Significant recent developments in estate planning.

• Author: Abbin, Byrle M.
• Position: Part 3

Cases and Rulings on Income Taxation of Trusts and Estates; Debts, Claims and Administration Expenses; Special Use Valuation; and Charitable Giving

Parts I and II of this article, published in October and November, discussed recent court decisions and IRS rulings on gift tax, disclaimers, life insurance, retained interests, powers of appointment, miscellaneous estate tax matters and the marital deduction. This final installment covers the income taxation of trusts and estates; special use valuation; debts, claims and administration expenses; and charitable giving.

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.

Income Taxation of Trusts and Estates

In the area of the income taxation of trusts and estates, developments included the following.

* A trust's investment management fees were subject to the 2% floor on itemized deductions.

* Taxable gain was not triggered by property distributed to satisfy the grantor's annuity right.

* Prearranged funeral arrangements constituted grantor trusts.

* The inability to locate the trust beneficiary did not prevent a simple trust's distribution deduction.

* Estate distributions during administration were not deductible since they were improper under state law.

* A basis step-up was allowed for a decedent's interest in another estate's undistributed property.

* A Crummey-power trust qualified as an S shareholder.

* Grantor trusts were qualified S shareholders even though trustees have a contingent remainder interest.

* Management fees incurred by trust

subject to 2% limitation

In O'Neill,[87] an irrevocable trust was established naming two individuals as cotrustees, neither of whom had experience in investment management. The cotrustees entered into an agreement with an investment consulting firm, which thereafter handled the investment strategy with respect to the $4.5 million corpus. The investment management fees were paid by the trust, but the cotrustees waived any fees for themselves. The fees were deducted in full on the trust's Federal income tax return. The IRS subsequently asserted that the 2% limitation under Sec. 67(a) applied and the Tax Court agreed.

Critique: Sec. 67(a) provides that certain miscellaneous itemized deductions may be deducted for Federal income tax purposes only to the extent that they exceed 2% of adjusted gross income. Sec. 67(e) creates a limited exception for trusts and estates to the extent that costs are paid or incurred in connection with the administration of the entity "which would not have been incurred if the property were not held in such trust or estate. . . ." The taxpayer asserted that the investment advisory fees fell within the Sec. 67(e) exception, since local law imposed on fiduciaries an obligation to prudently invest trust assets. Since neither cotrustee was an experienced investment manager, such local law requirements imposed an obligation to seek professional advice in order to comply.

The Tax Court disagreed. It interpreted Sec. 67(e) as excluding only those costs that are unique to the administration of an estate or trust, such as fees paid to a trustee and trust accounting fees mandated by law or the trust agreement. The court noted that individual investors routinely incur costs for investment advice as an integral part of their investment activities.

Local law provided the fiduciary with a detailed listing of preapproved investments that would obviate the need to incur investment advisory fees. The cotrustees could have avoided the risk of being surcharged for a breach of their fiduciary responsibilities simply by investing trust assets in the statutorily preapproved investments.

The taxpayer alternatively argued that the fees should be fully deductible as quasi-trustee fees. The trustees could have separately engaged an investment adviser to be paid from their own (presumably increased) trustee fee. The court did not accept or reject the proposition that investment advisory charges incorporated within a trustee fee are deductible within the Sec. 67(e) exception. It merely stated that the case should be adjudicated on the actual, rather than hypothetical, facts.

Planning hints: O'Neill represents the first case to address the Sec. 67 deductibility of the cost of rendering investment advice on behalf of a trust. It is not clear what the court would have decided had the cotrustees charged a trustee fee in an amount comparable to the investment advisory fees, and thereafter remitted these amounts to the investment management company. It is conceivable that the court may have ruled against the taxpayer.

It is far more questionable as to what the result would have been had the issue involved normal trustee fees charged by a professional corporate trustee. Professional trustees typically provide a myriad of services, including custodianship, investment advice, tax reporting, general accounting, administration and the like. The cost of these services obviously is included in the overall trustee fee, although virtually no institution divides the fee into its multiple components.

At this time, it would appear that tax preparers may continue to deduct the full amount of professional trustee fees. However, practitioners must wait and see what action the IRS will take in light of its victory in O'Neill.

* No taxable gain realized on distribution

of appreciated assets from grantor trust

In IRS Letter Ruling 9146025,[88] the taxpayer created an irrevocable trust for a term of years. Under the agreement, a specific annuity amount was to be distributed to the taxpayer during the term of the trust. In addition, to the extent that trust income and realized capital gains exceeded the annuity in a given year, such excess amount was required to be distributed in commutation of future payments. The trustee also had authority to distribute a portion of trust corpus in commutation of future payments. On termination of the trust, the remainder passed to the taxpayer's children.

The trust sought to distribute a portion of corpus, made up of appreciated closely held stock, to the taxpayer in complete satisfaction of future payments provided for under the instrument. On such distribution, the trust would terminate. The IRS concluded that no gain or loss would be realized on the proposed distribution.

Critique: For Federal income tax purposes, the annuity established under the trust was a fixed obligation. Typically, the satisfaction of a fixed obligation with appreciated property results in a taxable transaction and the realization of gain.

Sec. 671 provides that a grantor's taxable income shall include those items of income, deduction and credit that are attributable to the portion of the trust deemed owned by him. Set. 677(a)(1) states that a grantor will be treated as the owner of any portion of a trust whose income, without the approval or consent of an adverse party, may be distributed to such grantor. Rev. Rul. 85-13[89] concluded that if a grantor is treated as the owner of the entire trust, the trust assets are considered owned by him for Federal income tax purposes.

In Letter Ruling 9146025, trust income, including realized capital gains, was required to be distributed to the grantor. As such, both the income and corpus of the trust were subject to Sec. 671 and the taxpayer was considered to own the underlying assets. Since the grantor is treated as owning the assets, a partial distribution of those assets in commutation of the annuity obligation did not represent a taxable exchange for Federal income tax purposes. The ruling also noted that the shares received by the taxpayer under the transaction would have a carryover basis as determined under Sec. 1012.[90]

* Prearranged funeral contract results

in grantor trust

In IRS Letter Ruling (TAM) 9140006,[91] a funeral director-established a prearranged funeral plan under which customers contributed cash for future application against funeral expenses. Two options existed under the plan: First, amounts paid were contributed to an independent trustee and held for future use, except that on written notice the customer could cancel the arrangement and receive the corpus and accumulated income; and second, the same arrangement as the first option, except that the trust was noncancelable. Under both options, all trust income was accumulated. All customers' payments were aggregated and administered by the trustee as a single fund. A "consolidated" Form 1041, U.S. Fiduciary Income Tax Return, was filed, which treated each customer's account as a separate complex trust. The IRS ruled that each customer's account represented a separate grantor trust for which a Form 1041 was required to be filed.

Critique: Sec. 673(a) provides that a grantor will be treated as the owner of any portion of a trust in which he has a reversionary interest in either corpus or income, provided that such reversionary interest exceeds 5% of the value of that portion. Sec. 676(a) provides that a grantor will be treated as the owner of any portion of a trust when he has a power to revest that portion in himself, provided that power is exercisable by the grantor, a nonadverse party or both.

Citing Rev. Rul. 87-127,[92] the IRS concluded that the first option under the plan was a grantor trust within the meaning of Sec. 676(a), since the customer's unilateral ability to cancel the arrangement constituted a power to revest corpus and income in himself within the meaning of the statute. The second option resulted in grantor trust status under Sec. 673(a) since the mandatory application of plan assets and accumulated income in satisfaction of the customer's estate's local...