The following article originally appeared in newsletter of the Kansas Bar Association Real Estate, Probate and Trust Law Section. It is reprinted here by permission.
By Kent Meyerhoff
Fleeson, Gooing, Coulson & Kitch, L.L.C.
STATUTORY AND REGULATORY DEVELOPMENTS, AND IRS RULINGS
1. IRS Issues Final Regulations on Consistent Basis Rules for Inherited Property
In TD 9797, the IRS issued final regulations regarding consistent basis reporting between estate tax returns and income tax returns. The final regulations confirm the earliest due date for providing statements to the IRS and beneficiaries under these rules was June 30, 2016.
Under the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 (the “Act”), for property with respect to which an estate tax return is filed after July 31, 2015, the basis of any such property acquired from a decedent can’t exceed: (i) in the case of property the final value of which has been determined for purposes of the estate tax on the estate of the decedent, such value; and (ii) in the case of any other property, and with respect to which a statement has been furnished under new Code section 6035(a) identifying the value of such property, such value. The Act also provides for an accuracy-related penalty for underpayments attributable to an inconsistent estate basis. Code Section 6662(k) provides that there is an inconsistent estate basis if the basis of property claimed on a return exceeds the basis as determined under Code Section 1014(f).
Code section 6035(a)(1) provides that the executor of any estate required to file an estate tax return under Code Section 6018(a) must furnish, both to the IRS and to the beneficiary acquiring any interest in property included in the decedent’s gross estate for federal estate tax purposes, a statement that provides the value of each interest in such property as reported on the estate tax return and such other information as the IRS may prescribe. Under Code Section 6035(a)(2), a beneficiary required to file a return under Code Section 6018(b) must furnish to the IRS and each other person who holds a legal or beneficial interest in the property to which such return relates, a statement identifying the information described in Code Section 6035(a)(1). Code Section 6035(a)(3)(A) provides that each statement required to be furnished under Code Section 6035(a)(1) or Code Section 6035(a)(2) must be furnished at such time as the IRS prescribes, but in no case later than the earlier of: (i) 30 days after the date on which the return under Code Section 6018 was required to be filed (including any extensions); or (ii) 30 days after the date the return is filed.
2. IRS Provides Sample Language to Allow CRATS to Avoid Probability of Exhaustion Test
In Rev. Proc. 2016-42, the IRS provided a sample provision that could be included in charitable remainder trusts (CRATs) to help those trusts avoid violating the “probability of exhaustion test”.
Pursuant to Rev. Rul. 70-452, if there is a greater than 5% probability that payment of the annuity to the non-charitable beneficiary will exhaust the trust assets by the end of the trust term, resulting in no assets passing to charity at the end of the term, then the possibility that the charitable transfer will not occur is not so remote as to be negligible, and the CRAT does not qualify for an income, gift, or estate tax charitable deduction. This is often referred to as the “probability of exhaustion test”. Because of the historically low interest rates that have been in effect in recent years, the ability to use CRATS in planning has been limited. The new sample provision, if included in the CRAT document, will be treated as a “qualified contingency” that will not cause the trust to fail as a charitable remainder trust. The following sample provision is for a CRAT that uses one measuring life:
“The first day of the annuity period shall be the date the property is transferred to the trust and the last day of the annuity period shall be the date of the Recipient’s death or, if earlier, the date of the contingent termination. The date of the contingent termination is the date immediately preceding the payment date of any annuity payment if, after making that payment, the value of the trust corpus, when multiplied by the specified discount factor, would be less than 10 percent of the value of the initial trust corpus. The specified discount factor is equal to [1/(1 + i)]t, where t is the time from inception of the trust to the date of the annuity payment, expressed in years and fractions of a year, and i is the interest rate determined by the Internal Revenue Service for purposes of section 7520 of the Internal Revenue Code of 1986, as amended (section 7250 rate), that was used to determine the value of the charitable remainder at the inception of the trust. The section 7520 rate used to determine the value of the charitable remainder at the inception of the trust is the section 7520 rate in effect for [insert the month and year], which is [insert the applicable section 7520 rate].”
The revenue procedure includes variations of the sample provision for other types of CRATS. Using the sample provision is an alternative to satisfying the probability of exhaustion test. The revenue procedure applies for CRATS created after August 8, 2016, that (1) meet the requirements of Code Sec. 664(d)(1), (2) provide for annuity payments payable for one or more measuring lives, and (3) contain the sample provision.
3. State Court Reformations of IRA Beneficiary Designations Had No Effect on Federal Tax
In three private letter rulings (PLR 201628004, PLR 201628005, and PLR 201628006) the IRS ruled that a state court’s order to change the beneficiary designation of an IRA after the death of the IRA owner to correct an error by the IRA custodian had no effect on who the beneficiary was under the IRA rules that limit the distribution period based on the life expectancy of a designated beneficiary.
The decedent had two IRAs that named three trusts as beneficiaries. Those trusts met the requirements of Reg. § 1.401(a)(9)-4, Q&A-5, allowing the beneficiaries of the trusts to be treated as the designated beneficiaries for purposes of the required minimum distribution rules. When decedent, prior to his death, moved his IRAs to another firm, the beneficiary designation form named his estate as the sole beneficiary, not the trusts. After the decedent died, the trustees of the trust that had originally been designated as the beneficiaries of the IRAs sought a declaratory judgment from the state court to modify the beneficiaries of the IRAs to the trusts. The court granted the requested relief and ordered that the trusts be treated as the beneficiaries. The IRS ruled that, although the court’s order may have changed the IRA beneficiaries under state law, the retroactive reformation of the beneficiary designations did not change the tax consequences. Therefore, the IRS still treated the decedent’s estate as the sole beneficiary of the IRA.
4. IRS Issues Final Regs That Redefine Marriage-Related Terms in the Code to Include Same-Sex
In TD 9785, the IRS issued final regulations providing that, for federal tax purposes, the terms “spouse,” “husband,” and “wife” refer to an individual lawfully married to another individual, and the term “husband and wife” means two individuals lawfully married to each other. The definitions apply regardless of the sex of the parties. The terms do not include individuals who have entered into a registered domestic partnership, a civil union, or another similar relationship other than a marriage under the laws of a state, possession, or territory of the United States. This was made necessary in light of the Supreme Court decisions on same-sex marriage in U.S. v. Windsor, 133 S.Ct. 2675 (2103), and Obergefell v. Hodges, 135 S.Ct. 2584 (2015). The final regulations became effective on September 2, 2016.
5. IRS Will Not Ignore QTIP Elections Made for Trusts Not Required to Reduce Estate Tax to Zero If
Portability Election Also Made
In Rev. Proc. 2016-49, the IRS has stated it will not ignore a QTIP election that is made for a trust that would not be required to reduce federal estate tax liability to zero, provided that the executor of the estate also makes a portability election pursuant to Code Section 2010(c). In light of Rev. Proc. 2001-38, which stated that a QTIP election could be ignored if it was not necessary to reduce federal estate tax to zero, some had expressed concern that the IRS might ignore a QTIP election made on a federal estate tax return that was filed solely for the purpose of electing portability. The new revenue procedure, which was effective as of September 27, 2016, clarifies that the IRS will not ignore a QTIP election in such circumstances. Pursuant to the revenue procedure, a QTIP election still will be treated as void if all of the following requirements are satisfied: (1) The estate’s federal estate tax liability was zero, regardless of the QTIP election, based on values as finally determined for federal estate tax purposes, thus making the QTIP election unnecessary to reduce the federal estate tax liability; (2) The executor of the estate neither made nor was considered to have made the portability election as provided in § 2010(c)(5)(A) and the regulations thereunder; and (3) The procedural requirements set forth in section 4.02 of the revenue procedure are satisfied. A QTIP election will not be treated as void if: (1) A partial QTIP election was required with respect to a trust to reduce the estate tax liability and the executor made the election with respect to more trust property than was necessary to reduce the estate tax liability to zero; (2) A QTIP election was stated in terms of a formula designed to reduce the estate tax to zero. See, for example, § 20.2056(b)-7(h), Examples 7 and 8; (3) The QTIP election was a protective election under § 20.2056(b)-7(c); or (4) The executor of the estate made a portability election in accordance with § 2010(c)(5)(A) and the regulations thereunder, even if the decedent’s deceased spousal unused exclusion amount was zero based on values as finally determined for federal estate tax purposes.
6. IRS Releases Inflation-Adjustments for 2017
For 2017, the income tax rates and brackets for estates and trusts are:
If taxable income is: The tax is:
Not over $2,550 15% of taxable income
Over $2,550 but not $382.50 plus 25% of the
over $6,000 excess over $2,550
Over $6,000 but not $1,245 plus 28% of the
over $9,150 excess over $6,000
Over $9,150 but not $2,127 plus 33% of the
over $12,500 excess over $9,150
Over $12,500 $3,232.50 plus 39.6% of the
excess over $12,500
The exclusion amount for gifts made and estates of decedents who die in 2017 is $5,490,000. The generation-skipping transfer tax exemption for transfers that occur in 2017 also is $5,490,000.
The gift tax annual exclusion for gifts made in 2017 will remain at $14,000. The annual exclusion for gifts to noncitizen spouses in 2017 is $149,000.
The limit on the amount that the value of an estate can be decreased as a result of special use valuation is $1,120,000 for estates of decedents who die in 2017.
7. Private Letter Ruling Discusses Distribution Period for IRA That Named a Trust with Multiple
Beneficiaries as the Sole Beneficiary of the IRA
In PLR 201633025, the sole beneficiary of a decedent who died prior to taking any distributions from his IRA was a trust. The terms of the trust provided that the trustee was to distribute all of the trust’s net income to decedent’s child. The trustee also had discretion to make distributions of principal to a grandchild for such grandchild’s health, education, maintenance, and support. The trust will terminate when decedent’s child reaches the age of 50. At that time, the then-remaining principal and income of the trust will be distributed to decedent’s child. If the child dies before turning 50, the trust terminates and distributes to decedent’s grandchildren. If decedent’s child and grandchildren all were deceased at the time of a distribution of all of the trust assets, the then-remaining assets would be distributed to the decedent’s siblings.
The IRS first determined that the trust met the requirements of Reg. § 1.401(a)(9)-4, Q&A-5, so that the beneficiaries of the trust could be treated as the designated beneficiaries of the IRA for purpose of determining the applicable distribution period. The IRS then determined that the applicable distribution period for the IRA should be based on decedent’s child’s life expectancy. The IRS stated only the decedent’s children and grandchildren should be taken into account for purposes of determining the applicable distribution period. The decedent’s siblings would not be taken into account. Because decedent’s child had the shortest life expectancy as among the decedent’s child and grandchildren, the applicable distribution period would be based on the life expectancy of decedent’s child.
8. IRS Information Letter Discusses Distribution Rules for a Non-Spouse Beneficiary of a Roth IRA
The IRS was asked whether a non-spouse beneficiary’s failure to begin taking required minimum distributions within one year of the death of a Roth IRA owner under the life-expectancy rule of Code Section 401(a)(9) made the life expectancy rule inapplicable and required application of the five-year rule for distributions. In Information Letter 2016-0071, the IRS reviewed the required minimum distribution rules and advised that whether the life-expectancy rule or five-year rule applies is governed by Reg. §1.401(a)(9)-3, Q&A 4, which provides that if there is a designated beneficiary, distributions must be made in accordance with the life expectancy rule, unless the plan requires distributions to be made under the five-year rule or allows the beneficiary to elect to use the five-year rule. Determining which distribution method applies is made according to the plan rules and is not based on whether distributions are actually taken in a timely manner under the life-expectancy rule.
9. IRS Reverses Course in Letter Ruling Regarding Grantor Trust Status
In PLR 201642019, the IRS revoked a letter ruling that it had issued in 2014 regarding a trust’s status as a grantor trust. Under the facts of the private letter ruling, Settlor created an irrevocable trust that benefitted the Settlor, his daughters, the issue of his daughters, and six other individuals. The trust had a corporate trustee and a “distribution committee” that consisted of Settlor’s daughters and the six other individuals. The terms of the trust provide that the corporate trustee is to distribute as much income and/or principal as determined by a distribution committee to the members of a class that consisted of the Settlor and distribution committee members. The Settlor also had a testamentary limited power of appointment over the assets remaining in the trust at the time of his death. The trust provided that if, during Settlor’s lifetime, neither of Settlor’s daughters were serving as members of the distribution committee, or if there were fewer than two distribution committee members, the trust would terminate and the then-remaining assets of the trust would be distributed to the Settlor. In a 2014 private letter ruling, the IRS examined Code Sections 673 through 677 and concluded that the trust was not a grantor trust. In PLR 201642019, the IRS revoked the 2014 letter ruling and concluded that the trust is a grantor trust. In reaching this conclusion, the IRS found that the language that provided for the trust assets to be distributed to Settlor if neither of Settlor’s daughters were serving as members of the distribution committee, or if there were fewer than two distribution committee members, constituted a reversionary interest under Code Section 673.
10. Late Portability Election Not Allowed for Estate Over Filing Threshold
Although the IRS has routinely granted relief allowing late portability elections to be made in estates that were below the filing threshold, in Chief Counsel Advice 201650017 it stated a late portability election is not allowed when a decedent’s estate is large enough to require the filing of an estate tax return but failed to file one in a timely manner, even if the estate is not taxable due to a marital deduction.
11. Republican President, House, and Senate Make Repeal of Estate Tax Possible
With Republicans controlling the House, Senate, and White House, the prospect of estate tax repeal seems possible, and some would say probable. During the presidential campaign, President Trump promised to repeal the estate and GST taxes and proposed replacing them with a capital gains tax on assets above $10 million. It is unclear at this point exactly how or when the capital gains tax would apply; it also is not clear whether Trump’s proposal includes a repeal of the gift tax. Although Republicans do not have the 60 votes required in the Senate to avoid a filibuster, they could accomplish a 10-year repeal of the estate tax by a simple majority vote if it is done as part of a budget reconciliation bill.
12. Status of 2704 Regulations Also in Doubt
The prospect of a repeal of the current estate, GST, and possibly gift taxes also call into question whether the proposed Section 2704 regulations will ever be finalized. Treasury held a hearing on the proposed regulations on December 1, 2016. During the course of the hearing, Treasury officials clarified that they did not intend for the 2704 regulations to create an imputed put right in a family-controlled entity and that the three-year rule under Section 2704(a) (concerning a lapse of voting or liquidation rights) would not be retroactive.
13. Special Estate Tax Lien Had Priority Over Administrative Expenses: U.S. v. Spoor, 838 F.3d 1197
(11th Cir. 2016)
The Eleventh Circuit Court of Appeals in U.S. v. Spoor, 838 F.3d 1197 (11th Cir. 2016), held that special estate tax liens under Code Section 6324A are not subject to an executor’s claims for administrative expenses.
F. Gordon Spoor, who was the personal representative for the estate of Louise Paxton Gallagher and the trustee of the Louise P. Gallagher Revocable Trust, filed a federal estate tax return that reported the value of Ms. Gallagher’s estate as $36,624,546, with $34,936,000 of that amount consisting of membership units in Paxton Media Group, LLC. The IRS disagreed with the valuation of the Paxton Media Group units, as reported on the estate tax return, and issued a deficiency notice that valued the units at $35,761,760 and assessed $401,744 in additional tax. The estate filed a petition in the Tax Court to contest the determination of the deficiency.
The estate elected to defer and pay the estate tax in ten equal installments, pursuant to Code Section 6166. The estate agreed to a special deferred estate tax lien on the Paxton units, pursuant to Code Section 6324A. When the value of the Paxton units declined, the IRS demanded additional collateral from the estate. The estate was not able to provide additional collateral, so the IRS accelerated the remaining tax obligations that had been deferred pursuant to Section 6166. The district court held that Spoor’s claim for more than $1 million in personal representative fees took priority over the Section 6324A lien, because it arose before the tax liens were recorded and assessed. The Eleventh Circuit reversed the district court and held that an executors’ administrative expenses do not take priority over a Section 6324A lien. In doing so, the Eleventh Circuit examined the differences between the general estate tax lien imposed by Code Section 6324 and the special lien imposed by Section 6324A. While the language of Section 6324 specifically gives administrative expenses priority over the Section 6324 lien, the language of Section 6324A does not. The court also reasoned that the executor has the ability to choose which assets of the estate should be made subject to the Section 6324A lien and, therefore, could protect his right to be paid his executor’s fee by excepting certain property from the lien. Because the 6324A lien does not automatically apply to all estate property, if the executor’s fees were given priority, it could result in the IRS being undersecured, according to the court.
14. Attorney’s Malpractice No Excuse for Estate Filing Late Return: Specht v. U.S., 661 Fed. Appx.
357 (6th Cir. 2016)
The decedent, Virginia Escher, died December 30, 2008, leaving an estate worth $12 million. The decedent’s 73-year-old high-school educated cousin, Janice Specht, was named executor. The attorney hired by the executor was an experienced estate planner but had brain cancer. The attorney told Specht that the estate owed $6 million in federal estate tax and would need to sell some UPS stock – which was the main asset of the estate – in order to pay the tax liability. Although Specht thought her attorney had obtained extensions of time to file the federal estate tax return, the return was not filed, no extensions were obtained, and tax was not paid in a timely manner. Additionally, Specht’s attorney had represented to her that the attorney had taken steps to sell the UPS stock, but that had not occurred. After receiving several notices from the probate court and the state taxing authorities that Specht’s attorney had missed several filing deadlines, Specht terminated her attorney. The new attorney hired by Specht discovered the missed deadlines and promptly took steps to sell the UPS stock, file the estate tax return, and pay the tax. The IRS assessed penalties for failing to file the return and failing to pay the tax in a timely manner. The executor argued the penalties should not apply, because Specht had reasonably relied on her first attorney. The district court and Sixth Circuit Court of Appeals disagreed, finding that the executor had not met her burden of showing reasonable cause for failing to file the return and pay the tax. The court held that Specht had not reasonably relied on her attorney.
15. Charitable Deduction Denied for Failure to Obtain Contemporaneous Written
Acknowledgement: 15 West 17th Street, LLC. v. Commissioner, 147 T.C. No. 19 (2016)
The Tax Court held that a limited liability company could not take an income tax deduction of $64.49 million for a charitable contribution, because it did not obtain a contemporaneous written acknowledgment that stated the donor did not receive any goods or services in exchange for the gift.
The LLC purchased real estate in New York City in 2005. In 2007, the LLC executed a historic preservation deed of easement in favor of Trust for Architectural Easements, a 501(c)(3) organization. The gift was completed in December 2007, and the donee charity sent the LLC a letter acknowledging receipt of the easement in May 2008. The letter did not state whether the donee had provided any goods or services to the LLC or whether the donee had given the LLC anything of value in exchange for the easement. The LLC obtained an appraisal that concluded the easement had reduced the property’s value by $64,490,000, and the LLC deducted this amount as a charitable contribution on its 2007 income tax return. The IRS audited the LLC’s 2007 return, and in August 2011 issued a notice of final partnership administrative adjustment that disallowed the charitable deduction for the reason that the requirements of Section 170 for substantiating the contribution had not been met. The Tax Court agreed with the IRS. The Tax Court also held that the rule of Code Sec. 170(f)(8)(D), which provides a waiver of the requirement that a charitable donor secure and maintain contemporaneous written acknowledgment from the donee with respect to certain information if the donee files a return with that information “on such form and in accordance with such regulations as the Secretary may prescribe,” does not apply, because the IRS has not yet issued such regulations.
16. California Franchise Tax Board Prevails in Wrongful Taxation Suit in Kansas: Davis v. Bank of
America, No. 16-2506-CM, 2016 WL 7425937 (D. Kan. Dec. 23, 2016)
Ronald E. Davis, a pro se plaintiff, alleged he was wrongfully taxed $719.87 by the State of California. After the tax was deducted from his account at Bank of America, Davis filed a lawsuit that alleged violation of several state and federal statutes. The California Franchise Tax Board filed a motion to dismiss under Rule 12(b)(6), arguing it was immune from suit under Eleventh Amendment sovereign immunity and based on the principle of comity. Although the court recognized it must liberally construe a pro se complaint and apply “less stringent standards than formal pleadings drafted by lawyers,” it granted the motion and dismissed the action. Although admitting it had difficulty deciphering exactly what type of claim the plaintiff was alleging (in his Complaint, Mr. Davis cited a “wide array of federal and state civil statutes as well as criminal statutes that do not provide civil remedies”), the court determined that Mr. Davis’ claim was one for deprivation of his property via garnishment of taxes from his bank account and liberally interpreted the claim as a claim for deprivation of rights under 42 U.S.C. § 1983 and for intentional tort and negligence. The court then granted the Franchise Tax Board’s motion to dismiss.