EXECUTIVE SUMMARY:
Each year, Steve R.
Akers of Bessemer
Trust covers the University of Miami Law School's Heckerling
Institute on Estate Planning. As you know, this week long
experience is the largest gethering of estate planning
professionals in the U.S.
and in addition to in-dept analysis of topics of timely interest to experienced
planners, offers a unique opportunity for the exchange of ideas and a review of
the cutting edge in the tools, techniques, and technology.
2007 Heckerling
Institute Faculty: Jeffrey N. Pennell , Steve R. Akers, Carlyn S. McCaffrey , Louis A. Mezzullo
, Jonathan G. Blattmachr , S. Stacy Eastland , Stephan R. Leimberg , Natalie B.
Choate , Ronald D. Aucutt , Johathan C. Lurie , Kevin
S. Rosen , Linda S. Whitton , Kathryn W. Miree , Pam H. Schneider , Howard
M. Zaritsky , Farhad Aghdami, John W. Porter , Charles L. Ratner , Lawrence
Brody , Jerry J. McCoy , William LaPiana
, John P.C. Duncan , Bryan R. Dunn , Michael R. Conway , Sara S. Hamilton , Mary
Beth Robinson , Pamela A. Bresnahan , Daniel H. Maarkstein, III , Susan Porter , Alan S. Aker , Carol A. Harrington , Robert A. Weiss , Diana S.C. Zeydel , Dennis I. Belcher , John F. Bergner , Mary Ann
Mancini , Robert W. Goldman , Richard Robinson , John T. Rogers , Bridget A. Logstrom , Bruce M. Stone, Ann Hart Wernz
, David H. Pankey , Cono R.
Namorato , George F. Albright, Jr. , Alexander A.
Bove, Jr. , Jay D. Adkisson , Matthew P. Matiasevich
, Gideon Rothschild , Mitchell M. Gans , Wendy S. Goffe
, Scott B. Osborne , Jerome M. Hesch , Kevin McGrath ,
Richard Kaplin, and Mark B. Edwards.
Here's
Steve's super commentary! We've
hyperlinked it for LISI members' convenience.
TABLE OF CONTENTS
1.
Estate Tax Legislation Update
2. FLP Planning Issues
a.
Senda
Integrated Transaction Dictum
b. Full
Consideration Exception to Section 2036
c.
Conclusions
Regarding Section 2036 Application
d.
Section 2035 Conundrum
e.
Marital Deduction Mismatch Problem
3. Defined Value Clauses
a. Basic
Issue
b. Two
Fundamental Types of Defined Value Clauses
c.
Observations
Regarding Factual Background of McCord
d. Did
McCord Actually Recognize Defined Value Clause?
e. IRS
Reaction to These Clauses
f. Using Defined
Value Clauses in Sales Transactions
g. No
Excuse for Sloppy Planning
h. Formula Disclaimer Approach
4. GRAT Planning
a.
Deferred Payment GRAT
b. Spousal Annuity-Helpful if
Spouse Has Shortened Life Expectancy
c. Grantor Has Shortened Life
Expectancy
d. IRS
Looking At Annuity Payments
e.
Revocable
GRAT
f. Spendthrift
Clause
g. GST
Exemption Allocation at End of GRAT Term
h. Purchase of Remainder Interest by Grantor
i. Loan to Grantor’s Spouse
j. Possibility That
GRAT Does Not Trigger an ETIP Period; If So,
Risk of Automatic GST Exemption Allocation at Creation of GRAT
Unless Election Out of Automatic Allocation
k. Distributions From or Redemptions of Interests in Entities
Transferred to GRATs
l. Assets Subject to
Blockage Discount
m. Rolling
GRATs With Single Instrument
5.
Sale to Grantor Trust Planning
a. Debt
vs. Equity
b.
Sections 2701-2702
c.
Valuation
Risk
d.
Required Seed Gift Amount
6.
Deductibility of Investment Expenses of Trusts,
§67
7.
Private Annuity Proposed Regulation
8.
Life Insurance Planning
a.
Investor-Initiated Life Insurance
b.
Corporate Owned Life Insurance (COLI) Developments
c.
Pension Protection Act Changes for “EOLI”
d.
Insurable Interest in ILITs—Chawla
e. Basis
in Insurance Policy 17
f. Moving
Policies from One ILIT to Another
g. Sale of Policy to Avoid Three Year Rule of
§2035
h. Life
Insurance Sub-trust
9.
Retirement Plan and IRA Issues
a.
Funding Pecuniary Bequest by Transfer of Interest in IRA
b.
Transfer from IRA to Charity
c. Post
Death Rollovers by Non-spouse Beneficiaries
d. Health
Savings Account
e. Rev. Rul. 2006-26—Impact of Accounting Rules on Marital Deduction
for
Retirement Plans
f. Designated Roth
Account
10.
Malpractice Issues for Estate Planning Attorneys
a. Best
Defense: No Breach of Duty
b. How
the Jury Will View the Attorney?
c. Who
is the Client?
d.
Attorney Naming Self as Fiduciary
e.
Judgmental
Immunity
f. Testator’s Intent
g.
Privilege
h.
Privilege for Internal Discussions Regarding Possible Conflicts Issues?
11.
GST Planning Issues Involving Charitable Planning
a.
Allocation of GST Exemption to CLAT
b. CLAT; GST Effects of
“Negative” Inclusion Ratio
c. CLAT; Trust Grows At More Than
§7520 Rate So That It Is No Longer Fully GST Exempt
d. CLAT
vs. GRAT
e. CLAT vs. CLUT
f. CLT—No
Direct Skip
g. Interesting Aspects of
Subtracting Charitable Deduction in Applicable Fraction Denominator
h. CLT-Designing
So No Taxable Termination Can Occur
i. Using Charitable Trust In
Connection With Making Tuition/Medical Payments for Grandchildren/ Great
Grandchildren to Completely Avoid GST Tax
12.
Other GST Planning Issues
a.
Grandparent Transfer to UTMA Account for Grandchild; Grandparent is
Custodian
b. Death
of Child Before Termination of Trust Previously Created for
Grantor’s Descendants
c.
Qualified
Severance
d.
Reforming
Grandfathered or Exempt Trusts
e. GRAT ETIP
Rule and GST Exemption Allocation Planning
Opportunity
13.
Trustee Delegation
a.
Summary
b.
Investment
Guidelines
c.
Delegation
Agreement
d.
Relative as Investment Manager
e.
Disclosure of Documents to the Investment Advisors?
f. Duty to Monitor
Investment Advisor’s Actions
g.
Individual
Trustee
h.
Notification
i. Indemnification
j. Can the Trustee
Delegate to an Affiliate?
14.
Directed Trustees
a.
Summary
b.
Historical
c.
Drafting
Considerations
d. State
Law Approaches to Liability of the Directed Trustee
e. Case
Law Regarding Directed Trustees
f. Practical Planning
Suggestions
15.
Co-Trustees; Failure to Agree to Take Action
16.
Reliance on Asset Retention Power in Trust Agreement; Ruth Lilly Estate Recent
Case
17.
Private Annuity Planning
a.
Negative Income Tax Consequences Outweigh Income Tax Advantage of
Deferral
b.
Example Situation Where Private Annuity Sale to Irrevocable Grantor Trust
Makes Sense
18.
Funding Bypass Trust If Poor Spouse (Or Other Family Member) Dies First,
Using Trusts With General Powers of Appointment
a.
Significance; Applications
b. Mining
Unused Estate Exemptions of Older Relatives
c.
Private Letter Rulings
d.
Structure in Non-Marital Situations
e.
Building Best Case for Avoiding Estate Inclusion At Second Spouse’s Death
f. Notification of
Power
g.
Structure to Avoid Gain on Funding
h. Should
You Get a PLR?
i. Requests for Revenue Ruling
j. Risk That
Donee
Exercises Power in Unintended Way
k.
Creditors’
Rights
19.
Credit Shelter Trust That Is Grantor Trust as to Surviving Spouse
a. Goal
b.
Advantages
c.
Approach
d. Tax
Effects
e.
Reciprocal
Trusts
f. Caveat
20.
Ethics Issues for Estate Planning Attorneys
a. Limits
on Being Advocate for Client
b.
Revealing
Confidences; Conflict of Interests
c.
Knowledge of Client’s Omission; Duty to Amend Incorrect Returns
d. Advice
Regarding Tax Positions and Penalty Effects
21.
Long Term Health Care Insurance
a.
Significance
b. Limits
of Medicare Coverage
c.
Medigap
Limits
d.
Medicaid Limits
e. Long
Term Care Insurance
22.
Vacation Property
a. Family
Meeting to Address Long Term Intent
b.
Endowment Typically Insufficient
c.
Inflexibility of Trusts
d.
LLCs
e.
Revocable
Trust
f. Management
Agreement
g. Family
Homeowners Association
h. Be
Wary of Family Dysfunction
23.
Impact of Societal Megatrends on Estate Planners
a.
Perfect Storm of Forces of Change
b.
Summary of Changed Focus for Estate Planners
c.
Targeted
Giving
d. More
Concern With Own Support
e. Capacity Concerns
f. Power of Attorney
g.
Revocable
Trust
24.
Selected Resources and Forms
25.
Interesting Quotes of the Week
Introduction
The 41st Annual Philip E. Heckerling Institute on Estate Planning the week of January
8, 2007 was again outstanding. I have summarized some of my observations
from the week that I want to take away from the Institute. I attribute all
the good ideas to other speakers at the conference and other ideas that I have
recently heard. I have not researched the various issues to confirm the
correctness of or to endorse all of the ideas presented by the various speakers.
The summary includes some substantive items that I personally found
interesting and includes a wide variety of interesting and creative planning
strategies. (I obviously could not attend all of the meetings, and
doubtless there are many other highlights from the week that I have not
included.) I generally have not included a number of current developments
that were discussed at the Heckerling
Institute but that I have previously addressed in my “Fall Musings 2006.”
1.
Estate Tax Legislation Update:
Because of the difficulty of reaching 60 votes in the Senate in light of the
entrenched positions of Senators on the estate tax issue, it is certainly
possible (perhaps even more likely than not) that a compromise will not be
reached until 2009 when the “gun is at the heads” of Congressmen to avoid
the drastic changes that will occur in 2010 and 2011 under current law.
Both sides have taken very entrenched positions, as evidenced by the
Trifecta
bill this summer when the Republicans could not pick up any additional votes
even by adding an increase in the minimum wage that has been long awaited by the
Democrats.
An effect of the delay is that the ever important ten-year revenue cost of
legislation gets considerably larger closer to 2010, because the reform
legislation would replace a system for most of the ten-year window that is
based on pre-2001 law. We are likely to see extremely long phase-ins to reduce
the ten-year revenue cost.
Reform measures would likely include estate and GST exemptions in the
$3.5-5.0 million range and reduced rates (how low is a major point of
disagreement). As a measure of providing some revenue offset, it is likely
that there may be a provision disallowing some types of intra-family discounts.
Here’s an interesting viewpoint that I had not heard previously. Even in
2009, it may be difficult to reach agreement. While the Democrats will not
want the estate tax to be repealed for a year in 2010, the Republicans would
likely feel even stronger that they would not want to return to pre-2001 law in
2011. The Democrats may feel that they have the leverage to be very
hard-nosed in the negotiations, leading to stalemate (i.e., the failure to get
60 votes in the Senate). The Democrats, remembering the maneuvers of the
Republicans to achieve complete repeal or a 15% tax rate, may be reluctant to
agree to a tax rate below the 35% rate in the bill introduced by Louisiana
Senator Landrieu last summer, and may determine that they can wait until the
rate automatically returns to 55% (or 60% in the bubble) in 2011 to bargain with
the Republicans.
2. FLP Planning
Issues.
a.
Senda
Integrated Transaction Dictum. The Eighth Circuit recently approved this
indirect gifts case. 433 F.3d 1044,
aff’g, T.C. Memo. 2004-160. There is
dictum in the Tax Court case suggesting that a step transaction doctrine might
apply even if the contribution is made to the partnership prior to gifts of
partnership interests. The Eighth Circuit also had dicta that might be
interpreted to support that approach: “The tax court recognizes that even
if the Sendas’ contribution would have first been credited to their
accounts, this formal extra step does not matter.” The case specifically
said that the step transaction doctrine applies broadly to estate and gift
transactions.
Several speakers said that the step transaction
doctrine should not apply here. The step transaction doctrine ignores
unnecessary steps to determine tax consequences, and the
donees never ended up owning the underlying assets.
Nevertheless, the client should wait some period of
time after funding the partnership before making transfers. Several
respected speakers said that planners should merely wait a day, to clearly
document that the contribution to the partnership was made prior to gifts of the
limited partnership interests. Other planners suggest waiting 6 months.
Those who suggest just waiting one day say that waiting 6 months should not
really make a difference if there was the intent at the outset to make the
subsequent gift and if that intent is enough to apply a step transaction theory.
There is a pending case in audit where the IRS
agent argued this indirect gift theory even though the gift of the partnership
interest was not made until made 8 months after the partnership was formed.
(Part of the reason for the delay was that the client could not decide how much
gifts to make.) The agent has issued a notice of deficiency and that case
is now going to the Tax Court. (Perhaps it will be settled at Appeals.)
John Porter
tried the Holman case in December 2005 to the Tax Court and is still
awaiting decision. In that case, the IRS made the indirect gift argument
even though the partnership interest was not given until 8 days after the
partnership was created.
Practical planning pointers:
·
Make clear that assets are held by the partnership and verify that before making
gifts of limited partnership interests.
·
Discuss with the client the possibility of making gifts, but do not
discuss with the client how much the client wants to give when the FLP is
created. Leave that as an open question so no one can argue step
transaction or prearranged transaction.
·
To help rebut an integrated transaction attack, the planner should be
careful that documents do not describe overall transactions anticipating the
transfer of particular amounts of limited partnership units.
b.
Full Consideration Exception to Section 2036. There are two legs to
the “bona fide sale for full consideration” exception to §2036. There must
be a bona fide sale (addressed in the Rosen
[T.C. Memo 2006-115] and Korby [T.C. Memo
2005-102 and 2005-103] cases in 2006), and the transfer must be for “adequate
and full consideration.” The Bongard
[124 T.C. 95 (2005)] and Kimbell [371 F.3d 257
(5th Cir. 2004)] cases said that the full consideration requirement
is met by having proportionate transfers to a partnership that maintains capital
accounts and allocates distributions among the partners pursuant to the capital
accounts. However, the IRS is still arguing that the “full consideration” test
requires more than that. The IRS’s brief in the Korby case to the Eighth Circuit, argued:
·
The partnership must respect formalities (proportionate transfers
reflected in capital accounts, which is the test in Tax Court and Fifth
Circuit).
·
ALSO, the transaction must not deplete the estate (before and after the transfer
to the FLP).
·
The IRS recognizes that some immediate dissipation in value occurs whenever
there is a transfer to any entity, but “the diminution in value from the
partnership restrictions must be offset by some other advantage to holding
assets in partnership form.”
Conclusion: We cannot assume the “full consideration” issue is
resolved. The Third Circuit in Thompson said there is “heightened
scrutiny” if there is a dissipation in value, and a concurring opinion, joined
by 2 of the 3 judges, explained that the depletion rule would not apply in
“routine commercial transactions”—intimating that it would apply in other
transactions.
c.
Conclusions
Regarding Section 2036 Application. The IRS is attacking 2036 in bad
facts cases. (The Rosen and Korby cases both involved terrible fact situations.)
As a practical matter, unless there is a transfer of almost all of the
decedent’s assets to the FLP, the IRS is treating FLP cases as discount cases
and negotiating the amount of the discount. If agreement cannot be
reached, they may throw in a §2036 claim in a negotiating posture, but they
generally approach the case as a valuation case.
2036(a)(2)—IRS field agents generally are not attacking
partnerships under §2036(a)(2) or applying Judge Cohen’s broad “in conjunction with”
analysis. The “Appeals Coordinated Issue Settlement Guidelines” IRS
document published in the fall of 2006 is insightful, by omission, in merely
providing a very abbreviated summary of Judge Cohen’s oft-criticized §2036(a)(2) analysis in Strangi. As
a practical matter, §2036(a)(2) gets thrown in merely
as an additional argument when there is a bad facts §2036(a)(1) case.
BUT the arguments are there, and Judge Cohen’s
Strangi
2036(a)(2) discussion and Bongard’s finding
that control over cash flow to the partnership triggered §2036(a)(1) points out
that the §2036 risk is inherently always there.
Ron Aucutt Observations about §2036. We can easily avoid §2036(a)(1)
by not being sloppy. We can avoid §2036(a)(2)
because the broad §2036(a)(2) analysis is not supported by a single citable
consensus authority. But many are concerned about §§2036(a)(1) and a)(2). Why?
1. Out in
the field, IRS agents sometimes apply some of these authorities in a much more
sweeping and concerning manner than one would imagine by just reading the cases.
For example, in the Peracchio case, the IRS raised a lot of arguments,
which the client and counsel had to deal with, but the IRS before trial dropped
all of the arguments other than the valuation issue. As another example,
agents sometimes hold up any borrowing as showing an implied agreement of
retained enjoyment under §2036(a)(1).
2.
Section 2036 is an estate tax provision and brings lingering uncertainty—so it
brings back not just what is transferred but all intervening appreciation.
Also, there is no way to start the estate tax statute of limitations. “The
only way to start the estate tax statute of limitations is to die.”
3.
Clients want certainty. They want the planner to assure that there cannot
possibly be a §2036 problem.
Ron typically concludes that
whatever §2036 risk there is does not justify drastic measures to change an
existing partnership, and he usually is content to let the partnership continue.
But there are exceptions.
Possible solutions to the valuation uncertainty for FLPs
include a legislative answer or regulatory guidance. Estate tax reform
legislation may address valuation discounts for intra family transactions, and
further regulatory guidance under §2704(b) has been on the Treasury’s regulatory
guidance list for several years. While there is broad statutory
authorization for further regulations, the IRS may not want to be in the
political hot seat of basically outlawing discounts by regulations.
Any regulatory response is (1) likely to be prospective only, and (2) not likely
to be holistic (i.e., it won’t say these tools are the exclusive tools for the
IRS to use—and not §2036(1)(2).)
d.
Section 2035 Conundrum. The three-year was abolished in 1981, and was
revised with a substitute to deal with transfers like insurance or remainder
interest transfers on death bed. The legislative history in 1981 committee
reports dealt with a particular kind of interest that appreciated greatly in
value at the moment of death, such as a life insurance policy or remainder
interest. That is not true generally of a limited partnership interest
that continues to carry the characteristics that contribute to the discount.
So perhaps §2035 was not intended to apply to
FLPs in that way. But, good luck with that
argument. For example, Bongard (a full
Tax Court opinion), jumps directly from 2036 to 2035 without any discussion of
whether §2036 now applies to this type of transfer.
There are various possible ways to restructure to
avoid §2036 without triggering the three-year rule of §2035. If the agreement is
revised to limit distributions to ascertainable transfers, that may not be a
“transfer” under §2035.
Ron
Aucutt’s favorite approach, if one spouse contributed assets to
the FLP, is to revise the agreement to say that the contributing spouse has
responsibility over investments, and the other spouse has responsibility over
distributions.
e.
Marital Deduction Mismatch Problem. A marital deduction
mismatch possibility exists at the first spouse’s death for any underlying
assets brought back into a decedent’s estate under §2036 when the limited
partnership interests (rather than underlying assets) pass to the surviving
spouse by bequest under the decedent’s will. The IRS has argued in some
estate tax audits that only the (discounted) value of the limited partnership
interests “pass to” the surviving spouse and qualify for the marital deduction,
not the higher value of the partnership assets included under §2036. (The
issue was mentioned in footnote 13 of the Bongard case, and the parties stipulated in the Korby cases that the marital deduction would not
offset assets included in the estate under §2036 if only a portion of the assets
were included in the first spouse’s estate.)
A
possible planning strategy to avoid this risk, suggested by Kevin Matz,
would be to include provisions in the partnership agreement so that the
surviving spouse (or QTIP trust) would not have restrictions on liquidating the
partnership:
“Perhaps the best way to accomplish this would be
to provide in the FLP's
governing documents (which may need to be amended to allow this) that the holder
of the FLP interests that would pass to or for the benefit of the surviving
spouse (e.g., the trustee of the QTIP trust) would be able to liquidate the FLP
without the consent of any other person.
“For example, suppose that the partnership
agreement permits liquidation to occur upon the affirmative vote of the general
partner and limited partners holding more than two-thirds of the outstanding
limited partnership interests. In this situation, the trustee of the QTIP
trust—who pursuant to the decedent's estate plan would receive the general
partnership interest and more than two-thirds of the limited partnership
interests—would be able to liquidate the FLP without the consent of any other
person. Consequently, there would not appear to be any viable basis for the IRS
to argue that the value of the FLP interests passing to the surviving spouse
should be discounted.” Matz, “Special Concerns in FLP Planning Where Both
Spouses Are Living,” 34 EST. PL. 16 (Jan. 2007)
3. Defined Value
Clauses.
a.
Basic Issue. McCord [461 F.3d 614 (5th Cir. 2006),
rev’g 120 T.C. 358 (2003)] involves a gift made by a formula giving a
specified dollar amount of limited partnership interests. One attorney has
analogized this to going to a gas station and asking for $10 worth of gasoline.
While that seems straightforward enough (and is strikingly similar to marital
deduction formula clauses that are commonly accepted in testamentary
instruments), the IRS objects, largely on the grounds that the clause would make
IRS gift tax audits meaningless.
b.
Two Fundamental Types of Defined Value Clauses.
1.
Defined Value Clauses That Limit the Amount Transferred (i.e., transfer of a
fractional portion of an asset, with the fraction described by a formula)
2.
Defined Value Clauses That Allocate Amount Among
Transferees (i.e., transfer all of a particular asset, and allocating that asset
among taxable and non-taxable transferees by a formula)
(The McCord case used the second type of clause.)
c.
Observations
Regarding Factual Background of McCord. Apparently, the family was
very charitably inclined. If the clause operated to leave more assets than
originally contemplated to the donor advised fund at the Communities Foundation
of Texas, the family would have simply substituted distributions from the donor
advised fund for charitable contributions that the family would have made anyway
in future years. The defined value clause, with the “residue” passing to a
donor advised fund, coordinated well with the family goals in that situation.
The $6,910,932.52 number is rather curious.
Apparently, the taxpayers had a detailed appraisal prepared, and they wanted to
leave a targeted significant interest to the “residual” gift to the Communities
Foundation. They worked backwards in setting the dollar amount gift to the
sons, in order to leave the anticipated targeted amount to the charity. In
retrospect, the planners would probably use round figures in future transactions
(for example, $7.0 million instead of $6,910,932.52).
d.
Did McCord Actually Recognize Defined Value Clause? Some
commentators have concluded that the Fifth Circuit case merely held that the
Commissioner did not meet its burden of proof, and that it was error to use the
Confirmation Agreement to impact the determination of the gift tax.
The Current Developments outline by Richard
Covey and Dan Hastings concludes:
“Given the Fifth Circuit’s recognition that this [defined value] issue
was at the ‘heart’ of the case and ‘fractionated’ the Tax Court, one might have
expected a direct discussion of whether such clauses work or do not work.
No such discussion occurs. Instead the Fifth Circuit assumes they work…”
(The Fifth Circuit did not address the public policy concern, because that
argument was dropped by the IRS.)
John Porter
(and others) respond that courts do not bless and
broadly validate the use of general tax planning strategies. Instead,
courts just decide based on the facts of a particular case before them—and that
is what the Fifth Circuit did. Courts do not say, “Estate planners, start
your engines—you can now safely use this new strategy.”
e.
IRS Reaction to These Clauses. The IRS did not request a rehearing or
en banc review, or appeal to the Supreme Court. The IRS national office
has informally reported to some attorneys that the Fifth Circuit had the
opportunity to bless specifically the use of defined value clauses and declined
to do so. However, some IRS agents (in the Fifth Circuit) have indicated
that while they may not like the result, the Fifth Circuit has spoken and the
agents will recognize defined value transfers that follow the format of the fact
situation in McCord (including that the clause uses a “willing buyer-willing
seller” valuation standard rather than using “values as finally determined for
federal gift tax purposes,” that the pour-over transfer is to a charity that is
independent of the donor, that there was no collusion with the independent
charity over the value issue, and that the charity exercises reasonable due
diligence in determining the interests that pass under the defined value
clause.)
Speakers and other attorneys at the seminar told me of a broad number of audit
situations where they have used defined value clauses. Upon explaining to
the auditing agent how the clause operates, the valuation issue was disposed of
very quickly in the audit. (Another attorney has described an audit
situation in which the existence of the clause complicated the audit because the
agent somehow [inexplicably, in my view] took the position that the clause made
the entire transfer an incomplete gift.)
f. Using Defined
Value Clauses in Sales Transactions. Using defined value clauses would
seem to be practical mainly in cases involving relatively large transfers.
Therefore, it may be more likely to see them in sales transactions than in gift
transactions, because most clients transfer large values only in sales
transactions and not in gift transactions.
g. No
Excuse for Sloppy Planning. Using a defined value clause is not an excuse to
avoid getting a good appraisal.
h. Formula Disclaimer
Approach. The IRS is currently litigating a somewhat similar post-mortem
planning approach involving a formula disclaimer. One such case that
settled was Estate of Lowell Morfeld, Tax Court
Docket # 012750-03. In that case, the residuary beneficiaries disclaimed the
remainder of the estate exceeding “x” dollars (before payment of debts, expenses
and taxes) in which the decedent’s
will provided that any disclaimed assets would pass to a Community Foundation to
fund a Donor Advised Fund in the name of the disclaiming child. The estate
consisted in part of a 49% limited partnership interest that the estate’s
appraiser valued with a 45% discount for lack of marketability and lack of
control. The IRS agent refused to allow any discounts, citing Procter.
The case was settled prior to trial. John Porter,
who represented the taxpayer in Morfeld,
reports that he is handling another case involving a similar formula disclaimer
in which the IRS is again arguing that the disclaimer violates public policy
under the Procter rationale.
4. GRAT Planning
a.
Deferred
Payment GRAT. Assume that an asset will have no cash flow for 2 or 3
years, but will have great appreciation potential after that time. One way
around this problem is to use a long-term GRAT. For example, a 20 year
GRAT with an annuity that increases 20% per year would have very low annuity
payments in the first several years. The early annuity payments could be
paid from cash funded into the GRAT up front. Another way is using a
“Deferred Payment GRAT.” The GRAT would provide that annuity payments
would not begin for 3 years. For example, with a 6 year GRAT, with
payments beginning in the 4th year, the initial annuity payment would
be about 36%. This seems consistent with the statute and the regulations.
Section 2702(b) says that fixed payments are required, payable not less
frequently than annually. That does not say when the payments must start.
[Query: Since payments must be paid annually, does that imply that a
payment must be made in year one?] The regulations dealing with that
section also seem to allow deferred payments. Reg. 25.2702-3(d)(2)
is titled “Contingencies.” It says that the payment cannot be subject to
any contingency other than the right to revoke the qualified interest of the
transferor’s spouse or “the survival of the holder until the commencement,
or throughout the term, of that holder’s interest.” That seems explicitly
to sanction deferred payment GRATs.
Carlyn
McCaffrey thinks this should work under the
statute and regulations, but she is not aware of any cases or audits that have
addressed a deferred payment GRAT.
b. Spousal Annuity-Helpful if Spouse Has Shortened
Life Expectancy. If the grantor’s spouse has a shortened life
expectancy (but still has a greater than 50% chance of living at least one
year), consider using a GRAT with a contingent revocable interest for the
remaining lifetime of the spouse who has the shortened life expectancy.
Lower annuity payments can be used in the initial term in light of the fact that
the remainder interest is reduced by the assumed value of the contingent spousal
interest. If the spouse actually dies early, more passes to
remaindermen.
c. Grantor Has Shortened Life
Expectancy. If the grantor has a shortened life expectancy, the possible
planning is not as clear cut. If the GRAT continues until grantor’s death, §2036
would apply. But if the grantor creates the GRAT based on the grantor’s
life expectancy and simultaneously sells the remainder interest to a grantor
trust set up previously, then §2036 arguably would not apply.
d.
IRS Looking At Annuity Payments. There may be a trend of the
IRS looking to see if annuity payments are made timely and how annuity payments
are valued.
One speaker called six GRAT clients who had family
members as the GRAT trustee to ask when the annuity payments were made.
One of the six made the annuity payments on a timely basis. One of the clients
said that he never made a payment and GRAT term had ended. (The client said “if
IRS comes after me, I will sue you, because you had a duty to make sure the
trustee did his job right.”)
One
possible response is to do an assignment of each annuity payment at the creation
of the GRAT, taking effect at the payment date UNLESS the trustee changes it
before that time. This solves possible problem that the trustee will not
cut the check on the payment date (or 105 days later). There should be an
ordering rule of what GRAT assets to use first in satisfying the assignment
(i.e. cash first, then lowest basis assets, etc.) If there is a securities
law §16b problem with stock, that would be the last asset to be paid. A
similar approach would be to provide in the trust agreement that payments would
vest in the grantor on the annuity payment date even if not paid and the trustee
would act as agent for the grantor with respect to such vested amounts.
See Blattmachr, Zeydel &
Bramwell, Drafting and Administration to
Maximize GRAT Performance, 20 Probate & Property 16, 22-23 (Nov./Dec. 2006)
e.
Revocable GRAT. Some planners have suggested making a GRAT
revocable until all funds have been retitled in the
name of the GRAT. At that time the grantor would release the revocation
right. That would avoid a possible argument by the IRS that additional
contributions are being made to the trust (which is prohibited) if all assets
are not funded into the GRAT on the date that it is signed.
Manigault
& Hatcher, Revocable GRATs, Trusts &
Estates 30 (Nov. 2006).
f. Spendthrift
Clause. Do not include a spendthrift clause because it may not do much
good anyway, and more importantly, it prevents the remainder beneficiary from
assigning its interest in the GRAT. There are two reasons this may be
important:
1. In several recent cases, the
IRS was forced to value lottery annuity payments using a lower value than the
§7520 value because the annuity payments are nontransferable. Could the
IRS argue that the existence of the spendthrift clause means the annuity
payments are nontransferable, so that the grantor could not rely on §7520 in
placing a high value on the retained annuity payments?
2. It may be helpful for
remainder beneficiaries to transfer their interests in the trust (for example,
to a GST exempt trust or to the grantor).
g.
GST Exemption Allocation at End of GRAT Term. Using a GRAT is a
good way to utilize the client’s GST exemption during the client’s lifetime
without making a taxable gift. Potential concern: At the termination
of the GRAT, if the GRAT document says to transfer the portion of the remaining
assets that do not exceed the grantor’s remaining GST exemption to a GST exempt
trust and the balance to the grantor’s children outright, does it create an
argument that the grantor has retained the right to designate how the assets
pass meaning that the initial transfer to the GRAT was an incomplete gift?
An
alternative is not to define the transfer in terms of the grantor’s remaining
GST exemption, but to leave the GRAT assets to a trust and use a qualified
severance to sever out the portion of the trust that can be covered by
allocation of the grantor’s GST exemption. There is an excellent
discussion of this issue in Manigault & Hatcher,
GRATs
and GST Planning: Potential Pitfall and Possible Planning Opportunity, 20
Probate & Property 28 (Nov./Dec. 2006).
h.
Purchase of Remainder Interest by Grantor. If there is a really
successful GRAT and there is a worry that client might die before the end of the
GRAT term, the grantor might consider purchasing the remainder interest from the
remainder beneficiary for its present value. If the grantor dies during the term of the GRAT, all assets in the
GRAT will (likely) be included in the estate. But now, the
remainder beneficiary trust has the dollars paid for the remainder interest that
is excluded from the grantor’s estate. The grantor has no interest in it
and has no control over it, so it is excluded from the grantor’s estate for
estate tax purposes.
A potential risk is that the IRS might argue that
this is in effect a prohibited commutation. Presumably that might raise
the risk of an argument that the GRAT does not create qualified interests under
§2702, so the entire initial transfer to the GRAT would be treated as a gift.
To avoid that possible argument, wait to purchase the remainder interest until
after the statute of limitations has run on the gift tax return for the year the
GRAT was created (of course, that would not be possible with a two or three year
GRAT).
One
attorney at a seminar this fall reported doing this in a transaction where the
grantor of the GRAT was about to die and the grantor purchased the remainder
interest from the grantor trust that owned the remainder interest. That
sale was audited. In that case, there were different trustees of the
grantor trust remainder owner and the GRAT itself (to help show no merger).
The attorney even had the grantor trusts file a Form 1041 when initially
created, reporting them as grantor trusts. The grantor borrowed money from
a bank to pay for the remainder interest. The IRS agent didn’t like it,
but it passed the audit.
i. Loan to Grantor’s Spouse. If
the grantor or the grantor’s spouse needs access to value in the GRAT before an
annuity payment is made, may the trustee loan assets to the grantor’s spouse?
This should be permissible. The reason for the borrowing should not
matter—as long as the loan is a legitimate loan and not a disguised distribution
to the spouse. The trustee should be able to use the §7872 rates. A
potential concern is that if the loan is too favorable to the spouse, it could
be treated as an impermissible distribution to someone other than the grantor,
and if the loan is too favorable to the trust, it could be treated as a
prohibited additional contribution to the trust.
j. Possibility
That GRAT Does Not Trigger an ETIP Period; If So, Risk of Automatic GST
Exemption Allocation at Creation of GRAT Unless Election Out of Automatic
Allocation.
(i) Does the ETIP Rule Apply Before the Termination of the
GRAT? GST exemption cannot be allocated to a trust during the “estate tax
inclusion period” (or ETIP). The traditional thinking is that there is an
ETIP during the term of a GRAT, because the assets would be included in the
gross estate of the donor if the donor dies during the trust term.
However, there is a strange regulation saying that the ETIP rules do not apply
“if the possibility that the property will be included [in the gross estate of
the grantor or the grantor’s spouse] is so remote as to be negligible.” Treas. Reg.
§26.2632-1(c)(2)(ii)(A). The regulation
says that the risk of inclusion “is so remote as to be negligible if it can be
ascertained by actuarial standards that there is less than a 5 percent
probability that the property will be included in the gross estate.” There is
probably less than a 5% chance that the grantor will die within two years
(unless the grantor is older than about age 68). The regulation might
suggest that the GRAT is therefore not subject to the ETIP rules. (Various
attorneys pointed out this potential problem when this regulation was proposed,
but the regulation was finalized without any change.)
However, the context of the definition of an ETIP
in the regulation before the “so remote as to be negligible” clause may suggest
that the intent is to inquire whether there is a 5% chance that the value would
be included in the grantor’s estate if the grantor were to die within the GRAT
term. But, the regulation does not literally say that. As a
practical matter, attorneys are not relying on this possible interpretation to
allocate GST exemption at the creation of GRATs.
(ii) If the ETIP Rule Does Not Apply to
GRATs, How Much GST Exemption Would Have to Be Allocated To Achieve an
Inclusion Ratio of Zero? If $10 million is contributed to a GRAT with a $10
gift, can the grantor just allocate $10 of GST exemption to cover all of the
remainder interest? Probably not. IRC
§2642(a)(2)(B) says that the denominator of the
applicable fraction is “the value of the property transferred to the trust”
(reduced by taxes and the charitable deduction). The statute and
regulations do not refer to reducing the denominator by the amount of the
grantor’s retained interest.
The counter argument is that if there is a part
gift, part sale, the donor should not have to allocate GST exemption to the sale
portion. Under this approach, the “value of the property transferred” is
impliedly the net value of the property. Some GRATs
with highly speculative assets are expected to result in a zero transfer or a
huge
transfer. In that situation, a planner may want to consider allocating GST
exemption to the initial transfer equal to the “net value” of the transfer
[i.e., the value of the remainder interest] when the GRAT is created. For
example, a formula allocation could be made of “so much as is necessary to
achieve a zero inclusion ratio, but not more than the value of the remainder.”
In light of the uncertainty over the amount of GST exemption needed in this
circumstance, if GST exemption is allocated at the creation of a GRAT, it is
essential to put a cap on the amount allocated.
An outline and article in 1987 had a long
discussion of this issue, before the 1988 revisions that brought the ETIP rules.
Before the ETIP rules were passed, planners thought that this kind of leveraging
with the GST exemption was available for trusts like GRATs
(although they weren’t typically referred to as “GRATs”
back then). If GST exemption had to be allocated based on the full amount
transferred to the trust, why were the ETIP rules needed in the first place?
There is an excellent discussion of this issue in
Manigault
& Hatcher, GRATs and GST Planning:
Potential Pitfall and Possible Planning Opportunity, 20 Probate & Property
28 (Nov./Dec. 2006). The authors suggest the following approach:
·
Make a formula GST exemption allocation, with a cap (perhaps $100) when the GRAT
is created.
·
Allocate GST exemption on the gift tax return on which the GRAT is first
reported.
·
As a “belt and suspenders” approach, at the end of the annuity period,
the grantor would make a protective formula GST allocation (again, perhaps with
a cap depending on the circumstances) on a gift tax return.
(iii) Risk of Automatic Allocation of GST
Exemption. If the GRAT remainder will pass in a manner that could
potentially have distributions to skip persons, and IF the ETIP rule does not
apply, there would be automatic GST exemption allocation when the GRAT is
created. It is likely that the amount allocated would be the entire value
of the property transferred to the trust, even though all of that current value
(and more) will be distributed back to the donor—thus likely wasting GST
exemption. To be sure of preventing this result, an election against
automatic allocation of GST exemption could be filed when the GRAT is created.
(However, some of the nationally respected attorneys who have been aware of this
particular potential concern for years have not been electing out of
automatic allocation upon the creation of the GRAT, although I spoke with one
such attorney who may start doing so out of an abundance of caution.)
A separate issue, of which most planners are aware,
is that the gift tax return that is filed for the GRAT when it is created can
elect out of automatic allocation at the end of the ETIP—to avoid automatically
allocating an undetermined amount of GST exemption when the GRAT terminates.
See Treas. Reg. §26.2632-1(b)(2)(iii)(A)(1).
k. Distributions From or Redemptions of Interests
in Entities Transferred to GRATs. What if a
discounted limited partnership interest is transferred to a
GRAT, and large distributions are made from the partnership to the GRAT
in order that the GRAT could make cash payments (undiscounted) to the grantor in
making the annuity payments? To avoid an argument that the legal entity is
just a sham for tax purposes, consider using a 5 or 6 year GRAT, and funding the
GRAT with liquid assets (that could be used to make the annuity payments during
the first three years and) as well as discounted interests in partnerships or
other entities. After the statute of limitations has run on the gift value
passing to the GRAT, distributions from or redemptions of interests in the
partnership would not run the risk of a revaluation of the interest transferred
to the GRAT under a sham analysis.
l. Assets Subject
to Blockage Discount. If a large block of stock that is subject to a
blockage discount is contributed to a GRAT, there may be a large discount on the
value going into the GRAT (which would lower the annuity payments). If
smaller blocks are distributed each year, the blockage discount may not apply to
those payments, thus allowing a discount arbitrage advantage that could result
in a successful GRAT even if the combined appreciation and income of the assets
do not beat the §7520 rate.
m. Rolling
GRATs With Single Instrument. The GRAT trust instrument
could provide that annuity payments would be automatically transferred back into
a new GRAT under the terms of the original instrument, unless the grantor
directed the trust at the time of the termination to make the annuity payment
distribution directly to the grantor. This would avoid the necessity of
drafting a new GRAT instrument each year when an annuity payment is received.
[Query whether this might give rise to an IRS argument that the intent is to
create a continuing GRAT (and retained interest) until the grantor’s death, and
that all appreciation in the terminated GRATs that
presumably passed to other trusts should be brought back into the grantor’s
gross estate.]
5.
Sale
to Grantor Trust Planning
a.
Debt vs. Equity. If the note that is received from the trust is
treated as | 
