Law Offices of David L. Silverman, J.D., LL.M.

The Treasury has announced new regulations that allow most noncorporate entities to elect to be taxed under the partnership tax law provisions of the Code. Previously, this coveted tax treatment depended upon a favorable analysis of four “corporate characteristics” of the entity: continuity of life, centralization of management, limited liability, and free transferability of interests. If the entity possessed more than two, it was taxed as a corporation and (potentially) subject to two levels of taxation; otherwise, it was taxed, for federal income tax purposes, as a partnership.

The new regulations will eliminate the need for partnerships and LLCs to carefully structure their operating agreements (and to seek advance rulings from the Service) in order to ensure partnership tax treatment. Often, the need to avoid corporate classification has required provisions and restrictions in the partnership agreement that were at variance with the business objectives of the owners. Providing, as it does, a virtual “safe harbor” for many newly formed entities, the new regulations will add a measure of tax certainty into what had at times been a murky area of federal tax law.

Until now, the Service has on occasion attempted to reclassify as associations entities actually formed as partnerships under state law when those entities possessed more than two corporate characteristics. The result of this reclassification was the unwanted application of the corporate tax sections of the Code, which impose of two levels of taxation. The recalssification also resulted in the loss of the application of the favorable partnership tax provisions of the Code, which provide for a flow through of income and losses to the partners.

Even under the new regulations, not all entities will be permitted to elect partnership tax treatment. Most prominent among those entities that will continue to be taxed as corporations are entities which begin life as corporations under state law in any of the fifty states. Other entities (among eight) which will automatically attract corporate tax treatment are certain publicly traded partnerships, and any business entity wholly owned by a state or a political subdivision.

Entities not subject to automatic corporate tax treatment may elect to be taxed either as corporations or as partnerships. The election must be signed by all owners of the entity or by an officer authorized to file the election. In the event an entity fails to make an election, partnership tax treatment will generally obtain in any event under the “default rules.” (An election to be taxed as a corporation might be desirable in unusual circumstances, e.g., where no current distribution of profits is envisioned.)

The proposed regulations provide specific guidance for entities in existence prior to 1997. First, entities attracting mandatory corporate tax treatment under the new regulations will be taxed as corporations. Second, entities not subject to automatic tax treatment under the new regulations and which desire to retain the tax treatment previously claimed, need not taken any action. Although the regulations apply prospectively, they nevertheless preclude the IRS from challenging classification of an organization that has “consistently” claimed the same classification for prior periods and had a “reasonable basis” for doing so.

Since New York State income tax laws generally track federal tax laws, the new regulations will collaterally effect — and simplify — state (and local) income tax treatment for  many entities. One must remember, however, that many legal questions relating to the entity at the state level do not involve issues of taxation. In such cases, the new treasury regulations are likely to have less impact.

I.   New Pension Distribution Rules

The objective of many participants of qualified pension plans and IRAs is to delay distributions as long as possible and, when required to take distributions, to withdraw the least amount over the longest period of time. On January 11, 2001, the IRS revised the 1987 proposed regulations governing minimum required distributions from qualified pension plans and IRAs.

All qualified pension plans must provide for annual minimum required distributions that commence no later than the “required beginning date,” which is April 1^st following the year in which the participant attains the age of 70½, or retires, if later. The penalty for failing to take required distributions at the required beginning date and annually thereafter is a 50% excise tax, which is imposed on the difference between the minimum required distribution and the actual distribution made in any given year.

The 2001 proposed regulations, which are elective for 2001 but mandatory thereafter, change the distribution rules by (i) reducing minimum required distributions and greatly simplifying their determination; (ii) lengthening the distribution period; (iii) extending the deadline for designating a beneficiary without adverse consequences from the required beginning date to December 31^st following the year of death; and (iv) implementing new reporting requirements imposed upon IRA trustees.  Most of these changes, except for the new reporting requirements, are favorable to the participant. The following discussion will summarize current law and highlight important changes.

Participant’s Death Before

Required Beginning Date

If the participant dies before the required beginning date, plan benefits must be distributed (i) in annual installments over the life expectancy of the nonspouse designated beneficiary, with distributions commencing no later than December 31^st of the year after the year in which the participant died, with the life expectancy being reduced by one for each subsequent year; (ii) in annual installments over the life expectancy of a spouse beneficiary at the death of the participant, beginning no later than December 31^st of the year after the year in which the participant died or, if later, by December 31^st of the year in which the participant would have reached age 70½, with the life expectancy of the spouse being redetermined annually; or (iii) within five years of the participant’s death, if the participant has no designated beneficiary.  These rules are statutory and have not changed. The surviving spouse may also elect to roll over an IRA plan into her own.  These rules, which have been amended, are discussed below.

Under the 1987 regulations, if the participant died before the required beginning date having failed to name a designated beneficiary, distribution of the entire account balance was required within five years. Although in the same circumstances the new regulations appear to permit a distribution over the remaining life expectancy of the participant, calculated in the year of the participant’s death, reduced by one for each subsequent year, the regulations are unclear on this point.  Accordingly, until clarification is forthcoming, it is still important that a beneficiary designation be made early, even before the required beginning date.  Fortunately, under the new rules, making a beneficiary designation no longer binds the participant as under the previous regulations.

Previously, another trap could ensnare even the participant who had named a nonspouse designated beneficiary before his death and prior to the required beginning date:  distribution of the entire account balance was required within five years even if the participant had named a designated beneficiary prior to death before the required beginning date, unless the participant had also directed that minimum required distributions were to be made over the life expectancy of the designated beneficiary. The new regulations eliminate this harsh rule, and provide that if the participant dies before the required beginning date having named a designated beneficiary, distributions are to be made over the life expectancy of the designated beneficiary, unless the plan provides otherwise.

Lifetime Distributions After

Required Beginning Date

As indicated above, the estate of a participant who dies before the required beginning date having failed to name a designated beneficiary may be required to distribute the entire account balance within five years, even under the new rules. However, in the majority of cases, the participant is still alive at the required beginning date. Under the old regulations, a living participant’s failure to have named a designated beneficiary by the required beginning date had deleterious consequences that could never be cured, irrespective of whether participant subsequently named a designated beneficiary before his death.  By contrast, participants who have attained the required beginning date and have begun taking distributions fare much better under the new rules, even if they have not made a beneficiary designation.

Under the old rules, the participant who failed to make a beneficiary designation by the required beginning date was not permitted to take distributions over the joint life expectancy of the participant and designated beneficiary using the MDIB tables. Rather, the participant was required to take distributions based only upon his single life expectancy as of the required beginning date. At death, the consequences of having failed to name a designated beneficiary by the required beginning date were similar:  instead of being permitted to take distributions over the true life expectancy of the participant and the beneficiary determined as of the required beginning date, without regard to the MDIB rule, the beneficiary was required to take distributions over the (remaining) single life expectancy that the participant was using before death.  Thus, failure to make a beneficiary designation by the required beginning date shortened considerably the payout of the account balance both during and after the death of the participant.

The new regulations allow the participant more time — until December 31^st of the year following the participant’s death — in which to choose a designated beneficiary.  Under the new rules, calculation of the participant’s lifetime minimum required distribution is simply the participant’s account balance divided by the distribution period. This rule applies irrespective of whether the participant has or has not named a designated beneficiary by the required beginning date. The distribution period is now determined by reference to the MDIB divisor table (discussed below) whether or not a beneficiary designation has been made.  Consequently, failure to name a designated beneficiary by the required beginning date is now almost benign, provided the participant does not die before the required beginning date.

For lifetime required distributions under the new regulations, a uniform distribution period for all participants of the same age is provided by the minimum distribution incidental benefit (MDIB) divisor table.  That table,  used to calculate the distribution period, is based on the joint life expectancies of the participant and a survivor 10 years younger at each age beginning at age 70.  Using the MDIB table, most participants will be able to determine their required minimum distribution for each year based on nothing more than their current age and the account balance as of the end of the prior year. This greatly simplifies the determination of annual minimum required distributions while the participant is alive. The rationale for permitting use of the MDIB table, regardless of the age of the beneficiary chosen, and even if no beneficiary has been chosen, is that the participant’s beneficiary designation is subject to change until the death of the participant, and the beneficiary ultimately selected may be more than ten years younger than the participant.

Previously, even if a beneficiary designation was timely made, the participant was required to make an irrevocable choice between “recalculating” her life expectancy or not recalculating her life expectancy, as well as that of her spouse, at the required beginning date. Since the MDIB divisor table, which employs a fixed distribution period, is used for almost all participants, recalculation is no longer required. The only deviation from this rule occurs when calculating lifetime distributions for a participant married to a spouse more than ten years younger. In that case, a longer distribution period, measured by the joint and last survivor expectancy of the employee and spouse, may be used.

The old regulations implicitly required the participant to choose a designated beneficiary by the required beginning date, since failure to do so would result in the participant’s being forced to forego use of a joint life expectancy in determining lifetime minimum distributions.  Yet the required beginning date may well have occurred many years before the participant’s death. If the participant later decided to change the beneficiary designation, new calculations were required, which could shorten, but never lengthen, the distribution period, even if the new designated beneficiary were younger then the original designated beneficiary.  Under the new rules, the participant is not required to make a beneficiary designation until December 31^st of the year following the participant’s death.  Any designated beneficiary who is eliminated (e.g., through a disclaimer) by the end of the year following the participant’s date of death will be ignored for purposes of determining the minimum required distributions of remaining designated beneficiaries.

Death of Participant After

Required Beginning Date

Under the new regulations, the death of a participant who has begun taking lifetime distributions will result in a nonspouse designated beneficiary being required to take annual distributions, beginning no later than December 31^st of the year following the year of the participant’s death, over the beneficiary’s remaining life expectancy in the year following the participant’s death, reduced by one for each subsequent year. If the employee’s spouse is the sole designated beneficiary at the end of the year following the year of the participant’s death, the distribution period is the spouse’s single life expectancy, redetermined each year, with distributions commencing no later than December 31^st of the year following the participant’s year of death.  Following the death of the beneficiary spouse, the distribution period is the surviving spouse’s life expectancy calculated in the year of her death, reduced by one for each subsequent year.

Note that under the new regulations, distributions to designated beneficiaries after a participant’s death are the same whether the participant dies before or after the required beginning date, provided the participant has made a beneficiary designation. Also note that if, as of the end of the year following the participant’s death, the participant has more than one designated beneficiary (and the account has not been divided into separate accounts for each beneficiary), the beneficiary with the shortest life expectancy is the designated beneficiary for purposes of determining the required minimum distributions. This approach is consistent with the approach in the old regulations.

Trust as Beneficiary

The new regulations do not alter the existing requirements with respect to beneficiaries of trusts qualifying as designated beneficiaries. Pursuant to proposed regulations promulgated in 1997, the underlying beneficiary of a trust may be a participant’s designated beneficiary for purposes of determining the required minimum distribution when the trust is named as beneficiary of a retirement plan or IRA, provided documentation with respect to the underlying beneficiaries is provided to the plan administrator in a timely fashion.

However, consistent with the new rule permitting a designated beneficiary to be named by December 31^st in the year following the participant’s date of death, the trust need no longer be provided to the plan administrator by age 70½. It now suffices if the trust is provided to the plan administrator by December 31^st of the year following the year of the participant’s death. The new regulations also explicitly approve the use of testamentary trusts and QTIP trusts as beneficiaries of a retirement plan or IRA.

Election of Surviving Spouse to

Treat an Inherited IRA as Own

The new regulations clarify the rule that permits the surviving spouse of a decedent IRA owner to elect to treat an inherited IRA as the spouse’s own IRA. The 1987 proposed regulations provided that this election was deemed to have been made if the surviving spouse contributed to the IRA or did not take the required minimum distribution as beneficiary of the IRA.  The new regulations clarify that the deemed election may only be made after the minimum required distribution from the IRA, if any, has been made for the year of the participant’s death. The new rules permit the deemed election to be made by the surviving spouse only if the spouse is the sole beneficiary of the account and has an unlimited right of withdrawal from the account. This requirement cannot be met if a trust is named as beneficiary of the IRA, even if the spouse is the sole beneficiary of the trust. Note that if the surviving spouse is age 70½ or older, a required minimum distribution must be made, and this amount may not be rolled over.

New IRA Reporting Requirements

By reason of the “substantially simplified” calculation of the required minimum distributions from IRAs, IRA trustees will presumably be in a position to calculate the following year’s required minimum distribution. Accordingly, the trustee of each IRA will be now be required to report the amount of the required minimum distribution to the IRS. This requirement will apply regardless of whether the IRA owner intends to take the required minimum distribution from one particular IRA, or from another IRA. The report would also be required to indicate whether the IRA owner is permitted to take the required distribution from another IRA of the participant. During 2001, the IRS will be receiving public comments in evaluating the manner in which to implement the reporting requirement. Once the reporting requirement is implemented, amendment of current plan documents will be required.

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II.      Estate Administration Expenses

The IRS has issued new regulations addressing the allocation of administration expenses charged to the share of an estate which would otherwise qualify for a marital or charitable deduction. T.D. 8846, 64 Fed. Reg. 67763 (12/1999), corrected 64 Fed. Reg. 71021 (12/1999) and Announcement 2000-3, 2000-2 I.R.B. 296 (1/2000). The new regulations allocate expenses between estate “management expenses” and “transmission expenses.” The new regulations apply to estates of decedents dying after December 3, 1999, and attempt to address issues raised by Comr. v. Estate of Hubert, 500 U.S. 93 (1997), and the earlier proposed regulations.

Estate management expenses relate to expenses that would have been incurred by the decedent before death or by beneficiaries had they received the property on the date of death. They include the cost of maintaining or preserving estate assets during the period of estate administration, stock brokerage fees, investment advisory fees, and interest. Estate management expenses do not reduce the estate tax marital or charitable deduction, and may be paid from the marital or charitable share.

Estate transmission expenses are defined by exclusion as any expense which is not an estate management expense. Generally, these are expenses which would not have been incurred but for the death of the decedent. They relate to costs incurred to collect the decedent’s assets, to pay the decedent’s debts and transfer taxes, and to satisfy executor commissions and attorney fees. Estate transmission expenses paid from the marital share or charitable share reduce the marital or charitable deduction.

As a planning matter, in light of the new regulations, it may be advisable to insert language in a will or trust authorizing the trustee or executor to allocate expenses between income and principal in a such a manner as to reduce federal tax. Executors and attorneys may also be required to itemize expenses, distinguishing between management and transmission expenses.

III.    New Actuarial Tables

The IRS has issued new actuarial tables used to value life estates, annuities, remainder and reversionary interests. The new regulations apply to gifts made after April 30, 1999. Under the new tables, the value of a lifetime income interest is increased, and the value of a remainder interest is decreased. The effect of these changes on various estate planning techniques depends upon the type of trust.

The increased lifetime interest makes grantor retained annuity trusts (GRATs)  more attractive, since the remainder interest is reduced. This makes the initial taxable gift smaller. However, Qualified Personal Residence Trusts (QPRTs) fare slightly worse under the new regulations: the effect of the grantor living longer reduces the reversionary interest if the grantor dies during the term of the trust; this increases the initial taxable gift. T.D. 8886, 65 Fed. Reg. 36908-01 (6/2000), corrected 65 Fed. Reg. 58222-01 (9/2000).

IV.    Valuation Discounts

In TAM 19943003 (11/1999), the IRS allowed only a partition discount with respect to an undivided interest in real estate. The decedent had claimed discounts for lack of marketability. The advice, however, appeared to limit the available discount to that obtained by multiplying the value of the fee by the undivided interest, and subtracting the costs of partition allocable to the undivided interest. This formula would result in a much smaller discount.

In FSA 200049003 (12/2000), perhaps in response to the Strangi and Knight decisions, the National Office summoned its arguments against discounts in the context of a family limited liability company (LLC). It concluded that (i) the doctrine of “economic substance” compelled valuing the transferred interests without regard to the LLC; (ii) the transferring parent had retained beneficial enjoyment of the property, resulting in estate inclusion under IRC §2036; (iii) no gift occurs upon the formation of the LLC, because of the parent’s retention of the right to control beneficial enjoyment; and (iv) restrictions on liquidation of LLC interests should be disregarded as applicable restrictions under IRC §2704(b).

The Tax Court in Estate of Strangi and Estate of Knight appeared to reject the IRS arguments concerning IRC §2704. (See discussion in “From the Courts.”) In other respects, the field service advisory is useful in planning, as it suggests likely IRS objections to discounts in the context of family LLCs.

V.     Annual Exclusion Gifts

In TAM 199944003 (11/1999), the IRS confirmed what practitioners have long suspected, i.e., the gift of a partnership interest qualifies for the annual exclusion. The partnership agreement stated that general partners were solely responsible for the management of the partnership business, and had the right to determine the timing and amount of distributions. However, the agreement also gave the limited partner the right to assign his partnership interest. The right to assign the interest gave the limited partner the right to immediate use, possession, or enjoyment of the partnership interest. The gift therefore was therefor of a present interest and qualified for the annual exclusion. Note that by negative implication, the memorandum would appear to deny the use of the annual exclusion if the limited partnership interests were nonassignable and the general partner could withhold distributions.

VI.     “Defective” Grantor Trusts

PLR 299930018 (7/2000) indirectly sanctioned “defective” grantor trusts. In this ruling request, the grantor retained the power to remove the trustees and appoint any unrelated person as successor trustee. The IRS ruled that the trust was a grantor trust for income tax purposes because the trustees had the power to allocate income and principal among a class of beneficiaries, and a power to add beneficiaries. Since the grantor had not retained a reversionary interest and did not have the power to alter, amend or revoke the trust, the initial gift was sound, and the trust would not be included in the grantor’s gross estate. Since a grantor trust may be a shareholder in an S corporation, the ruling held that the trust could hold S corporation stock without terminating the S election.

VII.   Charitable Remainder Trusts

In Notice 2000-37, 2000-29 I.R.B. 118 (7/2000), the Service advised of its intention to issue new model forms for charitable remainder trusts. The new forms would respond to recent law changes, including (i) the 50% annuity or unitrust limit; and (ii) the 10% minimum value of the charitable remainder interest.

VIII.    Estate Taxes & Returns

The Service has issued proposed regulations permitting an automatic six-month extension in which to file a federal estate tax return. No showing of reasonable cause would be necessary. The application for extension must be timely filed before the due date of the estate tax return, and must contain an estimate of estate and GST tax liability. Prop. Regs. §§20.6075-1 and 20.6081-1, 65 Fed. Reg. 63025-01 (10/2000).

IX.     Gift Taxes & Returns

The IRS has issued final regulations explaining what constitutes adequate disclosure for purposes of commencing the three-year statute of limitations on gift tax audits. T.D. 8845, 64 Fed. Reg. 67767 (12/1999), corrected, 65 Fed. Reg. 1059 (1/2000). Under the regulations, adequate disclosure requires a description of (i) the property transferred; (ii) the relationship between the parties; (iii) the taxpayer identification number of any trust receiving property; (iv) the value of the property transferred; (v) the methodology of valuation; and (vi) a statement by the taxpayer advising of any position taken that conflicts with regulations or revenue rulings.

The new regulations clarify that adequate disclosure will not merely commence the statute of limitations with respect to valuation issues, but also with respect to issues involving the gift tax exclusion, the marital deduction, or the charitable deduction. If payments to family members are unclear, and are not reported as gifts, e.g., salaries to family members employed by family businesses, the regulations provide that adequate disclosure is made if such payments are reported on income tax returns.

In connection with the new regulations concerning adequate disclosure for gifts, the IRS has also set forth in Rev. Proc. 2000-34, 2000-34 I.R.B. 186 (8/2000) procedures for amending previously filed gift tax returns in order to adequately disclose prior gifts. In addition to providing all information which would be necessary in the first instance, the amended gift tax return must also be filed with the same IRS Service Center in which the original gift tax return was filed.

X.   GRATs & QPRTs

Final regulations issued prohibit the use of promissory notes issued by a GRAT or GRUT as annuity payments. T.D. 8899, Treas. Reg. §§25.2702-3(b), 25.2702-3(c), 25.2702-3(d)(5), 65 Fed. Reg. 53587 (9/2000), corrected (11/2000). The regulations further mandate that the governing instrument of a GRAT or GRUT created on or after September 20, 1999 must expressly prohibit the use of notes, debt instruments, options or similar financial arrangements. Failure to include this language will result in the GRAT or GRUT not being a qualified interest under IRC §2702. This would result in the grantor’s gift being valued without reference to the retained interest, resulting in a gift of the entire trust.  Treas. Reg. § 25.2702-3(d)(5)(i).  Clarifying an important area of concern, the regulations also provide that annuity payments may be made on either a calendar year or at the trust’s anniversary date.  To illustrate, a GRAT created on May 1, 2001, could require the trustee to make annual payments by April 30 of each trust year, or based on the taxable year of the trust.

President Clinton’s fiscal year 2001 budget proposal would have eliminated favorable treatment for Qualified Personal Residence Trusts (QPRTs). Such legislation was not enacted. Given the inclination of President Bush to eliminate the transfer tax, QPRTs may comprise an excellent hedge against such repeal.

XI.    Trusts as Beneficiaries of IRAs

PLRs 200041039 and 20004035 (10/2000) stated that where the decedent’s will provided that IRA proceeds would be divided among grandchildren, and that shares for grandchildren under the age of 21 would be held in trust until the minor reached the age of majority, the trust for each grandchild was a valid IRA beneficiary under Prop. Treas. Reg. §1.401-1(a)(9)-1, and that the grandchild was a “designated beneficiary” of that portion of the IRA. Beneficiaries of a trust may be “designated beneficiaries” for purposes of the regulations if (i) the trust is valid under state law or would be but for the fact that there is no corpus; (ii) the trust is irrevocable or states that it becomes irrevocable upon the death of the employee; (iii) the beneficiaries are identifiable from the trust instrument; and (iv) the plan administrator is provided with a copy of the trust or with a list of all trust beneficiaries as of the date of death.  Prop. Treas. Reg. §1.401(a)(9).

I.   New Pension Distribution Rules

The objective of many participants of qualified pension plans and IRAs is to delay distributions as long as possible and, when required to take distributions, to withdraw the least amount over the longest period of time. On January 11, 2001, the IRS revised the 1987 proposed regulations governing minimum required distributions from qualified pension plans and IRAs.

All qualified pension plans must provide for annual minimum required distributions that commence no later than the “required beginning date,” which is April 1^st following the year in which the participant attains the age of 70½, or retires, if later. The penalty for failing to take required distributions at the required beginning date and annually thereafter is a 50% excise tax, which is imposed on the difference between the minimum required distribution and the actual distribution made in any given year.

The 2001 proposed regulations, which are elective for 2001 but mandatory thereafter, change the distribution rules by (i) reducing minimum required distributions and greatly simplifying their determination; (ii) lengthening the distribution period; (iii) extending the deadline for designating a beneficiary without adverse consequences from the required beginning date to December 31^st following the year of death; and (iv) implementing new reporting requirements imposed upon IRA trustees.  Most of these changes, except for the new reporting requirements, are favorable to the participant. The following discussion will summarize current law and highlight important changes.

Participant’s Death Before

Required Beginning Date

If the participant dies before the required beginning date, plan benefits must be distributed (i) in annual installments over the life expectancy of the nonspouse designated beneficiary, with distributions commencing no later than December 31^st of the year after the year in which the participant died, with the life expectancy being reduced by one for each subsequent year; (ii) in annual installments over the life expectancy of a spouse beneficiary at the death of the participant, beginning no later than December 31^st of the year after the year in which the participant died or, if later, by December 31^st of the year in which the participant would have reached age 70½, with the life expectancy of the spouse being redetermined annually; or (iii) within five years of the participant’s death, if the participant has no designated beneficiary.  These rules are statutory and have not changed. The surviving spouse may also elect to roll over an IRA plan into her own.  These rules, which have been amended, are discussed below.

Under the 1987 regulations, if the participant died before the required beginning date having failed to name a designated beneficiary, distribution of the entire account balance was required within five years. Although in the same circumstances the new regulations appear to permit a distribution over the remaining life expectancy of the participant, calculated in the year of the participant’s death, reduced by one for each subsequent year, the regulations are unclear on this point.  Accordingly, until clarification is forthcoming, it is still important that a beneficiary designation be made early, even before the required beginning date.  Fortunately, under the new rules, making a beneficiary designation no longer binds the participant as under the previous regulations.

Previously, another trap could ensnare even the participant who had named a nonspouse designated beneficiary before his death and prior to the required beginning date:  distribution of the entire account balance was required within five years even if the participant had named a designated beneficiary prior to death before the required beginning date, unless the participant had also directed that minimum required distributions were to be made over the life expectancy of the designated beneficiary. The new regulations eliminate this harsh rule, and provide that if the participant dies before the required beginning date having named a designated beneficiary, distributions are to be made over the life expectancy of the designated beneficiary, unless the plan provides otherwise.

Lifetime Distributions After

Required Beginning Date

As indicated above, the estate of a participant who dies before the required beginning date having failed to name a designated beneficiary may be required to distribute the entire account balance within five years, even under the new rules. However, in the majority of cases, the participant is still alive at the required beginning date. Under the old regulations, a living participant’s failure to have named a designated beneficiary by the required beginning date had deleterious consequences that could never be cured, irrespective of whether participant subsequently named a designated beneficiary before his death.  By contrast, participants who have attained the required beginning date and have begun taking distributions fare much better under the new rules, even if they have not made a beneficiary designation.

Under the old rules, the participant who failed to make a beneficiary designation by the required beginning date was not permitted to take distributions over the joint life expectancy of the participant and designated beneficiary using the MDIB tables. Rather, the participant was required to take distributions based only upon his single life expectancy as of the required beginning date. At death, the consequences of having failed to name a designated beneficiary by the required beginning date were similar:  instead of being permitted to take distributions over the true life expectancy of the participant and the beneficiary determined as of the required beginning date, without regard to the MDIB rule, the beneficiary was required to take distributions over the (remaining) single life expectancy that the participant was using before death.  Thus, failure to make a beneficiary designation by the required beginning date shortened considerably the payout of the account balance both during and after the death of the participant.

The new regulations allow the participant more time — until December 31^st of the year following the participant’s death — in which to choose a designated beneficiary.  Under the new rules, calculation of the participant’s lifetime minimum required distribution is simply the participant’s account balance divided by the distribution period. This rule applies irrespective of whether the participant has or has not named a designated beneficiary by the required beginning date. The distribution period is now determined by reference to the MDIB divisor table (discussed below) whether or not a beneficiary designation has been made.  Consequently, failure to name a designated beneficiary by the required beginning date is now almost benign, provided the participant does not die before the required beginning date.

For lifetime required distributions under the new regulations, a uniform distribution period for all participants of the same age is provided by the minimum distribution incidental benefit (MDIB) divisor table.  That table,  used to calculate the distribution period, is based on the joint life expectancies of the participant and a survivor 10 years younger at each age beginning at age 70.  Using the MDIB table, most participants will be able to determine their required minimum distribution for each year based on nothing more than their current age and the account balance as of the end of the prior year. This greatly simplifies the determination of annual minimum required distributions while the participant is alive. The rationale for permitting use of the MDIB table, regardless of the age of the beneficiary chosen, and even if no beneficiary has been chosen, is that the participant’s beneficiary designation is subject to change until the death of the participant, and the beneficiary ultimately selected may be more than ten years younger than the participant.

Previously, even if a beneficiary designation was timely made, the participant was required to make an irrevocable choice between “recalculating” her life expectancy or not recalculating her life expectancy, as well as that of her spouse, at the required beginning date. Since the MDIB divisor table, which employs a fixed distribution period, is used for almost all participants, recalculation is no longer required. The only deviation from this rule occurs when calculating lifetime distributions for a participant married to a spouse more than ten years younger. In that case, a longer distribution period, measured by the joint and last survivor expectancy of the employee and spouse, may be used.

The old regulations implicitly required the participant to choose a designated beneficiary by the required beginning date, since failure to do so would result in the participant’s being forced to forego use of a joint life expectancy in determining lifetime minimum distributions.  Yet the required beginning date may well have occurred many years before the participant’s death. If the participant later decided to change the beneficiary designation, new calculations were required, which could shorten, but never lengthen, the distribution period, even if the new designated beneficiary were younger then the original designated beneficiary.  Under the new rules, the participant is not required to make a beneficiary designation until December 31^st of the year following the participant’s death.  Any designated beneficiary who is eliminated (e.g., through a disclaimer) by the end of the year following the participant’s date of death will be ignored for purposes of determining the minimum required distributions of remaining designated beneficiaries.

Death of Participant After

Required Beginning Date

Under the new regulations, the death of a participant who has begun taking lifetime distributions will result in a nonspouse designated beneficiary being required to take annual distributions, beginning no later than December 31^st of the year following the year of the participant’s death, over the beneficiary’s remaining life expectancy in the year following the participant’s death, reduced by one for each subsequent year. If the employee’s spouse is the sole designated beneficiary at the end of the year following the year of the participant’s death, the distribution period is the spouse’s single life expectancy, redetermined each year, with distributions commencing no later than December 31^st of the year following the participant’s year of death.  Following the death of the beneficiary spouse, the distribution period is the surviving spouse’s life expectancy calculated in the year of her death, reduced by one for each subsequent year.

Note that under the new regulations, distributions to designated beneficiaries after a participant’s death are the same whether the participant dies before or after the required beginning date, provided the participant has made a beneficiary designation. Also note that if, as of the end of the year following the participant’s death, the participant has more than one designated beneficiary (and the account has not been divided into separate accounts for each beneficiary), the beneficiary with the shortest life expectancy is the designated beneficiary for purposes of determining the required minimum distributions. This approach is consistent with the approach in the old regulations.

Trust as Beneficiary

The new regulations do not alter the existing requirements with respect to beneficiaries of trusts qualifying as designated beneficiaries. Pursuant to proposed regulations promulgated in 1997, the underlying beneficiary of a trust may be a participant’s designated beneficiary for purposes of determining the required minimum distribution when the trust is named as beneficiary of a retirement plan or IRA, provided documentation with respect to the underlying beneficiaries is provided to the plan administrator in a timely fashion.

However, consistent with the new rule permitting a designated beneficiary to be named by December 31^st in the year following the participant’s date of death, the trust need no longer be provided to the plan administrator by age 70½. It now suffices if the trust is provided to the plan administrator by December 31^st of the year following the year of the participant’s death. The new regulations also explicitly approve the use of testamentary trusts and QTIP trusts as beneficiaries of a retirement plan or IRA.

Election of Surviving Spouse to

Treat an Inherited IRA as Own

The new regulations clarify the rule that permits the surviving spouse of a decedent IRA owner to elect to treat an inherited IRA as the spouse’s own IRA. The 1987 proposed regulations provided that this election was deemed to have been made if the surviving spouse contributed to the IRA or did not take the required minimum distribution as beneficiary of the IRA.  The new regulations clarify that the deemed election may only be made after the minimum required distribution from the IRA, if any, has been made for the year of the participant’s death. The new rules permit the deemed election to be made by the surviving spouse only if the spouse is the sole beneficiary of the account and has an unlimited right of withdrawal from the account. This requirement cannot be met if a trust is named as beneficiary of the IRA, even if the spouse is the sole beneficiary of the trust. Note that if the surviving spouse is age 70½ or older, a required minimum distribution must be made, and this amount may not be rolled over.

New IRA Reporting Requirements

By reason of the “substantially simplified” calculation of the required minimum distributions from IRAs, IRA trustees will presumably be in a position to calculate the following year’s required minimum distribution. Accordingly, the trustee of each IRA will be now be required to report the amount of the required minimum distribution to the IRS. This requirement will apply regardless of whether the IRA owner intends to take the required minimum distribution from one particular IRA, or from another IRA. The report would also be required to indicate whether the IRA owner is permitted to take the required distribution from another IRA of the participant. During 2001, the IRS will be receiving public comments in evaluating the manner in which to implement the reporting requirement. Once the reporting requirement is implemented, amendment of current plan documents will be required.

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II.      Estate Administration Expenses

The IRS has issued new regulations addressing the allocation of administration expenses charged to the share of an estate which would otherwise qualify for a marital or charitable deduction. T.D. 8846, 64 Fed. Reg. 67763 (12/1999), corrected 64 Fed. Reg. 71021 (12/1999) and Announcement 2000-3, 2000-2 I.R.B. 296 (1/2000). The new regulations allocate expenses between estate “management expenses” and “transmission expenses.” The new regulations apply to estates of decedents dying after December 3, 1999, and attempt to address issues raised by Comr. v. Estate of Hubert, 500 U.S. 93 (1997), and the earlier proposed regulations.

Estate management expenses relate to expenses that would have been incurred by the decedent before death or by beneficiaries had they received the property on the date of death. They include the cost of maintaining or preserving estate assets during the period of estate administration, stock brokerage fees, investment advisory fees, and interest. Estate management expenses do not reduce the estate tax marital or charitable deduction, and may be paid from the marital or charitable share.

Estate transmission expenses are defined by exclusion as any expense which is not an estate management expense. Generally, these are expenses which would not have been incurred but for the death of the decedent. They relate to costs incurred to collect the decedent’s assets, to pay the decedent’s debts and transfer taxes, and to satisfy executor commissions and attorney fees. Estate transmission expenses paid from the marital share or charitable share reduce the marital or charitable deduction.

As a planning matter, in light of the new regulations, it may be advisable to insert language in a will or trust authorizing the trustee or executor to allocate expenses between income and principal in a such a manner as to reduce federal tax. Executors and attorneys may also be required to itemize expenses, distinguishing between management and transmission expenses.

III.    New Actuarial Tables

The IRS has issued new actuarial tables used to value life estates, annuities, remainder and reversionary interests. The new regulations apply to gifts made after April 30, 1999. Under the new tables, the value of a lifetime income interest is increased, and the value of a remainder interest is decreased. The effect of these changes on various estate planning techniques depends upon the type of trust.

The increased lifetime interest makes grantor retained annuity trusts (GRATs)  more attractive, since the remainder interest is reduced. This makes the initial taxable gift smaller. However, Qualified Personal Residence Trusts (QPRTs) fare slightly worse under the new regulations: the effect of the grantor living longer reduces the reversionary interest if the grantor dies during the term of the trust; this increases the initial taxable gift. T.D. 8886, 65 Fed. Reg. 36908-01 (6/2000), corrected 65 Fed. Reg. 58222-01 (9/2000).

IV.    Valuation Discounts

In TAM 19943003 (11/1999), the IRS allowed only a partition discount with respect to an undivided interest in real estate. The decedent had claimed discounts for lack of marketability. The advice, however, appeared to limit the available discount to that obtained by multiplying the value of the fee by the undivided interest, and subtracting the costs of partition allocable to the undivided interest. This formula would result in a much smaller discount.

In FSA 200049003 (12/2000), perhaps in response to the Strangi and Knight decisions, the National Office summoned its arguments against discounts in the context of a family limited liability company (LLC). It concluded that (i) the doctrine of “economic substance” compelled valuing the transferred interests without regard to the LLC; (ii) the transferring parent had retained beneficial enjoyment of the property, resulting in estate inclusion under IRC §2036; (iii) no gift occurs upon the formation of the LLC, because of the parent’s retention of the right to control beneficial enjoyment; and (iv) restrictions on liquidation of LLC interests should be disregarded as applicable restrictions under IRC §2704(b).

The Tax Court in Estate of Strangi and Estate of Knight appeared to reject the IRS arguments concerning IRC §2704. (See discussion in “From the Courts.”) In other respects, the field service advisory is useful in planning, as it suggests likely IRS objections to discounts in the context of family LLCs.

V.     Annual Exclusion Gifts

In TAM 199944003 (11/1999), the IRS confirmed what practitioners have long suspected, i.e., the gift of a partnership interest qualifies for the annual exclusion. The partnership agreement stated that general partners were solely responsible for the management of the partnership business, and had the right to determine the timing and amount of distributions. However, the agreement also gave the limited partner the right to assign his partnership interest. The right to assign the interest gave the limited partner the right to immediate use, possession, or enjoyment of the partnership interest. The gift therefore was therefor of a present interest and qualified for the annual exclusion. Note that by negative implication, the memorandum would appear to deny the use of the annual exclusion if the limited partnership interests were nonassignable and the general partner could withhold distributions.

VI.     “Defective” Grantor Trusts

PLR 299930018 (7/2000) indirectly sanctioned “defective” grantor trusts. In this ruling request, the grantor retained the power to remove the trustees and appoint any unrelated person as successor trustee. The IRS ruled that the trust was a grantor trust for income tax purposes because the trustees had the power to allocate income and principal among a class of beneficiaries, and a power to add beneficiaries. Since the grantor had not retained a reversionary interest and did not have the power to alter, amend or revoke the trust, the initial gift was sound, and the trust would not be included in the grantor’s gross estate. Since a grantor trust may be a shareholder in an S corporation, the ruling held that the trust could hold S corporation stock without terminating the S election.

VII.   Charitable Remainder Trusts

In Notice 2000-37, 2000-29 I.R.B. 118 (7/2000), the Service advised of its intention to issue new model forms for charitable remainder trusts. The new forms would respond to recent law changes, including (i) the 50% annuity or unitrust limit; and (ii) the 10% minimum value of the charitable remainder interest.

VIII.    Estate Taxes & Returns

The Service has issued proposed regulations permitting an automatic six-month extension in which to file a federal estate tax return. No showing of reasonable cause would be necessary. The application for extension must be timely filed before the due date of the estate tax return, and must contain an estimate of estate and GST tax liability. Prop. Regs. §§20.6075-1 and 20.6081-1, 65 Fed. Reg. 63025-01 (10/2000).

IX.     Gift Taxes & Returns

The IRS has issued final regulations explaining what constitutes adequate disclosure for purposes of commencing the three-year statute of limitations on gift tax audits. T.D. 8845, 64 Fed. Reg. 67767 (12/1999), corrected, 65 Fed. Reg. 1059 (1/2000). Under the regulations, adequate disclosure requires a description of (i) the property transferred; (ii) the relationship between the parties; (iii) the taxpayer identification number of any trust receiving property; (iv) the value of the property transferred; (v) the methodology of valuation; and (vi) a statement by the taxpayer advising of any position taken that conflicts with regulations or revenue rulings.

The new regulations clarify that adequate disclosure will not merely commence the statute of limitations with respect to valuation issues, but also with respect to issues involving the gift tax exclusion, the marital deduction, or the charitable deduction. If payments to family members are unclear, and are not reported as gifts, e.g., salaries to family members employed by family businesses, the regulations provide that adequate disclosure is made if such payments are reported on income tax returns.

In connection with the new regulations concerning adequate disclosure for gifts, the IRS has also set forth in Rev. Proc. 2000-34, 2000-34 I.R.B. 186 (8/2000) procedures for amending previously filed gift tax returns in order to adequately disclose prior gifts. In addition to providing all information which would be necessary in the first instance, the amended gift tax return must also be filed with the same IRS Service Center in which the original gift tax return was filed.

X.   GRATs & QPRTs

Final regulations issued prohibit the use of promissory notes issued by a GRAT or GRUT as annuity payments. T.D. 8899, Treas. Reg. §§25.2702-3(b), 25.2702-3(c), 25.2702-3(d)(5), 65 Fed. Reg. 53587 (9/2000), corrected (11/2000). The regulations further mandate that the governing instrument of a GRAT or GRUT created on or after September 20, 1999 must expressly prohibit the use of notes, debt instruments, options or similar financial arrangements. Failure to include this language will result in the GRAT or GRUT not being a qualified interest under IRC §2702. This would result in the grantor’s gift being valued without reference to the retained interest, resulting in a gift of the entire trust.  Treas. Reg. § 25.2702-3(d)(5)(i).  Clarifying an important area of concern, the regulations also provide that annuity payments may be made on either a calendar year or at the trust’s anniversary date.  To illustrate, a GRAT created on May 1, 2001, could require the trustee to make annual payments by April 30 of each trust year, or based on the taxable year of the trust.

President Clinton’s fiscal year 2001 budget proposal would have eliminated favorable treatment for Qualified Personal Residence Trusts (QPRTs). Such legislation was not enacted. Given the inclination of President Bush to eliminate the transfer tax, QPRTs may comprise an excellent hedge against such repeal.

XI.    Trusts as Beneficiaries of IRAs

PLRs 200041039 and 20004035 (10/2000) stated that where the decedent’s will provided that IRA proceeds would be divided among grandchildren, and that shares for grandchildren under the age of 21 would be held in trust until the minor reached the age of majority, the trust for each grandchild was a valid IRA beneficiary under Prop. Treas. Reg. §1.401-1(a)(9)-1, and that the grandchild was a “designated beneficiary” of that portion of the IRA. Beneficiaries of a trust may be “designated beneficiaries” for purposes of the regulations if (i) the trust is valid under state law or would be but for the fact that there is no corpus; (ii) the trust is irrevocable or states that it becomes irrevocable upon the death of the employee; (iii) the beneficiaries are identifiable from the trust instrument; and (iv) the plan administrator is provided with a copy of the trust or with a list of all trust beneficiaries as of the date of death.  Prop. Treas. Reg. §1.401(a)(9).