a true toggling technique, as gross estate inclusion or non-inclusion is automatic. That makes a difference if it turns out that the taxpayers do not value a step-up in basis in property as much as may have been assumed when the trust is created. Suppose, for example, that after the father s death, the family has no desire to sell ABC stock. The step-up in basis, therefore, is not important to them, as the ABC stock will never be sold or otherwise disposed of. Nevertheless, the formula inclusion clause may cause an increase in estate taxes if it turns out that estate tax savings from appreciation do not outweigh the (hypothetical) capital gains tax saving. The family, however, would have preferred the estate tax savings, even at the income tax cost, as it turns out that they are not interested in sale. Retained powers should not be used as a toggling strategy if the donor and the donor s spouse wish to split gifts. In theory, if the timing of sale can be predicted with certainty, the formula inclusion amount can be modified with a present value discount factor and achieve the ideal outcome. 32 In many cases, however, it will not be possible to predict in advance when the recipients of property will actually wish to sell. 33 Finally, formula inclusion clauses have tax downsides. Like any retained power causing gross estate inclusion immediately after the transfer, a formula inclusion clause prevents allocation of GST exemption and, therefore, is not compatible with GST tax planning. 34 Further, as with retained powers discussed previously, to avoid potential waste of the donor s spouse s gift and estate tax exclusion, the donor and the donor s spouse should not elect to split gifts for the year of the gift under Section The inability of spous- M A R C H V O L 4 4 / N O 3 T O G G L I N G I N C L U S I O N

6 8 es to split gifts further limits the utility of formula inclusion. Toggling inclusion on with conferred powers In principle, gross estate inclusion can be toggled from off to on by having a power described in Section 2038(a)(1) conferred on the donor before the donor s death. That section generally provides that the gross estate includes property transferred by the decedent during lifetime, if the decedent could change the beneficial enjoyment of the property through a power to alter, amend, revoke, or terminate. Importantly, the section applies without regard to when or from what source the decedent acquired the taxable power. Thus, a Section 2038(a)(1) power may trigger gross estate inclusion, even if the decedent did not reserve the power at the time of the initial transfer. Example. A father creates an irrevocable trust for his descendants, and designates another individual as trustee. The trustee, under the terms of the governing instrument, has the power to terminate the trust at any time and distribute all of the principal to the beneficiaries. Years later, the trustee resigns and exercises a power under the governing instrument to appoint the father as the successor trustee. The father later dies holding the powers of the trustee, including to terminate the trust. Section 2038(a)(1) could be used to cause gross estate inclusion of property that otherwise would have passed free of estate tax. In an early case, White v. Poor, 35 the Supreme Court held that the predecessor to Section 2038 did not cause gross estate inclusion in this circumstance. In the court s view, the predecessor section did not apply if the power, although possessed at death, was not retained or reserved but was instead conferred on the decedent by another. The White v. Poor holding still technically applies to transfers made on or before 6/22/ For transfers made after that date, however, Congress overturned White v. Poor by enacting what is now Section 2038(a)(1), which now may cause gross estate inclusion regardless of when or from what source the decedent acquired the taxable power. 37 In the example, therefore, the father s power at death to affect the beneficial enjoyment of trust property is sufficient to cause gross estate inclusion, even though the father did not retain the power at the time of the initial transfer to the trust. Making use of Section 2038(a). Given the absence of a retention requirement, Section 2038(a)(1) could be used to cause gross estate inclusion of property that otherwise would have passed free of estate tax. 38 The following are three mechanisms by which a donor could be given a Section 2038(a) power at the time of death that was not retained at the time of transfer: Appointment of donor as trustee. First, as in the White v. Poor situation, a person other than the donor could be given the power to appoint the donor as a trustee (or cotrustee) with discretionary distribution powers that are not limited by an ascertainable standard U.S. 98, 16 AFTR 977 (1935). 36 Section 2038(a)(2); Reg (c). 37 See Rev. Rul , CB 193 (holding that property of a Uniform Gifts to Minors Act account is included in the donor s gross estate if the donor was appointed custodian before his or her death). 38 As noted at the outset of this article, if property is pulled back into the gross estate under Section 2038(a) (or another section), the lifetime taxable gift is effectively purged from the wealth transfer tax base under the estate tax computation procedures of Section 2001(b), so that the property is taxed only once. Section 2001(b)(2) also effective gives a credit for any gift taxes payable on the gift. 39 See also Rev. Rul , supra note 37 (holding that property of a Uniform Gifts to Minors Act account is included in the donor s gross estate if the donor was appointed custodian before his or her death). Section 2036(a)(2) should not apply, as that section applies only where a power is reserved at the time of transfer. On the other hand, Section 2036(a)(2) does apply if the transferor retained the power to appoint himself or herself as trustee on the death or resignation of the prior trustee. Rev. Rul , CB 405; Estate of Farrel, 553 F.2d 637, 39 AFTR2d (Ct. Cl., 1977). Conceivably, although it does not appear that the IRS has made this argument, if a donor makes an irrevocable transfer but gives a third party a power to appoint the donor as trustee with discretionary distribution powers, the donor could be viewed as retaining a Section 2036(a)(2) power, subject to a contingency (namely, another s decision to appoint the donor as trustee). To avoid that argument, it seems that the choice of a Section 2038(a) trigger should be limited to a power that is exercisable only at the donor s death. 40 Several cases have rejected the application of Section 2038(a) where the decedent completely divested himself or herself of control over the trust property, but later acquired powers over the same property in an unrelated transaction. Estate of Reed, 36 AFTR2d (DC Fla., 1975); Estate of Skifter, 468 F.2d 699, 30 AFTR2d (CA-2, 1972), nonacq CB 4. Those cases should not deny gross estate inclusion if a Section 2038(a) power is conferred before death under one of the three mechanisms described in the text, as Section 2038(a) does still apply where the decedent sets the machinery in motion that purposefully allows powers to be returned to the donor. 41 Section 2036(a)(2) should not cause gross estate inclusion using the three techniques described in the text, as that section does not apply unless the donor retained (as opposed to merely possessed at death) the taxable power. Cf. Reg (a) ( [I]t is immaterial... from what source the decedent acquires his power ) with Reg (requiring that a power be retained or reserved in order for Section 2036(a) to apply); see also White v. Poor, supra note 35 (holding that the predecessor to Section 2038(a)(2) did not apply to a power possessed at death if the power was not reserved at the time of the transfer). In addition, if the power can be exercised only at death, Section 2036(a)(2) would not apply for an additional reason, namely, that that section does not apply to powers that cannot affect the enjoyment of income during lifetime. Reg (b)(3). 42 Reg (b); Rev. Rul , CB Reg (a); Helvering v. City Bank Farmers Trust Co., 296 U.S. 85, 16 AFTR 981 (1935); Rev. Rul , CB 194. E S T A T E P L A N N I N G M A R C H V O L 4 4 / N O 3

7 9 Third-party power of appointment, exercisable in a manner that can give the donor a Section 2038(a) power. Second, a person other than the donor could be given a special power to appoint the property of the trust. This power could then be exercised in favor of a trust over which the donor has a power described in Section 2038(a), such as a special testamentary power of appointment. Power to confer a testamentary power of appointment. A third possibility is for an independent person, such an independent trustee, to be given a power to confer on the donor a testamentary power of appointment, which could be used to affect the beneficial enjoyment at death. If the donor, by any of these mechanisms, is given a Section 2038(a) power by the time of his or her death, the trust property can be pulled back into his gross estate, should that be desirable. 40 Suppose, on the other hand, that the donor dies without a Section 2038(a) power actually having been conferred. In principle, the trust property should escape gross estate inclusion. 41 The reason is straightforward: Even if a taxable power could have been conferred on the decedent, Section 2038(a) does not apply unless the power was possessed at death. 42 Thus, Section 2038(a) does not cause gross estate inclusion if the donor does not possess the power at the time of his or her death. If the foregoing reasoning is correct, then it is possible to make gifts that will escape gross estate inclusion if a Section 2038(a) power is not conferred before death, but will be pulled back into the donor s gross estate (should that be desirable) if a Section 2038(a) power is conferred. In other words, it appears that it is possible, using Section 2038(a), to toggle gross estate inclusion on. That said, the strategy is not entirely free from risk. If it turns out that gross estate inclusion is not desirable, and a Section 2038(a) power is not conferred at the time of the grantor s death, the IRS might still attempt to treat the decedent as possessing the power at death. The IRS might take the position that the power existed at death on at least two grounds, as discussed below. First, the IRS might argue that the decedent held the power in conjunction with another; second, the IRS might argue that the decedent held the power de facto. These possible challenges are discussed below. Powers held in conjunction with another. Section 2038(a)(1) triggers gross estate inclusion regardless of whether the decedent holds a taxable power alone or in conjunction with others. Example. A father transfers property in trust for the benefit of his daughter, but retains the power, with the daughter s consent, to revoke the trust at any time. Despite the fact that the father may not revoke the trust without the consent of his daughter, his power to revoke will cause the trust property to be included in his gross estate at death. That the daughter has an interest in vetoing revocation does not matter: A power is considered exercisable in conjunction with another person regardless of whether that other person has an interest adverse to the exercise of the power. 43 The principle that a decedent is considered to possess a power at death under Section 2038(a)(1), even if the power is exercisable in conjunction with another, could M A R C H V O L 4 4 / N O 3 T O G G L I N G I N C L U S I O N

8 10 frustrate the use of a conferrable power to achieve gross estate inclusion toggling. Example. A father makes a gift of $5 million worth of XYZ Corp shares to an irrevocable trust for his descendants. Although the father does not retain any powers that trigger gross estate inclusion, the terms of the trust permit the trustee to resign and appoint the father as successor trustee, just in case the value of the shares declines and gross estate inclusion becomes desirable. In this manner, it is hoped, the father can have the shares pulled back into his gross estate, should they decline in value, by asking the trustee to appoint him as co-trustee. Suppose, however, that the shares of XYZ Corp do not decline but quadruple in value. The father now wants to be sure that the shares will not be included in his gross estate. It may seem that, unless the father is actually appointed as a cotrustee, he will not be considered to possess a Section 2038(a) power at death. But the IRS could, perhaps, see it differently. After all, the only thing standing in the way of the father having the power to affect the beneficial enjoyment of the trust property is the trustee resigning and appointing the father as successor trustee. If the trustee actually does resign and appoint the father as successor, then the father would clearly possess a Section 2038(a)(1) power. But even if the father is not formally appointed, the IRS could argue that he effectively already has the power, in conjunction with the initial trustee, to affect beneficial enjoyment of trust property. That is, with the cooperation of the trustee, the father can arrange to be appointed as trustee and thereby affect the beneficial enjoyment of the trust property. In short, the IRS could argue that the father has a Section 2038(a)(1) power merely by virtue of the trustee s ability to appoint the father as trustee. The IRS s possible appeal to the conjunction principle conflicts with another, equally well-established principle of Section 2038(a): namely, that that the section does not cause gross estate inclusion if the decedent s power to affect beneficial enjoyment was subject to a contingency beyond the donor s control. 44 For example, if a father transfers property irrevocably in trust, and appoints himself as successor trustee (with distribution powers) after the death of the initial trustee, Section 2038(a) will not cause gross estate inclusion if the father predeceases the initial trustee. 45 By the same token, if the donor cannot acquire a Section 2038(a) power unless the power is conferred on the donor by another, it seems that gross estate inclusion will not be triggered unless the power is actually conferred. Indeed, it appears that a longstanding ruling, Rev , 46 compels the IRS to view another person s ability to confer a taxable power on the donor as a contingency that defeats application of Section 2038(a)(1). 47 That ruling considered two situations. In the first, the donor retained the right to remove the trustee and appoint the donor as successor trustee; in the second, the donor could appoint himself as trustee only if the initial trustee resigned or was disqualified to act. The IRS ruled that Section 2038(a) caused gross estate inclusion only in the first situation but not in the second, unless at the time of the donor s death the initial trustee s resignation or disqualification had actually occurred. Importantly, in the second situation, the IRS did not view the donor as having possessed a Section 2038(a) power in conjunction with the trustee. On the contrary, the IRS viewed the possible resignation of the initial trustee 44 Reg (b). 45 Id. 46 Note 42, supra. 47 Revenue rulings are generally binding on the Treasury Department. Rauenhorst, 119 TC 157 (2002) (treating a revenue ruling as a concession by Commissioner); Van Alen, TCM Although Tully did not cite the case, Byrum, 408 U.S. 125, 30 AFTR2d (1972), further supports the holding of Tully. In Byrum, a case decided under Section 2036(a)(2), the court rejected the IRS argument that the decedent, through a retained power to vote shares of stock transferred to an irrevocable trust, retained a right to determine the individuals who shall enjoy the income from the stock. The term right, Byrum reasoned, must be construed to mean a legally enforceable power. A decedent who had to ask another person to confer a Section 2038(a) power does not have a legally enforceable power under the Byrum court s construction. 49 Cf. Byrum, supra note 48 ( The term right... connotes an ascertainable and legally enforceable power ). 50 In Rev. Rul , CB 193, the decedent transferred shares to a custodian for his children under the Uniform Gifts to Minors Act. Although the decedent was not initially appointed as custodian, the decedent was appointed as successor custodian by the time of his death after the initial custodian resigned. The IRS ruled that because the decedent was the transferor and died holding these shares as successor custodian for such minor children, the shares were included in the decedent s gross estate under Section 2038(a)(1). The basis of the ruling s holding, in other words, was that the decedent actually held the powers of a custodian at death. The mere fact that the decedent could have been appointed as custodian would not appear to have been sufficient to cause gross estate inclusion, without an actual appointment. 51 Cf. Byrum, supra note 48 ( The term right... connotes an ascertainable and legally enforceable power ) CB Estate of Wall, 101 TC 300 (1993); see also Estate of Vak, 973 F.2d 1409, 70 AFTR2d (CA-8, 1992), rev g TCM Rev. Rul , CB Unfortunately, the ruling s holding refers only to discretionary powers over income, but not principal. It seems, however, that the rationale for the ruling, which was to create a safe harbor in light of IRS losses in Estate of Wall, supra note 53, and other cases, would apply with equal force to discretionary powers over principal. 56 Section 672(c), an income tax section, defines the term related or subordinate party for purposes of Subpart E of Part I of Subchapter J of chapter 1 of the Code. 57 Note 53, supra. E S T A T E P L A N N I N G M A R C H V O L 4 4 / N O 3

9 11 as a contingency the nonoccurrence of which prevented Section 2038(a) from applying. Even if not foreclosed by Rev. Rul , any IRS argument that the decedent effectively possessed a Section 2038(a) power at death by virtue of another person s ability to confer such a taxable power would still be likely to fail. The reason is that Section 2038(a) applies to enforceable powers but not to mere powers of persuasion. In the foundational case of Estate of Tully, for example, the decedent owned half the shares of a corporation that had an agreement with the two shareholders, including the decedent, to pay a death benefit to the widow of a deceased shareholder. The IRS argued that the decedent held a Section 2038(a)(1) power at the time of his death by virtue of his ability, in conjunction with the other shareholder, to modify the death benefit. Rejecting that argument, the court in Tully held instead that the decedent did not possess a power within the meaning of Section 2038(a). 48 The court began by noting that the decedent did not expressly reserve the right to change the death benefit under any agreement under which the death benefit was created. Given the absence of an express reservation, reasoned the court, all that the decedent possessed at death was the possibility of persuading his fellow shareholder to modify the agreement and change the death benefit. But the term power, the court held, does not extend to powers of persuasion or to mere speculative powers. 49 The decedent s ability to coax his co-shareholder into changing the death benefit did not, Tully holds, rise to the level of a taxable power. 50 Where a donor gives another person the right to confer a Section 2038(a) power on the donor, and the power is not actually conferred, then the donor dies without a legally enforceable power to compel that other person to confer the taxable power. 51 The donor can, of course, attempt to remonstrate with the other person and ask that the taxable power be conferred. Under Tully, however, a mere power of persuasion is not a taxable power within the meaning of Section 2038(a). It seems, therefore, that where a donor gives another person the right to confer a Section 2038(a) power on the donor, but the power is not actually conferred, the donor will not be deemed to hold a taxable power at death. It seems, a mere power to request that the trustee resign would not cause the trustee s powers to be imputed to the grantor. De facto power. A second argument that the IRS could make in order to frustrate the use of Section 2038(a) to toggle on gross estate inclusion is that, even if an enforceable Section 2038(a) power is not actually conferred on the grantor, the grantor should in substance still be deemed to possess such a power at death. Example. Suppose, once again, that the father makes a gift of $5 million worth of XYZ Corp shares to an irrevocable trust for his descendants, and the terms of the trust permit the trustee to resign and appoint the father as successor trustee. Suppose, further, that the trustee, a close friend and business associate of the father, would, as a practical matter, always resign and appoint the father as successor trustee at the father s request. As things turn out, the XYZ Corp shares increase in value by the time of the father s death, and the trustee never resigns or appoints the father as trustee. Nevertheless, at the father s death, the IRS argues that the shares should be included in the father s gross estate, on the theory that the trustee, as a practical matter, would have resigned and appointed the father as successor at the father s request. Therefore, the IRS argues, the trustee s powers should be imputed to the father for tax purposes. At first, it might seem that the IRS s de facto powers theory has little chance of success. In Rev. Rul , 52 the IRS, after a series of court losses, 53 revoked prior rulings 54 that had held that a decedent s retained power to remove and replace a corporate trustee was equivalent to the decedent holding the trustee s discretionary distribution powers. Rev. Rul holds instead that a trustee s discretionary power over income 55 will not be imputed to the decedent, even if the decedent retained a power to remove and replace the trustee, so long as the decedent could not appoint a replacement trustee who was not related or subordinate to the decedent within the meaning of Section 672(c). 56 In the foregoing hypothetical, the father retains no power even to remove the trustee. Instead, all he can do is ask the trustee to resign and appoint him as successor trustee. But even an enforceable power to remove and replace the trustee will not, under Rev. Rul , cause the trustee s powers to be imputed to the grantor. A fortiori, it seems, a mere power to request that the trustee resign would not cause the trustee s powers to be imputed to the grantor. Court decisions. The Tax Court s opinion in Estate of Wall 57 likewise makes it unlikely that the IRS would successfully be able to M A R C H V O L 4 4 / N O 3 T O G G L I N G I N C L U S I O N

10 12 impute a trustee s powers to the decedent. In Wall, the decedent retained the power to remove and replace the corporate trustee of discretionary trusts that she had created for her daughter and granddaughters. The IRS, advancing a position that Rev. Rul later disavowed, 58 argued that retaining the power to remove and replace the corporate trustee was equivalent to retaining the trustee s powers directly. The Tax Court held on the contrary that Sections 2036(a)(2) and 2038(a) apply only where the decedent held an ascertainable and legally enforceable power, as the Supreme Court put it in Byrum. 59 A decedent does not retain a legally enforceable power of any kind, not even to replace the trustee, where the decedent s acquisition of a Section 2038(a) power depends entirely on the actions of another. Under Wall, therefore, it seems unlikely the IRS could successfully impute a taxable power to the decedent merely because such a power could be conferred on the decedent by a third party. That said, the de facto powers theory may be not as moribund as it might otherwise appear, in light of Rev. Rul and Estate of Wall. 60 For one thing, even in Wall, the court stated that the IRS had failed to provide any compelling reason to infer a fraudulent side agreement between the donor and the trustee. The court did not specify, exactly, how the existence of such an agreement might have affected the outcome. After all, given the court s holding that a legally enforceable power is required for Section 2038 to apply, the existence or nonexistence of a legally unenforceable side understanding or agreement would seem to be irrelevant. Nevertheless, the negative inference of the court s comment is that evidence of an agreement or understanding as to the potential granting of a legally enforceable power may be sufficient to impute the power to the grantor. Second, Estate of Beckwith, 61 apparently remains good law. In Beckwith, the court held that the decedent had not retained a right described in Section 2036(a)(2). (Beckwith did not address Section 2038(a); nevertheless, given the extensive overlap of the two sections, Beckwith s reasoning would apparently apply with equal force to Section 2038(a). 62 ) In so holding, however, the court took for granted that the application of Section 2036(a)(2) does not depend[] upon the express reservation of a legally enforceable right, but rather may apply based on a prearrangement, or at least an informal agreement or understanding, under which the right is retained. Beckwith declined to find that such an agreement existed under the facts of the case. Had such an agreement or understanding been found to exist, however, then section 2036(a)(2) would, under the principles adopted by Beckwith, have caused gross estate inclusion. Finally, recent cases have, perhaps, breathed new life into the de facto powers theory. In S.E.C. v. Wyly, 63 for example, the court held that the grantors of off-shore trusts, even though they did not retain any formal powers over trust decisions, nevertheless, for tax purposes, held the de facto power to veto discretionary distribution powers described in Section 674(a). The Wyly court rejected prior cases 64 that had held, following Byrum, that a legally enforceable right is required in order for a grantor to be considered to have the power to participate in or veto distribution decisions. Similarly, in Webber, 65 the court held that the taxpayer, even though he had no legal right to choose investments made through a trustowned private placement life insurance policy, nevertheless effectively controlled the investment decisions in substance. Neither Wyly nor Webber involved Section 2038(a), or estate and gift tax provisions more generally. Nevertheless, they demonstrate that courts 58 Note 54, supra. 59 Note 48, supra. 60 Reg (c) provides that, in the case of a transfer made before 6/23/1936, a power will be considered retained or reserved if there an understanding, express or implied that a power would later be created or conferred. To date, it does not appear that the IRS has sought to import the notion of an implied understanding to powers over property transferred on or after 6/23/1936. If that notion were so incorporated, then perhaps a grantor could be considered to hold a taxable Section 2038(a) power de facto, whether or not the alleged power is legally unenforceable TC 242 (1970). 62 See, e.g., Estate of Wall, supra note F.Supp.3d 394 (DC N.Y., 2014). 64 Goodwyn, TCM TC 324 (2015). 66 For further discussion of the significance of Wyly and Webber in estate planning, see Keenen and Zeydel, Is Designating an Independent Trustee a Tax Panacea?, 43 ETPL 3 (February 2016). 67 Reg (b). 68 The ETIP rule of Section 2642(f) should not apply, as the rule applies only if the transferred property would be included in the grantor s gross estate immediately after the transfer. If a section 2038 power is ultimately conferred and the transferred property is pulled back into the gross estate, no additional allocation of GST exemption would be required to achieve a zero inclusion ratio. Reg (a)(3) ( If the value of property held in a trust created by the transferor, with respect to which an allocation was made at a time that the trust was not subject to an ETIP, is included in the transferor s gross estate, the applicable fraction is redetermined if additional GST exemption is allocated to the property... If additional GST exemption is not allocated to the trust, then, except as provided in this paragraph (a)(3), the applicable fraction immediately before death is not changed, if the trust was not subject to an ETIP at the time GST exemption was allocated to the trust. ) Of course, if property has declined in value, GST exemption will have gone to waste, but that is the same result that obtains regardless of whether property is pulled back into the gross estate. 69 Actually, if gross estate inclusion is toggled on by having a Section 2038(a) power conferred on the grantor, it may still be possible, as discussed earlier in the text, to prevent gross estate inclusion, even if the grantor dies within three years, if a third party effectively expunges the grantor s Section 2038(a) taxable powers before death. E S T A T E P L A N N I N G M A R C H V O L 4 4 / N O 3