Prior to 2010, property acquired from a decedent generally received a stepped-up basis under IRC § 1014. The purpose of the statute is to avoid the double taxation that would result if the asset were first subject to estate tax at the death of the decedent, and then to income tax when the beneficiary sold the asset after the decedent’s death. Since the estate tax has, for the time being at least, been repealed, no double taxation would result from the loss of the step-up in basis at death.
For decedents dying after December 31, 2009, and before January 1, 2011, the basis of property acquired from a decedent is the lesser of (i) the decedent’s adjusted basis or (ii) the fair market value of the property at the decedent’s death. IRC § 1022(a)(2). Many estates that would not have been subject to estate tax at the $3.5 million applicable exclusion amount threshold will be subject to the new carryover basis regime. More estates with highly appreciated assets will be affected by the carryover basis provision in 2010 (if not retroactively repealed) than would have incurred estate tax with a $3.5 million applicable exclusion amount.
To temper the harshness of the new rule, Congress provided that the executor may allocate (i) up to $1.3 million to increase the basis of assets, and (ii) up to $3 million to increase the basis of assets passing to a surviving spouse, either outright or in a QTIP trust. The increase in basis provision references the basis of the asset, not its fair market value.
The $1.3 million basis adjustment is increased by loss carryovers and unused losses. Decedents who are nonresidents and noncitizens can claim only a $60,000 basis adjustment and cannot benefit from unused losses or carryover losses. This adjustment can be claimed for assets passing to anyone.
The $3 million basis adjustment applies only to property passing to a surviving spouse either outright or in a QTIP trust. Property passing to surviving spouse is eligible for $1.3 million basis adjustment as well as the $3 million basis adjustment. Therefore, a total of $4.3 million in basis adjustments may be allocated to property passing to a surviving spouse.
In order to qualify for the basis adjustment, the property must be “acquired from the decedent” and “owned” by the decedent at the time of death. Some property, while satisfying the former requirement, will not satisfy the latter requirement, and will therefore be ineligible for the basis adjustment.
For example, the interest of a surviving spouse in a QTIP trust will have been acquired by the surviving spouse, but will not be considered as being owned by that spouse at death. Therefore, the estate of the surviving spouse will be unable to utilize the basis adjustment respect to QTIP property required to be included in that estate.
Similarly, property owned in joint tenancy with a spouse will not qualify for the full basis adjustment. IRC §1022(d)(1). One-half of such property would be eligible for the basis adjustment. IRC § 1022(d)(1)(B)(i)(i). With respect to property owned jointly with a nonspouse, a basis adjustment will be permitted to the extent consideration was furnished by the decedent. IRC § 1022(d)(1)(B)(i)(II).
Some property is ineligible for the basis adjustment. Thus, property acquired by the decedent within three years of death for less than adequate and full consideration will not qualify for a basis adjustment. IRC §1022(d)(1)(C)(i). However, property acquired from a spouse for no consideration will qualify, provided the spouse did not acquire the property for less than adequate or full consideration. IRC §1022(d)(1)(C)(ii).
II. Procedure For
Making Basis Allocation
The Conference Report states that the basis allocation is to be done on an asset-by-asset basis by the Executor (or trustee of a revocable trust). IRC § 6018 provides for the filing of an information report by the Executor. If the Executor cannot file the return, he should file a description of the property and furnish the name of every person (e.g., trustee or beneficiary) who holds a legal or beneficial interest in the property. Information reporting applies to property “acquired from a decedent.” Property “acquired from a decedent includes, inter alia:
¶ Property acquired by bequest, devise or inheritance;
¶ property acquired by the decedent’s estate from the decedent;
¶ property transferred to a trust over which the decedent reserved the right to alter, amend or terminate the trust; and
¶ any other property passing by reason of the death of the decedent without consideration (e.g., property held in joint tenancy). IRC §1022(e).
Two transfers occurring at death must be reported: First, transfers at death of non-cash assets whose value exceeds $1.3 million must be reported; and second, appreciated property acquired by the decedent within three years of death which does not qualify for the basis adjustment must be reported. IRC §6018(a).
Information required with the return under IRC §6018 includes the following:
(i) Name and TIN of property recipient; (ii) an accurate property description; (iii) the adjusted basis and FMV at time of decedent’s death; (iv) the decedent’s holding period for the property; (v) information concerning character of potential gain; (vi) the amount of the basis increase allocated to the property; and (vii) any other information that the regulations may require. The Executor must also furnish to each property recipient a statement giving similar information. IRC §6018(e).
Failure to report to the IRS noncash transfers of over $1.3 million or certain transfers within three years of death may incur a penalty of $10,000 for each failure to report. IRC §6018(b)(2). Failure to report to beneficiaries may result in a penalty of $50 for each failure. IRC §6716(b). If the failure to file with the IRS or report to a beneficiary occurred by reason of an intentional disregard of the rule, a penalty equal to five percent of the fair market value of the property will be imposed. IRC §6716(d). However, no penalty will be imposed if there is reasonable cause. IRC §6716(c).
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SECTION 2053 FINAL REGULATIONS
I. General Rule Requires Payment
Final regulations issued by Treasury limit estate tax deductions for unpaid claims and expenses. With respect to decedents dying on or after October 20, 2009, an estate may, in general, deduct an expenditure only if the claim or debt is actually paid. However, up to $500,000 in unpaid claims (not expenses) may be deducted under certain conditions.
The failure to carefully parse the regulations and claim an impermissible expense could result in the IRS imposing a negligence penalty or even a preparer penalty. If a deduction for a claim or expense is taken in an ambiguous situation, the estate should consider making a disclosure on Form 8275R to avoid the imposition of a penalty.
Under Reg. § 20.2053-1(b)(2), only a bona fide claim or expense may be deducted. No deductions may be taken for amounts paid for claims if the transfer is “essentially donative in character.” Amounts paid to family members, beneficiaries and related entities are rebuttably presumed to lack legitimacy.
II. Determination of Amount
Under the new regulations, the amount of claim or expense may be determined by (i) court decree; (ii) consent decree; or (iii) settlement.
With respect to amounts paid pursuant a court degree after review, such as those incurred for funeral and administration expenses, are deductible. However, a court order allowing an expense issued without reviewing the merits of the claim will not establish deductibility under IRC § 2053, and could presumably even result in the imposition of penalties if the order is unreasonable.
A settlement of a claim will result in a deductible expense provided the interests of the parties involved are adverse. The regulations provide that unenforceable, contested, or contingent claims cannot be deducted.
In the event a portion of the payment made for a claim which was deducted is later refunded, the deduction will be reduced and additional estate tax imposed, provided the statute of limitations for assessment has not run. However, it is not clear that the executor has an obligation to contact the IRS with such information.
Several exceptions exist to the “actual payment” rule:
¶ Although in general a deduction may not be claimed to the extent a claim or expense is or could be reimbursed by insurance, such a claim may still be deductible if the executor provides a “reasonable explanation” of why the burden of collection outweighs the anticipated benefits of collection.
¶ A claim or expense may be deducted if the amount to be paid is ascertainable with “reasonable certainty and will be paid.”
¶ The aggregate value of otherwise deductible claims (not expenses) not exceeding $500,000 may be deducted provided the amount of the claim is determined by a “qualified appraisal” as defined in IRC § 170.
¶ Contingent claims that are almost certain to be paid may be deducted. However, the deductible amount may be reduced to reflect a contingency affecting the ultimate amount of payment.
III. Protective Claims for Refund
If a claim or expense cannot be deducted at the time of filing the estate tax return by reason of its not having been paid, but may later become deductible following payment, a “protective” claim for refund may be filed before the expiration of the period for claiming a refund under IRC § 6511. The protective claim must describe the reason for a delay in the actual payment of the claim or expense. However, the protective claim is not required to specify the amount. The protective claim may be made directly on the Form 706 estate tax return; a separate refund claim form is not required.
Notice 2009-84 provides that the IRS will not generally seek to offset a claim for refund with an offsetting claim relating to an underpayment of estate tax.
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AVOIDING STEP-DOWN IN BASIS
Many assets today will have a fair market value less than the adjusted basis. Since under IRC §1014 a basis adjustment is made at death to fair market value, a loss of basis could occur in many situations. Various strategies may be considered to reduce the likelihood of this issue:
¶ Losses may be recognized on sales to unrelated parties. IRC § 1001(a). Losses on sales to related parties cannot be recognized, but basis is carried over to related party. IRC §267.
¶ Transfers between spouses (gift or sales) are considered gifts. Therefore, the transferee spouse takes a carryover basis. IRC § 1041; Treas. Reg. § 1.1041-1T(d), Q&A 11. Since spousal gifts qualify for the marital deduction, no gift tax liability will arise. IRC §2523.
¶ Gifts of property with a realized loss to related parties who are non-spouses may have some benefit. If the property later increases in value, the basis for determining later gain is the original basis, increased by any gift tax paid. IRC §1015(d)(6). (The basis for determining later loss is the lower basis at the time of the gift under IRC § 1015(a).)
TRANSFERS TO NON-GRANTOR
TRUSTS BEGINNING IN 2010
IRC §2511(c) treats transfers to trusts made after December 31, 2009 as taxable gifts unless the trust is a wholly grantor trust under IRC §§ 671-679 as to the donor or the donor’s spouse. The statute is intended to prevent the donor from making a transfer complete for income tax purposes but incomplete for transfer tax purposes, thereby shifting income tax responsibility without incurring gift tax.
There had been some concern among estate planners that read literally, IRC §2511(c) meant that a transfer to a wholly owned grantor trust, such as a GRAT or to an intentional grantor trust could not be complete for gift tax purposes until an event which caused the grantor trust to lose its grantor trust status, and become a nongrantor trust. If this were the case, then the benefits associated with GRATs and intentional grantor trusts would be effectively lost. Notice 2010-19 allayed the concerns of estate planners by providing that the gift tax consequences of transfers to wholly owned grantor trusts would be determined under the rules in effect prior to 2010. Therefore, gifts to GRATs and intentional grantor trusts will continue to be complete gifts.
Treasury’s 2010 budget proposal proposes that all GRATs have a term of not less than 10 years. This is intended to ensure that the transaction has at least some downside risk. The 10 year requirement would make it unlikely that many taxpayers over 75 years of age would use a GRAT. The proposal would not effect the taxpayer’s ability to utilize a “zeroed-out” GRAT, which result in little or no current taxable gift. Nor would the proposal prevent the taxpayer from funding the GRAT with highly appreciating assets.
In a front-loaded GRAT, annuity payments during the early term of the GRAT are disproportionately large. If the grantor outlives this period, but dies at a time when the annuity payments are lower, fewer GRAT assets are included in the estate, since fewer assets would be required to fund the annuity. To reduce the effectiveness of front-loaded GRATs, Congress may limit the amount by which annuities can be reduced in later years.
For a GRAT to shift wealth, the asset transferred to the trust must outperform the Section 7520 rate. If the asset declines in wealth, no wealth will be transferred from the grantor’s estate. This situation is termed a “burned out” GRAT. Here, the grantor may do nothing and let the GRAT run its course. If so, the grantor will be in the same economic and tax situation that he would have been if no GRAT had been created. However, other options are available:
¶ One of the powers which confers upon a trust grantor trust status, is the power of the grantor to substitute assets of equal value. IRC § 675(4)(c). If the assets in the GRAT are performing poorly, the grantor can substitute other assets and form a new GRAT to hold the underperforming asset. Since there will be lower required annuity amount in the new GRAT, the potential for wealth transfer increases. (If the grantor trust does not contain a swap provision, the grantor can simply purchase the asset for cash or a promissory note and create a new GRAT.)
¶ The grantor can sell the poorly perform asset to a second grantor trust (with the same beneficiaries) for cash or a promissory note. For most of these techniques, the GRAT should possess the following attributes: (i) the GRAT should provide that the grantor may substitute assets of equal value; (ii) the GRAT should not contain a spendthrift clause, as this would impair the ability of the grantor to transfer his annuity interest; and (iii) the GRAT should not contain provisions that would impair the ability of the Trustee to sell assets to outside purchasers.
The grantor could also sell the asset for cash or a promissory note. GRAT assets may perform so well that the wealth transfer to beneficiaries exceeds that which the grantor desired. Here, the grantor can (i) purchase the over performing asset from the GRAT, thereby limiting further wealth shift; (ii) substitute cash or other assets not expected to perform as well; (iii) add or change trust beneficiaries; or (iv) turn off grantor trust status. This will cause trust income to be taxed to the now nongrantor trust, rather than to the grantor, thereby reducing the value of trust assets by the income tax liability of the trust. The grantor may also expressly limit the amount a beneficiary can receive from the trust.
The GRAT assets may be illiquid or difficult to value. Although an in kind distribution may be made, valuing the interest may be difficult, and this difficulty may be compounded by applicable valuation discounts available. Paying the annuity with a note is forbidden by Treasury Regulations. However, the trust may borrow money from a third party. Some believe that the loan may be guaranteed by the grantor, provided the GRAT pays the grantor a fee for guaranteeing the note. Problems associated with an illiquid GRAT may be avoided by using a long-term GRAT whose annuity payments increase over the years. It may be advisable to fund the GRAT with some cash or liquid assets at inception.
If the Grantor dies during the term of the GRAT, all or part of the trust assets will be included in the Grantor’s estate. To prevent the estate from exceeding the applicable exclusion amount, the GRAT could provide that in the event of the death of the grantor prior to the trust term, the assets could be distributed to the surviving spouse.
Since the assets in the GRAT will be included in the grantor’s estate if the grantor dies during the trust term, the GRAT is subject to an “ETIP”. A GST exemption is effective only at the end of an ETIP. Since the GST exemption is automatically allocated, the grantor should elect out of automatic allocation, by attaching a statement to the gift tax return. If the grantor fails to properly elect out of the automatic GST allocation, relief can be sought under Treas. Reg. § 301.9100-3.
If the grantor fails to file a gift tax return adequately reporting the transfer to the GRAT, the statute of limitations will not commence. Here, the grantor should file a late or amended gift tax return adequately disclosing the transaction. As is the case with many estate plans involving family entities and documents, adherence with formalities is important. If necessary formalities are not observed, the IRS may argue that the GRAT is not entitled to favorable tax treatment under IRC §2702.