Recent Developments in Estate Planning.

AuthorRansome, Justin
PositionPart 2

This is the second part of a two-part article examining developments in estate, gift, and generation-skipping transfer (GST) tax and fiduciary income tax between June 2016 and May 2017. Part 1, on p. 648 of the September issue, discussed gift and estate tax developments. Part 2 discusses GST tax and trust tax developments, as well as tax reform proposals and inflation adjustments for 2017.

Generation-skipping transfer tax

Substantial compliance

In Letter Ruling 201640013, the IRS concluded that a GST tax exemption allocation election that does not strictly comply with the instructions on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, will still be considered valid if the information on the return shows that the taxpayer intended to make the election.

A couple made gifts to three trusts in year 1 for the benefit of their grandchildren and more remote descendants. The husband made a gift to Trust 1 and Trust 3, while the wife made a gift to Trust 2. The husband wished to allocate GST exemption to the gifts to Trust 1 and wished not to allocate GST exemption to the gifts to Trust 3. The wife wished to allocate GST exemption to the gifts to Trusts 2.

In preparing the gift tax returns for the couple for year 1, the couple's accounting firm prepared the husband's return properly reflecting the gift to Trust 1 on Schedule A, Part 2, of the return (regarding gifts that are direct skips) and the automatic allocation of GST exemption to the gift and the wife's return properly reflecting the gift to Trust 2 and the automatic allocation of GST exemption to the gift. However, the accounting firm incorrectly checked the box on both returns to elect out of the automatic allocation of GST exemption to the trusts. With regard to Trust 3, the accounting firm incorrectly listed the transfer on Schedule A, Part 3 (regarding gifts to a trust that may be subject to the GST tax that are not direct skips), and checked the box on the return to indicate a Sec. 2632(c) election was made. However, it did attach a statement to the return electing out of the automatic allocation rules. The couple requested rulings that (1) they made an allocation of GST exemption to Trust 1 and Trust 2, notwithstanding that boxes on the returns had been checked to elect out of the allocation, and (2) that the husband had substantially complied with the requirements to elect out of the automatic allocation of GST exemption to Trust 3.

Regarding the transfers to Trust 1 and Trust 2, the IRS ruled that they were both properly reported on the couple's respective gift tax returns. It further ruled that the fact that the election-out box was checked for each transfer on the respective returns did not negate the fact that a proper allocation of GST exemption was made.

With regard to the husband's gift to Trust 3, the IRS noted that the transfer should have been listed on Schedule A, Part 2, of the return indicating a direct skip to which GST exemption is automatically allocated, and not on Part 3 of the return. However, it also noted that the husband's return contained a statement electing out of the automatic allocation rules. Thus, it determined that although the husband did not literally comply with the instructions to the gift tax return or the requirements for making an election out of the automatic allocation rules, literal compliance with the procedural instructions to make an election is not always required. Citing Hewlett-Packard Co., (1) the court said, "Elections may be treated as effective where the taxpayer complied with the essential requirements of a regulation (or the instructions to the applicable form) even though the taxpayer failed to comply with certain procedural directions therein."

Comment: The IRS reached the correct result. Generally, when the box is checked for a gift in Schedule A, Part 2, it indicates the taxpayer did not wish the automatic allocation of GST exemption to apply to a direct skip. Such an election requires the taxpayer to remit the GST tax with the return making the election. The facts do not indicate that the couple made such a payment, and the facts reflect that the return was completed as if there were an automatic allocation of GST exemption to the transfers. If a payment is not remitted with the return making such an election, one would assume that the election would be invalid and the automatic allocation rules would otherwise apply to the direct skips. As to the transfer by the husband to Trust 3, Sec. 2642(g) contains a relief provision for substantial compliance regarding allocations of GST exemption. The IRS concluded that the Form 709 contained sufficient information to constitute substantial compliance, even though the ruling does not cite Sec. 2642(g).

Special valuation rules

Proposed regulations under Sec. 2704

Treasury and the IRS issued long-anticipated proposed regulations (2) that provide guidance on how the value of interests in corporations, partnerships, limited liability companies (LLCs), and other business entities should be determined for estate, gift, and GST tax purposes. The proposed regulations focus in particular on the treatment of certain lapsing rights and restrictions on liquidation. They affect certain transferors of interests in these entities and are aimed at preventing artificial undervaluation of these interests in transfers among family members. Although these regulations are among eight sets of final or proposed regulations issued since 2016 that Treasury has earmarked in response to a presidential order as potentially burdensome, (3) casting doubt on whether they will be finalized substantially in their proposed form, tax advisers should nonetheless familiarize themselves with their provisions and potentially serious constraints on some common strategies in estate planning.

For more than 15 years, the IRS has challenged the use of family-formed entities that it viewed as formed purely for tax reasons--specifically, to reduce the gift and/or estate tax consequences associated with transferring interests in these entities to younger generations. A significant estate tax benefit of creating these entities is the valuation discounts associated with the transfers of these interests. Two discounts are generally associated with the transfer of interests in family-held entities: (1) lack of marketability, derived from restrictions on the transfer of interests in the entity, and (2) lack of control (or minority interest), derived from the limited powers associated with not having control of the entity.

In the past, the IRS has often argued that these discounts should be disregarded under Sec. 2704, which disregards certain lapsing rights or restrictions on liquidations contained in operating agreements of closely held entities for estate and gift tax valuation purposes if certain conditions exist at the time of the transfer of the interest. However, the courts have generally disagreed with the IRS's interpretation of Sec. 2704. For example, in Kerr, (4) the Fifth Circuit held that the value of limited partnership interests transferred to the taxpayer's children and to two trusts for the benefit of the taxpayer's children was not affected by Sec. 2704 and could be reduced by lack-of-marketability discounts, due to restrictions contained in the partnership agreement on the ability of the partners to liquidate their interests in the partnership.

Sec. 2704 provides rules for valuing transfers among family members of interests in corporations or partnerships that are subject to (1) lapsing voting or liquidation rights or (2) restrictions on liquidation.

Citing Sec. 2704's legislative history, the preamble to the proposed regulations explains that the section is partly intended to prevent results similar to that in Estate of Harrison, (5) in which the decedent and two of his children held general partnership interests in a partnership immediately before the decedent died. In addition to a general partnership interest, the decedent held all of the limited partner interests in the partnership. The general partnership interests each carried with them the right to liquidate the partnership. A general partner's right to liquidate, however, terminated upon that general partner's death. In determining the estate tax value of the decedent's limited partnership interests, the court determined that the right of liquidation could not be taken into account because it lapsed at the decedent's death. As a result, the court concluded that the value of the limited partner interests for transfer tax purposes was lower than its value either to the decedent immediately before he died or to the other general partners immediately after his death.

Under Sec. 2704(a)(1), a lapse of any voting or liquidation right in a corporation or partnership that is controlled by an individual and members of his or her family both before and after the lapse is treated as a transfer by the individual by gift or a transfer includible in the gross estate of the decedent. The amount of the transfer is calculated as the fair market value (FMV) of all of the interests held by the individual immediately prior to the lapse over the FMV of these interests after the lapse. A liquidation right is defined as the right or ability to compel the entity to acquire all or part of the holder's equity interest in the entity, whether or not this would cause the entity to liquidate. (6) A lapse of a liquidation right occurs when an exercisable liquidation right is restricted or eliminated. (7)

This rule, however, generally does not apply if the rights with respect to the transferred interest are not restricted or eliminated. (8) As a result of this exception, if an interest holder who has the aggregate voting power to compel the entity to acquire the holder's interest makes an inter vivos transfer of a minority interest that results in the loss of the interest holder's ability to compel the entity to...

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