I. Disputes Involving Sales of Assets to Grantor Trusts Reach the Tax Court
Tax News & Comment — March 2015 View or Print
In Estate of Woelbing v. Com’r, Docket No. 30261-13, filed on December 26, 2013, the IRS made several arguments seeking to negate the tax benefit sales of stock to grantor trusts based upon Rev. Rul. 85-13. That ruling stated that no realization event for federal income tax purposes occurs when a taxpayer sells an asset to a grantor trust. While the sale is invisible for income tax purposes, practitioners had concluded that the same was not the case for gift and estate tax purposes. Thus, sales to grantor trusts were made which were presumptively complete for transfer but not for income tax purposes. These sales shifted appreciation out of the grantor’s estate, while at the same time resulted in the income tax for the grantor trust being attracted like a magnet to the grantor. This permitted trust assets to appreciate without the imposition of yearly tax. An added bonus of this planning technique was that the payment of the income tax of the trust by the grantor was not deemed to constitute a gift to the trust.
Risks associated with this estate planning transaction had always been presumed to exist. However, it appeared that careful tax planning could minimize those risks. The IRS in Estate of Woelbing has fired the first salvo in contesting the sale of assets to “defective” grantor trusts, as has been their sobriquet.The IRS first argued that the promissory note received in exchange for the sale of stock was undervalued, and that the difference between the value of the Note and the actual value of the stock transferred constituted a taxable gift. The IRS then argued that that the stock should be included in the decedent’s estate under IRC §§ 2036 and 2038 as “retained” interests. Finally, the Service asserted that a 20 percent underpayment penalties amounting to more than $25 million should be imposed.
The principal hurdle that the taxpayer in Woelbing — as in other cases — must surmount, aside from ensuring that the formalities of the transfer are well documented, and that the transaction is bona fide, is that the promissory note received in exchange for the assets (i) constitutes debt rather than equity and (ii) is fairly valued. One way of ensuring that the Note is bona fide debt is transfer to trust sufficient assets such that there are sufficient assets to satisfy the Note even if the trust has an income deficit.In practice, the requirement of the promissory note comprising debt has been accomplished by making a gift of “seed” money into the trust prior to the sale. If the trust produces just enough income such that the Note is satisfied, it begins to look as if the transferor has retained an interest in the transferred assets such that Section 2036 comes into play. If ample trust assets assure that the terms of the Note will indeed be repaid without incident, the Note will more likely have independent significance. It will be interesting to see how Woelbing is decided. As insurance against a successful IRS argument that the promissory note is undervalued, trusts have been drafted to contain formula clauses shifting any excess value that could be deemed a taxable gift, to an entity for which a deduction was available.
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Until Woelbing is decided, some have suggested that GRATs be used frequently, at least for extremely wealthy individuals. However, GRATs are like the Model T of estate planning — their time has passed. GRATs are much less effective as estate planning vehicles than are sales to trusts, and are generally inferior to other estate-planning strategies. While one well-known tax practitioner has suggested that GRATs be rehabilitated at least until one gets a sense of how disputes involving sales to grantor trusts will be resolved, this approach has little to commend it. The sensible approach, suggested by Dennis Belcher at the University of Miami tax conference in Orlando in January is that clients should be advised of the current litigation involving sales to grantor trusts, but having been made aware of the risk, are competent to make their own decision as to whether or not to fly into the turbulence hoping, as most do, that sales to grantor trusts will end up being vindicated for tax purposes.
Interestingly, other speakers at the Orlando conference noted that for all but fewer than one percent of taxpayers, sophisticated tax planning involving sales to grantor trusts (or GRATs for that matter) is no longer even necessary, given the combined spousal exemption amount which is now more than $10.86 million. Since 2012, 87 percent fewer federal estate tax returns have been filed. Although it may be a slight overstatement, it is clear that income tax planning has now taken center stage, and federal estate tax planning has been relegated in importance. New York state estate tax planning is still important, however, at least until 2019, when New York’s exemption reaches parity with the Federal exemption amount.
Despite efforts to abolish it, the federal estate tax appears to have a considerable life expectancy since it generates considerable revenues even though the tax reaches only a fraction of a percent of all taxpayers. Abolishing the estate tax appears to be an excellent “talking point” for Republicans, but no one seems to care very much about eliminating the estate tax. In fact. President Obama indicated that he favored reducing the federal exemption amount. Given the current makeup of Congress, Mr. Obama’s position appears to have scant likelihood for success. In the end, Congress appears unlikely likely to forego this source of revenue which is imposed on only a few thousand taxpayers, regardless of who next occupies the White House.
II. Corporate Goodwill
Several cases involving the taxation of goodwill in the context of the sale of a corporate enterprise were decided. To avoid a successful IRS assertion that goodwill belongs to the corporation rather than to the individual, taxpayers should understand both positive and negative factors which affect that determination, and plan accordingly. Goodwill, for federal tax purposes was defined by Justice Story as “[t]he advantage or benefit, which is acquired by an establishment . . . in consequence of the general public patronage and encouragement, which it receives from habitual customers, on account of its local position, or common celebrity, or reputation for skill or affluence.”
Courts have recognized two types of goodwill: “Business Goodwill” and “Personal (or professional) Goodwill.” Business goodwill refers to going-concern value, or goodwill attaching to the enterprise. Personal goodwill, on the other hand, takes into consideration the seller’s reputation and expertise, and may be considered separate and apart from the assets of the firm. When applied to professional businesses, such as medical practices, the term personal goodwill is often referred to as “Professional Goodwill.” One author provides an example of personal goodwill in a medical practice: “[I]f a doctor was a neurosurgeon with extensive experience, an excellent reputation for successfully treating highly complex and difficult neurological problems, and a good bedside manner, it is likely that patients would come to see the doctor not because of an established practice with a solid reputation in a particular locale, but because of the surgeon’s unique skills, abilities, and reputation.”
Several cases involving professional service corporations inform the contours of what may be properly characterized as professional goodwill. In Norwalk v. Com’r, T.C. Memo 1998-279 (1989), the Tax Court held that in the absence of a noncompetition agreement or other agreement with the corporation whereby goodwill in connection with existing clients became the property of the corporation, the goodwill constituted professional goodwill, since the clients had no meaningful value to the corporation. However, in Schilbach v. Com’r, T.C. Memo 1991-556, a different (and adverse) result was reached where the Court found that the sole shareholder of a professional corporation was unable to obtain malpractice insurance, was leaving the state, and it appeared doubtful that the physician would “set up a new practice in direct competition with [the purchaser].”” The Court in Schilbach imposed a 25 percent accuracy-related penalty under [then] IRC § 6661.
In a more recent case, Howard v. United States, No. 10-35768, decided by the Ninth Circuit Court of Appeals in 2011, the Court noted that “there is no corporate goodwill where ‘the business of a corporation is dependent upon its key employees, unless they enter into a covenant not to compete with the corporation or other agreement whereby their personal relationships with clients become property of the corporation’; Martin Ice Cream Co., 110 T.C. at 207-08 (finding that “personal relationships . . . are not corporate assets when the employee has no employment contract [or covenant not to compete] with the corporation.’; Macdonald v. Com’r, 3 T.C. 720, 727 (1944) (finding “no authority which holds that an individual’s personal ability is part of the assets of the corporation . . . where . . . the corporation does not have a right by contract or otherwise to the future services of that individual.” In determining whether goodwill has been transferred to a professional practice, we are especially mindful that “each case depends upon particular facts. And in arriving at a particular conclusion . . .we take into consideration all the circumstances . . . [of] the case and draw from them such legitimate inferences as the occasion warrants.” Grace Brothers v. Com’r, 173 F.2d 170, 176 (9th Cir. 1949).
In Howard, the Ninth Circuit found that the taxpayer’s dental practice was the property of the “Howard Corporation” and its sale did not generate professional goodwill. The purchase contract did recite that “[t]he personal goodwill of the [p]ractice . . . [was] established by Dr. Howard . . . [and] is based on the relationship between Dr. Howard and the patients.” However, in rejecting the significance of the contractual language, and in affirming an order of summary judgment in favor of the IRS, the Ninth Circuit concluded that the purchase agreement did not reflect the “realities” of the transaction, noting: “By now it is well established that “the incidence of taxation depends upon the substance, not the form of [a] transaction.” Com’r v. Hansen, 360 U.S. 446, 463 (1959). . . Self-serving language in a purchase agreement is not a substitute for a careful analysis of the realities of the transaction.”
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In Bross Trucking v. Com’r, T.C. Memo 2014-17, the IRS alleged that where the sons succeeded to father’s business, which suffered a loss of goodwill from negative publicity, the assets of the company were distributed to father as ordinary income, and that father made a gift of the corporate goodwill to sons. The Tax Court held for the taxpayer, finding that there was little corporate goodwill for the corporation to have distributed. Citing to Martin Ice Cream v. Com’r, 110 T.C. 189 (1998), the Tax Court found that corporate goodwill was lacking, since (i) Mr. Bross had no employment or noncompetition agreement with Bross Trucking; (ii) clients patronized Bross Trucking by reason of the relationships “forged” by Mr. Bross; (iii) goodwill was “the expectation of continued patronage,” the regulatory problems encountered by Bross Trucking actually resulted in a loss of corporate goodwill; (iv) the sons of Mr. Bross had personally “cultivat[ed]” relationships with clients; and accordingly (v) the sons’ profiting thereby from “independently created relationships” was not the same as “receiving transferred goodwill.””
III. Adequate Disclosure on Gift Tax Returns
The three-year period of assessment for timely filed gift tax returns presumes that “adequate disclosure” has been made. In Estate of Sanders v. Com’r, T.C. Memo 2014-100, the estate argued in a motion for partial summary judgment that the statute had run on the ability of the IRS to challenge the value of the gift. The Tax Court cited Reg. §301.6501(c)-1(f)(2)(iv) for the proposition that a gift is adequately disclosed if the taxpayer provides a “detailed description of the method used to determine the fair market value of the property.” In this case, the Tax Court denied the motion for partial summary judgment, concluding that a genuine dispute existed as to whether the gift tax returns adequately disclosed the value of the gift. Although the Regulations do not explicitly require that the taxpayer engage an expert to value a gift when preparing a gift tax return, it may make sense to do so anyway. If no expert appraisal for a large gift is made at the time of the gift, it may be necessary to engage an expert later — even after the donor dies — if the IRS challenges the adequacy of initial disclosure, as it did in Estate of Sanders. It may be more difficult at a later time to accurately value the gift. Gifts of some assets, such as real estate, may be far easier to value at the time of the gift, rather than many years later. Other gifts, for example, the gift of a rare coin, might not be more difficult to value at a later time.
IV. Overpayment of Estate Tax Applied to Deferred Portion of Tax
In Estate of McNeely v. U.S., 2014 WL 2617418, USTC §60679 (D. Minn. 2012), the estate made an estimated estate tax payment of $2.494 million. The estate also sought to defer payment of estate tax under IRC §6166. The estate tax return when filed showed an actual nondeferrable estate tax liability of only $512,226. The request by the estate for a refund of $1.9179 million was denied. The District Court for Minnesota held for the government in a refund action brought by the estate, reasoning that under IRC §6402, the IRS may in its discretion credit an overpayment to an outstanding tax liability.
V. 3.8 Percent Net Investment Income Tax
In Frank Aragona Trust v. Com’r, 142 T.C. No 9 (2014), the trust conducted real estate operations through an LLC. The children of the deceased grantor were trustees. The issue was whether the 3.8 percent tax on net investment income applied to the trust, which claimed that through its activities which were “regular, substantial and continuous,” the trust qualified as a “real estate professional,” and could therefore deduct its rental real estate losses. At issue was also whether the trust materially participated in the real estate activities through the trustees. The trust prevailed. The Tax Court ruled that the trust could indeed qualify as a “real estate professional.” Even though the trust could not itself perform “personal services,” those services could be provided by the trustees. The court also rejected the IRS argument that the trustees did not materially participate in the real estate activities, finding that the trustees were in fact involved in the daily activities of the real estate business.
VI. Conservation Easements
The Second Circuit affirmed a decision of the Tax Court which held that the donation of a conservation easement consisting of the façade of a brownstone in Brooklyn’s Fort Greene Historic District had not been shown to reduce the value of the property, and that the IRS was correct in challenging the charitable deduction taken by the taxpayer under IRC §170(f)(B)(iii). Schneidelman v. Com’r, Docket No. 13-2650 (6/18/2014). [The taxpayer donated the easement and claimed a charitable deduction of $115,000, premised upon the reduction in value of the property by reason of the gift. Following audit, the IRS determined that the taxpayer had not established a fair market value for the easement. The Tax Court agreed and found that the taxpayer was not entitled to claim the deduction because it had not obtained a “qualified appraisal” showing a reduction in value of the property.]
The Court noted preliminarily that its review of factual matters determined by the Tax Court was “particularly narrow when the issue is one of value” and that the conclusion of the Tax Court must be upheld if supported by “substantial evidence.” The Court then recited the familiar precept that the fair market value of property is based upon a hypothetical willing buyer–willing seller rule. The Court acknowledged that while encumbrances on real property generally reduce value, the grant of a conservation easement may, according to the regulations, increase the value. In the instant case, the appraisal the taxpayer obtained failed to take into account the particular facts and circumstances. The appraiser merely opined as to an IRS “accepted range” of percentages, which was inadequate.
The IRS, on the other hand, analyzed “the particular terms of the easement, zoning laws, and regulations” and concluded that the grant of the easement did not materially affect the value of the property. Ironically, the witness proffered by the taxpayer — the Chairman of the Fort Greene Association — testified that the Fort Greene Historic District was an “economic engine,” from which the Tax Court had properly concluded that the preservation of the façade was a benefit, rather than a detriment, to the property. The case underscores the importance of obtaining a qualified appraisal. Ironically, even if the taxpayer had been armed with a qualified appraisal, she would probably not have emerged victorious. Courts have been skeptical of deductions taken for conservation easements for good reason. It is difficult to perceive how promising not to destroy the façade of an historic building could reduce its value.
From Washington & Albany — Income & Estate Tax Planning in 2015
Tax News & Comment — March 2015 View or Print
I. From Washington
Income tax planning in 2015 will seek to reduce the effect of high federal and New York tax rates. Avoidance of unnecessary capital gain realization through basis increases or nonrecognition transactions will remain important. Estate tax planning is simplified by portability at the federal level. The top federal income tax rate is now 39.6 percent, its highest since 2000. Capital gains are taxed at 23.8 percent, which includes the 3.8 percent net investment income tax. The top New York rate levels off at 8.82 percent, while New York City adds another three and a half percent for most residents. Wage earners must pay social security and Medicare tax. All told, ordinary income tax rates in New York for wage earners now top out at 52.26 percent; long-term capital gains rates reach 37.69 percent.
The cost of living in New York is higher than in other states not only because of high tax rates, but also because of high living costs. However, many people who leave New York to avoid northeast winters seem to come back when the weather moderates. The Department of Taxation is well aware of this and keeps a vigil over those persons who seek to enjoy the benefits of New York without paying tax here. Residency audits continue to spark litigation. Income tax planning is now prominent in estate planning, not so much for reasons of the federal estate tax, which has whimpered out, but because of the importance of basis; more particularly, the basis step up at death. While placing assets in a credit shelter trust will remove those assets from the estate of both spouses forever, the cost will be a second basis step up at the death of the surviving spouse. In contrast, if assets are gifted to the surviving spouse in a QTIP, a second basis step up is possible with no loss of the federal estate tax exemption, due to portability.
Trusts other than grantor trusts are taxed at 39.6 percent when fiduciary income reaches only $12,150. This means that trusts should distribute income to beneficiaries in lower tax brackets whenever feasible. Trust losses in excess of income benefit no one until the final year of the trust. Accordingly, it may be prudent to defer the timing of trust operating losses until the final year of the trust when the losses may be taken as itemized deductions by beneficiaries. Grantors who sold assets to grantor trusts to save estate taxes may no longer wish to report the tax of the trust they created, since the income tax liability may exceed 50 percent on the personal level, and reducing estate tax planning may no longer be necessary. One solution to these “burned out” trusts may be to “turn off” grantor trust status. Many trusts will contain language expressly permitting such “toggling.” If the trust does not so expressly provide, the grantor may consider amending the trust or decanting the trust into another trust that does contain express language permitting toggling.
While the IRS has not issued regulations concerning the tax implications of turning off grantor trust status, the situation is somewhat muddled, and Revenue Ruling 85-13 — whose tenets are consistent with permitting such a switch — has assumed such prominence, that the tax risk of turning off grantor trust status may be one well worth assuming. The government may be uninterested in challenging these transactions, since at best the taxpayer achieves small or moderate rate bracket benefit. Someone is going to continue to pay the tax; if not the grantor, then the trust or the trust beneficiaries. However, once grantor trust status is turned off, it may be risky to attempt to turn grantor trust status back on at a later date. This “toggling” might present an opportunity for the IRS to argue that the device was being used for tax-avoidance. Somehow it seems inappropriate for a trust to toggle between being a grantor trust or nongrantor trust at the whim of the grantor on a yearly basis.
Especially with the advent of portability, marriage itself is an extremely effective estate tax plan for more affluent taxpayers with accumulations of wealth. Gifts between spouses occasion no income and except in rare occasions no gift tax. Gifts of low basis property to an ailing spouse who lives one year can accomplish a valuable basis step up if the property is willed back to the donor spouse. If the ailing spouse cannot be expected to live a year, giving property to the ailing spouse and having the ailing spouse will the property to children will also lock in the basis step up with no tax risk. (Although in the latter case the children, rather than the surviving spouse, will end up with the property.)
Predicting which spouse may die first is an unseemly proposition, yet the life expectancy of men is statistically shorter than women. As a general rule it may make sense to title lower basis assets (which would benefit most from a basis step up) in the name of the husband. The basis of assets may also be stepped down at death if the asset has declined in value. Avoiding a step down in basis can best be achieved by selling the asset before death. Familiar nonrecognition transactions, which taxpayers take for granted, such as 1031 exchanges, or 121 exclusions, are gem-like tax provisions that can save vast amounts of capital gains tax when highly appreciated residences or business property is disposed of. If the taxpayer is willing to wait seven years, these twin Code provisions can also be used together, magnifying tax benefits.
For those inclined to retire in sunny locations without income tax, moving to Texas, Arizona, or Florida may preserve retirement capital by eliminating the burden of New York income tax. Again, those making the decision to leave will risk being subject to a residency audit if they return too frequently. Much tax planning over the past fifteen years has focused on reducing the size of one’s estate for estate tax purposes. Ironically, some of that planning may turn out to have been counterproductive, since it may be preferable to have property previously transferred out of the estate brought back into the gross estate to benefit from the basis step up at death. Various strategies can be employed to attempt to reverse tax planning that has now become a liability.
The taxpayer whose earlier estate-planning entities are now a liability may attempt to liquidate the entity or undo discounts that no longer provide any tax benefit. This may be achieved by amending or restating the operating or partnership agreement. Alternatively, the taxpayer may utilize a “swap” power in a grantor trust to substitute a higher basis asset — perhaps even cash — for a lower basis asset, in order to take title to low basis property that can most benefit from a basis step up at death. It is not clear to this writer whether the “swap” power which so many have espoused for so long, actually works. See, Tax News & Comment, February 2014, “Rev. Rul. 85-13: Is There a Limit to Disregarding Disregarded Entities.” If the taxpayer is willing to take the risk and it does work, great.
The taxpayer may be tempted to argue that poorly maintained vehicles previously established with the intention of transfer assets — and the appreciation thereon — out of the grantor or donor’’s estate should be pulled back into the estate by virtue of IRC §2036. However, the IRS — quite understandably — does not like to be “whipsawed,” and one would expect the IRS to fiercely challenge such strategies. In essence, it is possible that the arguments previously made by the IRS may not be made by the taxpayer. The taxpayer might attempt to make these arguments due to the attenuation of the estate tax and the invigoration of the income tax. In the end, the difference between capital gains rates and estate tax rates, which only recently were significant, have now narrowed to the extent that complicated analyses may be required to determine whether or not to rely on portability or whether to use a credit shelter trust. Even such analyses are subject to the vagaries of the market and the economy, but may be probative of the best course of action. When presented with a clean slate, and everything else being equal, most agree that portability and the second basis step up it carries with it, is the best estate planning option in most cases.
To reduce the value of assets in the decedent’s estate that will be entitled to a basis step up, but whose inclusion in the estate would no longer produce estate tax revenue, the IRS may now accept questionable valuation discounts claimed by the taxpayer that the Service might previously have challenged for a multitude of reasons. One reason might have been that the basis for the discount was not adequately disclosed. The doctrine of substance over form, first enunciated by the Supreme Court in 1935 in Gregory v. Helvering, 293 U.S. 465, provides that for federal tax purposes, a taxpayer is bound by the economic substance of a transaction where the economic substance differs from its legal form. However, the taxpayer, once having chosen a form, may not later assert that the form chosen should be ignored.
In seeking to ignore a questionable valuation which would now benefit the government, the IRS might argue that the taxpayer, having chosen the form, must be bound by that form, and that the IRS may accept even a valuation that appears questionable, since it was reported by the taxpayer. However, this would seem to be a distorted view of the doctrine of substance over form. In practice, the IRS might achieve its goal anyway since there appears to be no way that the taxpayer could effectively argue that earlier valuation was incorrect, without inviting other, more serious problems. Moreover, the taxpayer would be placed in the peculiar and unenviable position of essentially requesting that the IRS to audit a previous gift tax return.
Proving basis at death is not generally necessary due to the basis step up occasioned upon death by virtue of IRC §1014, but at times the determination of historical basis may be necessary when capital gains must be calculated with respect to property held for many years. While an old saw provides that if the taxpayer cannot prove basis, basis is zero, this is simply not true. Just as the courts have consistently held that difficulty in valuing property or services will not prevent the calculation of realized gain, the taxpayer may establish basis by the best available means. It is true that the taxpayer may have the initial burden of proof when establishing basis, but under IRC §7491 that burden can change “if the taxpayer comes forward with credible evidence with respect to any factual issue relevant to ascertaining the liability of the taxpayer.”
Portability is now a permanent fixture on the estate tax landscape, and levels the playing field for taxpayers who have been lax in their estate planning. As Howard Zaritsky noted at the University of Miami conference in Orlando, portability is the default means of ensuring best use of the large federal estate exemption. In advising a client to implement estate plans not utilizing portability, Mr. Zaritsky aptly observed that the advisor should be sure that what he or she is counsels, if portability is foregone, will not be worse. Of course in New York some additional estate tax planning is necessary to utilize the increasing New York estate exemption, since New York — like almost all other states — has not adopted the concept portability.
New York has also prevented an obvious end-run around its own estate tax by residents making large gifts before death. Now, gifts made within three years of death will be included in the taxable estate of New Yorkers for state estate tax purposes, and will attract estate tax at rates of between 10 and 16 percent. The “cliff” rule will penalize those estates which dare to exceed the New York exemption amount by between 0 and 5 percent. In fact, once the estate exemption amount is exceeded by 5 percent, New York will grant the estate no exemption; the entire taxable estate will be subject to estate tax.
The use of QTIP trusts in devising property to surviving spouses will continue to ensure a basis step up while accomplishing portability of the federal exemption. QTIP trusts and portability elections are now the magic elixir of most moderate to high net worth individuals who seek to implement an effective estate plan. Portability, still new, does have some issues which need to be resolved by Congress. For example, basing the unused exclusion amount on the last-to-die spouse may produce inequitable results. Some have called upon Treasury to fix this problem. In the interim, especially in second marriage situations, a provision in a prenuptial agreement regarding portability may be a good idea. This will protect the heirs of both spouses against uncertainties in the portability statute.
Asset protection using trusts established in Nevada, Delaware, North Dakota or Alaska have proved to be only marginally superior to asset protection trusts created in, for example, the Cayman Islands. Those trusts have generally been ineffective when challenged in state court. However, implementing trusts in those tax-friendly jurisdictions may be quite effective in saving tax.
New York has implemented new rules which seek to restrict tax benefits to New Yorkers who implement trusts in these jurisdictions. There may still be some benefit to be availed of by a New York grantor who establishes such a trust for beneficiaries who do not reside in New York.
In planning for a possible IRS audit, taxpayers should keep in mind that email exchanges to non-attorneys are not privileged, and the privilege extending to exchanges with attorneys may be lost if other persons are copied. Memoranda of law espousing a particular tax-saving strategy may become discoverable in litigation, and even if marked “confidential,” may find its way into the hands of the IRS. It is best not to explicitly detail the merits of a particular tax-saving strategy even in confidential memoranda.
When implementing a tax planning strategy, courts have been particularly impressed with arguments made by taxpayers which emphasize non-tax motivations for a tax-saving transaction. Where valuations are required for returns, taxpayers should be aware that drafts of appraisals can be used against the taxpayer. The IRS has immense information-gathering power and the taxpayer should assume that at audit the IRS will possess more information than the taxpayer might otherwise assume.
Fiduciaries determining trust distributions may now be required to be more mindful of IRS scrutiny. The trust may provide for a discretionary distribution standard based upon the “health, education, maintenance and support (“HEMS”) of the beneficiary.” The trustee may be inclined to make larger distributions to lower-bracket beneficiaries to reduce the incidence of taxation to the trust which is in a higher tax bracket. However, in the event of a large distribution to a beneficiary which appears unjustified, the IRS may argue that the distribution violated the HEMS standard, and that the trust should pay tax at higher rates on amounts distributed in excess of what is required to satisfy the HEMS standard.
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