Significant recent developments in estate planning: this article examines developments in estate and gift tax planning and compliance. It discusses legislative developments, recent cases and rulings, and administrative and procedural changes.

• Author: Ransome, Justin P.

EXECUTIVE SUMMARY

* Both the Pension Protection Act of 2006 and the Tax Relief and Health Care Act of 2006 included changes significant for estate planners.

* In Rosen, the Tax Court analyzed the factors needed to evidence a true debtor-creditor relationship between an FLP and a decedent.

* The Service proposed regulations providing guidance under Sec. 2053 on the extent to which post-death events may be considered in determining a taxable estate's value.

* By agreeing to review the Second Circuit's decision in Rudkin, the Supreme Court will resolve the issue of whether investment advisory fees paid to outside advisers are fully deductible by a trust.

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This article examines developments in estate and gift tax planning and compliance. It discusses legislative developments, recent cases and rulings, and administrative and procedural changes.

This article examines developments in estate and gift tax planning and compliance between June 2006 and May 2007. It discusses legislative developments, cases and rulings, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) changes taking place in 2007, and the annual inflation adjustments for 2007 relevant to estate and gift tax.

Legislative Developments

Major tax legislation signed by President Bush includes the Pension Protection Act of 2006 (PPA '06) and the Tax Relief and Health Care Act of 2006 (TRAHCA '06). The major changes in these acts that are of significance to estate planners are as follows:

UBTI and Charitable Remainder Trusts

In general, a charitable remainder trust (CRT) that meets the requirements set forth in Sec. 664 is a tax-exempt entity. This exempt stares, however, is lost in any year in which a CRT has unrelated business taxable income (UBTI). If a CRT has UBTI, the CRT is treated as a complex trust (described in Sec. 661) and is taxed on its net income for the year. TRAHCA amends Sec. 664 to provide that a CRT does not lose its tax-exempt status in a year in which it has UBTI. Instead, a CRT must pay a 100% excise tax on any UBTI it may have in a given year.

For many years, practitioners advocated for a change in the law that caused a CRT to lose its exempt status due to its having UBTI, because of the potential double tax on the CRT's income for a particular year in which such status was lost. The amendment accomplishes this purpose with regard to income that is not UBTI. However, the amendment continues to impose a double tax on UBTI, as the excise tax paid by a CRT on its UBTI is allocated to corpus. The amendment is effective for tax years beginning after December 31, 2006. (For more on this issue, see Tax Clinic, p. 500.)

Employer-Owned Life Insurance

Life insurance proceeds are generally excluded from a recipient's gross income. PPA '06 added Sec. 101(j), which provides that in the case of employer-owned life insurance contracts on the life of certain employees, (1) the amount excluded from the applicable policyholder's income as a death benefit cannot exceed the premiums and other amounts paid by the employer for the contract. The excess death benefit is included in income.

The provision, however, allows numerous exceptions. When new notice and consent requirements (discussed below) are met, the income-inclusion rule does not apply if the insured was an employee during the 12-month period before the insured's death or, at the time the contract was issued, was a "highly compensated employee" or a "highly compensated individual." (2) In addition, the rules do not apply if the death benefits are paid to the insured's family, any individual designated by the insured (or to trusts for the benefit of either), or the insured's estate, or if the proceeds are used to purchase an equity interest in the company that owns the policy. The last exception should cover most buy-sell agreements.

The notice (by the employer) and consent (by the employee) requirements (3) provide that before the issuance of the contract, the employee must be notified, in writing, that the employer intends to insure the employee's life, the maximum face amount of the policy for which the employee could be insured, and that the employer will be the beneficiary of the policy. The employee must provide written consent to being insured and must agree that the employer may continue coverage even Her the insured terminates employment.

Sec. 101(j) applies to contracts issued after August 17, 2006 (except for certain tax-free Sec. 1035 exchanges) and to preexisting policies with significant increases in death benefits after that date (this may commonly occur in buy-sell situations).The provision also adds new reporting requirements on the employer for contracts issued after that date (see Sec. 6039I(a)).

Valuation Penalties

PPA '06 decreases the thresholds at which substantial or gross valuation misstatements occur. For returns filed after August 17, 2006, substantial valuation misstatement will apply if the value of any property claimed on the estate or gift tax return is 65% or less of the amount determined to be correct (up from 50% under prior law). Gross valuation misstatement will occur if the value of any property claimed on the estate or gift tax return is 40% or less of the amount determined to be correct (up from 25% under prior law).

Significant Cases and Rulings

FLPs

The IRS has successfully argued for including assets transferred to family limited partnerships (FLPs) in a transferor's gross estate under Sec. 2036(a)(1). Successful cases invariably have involved transferors (usually terminally ill or in poor health) who transferred almost all of their assets to an FLP, but still continued to enjoy access to the transferred property (or its income). One factor that the courts have found as indicative of continued access to the transferred assets is the transferor's retention of insufficient assets to meet his or her living expenses Her the transfer, coupled with substantial disbursements from the FLP to the transferor. What if the disbursements were classified as loans and evidenced by a written note? The Tax Court analyzed the factors required to evidence a true debtor-creditor relationship in Rosen. (4)

Rosen: Rosen had all the typical facts of a successful Sec. 2036(a) case: an elderly decedent (age 88) suffering from a terminal illness (Alzheimer's) at the time of the FLP's formation; virtually all of the decedent's assets transferred to the FLP; insufficient funds (less than 5% of total assets) retained by the transferor; and FLP disbursements to the transferor to pay for living expenses. However, the disbursements during the decedent's lifetime were classified as loam and evidenced by a single note--unsecured, payable on demand, with interest accruing at the federal blended rate. On the decedent's death (four years after the FLP's formation), the IRS sought to include the entire value of the FLP's assets in the decedent's estate. The estate argued: (1) that the transfer met the bona-fide-sale exception, citing several nontax reasons (management of assets, creditor protection, ease of gifting); and, alternatively, (2) that even if the bona-fide-sale exception was not met, the decedent did not continue to "enjoy" the assets post-transfer, as any disbursements she received were the result not of distributions from the FLP but of loans--i.e., the clear obligation to pay back the amounts precluded a finding that she enjoyed the funds.

The court stated that, while a written note weighs toward a true debtor-creditor relationship, it was not sufficient to create a true debtor-creditor relationship. The other factors the court cited in determining if there was no genuine debt included: (1) the absence of a fixed maturity date and a fixed obligation to repay; (2) no reasonable (or market) interest rate; (3) repayments that depend solely on the FLP's success; (4) absence of security; and (5) the inability to obtain comparable financing from an independent source.

Some factors used by the court to justify its conclusion that the bona-fide-sale exception did not apply are not only inconsistent with existing law, but also unnecessary to reach the intended result--that there was no bona-fide sale.

Kimbell: In Kimbell, (5) the Fifth Circuit rejected concepts such as "mere recycling," "lack of legitimate negotiations," "pooling of assets," and "legitimate and significant business or nontax reasons" as essential to the bona-fide-sale exception inquiry because these tests placed undue emphasis on the taxpayer's subjective motives. Instead, the court...