ACTEC 2006 Summer Meeting Musings
1. Estate Tax Reform Legislative Developments
2. Drafting Technique: Refer Often to Settlor’s Intent
3. Deduction For Domestic Production Activities
4. Planning With Large IRAs to Fund Bequests Under the Will
5. Grantor Trust Triggers-Power to Add Beneficiaries
6. Buy Sell Agreements Fixing Estate Tax Value; Estate of Amlie, T.C. Memo 2006-76
7. Huber T.C. Memo 2006-96; Gift Tax Case
8. Rosen; Judge Laro’s Latest Exposition On FLPs, T.C. Memo 206-115
9. Sale to Grantor Trusts
10. Section 6166 Trade or Business Requirement For Real Estate; Rev. Rul. 2006-34
11. 9100 Relief For Late GST Exemption Allocations; New IRS Policy If A Partnership or Huge Appreciation Is Involved
12. Patenting Estate Planning Techniques
This is a summary of observations from the ACTEC 2006 Summer Meeting held in Los Angeles on July 6-9, 2006.
1. ESTATE TAX REFORM LEGISLATIVE DEVELOPMENTS.
A. Thomas Bill.
The uncertainty about what the House of Representatives would do in the event that the Senate could reach a compromise was dramatically changed by the very surprising compromise proposal introduced by Representative Bill Thomas, Chairman of the House Ways and Means Committee, on June 19, 2006, and that was passed by the House on June 22 by a vote of 269-156. The bill retains the estate tax with a $5 million exemption (indexed for inflation) and lower rates. A Joint Committee on Taxation Report estimates that the ten-year cost of the bill will exceed $283 billion. The following is an overview of the general provisions of H.R. 5638, the “Permanent Estate Tax Relief Act of 2006:”
(1) Permanent estate tax relief. The estate tax would not revert to 2001 law beginning in 2011.
(2) Increased and unified estate, gift, and generation-skipping transfer tax exemption. The exemption would be $5 million for all three taxes, indexed for inflation by rounding up to the nearest $100,000 increment. (The indexing provision was added at the last minute before the House vote.) There would no longer (after 2009) be the scenario of an estate and GST exemption that is much larger than the current $1 million gift exemption.
(3) Lower rates. The rates would be the long term capital gains rate (15% in 2010 and 20% thereafter under current law) on the first $25 million of cumulative transfers and two times the long term capital gains rate on cumulative transfers above $25 million. (There is a good example in the Technical Explanation of the bill describing how the mechanical calculations will work where there have been prior gifts.)
(4) Portability between spouses of unused exemption amount. The act “would simplify estate planning” by allowing any unused exemption amount at the death of the first spouse to be used by the surviving spouse (in addition to his or her own exemption). The aggregate amount of unused exemption amounts that can be used by a surviving spouse from all predeceased spouses cannot exceed $5 million. (Many clients will want to continue using bypass trusts planning so that future income and appreciation in the bypass trust will also be excluded from the taxable estate at the second spouse’s death and so that they can take advantage of the asset protection features of a typical spendthrift trust. However, couples with combined assets well under $10 million may decide to forego bypass trust planning under this proposal.) The carryover amount can be used by the surviving spouse for transfers made during lifetime or at death. The unused exemption is available to a surviving spouse only if an election is made on a timely filed estate tax return (including extensions) of the predeceased spouse (regardless of whether the predeceased spouse otherwise is required to file an estate tax return). The IRS can examine the return of a predeceased spouse for purpose of determining the amount of unused exemption available for the surviving spouse, notwithstanding the statute of limitations for assessing estate or gift tax with respect to the predeceased spouse.
(5) No federal estate tax deduction for state estate taxes. No federal credit or deduction will be allowed for state estate taxes. (For residents of states that have state estate taxes, this will generate a significant additional cost.)
(6) Stepped up basis. Stepped up basis will continue to apply.
(7) Effective date. The effective date of the above provisions is for transfers after 12-31-2009. (Therefore, substantial differences would continue between the gift exemption [fixed at $1 million] and the estate and GST exemptions from now to 2010.)
(8) New timber deduction. There is a new 60% deduction for qualified timber capital gains (effective for qualifying gains recognized from the date of enactment through 2008). (This income tax provision was reportedly added as a “sweetener” to garner some key votes for the bill, an Oregon Senator and the two Washington Senators.)
A press release from the House described the passage as follows:
“Today, the U.S. House of Representatives approved H.R. 5638, the Permanent Estate Tax Relief Act of 2006 with a vote of 269 – 156. This bill would give Americans permanency and certainty for their estate tax planning.
H.R. 5638 would permanently eliminate the estate tax for 99.7 percent of all Americans. Those who are still required to pay the estate tax would have much lower rates.
‘The House of Representatives has voted time after time in a bipartisan manner to fully repeal the estate tax,’ said Ways and Means Chairman Bill Thomas (R-CA). ‘So far, those efforts have died in the Senate. Today the House had a choice: make another political statement or approve a bill that can become law. The strong bipartisan support today shows this House is ready to make law.’”
Observations and Planning Implications .1. When Senator Kyl agreed to a 30% bracket for large estates, the Republican position over the last year insisting on a flat 15% rate was dead. It was then apparent that the rate is “in play” for negotiation.
2. The $25 million rate bracket break is not indexed for inflation.
3. The portability provision allows portability of the estate and gift tax exemption, but NOT the GST exemption.
4. The rate is tied to the capital gains rate, so it is not a “permanent” fix. The rate floats; indeed, the rate returns to 20% in 2011 unless the law is changed.
5. Portability Issues.
a. The portability provision will make planning simpler for many. But an estate tax return must be filed at the first spouse’s death to make the portability election on a timely filed return. There is no possibility of 9100 relief if the election is not filed timely. If the election is made, the statute of limitations stays open forever for purposes of determining the amount of the first deceased spouse’s unused exemption. (That would only be important if there are bequests to beneficiaries other than the surviving spouse or charities.)
b. If there is unused exemption at the first spouse’s death, making the election is almost always desirable. (The only downside is the cost of preparing the estate tax return for the deceased spouse.)
c. Using the portability provision rather than creating a bypass trust gives up removing future growth and income from the surviving spouse’s estate.
6. There would no longer be a flat tax. Equalization clauses may again become important to minimize the amount that would be subject to a doubled rate (for the portion of the estate over $25 million).
7. GST Planning. Planning in the past was to give children a general power of appointment over sufficient assets to minimize the overall estate and GST tax, in light of the fact that the GST tax rate is automatically at the highest estate tax rate. The importance of that approach has diminished over the last several years with the advent of a flat estate tax rate. That planning will become important again, if the highest rate is 30% vs. the lower 15% bracket (or 40% vs. 20% if the capital gains rate increases to 20%, as scheduled, in 2011).
8. State Disparities. There would be even greater differences in the future between coupled states (i.e., no state estate tax) and de-coupled states. The difference would be a 15% rate in coupled states compared to (15% federal +16% state), or a 31% combined rate in decoupled states. That’s more than double as much estate tax, depending on the state of domicile. Also, the greatly increased federal exemption makes it even more difficult to get back to unity among the states, which already have many different exemption amounts.
9. The bill is premised on providing certainty and the title refers to a “Permanent” estate tax change. Ron Aucutt is skeptical—he asks how permanent can it be when it is the “Permanent …Act of 2006.”
10. There is no possibility of Section 9100 relief if the portability election is not made on a timely filed return following the first spouse’s death. There seems to be no valid policy reason for that. Indeed, what is the policy of having to make an election at all? However, Representative Thomas has said that he is not willing to make ANY changes to this bill other than correcting clear mistakes. (For example, there is a technical mistake in the calculation provision and that change would be made.)
B. Senate Bill 3626; Democratic Response
1. Basic Provisions.
(1) Rate is flat 35%. (Observe, in 2011 that is less than the 40% top rate that would apply under the Thomas bill [if the capital gains tax rate increases as scheduled to 20% in 2011].)
(2) $5 million applicable exclusion amount for estate and GST purposes. The gift exemption would stay at $1 million.
(3) Phase out of the exemption for estates over $100 million, by 5% of the amount above $100 million, but not below zero. (So for a $200 million or larger estate, there would be no applicable exclusion amount.)
(4) The exemption amount is indexed for inflation at $10,000 increments (compared to $100,000 increments in the Thomas bill).
(5) The aggregate reduction in value under the §2032A special use valuation would be increased from $900,000 to $5 million, indexed for inflation.
(6) The QFOBI deduction under §2057 is increased from $675,000 to $2.5 million, which is not indexed for inflation. (Therefore, for §2032A and 2057 combined, there would be a maximum reduction of $7.5 million.)
(7) Stepped up basis would continue to apply.
(8) There is no provision for portability of exemptions.
(9) The deduction for state estate taxes under §2058 is preserved.
The Democratic Senate bill is more favorable for small businesses. It is ironic that the superrich are better under the Democrat bill than the Republican Thomas bill (largely because the 35% rate is lower than the top 40% rate under the Thomas bill).
c. Conclusion. Many think it is still unlikely that a compromise will be reached this summer. The alternative for permanent estate tax relief window is closing. With the anticipated loss of seats, Republicans are becoming more conciliatory and Democrats are becoming less conciliatory.
2. DRAFTING TECHNIQUE: REFER OFTEN TO SETTLOR’S INTENT.
One attorney said that he includes lots of expressions of intent. He uses these intent clauses “all the time” because he realizes how easy it is to make an inadvertent mistake in drafting no matter how careful we are—sometimes because of the inherent uncertainty surrounding some types of planning strategies. For example, in creating a non-grantor incomplete gift trust, say that the settlor intends that the trust is not a grantor trust and that transfers to it are not completed gifts. The instrument should be construed and implemented to carry out that intent. If both intents cannot be met, the instrument would make clear to meet the “not a gift” intent.
The recent Focardi Tax Court case (by Judge Laro) said it would not respect statements in the trust about disregarding certain provisions in the trust, citing Procter. However, other cases have given effect to these types of intent statements. Reid (trust said she could appoint successor trustees and did not preclude appointing herself, but instrument said intent was to exclude from her estate; intent was not to include in her estate, so she did not have power to appoint herself as successor trustee); Hedrick (9 th Cir. 1994) (looked to testimony of lawyer about intent of trust to qualify for marital deduction).
3. DEDUCTION FOR DOMESTIC PRODUCTION ACTIVITIES.
Section 199 was passed as part of JOBS Act of 2004. It was intended to correct problems with World Trade Organization, which thought that the U.S. was giving too much protection to domestic production. There is a special deduction that applies when the taxpayer owns an interest in an entity that produces goods (it does not apply to service entities). The tax returns from the entity in future years will tell owners if there’s anything they can deduct If pass-through entities own interests in these types of companies, the information will be on the Schedule K-1s. Final regulations were issued on June 1 2006, and contain many very detailed rules about applying these rules to pass-through entities, including interests owned by trusts or estates. Treas. Reg. 1.199-9 (which includes a preamble with a good description of the new deduction).
For pass-through entities, the deduction is at the partner or beneficiary level. The general approach of this new deduction is as follows: (a) Determine how much of the entity’s gross receipts is attributable to domestic production (the statute refers to domestic gross production receipts, or “DBGR”); (b) Subtract the cost of goods sold that is attributable to DBGR (the regulations say that trusts and estates use the rules of §652 to apportion expenses among different categories of income); (c) The difference is qualified production activities income, and the deduction is 9% of that amount, subject to a limit of 50% of “W-2 wages”. (Only W-2 wages attributable to a trade or business are used for this purpose, and the regulations look to the §6166 rules to determine if there is a trade or business; for this purpose, expenses of administering a trust or estate are not trade or business expenses.) The 2005 Tax Act (“TIPRA”) changed some of the rules regarding the W-2 wage limits after May 17, 2006, and the IRS is working on new proposed regulations regarding the W-2 wage limits.
4. PLANNING WITH LARGE IRAS TO FUND BEQUESTS UNDER THE WILL.
Some situations may be too complicated to just provide for a series of distributions in the IRA beneficiary designation. For example, there may be a number of charitable bequests that would be funded by the IRA. One alternative is to leave the IRA to the estate, and the estate could use those proceeds to pay bequests. If that is done, you would like to avoid income recognition if possible when the distribution is made. If income is recognized, you would want the estate to receive an offsetting §642(c) deduction if the distribution is made to charity.
Ltr. Rul. 200526010 says that if the IRA proceeds are left to a trust and are used to satisfy the residuary trust distribution to charity, there is no income recognition. However, not addressed by that letter ruling is a distribution to satisfy a pecuniary bequest. For example, it the IRA proceeds are used to satisfy a $10,000 pecuniary bequest to charity, there would be income recognition. (The trust or estate should get a §642(c) deduction because the item that produces the gross income is passing to charity. Ltr. Rul 200526010 allowed a §642(c) deduction for amounts distributed to the trust from the IRA that the trust used to satisfy the charitable distribution.)
Would it be possible to avoid income recognition by saying that the executor shall use the IRA proceeds first to satisfy the bequest—so it no longer looks like discretion is exercised to choose to “sell” the IRA to satisfy a pecuniary bequest, but instead it looks like a specific bequest of the IRA? However, there is some concern that would be treated as a distribution in satisfaction of a pecuniary bequest. An attorney told me after the meeting that a PLR in the fall of 2005 had that fact situation (i.e., direction to fund a pecuniary bequest with the IRA). The IRS refused to rule whether satisfying the pecuniary bequest would trigger taxable income to the trust.
Another approach is to use a fractional share approach—for example, make a bequest of a fractional share of the IRA equal to 10,000/total value of the IRA. Several attorneys said that is their typical approach.
If only part of the IRA is passing to charity, consider making the beneficiary a trust rather than the estate. If the estate is the beneficiary, it would not be a “designated beneficiary” and an accelerated payout would be required. However, if a trust is a beneficiary, and if all of the charity’s interest has been satisfied by the date (September 30) for determining if the IRA beneficiary qualifies as a designated beneficiary, then the trust will qualify as a designated beneficiary. Consider using an unfunded revocable trust for that purpose. If a testamentary trust is named as beneficiary and if there is a will contest, funding the testamentary trust and the charitable bequest by the September 30 date may be impossible.
If the state has the equivalent of §409a of the Uniform Principal and Income Act, and state law says that 10% of the distributions from the retirement plan are income, distribution of that 10% amount may not be sufficient to satisfy the “all income” requirement of a QTIP trust. (This was addressed in Rev. Rul. 2006-26.) Drafting: If the trust provides that the spouse has the right to require the distribution of all income from the IRA and from the trust, you may want to specifically negate the application of the 10% rule for this purpose.
The ACTEC Website, Employee Benefits page has a special projects item. There is a state by state chart of the adoption of §409a of the Uniform Principal and Income Act.
5. GRANTOR TRUST TRIGGERS-POWER TO ADD BENEFICIARIES.
One attorney says that he permits the designated person to add more than just charities as additional beneficiaries. The concern is that a power to distribute to charities is an exception to the grantor trust rules in §674(b)(4). So he adds collateral relatives to the power to add beneficiaries.
6. BUY SELL AGREEMENTS FIXING ESTATE TAX VALUE; ESTATE OF AMLIE, T.C. MEMO 2006-76.
The legal issue was whether the price set in a buy sell agreement as part of a large corporate acquisition of a bank set the estate tax value. The court analyzed the case law requirements in order for a buy sell agreement to set the value for estate tax purposes, and found that those requirements were met. It then addressed the statutory requirements under §2703, finding they were satisfied also.
Two things are particularly interesting about the §2703 analysis.
(1) One of the requirements is that there is a bona fide business arrangement. The IRS argued that bona fide business arrangement means an actively managed business interest, and passive investments do not suffice. The court did not agree. (Other cases have consistently held that it is easy to find a bona fide business arrangement with a buy sell agreement—such as the desire to provide liquidity for the shareholder’s estate.)
(2) The court addressed the increasingly problematic comparability requirement in §2703. The regulations reference that as a general rule, isolated transactions cannot be considered to determine comparability. The court said that is just a safe harbor. In this case, an isolated transaction could be taken into account because there were arms length negotiations between the conservator for the decedent and the acquiring bank.
7. HUBER T.C. MEMO 2006-96; GIFT TAX CASE.
The Huber Company was a family owned business for many generations. There were 250 family members who were shareholders as well as charitable shareholders. For 7 years, Ernst & Young annually appraised the stock based on publicly traded company comparables and a 50% discount. The EY appraisals were used to determine the purchase price in over 90 transactions (some involving close family members, remote family members [second cousins], and charities). None were required to use the EY appraisals. The EY appraisals were also used in determining the compensation of officers and directors and for performance comparison purposes.
The IRS argued that these were not arms length comparable sales for purposes of determining the gift tax value of transfers. The court disagreed, emphasizing among other things the independent appraisals.
The IRS arguments were interesting. 1. The company should have gone public and the value should be the anticipated stock price if the company had gone public. The court said there are business reasons that they did not do so, and there is no obligation to go public. 2. The transactions cannot be arms length because there must be negotiations (familiar with their argument in FLP cases). The court said there is no authority for that, and cited Kimbell as contrary authority. (This case is an example of the IRS making its standard FLP arguments in the context of valuing corporate stock.)
8. ROSEN; JUDGE LARO’S LATEST EXPOSITION ON FLPS, T.C. MEMO 206-115.
Judge Laro took what could have been an easy decision (substantially all of the elder Alzheimer’s patient’s assets were transferred to the partnership), as an opportunity to expound his views in great detail. He went through a long analysis of 7 reasons for the creation of this partnership not being a bona fide sale, some of which are: 1. No legitimate business operations. (This sounds like the business purpose test that he tried to push through in Bongard, but he acknowledged that the majority did not agree with him.) He acknowledged that investment activities could represent legitimate business operations. However, despite the fact that there was a substantial shift in the asset allocation, far beyond the investment activity in the other reported FLP cases where there was typically just a continued holding of investment assets, the court regarded that as insufficient activity to rise to the level of business operations. 2. No negotiations (ignoring various other cases, such as Kimbell and Bongard that have not required negotiations). 3. De minimis contributions by children who contributed 1%, a throwback to the old recycling of value argument in the pre- Bongard Tax Court cases, again failing to cite the contrary law in Kimbell . 4. Substantially all assets of decedent were transferred to the partnership. The Judge then considered and rejected the various non tax reasons offered by the estate.
Having concluded that the bona fide sale exception did not apply, the court then found that §2036(a)(1) applied because there was an implied agreement that the decedent had access to partnership assets. In the analysis, Judge Laro seems to say that following advice of estate planning counsel in an effort to minimize estate taxes of and by itself reflects retained enjoyment.
Distributions to the decedent during her lifetime were treated as advances, documented by a single note (which contemplated that additional advances would be governed by the same note terms.) Judge Laro had an extended discussion of the factors suggesting that a debt relationship is created. He did not respect the distributions as mere advances, and treated them as distributions to the decedent. (Distributions were made only to the decedent despite the fact that the decedent only owned about 35% of the partnership at her death.)
At trial, when Judge Laro did not feel IRS attorney had elicited enough testimony, he questioned the witnesses himself to get the testimony that he needed to write his opinion. “If you go before Laro on an FLP case, you will lose.”
9. SALE TO GRANTOR TRUSTS.
Several attorneys commented that the extended debt discussion in Rosen was just pointing out that the judge was saying that the debt was not real and was contrived after the fact. The analysis should not be extended to the sale to grantor trust area to determine when the note is treated as debt rather than equity for estate tax purposes. No one was aware of the IRS attacking sales to grantor trusts as representing retained equity rather than debt (other than the Karmazin case which was settled favorable for the taxpayer). Two audit situations were mentioned, both of which were resolved favorably. In one, the trust had substantial assets with plenty of “seed” money. In the other, stock was sold in an installment sale 8 years before death for a SCIN. There was only 5% equity in the trust, but there were guarantees by the children/beneficiaries who were wealthy. The sale was reported on the decedent’s final income tax return on advice of accountants. The agent requested and the attorney provided the agent with documents related to the sale. The agent passed on auditing it further.
10. SECTION 6166 TRADE OR BUSINESS REQUIREMENT FOR REAL ESTATE; REV. RUL. 2006-34.
This is the first time the IRS has given public guidance since 1975 on whether real property interests owned by a decedent or an entity in which decedent had an interest qualifies under §6166. The ruling addressed 5 different situations.
Some of the principles gleaned from the new ruling are:
a. To qualify, the decedent must conduct an active trade or business or hold interests in partnership, LLC or corporation that carries on an active trade or business as opposed to “the mere management of passive investment assets.” (When the IRS or a court uses the word “mere,” bad news follows.)
b. Activities of agents or employees are properly considered in determining if an active trade or business exists. The use of independent contractors will not disqualify the interest so long as the decedent has not ceded so much of the day-to-day operations that his activity is reduced to “merely holding investment property.”
c. When an unrelated management company is employed to perform most of the management activities, the ruling says that suggests that an active trade or business does not exist. Reading between the lines, you are “dead in the water” if you use an independent management company to perform most of the activities.
d. The IRS is offering a new safe harbor we did not have before. If the decedent owns at least 20% of the management company that performs most of the management activities, the decedent will likely meet the trade or business requirement. There is no requirement that the decedent be actively involved in the management activities of the management company—it is just a 20% ownership test. This is not the same 20% test as in 6166(b)(1), which refers to the portion of the business that is in the estate. This 20% rule has nothing to do with the ownership of the business for which §6166 treatment is sought. It is just the ownership of the management company that is managing that interest.
e. The IRS is acknowledging that the use of an independent contactor is not fatal. The Ruling broadens the way the IRS will look at facts and circumstances.
f. One of the situations allows 6166 treatment in the common situation where the real estate is owned separate from the operation of the business (an auto dealership in that example).
g. The Ruling does not address a QTIP situation. To the extent the Ruling provides safe harbors, there is no discussion of how it applies to QTIP trusts. If a client wants to use the safe harbors, it may be necessary at the first spouse’s death to leave interests outright to first spouse. The issue is whether activities by the trustee satisfy the trade or business requirement or do you have to look only to activities of the surviving spouse? In that situation, utilizing the 20% ownership in a management company would be preferable; however, it is not clear whether the surviving spouse must own that 20% or whether it is sufficient for the surviving spouse and QTIP trust collectively to own the required 20%.
11. 9100 RELIEF FOR LATE GST EXEMPTION ALLOCATIONS; NEW IRS POLICY IF A PARTNERSHIP OR HUGE APPRECIATION IS INVOLVED.
One attorney reported that the IRS apparently is using a new approach in reviewing applications for 9100 relief for late GST exemption allocations. The IRS apparently will request additional detailed information if the IRS determines that assets have appreciated “too much.” The IRS will require information about the initial trust value and all transactions that have resulted in the appreciation. There is no reason for that information because the taxpayer just wants to allocate GST exemption at the time of the gift; the taxpayer is not asking for a ruling on the inclusion ratio of the trust after the exemption allocation.
12. PATENTING ESTATE PLANNING TECHNIQUES.
A patent has been issued for contributing options to a GRAT. In January of 2006, an infringement action lawsuit was filed in Connecticut by the holder of the patent. A large New York law firm set up the GRAT, funded with options. Disclosure of the transfer was filed with the SEC. The patent holder apparently watches those filings for transfers of options to GRATs.
Summary of Effect on Planners: If a client is considering doing a GRAT with options, one attorney said that he will always advise the client about the patent. He is concerned that if the client funds a GRAT with options, gets sued for patent infringement, and has to pay big bucks to defend the infringement suit or pay damages, the client will come back to the attorney seeking recompense because the attorney did not advise about the existence of the patent.
A practical concern is how an estate planning attorney would know of the existence of patents that might cover what seem to be standard estate planning strategies.
The United States Patent and Trademark Office (“PTO”) has a separate category for tax strategy patents. The PTO website shows that 48 patents have been issued in that subclass and 81 such applications are pending. These tax strategy patents have involved many aspects of the tax law, including financial products, charitable giving, estate planning, and tax-deferred exchanges.
The House Ways and Means Committee has called for hearings on the issuance of patents for tax strategies. Dennis Belcher has been invited to testify at that hearing.
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