Significant recent developments in estate planning.

• Author: Abbin, Byrle M.
• Position: Part 1

Once again, we have prepared our annual review of significant recent court decisions and IRS rulings. The results, contained in this issue and in the November and December issues, concern estate planning developments during the period Apr. 1, 1991 through Mar. 31, 1992. The summaries of developments will be supplemented by editorial comments (i.e., "Critiques" or "Planning hints") as they occur to us.

As a general note of caution, the estate planner should determine the current status of a reported development, particularly if the IRS has appealed or otherwise indicated that it will not follow a court decision. In such cases, the estate planner should emphasize to clients that the recommended plan, although supported by a court decision, may lead to litigation in which the IRS may prevail.

Part I, below, will discuss the following topics: gift tax, disclaimers, life insurance and retained interests.

In general, no developments occurring after Mar. 31, 1999. are included within this review, except when a court case or ruling has been issued affecting a development included in the text of this article.

Gift Tax

In the area of gift tax, the following developments occurred.

* Transfers in trust constituted completed gifts and were not includible in the grantor's estate despite limited powers retained as trustee.

* A court order was ineffective to rescind a trust termination for Federal gift tax purposes.

* Relinquishment of powers resulted in a completed gift.

* Annual exclusion gifts to intermediaries were deemed a sham.

* Payments to mistresses were gifts, not taxable income.

* State law provision terminating QTIP trust on divorce prevents marital deduction qualification.

* Transfers in trust were completed gifts even though grantor retained limited powers as trustee

In IRS Letter Ruling 9113010,[1] in 1987, the grantor established five irrevocable trusts, one for each of his two children (adults) and three grandchildren {minors). The trust instrument granted each beneficiary the right to withdraw annually any property contributed to the trust, and imposed on the trustee the obligation of giving notice of such contributions. The children's trusts terminated on their attaining age 35, the grandchildren's trusts provided for staggered distributions of principal and accumulated income when the named beneficiary attained the ages 25, 30 and 35. I/a beneficiary died before age 35, trust property would be distributable either pursuant to a testamentary general power of appofntment or, in the absence of such appofntment, to the beneficiary's estate.

The grantor, as trustee, possessed the power to accumulate trust income or distribute income and principal to a beneficiary for purposes of support, maintenance, medical care or education. A disinterested trustee [who could not be the grantor) had the additional power to distribute accumulated income or principal for purposes of beneficiary travel, the purchase of a first home or the acquisition of a business.

The IRS concluded that the gifts in trust were complete and, on the death of the grantor, no portion of such trusts' property was includible in the grantor's estate.

Critique: The IRS noted that the powers of invasion retained by the grantor were expressly limited to purposes of health, education, maintenance and support, ascertainable standards under Regs. Sec. 25.2511-2[c]. The more expansive powers to make distributions for travel, the purchase of a first home or the acquisition of a business, while not falling within the ambit of an ascertainable standard, did not result in an incomplete gift because the grantor expressly was unable to exercise those powers under the terms of the instrument.

The IRS further ruled that no portion of the trust property was includible in the grantor's estate since his retained powers of invasion were limited by an ascertainable standard and, therefore, fell outside the provisions of both Sec. 2036 and Sec. 2038.

Planning hints: The trust instruments in this ruling were well crafted and achieved multiple objectives. First, they allowed for annual gifts to be made to the trust that would qualify for the annual exclusion under the Crummey rule. Second, the primary trustee remained the grantor, but his powers were limited by an ascertainable standard. The imposition of this ascertainable standard allowed the gifts to be complete when made and also excluded the trust property from the grantor's estate at death. Finally, additional flexibility was provided in the instrument/or discretionary distribution of other amounts, provided a disinterested trustee was named and decided to act.

* State court order rescinding trust termination ignored for gift tax purposes

In IRS Letter Ruling (TAM)9127008,[2] in 1976, the grantor transferred shares of corporate stock to a revocable trust. This trust was to continue in existence until Dec. 31, 1983, unless the grantor extended the term by written notification to the trustees. Income was payable to the grantor. On termination, the trust property was distributable among beneficiaries designated by the grantor in the trust document.

In 1983, the grantor properly extended the trust term until Dec. 31, 1986. In January 1987, the trustee informed the grantor that the trust must be terminated in accordance with the terms of the instrument. The grantor attempted to prevent this by orally expressing his intention to further extend the trust term. Nevertheless, on advice of counsel, the trustee terminated the trust and distributed the stock to the named beneficiaries.

The grantor died in January 1988 and, on a review of his estate, the executor concluded that it would be advantageous to include the stock in the Federal estate tax return to achieve a basis stepup. The estate secured a local court order rescinding the termination and restoring the stock to the trust through the date of death.

The IRS ruled that the local court order was ineffective for gift tax purposes and that the trust, in fact, terminated in 1986, at which time a Federal gift tax liability arose. It also concluded that the trust assets were fully includible in the estate under Sees. 2035 and 2038.

Critique: The trust terms clearly stated that termination would occur in the absence of any positive action by the grantor expressed in writing by midnight Dec. 31, 1986. No such written notification was given, so the grantor's power to alter, amend or revoke the trust also terminated. The termination of the grantor's dominion and control resulted in a completed gift at that time.

The IRS noted that circuit courts have consistently held that judicial reformation cannot change the Federal tax consequences of a completed transaction? In light of this judicial authority, the action taken by the local court was deemed not to rescind the termination or eliminate the grantor's obligation to file a gift tax return and pay any gift taxes that might be due.

With respect to the estate tax issue, however, the IRS concluded that the trust property was fully includible in the gross estate of the grantor at its Federal estate tax value. Sec. 2038(a)(1) provides that a decedent's gross estate will include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in the case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, when the full enjoyment of the property was subject at the time of the transferor's death to any power to alter, amend, revoke or terminate, or when such power is relinquished during the three-year period ending on the date of the decedent's death.

As of Dec. 31, 1986, the decedent had the power to amend or extend the trust. According to the IRS, his failure to do so and the resulting termination of the trust were equivalent to a relinquishment within the meaning of Sec. 2038. Since this relinquishment occurred within three years of the decedent's death, the value of the trust was includible in his gross estate under Sec. 2038. The IRS also stated that inclusion would also be mandated under Sec. 2035[d][1].

Planning hints: Letter Ruling 9127008 once again demonstrates the/utility,/or Federal transfer tax purposes, of incurring the cost and aggravation of obtaining a state court order to reverse or perfect a transaction that has closed during a previous period. In this instance, the facts are particularly poor. The grantor/ailed to make the required written notification, the trustee informed the grantor that the trust terminated, and all trust assets were distributed to the named beneficiaries be/ore the grantor's death.

Interestingly, the estate received the desired basis stepup anyway. The IRS's strict interpretation of the Sec. 2038(a)(1) relinquishment language has been costly/or many taxpayers [see the discussion of IRS Letter Ruling 9141005 in the "Retained Interests" section, infra]. In this instance, it was fortuitous.

* Gift completed on relinquishment of certain powers

In Val. [4] in 1981, the grantor transferred shares of a family corporation to a trust. The trustees possessed the unfettered power to accumulate or distribute income for any or all of the trust's beneficiaries. The trustees also possessed an unrestricted sprinkling power among the beneficiaries for both corpus and income. No beneficiary was entitled to a corpus distribution as a matter of right except on the final termination of the trust.

Beneficial interest in the trust was divided into 100 units. Many of these units were given, over a period of time, to various members of the grantor's family. The grantor retained the unfettered ability to remove trustees without cause and to appofnt successor trustees.

In 1984, the grantor's son was named his father's conservator. In that capacity, he obtained a court order amending the trust, under which the grantor relinquished his rights to remove and appofnt trustees and any eligibility...