Recent developments in estate planning.

• Author: Ransome, Justin P.
• Position: Part 1

This two-part article examines 1 developments in estate planning and compliance between June 2011 and May 2012. Part I discusses developments regarding gift tax and trusts, an outlook on estate tax reform, and annual inflation adjustments for 2012 relevant to estate, gift, and generation-skipping transfer (GST) tax. Part II, in the October issue, will cover developments in estate tax.

Estate Tax Reform

On Dec. 17, 2010, the president signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act. (1) With regard to gift, estate, and GST taxes, the act reunifies the gift and estate tax; increases the gift, estate, and GST tax exemption amount to $5 million (indexed for inflation); provides for a top gift, estate, and GST tax rate of 35%; allows portability between spouses of their estate tax exemption amounts; and preserves the taxpayer-favorable GST tax rules contained in the Economic Growth and Tax Relief Reconciliation Act of 2001. (2) Without action by Congress this year, these provisions will expire on Dec. 31, 2012, and the gift, estate, and GST tax regimes in existence in 2000 will return. The exhibit on p. 601 illustrates those changes.

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A number of bills have been introduced in Congress regarding estate tax reform, but there has been no action yet on any of them. While there will be efforts to address the estate tax reform before the current gift, estate, and CST tax provisions expire, there are no guarantees. Given this legislative uncertainty, taxpayers should be planning to take advantage of the favorable rules now.

Gift Tax

Annual Exclusion for Transfers to Trusts

Under Sec. 2503(b), a donor may exclude the first $13,000 of gifts made to each donee during a calendar year in determining the total amount of gifts for that calendar year (the gift tax annual exclusion). For a transfer to qualify for the gift tax annual exclusion, Sec. 2503(b) requires that the transfer be the gift of a present interest. Under Regs. Sec. 25.2503-3(b), a gift of a present interest requires that the donee have an unrestricted right to the immediate use, possession, or enjoyment of property, or the income from, the property.

Exhibit: Estate, gift, and GST tax rates and exemptions Estate tax Gift tax Exemption Top rate Exemption Top rate 2012 $5,120,000 35% $5,120,000 35% (portable) 2013 $1,000,000 35% $1,000,000 35% (portable) Generation-skipping transfer tax Exemption Top rate 2012 $5,120,000 35% 2013 $1,000,000 35% In general, most transfers to trusts fail to qualify as the gift of a present interest because the donee does not have an unrestricted right to the immediate use, possession, or enjoyment of property, or the income from the property. In order to have transfers to a trust qualify as the gift of a present interest and, thus, be eligible for the gift tax annual exclusion, the trust's governing instrument generally contains a provision giving certain persons "withdrawal rights" with respect to transfers to the trust. This withdrawal right is drafted with the attributes acknowledged by the Ninth Circuit in Crummey, (3) as meeting the requirements of the gift of a present interest.

Although Crummey did not explicitly so hold, the IRS's position is that the present interest requirement is not satisfied unless a beneficiary has actual notice of the withdrawal right and a reasonable time within which to exercise the right prior to its lapse. In Rev. Rul. 81-7, (4) the IRS ruled that if a beneficiary is not informed of the right to withdraw transfers to the trust, the beneficiary's right to the immediate possession and enjoyment of the property is postponed, and he or she effectively receives a future interest at the time the gift is made. Given the IRS's notice requirement, most trusts to which transfers are intended to qualify for the gift tax annual exclusion contain a provision in their trust instruments requiring that beneficiaries with a Crummey power be given notice of the right to exercise this power by the trustees of the trust.

In a recent case, (5) the Tax Court ruled that such notice is not required. In Turner, the decedent, during his life, created a trust to own life insurance policies on his life for the benefit of his children and grandchildren. The trust instrument provided that after a direct or indirect transfer to the trust, the beneficiaries of the trust had the right to withdraw the lesser of: (1) the gift annual exclusion amount; or (2) the amount of the direct or indirect transfer divided by the number of beneficiaries. The facts do not indicate whether the trustees were required to give notice of the withdrawal power to the beneficiaries who possessed the power. For the years in question (the three years prior to the decedent's death), the decedent made premium payments directly to the insurance companies on life insurance policies owned by the trust. The trust instrument provided that upon notice of a beneficiary's exercise of his or her withdrawal power, the trustees were authorized to distribute cash or other trust property or to borrow against the cash value of any life insurance policies to obtain cash to distribute to the requesting beneficiary.

The IRS included the life insurance policy premiums in the decedent's adjusted taxable gifts because it concluded that the payments did not qualify for the gift tax annual exclusion. The IRS argued that the withdrawal rights were illusory for two reasons: (1) the decedent did not deposit money with the trustees of the trust but, instead, paid the life insurance premiums directly and (2) the beneficiaries did not receive notice of the transfers.

The Tax Court summarily dismissed both of the IRS's arguments. The court stated that the fact that the decedent did not transfer money directly to the trust was "irrelevant." It further stated that the fact that some or all of the beneficiaries of the trust may not have known they had the power to withdraw sums from the trust did not affect their legal right to do so. In support of its conclusion on the notice requirement, the court cited Crummey and Estate of Christofani. (6)

On the first issue regarding transfers to the insurance companies, it seems logical that the gift tax annual exclusion should be allowed for indirect gifts to a trust as long as the trust has sufficient assets to satisfy the withdrawal powers of beneficiaries that arise when a particular transfer has been made to a trust. The Tax Court's more surprising conclusion is that notice of the withdrawal power is not required to be given to a beneficiary possessing such power. Further, the court's conclusion is supported by little analysis--just one sentence and cites of two cases that did not directly address the issue. Given the court's lack of reasoning, it is difficult to determine whether taxpayers can rely on the case. The IRS is still likely to enforce the notice requirement, and the safe course of action is to continue to advise clients to give notice if a gift tax annual exclusion is being claimed for a transfer to a trust. However, if the notice requirement is not satisfied for a particular transfer to a trust, the taxpayer now has an argument that notice is not required.

Formula Clauses to Limit Gift Tax Consequences

Taxpayers use formula clauses to avoid unintended gift, estate, and GST tax consequences when transferring property. There are two general types of formula clauses: (1) a definition formula clause (or defined value clause), which defines a transfer by reference to the value of a possibly larger, identified property interest and (2) an adjustment formula clause, which retroactively adjusts the value of a transfer to reflect a later valuation determination. The IRS has succeeded in having adjustment clauses disregarded as against public policy because they prevent the IRS from properly administering the Code. As the following cases will highlight, the IRS has not been successful using this same argument with definition clauses.

The definition clause is a relatively new clause being used in estate planning. These types of formula clauses generally fall into two categories: (1) a defined transfer clause, which defines the amount of the transfer with any excess property resulting from a different valuation than the original valuation used to make the transfer returning to the donor; and (2) a defined allocation clause, which defines the amount of the transfer with any excess property resulting from a different valuation than the original valuation used to make the transfer being reallocated among the transferees. The courts that have...