Recent developments in estate planning.

• Author: Ransome, Justin
• Position: Part 1

This article is the first of two parts of an annual update on recent developments in trust, estate, and gift taxation. It covers trusts and gift tax issues. The second part, in the November issue, will cover developments in estate and generation-skipping transfer (GST) taxation, as well as inflation adjustments.

Trusts

Treasury and the IRS issued proposed regulations (1) under Sec. 67(g) clarifying that certain deductions allowed to an estate or nongrantor trust are not miscellaneous itemized deductions and, thus, are not affected by the suspension of the deductibility of miscellaneous itemized deductions contained in the law known as the Tax Cuts and Jobs [Act.sup.2] (TCJA). The proposed regulations affect Secs. 67 and 642.

Added to the Code by the TCJA, Sec. 67(g) suspends the deduction of certain miscellaneous itemized deductions for tax years 2018 through 2025. For purposes of Sec. 67, miscellaneous itemized deductions are defined as itemized deductions other than those listed in Secs. 67(b)(1) through (12).

The adjusted gross income (AGI) of an estate or trust generally is computed for Sec. 67 purposes in the same manner as AGI for an individual, although certain additional deductions are allowed. Specifically, Sec. 67(e) allows these items to be factored into determining AGI: Deductions for costs paid or incurred in connection with the administration of the trust or estate if those costs would not have been incurred if the property were held by an individual; Deductions available under:

* Sec. 642(b) (the personal exemption);

* Sec. 651 (income distribution deduction for trusts distributing current income only); and

* Sec. 661 (income distribution deduction for estates and trusts accumulating income or distributing corpus).

Sec. 67(e) effectively removes these deductions from being itemized deductions under Sec. 63(d) and treats them as deductions that may be taken in calculating AGI under Sec. 62(a).

In July 2018, the IRS issued Notice 2018-61 to announce its intention to issue regulations clarifying the effect of Sec. 67(g) on the deductibility of certain expenses described in Secs. 67(b) and (e) that are incurred by estates and non-grantor trusts. The notice stated that the regulations would clarify that expenses described in Sec. 67(e) are deductible in determining the AGI of an estate or nongrantor trust for the tax years in which Sec. 67(g) applies.

Sec. 642(h) allows beneficiaries succeeding to estate or trust property to deduct the carryover or excess if, upon termination, the estate or trust has: (1) a Sec. 172 net operating loss carryover or a Sec. 1212 capital loss carryover; or (2) deductions for its last tax year that exceed gross income for the year. The excess deduction under Sec. 642(h)(2), however, may only be allowed in computing taxable income, must be taken into account in computing the beneficiaries' tax preference items, and may not be used in computing gross income. (3) This means that the existing regulations treat excess deductions on termination of an estate or trust as a single miscellaneous itemized deduction for the beneficiary that may be disallowed under Sec. 67(g).

An excess deduction under Sec. 642(h)(2) may be composed of: (1) deductions allowable in calculating AGI under Secs. 62 and 67(e); (2) itemized deductions under Sec. 63(d) allowable in calculating taxable income; and (3) miscellaneous itemized deductions, which are currendy disallowed under the TCJA.

Regarding Sec. 67, the proposed regulations would amend the language in Regs. Sec. 1.67-4 to clarify that Sec. 67(g) does not prevent an estate or nongrantor trust from claiming deductions for expenses described in Sec. 67(e)(1) or (2), because these deductions are not miscellaneous itemized deductions.

Addressing Sec. 642(h), the proposed regulations provide that each deduction that is part of the Sec. 642(h)(2) excess deduction retains its separate character as: (1) an amount allowed in arriving at AGI; (2) a non-miscellaneous itemized deduction; or (3) a miscellaneous itemized deduction. The character of the deductions does not change when succeeded to by a beneficiary or when the estate or trust terminates. The proposed regulations would also require the fiduciary to separately identify deductions that may be limited when the beneficiary claims those deductions.

The proposed regulations use the principles under Regs. Sec. 1.652(b)-3 to allocate each deduction among the classes of income in the year the estate or trust terminates to determine the character and amount of the excess deductions under Sec. 642(h)(2). Under Regs. Sec. 1.652(b)-3(a), deductions that are directly attributable to one class of income are allocated to that income. The proposed regulations would treat the amount and character of any remaining deductions, after applying Regs. Sec. 1.652(b)-3, as excess deductions available to beneficiaries under Sec. 642(h)(2).

The proposed regulations under Regs. Sec. 1.67-4 simply set forth the correct construction of Sec. 67 as it applies to trusts and estates and, therefore, are nothing new.

The interesting changes set forth in the proposed regulations are in the regulations under Sec. 642(h). Before the release of the proposed regulations, many practitioners believed that excess deductions that might have been deductible by a trust or estate under Sec. 67(e) may be a miscellaneous itemized deduction in the hands of the beneficiary. For example, tax preparation fees that would be deductible by a trust or estate would be a miscellaneous itemized deduction in the hands of a beneficiary and would therefore be nondeductible. The proposed regulations instead divide the excess deductions into three categories: (1) deductions allowable in calculating AGI under Secs. 62 and 67(e); (2) itemized deductions under Sec. 63(d) that are allowed in calculating taxable income; and (3) miscellaneous itemized deductions, which are temporarily disallowed under the TCJA. In the case of tax preparation fees, they would be a category 1 deduction and, therefore, deductible in computing the beneficiary's AGI--a logical approach that is very taxpayer-friendly.

Transfers between grantor trusts

In IRS Letter Ruling 202022002, the IRS ruled that the sale between a trust from which the beneficiary had a general power of appointment and a grantor trust created by that beneficiary is not recognized as a sale for federal income tax purposes because the beneficiary is treated as the owner of both trusts.

Trust 1, a nongrantor trust, was established by the settlor creating sub-trusts for the benefit of the each of the settlor's children and grandchildren. The settlor funded Trust 1 with shares in a company. The trust agreement prohibited a distribution of the shares but allowed for the distribution of the proceeds from the sale of the shares. Trust 1 subsequently transferred the shares to a limited liability company (LLC) treated as a partnership for tax purposes in exchange for interests in the LLC. The same restriction applicable to the shares in the company also applied to the interests in the LLC.

The trust agreement of Trust 1 provides that when a beneficiary reaches the age of 40, the beneficiary has the right to withdraw all of the assets of his or her subtrust except the LLC interests. The beneficiary who was the subject of the ruling request withdrew all of the assets of her subtrust except the LLC interests.

The beneficiary created Trust 2, a grantor trust as to the beneficiary. The beneficiary's subtrust created under Trust 1 agreed to sell the interests in the LLC to Trust 2 in exchange for cash and a promissory note. Trust 1 represented that the beneficiary would have the right to withdraw the cash and promissory note from her separate trust after the sale of the interests in the LLC. Trust 1 requested a ruling confirming that it would not recognize gain on the sale of the interests in the LLC to Trust 2.

The IRS s analysis relied almost exclusively on Rev. Rul. 85-13, which sets forth the IRS's long-standing position that grantor trusts are disregarded entities and, therefore, transactions between a grantor and his or her grantor trust are disregarded for income tax purposes. Applying Rev. Rul. 85-13 to the proposed transaction, the IRS concluded that the sale would not be recognized because the beneficiary would be treated as wholly owning the assets of both trusts. Regarding her subtrust under Trust 1, the beneficiary would be treated as the owner after the transaction under Sec. 678(a)(1) because of her power to withdraw the trust's assets (i.e., the cash and promissory note) received from Trust 2 in exchange for the LLC interest.

In Rev. Rul. 2007-13, following several letter rulings it previously released, the IRS provides that transfers between two grantor trusts created by the same grantor are disregarded under the reasoning of Rev. Rul. 85-13. This is the first letter of which the author is aware where the IRS ruled that Rev. Rul. 85-13 applies to transfers between a grantor trust created by the grantor and a grantor trust created as a result of the application of Sec. 678. The result is a logical application of Rev. Rul. 85-13. Going one step further, it would seem the same nonrecognition principle should apply to transfers between nongrantor trusts with two different grantors (neither of whom is the beneficiary), over which the same beneficiary has a power that would create grantor trust status under Sec. 678.

It is curious that the IRS ruled that the sale between the trusts occurred while the trusts were grantor trusts, as it was the sale that triggered grantor trust status of the beneficiary's separate trust under Sec. 678 as to her subtrust in Trust 1. Before the sale, the subtrust was a nongrantor trust as to the beneficiary, as it held an asset the beneficiary could not withdraw, the LLC interest. It was the sale of the LLC interest by the subtrust that triggered the grantor trust status...