Recent developments in estate planning.

• Author: Ransome, Justin
• Position: Part 1

PREVIEW

* There were many developments of interest in the area of estate, gift, and trust taxation in the past year.

* Decisions by courts in several cases provide insights regarding the correct valuation of assets for estate or gift tax purposes.

* See how the "so remote as to be negligible" standard was applied to deny an estate a charitable deduction.

This is the first part of a two-part article examining developments in estate, gift, and trust income tax between June 2014 and May 2015. Part 1 discusses gift and estate tax developments. Part 2, which will be published in the October issue, covers trust taxation, President Barack Obamas estate and gift tax proposals, inflation adjustments for 2015, and the final regulations on the portability of a deceased spouse's unused exclusion amount.

Gift Tax

Annual Exclusion

In Mikel, (1) the Tax Court concluded that taxpayers were entitled to annual exclusions under Sec. 2503(b) for gifts made to a trust, despite the IRS's argument that the withdrawal powers were illusory and did not confer present interests in the property because the trust's in terrorem clause could deter beneficiaries from exercising their legal rights.

The taxpayers transferred real property to an irrevocable trust, the beneficiaries of which were the couple's children, lineal descendants, and their spouses. The trust made discretionary distributions for the beneficiaries' health, maintenance, education, and support. At the time of the gift, the trust had 60 beneficiaries, many of whom were under 18. The beneficiaries had a right to withdraw immediately some or all of a transfer to the trust within 30 days of the transfer, which was designed so that the transfers qualified for the Sec. 2503(b) annual gift tax exclusion. The trust also contained an in terrorem clause that excluded any beneficiary who filed a claim challenging the trustee's absolute discretion.

On their federal gift tax returns, the taxpayers claimed annual exclusions for the trust's 60 beneficiaries, each of whom possessed withdrawal rights, for total exclusions of $720,000 by each spouse. The IRS argued that the Mikels were not entitled to the annual exclusions because the beneficiaries did not receive a present interest (as required by Sec. 2503(b)). The IRS claimed that they did not receive a present interest because their withdrawal rights for the transfers were not "legally enforceable in practical terms" due to the in terrorem clause, and thus were not "unrestricted."

The Tax Court clarified that, under the rule in Crummey, (2) "all that is necessary is to find that the demand could not be resisted." (3) Thus, the analysis is not whether the beneficiaries are likely to actually receive present enjoyment of the property but whether they have a legal right to demand payment from the trustee.

While the IRS has acquiesced to the position taken in Crummey, it has stated it would continue to disallow annual exclusions where there is no bona fide gift of a present interest in property, such as when there is a prearranged understanding not to withdraw, or when the exercise of withdrawal rights would result in adverse consequences to the beneficiaries. Consistent with this position, the IRS argued that the withdrawal rights were illusory because any attempt to enforce the right legally would result in adverse consequences under the in terrorem clause.

The Tax Court disagreed. Instead, the court viewed the in terrorem clause as consistent with the trust's overall intent--to provide absolute discretion for the trustee to make distributions. First, the court noted that the in terrorem clause prevents suits "challenging a distribution" and that a suit to compel the trustee to honor a timely withdrawal would not be covered by that language. Second, the provision was intended to ensure that no beneficiary challenges discretionary distributions made to other beneficiaries and that the right to withdraw is not a discretionary distribution. Accordingly, the court held that the beneficiaries' withdrawal rights could not be legally resisted and were both literally and practically available such that a present interest in the property was created and the annual exclusions were proper.

Observation: Withdrawal powers have become common fixtures in modern estate planning, with relatively little IRS interference. However, as this case makes clear, the IRS will still challenge annual exclusions if it believes that there has been no bona fide gift of a present interest because the withdrawal right is illusory. Thus, when drafting and administering a trust with withdrawal provisions, it is imperative to ensure that the rights are in substance what they purport to be in form.

Sec. 2701

In Chief Counsel Advice 201442053, the IRS ruled that the recapitalization of a limited liability company (LLC) was a transfer from a donor to her two sons under Sec. 2701, constituting a gift for gift tax purposes.

The donor and her two sons formed an LLC, the sole asset of which was real property the donor contributed. Under the terms of the operating agreement, each member's capital account was credited with the amount of that member's capital contribution, with profits and losses allocated based on that member's pro rata interest. Soon after formation, the donor gifted LLC membership interests to her sons and grandchildren. Later, the LLC was recapitalized. In exchange for the two sons' agreement to manage the company, the operating agreement was amended to provide that all future profits and losses, including gains attributable to company assets, would be allocated between them equally. After the recapitalization, the donor's and the grandchildren's equity interests were based solely on their capital account balances as they existed immediately before the transaction. As a result, all future income and appreciation in the LLC inured solely to the two sons' benefit, instead of pro rata based on percentage of ownership.

Sec. 2701 provides special valuation rules to determine the amount of a gift when an individual transfers an equity interest in a family-controlled corporation or partnership to another family member, even if the transfer is for full and adequate consideration. This section applies to a recapitalization of a corporation or partnership if the transferor holding an "applicable retained interest" before the redemption surrenders an equity interest that is junior to the retained interest and receives property other than the retained interest. An "applicable retained interest" includes any equity interest in a controlled entity for which there is a distribution right.

The IRS noted that the LLC was family controlled and that the donor held an applicable retained interest (i.e., a distribution right) both before and after the recapitalization. Further, the IRS stated that the donor's interest, which was based on her existing capital account balance, was senior to the transferred interests, which carried only a right to distributions based on future profit and gain. In addition, the donor received property in the form of the agreement by the sons to manage the company. Consequently, the redemption fell under Sec. 2701 and, as such, the amount of the transferor's gift, if any, was determined using the subtraction method contained in Regs. Sec. 25.2701-3. (4)

The regulations under Sec. 2701 use a very broad definition of "recapitalization." Merely changing the rights in an operating agreement will trigger application of the section.

Scrivener's Error

In Letter Ruling 201442042, the IRS ruled that it would allow a trust modified to correct a scrivener's error to have retroactive effect for federal tax purposes when the trust provision being modified was contrary to the settlor's original intentions. Specifically, the IRS was asked to rule that the modification would not cause the settlor to make an additional gift, would not result in the trust's assets being included in the settlor's estate, and would not cause any current or future beneficiary to make a gift to any other beneficiary.

The settlor created two grantor retained annuity trusts (GRATs) with different terms and remainders that passed to a trust created for his four children (Children's Trust).The drafting attorney mistakenly drafted the Children's Trust as a revocable trust, which defeated the purpose of creating the GRATs. In the following year, the settlor's accountant who prepared the G RAT's gift tax returns noticed the Children's Trust was revocable and told the settlor that the mistake would cause the gifts to the GRATs to be incomplete, the GRATs' remainder interests to be includible in the settlor's estate, and any distributions from the Children's Trust to the children to be taxable gifts.

When the settlor's accountant contacted the drafting attorney, he insisted the Children's Trust was properly executed and noted that the accountant lacked the necessary expertise to determine otherwise. The accountant memorialized his communications with the attorney and filed the settlor's gift tax returns showing completed gifts. Years later, the settor's company hired a financial planner, who also noticed the mistake and contacted the drafting attorney who again insisted it was properly drafted. The financial planner engaged another attorney to provide an opinion, and that attorney confirmed the mistake and reformed the Children's Trust under state law.

The local court approved the modification to correct the mistake, conditioned upon the IRS's issuance of a favorable ruling that it would respect the court's retroactive reformation of the Children's Trust for federal gift and estate tax purposes.

In the letter ruling, the IRS cited Bosch, (5) stating that a lower state court decision was not binding on the IRS. Instead, the Service must apply what it finds to be state law (looking to decisions of the highest state court) after giving proper regard to the state trial court's...