Congress was busy in the second half of 1996, passing some important and broad-ranging laws. Several significant changes affecting estate planners are contained in legislation concerning jobs, the environment, immigration and Medicaid fraud. Brief updates follow on some of the key new laws of interest to estate planners.

Fiduciary Liability Under CERCLA
One significant legislative effort provides environmental liability relief for fiduciaries. The Asset Conservation, Lender Liability, and Deposit Insurance Protection Act of 1996, 2501-2505 of the Omnibus Consolidated Appropriations Act, Pub. L. 104-208, 110 Stat. 3009, limits the liability of a fiduciary under CERCLA to the assets held in fiduciary capacity. One exception provides that a fiduciary may be personally liable to the extent that the fiduciary's negligence caused a release of a hazardous substance. The new law also provides relief for lenders concerned with CERCLA liability arising out of collateral held by the lender. This legislation will be discussed in more detail in the May/June 1997 issue of Probate & Property.

Moratorium on Excess Distribution Excise Tax
By Judy Mazo
Section 1552(b) of the Small Business Job Protection Act of 1996, Pub. L. 104-188, 110 Stat. 1755 (to be codified at 42 U.S.C. 9601 (20)), suspends for 1997, 1998 and 1999 the application of Code 4980A, which imposes a 15% excise tax on "excess distributions" and a 15% additional estate tax on "excess accumulations."

The suspended excise tax applied to amounts withdrawn from qualified plans and IRAs in a single year to the extent that they exceeded $160,000 (for 1997) or $800,000 if taken in a lump sum. The suspended estate tax applied to the present value of the amounts to which the decedent was entitled under IRAs and qualified plans at the time of death in excess of the present value of a $160,000 single life annuity. Amounts owed or paid to ex-spouses and family members entitled to distributions by court order ("alternate payees") were excluded from the calculation.

These taxes were suspended for two reasons:

  • Politically, the most important reason was the hope of higher fed-eral tax receipts during the three years. This could result if the mora-torium prompts high income individuals to withdraw large amounts from their qualified plans and IRAs, on which they would pay regular income tax (an incentive that, presumably, does not apply to estate taxes).
  • The theoretical reason for the three year suspension was that the legislation also repeals Code 415(e), which imposes a combined limit on benefits from a mix of defined benefit and defined contribution plans maintained by the same employer, but not until the year 2000. Suspending these taxes for the interim period offers taxpayers similar relief.

Judy Mazo is a lawyer with The Segal Company in Washington, D.C.

Update on S Corporations

By Louis A. Mezzullo
The Small Business Job Protection Act of 1996, Pub. L. 104-188, 110 Stat. 1755 (the Act), made a number of significant changes to the rules governing S corporations. Some of these changes will have a direct impact on estate planning. They include:
  • the expansion of the number of permitted shareholders to 75 and the addition of a new type of trust that qualifies as an S corporation shareholder;
  • an extension of time for certain trusts to dispose of S corporation stock after the death of an individual who owned S corporation stock directly or as the grantor of a trust;
  • the characterization of untaxed S corporation income on a shareholder's death as income in respect of a decedent; and
  • the addition of tax-exempt organizations as permitted S corporation shareholders.

Other changes such as elimination of the restriction on the amount of stock of another corporation that an S corporation can own will also make S corporations more usable. Whether these changes will lead to increased use of S corporations in the future depends in part on the impact of the check-the-box regulations dealing with the classification of an unincorporated entity for federal tax purposes. Because of these regulations, which were effective January 1, 1997, limited liability companies (LLCs) and limited partnerships will likely remain the entities of choice for many practitioners. In addition, in any choice of entity analysis, state law, including state tax law, will be an important consideration.

The expansion to 75 from the previous 35 permitted shareholders, effective for taxable years beginning after 1996, will be of benefit to those family-held S corporations in which younger generations have expanded the number of family members holding shares. The increased number will also become important if the electing small business trust, discussed below, is used for estate planning purposes to hold S corporation stock. All beneficiaries of an electing small business trust who are either entitled to current distributions or who may receive current distributions at the discretion of any person are treated as shareholders for purposes of the 75 shareholder limit.

Under the law before the Act, a trust could not be an S corporation shareholder unless it was a grantor trust, a voting trust, a grantor trust after the death of the grantor for a limited period, a testamentary trust for a limited period after the testator's death or a qualified subchapter S trust (QSST). A QSST may have only one individual as a current beneficiary and all the income of the trust must be distributed annually to that beneficiary. If the trust terminates during the beneficiary's lifetime, the assets must be distributed to the beneficiary. Because the QSST is not very flexible, it does not comport with traditional estate planning, which in many cases calls for discretionary trusts with multiple beneficiaries.

Electing Small Business Trusts
An electing small business trust may be an S corporation shareholder for taxable years beginning after 1996. In addition to making an affirmative election to be treated as an electing small business trust, all beneficiaries of the trust must be either individuals, exempt nonresident aliens or estates. In 1997 a charitable organization may be a contingent beneficiary, and after 1997 a charitable organization may be a current beneficiary. No interest in the trust may be acquired by purchase. As mentioned above, all the potential current beneficiaries will be treated as shareholders for purposes of the 75 shareholder limit.

If a trust makes an election to be treated as an electing small business trust, all income attributable to the S corporation stock held by the trust will be taxed at the maximum federal rate applicable to individuals, which is currently 39.6%. To accomplish this, the portion of the trust holding the S corporation stock is treated as a separate trust. The IRS is to issue regulations that will allow deductions for state and local taxes and administration expenses attributable to the S corporation stock. There will be no deduction for distributions of income from the S corporation stock to the beneficiaries, and the beneficiaries will not include in income distributions from the trust attributable to the S corporation stock.

Although in many cases a family may refrain from using an electing small business trust because of the high tax rate applicable to the S corporation income, in some instances all family members may already be in the maximum tax bracket. These cases include those in which the beneficiaries of the trust are under age 14 and their unearned income is taxed at their parents' marginal rates. Before 1997 a trust that did not otherwise qualify as a QSST had to dispose of any S corporation stock it held within 60 days after the death of the grantor, unless the assets were includable in the grantor's estate, in which case the period was two years. In addition, a testamentary trust that did not qualify as a QSST had 60 days to dispose of S corporation stock. For taxable years beginning after 1996, the Act increases to two years the period within which the S corporation stock must be disposed of.

Under the Act, untaxed income allocable to S corporation stock held by a decedent who dies after August 20, 1996 will be treated as income in respect of a decedent (IRD). Note that the beneficiary entitled to the S corporation stock would have reported such income as taxable income even before this change, but as a result of this change the beneficiary will be entitled to a deduction with respect to any federal estate tax attributable to the inclusion of the income in the decedent's estate. In addition, there will be no step-up in basis for the untaxed income. In many cases, the treatment of the untaxed income as IRD will have little or no effect on basis because the value of the stock held by the decedent at the date of death will likely be unaffected by the amount of income of the S corporation for the part of the year before the decedent's death allocable to the shares held by the decedent.

Before the Act, a tax-exempt organization could not be a shareholder in an S corporation. For taxable years beginning after 1997, tax-exempt organizations described in Code 401(a) (qualified retirement plans) and 501(c)(3) (charitable organizations) will be permitted S corporation shareholders. A tax-exempt organization holding S corporation stock will be required to treat items of income or loss attributable to the S corporation stock and gain or loss on the sale or other disposition of such stock as unrelated business taxable income. An employee stock ownership plan (ESOP) that owns stock in an S corporation will not be entitled to the additional tax benefits usually available to an ESOP. In addition, certain dividend distributions with respect to S corporation stock purchased by a tax-exempt organization will reduce the organization's basis in the stock, except as provided in regulations, which may limit the basis reduction to dividends deemed to be allocable to subchapter C earnings and profits that accrued on or before the date of acquisition.

Among the other changes to the rules governing S corporations that may indirectly affect estate planning is the removal of the limit on the amount of stock of another corporation that an S corporation may own. Before 1997, because an S corporation could not be a member of an affiliated group of corporations, it could not own 80% or more of either the voting stock or the value of another corporation. For taxable years beginning after 1996, an S corporation may own any percentage of the stock of another corporation, although it will not be eligible to file a consolidated return with the other corporations. The other corporations may file a consolidated return. Although the rule prohibiting a corporation as an S corporation shareholder has not changed, for taxable years beginning after 1996, an S corporation that owns 100% of the stock of another corporation may elect to have that corporation treated as a qualified subchapter S subsidiary. If this election is made, the subsidiary will be disregarded for federal income tax purposes.

Disregarding the wholly-owned subsidiary is similar to the treatment of a one-member LLC under the check-the-box regulations, which also disregard a one-member LLC for federal tax purposes unless an election is made to treat the LLC as a corporation. In 1996 Congress made significant changes to the rules governing S corporations that add increased flexibility for estate planners. This summary focuses only on those changes made by the Act that directly affect trusts and estates and on the removal of the limitation on an S corporation's ownership of stock in other corporations. Other changes in the Act make electing and remaining an S corporation easier. Although these changes may not lead to an increased use of S corporations, they will be welcome to those existing S corporations that must remain corporations because of the tax cost associated with liquidating the corporation.

Louis A. Mezzullo is a member of Mezzullo & McCandlish in Richmond, Virginia. He is a member of the Section's Council (Probate and Trust Division) and is Supervisory Council Member for the Committees (Group C) on Business Planning.

Criminalizing Medicaid Planning

By David M. English and
Rebecca C. Morgan

To qualify for Medicaid, an individual generally must have less than $2,000 in countable resources. For individuals with excess countable resources, a frequently used planning technique is to transfer the excess resources to others. Although such transfers may bring the individual's countable resources within the $2,000 limit, these transfers usually will trigger a period of ineligibility for Medicaid. The period of ineligibility may last up to 60 months for transfers into trusts and 36 months for other transfers. For moderate sized transfers, the period of ineligibility will often be less, the issue being how long the transferred assets would have financed nursing home care based on the average cost of care in the community.

Without changing the eligibility requirements for Medicaid, or the basic 36 or 60 month ineligibility period rules, Congress in 1996 at-tempted to stop Medicaid planning transfers by making many such transfers a criminal offense. The amendment, which is contained in 217 of the Health Insurance Portability and Accountability Act of 1996, Pub. L. 104-191, 110 Stat. 1936, adds the following new paragraph to one of the Medicaid/Medicare fraud provisions:

(6) [Anyone who] knowingly and willfully disposes of assets (including any transfer in trust) in order for an individual to become eligible for medical assistance under a State plan under title XIX, if disposing of the assets results in the imposition of a period of ineligibility for such assistance under [42 U.S.C. 1396p(c)].

42 U.S.C. 1320a-7b(a). The new paragraph is an addition to a list of other criminal acts, the violation of which, in the case of persons not providing medical services, is a misdemeanor punishable by a fine of up to $10,000 and a year in prison. The statute is effective for transfers occurring on or after January 1, 1997.

Because of an almost complete lack of legislative history, analysis is difficult. Arguably, the new crime does not provide for a penalty because the penalty portion of 1320a-7b(a) punishes only a "statement, representation, concealment, failure, or conversion." These terms fit the actions described in the first five paragraph rather well, but do not fit the willful "transfers" proscribed by new paragraph (6).

Paragraph (6) punishes willful transfers that result "in the imposition of a period of ineligibility," but are all such transfers criminal? What if the transferor never applies for Medicaid? Or does a criminal penalty apply only if an application is made during the look-back period, whether 60 months or 36 months? Or might the transferor be off the police blotter on smaller transfers after the expiration of the period determined by the average cost of care? The meaning of "knowingly and willfully" requires explication. Presumably there must be some close nexus between the transfer and an intent to qualify for Medicaid. Otherwise, all lifetime gifts could theoretically become criminal acts.

Who is subject to prosecution under the new provision? The elderly transferor able to form the requisite criminal intent would seem to be the prime candidate, but what about the agent under a durable power of attorney, a guardian or the state court judge approving transfers by a guardian? Are lawyers and other counselors who advise on proposed transfers subject to prosecution under 18 USC 2 for aiding and abetting? What if the counselor merely advises on the current state of the law without making a recommendation? Finally, what happens if the otherwise criminal transfer is undone and the assets returned to the transferor? Will such an act of remorse undo the crime?

Whatever the answers to these questions, certain transfers are still legal. The new provision applies only to transfers resulting in a period of ineligibility, and not all transfers fall within that category. The most important exception is transfers to a spouse, including transfers for the purpose of protecting the "Community Spouse Resource Allowance." Transfers to certain OBRA '93 trusts for the disabled, under which the state has an eventual right to be reimbursed for public benefits paid, also would appear to be exempt. Efforts are currently underway to repeal this statute. Many practitioners hope these efforts will meet with quick success.

David M. English is a professor of law at Santa Clara University in Santa Clara, California and is Group Chair of the Probate Division Committees on Retirement and Disability Planning. Rebecca C. Morgan is a professor of law at Stetson University in St. Petersburg, Florida and is vice-chair of the Probate Division Study Committee (E-6) on Law Reform.

International Estate Planning

By Barbara R. Hauser Four areas of international estate planning are affected by 1996 legislation, as discussed below. Asset Protection Trusts Congress turned its attention to asset protection trusts (APTs) in 1996. Rep. Sam Gibbons (D-FL) explained that he found that "many other wealthy individuals, while retaining their citizenship in this country, are abusing our tax laws by hiding their assets in offshore trusts . . . located in tax havens with bank secrecy laws designed to facilitate tax evasion." He estimated that over $644 billion had been transferred by U.S. persons to the Cayman Islands, Luxembourg and the Bahamas, and that only $1.5 billion (in 1993) had been reported to the IRS.

The Small Business Job Protection Act of 1996, Pub. L. 104-188, 110 Stat. 1755 (the Act), signed into law on August 20, 1996, requires new reporting about Apts. The new "reportable events" (which must be reported within 90 days) are:

  • the creation of any foreign trust by a U.S. person;
  • the transfer of any money or property (directly or indirectly) to a foreign trust by a U.S. person, including a transfer by reason of death (sales at fair market value are excluded); and
  • the death of a U.S. person who was the owner of, or whose estate included, any portion of a foreign trust.
The report must be filed by the grantor, the transferor or the executor, respectively, and must include the amount of the transfer and the identity of the trust, each trustee and each beneficiary or class of beneficiaries. The U.S. taxpayer-owner must ensure that an annual return is filed for the trust, including complete accounting of transactions during the year and the name of the U.S. agent for the trust. Failure to file, or the filing of incomplete information, can result in a penalty of 35% of the gross reportable amount; a failure that continues more than 90 days after notice incurs an additional penalty of $10,000 per month. This requirement applies to all reportable events that occur after August 20, 1996.

Foreign Grantor Trusts
Until the Act changed the law, it had been possible for a foreign grantor to create a foreign trust for a U.S. beneficiary that would incur no U.S. income tax. This was because the grantor trust rules treat the grantor as the owner for income tax purposes, and no (U.S.) income tax would be payable by a foreign grantor on a foreign trust with non-U.S. assets. Thus, trust distributions to a U.S. beneficiary would not carry out taxable income.

Section 1904 of the Act, titled "Foreign Persons Not to be Treated as Owners Under Grantor Trust Rules," allows foreign persons to be treated as owners only to the extent that there is U.S. taxable income. There are two narrow exceptions: 1) a trust wholly revocable by the grantor (without requiring consent of an adverse party); and 2) a trust that permits distributions (during the grantor's life) only to the grantor or the grantor's spouse. The effective date for this section is also August 20, 1996, except that amounts in trusts as of September 19, 1995 are excluded.

Receipt of Foreign Gifts
Many persons in the United States receive gifts and inheritances from foreign relatives and others. There has never been a requirement to report these gifts and bequests because the receipt of them does not cause a U.S. transfer tax. Now, as part of the Act, whenever a U.S. person receives more than $10,000 in the aggregate during any one calendar year from foreign persons or estates, those gifts must be reported. There is also a new requirement to report any amount received from a foreign trust, including the name of the trust and the total received in a year. Failure to report can result in a penalty tax equal to 5% of the amount for each month, up to a maximum of 25%. This requirement applies to gifts (or bequests) received after August 20, 1996.

There have been many proposals to impose some sort of "exit tax" on those who give up their U.S. citizenship. Because the U.S. estate and gift tax applies to all assets, wherever located, for anyone who is a U.S. citizen, the only way to avoid this tax has been to own no U.S. assets, give up U.S. residency and give up U.S. citizen-ship. During 1995 this "billionaire's loophole" received substantial attention in Congress. Although no "exit tax" proposals passed, there are new reporting requirements, some modifications to the existing tax rules and a very surprising addition to the immigration laws that may preclude expatriates from reentering the United States.

First, the modifications to the existing 10 year continuing taxation on U.S. source income, at U.S. person rates, which tax applies whenever tax avoidance was a "principal purpose" of expatriation, provides that this tax will automatically apply to the "wealthy." This includes any person with a net worth of $500,000 or more or a five year average net income tax over $100,000. The exceptions from this are those who: 1) became dual citizens at birth and continue to be citizens of the other country; 2) become citizens of the country where they, their spouse or either parent was born; 3) were present in the U.S. less than 31 days in each of the last 10 years; or 4) renounce citizenship before age 18 1/2.

For the first time, certain permanent residents (e.g., "green card" holders) who lose that status will be treated for tax purposes the same as those who renounce citizenship. This rule applies to those who were permanent residents in at least eight of the last 15 years. A statement must be filed in connection with the actual loss of citizenship and the INS is required to provide a copy, or the names of those who refuse to provide a report, to the Treasury Department. The statement must include the taxpayer's identification number, the mailing address of the principal foreign residence, the foreign country of residence, the foreign country of citizenship and, for the "wealthy" (those with net worth of $500,000 or more), a detailed statement of assets and liabilities.

The names of those who renounce citizenship will be published in the Federal Register each quarter. The penalty for failure to file is 5% per year of the income tax required under 877 (minimum $1,000). The effective date continues to be (as it was with the "exit tax" proposals) February 5, 1995. The changes were included in the Health Insurance Portability and Accountability Act of 1996, Pub. L. 104-191, 110 Stat. 1936, signed into law on August 21, 1996, and were intended to be a source of revenue. The Treasury Department is also to submit a report on measures to improve tax compliance by Americans residing abroad.

Surprisingly, the following expatriation provision was added as Section 352 to the Illegal Immigration Reform and Immigrant Responsibility Act of 1996, Pub. L. 104-208, 110 Stat. 3009, which was signed on September 30, 1996:

Any alien who is a former citizen of the United States who officially renounces United States citizenship and who is determined by the Attorney General to have [done so] for the purpose of avoiding taxation . . . is excludable.

This provision applies only to those who renounce citizenship after September 29, 1996.

Barbara R. Hauser is in-house counsel for Carlson Holdings, Inc. in Minneapolis, Minnesota, and is vice-chair of the Section's Committee on International Activities.


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