Post Mortem Estate Planning
Calculation and remittance of federal and NYS estate tax is of primary concern in administering an estate. An estate tax return must generally be filed within nine months of the decedent’s death, and payment must also accompany the Form 706. IRC § 6075. A request for an automatic six-month extension may be made on Form 4768. Such request must include an estimate of the estate tax liabilities. An extension of time to file does not expand the time in which the tax must be paid. However, a request for an extension of time to pay the estate tax may be made under IRC § 6161 or IRC § 6166.
New York State imports most of the information contained on the federal 706 onto its own estate tax return, Form ET-706. Since the New York State exemption amount is only $1 million, an estate must complete and submit a federal Form 706 along with the ET-706 whether or not the federal Form 706 is required to be filed with the IRS.
Under IRC § 6161, the IRS may, for “reasonable cause” or “undue hardship,” grant an extension of up to ten years to pay the estate tax. Treasury regulations provide examples of what may constitute reasonable cause or undue hardship. Under IRC §6166, an election may be made to pay estate tax in installments over 14 years, provided a “closely held business” interest exceeds 35 percent of the estate.
A failure-to-file penalty of 5 percent per month is imposed for each month the failure causes the return to be filed past the due date (including extensions). The penalty may not exceed 25 percent of the tax, and it may be waived for reasonable cause.
New York imposes a similar penalty under Tax Law § 685(a)(1), which may also be abated for reasonable cause. See 20 NYCRR § 2392.1(a)(1); § 2392.1(d)(5), and § 2392.1(h); and Matter of Northern States Contracting Co., Inc., DTA No. 806161, Tax Appeals Tribunal (1992), (“in determining whether reasonable cause and good faith exist, the most important factor to be considered is the extent of the taxpayer’s efforts to ascertain the proper tax liability”); and Matter of AILS Systems, Inc., DTA No. 819303, Tax Appeals Tribunal (2006), (the Tribunal took notice of the “hallmarks of reasonable cause and good faith,” which included “efforts to ascertain the proper tax liability.”
A failure-to-pay penalty of 0.5 percent per month is imposed for each month the failure causes payment to be made past the due date (including, if applicable, extensions for time to pay). The penalty may not exceed 25 percent of the tax, and it may be waived for reasonable cause. New York State imposes a similar penalty. Tax Law § 685(a)(2), which may also be abated for reasonable cause.
Under revised IRC §6694, a return preparer (or a person who furnishes advice in connection with the preparation of the return) is subject to substantial penalties if the preparer (or advisor) does not have a reasonable basis for concluding that the position taken was more likely than not. If the position taken is not more likely than not, penalties can be avoided by adequate disclosure, provided there is a reasonable basis for the position taken. Under prior law, a reasonable basis for a position taken means that the position has a one-in-three chance of success. P.L. 110-28, §8246(a)(2),110th Cong., 1st Sess. (5/25/07).
This penalty applies to all tax returns, including gift and estate tax returns. The penalty imposed is $1,000 or, if greater, one-half of the fee derived (or to be derived) by the tax return preparer with respect to the return. An attorney who gives a legal opinion is deemed to be a non-signing preparer. The fees upon which the penalty is based for a non-signing preparer could reference the larger transaction of which the tax return is only a small part.
Under IRC § 6321, a general tax lien may be imposed on all property owned by any person liable to pay any tax who neglects or refuses to pay such tax after a demand has been made. The general tax lien applies not only to all property owned by the taxpayer at the time the lien comes into effect, but also to all after-acquired property. Under IRC § 6322, the lien commences when the tax is assessed and continues until it becomes unenforceable by lapse of time. Under IRC § 6502, the period of collection is ten years.
Under IRC § 6324, a special estate tax lien attaches to all property which comprises part of the decedent’s estate at death. No formal assessment need be made in order to create this special lien. The special lien for estate taxes differs from the general tax lien under IRC § 6322 in that it expires 10 years from the date of death.
An executor is a fiduciary. If an estate possesses insufficient assets to pay the deceased’s debts, the government will have first priority in proceedings under Chapter 11. The IRS also has the power to proceed directly against a fiduciary for the payment of estate taxes if any assets of the estate have been distributed before the executor has obtained a release from liability. In correspondence from the IRS to an executor which the IRS seeks to hold liable for unpaid estate taxes, the IRS may reference 31 U.S.C. § 3713. This statute, which creates fiduciary liability, provides that the government must be paid first out of estate funds. The statute provides that “[a] representative of a person or an estate . . . paying any part of a debt of the person or estate before paying a claim of the Government is liable to the extent of the payment of unpaid claims of the Government.”
Although the statute does not create a lien per se, it does set forth a priority of payment. The statute would prevent the executor from paying any debts to others while debts are owing to the United States. The case law, though not uniform, has held that the distribution by an executor of assets would subject the executor to personal liability.
On the other hand, if no assets are distributed, the fiduciary does not bear personal responsibility for the payment of estate taxes. If the fiduciary distributes assets or sells assets and distributes the proceeds while estate tax liability exists, the IRS may hold the fiduciary liable for the payment of estate taxes.
The same procedures used by the IRS when collecting taxes from an estate are available in enforcing the personal liability of a fiduciary. Under IRC § 6901(c)(3), the IRS may assess taxes against a fiduciary until the expiration of the period for collection of the estate tax. Although the Code does not specifically provide for a collection period against a fiduciary, presumably the ten year collection period would be applicable.
The executor may request a discharge from personal liability within nine months of making such request. An executor so discharged cannot be held personally liable for any deficiency in the estate tax.
Beneficiaries of an estate also bear personal liability for unpaid estate taxes with respect to both probate and nonprobate assets. IRC §§ 6901(a)(1) and 6324(a)(2). Transferee liability cannot exceed the value of the assets on the date of transfer. Com’r v. Henderson’s Estate, 147 F.2d 619 (5th Cir. 1945). Under IRC § 6901(c), the IRS may impose transferee liability for one year after the expiration of the period of limitations for imposing liability on the transferor.
Under IRC § 2032(a), an executor may elect to value estate assets six months after the decedent’s date of death. This election, made on the estate tax return, can be useful if estate assets have depreciated between the date of death and the “alternate valuation date.” If the election is made to value estate assets on the alternate valuation date, it will apply to all estate assets. Once made, the election is irrevocable. Any assets sold during the six month period preceding the alternative valuation date are valued as of the date of sale or distribution.
An accurate valuation of estate assets is essential in determining the estate tax and withstanding an audit. If the IRS or NYS determines on audit that the value of assets reported is incorrect, not only will the estate tax liability increase, but penalties may apply. Valuation discounts that are successfully challenged by the IRS may result in tax deficiencies of a magnitude sufficient to attract underpayment penalties.
The value of stocks traded on an established exchange or over the counter is determined by calculating the mean between the highest and lowest quoted selling price on the date of the gift. Treas. Reg. §25.2512-2(b)(1). Publicly traded stocks reference their market value and should include the CUSIP (Committee on Uniform Identification Procedure). Valuation services provide historical information for a fee. Historical stock quotes are also available on the internet. If no sales on the valuation date exist, the instructions state that the mean between the highest and lowest trading prices on a date “reasonably close” to the valuation date may be used. If no actual sales occurred on a date “reasonably close” to the valuation date, bona fide bid and asked prices may be used. Treas. Reg. §20.2031-2(e) provides that a blockage discount may be applied where a large block of stock may depress the sales price.
As surprising as it may sound, real estate requires no appraisal or formal valuation. Although not required, if an appraisal if obtained, it should be attached to the return. Contrary to what clients often surmise, Treas. Reg. §25.2512-1 provides that local property tax values are not relevant unless they accurately represent the fair market value. Even though not required, a date of death valuation is often obtained in the event an audit may be anticipated. Generally, the value of real property is the price paid in an arm’s length transaction before the valuation date. If none exists, comparable sales may be used.
Treas. Reg. §25.6019-4 provides that a legal description should be such that real property may be “readily identified.” This would include a metes and bounds description (if available), the area, and street address.) When determining the fair market value of real property, valuation discounts for (i) lack of marketability; (ii) minority interest; (iii) costs of partition; (iv) capital gains; and certain other discounts may be taken into consideration.
Lack of marketability and minority discounts may be available for gifts of closely held stock. Rev. Rul. 59-60, an often-cited ruling, sets forth a list of factors to be considered when valuing closely held businesses: (i) the nature of the business and the history of the enterprise; (ii) the economic outlook in general and the condition and outlook of the specific industry in particular; (iii) the book value of the stocks and the financial condition of the business; (iv) the earning capacity of the company; (v) the dividend-paying capacity of the company; (vi) goodwill and other intangible value; (vii) sales of stock and the size of the block of stock to be valued; (viii) the market price of stocks of a corporation engaged in the same or a similar line of business having their stocks actively traded in a free open market, either on an exchange or otherwise. If the decedent was a key person in the closely held business, an additional discount may be applicable. Furman v. Com’r, T.C. 1998-157, recognized a key man discount of 10 percent where the services of the decedent were important in the business.
Closely held stocks should be valued by an appraiser. The fair market value of closely held stock is determined by actual selling price. If no such sales exist, fair market value is determined by evaluating the “soundness of the security, the interest yield, the date of maturity and other relevant factors.” Treas. Reg. §25.2512-2(f). The gift tax instructions (by analogy) state that complete financial information, including reports prepared by accountants, engineers and technical experts, should be attached to the return, as well as the balance sheet of the closely held corporation for “each of the preceding five years.”
Despite persistent opposition by the IRS, courts have consistently held that the cost of an eventual capital gains tax reduces the value of the gross estate. Jelke v. Com’r, a typical case, allowed a full built-in capital gains discount. Discounts applicable to closely held corporations may well exceed those for partnerships or LLCs, since not only may built-in capital gains depress the value of the stock, but less of a market may exist for stock in a closely held family business compared to an interest in an LLC or partnership, which typically hold interests real estate.
No appraisal is required for tangible property such as artwork, but if one is obtained, it should be attached to the return. Rev. Rul. 96-15 delineates appraisal requirements, which include a summary of the appraiser’s qualifications, and the assumptions made in the appraisal. If no appraisal is made, the return should indicate how the value of the tangible property was determined. The provenance of artwork will greatly affect its transfer tax value. As is the case with large blocks of stock, if large blocks of artwork are gifted, a blockage discount may apply. Calder v. Com’r, 85 TC 713 (1985). The IRS does not recognize fractional interest discounts in the context of artwork, since the IRS believes that there is “essentially no market for selling partial ownership interests in art objects. . .” Rev. Rul. 57-293; see Stone v. U.S., 2007 WL 1544786, 99 AFTR2d 2007-2292 (N.D. Ca. 5/25/07), (District Court found persuasive testimony of IRS Art Advisory Panel, which found discounts applicable to real estate inapplicable to art; court allowed only 2 percent discount for partition.)
Planning for and preserving the marital deduction is always an important objective. However, it reaches its zenith when the estate tax is in a state of flux, as is currently the case. By making a “QTIP” election, the Executor will enable the decedent’s estate to claim a full marital deduction. To qualify, the trust must provide that the surviving spouse be entitled to all income, paid at least annually, and that no person may have the power, exercisable during the surviving spouse’s life, to appoint the property to anyone other than the surviving spouse. Since the Executor may request a 6 month extension for filing the estate tax return, the Executor in effect has 15 months in which to determine whether to make the QTIP election.
Electing QTIP treatment is not always advantageous. Inclusion of trust assets in the estate of the first spouse to die may “equalize” the estates. Equalization may have the effect of utilizing the full exemption amount of the first spouse and avoiding higher rate brackets that apply to large estates. Still, the savings in estate taxes occasioned by reason of avoiding the highest tax brackets may itself be diminished by the time value of the money used to pay the estate tax at the first spouse’s death. On the other hand, if no marital deduction is claimed, and the second spouse dies soon after the first, a credit under IRC §2013 may reduce the estate tax payable at the death of the surviving spouse.
The executor may elect QTIP treatment for only a portion of the trust, with the nonelected portion passing to a credit shelter trust. If such a partial QTIP election is anticipated, separating the trusts into one which is totally elected, and second which is totally nonelected, may be desirable. In this way, future spousal distributions could be made entirely from the elected trust, which would reduce the size of the surviving spouse’s estate.
QTIP property is included in the estate of the surviving spouse at its then FMV. The estate of the surviving spouse is entitled to be reimbursed for estate tax paid from recipients of trust property. IRC § 2207A. Reimbursement is calculated using the highest marginal estate tax bracket of the surviving spouse. The failure to seek reimbursement is treated as gift made to those persons who would have been required to furnish reimbursement. However, the failure by the estate of the surviving spouse to seek reimbursement will not be treated as a gift if the decedent’s will expressly waives the right of reimbursement with respect to QTIP property.
Care must be taken when making the QTIP election, since the IRS takes the position that if the election taken on the initial federal and state estate tax returns was defective — but the IRS did not notice the defect and allowed the marital deduction — the assets will nevertheless be includible in the estate of the surviving spouse under IRC §2044. In other words, the IRS takes the position that the assets are includible in the estate of the surviving spouse even if the estate of the first spouse would have incurred no estate tax had the QTIP election not been made. See PLR 9446001.
On the other hand, a properly made but unnecessary QTIP election will occasion of fewer harsh results. Under Rev. Proc. 2001-38, an unnecessary QTIP election for a credit shelter trust will be disregarded to the extent that it is not needed to eliminate estate tax at the death of the first spouse. Similarly, a mistaken overfunding of the QTIP trust will not cause inclusion of the overfunded amount in the estate of the surviving spouse. TAM 200223020.
Since the estate tax is a “tax inclusive,” as opposed to the gift tax, which is “tax exclusive,” there is a distinct tax benefit to making lifetime, as opposed to testamentary, transfers. Distributions from a QTIP trust can assist in accomplishing this objective.
A surviving spouse’s right to withdraw principal may be used by the surviving spouse to make gifts. Treas. Reg. §20.2056(b)-7(d)(6) provides: “The fact that property distributed to a surviving spouse may be transferred by the spouse to another person does not result in a failure to satisfy the requirement of IRC § 2956(b)(7)(B)(ii)(II).”
The trust instrument may limit the right of the surviving spouse no right to withdraw principal, and may grant the trustee discretion to make distributions of principal. If such discretionary distributions were disallowed, the gifts could be brought back into the estate of the surviving spouse. However, Estate of Halpern v. Com’r, T.C. Memo. 1995-352 held that discretionary distributions made to the surviving spouse which were later used to make gifts would not result in inclusion in her estate. However, the trust may not require the surviving spouse to apply the principal to make gifts, as this would as this would constitute an impermissible limitation on the spouse’s unqualified right to income during his or her lifetime.
The IRS has ruled that granting the surviving spouse a power to withdraw the greater of 5 percent of trust principal or $5,000 per year (a “five and five” power) will not result in disqualification of QTIP treatment. If the spouse were given an unlimited right to withdraw principal, the QTIP trust could morph into a general power of appointment trust. While the unlimited marital deduction would be secure, the decedent’s right to choose who would ultimately receive the property would effectively be defeated if the surviving spouse appointed all of the property during his or her lifetime.
If greater rights of withdrawal were given to the surviving spouse under an intended QTIP, but those rights did not rise to the level of an unrestricted right to demand principal, the trust would be neither fish nor fowl. The trust would constitute neither a general power of appointment trust nor a QTIP trust. This would result in a trust “meltdown” for tax purposes. The marital deduction would be lost and the entire trust would be brought back into the estate of the first spouse to die, and the decedent’s power to determine ultimate trust beneficiaries would be severely curtailed.
To illustrate, assume at a time when the applicable exclusion amount is $5 million, father has an estate of $8 million, and mother has an estate of $2 million. Father (who has made no lifetime gifts) wishes to give his four children $6 million outright. If $6 million were left to the children, $1 million would be subject to federal estate tax, and $5 million would be subject to New York estate tax. The total estate tax liability would be approximately $1.15 million [($1 million x .35) + ($5 million x. .16)].
This would leave $4.85 million of the $6 million bequest to the children. If instead of leaving $6 million to the children outright, father were to leave only $1 million to them outright, and place $5 million in a trust qualifying for a QTIP election, federal and New York estate tax would be eliminated at father’s death. If mother’s estate were not to increase during her lifetime, no federal estate tax would be owed at her death, since here estate would not exceed the (combined) applicable exclusion amount of $10 million.
If the surviving spouse made absolutely no taxable gifts during her lifetime, the New York State estate tax of $800,000 deferred by the marital deduction ($5 million x .16) would be payable upon her death by her estate. If, however, the surviving spouse were to make gifts to the children during her lifetime, the eventual New York State estate tax could be diminished or even eliminated.
Consider the effect of the surviving spouse, would now be worth $7 million, making gifts of $0.25 million to each child per year for a few years. Each year, the surviving spouse would report a gift of $1 million for federal gift tax purposes. Since the gift and estate taxes have been reunified, no transfer tax liability would result for federal purposes.
Since New York State has no gift tax, no New York transfer tax liability would arise by reason of the surviving spouse making yearly gifts of $1 million. Each year in which the surviving spouse made those gifts, the eventual New York State estate tax liability would be reduced by approximately $160,000.
Although this strategy appears sound — and perhaps nearly unimpeachable — for tax purposes, it must be remembered that for the strategy to work, the surviving spouse must actually make the gifts contemplated. The cost of insuring against the risk of the surviving spouse not making the contemplated gift is the transfer tax savings, since any attempt to impose a legal obligation on the surviving spouse to make the gifts would result in the QTIP failing.
Accordingly, this strategy would likely not work in second marriage situations, or in situations where the surviving spouse could not be depended upon to make the contemplated gratuitous transfers. Although these considerations do circumscribe the utility of this strategy, the risk of the surviving spouse not making the gifts could conceivably be reduced to an acceptable level by leaving a substantial sum of money to the children outright, and while leaving some to the trustee of a QTIP trust.
The strategy of making gifts consisting of distributions of principal depends upon the availability of funds for distribution. Principal may consist of land, or interests in a closely held company — in other words, property that cannot easily be distributed. Even if principal could otherwise be made, the trust may not provide for distributions of principal, or may limit the Trustee’s ability to make distributions of principal. A QTIP trust need only provide that all income be distributed to the surviving spouse.
If the surviving spouse has no right to withdraw principal and the trustee cannot make discretionary distributions of principal, gift planning is more difficult, but may still possible by falling back to a release or a disclaimer. The surviving spouse may contemplate making a transfer of his or her lifetime income interest. However, IRC §2519 may pose a problem with a release. As is the case with gifts of principal, although there must be no prearranged agreement that the spouse will make a transfer of his or her lifetime income interest, use of a QTIP trust can leverage the applicable exclusion amount by leaving assets to the surviving spouse who would then be expected — but not required — to make a gift of the qualifying income interest.
Reliance on a disclaimer is inherently risky for two reasons: First, a “qualified” disclaimer must be made within a relatively short time period; and second, the disclaimant must not have accepted any of the benefits of the property to be disclaimed. This requirement may pose problems. While a nonqualified disclaimer may still be possible, such a disclaimer will be less attractive from a tax perspective.
Let us first examine a release of the surviving spouse’s right to income. The surviving spouse can make a gift of — or release — her qualifying income interest in the trust property to which she would otherwise be entitled. This would constitute a garden variety gift under IRC §2511. However, the disposition would also trigger IRC §2519.
IRC §2519 provides that “any disposition of all or part of a qualifying income interest for life in any property to which this section applies is treated as a transfer of all interests in the property other than the qualifying income interest.” Therefore, were wife to gift one-half of her qualifying income interest, she would be deemed to have made a gift of the entire remainder interest in trust, in addition to the gift of the income interest. Under IRC §2207A(a), she would have a right to recover gift tax attributable to the deemed transfer of the remainder interest under IRC §2519.
IRC §2519(a) provides that the disposition of “all or part of a qualifying income interest for life in any property” for which a QTIP election was made is treated as a “transfer of all interests in such property other than the qualifying income interest.” IRC §2519 provides that if a surviving spouse disposes of a qualifying income interest in trust property, he is deemed also to have disposed of all interests in that property other than the qualifying income interest. If the surviving spouse releases part of his qualifying income interest, he will be treated, under IRC §2519, as having disposed of all trust property. Therefore, were spouse to gift one-half of a qualifying income interest, he or she would be deemed to have also made a gift of the entire remainder interest in the trust, in addition to the gift of the income interest.
This means that a gift tax would be imposed on all trust property, even though the income interest released by the surviving spouse pertained only to part of the trust property. The harshness of the rule is unjustified from a transfer tax standpoint. If the statute required reporting as a gift only that portion of the trust property which related to the qualifying income interest disposed of — which most commentators believe is correct — then the estate of the surviving spouse would include the trust assets not previously reported as a gift. Nevertheless, this is not the case, and a gift of a partial qualifying income interest will in fact trigger the harsh result mandated by IRC §2519, and if no curative measure is found to alter this result, the surviving spouse would be required to report as a gift the entire value of the QTIP trust. Fortunately, the IRS allows taxpayer to sever QTIP trusts prior to the surviving spouse disposing of a partial income interest in the QTIP. This avoids the harshness of the “transfer of all interests” rule. See PLRs 200438028, 200328015.
To illustrate, assume the surviving spouse is 85 years old and releases his qualifying income interest in a trust worth $1 million. Under the prevailing applicable federal rate (AFR) and using actuarial tables, the surviving spouse is deemed to have made a gift of $180,000. For purposes of IRC §2511, the surviving spouse has made a taxable gift of $180,000. For purposes of IRC §2519, the surviving spouse is deemed to have made a gift of $820,000, i.e., all interests in the property other than the qualifying income interest. Under IRC §2207A, the QTIP trust would have a right to recover gift tax attributable to the deemed transfer of the remainder interest under IRC §2519.
Under IRC §2207A, if the surviving spouse is deemed to have made a gift under IRC §2519, he has a right of reimbursement for gift taxes paid. Proposed regulations provide for “net gift” treatment of the deemed gift of a remainder interest under IRC §2519. (A net gift occurs if the donee is required, as a condition to receiving the gift, that he pay any gift taxes associated with the gift.) Since the value of what the donees receive is reduced by the gift tax reimbursed to the surviving spouse, the amount of the gift reportable is also reduced by the reimbursement. The gift taxes so paid by the donee may be deducted from the value of the transferred property to determine the donor’s gift tax.
Assume the value of the income and remainder interest in a QTIP trust is $500,000. Wife makes a gift of one-half of her income interest, or $250,000. Under IRC § 2519, she will be deemed to have made a gift of the entire $500,000. An interrelated calculation gives the result that at a 50 percent gift tax rate, a gift of $333,333 would result in a gift tax of $166,667. Backing into the hypothetical, a gift of $500,000 would result in a net gift of $333,333, since the value of the gift is reduced by the gift tax, which in this case is $166,667. In this case, $500,000 is reduced by $166,667, to leave $333,333.
Although releasing a qualifying income interest may be effective if the surviving spouse cannot withdraw principal and the trustee cannot make discretionary distributions of principal, spendthrift limitations which appear in most testamentary trusts may pose problems. An income beneficiary of a spendthrift trust generally cannot assign or alienate an income interest once accepted. See, e.g., Hartsfield v. Lescher, 721 F.Supp. 1052 (E.D. Ark. 1989). Is this the end of the road? Not necessarily.
If a spendthrift limitation bars the spouse from alienating the income interest, it may still be possible to disclaim the interest under New York’s disclaimer statute, EPTL 2-1.11. Note that if instead of releasing the qualifying income interest, the surviving spouse had made a qualified disclaimer with respect to that interest, no gift would have resulted. New York law requires that the disclaimer be made within nine months, but the time period may be extended for “reasonable cause”.
To constitute a qualified disclamer under federal law, the disclaimer must meet the requirements of state law, and it must be made within nine months. If a New York Surrogate extended the time for reasonable cause, the renunciation would not constitute a qualified disclaimer under IRC §2519. Rather, the disclaimer would be a “nonqualified disclaimer.” A nonqualified disclaimer could trigger IRC §2519, since such a disclaimer would be ineffective for federal transfer tax purposes.
IRC §2044 requires that remaining QTIP assets be included in the gross estate of the surviving spouse. However, those assets are not aggregated with other assets in the estate of the surviving spouse. Thus, in Estate of Bonner v. U.S., 84 F.3d 196 (5th Cir. 1996) the surviving spouse at her death owned certain interests outright, and others were included in her estate pursuant to IRC §2044. The estate claimed a fractional interest discount, which the IRS challenged. The Fifth Circuit held that assets included in the decedent spouse’s gross estate which were held outright were not aggregated with those included under IRC §2044 by virtue of the QTIP trust. The estate was entitled to take a fractional interest discount. Apparently, even if the surviving spouse were a co-trustee of the QTIP trust, no aggregation would be required. See FSA 200119013.
Under Bonner, could the trustee of the QTIP trust distribute a fractional share of real estate owned by the QTIP trust in order to generate a fractional interest discount at the death of the surviving spouse? Possibly, but in Bonner, the surviving spouse owned an interest in certain property, and then became the income beneficiary of a QTIP trust which was funded with interests in the same property. The surviving spouse in Bonner already owned a separate interest in the same property. This situation is distinguishable from one in which the QTIP trusts owns all of the interest in a certain piece of property, and then distributes some of that interest to the surviving spouse. In that case, it is less clear that the IRS would not succeed in attempting to aggregate the interests in the same property for the purpose of precluding the estate from claiming a valuation discount. The case would be weaker if the distribution of the fractional interest to the surviving spouse had, as one of its principal purposes, no intention other than to support a later assertion of a fractional interest discount.
A QTIP trust may be asset protected with respect to corpus. The income interest would be subject to creditor claims.
Disclaimers can be useful in accomplishing post-mortem estate planning. A person who disclaims property is treated as never having received the property for gift or estate or tax purposes under IRC § 2516. Although the disclaimer statute appears in Chapter 11, the gift tax provisions, a disclaimer under IRC § 2516 is also effective for income tax purposes.
The significance of a disclaimer is that had the disclaimed property been received and then transferred, gift tax liability would attach. If the diclaimer meets the requirements of IRC § 2518, the disclaimant is treated as never having received the property. A fortiori, the disclaimant will have made no transfer.
Although Wills frequently contain express language advising a beneficiary of a right to disclaim, such language is superfluous, or advisory in nature, since a beneficiary may always disclaim.
For a disclaimer to achieve the intended federal tax result, it must constitute a “qualified disclaimer”“ under IRC §2518. If the disclaimer is not a “qualified,” the disclaimant is treated as having received the property and then having made a taxable gift. Treas. Regs. §25.2518-1(b).
Under the NY EPTL, as well as under the law of most states, the person disclaiming is treated as if he had predeceased the donor, or died before the date on which the transfer creating the interest was made. Neither New York nor Florida is among the ten states which have adopted the Uniform Disclaimer of Property Interests Act (UDPIA).
For a disclaimer to be qualified under IRC § 2518, the disclaimer must meet the following requirements:
(i) The disclaimer must be irrevocable and unqualified. PLR 200234017 stated that a surviving spouse who had been granted a general power of appointment had not made a qualified disclaimer of that power by making a QTIP election on the estate tax return, since the estate tax return did not evidence an irrevocable and unqualified refusal to accept the general power of appointment.
(ii) The disclaimer must be in writing, identify the property disclaimed and be signed by the disclaimant or by his legal representative. Under EPTL § 2-1.11(f) the right to disclaim may be waived if in writing;
(iii) The disclaimer must be delivered to either the transferor or his attorney, the holder of legal title, or the person in possession. Copies of the disclaimer must be filed with the surrogates court having jurisdiction of the estate. If the disclaimer concerns nontestamentary property, the disclaimer must be sent via certified mail to the trustee or other person holding legal title to, or who is in possession of, the disclaimed property;
(iv) The disclaimer must be made within nine months of the date of transfer or, if later, within nine months of the date when the disclaimant attains the age of 21. It is possible that a disclaimer might be effective under the EPTL, but not under the Internal Revenue Code. For example, under EPTL §2-1.11(a)(2) and (b)(2), the time for making a valid disclaimer may be extended until “the date of the event by which the beneficiary is ascertained,” which may be more than 9 months after the date of the transfer. In such a case, the disclaimer would be effective under New York law but would result in a taxable gift for purposes of federal tax law;
(v) The disclaimer must be made at a time when the disclaimant has not accepted the interest disclaimed or enjoyed any of its benefits. Consideration received in exchange for making a disclaimer would constitute a prohibited acceptance of benefits under EPTL §2-1.11(f); and
(vi) The disclaimer must be valid under state law, so that it passes to either the spouse of the decedent or to a person other than the disclaimant without any direction on the part of the person making the disclaimer. EPTL §2-1.11(g) provides that a beneficiary may accept one disposition and renounce another, and may renounce a disposition in whole or in part. One must be careful to disclaim all interests, since the disclaimant may also have a right to receive the property by reason of being an heir at law, a residuary legatee or by other means. In this case, if the disclaimant does not effectively disclaim all of these rights, the disclaimer will not be a qualified disclaimer with respect to the portion of the disclaimed property which the disclaimant continues to have the right to receive. IRC §2518-2(e)(3).
(Note: An important exception to this rule exists where the disclaimant is the surviving spouse. In that case the disclaimed interest may pass to the surviving spouse even if she is the disclaimant. Treas. Reg. §25.2518-2(e); EPTL §2-1.11(e).)
IRC § 2518(c) provides for what is termed a “transfer disclaimer.” The statute provides that a written transfer that meets requirements similar to IRC § 2518(b)(2) (timing and delivery) and IRC § 2518(b)(3) (no acceptance) and which is to a person who would have received the property had the transferor made a qualified disclaimer, will be treated as a qualified disclaimer for purposes of IRC §2518. The usefulness of IRC § 2518(c) becomes apparent in cases where federal tax law would permit a disclaimer, yet state law would not.
To illustrate, in Estate of Lee, 589 N.Y.S.2d 753 (Surr. Ct. 1992), the residuary beneficiary signed a disclaimer within nine months, but the attorney neglected to file it with the Surrogates Court. The beneficiary sought permission to file the late renunciation with the court, but was concerned that the failure to file within nine months would result in a nonqualified disclaimer for federal tax purposes.
The Surrogates Court accepted the late filing and opined (perhaps gratuitously, since the IRS is not bound by the decision of the Surrogates Court) that the transfer met the requirements of IRC § 2518(c). [Note that in the converse situation, eleven states, but not New York or Florida, provide that if a disclaimer is valid under IRC § 2518, then it is valid under state law.]
Treas. Reg. § 20.2055-2(c) provides that a charitable deduction is available for property passing directly to a charity by virtue of a qualified disclaimer. If the disclaimed property passes to a private foundation of which the disclaimant is an officer, he should resign, or at a minimum not have any power to direct the disposition of the disclaimed property. The testator may wish to give family members discretion to disclaim property to a charity, but yet may not wish to name the charity as a residuary legatee. In this case, without specific language, the disclaimed property would not pass to the charity. To solve this problem, the will could provide that if the beneficiary disclaims certain property, the property would pass to the specified charity.
Many existing wills contain “formula” clauses which allocate to the credit shelter trust the maximum amount of money or property that can pass to beneficiaries (other than the surviving spouse) without the imposition of federal estate tax. If the applicable exclusion amount is exceeds the value of the estate, the surviving spouse could be disinherited unless the beneficiaries of the credit shelter trust disclaim part of their interest. To the extent such interest is disclaimed and passes to the surviving spouse (either by the terms of the Will or by operation of law) it will qualify for the marital deduction.
Another use of the disclaimer in a similar situation is where either the surviving spouse renounces a power of appointment so that the trust will qualify as a QTIP trust. A surviving spouse who is granted a general power of appointment over property intended to qualify for the marital deduction under IRC § 2056(b)(5) may disclaim the general power, thereby enabling the executor to make a partial QTIP election. This ability to alter the amount of the marital deduction allows the executor to finely tune the credit shelter amount. If both spouses die within nine months of one another, a qualifying disclaimer by the estate of the surviving spouse can effect an equalization of estates, thereby reducing or avoiding estate tax.
Consider the effect of a qualified disclaimer executed within nine months by a surviving spouse of his lifetime right to income from a credit shelter trust providing for an outright distribution to the children upon his death. If, within nine months of his spouse’s death, the surviving spouse decides that he does not need distributions during his life from the credit shelter trust, and disclaims, he will treated as if he predeceased his wife. If the will of the predeceasing wife provides for an outright distribution of the estate to the children if husband does not survive, then the disclaimer will have the effect of enabling the children to receive the property that would have funded the credit shelter trust at the death of the first spouse.
Disclaimers can also be utilized to increase basis in inherited assets by causing property that would otherwise pass by operation of law, to pass through a predeceasing spouse’s estate. Assume surviving spouse paid no consideration for certain property held jointly with that spouse’s predeceasing spouse. If second spouse disclaims within nine months, the property would pass through the predeceasing spouse’s probate estate. If the Will provided for a residuary bequest to the surviving spouse, that spouse would inherit the disclaimed property with a full basis step up under the terms of the Will.
A qualifying disclaimer executed by the surviving spouse may also enable the predeceasing spouse to fully utilize the applicable exclusion amount. For example, assume the will of the predeceasing spouse leaves the entire estate of $10 million to the surviving spouse (and nothing to the children). Although the marital deduction would eliminate any estate tax liability on the estate of the first spouse to die, the eventual estate of the surviving spouse would likely have an estate tax problem. By disclaiming $5 million, the surviving spouse would create a taxable estate in the predeceasing spouse, which could then utilize the full applicable exclusion amount of $5 million. The taxable estate of the surviving spouse would be reduced to $5 million.
To refine this example, the will of the first spouse to die could provide that if the surviving spouse disclaims, the disclaimed amount would pass to a family trust of which the surviving spouse has a lifetime income interest. The Will could further provide that if the spouse were also to disclaim her interest in the family trust, the disclaimed property would pass as if she had predeceased.
The grantor may wish to ensure that the named trustee will be liberal in making distributions to his children. By giving the child beneficiary the unrestricted right to remove the trustee, this objection can be achieved. However, if the child has the ability to remove the trustee, and the trust grants the trustee the power to make distributions to the child that are not subject to an ascertainable standard, the IRS may impute to the child a general power of appointment. If the IRS were successful, the entire trust could be included in the child’s taxable estate. To avoid this result, the child could disclaim the power to remove the trustee. This might, of course, not accord with the child’s nontax wishes.
If a surviving spouse is given a “five and five” power over a credit shelter or family trust, 5 percent of the value of the trust will be included in her estate under IRC §2041. However, if the surviving spouse disclaims within nine months, nothing will be included in his or her estate
At times, all beneficiaries may agree that it would be better if no trust existed. If all current income trust beneficiaries (which might include the surviving spouse and children) disclaim, the trust may be eliminated. In such a case, the property could pass to the surviving spouse and the children outright. Note that if minor children are income beneficiaries, their disclaimers would require the the appointment (and consent) of guardians ad litem.
Under New York law, if one disclaims, and by reason of such disclaimer that person would cause one to retain Medicaid eligibility, such disclaimer may be treated as an uncompensated transfer of assets equal to the value of any interest disclaimed. This, in turn, could impair Medicaid eligibility. In some states, if a disclaimer defeats the encumbrance or lien of a creditor, it may be alleged that the disclaimer constitutes a fraudulent transfer. Not so in New York and California, where a disclaimer may validly be utilized o defeat the legitimate claims of creditors. In Florida, the result in contra: A disclaimer cannot prevent a creditor from reaching the disclaimed property.
Until 1999, it had been unclear whether a qualified disclaimer could defeat the claim of the IRS. The 2nd Circuit in United States v. Camparato, 22 F3d. 455, cert. denied, 115 S.Ct. 481 (1994) held that it did not, finding that a federal tax lien attached to the “right to inherit” property. Therefore, a subsequent disclaimer did not affect the federal tax lien under IRC §6321. Resolving a split among the circuits, the Supreme Court, in Drye v. United States, 528 U.S. 49 (1999), adopted the view of the Second Circuit, finding that the federal tax lien attached to the property when created, and that any subsequent attempt to defeat the tax lien by disclaimer would not eliminate the lien.
Bankruptcy courts have generally reached the same result as in Drye. The disclaimer of a bequest within 180 days of the filing of a bankruptcy petition has in most bankruptcy courts been held to be a transfer which the trustee in bankruptcy can avoid. Many courts have held that even pre-petition disclaimers constitute fraudulent transfers which the bankruptcy trustee can avoid. If the Drye rationale were applied to bankruptcy cases, it would appear that pre-petition bankruptcy disclaimers would, in general, constitute transfers which the bankruptcy trustee could seek to avoid. However, at least one bankruptcy court, Grassmueck, Inc., v. Nistler (In re Nistler), 259 B.R. 723 (Bankr. D. Or. 2001) held that Drye relied on language in IRC §6321, and should be limited to tax liens.
The acceptance of benefits will preclude a disclaimer under state law. EPTL §2-11(b)(2) provides that “a person accepts an interest in property if he voluntarily transfers or encumbers, or contracts to transfer or encumber all or part of such interest, or accepts delivery or payment of, or exercises control as beneficial owner over all or part thereof . . . ”
Similarly, a qualified disclaimer for purposes of IRC § 2518(c) will not occur if the disclaimant has accepted the interest or any of its benefits prior to making the disclaimer. Treas. Regs. §25.2518-2(d)(1) elaborates, providing that actions “indicative” of acceptance include (i) using the property or interest in the property; (ii) accepting dividends, interest, or rents from the property; or (iii) directing others to act with respect to the property or interest in the property. However, merely taking title to property without accepting any benefits associated with ownership does not constitute an acceptance of benefits. Treas. Regs. §25.2518-2(d)(1). Nor will a disclaimant be considered to have accepted benefits merely because under local law title to property vests immediately in the disclaimant upon the death of the decedent. Treas. Regs. §25.2518-2(d)(1).
The acceptance of benefits of one interest in property will not, alone, constitute an acceptance of other separate interests created by the transferor and held by the disclaimant in the same property. Treas. Regs. §25.2518-2(d)(1). Thus, TAM 8619002 advised that a surviving spouse who accepted $1.75x in benefits from a joint brokerage account effectively disclaimed the remainder since she had not accepted the benefits of the disclaimed portion which did not include the $1.75x in benefits which she had accepted.
The disclaimant’s continued use of property already owned is also not, without more, a bar to a qualifying disclaimer. Thus, a joint tenant who continues to reside in jointly held property will not be considered to have accepted the benefit of the property merely because she continued to reside in the property prior to effecting the disclaimer. Treas. Regs. §25.2518-2(d)(1); PLR 9733008.
The existence of an unexercised general power of appointment in a will before the death of the testator is not an acceptance of benefits. Treas. Regs. §25.2518-2(d)(1). However, if the powerholder dies having exercised the power, acceptance of benefits has occurred. TAM 8142008.
The receipt of consideration in exchange for exercising a disclaimer constitutes an acceptance of benefits. However, the mere possibility that a benefit will accrue to the disclaimant in the future is insufficient to constitute an acceptance. Treas. Regs. §25.2518-2(d)(1); TAM 8701001. Moreover, actions taken in a fiduciary capacity by a disclaimant to preserve the disclaimed property will not constitute an acceptance of benefits. Treas. Regs. §25.2518-2(d)(2).
A disclaimant may make a qualified disclaimer with respect to all or an undivided portion of a separate interest in property, even if the disclaimant has another interest in the same property. Thus, one could disclaim an income interest while retaining an interest in principal. PLR 200029048. So too, the right to remove a trustee was an interest separate from the right to receive principal or a lifetime special power of appointment. PLR 9329025. PLR 200127007 ruled that the waiver of the benefit conferred by right of recover under IRC §2207A constituted a qualified disclaimer.
A disclaimant makes a qualified disclaimer with respect to disclaimed property if the disclaimer relates to severable property. Treas. Regs. §25.2518-3(a)(1)(ii). Thus, (i) the disclaimer of a fractional interest in a residuary bequest was a qualified disclaimer (PLR 8326033); (ii) a disclaimer may be made of severable oil, gas and mineral rights (PLR 8326110); and (iii) a disclaimer of the portion of real estate needed to fund the obligation of the residuary estate to pay legacies, debts, funeral and administrative expenses, is a severable interest. PLR 8130127.
For disclaimants (other than a surviving spouse) who are residuary legatees or heirs at law, the disclaimant must be careful not only to disclaim the interest in the property itself, but also to disclaim the residuary interest. If not, the disclaimer will not be effective with respect to that portion of the interest which the disclaimant has the right to receive. §25.2518-2(e)(3). To illustrate, in PLR 8824003, a joint tenant (who was not a surviving spouse) was entitled to one-half of the residuary estate. The joint tenant disclaimed his interest in the joint tenancy, but did not disclaim his residuary interest. The result was that only half of the disclaimed interest qualified under IRC §2518. The half that passed to the disclaimant as a residuary legatee did not qualify.
The disclaimant may not have the power, either alone or in conjunction with another, to determine who will receive the disclaimed property, unless the power is subject to an ascertainable standard. However, with respect to a surviving spouse, the rule is more lenient. Estate of Lassiter, 80 T.C.M. (CCH) 541 (2000) held that Treas. Reg. §25.2518-2(e)(2) does not prohibit a surviving spouse from retaining a power to direct the beneficial enjoyment of the disclaimed property, even if the power is not limited by an ascertainable standard, provided the surviving spouse will ultimately be subject to estate or gift tax with respect to the disclaimed property.
An impermissible power of direction exists if the disclaimant has a power of appointment over a trust receiving the disclaimed property, or if the disclaimant is a fiduciary with respect to the disclaimed property. §25.2518-2(e)(3). However, mere precatory language not binding under state law as to who shall receive the disclaimed property will not constitute a prohibited “direction”. PLR 9509003.
Limits on the power of a fiduciary to disclaim may have tax implications. PLR 8409024 stated that trustees could disclaim administrative powers the exercise of which did not “enlarge or shift any of the beneficial interests in the trust.” However, the trustees could not disclaim dispositive fiduciary powers which directly affected the beneficial interest involved. This rule limits the trustee’s power to qualify a trust for a QTIP election.
In some states, representatives of minors, infants, or incompetents may disclaim without court approval. EPTL §2-1.11(c) permits renunciation on behalf of an infant, incompetent or minor. However such renunciation must be “authorized” by the court having jurisdiction of the estate of the minor, infant or incompetent. In Estate of Azie, 694 N.Y.S.2d 912 (Sur. Ct. 1999), two minor children were beneficiaries of a $1 million life insurance policy of their deceased father. The mother, who was the guardian, proposed to disclaim $50,000 of each child. The proposed disclaimer would fund a marital trust and would save $40,000 in estate taxes. The Surrogate, disapproving the proposed disclaimer, stated that the disclaimer must be advantageous to the children, and not merely to the parent.
A disclaimer may be valid under the EPTL but not under the Code. EPTL §2-1.11-(b)(2) provides that a renunciation must be filed with the Surrogates court within 9 months after the effective date of the disposition, but that this time may be extended for “reasonable cause.” EPTL §2-1.11(a)(2)(C) provides that the effective date of the disposition of a future interest “shall be the date on which it becomes an estate in possession.” Since under IRC §2518, a renunciation must be made within nine months, the grant of an extension by the Surrogates court of the time in which to file a renunciation might result in a valid disclaimer under the EPTL, but under federal tax law. Similarly, while the time for making a renunciation of a future interest may be extended under EPTL §2-1.11(a)(2)(C), such an extension would likely be ineffective for purposes of IRC §2518.
The rules for disclaiming jointly owned property can generally be divided into two categories. The first category consists of joint bank, brokerage and other investment accounts where the transferor may unilaterally regain his contributions. With respect to these, the surviving co-tenant may disclaim within nine months of the transferor’s death but, under the current EPTL, only to the extent that the survivor did not furnish consideration.
The second category comprises all other jointly held interests. With respect to all other interests held jointly with right of survivorship or as tenants by the entirety, a qualified disclaimer of the interest to which the disclaimant succeeds upon creation must be made no later than nine months after the creation.
A qualified disclaimer of an interest to which the disclaimant succeeds upon the death of another (i.e., a survivorship interest) must be made no later than nine months after the death of the first tenant. This is true (i) regardless of the portion of the property contributed by the disclaimant; (ii) regardless of the portion of the property included in the decedent’s gross estate under IRC §2040; and (iii) regardless of whether the property is unilaterally severable under local law.
A bill has been introduced in the New York legislature which would conform New York law to federal law. EPTL 2-1.11(b)(1) now provides that a surviving joint tenant or tenant by the entirety may not disclaim the portion of property allocable to amounts contributed by him with respect to such property. Under the proposed legislation, the surviving joint tenant or tenant by the entirety may disclaim to the extent that such interest could be the subject of a qualified disclaimer under IRC § 2518.
Transfer made by gift or by sale are frequently expressed by formula to avoid adverse gift tax consequences that could result if the value of the transferred interest were successfully challenged by the IRS on audit. There are two principal types of formula clauses: “value adjustment” clauses and “value definition” clauses.
A value adjustment clause provides for either an increase in the price of an asset or a return of a portion of the transferred asset to the donor if the value of the transferred asset is determined to be greater than anticipated at the time of the transfer. However, this technique, which utilizes a condition subsequent to avoid a transfer in excess of that which is contemplated, is generally ineffective. A number of courts have ruled this would constitute a condition subsequent which would have the effect of undoing a portion of a gift. That would be against public policy and therefore void.
A value definition clause defines the value of the gift or sale at the time of the transfer. The agreement between the parties does not require a price adjustment or an adjustment in the amount of property transferred. The transaction is complete, but the extent of the property sold or given is not fully known at that time. An adjustment on a revaluation by the IRS will simply cause an adjustment of the interests allocated between the transferor and transferee(s). A value definition clause could allocate the transferred amount among non-taxable transferees, which could include charities, QTIP trusts, or outright transfers to spouses.
The Eighth Circuit, in Estate of Christiansen, approved the use of formula disclaimers. __F.3d__, No. 08-3844, (11/13/09); 2009 WL 3789908, aff’’g 130 T.C. 1 (2008). Helen Christiansen left her entire estate to her daughter, Christine, with a gift over to a charity to the extent Christine disclaimed her legacy. By reason of the difficulty in valuing limited partnership interests, Christine disclaimed that portion of the estate that exceeded $6.35 million, as finally determined for estate tax purposes. Following IRS examination, the estate agreed to a higher value for the partnership interests. However, by reason of the disclaimer, this adjustment simply resulted in more property passing to the charity, with no increase in estate tax liability. The IRS objected to the formula disclaimer on public policy grounds, stating that fractional disclaimers provide a disincentive to audit.
In upholding the validity of the disclaimer, the Court of Appeals remarked that “we note that the Commissioner’s role is not merely to maximize tax receipts and conduct litigation based on a calculus as to which cases will result in the greatest collection. Rather, the Commissioner’s role is to enforce the tax laws.” Although “savings clauses” had since Com’r. v. Procter, 142 F.2d 824 (4th Cir.), cert. denied, 323 U.S. 756 (1944), rev’g and rem’g 2 TCM [CCH] 429 (1943) been held in extreme judicial disfavor on public policy grounds, carefully drawn defined value formula clauses have seen a remarkable rehabilitation. So much so that the Tax Court in Christiansen concluded that it “did not find it necessary to consider Procter, since the formula in question involved only the parties’ current estimates of value, and not values finally determined for gift or estate tax purposes.”
New York estate tax can be paid out of either the marital trust or the credit shelter trust. Since estate tax imposed by New York will again qualify as a deduction for federal estate tax purposes beginning in 2011, it is inconsequential for federal estate tax purposes whether New York estate taxes are paid out of the marital share or the credit shelter share. However, New York estate tax liability will differ depending on the source of the payment.
If payment is made from the credit shelter share, the amount that can ultimately pass free from federal estate tax will be reduced. This could result in greater exposure to future federal estate tax. If New York estate taxes are paid out of the marital share, a loss of the marital deduction will cause an immediate increase in New York estate tax. However, credit shelter share will not be reduced.
New York imposes estate tax on a pro rata basis to nonresident decedents with property subject to New York estate tax. New York imposes no estate tax on nonresidents’ intangibles. TSB-M-92 provides that “New York has long maintained a tax policy that encourages nonresidents to keep their money, securities and other intangible property in New York State.” TSB-A-85(1) further provides that shares of stock of a New York corporation held by a nonresident are not subject to New York estate tax since shares of stock are considered intangible personal property. TSB-A-08(1)M, provides that an interest of a nonresident in an S Corporation which owns a condominium in New York is an intangible asset provided the S Corporation has a legitimate business purpose. Presumably, if the S Corporation had only a single shareholder, and its only purpose was to hold real estate, New York could attempt to “pierce the veil” of the S Corporation and subject the condominium to New York estate tax in the estate of the nonresident.
Real property is generally taxed in the state where it is situated. Since LLC or partnership interests are intangibles, they would not be subject to New York estate tax. Therefore, nonresidents who own New York real property might consider converting the real property to personal property by contributing the real might consider converting the real property to personal property by contributing the real proprty to an LLC and taking back membership interests.
The mechanics of electing QTIP treatment are fairly simple. An election is made by completing Schedule M on the estate tax return. The executor Separate New York State QTIP Election. One New York State estate tax problem in connection with generously funding a QTIP was recently resolved by the New York State Department of Finance in a manner beneficial to New York residents.
Previously, New York had not recognized a “state-only” QTIP election. That is, if no QTIP election were made on the 706 (and no election would be made in 2010 since none is needed to eliminate the federal tax in 2010), no separate New York QTIP election was possible.
i. Separate NYS QTIP Election TSB-M-10(1)M, issued in February, 2010, now provides that a QTIP Election for New York State purposes when no Federal Return is Required. “In certain cases, an estate is required to file a return for New York State estate tax but is not required to file a federal return. This may occur if there is no federal estate tax in effect on the decedent’s date of death or if the decedent died while the federal estate tax was in effect but the value of his or her gross estate was too low to require the filing of a federal estate tax return. In either instance, and if applicable, the estate may still elect to take a marital deduction for Qualified Terminal Interest Property (QTIP) on a pro-forma federal estate tax return that is attached to the New York State estate tax return.” For dates of death on or after February 1, 2000, the New York State estate tax conforms to the federal Internal Revenue Code of 1986 (IRC) including all amendments enacted on or before July 22, 1998. Because the IRC in effect on July 22, 1998, permitted a QTIP election o be made for qualifying life estates for a surviving spouse (see IRC § 2056(b)(7)), that election may be made for purposes of a decedent’s New York State estate tax return even if a federal return is not required to be filed. If no federal return is required, the election must be made on the pro-forma federal estate tax return attached to the New York State return. As provided in IRC § 2056(b)(7), once made, this election is irrevocable. In addition, the value of the QTIP property for which the election is made must be included in the estate of the surviving spouse. See IRC § 2044 and New York Tax Law § 954.
Real estate and farm property is generally valued at fair market value based on its highest and best use for estate tax purposes. If elected, the special use valuation election under § 2032A can reduce the estate tax value of qualified real property or an existing business based on its actual or “special” use. The greatest decrease in value allowed in 2011 is $1 million. The qualified real property must be located in the U.S. and have been used by the decedent or a member of his or her family who materially participated in the trade or business for at least five of the eight years preceding the date of death, disability or retirement. To qualify for the election, the adjusted value of the real or personal property must equal 50 percent or more of the adjusted value of the gross estate. In addition, the adjusted value of the real property must equal 25 percent or more of the adjusted value of the gross estate. The property also must pass from the decedent to a “qualified heir”, as defined in IRC §§ 2032A(e)(1) and (e)(2). The election is made by the executor on the estate tax return and once made, is irrevocable. A properly executed “notice of election” and a written agreement signed by each person with an interest in the property must be attached to the estate tax return. Any estate can be recaptured if, within 10 years after the decedent’s death, the property is disposed of, or if the qualified heir ceases to use the property for the qualified use. The written agreement subjects all qualified heirs to personal liability for payment of the recaptured estate tax.
Where a QTIP election is made by the executor, the donor’s estate takes the marital deduction. Normally, the surviving spouse is considered to be the the transferor for GST tax purposes. However, the executor of the donor spouse may make a second election to treat the donor spouse as the transferor for GST tax purposes. IRC § 2652(a)(3).
Expenses of administration actually an necessarily incurred in administering the estate are deductible. IRC § 2053; Treas. Regs. § 1.2053-3.
Some estate administration expenses may be deducted either on the estate tax return or on the fiduciary income tax return. Under IRC § 642(g), no income tax deduction for expenses is allowed unless the executor files a statement with the IRS agreeing not to claim those expenses as deductions on the estate tax return. The election may be made on an item-by-item basis. Treas. Regs. § 1.642(g)-2. The election is irrevocable after the statement is filed. The waiver statement must be filed before the statute of limitations for assessment on the income tax return runs. Therefore, if it is unclear on which return it would be preferable to take the expenses, it may be prudent to wait until the statute of limitations is about to expire.
Expenses deductible either on the estate or fiduciary income tax return (or split between them) include (i) appraisal expenses; (ii) court costs; (iii) executor’s commissions; (iv) attorney’s fees; (v) accountant’s fees; (vi) selling expenses; and (vii) costs of preserving, maintaining and distributing estate property. Medical expenses paid within a year of death may be deducted on either the 706 or the 1041, but may not be split.
Some expenses may be deducted only on the estate tax return. These include (i) personal expenses that are not deductible for income tax purposes (e.g., funeral expenses); (ii) income and gift taxes; (iii) or expenses incurred in producing tax-exempt income.
Other expenses are deductible only on the decedent’s final income tax return. These include (i) net operating losses of the decedent; (ii) capital losses of the decedent; and (iii) unused passive activity losses of the decedent.
Deductions in respect of a decedent, which are the mirror-image of income in respect of a decedent, may be deducted on the fiduciary income tax return under IRC § 691(b), as well as the estate tax return under IRC § 2053. These deductions consist of income tax deductions which accrued prior to the decedent’s death, but which were never deducted on an income tax return. They are deductible under IRC § 2053 as expenses that reduce the size of the gross estate. These include interest expenses, taxes, and investment expenses that were incurred prior to death.
Any loss carryovers which exist when the estate terminates may be utilized by the beneficiaries under IRC § 642(h).
In most cases, if there is an estate tax liability, it will be preferable to claim the expense on the decedent’s estate tax return, since the estate tax rate exceeds the income tax rate. The estate tax is also due nine months after the date of the decedent’s death, whereas the income tax may be deferred until a later year. However, the disparity has been reduced of late since the maximum estate tax rate is now 35 percent. If there is no estate tax liability — either because the taxable estate does not exceed the applicable exclusion amount, or the taxable estate has been vanquished by the marital deduction — then taking the deduction on the income tax return will be the only viable option.
All federal circuits, except the Eighth, have long adhered to the view that post-mortem events must be ignored in valuing claims against an estate. Ithaca Trust Co. v. U.S., 279 U.S. 151 (1929) held that “[t]empting as it is to correct uncertain probabilities by the now certain fact, we are of the opinion that it cannot be done, but that the value of the wife’s life interest must be established by the mortality tables.”
However, Proposed Regs. §20.2053-1(a)(1) state that post mortem events must be considered in determining amounts deductible as expenses, claims, or debts against the estate. Those proposed regulations limit the deduction for contingent claims against an estate by providing that an estate may deduct a claim or debt, or a funeral or administration expense, only if the amount is actually paid. An expenditure contested by the estate which cannot not be resolved during the period of limitations for claiming a refund will not be deductible. However, the executor may file a “protective claim” for refund, which would preserve the estate’s ultimate right to claim a deduction under IRC §2053(a). A timely filed protective claim would thus preserve the estate’s right to a refund if the amount of the liability is later determined and paid.
Although a protective claim would not be required to specify a dollar amount, it would be required to identify the outstanding claim that would be deductible if paid, and describe the contingencies delaying the determination of the liability or its actual payment. Attorney’s fees or executor’s commissions that have not been paid could be identified in a protective claim. Prop. Regs. §20.2053-1(a)(4).
A second limitation on deductible expenses also applies: Estate expenses are deductible by the executor only if approved by the state court whose decision follows state law, or established by a bona fide settlement agreement or a consent decree resulting from an arm’s length agreement. This requirement is apparently intended to prevent a deduction where a claim of doubtful merit was paid by the estate.
The proposed regulations suffer from some defects. To illustrate one, assume the will of the decedent dying in 2008 whose estate is worth $10 million, designates that $2 million should fund the credit shelter trust, with the remainder funding the marital trust. Assume also the existence of a $3 million contested claim against the estate. If the executor sets apart $3 million for the contested claim and files a protective claim for refund, the marital trust would be funded with only $5 million, instead of $8 million. If the claim is later defeated, the $3 million held in reserve could no longer be used to fund the marital trust, and would be subject to estate tax.
Alternatively, the executor could simply fund the marital trust with $8 million, not set aside the $3 million, and not file a protective claim. If the claim is later determined to be valid, payment could be made from assets held in the marital trust. However, by proceeding in this manner, the IRS could later assert that the marital deduction was invalid.
Some have speculated that the existence of a large protective claim might also tempt the IRS to look more closely at other valuation issues involving other expenses claimed by the estate as a hedge against the possibility of a large future deduction by the estate.