FEDERAL TAXES ON GRATUITOUS TRANSFERS

ASPEN CASEBOOK SERIES FEDERAL TAXES ON GRATUITOUS TRANSFERS LAW AND PLANNING JOSEPH M. DODGE Steams Weaver Miller Weissler Alhadeff & Sitterson Professor of Law Florida State University College of Law WENDY C. GERZOG Professor University of Baltimore School of Law BRIDGET J. CRAWFORD Professor Pace Law School Wolters Kluwer Law & Business

SUMMARY OF CONTENTS Contents Preface 1. Setting the Stage: The Basics of Gratuitous Transfers 2. Overview of the Federal Transfer Taxes 3. Gift Tax Basics 4. The Basic Estate ; 5. Nonprobate Transfers 6. Marital Transfers 7. Long-Term Trusts 8. Gifts with Retained Interests and Powers 9. Advanced Valuation Issues Table of Cases Table of Statutes Table of Regulations Table of Revenue Rulings and Revenue Procs. Table of Private Letter Rulings and Technical Advice Memoranda Revenue Ruling 59-60 Index xi xxi 1 31 61 141 199 263 313 369. 473 513 525 535 539 543 545 553 IX

CONTENTS Preface. xxi ]T] SETTING THE STAGE: THE BASICS OF GRATUITOUS TRANSFERS 1 11.1. Review of Property Concepts 1 A. History of Law of Gratuitous Transfers 1 B. Glossary of Terms 5 11.2. Review of Basic Income Tax Concepts Relating to Gratuitous Transfers 16 A. Gratuitous Receipts 16 1. Income Exclusions. 16 2. Nondeductibility of Gifts ' 16 3. Basis of Transferee 17 B. Post-Transfer Income: Trusts and Beneficiaries 18 C. The Estate as an Income Tax Entity 19 11.3. Looking at the Big Picture 21 A. Relation of the Transfer Taxes to the Income Tax 21 B. Typology of Wealth (Transfer) Taxes 22 C. Should the Federal Transfer Taxes Be Retained? 23 Gerald Jantscher, Aims Of Death Taxation / 23 OVERVIEW OF THE FEDERAL TRANSFER TAXES 31 $2.1. Prelude 31 $2.2. The Federal Estate Tax, 32 A. Net Estate Subject to Tax 32 B. Rates and Exemptions 32 C. Augmented Gross Estate 33 2.3. The Federal Gift Tax 35 A. What is a "Gift" Under the Gift Tax? 35 B. Incomplete Gifts 36 C. The Annual Exclusion 36 D. Gift Tax Computation 36 $2.4. Husband and Wife: The Gift and Estate Tax Marital Deductions 39 A. Husband and Wife as Separate Taxpayers 39 XI

xii Contents B. Tax Advantages of Owning Community Property 39 C. The Gift-Splitting Election 40 D. The Marital Deduction 40 1. The Original Version 40 2. The Current Unlimited Marital Deduction 40 $2.5. Relation of Estate and Gift Taxes 41 A. Unification of Estate and Gift Taxes 42 B. Transfers Subject to Both Gift and Estate Tax 43 C. Pros and Cons of Gifts 45 1. Gifts in Excess of the Reduced Gift Tax Exemption 45 2. The Taxability of the Gift Tax Paid 46 3. The Bracket Effect 47 4. The Gift Tax Exclusions 47 5. Support Obligations 48 12.6. Overlapping Transfer Tax Jurisdictions 49 A. State Death Taxes 49 1. The Credit for State Death Taxes 49 2. Transition to a Deduction System 50 B. Credit for Foreign Death Taxes 50 $2.7. Credit for Prior Estate Transfers 50 $2.8. The Federal Generation-Skipping Transfer Tax 52 $2.9. The 2001 and the 2010 Acts 55 A. Repeal of Estate and GST Taxes 56 B. The 2002-2009 Transition Period, 56 C. Partial Repeal of Stepped-Up Basis 56 D. Deferred Sunset of the 2001 Act 57 GIFT TAX BASICS 6i $3.1. Transfers Subject to Gift Tax 61 A. Transfer of Wealth for Insufficient Consideration 62 1. Meaning of "Money's Worth" 62 2. Transfers for Partial Consideration 63 3. Below-Market Term Loans 64 4. Sham Loans 66 Revenue Ruling 77-299 67 5. Below-Market Demand Loans 68 B. Non-Gift Wealth Transfers 73 1. Personal Consumption and Economic Waste 73 2. Political Contributions 74 3. Transfers Mandated by Law 75 4. Divorce-Related Transfers 77 5. Paying for Education and Medical Care 78 P.L.R. 200602002 79

Contents xiii 3.2. Identifying the Donor 81 A. Transfers by Entities and Fiduciaries 82 B. Indirect Transfers 82 Revenue Ruling 76490 83 C. Constructive Transfers 85 1. Allowing Another to Dispose of One's Property 85 2. Refusing to Accept a Gratuitous Transfer 87 Commissioner v. Estate of Vease 90 13.3. When Does a Gift Occur? 95 A. Completion of Gift ' ' 95 1. What Is an Incomplete Transfer? 95 2. Completion of Incomplete Transfers 98 3. Jointly-Held Powers 99 B. Binding Agreement to Make Future Transfers 102 Estate ofdimarco v. Commissioner 104 3.4. Valuation of Gifts ' 109 A. The Willing-Buyer Willing-Seller Test 110 B. Can the Gift Itself Affect Its Value? 112 Revenue Ruling 93-12 112 C. Actuarial Tables 114 1. Construction and Use of the Tables.114 2. Retained-Interest Gifts 116 D. Defined-Value Clauses 117 13.5. The Annual Exclusion 122 A. General Outline of the Annual Exclusion 122 B. Exclusion for Present-Interest Gifts Under 25O3(b) 123 Maryland Nat'l Bank v. United States 125 C. Gifts to Minors 129 D. Crummey Trusts 131 THE BASIC ESTATE HI $4.1. Property Passing by Will or Intestacy 142 A. What Is "Property" of the Decedent Under 2033? 142 B. Interests that Expire by Reason of the Decedent's Death 146 C. Interests that Spring into Existence at the Decedent's Death 147 D. Amounts Payable to the Decedent's Estate 148 E. Property Owned by Another 150 F. The Role of State Law in Tax Disputes 152 $4.2. Negative Assets: The Deductions Under $$2053, 2054, and 2058 157 A. Overview 157 B. Claims Against the Decedent Arising Before Death 158 1. Estate Tax Treatment 158 2. Income Tax Treatment 160 3. The $691(c) Income Tax Deduction 162

xiv Contents C. Claims Against the Estate (Other than Death Taxes) Arising After Death 162 D. Death Taxes 164 4.3. Income Taxation of Estates 167 $4.4. Estate Tax Valuation 172 A. Estate Tax Valuation Date 173 B. Additional Valuation Rules 174 C. Special Statutory Valuation Rules 176 1. Special Valuation Real Estate 176 2. Qualified Conservation Easements 177 D. The Effect of the Decedent's Death on Valuation 182 Estate of McClatchy v. Commissioner 182 E. Buy-Sell Agreements 187 Holman v. Commissioner 189 4.5. Estate Tax Procedure 196 A. Returns 196 B. Payment 197 C. Burden of the Estate Tax 197 { ] NONPROBATE TRANSFERS. 199 $5.1. Revocable Trusts 199 15.2. Jointly-Held Property 202 A. Effect of State Law 202 B. Gift Tax Treatment of the Creation and Termination of Joint Tenancies 203 1. Creation of Joint-Ownership Property 204 2. Creation of Joint Bank and Brokerage Accounts 205 3. Termination of Joint Ownership During life - 205 C. Estate Tax Treatment of Joint-Ownership Arrangements 206 1. Non-Spousal Joint Tenancies 207 2. Spousal Joint Tenancies 209 3. Joint Tenancies Created by Third Parties 209 4. Valuation of Included Portion 209 5. Income Tax Basis 210 D. Avoiding J2040 210 1. Surrender Within Three Years of Death 210 2. Terminations and Transfers to Avoid 2040(a) 210 15.3. Commercial Annuities 213 A. Nature and Function of Commercial Annuities 213 B. Gift Tax Treatment of Commercial Annuities 214 C. Estate Tax Treatment of Commercial Annuities 214 D. Annuity-Insurance Combinations 216 Estate of Montgomery v. Commissioner 216 E. Valuation of Lottery Payments Included Under $2039 217

Contents xv 5.4. Survivor Benefits Under Employee Plans 220 A. Characteristics and Income Tax Treatment of Employee Plans and Survivor Benefits 220 1. Qualified Plans 221 2. Individual Retirement Accounts 222 3. Nonqualified Plans 223 4. Income Tax Treatment of Survivor Benefits 223 B. Estate Tax Treatment of Survivor Benefits 224 1. Survivor Benefits Under 2039 224 Estate of Bahen v. United States 224 2. Survivor Benefits Outside of 2039' 228 3. Effect of Community Property Laws 229 4. Gift Tax Treatment of Employee Survivor Benefits 229 5. Statutory Survivor Benefits 230 5.5. Life Insurance 231 A. Nature of Life Insurance^ 232 1. Economics of Life Insurance 232 2. Distinguishing Life Insurance from Other Survivor Benefits 233 3. Income Tax Treatment of Life Insurance 234 B. Nontax Uses of Life Insurance 235 1. Revocable Insurance Trusts 235 2. Using Life Insurance to Pay Estate Obligations 236 C. Section 2042(2) 239 1. Possible Approaches 239 2. History of 2042(2) 240 3. Meaning of "Incidents of Ownership" 241 Estate of Skifter v. Commissioner 241 D. Avoiding Incidents of Ownership 249 1. Gift Tax Treatment 249 2. Mechanics of Gifts of Life Insurance 250 Commissioner v. Estate of Noel " 250 3. Irrevocable Life Insurance Trusts 251 4. Transfers Within Three Years of Death 252 5. Taking Out Insurance on Another's Life 252 E. Effect of Premium Payments 256 1. Payment by the Insured on a Policy Owned by Another 256 Estate of Leder v. Commissioner 256 2. Can the Payment of Premiums Be a "Transfer" of the Proceeds Outside of 2035? 258 3. Effect of Premium Payments by the Non-Insured Owner 259 MARITAL TRANSFERS 263 5.1. Purpose and Effect of the Marital Deduction 263 A. Background 263 B. Qualification Requirements 265

xvi Contents 1. The "Passing" and "Taxable Transfer" Requirements 266 2. The Terminable Interest Rule 267 3. The PAT and QTIP Trust "Income" Requirement 273 4. Gift Tax Treatment of Transfers of Interests in PATs and QTIP Trusts 277 C. The Amount Deductible 280 6.2. Marital Deduction Planning 287 A. Aims of Marital Deduction Planning 287 1. Why Marital Deduction Planning Is Mostly a "Tax Game" "" 287 2. Exemption Amounts and the Two-Track Estate Plan 288 3. Allocating Values Between Marital and Non-Marital Transfers 291 4. Shifting Post-Death Wealth to the By-Pass Trust 293 B. Post-Mortem Adjustments 294 C. Generation-Skipping Tax Planning Involving Spouses 294 16.3. Drafting the Marital Deduction Transfer 296 A. Formula Clauses 297 1. The Problem of Coordination 297 2. Types of Formula Clauses ' 298 B. Pecuniary, Fractional-Share, and Hybrid Formula Transfers 302 1. Pecuniary Formula 302 2. Fractional-Share Formula Transfer 303 3. Hybrid Formula Clause 305 Revenue Procedure 64-19 305 C. Funding Marital Deduction Transfers 306 LONG-TERM TRUSTS 313 7.1. Powers i of Appointment 313 A. Nontax Definition and Role of Powers of Appointment 313 B. Powers of Appointment Under 2033 315 C. Powers of Appointment Under 2041 and 2514 317 1. Transfer Tax Meaning of Power of Appointment 317 2. Estate and Gift Tax Consequences of General Powers of Appointment 317 3. Transfer Tax Definition of "General Power of Appointment" 318 Revenue Ruling 7/ 7-60 319 Revenue Ruling 76-368 321 4. Jointly-Held Powers 322 Revenue Ruling 79-63 323 D. Effect of Action or Inaction by the Donee of a General Power 326 1. "Possession" of a General Power 326

Contents xvii 2. Exercise or Release of General Power 327 3. Lapse of General Power 328 7.2. Income Tax Effects of Possessing an Inter Vivos General Power 333 7.3. Tax Consequences of Exercising a Special Power of Appointment 3 34 A. Exercise of Special Power as Gift 335 Estate of Regester v. Commissioner 335 B. The "Delaware Tax T.rap" 337 7.4. Giving Content to the Generation-Skipping Transfer Tax 339 A. Review of Major GST Tax Features 339 B. Additional Rules for Identifying Generation-Skipping Transfers 341 1. Effective Date of the Tax 341 2. Effect of Reverse QTIP Election on the Identity of the Transferor 342 3. Marital and Charitablt Transfers 342 4. Special Rules Concerning Beneficiary Status 343 C. Rules Relating to the Amount of a Generation-Skipping Transfer 345 1. Exclusions 346 2. Valuation 348 3. Transmission Costs 348 4. Effect of the GST Tax on the GST Tax Base (and the Gift Tax Base) 348 D. Implications of Tax Base Rules for Planning 349 E. Effect of the Exemption Amount on Planning 351 1. Operation of the Exemption Amount 351 2. Effect of the Estate Tax on the Exemption Amount 351 3. Leveraging the Exemption 352 4. Allocating the GST Tax Exemption 353 5. Estate-Includible Completed Gift Transfers 354 6. Effect of Having Two or More Transferors ' 3 54 F. Powers of Appointment and the GST 355 1. Giving a General Testamentary Power of Appointment to Beneficiaries 355 2. Effect of the Exercise of a Special Power of Appointment 355 F. Basis Adjustments 356 G. Postscript: The Perversion of the Concept of a GST Tax: How the Present Tax Encourages the Making of Generation-Skipping Transfers 357 7.5. Income Taxation of Subchapter J Trusts and Their Beneficiaries 360 A. Overview 360 B. Trust Net Income 361 C. How Trust Income Is Shifted to Beneficiaries 361 D. Allocation of Income Among Beneficiaries 363 E. The Conduit Principle 365

xviii Contents =013 GIFTS WITH RETAINED INTERESTS AND POWERS 5.1. Estate Tax f 2036-2038 A. Overview 1. Brief History of 2036-2038 2. Elements Required for Inclusion Under 2036-2038 B. The Interests and Powers that Trigger 2036-2038 1. Prototypical Situations 2. Holding the String at Death 3. Assigning or Releasing the String Within Three Years of Death United States v. Allen 4. Contingent Interests and Powers 5. Relations Among 2036-2038 C. The Neutering of the Concept of a Taxable Retained Power 1. Jointly-Held Powers 2. The Helmholz Doctrine 3. Vicarious Powers Estate of Wall v. Commissioner 4. Powers of Independent Significance Estate of Tully v. United States 5. Administrative Powers Old Colony Trust Co. v. United States 6. The Power to Control Business-Entity Distributions 7. Dispositive Powers Limited by Standards United States v. Powell D. The "Retention" of an "Interest" (or Power) Under 2036 and 2037 1. Meaning of "Retention" in Connection with Outright Transfers Estate oflinderme v. Commissioner ' 2. Retention in Trusts for the Benefit of the Settlor Commissioner v. Irving Trust Company Estate of Skinner v. United States 3. Indirect Retention by a Settlor Through the Rights of the Settlor's Creditors Outwin v. Commissioner, 4. Retaining an Interest Vicariously: Trusts for the Support of the Settlor's Dependents Estate of Chrysler v. Commissioner 5. Transfers to a Trust Created by Another United States v. Estate of Grace 6. Effect of Interest Retained on the Amount Includible 7. Can Inter Vivos Transfers Avoid Both Gift and Estate Tax? 369 369 370 370 372 372 372 375 376 376 378 379 384 384 385 386 387 388 389 390 391 392 394 394 400 400 400 402 402 404 406 406 408 409 411 411 414 414

Contents xix E. The Requirement that the Retained Interest (or Power) Be "in" the Property Transferred 421 1. Segregation into Separate Funds 421 Fidelity-Philadelphia Trust Co. v. Smith 421 2. Private Annuities 423 Fabric v. Commissioner 423 F. The Requirement of a Transfer for Less than Full Consideration * 430 1. Inter Vivos Transfer by the Decedent 430 2. Transfers for Consideration in Money or Money's Worth 434 United States v. Righter 436 Estate of D'Ambrosio v. Commissioner 438 8.2. Section 2702 and Its Impact on Retained-Interest Gifts 446 A. Section 2702 446 1. Basic Operating Rule 446 2. Why 2702 Was Enacted 447 3. Prerequisites for Applying 2702 447 4. Explicit Exceptions to 2702 448 B. GST Tax Treatment of Retained-Interest Transfers 449 C. Applying the Adjusted Taxable Gift Exclusion 449 8.3. Split-Interest Charitable Transfers 454 A. Background 454 B. General Qualification Rules 456 C. Charitable Remainder Trusts 457 1. The Charitable Remainder Annuity Trust (CRAT) 457 2. The Charitable Remainder Unitrust (CRUT) 458 3. The Pooled Income Fund 459 4. GST Tax Issues 459 5. Income Taxation of the Charitable Remainder Trust 459 6. Direct Charitable Annuities 460 D. Charitable Lead Trusts 460 1. Qualification 460 2. Estate and Gift Tax Deduction 460 3. Generation-Skipping Tax Treatment 461 4. Income Tax Treatment 461 E. Non-Trust Partial Interests 461 8.4. Income Tax Treatment of Transfers with Retained Interests and Powers 466 8.5. How Should Transfers with Retained Interests and Powers Be Treated Under the Transfer and Income Taxes? 469 A. Revocable Transfers 469 B. Transfers with Retained Reversions 469 C. Transfers with Retained Income Interests 470 D. Retained-Power Transfers 472 E. Income Tax Rules 472

xx Contents p] ADVANCED VALUATION ISSUES 473 $9.1. The Byrum Case 473 9.2. Section 2701 and Entity Estate Freeze Transactions 477 A. Status of Entity Estate Freezes Under 2036(a) 478 Estate ofboykin v. Commissioner 478 B. Entity Estate Freezes Under 2701 480 $9.3. Family Limited Partnerships 484 A. Use offlps (and Other Entities) to Obtain Valuation Discounts 484 Estate of Kelley v. Commissioner 485 B. Status of FLPs Under 2036(a) 488 C. The Bona Fide Sale Exception Under 2036(a) 490 Estate of Thompson v. Commissioner 490 Estate of Bongard v. Commissioner 493 D. Indirect Gifts of FLP Assets and the Step-Transaction Doctrine 500 9.4. Section 2704: Voting and Liquidation Rights and Restrictions 506 A. Section 2704(a): Lapsing Redemption and Voting Rights 506 B. Section 2704(b): Transfers Subject to Restrictions on Liquidating the Entity 509 Kerr v. Commissioner 510 Table of Cases 513 Table of Statutes 525 Table of Regulations 535 Table of Revenue Rulings and Revenue Procs. 539 Table of Private Letter Rulings and Technical Advice Memoranda 543 Revenue Ruling 59-60 545 Index 553