Significant recent developments in estate planning.

• Author: Pye, Nicholas I.
• Position: Part 2

EXECUTIVE SUMMARY

* Final regulations address five basic areas of CRT planning and administration.

* Davis and Eisenberg allowed valuation discounts on closely held stock for built-in capital gains tax liability.

* Congress and the Administration have proposed numerous, significant legislative changes in the estate planning area.

Part I of this two-part article, in the last issue, analyzed current developments in estate, gift and generation-skipping tax planning. Part II examines income tax planning developments, including (1) final regulations on charitable remainder trusts, (2) proposed regulations on the separate share rules for estates and (3) final regulations on foreign trusts. The article then reviews certain important rulings and releases on various valuation issues and concludes with a look at proposed legislation.

Part II of this two-part article focuses on income tax planning developments, including (1) final regulations on charitable remainder trusts (CRTs), (2) proposed regulations on the separate share rules for estates and (3) final regulations on foreign trusts. The article then reviews certain important rulings and releases on various valuation issues and concludes with proposed legislation. The period covered is May 1998-May 1999.

Income Tax Planning

The past period has produced some very favorable income tax developments, especially for wealthy, charitable donors.

Qualified Appreciated Property

First, Section 1004(a)(1) of the Tax and Trade Relief Extension Act of 1998 made permanent the Sec. 170(e)(5) provision allowing a donor to take a fair market value (FMV) charitable deduction for gifts of qualified appreciated stock (generally, publicly traded stock) to a nonoperating private foundation. This change was effective for gifts made after June 30,1998.

Observation: Until the passage of this legislation, the qualified appreciated stock provision under Sec. 170(e)(5) was a constant "extender"; thus, it caused much angst amongst wealthy donors over the creation of nonoperating private foundations and the timing of contributions thereto.

CRTs

Another significant development was the issuance of CRT final regulations under Sec. 664 and the Sec. 2702 special valuation rules. The final regulations,(29) effective Dec. 10, 1998, adopt, with some revisions, proposed regulations(30) issued in 1997. The final regulations address five basic areas of CRT planning and administration, including (1) establishing a "flip charitable remainder unitrust" (Flip CRUT), (2) modifying the timing of year-end annuity payments and unitrust payments for fixed-percentage CRUTs, (3) appraisals of unmarketable assets held by CRTs, (4) modifying the gift tax consequences of transferring unitrust interests in "income exception" CRUTs (e.g., net income makeup CRUTs (NIMCRUTs)) and (5) new rules on the allocation of precontribution gain to principal. Flip CRUTs and the timing of annuity and unitrust payments are discussed below.

Flip CRUTs: A Flip CRUT begins as an income-exception CRUT, but flips to a fixed-percentage CRUT on the occurrence of a "triggering event." In contrast to the proposed regulations (which limited the availability of this planning technique to a fairly small population of taxpayers), the final regulations dramatically expand the availability, of this new type of CRUT to all otherwise-eligible CRUT donors and annuitants.

Under Regs. Sec. 1.664-3(d), a CRUT's governing instrument can now provide for a flip on the occurrence of marriage, divorce, death, birth of a child, date certain, achieving a certain age or sale of an unmarketable asset. However, Regs. Sec. 1.664-3(e), Examples 3, 9 and 10, provide that impermissible triggering events include the sale of marketable assets, a determination by the CRUT recipient's financial adviser that the trust should switch methods or a request from the CRUT recipient that the trust convert to the fixed-percentage method. Each of these triggering events is impermissible because, for regulation purposes, it is deemed to be within a person's control.

Observation: Generally, a triggering event is permissible if the date or event is outside the control of the trustee or any other person. Thus, a triggering event not within a person's control should be permissible, regardless of whether it is specified in the final regulations.

Similar to the proposed regulations, Regs. Sec. 1.664-3(c)(2) provides that the flip to the fixed-percentage method occurs at the beginning of the tax year immediately following the one in which the triggering date or event occurs. Regs. Sec. 1.664-3(c)(3) provides that any make-up amount described in Sec. 664(d) (3)(13) is forfeited when the trust converts to the fixed-percentage method.

Observation: Care should be taken not to inadvertently forfeit the makeup amount. In the year the triggering event occurs, the make-up amount should be paid to the annuitant if possible.

According to Regs. Sec. 1.664-3(c), a CRUT may flip only once; the Flip CRUT allowed by the final regulations is the only type of conversion or flip permissible. Thus, a charitable remainder annuity trust (CRAT) cannot convert to a CRUT; a CRUT using the fixed-percentage method cannot flip to an income-exception method without losing its status as a CRUT. The Flip CRUT rules are effective for CRUTs created after Dec. 9, 1998. A window period is available for an income-only CRUT to convert to a Flip CRUT if the trustee initiates legal proceedings to reform the trust by June 30, 2000.(31)

Observation: Despite the government's trend of "tightening the screws" in the area of CRT planning,(32) the Flip CRUT provisions appear to provide new planning opportunities (especially in light of the flexibility regarding the triggering event that may cause a conversion). In essence, a permissible triggering event includes all dates or events outside the trustee's or any one else's control. In addition, and unlike the proposed regulations, a Flip CRUT can be used even if the trust is funded with marketable assets.

Timing of annuity and unitrust payments: To curb the planning opportunities associated with the use of accelerated CRTs(33) described in Notice 94-78,(34) the proposed amendments to the Sec. 664 regulations provided that the payment of all annuity or unitrust amounts of fixed-percentage CRUTs had to be made by the close of the tax year in which due. Although recent legislative changes(35) have significantly reduced the potential tax benefits of accelerated CRTs, according to the preamble to the final regulations, the Service and Treasury continue to be concerned about the potential abuse of the post-year-end grace period to produce a tax-free return of appreciation in the assets contributed to a CRAT or a fixed-percentage CRUT.

Thus, with certain modifications, the final regulations adopt rules similar to those in Notice 97-68.(36) Effective for tax years ending after April 18, 1997, Regs. Sec. 1.664-3(a)(1)(i)(g) provides that, for CRATs and fixed-percentage CRUTs, the annuity or unitrust amount may be paid within a reasonable time after the close of the year for which due if (1) the character of the annuity or unitrust amount in the recipient's hands is income under Sec. 664(b)(1), (2) or (3); and/or (2) the trust distributes property (other than cash) it owned as of the close of the tax year to pay the annuity or unitrust amount and the trustee elects on Form 5227, Split-Interest Trust Information Return, to treat any income generated by the distribution as occurring on the last day of the tax year for which the amount is due.

In addition, for CRATs and fixed-percentage CRUTs created before Dec. 10, 1998, the annuity or unitrust amount may be paid within a reasonable time after the close of the tax year for which due if the percentage used to calculate the annuity or unitrust amount is 15% or less, according to Regs. Sec. 1.664-2(a)(1)(i)(b) (for CRATs) and -3(a)(1)(i)(h) (for CRUTs).

Observation: Although the final regulations restrict the timing of annuity payments and unitrust payments from fixed-percentage CRUTs, they are significantly more favorable than the proposed regulations, which required trustees of all CRATs and fixed-percentage CRUTs to pay the annuity or unitrust amount by the close of the tax year in which due. The proposed regulations would have caused much administrative grief at year-end, especially if the CRT had a year-end valuation.

In addition, income-exception CRUTs (e.g., NIMCRUTs) are not subject to these year-end roles; by definition, any distributable amount of such a trust is income to the unitrust recipient. Thus, income-exception CRUTs can continue to use the "administrative period" in making the required unitrust payment.

Separate Share Rules

Under the separate share rules, a beneficiary is taxed only on the amount of income belonging to his separate share. Although trusts have been subject to separate share rules for many years, the Service issued proposed regulations in January 1999 on the separate share rules applicable to estates.(37) The rules reflect TRA '97 Section 1307(a), which amended Sec. 663 to extend the separate share rules to estates.

Before this amendment, a distribution to an estate beneficiary in the ordinary course of administration often resulted in his being taxed on a disproportionate share of the estate's income. The preamble to the proposed regulations provides that the extension of the separate share rule to estates promotes fairness by more rationally allocating the income of the estate among the estate and its beneficiaries, thereby reducing the distortion that may occur when a disproportionate distribution of estate assets is made to one or more estate beneficiaries in a year when an estate has distributable net income (DNI). Thus, the proposed regulations provide that substantially separate and independent shares of different beneficiaries are to be treated as separate estates for purposes of computing DNI...