I. New York State Matters
NYS Amends Estate & Gift Tax
Beginning April 1, 2014, the NYS estate exemption will increase every 12 months through 2017. On April 1, 2014, the NYS exemption became $2.0625; on April 1, 2015, $3.125 million; on April 1, 2016, $4.1875 million; on April 1, 2017, $5.25 million. On January 1, 2019, the phase-in will end and the rates will be unified. The NYS legislature chose to provide no estate exemption to New York decedents whose estates exceed 105 percent of the exemption amount. In order to achieve this sharp cutoff for estates between 100 and 105 percent of the exemption amount, the effective rate of tax imposed on the incremental 0 to 5 percent will paradoxically far exceed the increase in the actual estate. For example, a decedent dying in 2018 with a taxable estate of $5.25 million would owe no NYS estate tax. However, if that decedent’s estate were 105 percent of the exemption amount, or $5.5125 million, no exemption would be allowed — not even the $1 million exemption that existed prior to the change in the law.
If that same decedent died in 2018 with a taxable estate of $5.3 million, which is only $50,000 above the $5.25 million amount which would result in no NYS estate tax, because of the sharp phase out of the exemption, that $50,000 increase in estate size would result in estate tax liability of $119,200, an effective rate of tax on the incremental $50,000 of 238.4 percent. Obviously, one would want to avoid being within phase-out zone. There are several methods of accomplishing this, one being to employ a formula clause in the testamentary instrument, shifting the incremental excess to a spouse or a charity for whom an estate tax deduction is available. Another method would be to make gifts before death. However, New York has closed a loophole which enabled New York residents to avoid estate tax by making such large gifts before death thereby reducing the size of the gross estate. Since New York imposes no gift tax large gifts by residents before death had resulted in avoidance of the estate tax at no tax cost.
New York has not reimposed a gift tax, although that was considered. Instead, New York has enacted legislation that will pull back into a decedent’s estate gifts made within 3 years of death. Interestingly, some gifts pulled back into the estate under the new law would not even have been part of the decedent’s estate had the decedent died owning them. To further complicate the situation, gifts made within three years of death will not be included in the federal estate. In calculating the federal estate tax, a deduction is allowed for state estate taxes resulting from assets included in the federal estate. Since (outright) gifts made within three years are not included in the federal estate, no federal deduction will be allowed for those gifts brought back by New York and included in the New York resident’s estate for New York estate tax purposes. The loss of the federal deduction will increase the effective cost of the gift for New York estate tax purposes.
Although the Legislature considered changing the estate tax rate, the top rate remains unchanged at 16 percent. The general result of the change in the estate tax law can be summarized as follows: (i) wealthy New York residents will not be able to avoid the estate tax by making large gifts shortly before death; (ii) the “cliff” rule counsels serious tax planning to avoid tax penalties for estates which exceed the exemption amount by between 0 and 5 percent; (iii) estates under the exemption amount will incur no estate tax; and (iv) gifts of certain assets which would have not been included in the estate will by reason of the new three-year rule become part of the estate, even though they would not otherwise have become part of the estate.
Like most states, New York has not adopted the federal rule of portability, meaning that a surviving spouse cannot derive any benefit from an unused estate tax exemption of a predeceasing spouse. Under the federal rule, the unused exemption of the first spouse to die can be utilized by the surviving spouse, provided an estate tax return is filed. However, since New York does not allow the surviving spouse to utilize the unused exemption of the predeceasing spouse, other planning techniques are required. The simplest and most logical technique is to fund a testamentary trust of the first spouse to die with a formulaic amount equal to the then applicable New York State exemption amount. The rest of the estate could be given outright or in QTIP form to the surviving spouse. This method would ensure full use of the New York State exemption, and would result in no federal or New York State estate tax at the death of the first spouse. One drawback to this approach is that although assets passing into the credit shelter trust would receive a basis step up for income tax purposes, a second basis step up at the death of the surviving spouse would not be possible.
Those assets passing to the surviving spouse outright or via QTIP would receive a second basis step up at the death of the surviving spouse. There may be situations where it makes sense to forego the NYS exemption — and pass all assets to the surviving spouse in a QTIP or outright — in order to obtain a second basis step up at the death of the surviving spouse. This may depend upon whether the assets are expected to appreciate substantially following the death of the first spouse. If this is the case, the second step up in basis may be worth more than the foregone New York State exemption. One must be aware of a trap in the federal portability rule. The amount of the unused exemption is measured by the amount possessed by the “last” surviving spouse. This means that if the surviving spouse remarries and survives the spouse of her remarriage, her available federal exemption amount will be calculated with reference to her last predeceasing spouse, which is the spouse whom she married after the death of her initial spouse. If the “last surviving spouse” has no unused exemption amount, it is possible that the entire “ported” unused exclusion amount of the first spouse to die could be wasted in the event of remarriage.
There is another problem with foregoing use of the credit shelter trust in favor of portability: There is no way to compel an executor to file a federal estate tax return, which is a prerequisite for electing portability. Although one need not formally “elect” portability on a federal estate tax return — the mere filing of the return will result in portability unless the executor elects out — the only way to elect portability is to file a federal estate tax return. Another approach to estate planning for large estates has been suggested. This involves gifting assets to the likely surviving spouse — in the case of New York presumably more than three years before death — and then having the surviving spouse gift or sell assets to a “defective” grantor trust. This will result in trust assets appreciating without the imposition of yearly income tax on the trust. As income tax rates have risen dramatically, this strategy is attractive.
Whether or not the assets in the trust receive a basis step up at the death of the surviving spouse — and the general consensus is that they will not — the strategy makes sense since the trust will grow quickly without the imposition of a yearly income tax. Any income tax liability will be reported by the surviving spouse on that spouse’s own individual income tax return. This will have the salient effect of reducing the size of the estate of the surviving spouse that could be subject to federal estate tax. The problem with this approach is not a tax problem, but rather a practical problem. It assumes that the surviving spouse will make a large gift (or sale) to an irrevocable trust with respect to which s/he has no interest. Recall that if the surviving spouse were to have an interest in this trust, IRC § 2036 would pull the assets back into the estate. This means that the grantor can have no income interest in the trust.
Older persons whose estates appear large enough to support them in their manner of living for many years may decide that they do not wish to irrevocably part with assets which they might conceivably need. It is unusual that even older parents make substantial gifts of large portions of their estate before death. For this reason, relying on a surviving spouse to make a large gift or sale to a “defective” grantor trusts should be contemplated only where it appears reasonably certain that the surviving spouse will actually make the gift or complete the sale.
New York Obviates Federal Grantor Trust Rule for Certain Trusts
To the chagrin of New York, the IRS announced in PLR 201310002 that certain trusts established by New York residents in Nevada or Delaware were not “grantor” trusts under federal law. Since these non-grantor trusts operated outside the orbit of New York income tax, New York grantors were not taxed on income earned by these trusts. To Albany, this appeared to open up a tax loophole the width of the Mississippi. As a result, the Department of Taxation appears to have lobbied for legislation which treats the grantor as the tax owner of the assets contained in these out of state trusts even though for federal purposes the grantor is not treated as the tax owner. Although these “NING” or “Nevada incomplete gift nongrantor trusts” will still benefit residents of other states, New York residents will no longer derive a tax benefit from implementing these trusts, since the New York resident will be required to report income earned by these trusts on the resident’s New York income tax return, Form IT-201. This, despite the fact that the income will not be reported on the New York resident’s Form 1040 federal income tax return, but rather on the fiduciary income tax return of the out-of-state trust.
New York Imposes ““Throwback” Rule to Capture Undistributed Net Income of Out of State Trusts
In Taylor v. NYS Tax Commission, 445 N.Y.S.2d 648 (3rd Dept. 1981), a New York domiciliary created a trust consisting of Florida property. Neither the trustees nor the beneficiaries were New York residents. The Appellate Division held that under the 14th Amendment “[a] state may not impose tax on an entity unless that state has a sufficient nexus with the entity, thus providing a basis for jurisdiction.” Following Taylor, New York codified an exception to the imposition of income tax imposed on New York “resident” trusts where (i) no trustees resided in New York; (ii) no property (corpus) was situated in New York; and (iii) where the trust had no New York source income. (A New York “resident” trust is a trust created under the will of a New York domiciliary or a trust created by a New York domiciliary at the time the trust was funded.)
As a result of this exception, it was sometimes prudent for New York residents to implement New York resident trusts in Nevada or Delaware. New York would not trust income from such trusts except to the extent income was currently distributed to New York beneficiaries. If the trust accumulated income, beneficiaries would have no income to report. The accumulated income, when later distributed, to the extent it exceeded the distributable net income (DNI) of the trust, would forever escape income tax in New York.
To change this result, principles of federal taxation of foreign non-grantor trusts were imported. Now, beneficiaries receiving “accumulation distributions” will be taxed on those distributions, even if they exceed trust DNI. However, a credit will be allowed for (i) taxes paid to New York in prior years on accumulated income and (ii) taxes paid to other states. Under the new law, trusts meeting the three exceptions, “exempt” trusts, will now be subject to reporting requirements for years in which accumulation distributions are made. The law became effective for accumulation distributions after June 1, 2014. Although the rule is harsh, two factors mitigate against this harshness: First, the rule applies only to beneficiaries who reside in New York. Out of state beneficiaries will not be affected, since they will not owe any tax to New York. Second, “UNI” or undistributed net income, can be minimized by the trust investing in assets producing capital gains. Capital gains are not included in distributive net income (DNI) and accordingly, the retention by the trust of income derived from capital gains will not become subject to the throwback rule when the income is later distributed. (See Taxation of Foreign Nongrantor Trusts: Throwback Rule, Tax News & Comment, August, 2014.)
II. IRS Matters
Final Regulations on Portability
Treasury promulgated final regulations concerning portability. Reg. § 20.2010-2T(a)(1)(4) requires the filing of a federal estate tax return in order to elect portability. The return may be filed by an executor or any person in possession of property of the decedent. The executor may refuse to file a 706 where none is required if the gross estate is not large enough to require an estate tax return. In a situation where beneficiaries (children) of the deceased spouse have received all that they will under a credit shelter trust, they may refuse to file an estate tax return merely to make a portability election with respect to which they will not benefit. The surviving spouse, who may not be the executor, cannot compel the child executor to file a 706. Disputes may arise. Children may argue that the deceased may have engaged in earlier transactions during life that could be reviewed if an estate tax return were filed. The refusal could also be groundless and petty, such as the refusal to pay for the cost of the return, or some other imagined transgression that warrants recalcitrance.
Until Congress or Treasury addresses this serious issue, spouses should agree between themselves to a resolution of this potential problem, either in a prenuptial agreement, post-nuptial agreement, or other writing. Fortunately, the IRS has been liberal in permitting late filings of estate tax returns to make a portability election. In many cases, it makes sense to delay filing an estate tax return until the latest time moment because it is not always clear whether and to what extent assets which may appreciate post-death should fund the QTIP as opposed to the credit shelter trust. Some practitioners are concerned that an estate tax return filed to elect portability which contains a QTIP election will be “ignored” since Rev. Proc. 2001-38 provided that the IRS will ignore a QTIP election if the election was not necessary to reduce estate tax. However, this concern seems unjustified. Rev. Proc. 2001-38 was ameliorative in nature, it appears remote that the IRS would use the procedure offensively to undermine the concept of portability.
IRS Sanguine Regarding Scrivener’s Errors
PLR 201442042 posed a situation where a GRAT was created which provided for the transfer of property following termination of the GRAT to a revocable trust which the grantor of the GRAT could revoke. This problem with this plan was that it was internally inconsistent. The transfer to the GRAT was complete for transfer tax purposes once the GRAT term ended. The transfer to a trust that could be revoked by the grantor would appear to bring the property back into the grantor’s estate — exactly the result which the GRAT was intended to obviate. The IRS sensibly concluded that under state law the trust could be amended to correct the error, since the grantor’s intent was clearly frustrated by the incongruity of the two instruments.
Taxpayers May Benefit From Arguing Poorly Maintained Asset Sales Should be Ignored
In the past, the IRS has argued, principally under IRC § 2036, that transfers putatively made to reduce the size of the grantor’s or donor’s estate should be ignored, and that the assets should be brought back into the estate for estate tax purposes. Now, given the tectonic shift where income tax considerations are now much more important than estate tax considerations, the taxpayer may actually benefit from arguing that poorly maintained estate plans should be ignored, and by virtue of IRC § 2036, assets should be included in the grantor’s estate. If successful, this argument would likely provide an invaluable basis step up where none would otherwise occur. In contemplating whether to so argue, it would be necessary to include in this calculus any estate tax cost that might be occasioned. If it could be successfully argued that the assets were never effectively transferred out of the donor’s estate, and that no deleterious estate tax consequences would ensue, then the importance of generating a basis step up could inveigh against seeking to maintain such estate plans which have now become a liability rather than a benefit. It is unclear how the IRS would respond to this argument.
PLR 20140011: Contingency in Prenup Will Not Void QTIP
In order to validly elect QTIP treatment, there must be no “contingency” that would preclude a marital deduction under IRC § 2056(b)(1). PLR 201410011 stated that a prenuptial agreement that contained a provision allowing a surviving spouse to elect to take either under the terms of the prenuptial agreement or under the terms of a revocable trust would actually “pass from the decedent to his surviving spouse,” and would therefore not violate Section 2056(b)(1).
Relief From Late Portability Elections
Portability must be elected with a timely filed estate tax return. An estate tax return must be filed within nine months after the decedent’s death, or if an extension is requested, by the end of that period. In several cases where the value of the decedent’s estate was less than the exemption amount, a timely estate tax return was not filed. In granting an extension of time to make a portability election, the IRS reasoned that the portability election is “regulatory” rather than statutory, and thus relief was available under Reg. §301.9100-3, which provides that the IRS may grant a reasonable extension of time to make a regulatory election, provided the taxpayer acted reasonably and in good faith. PLRs 201406004; 201407002; 201410013; and others.
Final Regulations on 2 Percent Floor on
Miscellaneous Itemized Deductions Under IRC §67(a)
Final regulations were issued under IRC §67(a), which provides that expenses incurred by trusts and estates are subject to the two percent floor for miscellaneous itemized deductions. The Supreme Court, in Knight v. Com’r, 552 U.S. 181 (2008), gave an exceptionally narrow reading to IRC §67(e). That section exempts from the two percent floor expenses incurred in administering the estate or trust that would not have been incurred if the property were not held in the estate or trust. According to the interpretation placed upon the statute by the Supreme Court, the test is whether a hypothetical individual holding the same property outside a trust would customarily incur the expense. If that individual would incur the expense, then the expense would be subject to the two percent floor if incurred by an estate. Taking its cue from Knight, the regulations take the position that ownership costs are subject to the two percent floor. Investment or advisory fees incurred by an estate or trust that exceed those fees that would be incurred by an individual would not be subject to the two percent floor. Probate fees, fees to prepare estate tax returns, and trust returns, but not gift tax returns, are not subject to the two percent floor. The regulations provide that fiduciary fees not computed on an hourly basis are also not subject to the two percent floor.