President Obama, still seeking to get Congressional Republicans to join in a bipartisan commission to reduce the federal debt, suggested he would be willing to break his campaign promise against raising taxes on households with less than $250,000 annual income.
“The whole point of it is to make sure that all ideas are on the table,” the president said in the interview on Tuesday with Bloomberg BusinessWeek that the publication released online today. That included not only tax increases, he added, but also spending on the popular government health programs, Medicare and Medicaid, whose fast-growing costs are driving the projections of unsustainable annual deficits in coming years.
“What I can’t do is to set the thing up where a whole bunch of things are off the table,” Mr. Obama said. “Some would say we can’t look at entitlements. There are going to be some that say we can’t look at taxes, and pretty soon, you just can’t solve the problem.”
Budget experts from conservative to liberal have long agreed that future deficits can only be brought under control by a combination of tax increases and spending cuts, especially in the benefit programs. Many of them criticized Mr. Obama during the campaign for promising in effect to exempt 95 percent of Americans from any tax increase; the wealthiest 5 percent, the critics said, cannot shoulder the likely load without harming investment and economic growth.
Last summer, with the recession’s costs having forced deficits above $1 trillion annually on average, Mr. Obama’s spokesman, Robert Gibbs, said the president stood by his campaign promise after the top economic advisers — Lawrence H. Summers and Timothy F. Geithner, the Treasury secretary — suggested the administration was reconsidering in light of the worsened fiscal forecasts.
Now the president has made clear he is willing to reconsider, if Republicans will come to the table to negotiate ways to reduce deficits. But the Republican Party opposes all tax increases, and so the Congressional Republican leaders, Senator Mitch McConnell of Kentucky and Representative John A. Boehner of Ohio, have resisted committing to a bipartisan commission. But neither did they rule it out at a White House meeting on Tuesday, participants say.
At that meeting, Mr. Obama gave the Republicans a paper describing the executive order he is planning for creating a commission. The group would have 18 members, 10 Democrats and eight Republicans. The president would name two of the Republicans along with four Democrats; none would be administration officials. For the remaining 12 members, the leaders of both parties in the House and Senate each would choose three lawmakers.
The commission would be charged with reporting by December — after the midterm elections — on how to balance the budget by fiscal year 2015, not counting federal interest payments on the national debt; those are projected to be nearly 3 percent of the gross domestic product that year, a level that most economists say is about the maximum desirable deficit for any year. Also, Mr. Obama wants a commission to also propose longer term changes in revenues and the entitlement programs to rein in a debt projected to be nearly 80 percent of the economy’s total output by 2020.
While the president cannot force Congress to vote on any package the commission comes up with, the Democratic leaders, Representative Nancy Pelosi of California and Senator Harry Reid of Nevada, have committed in writing to have vote.
In Estate of Welch v. Comr., 208 F.3d 213 (6th Cir. 3/2000), the Court of Appeals held that a discount to reflect built-in capital gains of real property was appropriate, despite the fact that the corporation might avoid the capital gains tax by reinvesting the proceeds. Citing Eisenberg v. Comr., 155 F.3d 50 (2d Cir. 1998), acq. 199-4 I.R.B. 4, the court held that the principal issue was whether a hypothetical purchaser would take into account built-in capital gains in computing the value of the stock.
Similarly, the Tax Court allowed a 5% discount for built-in capital gains in Estate of Dunn, 79 TCM 1337 (2000), observing that a new owner could avoid the built-in capital gains tax by continuing to use the property over its entire useful life. According to the court, only if the buyer intended to liquidate in the “short-term” would the buyer seek a reduction in price for built-in capital gain.
II. Valuation Discounts
The Tax Court decision in Estate of Simplot, 112 T.C. 130 (3/1999), brief filed (9th Cir. 4/2000) was appealed to the Ninth Circuit. In Simplot, the Tax Court allocated a percent of equity of the entire corporation to 76 shares of voting stock, causing those shares to be worth $215,539 for estate tax purposes, rather than $2,650 as the taxpayer had reported.
The Tax Court, in Estate of Knight, 115 T.C.__ (No. 36) (11/2000), rejected an IRS attempt disregard transfers made to a Texas family limited partnership in valuing the gifts of limited partnership interests. The court reasoned that since the partnership was a valid entity under Texas law, it was also valid for federal tax purposes. While the case is helpful for its apparent recognition of the family limited partnership as a viable estate planning entity, the holding was double-edged: the court also disallowed the taxpayer’s claimed 44% discount, and allowed a discount of only 15%, which was substantially less than had been allowed in previous cases. The Knight decision has prompted commentators to suggest that the size of the valuation discount may be a point of contentious disagreement in the future. If this surmise is correct, the importance of obtaining an expert professional discount valuation in the context of transfers to family limited partnerships and LLCs is even more pronounced.
Another blow to the IRS in the family limited partnership discount arena came in Estate of Strangi, 115 T.C. ___ (No. 35) (11/2000), where the Tax Court allowed valuation discounts with respect to transfers effected two months before the decedent’s death. Although the Tax Court doubted some of the asserted business motives for the partnerships, it stated that Congress, in enacting the partnership tax laws, did not intend to tax assets of a validly-existing partnership as if they had been owned directly by the decedent. As in Knight, supra, the Tax Court trimmed the allowable discount, from 43.75% as claimed by the taxpayer, to 31%. The court also noted that the 31% discount allowed was based on the Service’s failure to challenge it, and as a result might be “overly generous to petitioner.”
In Shepherd v. Comr., 115 T.C. ___ (No. 30) (10/2000), the taxpayer transferred land and stock to a partnership of which the taxpayer’s children were named as limited partners. However, the children did not actually sign the agreement until after the property was transferred into the partnership. The Tax Court held that the children had received gifts of land and stock, rather than of partnership interests, reasoning that the partnership did not exist until the children signed the partnership agreement. This case vividly illustrates the necessity of respecting the formalities when creating a family limited partnership. The partnership should be formed, and documents executed prior to deeding any property into the partnership. Only after completing these steps should the parent make gifts of partnership interests.
In Estate of Reichardt v. Comr. 114 T.C. No. 9 (2000), the entire value of assets transferred to a family limited partnership were included in the decedent’s estate under IRC §2036. The Tax Court found an implied agreement that the decedent would continue to possess and enjoy the property and retain a right to income. The Court noted that “[n]othing changed except legal title.” The case is of concern to estate planners since IRC §2036(a) had not found routine application in the context of family limited partnerships; the fiduciary duty of the manager (or partner) was thought to preclude its relevance. If IRC §2036 is to be avoided, the fiduciary duties of the managing member of the entity must be taken seriously. A mere recital in the operating agreement of the manager’s duties may be insufficient.
In Kerr v. Comr., 113 T.C. 449, (12/1999) the Tax Court rejected an IRS attempt to disallow discounts for transfers of family limited partnership interests based on the argument that certain restrictions in the partnership agreement violated IRC §2704(b). Granting summary judgment to the taxpayer, the court held that the restrictions in the agreement were not “applicable restrictions” for the purpose of IRC §2704(b). Similarly, in Estate of Harper v. Comr., the Tax Court, citing Estate of Kerr, supra, held that partnership restrictions were not applicable restrictions under IRC §2704(b), because they were no more restrictive than conditions imposed by state law. Thus, the decision appeared to validate the old saw that restrictions in a partnership agreement should be no more restrictive than those under state law.
The Tax Court, in Estate of Busch, 79 TCM 1276 (2000), allowed a 10% undivided interest discount in real property, which represented the “reasonable costs of partition.” In Estate of Brocato, 78 TCM 1243 (1999), the Tax Court allowed a 20% undivided interest discount. The court also allowed an 11% “blockage” discount, which reflected the expected decrease in market price if multiple properties were introduced into the market simultaneously.
III. Power of Attorney Gifts
The Tax Court, in Estate of Swanson v. U.S., 46 Fed. Cl. 338 (3/2000) granted summary judgment in favor of the IRS, holding that under California state law, the power to make gifts under a power of attorney may not be implied. The case underscores the importance of including such a power in New York powers of attorney. If the form power of attorney used contains a provision explicitly authorizing annual exclusion gifts, broader powers should be included if gifts in excess of the annual exclusion are desired.
IV. Estate Taxes & Returns
In Estate of Devlin v. Comr., T.C. Memo 1999-406 (12/1999), gifts authorized by a court before, but not made until after the death of the decedent, were included in the gross estate. The Tax Court held that no constructive trust arose in favor of the beneficiaries since the gifts were not required.
In Estate of Smith v. Comr., 198 F.3d 515 (5th Cir. 12/1999), the Tax Court, held that the estate could deduct only $681,139, the amount of a debt which it eventually paid to settle a claim. In reversing the Tax Court decision, the Fifth Circuit stated that the estate was allowed to deduct the entire amount of the liability “as of” the date of the decedent’s death, which was $2.48 million. The Fifth Circuit ruled that post-death events are irrelevant when claims “are for sums certain and are legally enforceable as of the date of death.” The IRS has stated that it will not follow the decision.
In Armstrong v. Comr., 114 T.C. 94 (2/2000), the decedent made large taxable gifts in 1991 and 1992, and paid gift taxes of $4.7 million. As a result of these gifts, the decedent was nearly insolvent at his death in 1993. Although an estate tax return was filed, gift taxes occasioned by application of the three-year rule of IRC § 2035(c) were not included with the return. The IRS assessed a deficiency of $2.3 million. The donees of the gifts claimed that they were not liable for payment of estate taxes, since the stock given to them was not the source of the estate tax deficiency. Nevertheless, the Tax Court looked to the beneficiaries for payment of the estate taxes, finding authority, somewhat implausibly, in IRC §6324(a)(2), which imposes personal liability upon transferees of property included in the decedent’s gross estate under IRC §§2034 to 2042.
V. Tax Payment Provisions
Estate of Miller v. Comr., 209 F3d. 720 (5th Cir. 2/2000), aff’g per curium T.C. Memo, 1998-416, illustrates the importance of consistent tax payment provisions in will and trust documents. In this case, the decedent’s will stated that all estate taxes were to be “borne by my residuary estate . . . as an expense of administration, without apportionment and without contribution or reimbursement from anyone.” The decedent’s will left half of her residuary estate to her husband, and half to a revocable trust. The revocable trust authorized the trustee to pay estate taxes from the trust fund.
The executor in Miller apportioned all of the estate taxes to the nonmarital portion of the residuary estate passing under the trust. The decision of the Tax Court, upheld on appeal to the 5th Circuit, stated that the decedent’s will had been clear in providing that there be no discrimination between marital and nonmarital residual beneficiaries. Accordingly, estate taxes were required to be paid in part from the deductible marital share. The result of the decision, a reflection of imprecisely drafted documents, caused estate taxes to be paid and to reduce the marital share, which was deductible. The case illustrates the importance of a careful review of all estate planning documents in order to ensure that tax payment provisions are consistent and clear.
VI. Annual Exclusion Gifts
The Tax Court in Estate of Bies v. Comr., T.C. Memo 2000-338 (11/2000), recognized and rejected an idea sometimes proposed by taxpayers: make annual exclusion gifts to others with an “understanding” that the donee then regift the property to the donor’s “ultimate” beneficiary. In Bies, gifts of a business interest were made to sons and daughters-in-law, the latter of whom quickly re-gifted the interest to sons. The court held that the “facts and circumstances” evidenced the intent of the decedent to make indirect gifts to her sons. Taxpayers should be dissuaded from this type of transaction, which constitutes a thinly-veiled attempt to leverage the annual exclusion. Though perhaps not easily distinguishable from “Crummey” annual exclusion gifts, which have been sanctioned by the courts (over the strenuous objection of the IRS), the type of gifts attempted in Bies dispenses with even the legal fiction upon which Crummey gifts are predicated.
VII. Disclaimers
In Chamberlain v. Comr., T.C. Memo 1999-181, briefs filed (9th Cir. 11/2000), the Tax Court held that an unsigned disclaimer which did not list specific assets to be disclaimed failed to accomplish a valid disclaimer. The estate’s attorney had prepared a disclaimer listing the total value of assets to be disclaimed, but pending a determination of a value of the estate’s assets, a list specific assets was not prepared. The surviving spouse died without executing the disclaimer. The court noted that valid disclaimer under IRC §2518 must (i) be written; (ii) irrevocably refuse to accept the assets passing from the decedent’s estate; and (iii) specifically identify the disclaimed property.
VIII. Imputed Interest
Where taxpayers advanced monies to a wholly-owned family corporation to pay expenses, recorded the advances in the corporate books as increases in “shareholder loan accounts,” and were later reimbursed without interest, Tax Court held in Estate of Hoffman v. Comr, T.C. Memo 1999-395 (12/99) that advances were demand loans rather than capital contributions, which required the shareholders to report imputed interest under IRC §7872. The case illustrates the principle that the taxpayer, once having chosen the form of a transaction, will usually be foreclosed from arguing that the substance of the transaction should prevail over its form.
IX. Income Tax Liens
In Drye Jr., v. U.S., 526 U.S. 1063 (12/99), aff’g 152 F.3d 892 (8th Cir. 1998), the beneficiary of an estate who owed the IRS $325,000 in income tax disclaimed his legacy. Although the disclaimer was valid under Arkansas law, the district court held that the disclaimer was void and fraudulent against the IRS where the disclaimed assets went first to the debtor’s daughter, and then into a trust for the benefit of the daughter and her parents. The trust was a discretionary trust which contained spendthrift provision.
The Drye decision was upheld on appeal to the Eighth Circuit and again on appeal to the Supreme Court. An opinion written by Justice Ginsburg stated that the tax law looks to federal law, rather than state law, in determining whether a taxpayer has a beneficial interest in any property upon which the IRS can levy. Although state law determines a taxpayer’s rights in property, federal law determines whether these rights are “property” for purposes of a tax levy.
IRS Continues to Increase Oversight of Tax Return Preparers to Improve Compliance, Taxpayer Service
IR-2010-44, April 7, 2010
WASHINGTON — As the April 15 tax deadline approaches, the Internal Revenue Service today announced initial results from its stepped-up effort involving enforcement and education to combat unscrupulous tax return preparers and protect the nation’s taxpayers.
The IRS said it has conducted more than 5,000 field visits to tax return preparers this fiscal year. In addition, the IRS has worked with the Department of Justice to pursue questionable return preparers, an effort that has led to 56 indictments, 25 convictions and 21 civil injunctions since Jan. 1, 2010.
“We are working to help ensure taxpayers receive competent and ethical service from qualified tax professionals,” said IRS Commissioner Doug Shulman. “Our efforts this tax season are part of a longer-term effort to improve the oversight of this critical part of the tax system. The vast majority of tax return preparers provide solid service, but we need to do more to protect taxpayers.”
Shulman announced in January the results of a six-month study of the tax return preparer industry, which proposed new registration, testing and continuing education of tax return preparers. With more than 80 percent of American households using a tax preparer or tax software to help them prepare and file their taxes, higher standards for the tax return preparer community will significantly enhance protections and service for taxpayers, increase confidence in the tax system and result in greater compliance with tax laws over the long term. While this longer-term effort is underway, the IRS has taken several immediate steps this filing season to assist taxpayers.
Enforcement Efforts
The IRS has worked closely with the Justice Department this tax season to increase legal actions against unscrupulous tax return preparers, obtaining 21 civil injunctions, 56 indictments and 25 convictions of return preparers so far in 2010. More information is available at the IRS Civil and Criminal Actions page on irs.gov. and at the Department of Justice Tax Division page on DOJ.gov.
“The IRS appreciates the strong support of the Justice Department for its efforts to pursue and shut down bad actors in the tax return industry,” Shulman said. “This effort makes a real difference for the nation’s taxpayers and helps protect the many tax professionals who play by the rules.”
“While the majority of return preparers provide excellent service to their clients, a few unscrupulous tax preparers file false and fraudulent returns to defraud the government and the tax-paying public. Those actions are illegal, and can result in substantial civil penalties as well as criminal prosecution, for both the return preparers and their customers who knew or should have known better. Taxpayers should choose carefully when hiring a tax preparer,” said John A. DiCicco, Acting Assistant Attorney General of the Justice Department’s Tax Division.
Also during this filing season, the IRS used investigative tools on a broad basis, including agents posing as taxpayers, to seek out and stop unscrupulous preparers from filing inaccurate returns. To date, the IRS conducted 230 undercover visits to tax return preparers. In addition, dozens of search warrants have been completed.
The IRS will continue to work closely with the Department of Justice to pursue civil and criminal action as appropriate.
Education Efforts
In January, the IRS sent more than 10,000 letters to tax return preparers. These letters reminded them of their obligation to prepare accurate returns for their clients, reviewed common errors, and outlined the consequences of filing incorrect returns. The letters went to preparers with large volumes of specific tax returns where the IRS typically sees frequent errors, although simply receiving a letter was not an indication the preparer had problems.
The IRS followed up with field visits to about 2,400 tax return preparers who received these letters to discuss many of the issues mentioned in the letter. Separately, the IRS conducted other compliance and educational visits with return preparers on a variety of other issues. All told, IRS representatives visited more than 5,000 paid preparers to encourage and help them avoid filing incorrect or fraudulent returns for their clients.
The IRS will be reviewing the results of these letters and visits to determine steps for future filing seasons.
Future Efforts
The IRS has recently begun to implement a number of steps to increase oversight of federal tax return preparers. This includes proposed regulations that would require paid tax return preparers to obtain and use a preparer tax identification number (PTIN). Later this year, the IRS will propose additional regulations requiring competency tests and continuing professional education for paid tax return preparers who are not attorneys, certified public accountants and enrolled agents.
Setting higher standards for the tax preparer community will significantly enhance protections and services for taxpayers, increase confidence in the tax system and result in greater compliance with tax laws over the long term. Other measures the IRS anticipates taking are highlighted in Publication 4832, Return Preparer Review, issued earlier this year.
Help for Taxpayers before April 15
As the tax deadline approaches, the IRS reminds taxpayers that most tax return preparers are professional, honest and provide excellent service to their clients. But a few simple steps can help people choose a good tax return preparer and avoid fraud:
* Be wary of tax preparers who claim they can obtain larger refunds than others.
* Avoid tax preparers who base their fees on a percentage of the refund.
* Use a reputable tax professional who signs the tax return and provides a copy. Consider whether the individual or firm will be around months or years after the return has been filed to answer questions about the preparation of the tax return.
* Check the person’s credentials. Only attorneys, CPAs and enrolled agents can represent taxpayers before the IRS in all matters, including audits, collection and appeals. Other return preparers may only represent taxpayers for audits of returns they actually prepared.
* Find out if the return preparer is affiliated with a professional organization that provides its members with continuing education and other resources and holds them to a code of ethics.
As the current economic downturn continues to ripple through every sector of the economy, state governments from North Carolina to California are struggling to develop innovative tax policies to boost their plummeting revenues. Traditional methods of taxation are no longer sufficient to satisfy state expenditures—either government spending must change drastically or legislatures must approve new taxes to bolster falling revenues. The recent “Amazon tax” passed by the New York State Assembly is a prime example of the latter. The tax requires out-of-state retailers—such as Amazon.com, Inc. and Overstock.com, Inc.—to collect a use tax from in-state consumers if the retailers have marketing affiliates in the state which produce at least $10,000 in sales. In Quill Corp. v. North Dakota, however, the United States Supreme Court held that, under the Commerce Clause of the U.S. Constitution, a state cannot require an out-of-state retailer to collect and remit a use tax unless the retailer has a “substantial nexus” with the taxing state. The Court invalidated a sales tax imposed by North Dakota on an out-of-state mail-order retailer, which had no offices or employees in the state. By invalidating this tax, the Court reaffirmed the bright-line rule of National Bellas Hess, Inc. v. Department of Revenue of Illinois that “a vendor whose only contacts with the taxing State are by mail or common carrier lacks the ‘substantial nexus’ required by the Commerce Clause;” in other words, some physical presence is required. Attempts by New York and other states to create statutorily this “substantial nexus” between out-of-state Internet retailers and the taxing state through the retailers’ marketing affiliates run afoul of Quill and its bright-line rule.
This Recent Development analyzes the recent New York County Civil Supreme Court decision, Amazon.com v. New York State Department of Taxation & Finance, which upholds the constitutionality of the tax. The focus is on Amazon’s Dormant Commerce Clause argument and the trial court’s application of the Supreme Court’s decision in Quill. This Recent Development argues that the New York trial court failed to apply Quill’s “substantial nexus” test properly and exaggerated the role of Amazon’s associates. As a result, the trial court incorrectly held that the tax on Amazon did not violate the Commerce Clause. When applied correctly, the Quill decision should invalidate New York’s tax on Amazon and similar out-of-state Internet retailers.
With little Congressional interest in increasing the $1 million lifetime exemption, familiarity with gift tax is important in estate planning. This seminar will first consider legal requirements for a completed gift. Filing requirements will then be reviewed. Gifts exempt from the gift tax, gifts for which a deduction is available, and split gifts will be discussed. Current valuation issues will be examined in connection with determining the value of gifted assets. The importance of expert appraisals and adequate disclosure will be emphasized. Penalties, deficiencies and preparer penalties will be reviewed, as will issues involving compliance, collection and liens. The relationship with the estate tax will be analyzed. Finally, a completed Form 709, illustrating concepts presented, will be studied in detail.
Tax Professionals preparing 2009 New York State corporate, income, employment and sales tax returns should be alert to statutory changes which create new tax offenses and which impose stricter criminal penalties for existing offenses. In some cases, tax professionals may be prosecuted under an accomplice theory for aiding or abetting dishonest taxpayers. This Memorandum summarizes the new tax legislation, whose objective is to improve tax compliance and prevent tax evasion by drastically increasing penalties for serious acts of tax evasion and tax fraud. This Memorandum discusses the new statute.
The March 2010 issue of Tax News & Comment focuses on tax and estate planning in 2010.
“IRS Matters” discusses 2009 Regulations and Rulings of Note;
“From the Courts” discusses 2009 Gift & Estate Tax Decisions of Note:
“From Washington” contains a 2010 Tax Outlook.
Featured articles discuss Estate Planning in 2010, Domestic Asset Protection Trusts, and 2009 Decisions and Rulings Under IRC Section 1031 (Like Kind Exchanges).
Click here to download full March 2010 Tax News & Comment.
The federal estate tax was repealed midnight, December 31, 2009. If Congress fails to act in 2010, the estate of every decedent who dies this year will owe no federal estate tax. This could complicate existing wills. As it now stands, the estate tax will return on January 1, 2011, and the exemption amount will be reset at pre-2001 levels. This means the applicable exclusion amount will be $1 million, and the highest estate tax rate will be 55%.
This “default” scenario could change if Congress passes legislation later this year (retroactive legislative action after 2010 would likely raise constitutional problems) which President Obama signs. The House passed a bill in December that would have permanently extended the $3.5 million exemption and the 45% top estate tax rate in effect in 2009. However, the Senate failed to act, with Republicans and conservative Democrats favoring a higher exemption amount of $5 million. Mr. Obama favors a $3.5 million exemption amount and a top estate tax rate of 45%.
Given fiscal considerations, Congress may reinstate the estate tax retroactively to January 1, 2010. Most believe that the longer Congress takes to act, the less likely it is that reinstatement of the estate tax will be retroactive. However, if accomplished within the next few months, retroactive reinstatement would probably not be unconstitutional. The Supreme Court, in U.S. v. Carlton, 512 U.S. 26 (1994), held that Congress may validly impose retroactive legislation concerning an estate tax deduction. The Court remarked: “The amendment at issue here certainly is not properly characterized as a `wholly new tax,’ and its period of retroactive effect is limited.”
If Congress waits past the summer to reinstate the estate tax, Congress may decide to forego retroactivity. This, despite the significant loss in tax revenues. If Congress does elect to reinstate the estate tax retroactively any time this year, the Supreme Court will more than likely be called upon to decide the constitutionality of the measure.
Note: New York still imposes an estate tax on taxable estates in excess of $1 million. Therefore, it may be prudent for a New York testator to leave at least that amount outright or to a credit shelter trust to make use of the $1 million New York exemption amount.
II. Carryover Basis
Prior to 2010, property acquired from a decedentby bequest, devise or inheritance generally received a stepped-up basis under IRC § 1014. The purpose of the statute is to avoid the double taxation that would result if the asset were first subject to estate tax at the death of the decedent, and then to income tax when the beneficiary sold the asset after the decedent’s death. Since the estate tax has, for the time being at least, been repealed, no double taxation would result from the loss of the step-up in basis at death.
For decedents dying after December 31, 2009, the basis of property acquired from a decedent is the lesser of (i) the decedent’s adjusted basis or (ii) the fair market value of the property at the decedent’s death. IRC § 1022(a)(2). Many estates that would not have been subject to estate tax at the $3.5 million applicable exclusion amount threshold will be subject to the new carryover basis regime.
To temper the harshness of the new rule, Congress provided that the executor may allocate (i) up to $1.3 million to increase the basis of assets, and (ii) up to $3 million to increase the basis of assets passing to a surviving spouse, either outright or in a QTIP trust. Although constitutional arguments could be made against the retroactive repeal of the new carryover basis provisions, few would likely object, since it is difficult to envision a situation in which the new carryover basis provision could benefit an estate.
If Congress does not retroactively repeal the carryover basis provisions in 2010, failure to either make an outright bequest to a spouse, or failure to fund a QTIP trust might waste the $3 million basis allocation that could be made to the QTIP trust. (An income interest in a credit shelter trust given to a surviving spouse would not qualify for the $3 million spousal allocation of basis.)
III. Transfers to Trusts
IRC §2511(c) treats transfers to trusts made after December 31, 2009 as taxable gifts unless the trust is a wholly grantor trust under IRC §§ 671-679. The statute is intended to prevent the donor from making a transfer complete for income tax purposes but incomplete for transfer tax purposes, thereby shifting income tax responsibility without incurring gift tax.
IV. GST Tax Uncertainties in 2010
Although technically not repealed in 2010, the generation-skipping transfer (GST) tax will have no application in 2010, as there is no estate tax. This also means that transferors will not be able to allocate any GST exemption to transfers made in 2010. As is the case with the estate tax, the GST tax will “spring back” into life on January 1, 2011.
However, by reason of the language in the sunset provision in the 2001 Tax Act, i.e., “the the Internal Revenue Code of 1986 shall be applied . . . as if the provisions [in the 2001 Tax Act] had never been enacted,” various uncertainties arise in the application of the GST tax. For example, will GST exemptions allocated trusts after 2001 but before 2010 be allowed? Also, will decedents who die in 2010 with testamentary trusts be treated as transferors for GST purposes? Since transfers to trusts will not be subject to estate tax in 2010, such decedents might not be considered “transferors” within the meaning of IRC § 2652(a).
A number of GST provisions are also scheduled to sunset in 2011 without further legislation. Among those are the allowance of a retroactive allocation of GST exemption under certain circumstances, and a late election to allocate the GST exemption.
V. Review of Existing Documents
Wills for testators at risk of death in 2010 should be reviewed. Existing wills may contain a formula provision allocating the maximum amount which can pass free of estate tax to a credit shelter trust. Since there is no estate tax in 2010, the amount called for in the formula could consume the decedent’s entire estate. Most testators who included this formula provision were motivated by a desire to avoid burdening the estate of the surviving spouse with unnecessary estate tax liability, not a desire to disinherit the spouse. However, if no estate tax exists, then this could result. Similarly, a bequest to a QTIP trust of the maximum amount qualifying for the estate tax deduction may be difficult to interpret if there is no estate tax for which a deduction could be claimed.
A client, even an elderly one at risk of death in 2010, may resist drafting a new will which might be effective only for only one year, since it is remote that estate tax reprieve will more than temporary. A simple codicil may provide an effective solution. The codicil could provide that (i) should the client die at a time when the estate and GST tax do not apply, and (ii) if the estate tax and GST tax are not retroactively reinstated, then (iii) notwithstanding any contrary provisions in the will, for purposes of all formula computations, it would be conclusively presumed that the estate tax laws in effect on December 31, 2009 would be applicable at the client’s death. This would prevent the overfunding of the credit shelter trust. The language of such a codicil could read:
Article [ ]
Intent if No Federal Estate Tax
“For purposes of gifts made under this Will, if at the time of my death there is no federal estate tax, and it appears to my Executor that retroactive reinstatement by Congress of the federal estate tax is unlikely to occur, it is my intention that all dispositive provisions under my Will be given the same force and effect as if I had died in 2009, and that all dispositive provisions in my Will be interpreted according to the federal tax law as it existed in 2009, regardless of the federal tax law in effect at the time of my death.”
VI. Planning for Married Persons
It appears likely that the estate tax will be reinstated no later than 2011, and that the exemption amount could be between $3.5 million and $5 million. As seen, under many current wills, if either spouse were to die in 2010 at a time when there is no estate tax, the credit shelter trust could be overfunded. Overfunding of the credit shelter trust could also result in unintended (and costly) New York state estate tax consequences, since the New York state estate tax exemption amount is only $1 million.
One interesting approach discussed at the University of Miami Heckerling Institute on Estate Planning in Orlando during the week of January 25th, 2010, which seeks to exploit the uncertainty in the estate tax in 2010, is to maximize dispositions to QTIP trusts.
Assets in a QTIP trust with respect to which no estate tax marital deduction is allowed at the death of the first spouse will not be includible in the estate of the surviving spouse under IRC § 2044. If no estate tax exists at the death of the first spouse in 2010, and all of the estate is left to a QTIP trust, no QTIP election will be necessary to save estate taxes on the first spouse to die. If no QTIP election is made, none of the assets in the QTIP trust will be included in the estate of the surviving spouse, even if the estate tax is reenacted prior to the death of the surviving spouse.
[Note: The rights accorded to a surviving spouse in a QTIP trust are insufficient to pull the QTIP trust assets back into the her estate under §2036. QTIP assets are includable only if the executor of the first spouse to die makes a QTIP election and deducts the value of the assets from the gross estate of the first spouse. By making the election, the executor is agreeing to include the value of the assets in the estate of the second spouse (at their fair market value at the death of the surviving spouse). If no election is made, QTIP trust assets will not be included in the estate of the surviving spouse. Inclusion arises by virtue of the QTIP election, not by virtue of the QTIP trust being funded. If no election is made, no inclusion in the estate of the surviving spouse will result even if the QTIP trust was funded.]
In contrast, if all of the assets are instead left outright to the surviving spouse, those assets would be included in the estate of the surviving spouse if the estate tax were reenacted prior to the death of the suriviving spouse. Therefore, a QTIP trust may effectively shield the estate of the surviving spouse from potential estate tax liability. The QTIP trust may also impart a significant degree of asset protection into the inherited assets, when compared to an outright bequest. Another advantage to funding the QTIP trust is to ensure that the $3 million spousal basis adjustment can be utilized, if needed. By inserting a disclaimer provision in the will, the surviving spouse could decide whether to disclaim amounts not needed for the $3 million spousal basis adjustment.
Despite the alluring federal estate tax consequences of generously funding a QTIP trust in 2010, a dark cloud in the form of New York state estate tax liability may appear, since New York does not recognize a “state-only” QTIP election. That is, if no QTIP election is made on the 706 (and no election will be made since none is needed to eliminate the federal tax in 2010, no separate New York QTIP election would also likely be possible, since New York does not appear to allow a QTIP election if no federal QTIP election is made.
This means that if all assets are transferred to a QTIP trust, the cost of obtaining no federal estate tax bill on the death of the first spouse (by reason of there being no estate tax) or on the death of the second spouse (by reason of there having been no QTIP election, meaning that while a transfer to a QTIP trust was made, no election was made to deduct the amounts transferred, and therefore no obligation to include those assets at fair market value on the 706 of the surviving spouse arose) may be a New York state estate tax on the size of the entire estate, less $1 million (the QTIP trust would qualify for New York’s $1 million lifetime exemption amount, since it would be treated for New York estate tax purposes as a garden variety credit shelter trust.)
Although the New York state estate tax could be avoided — and no increase in federal estate tax would arise — by making an outright disposition to the surviving spouse in 2010, this would result an avalanche of potential future federal estate tax on the death of the surviving spouse, unless of course, the surviving spouse also dies before 2011, or consumes or gifts the entire amount before her death.
Another peculiar disadvantage to funding the QTIP trust with all of the estate assets, rather than leaving assets directly to the children, is that the surviving spouse will incur taxable gifts if lifetime transfers to children are desired. That is, the surviving spouse may not wish to wait until her will takes effect to transfer wealth to children. Recall that although the estate tax has been repealed, the gift tax exemption remains at $1 million in 2010. (The rate of tax applied to gifts has been reduced, however, from 45% to 35%.)
Although a disclaimer creates post-mortem flexibility, a significant disadvantage to disclaimers is that the surviving spouse must actually disclaim. Some surviving spouses may not disclaim, even if sensible from a tax standpoint. If this is a concern, the surviving spouse may instead be given more rights and powers over assets funding the credit shelter trust. For example, (i) the spouse might be named co-trustee of the trust; (ii) the spouse might be given a testamentary limited power of appointment over the credit shelter trust; (iii) the trustee might be directed to make greater distributions to the surviving spouse; or (iv) the trustee or “trust protector” might be given authority to make discretionary distributions to the spouse of as much of the income or principal of the trust as the trustee or trust protector believes is in the best interest of the spouse. The credit shelter trust could also provide that the spouse would no longer be a beneficiary if the spouse were to remarry.
Giving the spouse more rights in a credit shelter trust (as would transfers to a QTIP trust where no QTIP election is made) may eliminate the need to rely on a disclaimer. However, this solution would result in significantly less flexibility, and would almost certainly result in New York state estate tax on the death of the first spouse. (Again, the only way to avoid New York estate tax on the death of the first spouse is to make a transfer qualifying for the New York state estate tax deduction. This type of transfer could be (i) an outright transfer to the surviving spouse; (ii) a QTIP transfer for which a QTIP election is made on the 706; or (iii) a general power of appointment trust. A final disadvantage to foregoing the QTIP in favor of a credit shelter trust is that as indicated above, only outright transfers or transfers for a QTIP trust are eligible for the $3 million basis allocation at the death of the first spouse.
VII. Transfer Planning in 2010
Many clients wish to transfer assets to their children during their lifetimes rather than at their death. Therefore, lifetime transfer planning remains important for reasons wholly independent from the fate of the estate tax. While the $1 million lifetime gift tax exclusion amount is a hindrance to large gratuitous transfers, gifts of interests in discounted family entities, installment sales to grantor trusts, and transfers to annuity trusts can significantly leverage the $1 million gift tax exclusion amount.
The federal gift tax (New York has no gift tax) has not been repealed, although the tax rate for gifts in 2010 is 35%, down from 45%. Although the 35% rate is not scheduled to increase in 2011, Congress has historically imposed the same rate of tax on both gifts and estates. Since the 35% tax rate may be only temporary, large gifts of $1 million or more made in 2010 may be considerably less expensive than the same gifts would be in 2011. Another important reason to consider transfer planning in 2010 is that President Obama seeks to curtail valuation discounts, either by means of new legislation, or by issuing regulations under IRC §2704. This prospect, in combination with the historically low gift tax rates now in effect, makes transfer planning in 2010 particularly attractive.
¶ Although Congress is contemplating requiring a minimum 10-year period for GRATs, this would not effect the client’s ability to utilize a “zeroed-out” GRAT, which would result in little or no current taxable gift.
¶ The gift tax annual exclusion amount remains for 2010 remains at $13,000. Much wealth can be transferred without gift or estate tax consequences by prudent use of annual exclusion gifts, either outright or in trusts providing Crummey powers.
2000 Estate and Gift Tax Decisions of Note
I. Built-in Capital Gains
In Estate of Welch v. Comr., 208 F.3d 213 (6th Cir. 3/2000), the Court of Appeals held that a discount to reflect built-in capital gains of real property was appropriate, despite the fact that the corporation might avoid the capital gains tax by reinvesting the proceeds. Citing Eisenberg v. Comr., 155 F.3d 50 (2d Cir. 1998), acq. 199-4 I.R.B. 4, the court held that the principal issue was whether a hypothetical purchaser would take into account built-in capital gains in computing the value of the stock.
Similarly, the Tax Court allowed a 5% discount for built-in capital gains in Estate of Dunn, 79 TCM 1337 (2000), observing that a new owner could avoid the built-in capital gains tax by continuing to use the property over its entire useful life. According to the court, only if the buyer intended to liquidate in the “short-term” would the buyer seek a reduction in price for built-in capital gain.
II. Valuation Discounts
The Tax Court decision in Estate of Simplot, 112 T.C. 130 (3/1999), brief filed (9th Cir. 4/2000) was appealed to the Ninth Circuit. In Simplot, the Tax Court allocated a percent of equity of the entire corporation to 76 shares of voting stock, causing those shares to be worth $215,539 for estate tax purposes, rather than $2,650 as the taxpayer had reported.
The Tax Court, in Estate of Knight, 115 T.C.__ (No. 36) (11/2000), rejected an IRS attempt disregard transfers made to a Texas family limited partnership in valuing the gifts of limited partnership interests. The court reasoned that since the partnership was a valid entity under Texas law, it was also valid for federal tax purposes. While the case is helpful for its apparent recognition of the family limited partnership as a viable estate planning entity, the holding was double-edged: the court also disallowed the taxpayer’s claimed 44% discount, and allowed a discount of only 15%, which was substantially less than had been allowed in previous cases. The Knight decision has prompted commentators to suggest that the size of the valuation discount may be a point of contentious disagreement in the future. If this surmise is correct, the importance of obtaining an expert professional discount valuation in the context of transfers to family limited partnerships and LLCs is even more pronounced.
Another blow to the IRS in the family limited partnership discount arena came in Estate of Strangi, 115 T.C. ___ (No. 35) (11/2000), where the Tax Court allowed valuation discounts with respect to transfers effected two months before the decedent’s death. Although the Tax Court doubted some of the asserted business motives for the partnerships, it stated that Congress, in enacting the partnership tax laws, did not intend to tax assets of a validly-existing partnership as if they had been owned directly by the decedent. As in Knight, supra, the Tax Court trimmed the allowable discount, from 43.75% as claimed by the taxpayer, to 31%. The court also noted that the 31% discount allowed was based on the Service’s failure to challenge it, and as a result might be “overly generous to petitioner.”
In Shepherd v. Comr., 115 T.C. ___ (No. 30) (10/2000), the taxpayer transferred land and stock to a partnership of which the taxpayer’s children were named as limited partners. However, the children did not actually sign the agreement until after the property was transferred into the partnership. The Tax Court held that the children had received gifts of land and stock, rather than of partnership interests, reasoning that the partnership did not exist until the children signed the partnership agreement. This case vividly illustrates the necessity of respecting the formalities when creating a family limited partnership. The partnership should be formed, and documents executed prior to deeding any property into the partnership. Only after completing these steps should the parent make gifts of partnership interests.
In Estate of Reichardt v. Comr. 114 T.C. No. 9 (2000), the entire value of assets transferred to a family limited partnership were included in the decedent’s estate under IRC §2036. The Tax Court found an implied agreement that the decedent would continue to possess and enjoy the property and retain a right to income. The Court noted that “[n]othing changed except legal title.” The case is of concern to estate planners since IRC §2036(a) had not found routine application in the context of family limited partnerships; the fiduciary duty of the manager (or partner) was thought to preclude its relevance. If IRC §2036 is to be avoided, the fiduciary duties of the managing member of the entity must be taken seriously. A mere recital in the operating agreement of the manager’s duties may be insufficient.
In Kerr v. Comr., 113 T.C. 449, (12/1999) the Tax Court rejected an IRS attempt to disallow discounts for transfers of family limited partnership interests based on the argument that certain restrictions in the partnership agreement violated IRC §2704(b). Granting summary judgment to the taxpayer, the court held that the restrictions in the agreement were not “applicable restrictions” for the purpose of IRC §2704(b). Similarly, in Estate of Harper v. Comr., the Tax Court, citing Estate of Kerr, supra, held that partnership restrictions were not applicable restrictions under IRC §2704(b), because they were no more restrictive than conditions imposed by state law. Thus, the decision appeared to validate the old saw that restrictions in a partnership agreement should be no more restrictive than those under state law.
The Tax Court, in Estate of Busch, 79 TCM 1276 (2000), allowed a 10% undivided interest discount in real property, which represented the “reasonable costs of partition.” In Estate of Brocato, 78 TCM 1243 (1999), the Tax Court allowed a 20% undivided interest discount. The court also allowed an 11% “blockage” discount, which reflected the expected decrease in market price if multiple properties were introduced into the market simultaneously.
III. Power of Attorney Gifts
The Tax Court, in Estate of Swanson v. U.S., 46 Fed. Cl. 338 (3/2000) granted summary judgment in favor of the IRS, holding that under California state law, the power to make gifts under a power of attorney may not be implied. The case underscores the importance of including such a power in New York powers of attorney. If the form power of attorney used contains a provision explicitly authorizing annual exclusion gifts, broader powers should be included if gifts in excess of the annual exclusion are desired.
IV. Estate Taxes & Returns
In Estate of Devlin v. Comr., T.C. Memo 1999-406 (12/1999), gifts authorized by a court before, but not made until after the death of the decedent, were included in the gross estate. The Tax Court held that no constructive trust arose in favor of the beneficiaries since the gifts were not required.
In Estate of Smith v. Comr., 198 F.3d 515 (5th Cir. 12/1999), the Tax Court, held that the estate could deduct only $681,139, the amount of a debt which it eventually paid to settle a claim. In reversing the Tax Court decision, the Fifth Circuit stated that the estate was allowed to deduct the entire amount of the liability “as of” the date of the decedent’s death, which was $2.48 million. The Fifth Circuit ruled that post-death events are irrelevant when claims “are for sums certain and are legally enforceable as of the date of death.” The IRS has stated that it will not follow the decision.
In Armstrong v. Comr., 114 T.C. 94 (2/2000), the decedent made large taxable gifts in 1991 and 1992, and paid gift taxes of $4.7 million. As a result of these gifts, the decedent was nearly insolvent at his death in 1993. Although an estate tax return was filed, gift taxes occasioned by application of the three-year rule of IRC § 2035(c) were not included with the return. The IRS assessed a deficiency of $2.3 million. The donees of the gifts claimed that they were not liable for payment of estate taxes, since the stock given to them was not the source of the estate tax deficiency. Nevertheless, the Tax Court looked to the beneficiaries for payment of the estate taxes, finding authority, somewhat implausibly, in IRC §6324(a)(2), which imposes personal liability upon transferees of property included in the decedent’s gross estate under IRC §§2034 to 2042.
V. Tax Payment Provisions
Estate of Miller v. Comr., 209 F3d. 720 (5th Cir. 2/2000), aff’g per curium T.C. Memo, 1998-416, illustrates the importance of consistent tax payment provisions in will and trust documents. In this case, the decedent’s will stated that all estate taxes were to be “borne by my residuary estate . . . as an expense of administration, without apportionment and without contribution or reimbursement from anyone.” The decedent’s will left half of her residuary estate to her husband, and half to a revocable trust. The revocable trust authorized the trustee to pay estate taxes from the trust fund.
The executor in Miller apportioned all of the estate taxes to the nonmarital portion of the residuary estate passing under the trust. The decision of the Tax Court, upheld on appeal to the 5th Circuit, stated that the decedent’s will had been clear in providing that there be no discrimination between marital and nonmarital residual beneficiaries. Accordingly, estate taxes were required to be paid in part from the deductible marital share. The result of the decision, a reflection of imprecisely drafted documents, caused estate taxes to be paid and to reduce the marital share, which was deductible. The case illustrates the importance of a careful review of all estate planning documents in order to ensure that tax payment provisions are consistent and clear.
VI. Annual Exclusion Gifts
The Tax Court in Estate of Bies v. Comr., T.C. Memo 2000-338 (11/2000), recognized and rejected an idea sometimes proposed by taxpayers: make annual exclusion gifts to others with an “understanding” that the donee then regift the property to the donor’s “ultimate” beneficiary. In Bies, gifts of a business interest were made to sons and daughters-in-law, the latter of whom quickly re-gifted the interest to sons. The court held that the “facts and circumstances” evidenced the intent of the decedent to make indirect gifts to her sons. Taxpayers should be dissuaded from this type of transaction, which constitutes a thinly-veiled attempt to leverage the annual exclusion. Though perhaps not easily distinguishable from “Crummey” annual exclusion gifts, which have been sanctioned by the courts (over the strenuous objection of the IRS), the type of gifts attempted in Bies dispenses with even the legal fiction upon which Crummey gifts are predicated.
VII. Disclaimers
In Chamberlain v. Comr., T.C. Memo 1999-181, briefs filed (9th Cir. 11/2000), the Tax Court held that an unsigned disclaimer which did not list specific assets to be disclaimed failed to accomplish a valid disclaimer. The estate’s attorney had prepared a disclaimer listing the total value of assets to be disclaimed, but pending a determination of a value of the estate’s assets, a list specific assets was not prepared. The surviving spouse died without executing the disclaimer. The court noted that valid disclaimer under IRC §2518 must (i) be written; (ii) irrevocably refuse to accept the assets passing from the decedent’s estate; and (iii) specifically identify the disclaimed property.
VIII. Imputed Interest
Where taxpayers advanced monies to a wholly-owned family corporation to pay expenses, recorded the advances in the corporate books as increases in “shareholder loan accounts,” and were later reimbursed without interest, Tax Court held in Estate of Hoffman v. Comr, T.C. Memo 1999-395 (12/99) that advances were demand loans rather than capital contributions, which required the shareholders to report imputed interest under IRC §7872. The case illustrates the principle that the taxpayer, once having chosen the form of a transaction, will usually be foreclosed from arguing that the substance of the transaction should prevail over its form.
IX. Income Tax Liens
In Drye Jr., v. U.S., 526 U.S. 1063 (12/99), aff’g 152 F.3d 892 (8th Cir. 1998), the beneficiary of an estate who owed the IRS $325,000 in income tax disclaimed his legacy. Although the disclaimer was valid under Arkansas law, the district court held that the disclaimer was void and fraudulent against the IRS where the disclaimed assets went first to the debtor’s daughter, and then into a trust for the benefit of the daughter and her parents. The trust was a discretionary trust which contained spendthrift provision.
The Drye decision was upheld on appeal to the Eighth Circuit and again on appeal to the Supreme Court. An opinion written by Justice Ginsburg stated that the tax law looks to federal law, rather than state law, in determining whether a taxpayer has a beneficial interest in any property upon which the IRS can levy. Although state law determines a taxpayer’s rights in property, federal law determines whether these rights are “property” for purposes of a tax levy.
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