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

Americans seem to regard estate and gift taxes as necessary to prevent unwanted intergenerational accumulations of wealth. Although only 2% of estates now pay the estate tax, considerable revenues are generated. Since the insurance industry and the ABA would likely oppose their abolition, look for transfer taxes to continue, but to affect fewer taxpayers. Note: President Clinton’s budget proposal would eliminate non-business valuation discounts, and would repeal the QPRT exception to Chapter 14’s valuation rules. Whether or not this legislation passes, considerable transfer tax savings are still possible with effective tax planning. . .

Consumption taxes have never gained in popularity despite being praised by Republicans for years, perhaps because Americans resent inherited, but not earned wealth, and are therefore disinclined to tax even conspicuous consumers. . . The flat tax remains the “neglected stepchild” of conservative presidential aspirants who resurrect the proposal every 4 years. Most people reject the premise that all taxpayers should be taxed at identical rates. Expect more progressive income tax rates, a continuation of the post-Reagan trend. . . Popular antagonism is, however, exhibited toward capital gains taxes which, although still above historic levels, are well below the summits reached in the mid 1980’s. Too much revenue would be lost by eliminating capital gains tax. Expect no significant near-term changes — but possibly a downward bias. Legitimate conversion of ordinary income to capital gain seems a fertile area for tax planning.

The IRS appears to be on the verge of becoming an entirely changed agency — one that is actually accountable. Bruised badly by negative public sentiment and calls for its abolition, forced collections and levies are down sharply. Everyday dealings with the Service have become easier. Look for this trend to continue. To prevent a decrease in compliance, expect withholding and reporting rules to be strengthened, and penalties to be increased. A case in point: President Clinton proposes increasing the substantial understatement penalty for corporate taxpayers from 20% to 40%.

Neither Republicans nor Democrats appear willing to risk the political fallout of underfunding Social Security, even if it results in foregoing an immediate tax cut. Competing proposals ensure robust funding to strengthen the Social Security system. Despite Republican Representative Hastert’s complaint that Mr. Clinton’s budget proposal “ambitiously spends almost every cent of the surplus,” the President would likely relish vetoing tax legislation that would divert funding from programs he supports.

The President’s budget proposal would grant small businesses a modest tax credit for implementing a SIMPLE plan. A new defined benefit plan exclusively for small businesses would provide minimum guaranteed payments, an option to receive payments over a term of years after retirement, and the ability to benefit from favorable investment returns. . . Mr. Clinton has also proposed permitting employees to make pre-tax contributions to IRAs by having those wages withheld. Although the IRA deduction would be eliminated, overall savings to employees would result compared to current rules.

Some proposed tax accounting provisions bear note: (i) the installment method would be repealed for accrual basis taxpayers; (ii) no deduction would be allowed for punitive damages paid by a taxpayer; punitive damages paid by an insurer would be includible in the income of the insured; (iii) basis adjustments with respect to partnership distributions would be made mandatory; (iv) heirs would be required to use reported estate tax values as the basis for income tax purposes; and (v) basis allocations would be required in part-gift, part-sale transactions.

Proposed Regulations would treat an LLC member as a limited partner unless the member (a) had personal liability for debts of the LLC; (b) had the ability to contract on behalf of the LLC; or (c) participated more than 500 hours. Since Congress has not acted, it is unclear whether self-employment tax should be reported on the entire distributive share of LLC income, or only on that portion which is not a “capital” interest. Since reliance on Treasury Regs would negate the negligence penalty, an aggressive stance may be justified.

TRA 1997 increased the applicable exclusion amount from $600,000 to $1 million, effective January 1, 2006. As of February 1, 2000, the amount of one’s taxable estate that can pass free of NY estate taxes will equal the federal amount, which at that time will be $675,000. Thereafter, if the taxable estate exceeds the applicable exclusion amount (i.e., federal estate tax is owed), the NY estate tax will be equal to the maximum state tax credit shown on the Form 706.

Title need not be held jointly between spouses where a joint tax return is filed to claim the $500,000 exclusion for home sales provided both spouses resided in the home for at least 2 years and neither claimed an exemption during the previous 2-year period. The new exclusion may also be claimed by a taxpayer who has previously taken the old $125,000 exclusion. Furthermore, PLR 199912026 provides that the trustee of an inter vivos grantor trust into which the residence has been deeded may utilize the exclusion provided the trust beneficiary has occupied the home for the required 2-year period.

The 1998 Tax Act provides that the value of a gift for gift tax purposes has been “finally determined” either when the amount is (i) reported on a gift tax return, (ii) determined by the IRS, or (iii) determined by a court. An item is shown on a return if the item is disclosed on the return or if an attached statement apprises the IRS of the nature of the item. Since the IRS has indicated that it will scrutinize gift tax returns for which discounts are claimed, it appears advisable to report all gifts including annual exclusion gifts, on a gift tax return, if value could be an issue.

Effective in 1999, home offices maintained for administration or management purposes will be considered a “principal place of business” and will qualify for the home office deduction. . . The above-the-line deduction for health insurance premiums for self-employed taxpayers rises to 60% in 1999.

A recent GAO report  reveals that 59% of audited returns were selected using the “discriminant function system” (DIF), which is a calculation based on a classified formula designed to choose the returns with the highest probability of a tax change if audited. Non-DIF audits resulted primarily from IRS special projects, books and records audits, and audits of tax preparers whom the IRS views as questionable.

Under new IRC §7525, the attorney-client confidentiality privilege also applies to communications involving tax advice between a taxpayer and any federally-authorized tax practitioner. However, the new privilege does not extend to communications related to return preparation or to criminal tax proceedings.

IRC §7520 values a term interest according to published actuarial tables. §2702(a)(2)(a) excepts certain retained interests in trust and values them zero. §2702(a)(2)(B), which governs personal residence trusts, excepts certain “qualified” retained interests from the first exception, and permits them to be valued under §7520. One “qualified” interest is a personal residence trust (QPRT), in which a family member is granted a remainder interest. Properly structured, the remainder interest in a QPRT is valued according to §7520, which results in a greatly reduced taxable gift. However, since §2702 does not apply to “incomplete” transfers, the grantor must outlive the trust term to qualify. To curtail perceived abuses, the Regs now prohibit the grantor from repurchasing the residence during or after the trust term. This prevents the depletion of the donor’s estate due to the repurchase money, and also prevents heirs’ from taking a stepped-up basis in the residence. QPRTS have recently drawn the attention of Mr. Clinton, who has proposed repealing the §2702 exception.  See From Washington.

TRA 1997 now prohibits the IRS from revaluing prior adjusted taxable gifts after the expiration of the statute of limitations (see January Comment). The exemption equivalent, now the “applicable exclusion amount” will rise to $650,000 in 1999. New Code Sec. 2033A excludes from the gross estate all or part of the value of a qualified family owned business (QFOB). The QFOB exclusion equals $1.3 million less the applicable exclusion amount. Qualification for the exclusion may require advance tax planning, as limitations and restrictions are significant.

Gifts made from a revocable trust within three years of death are excluded from the decedent’s estate. This result statutorily overrules a line of cases which held that inclusion was dictated under Code Secs. 2036 and 2038. Effective for gifts made after the date of enactment, TRA 1997 repealed the requirement that a gift tax return be filed to report gifts which, but for the charitable deduction, would result in gift tax liability.

TRA 1997 also provides that the three-year statute of limitations for challenging gift tax valuations will be commenced only if the gift is adequately disclosed on the gift tax return. The Conference Report envisions full disclosure to include (a) a description of the transferred interest and its value; (b) the identification and relationship to the donor of all persons involved in the transaction; and (c) a detailed description of how the transferred interest is valued, including relevant actuarial and financial data. TRA 97 confers jurisdiction on the Tax Court (new Code Sec. 7476) to issue a declaratory judgment of the value of a gift in the case of an “actual controversy” after the taxpayer has exhausted all administrative remedies.

The Clinton Administration’s attempt to eliminate the use of “Crummey” withdrawal powers to obtain the annual $10,000 gift tax exclusion failed. After 1998, the gift tax exclusion will be indexed for inflation in $1,000 increments.

TRA 97 eliminated many distinctions between estates and revocable trusts for income tax purposes. The executor and trustee may together elect to have the revocable trust treated as part of the estate for income tax purposes. This change would allow the post-mortem trust, like the estate, to take charitable deductions for amounts permanently set aside for charitable purposes, and to qualify for a two-year waiver of the active participation requirement under the passive loss rules.

TRA 97 also permits estates to treat a distribution of income as having been made in a taxable year if the distribution is made within 65 days after the end of the taxable year. TRA 97 also amends Code Sec. 267 insofar as it now operates to disallow losses on the sale of assets between a beneficiary and an estate.

Rules governing charitable remainder trusts (CRTs) were changed by TRA 97. First, the present value of a remainder interest must now equal or exceed 10 percent of the net fair market value of property contributed to the trust; and second, in order to deter short-term, high-payout CRTs, the unitrust or annuity amount may not exceed fifty percent of the value of the trust fund. The IRS will issue proposed regulations detailing the manner in which capital gains are taxed to trust beneficiaries. Under the current ordering rules, distributions from a CRT are deemed to be made first from income taxed at the highest federal income tax rate.

TRA 1997 also provides that the taxable year of a partnership closes with respect to a partner whose interest in the partnership terminates by reason of death. Thus, a decedent’s share of partnership income, etc., will be reported on the decedent’s final income tax return.

The 5th Circuit, in Estate of McLendon, 98-1 USTC ¶60,303, reversing the Tax Court, held that the decedent, who was terminally ill and died six months later, was entitled to rely on Rev. Rul. 80-80, which permits the use of actuarial tables to value an annuity unless death is “clearly imminent.” The Court also remarked that the IRS must follow its own pronouncements.

In Estate of McClatchy v. CIR, __F3d__ the 9th Circuit reversed the Tax Court and held that the estate tax value of stock whose restrictions disappear at death is the (depressed) value immediately prior to death, not the value in the hands of the estate.

The Tax Court, in Williams v. CIR, 75 TCM 1758, allowed a 44 percent discount for a minority interest in an undivided one-half interest in real property. The taxpayer’s expert witnesses included a real estate appraiser, who valued the realty, a business appraiser, who valued the partial interest, and a real estate attorney, who valued partition costs.

In Estate of Newman, 111 T.C. __ (No.3), the Tax Court held that checks not actually cashed before the decedent’s death were includible in her estate, since the decedent still had the power to stop payment. Decedent’s son had written $95,000 of checks under a durable power of attorney shortly before her death.

McKeon v. U.S.  __F3d__, (9th Circuit) underscores the importance of consistency when drafting estate tax payment provisions. Estate taxes of $245,961 were paid out of nonmarital Trust B, and the IRS proposed a $98,282 deficiency, asserting that the estate taxes should have been paid out of marital Trust A, reducing the marital deduction and increasing estate taxes. The 9th Circuit, reversing the District Court, held that since the California Probate Code required estates taxes to be apportioned absent a clear indication otherwise in a testamentary instrument, those taxes must be paid from Trust B.

In Leggett v. U.S., 120 F.3d 592, the 5th Circuit, rejecting IRS arguments, held that no federal tax lien attached to a disclaimed inheritance. The 8th Circuit reached the opposite result in Drye 1995 Family Trust v. U.S., __F3d__ where the taxpayer disclaimed his entire interest in the estate of his mother, who had died intestate. There, the disclaimed property passed to the taxpayer’s daughter, who transferred the assets into a family trust which contained a spendthrift clause. The Court found that the disclaimer was void and fraudulent against the IRS.

In U.S. v. Simpson, __F.Supp.__, the court held no federal tax lien attached to real property where the taxpayer deeded his interest in property held jointly with his wife as tenants by the entirety, where the transfer preceded the filing of the federal tax lien. The Court noted that property held by the entireties was not reachable by any creditor.

The Tax Court, in Estate of Davis v. CIR, 110 T.C.__ (No. 35), recognized a lack of marketability discount reflecting built-in capital gains.  IRS had argued that federal law precluded the consideration of built-in gains in calculating such a discount. Judge Chiechi noted that earlier cases holding that capital gains taxes do not reduce the value of closely held stock were decided prior to the repeal of the General Utilities doctrine, which had permitted tax-free liquidations.

In Hewitt v. CIR, 109 T.C. 258, the Tax Court upheld an IRS decision to allow a charitable deduction equal to the basis, but not the higher FMV, of charitable gifts made by a closely held corporation. Despite correctly reported valuations, the taxpayer had not substantiated the values as required by attaching a qualified appraisal to the income tax return.

In NYS Bar Assoc. v. Reno, 97-CV-1768, (N.D. NY), the Constitutionality of 42 USCS 1320-7b, which provides for criminal penalties against attorneys engaging in Medicaid planning, was challenged. Attorney General Reno announced that the Justice Department would not defend the Constitutionality of the law since the statute was plainly unconstitutional under the 1st Amendment.

After losses in three circuits, the IRS, in TD 8779, issued final regulations which permit “contingent” QTIP elections, which allow greater post-mortem estate planning. The regs provide that property is eligible for the QTIP election if the spouse’s income interest is contingent on the QTIP election, but if no election is made the property will pass to beneficiaries other than that spouse. In planning for the election, it may be prudent to provide for the funding of several QTIP trusts, to avoid making the election an all-or-nothing proposition.

In Ltr. Rul. 9751003, the IRS held that gifts of limited partnership interests are future interests that do not qualify for the annual exclusion where the partnership agreement provides that the general partner may, in its complete discretion, make or withhold distributions. (To circumvent this result, the agreement might provide limited partners with a 30-day Crummey power to withdraw their shares of the partnership capital accounts immediately following a gift of a partnership interest.) In a related matter, the IRS reaffirmed the validity of Crummey powers for remote contingent beneficiaries in Ltr. Rul. 9751003.

In Rev. Rul. 98-21, the Service held that gift tax will be imposed with respect to the transfer of employer stock options from parent to child when the child eventually exercises the options, not on the earlier transfer date, prior to appreciation.

In Ltr. Rul. 9815023 the IRS ruled that the commutation of an irrevocable trust in which the grantor had retained a lifetime income interest (with the consent of all beneficiaries pursuant to NY EPTL § 7-1.9) resulted in no taxable gift to the beneficiaries, since a completed gift of the remainder interest had already been made at trust inception. The commutation would also avoid the inclusion of the entire trust fund in the grantor’s estate because of the retained interest under Code Sec. 2036.

Under new Regs. § 25.2518-2(c), an interest in jointly held property must be disclaimed within 9 months of the date of death of the first joint tenant, regardless of whether that interest was unilaterally severable. Since the new rule applies irrespective of the contribution of either joint tenant, the surviving joint tenant could disclaim one-half of an interest for which he paid the entire consideration.

Final regulations provide that a qualified personal residence trust (QPRT) must prohibit the repurchase of a residence from the trust. However, the new rule would not prohibit either (i) the retention of a contingent reversionary interest, (ii) a testamentary power of appointment, or (iii) a spousal interest that would arise in the event of the death of the grantor before the expiration of the reserved term. The tax result is unclear if the trustee, despite the prohibition, sold the residence back to the grantor.

The minimum distribution requirements of Code Sec. 401(a)(9) provide that retirement death benefits not paid to a surviving spouse must be distributed within 5 years unless paid to a “designated beneficiary,” in which case payments may continue over that person’s lifetime. Proposed regs detail the manner in which a trust, which cannot be a designated beneficiary, may still be a beneficiary, with trust beneficiaries named designated beneficiaries. The regs now also permit plan benefits to be paid to a revocable trust, provided the trust becomes irrevocable at the participant’s death.

In Ltr. Rul. 9829025, husband and wife transferred two parcels of real property to a grantor trust, entered into a like-kind exchange agreement with a bank, and then sold the properties. The husband died after identification, but before purchase, of the replacement property. Since the exchange would have been a valid three-cornered like-kind exchange, the sales proceeds held by the trust did not constitute IRD, and the surviving spouse was entitled to a stepped-up basis pursuant to Code Sec. 1014(b)(6).

Reg 301.7701-3 now permits non-corporate entities to elect classification for tax purposes. Absent an election, most non-corporate entities, except single-owner entities, are taxed as partnerships. A non-corporate entity may also elect to be taxed as an association. Such an election, though unusual, might be advantageous if current losses of the partnership or LLC  could not be used by partners or members.