Significant recent developments in estate planning.

• Author: Nager, Ross W.
• 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 the November and December issues, concern estate planning developments from Apr. 1, 1993 to Mar. 31, 1994. 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: gifts, disclaimers, debts, claims and administration expenses, powers of appointment, retained interests and charitable deductions.

In general, no developments occurring after Mar. 31, 1994 are included within this review, except when a case or ruling has been issued affecting a development included in the text of this article.

Gifts

Recent developments involving gifts included the following.

* The exercise of a limited power of appointment creating a new trust was not a taxable gift.

* The exercise of a limited power of appointment in favor of family members resulted in a taxable gift.

* When considered together, the issuance of an employment agreement and voting stock constituted a gift.

* Funds transferred after death from a brokerage account were not completed gifts.

* Transfers made under a durable power of attorney were incomplete gifts.

* Exercise of power of appointment creating new trust not a gift

In Letter Ruling 9352005,(1) a trust was created in the taxpayer's spouse's will. Under its terms, the trustee could accumulate or pay income to the taxpayer and/or her son. Principal could not be distributed. Two individuals were named as trustees and a bank was designated the successor trustee. The son received a limited power of appointment over corpus that could be exercised among a class of individuals, including the taxpayer.

The son proposed to exercise his limited power in favor of the taxpayer, subject to an agreement under which the taxpayer would immediately retransfer the principal to a new, identical trust in which the taxpayer and son were co-trustees and there was no limited power of appointment. These transactions were designed solely to avoid the old trust's corporate trustee expenses. The IRS ruled that neither a sale nor a gift resulted from the proposed transaction, and that the taxpayer would not be deemed to possess an includible power over the trust within the meaning of Secs. 2036, 2038, 2041 and 2043.

Critique: Citing the Seventh Circuit's decision in Silverstein,(2) the IRS stated that no sale had occurred within the meaning of Sec. 1001, because the effect of the transaction was to leave the taxpayer in the same economic condition, with the same level of benefits, as she possessed before it. Regarding the gift issue, the IRS similarly concluded that the transaction had an economically neutral impact with respect to all parties, as if the old trust were still in force. Thus, the principal transfer to the new trust was not a gift by the taxpayer, nor was she the trust grantor under Secs. 671 through 677.

A similar result occurred in Letter Ruling 9344016,(3) in which the taxpayer proposed exercising a general power of appointment in favor of one of her daughters, subject to a prior agreement under which the daughter would convey the principal to a new trust with identical terms. The taxpayer was dissatisfied with the manner in which the existing corporate trustee administered the trust, but the existing document did not allow for trustee substitution. The proposed new trust corrected this deficiency.

Planning hints: A limited power of appointment can create flexibility for beneficiaries to change trustees, especially if a replacement power is not otherwise provided. In some cases, it may even allow beneficiaries to recast the trust terms without adverse tax consequences.

* Exercise of limited power treated as general power

In Letter Ruling (TAM) 9419007,(4) a settlor created 11 separate trusts for the benefit of family members. During the first 15 years of each trust, income would be accumulated, followed by five years of income payout to a designated older-generation family member. Thereafter, the trust would benefit a designated grandchild until that grandchild attained age 30, at which time the trust would terminate. Between the expiration of the initial 20-year term and the grandchild's attaining age 30, income would be paid to that grandchild. If a grandchild died before attaining age 30, the accumulated income and principal would be paid to his issue or, if none, to other younger-generation family members.

The trust instrument provided each grandchild a limited power of appointment over his trust that could be exercised in favor of certain family members. The grandchildren were expressly prohibited from exercising the power in favor of themselves, their estates, their creditors or creditors of their estates. After the expiration of the 20-year initial term, but prior to attaining age 30, a grandchild exercised the limited power of appointment in favor of certain family members. The IRS ruled that a taxable gift occurred by reason of the exercise.

Critique: In asserting that no taxable gift had occurred, the taxpayer relied on Self.(5) There, the Court of Claims held that the relinquishment of a power holder's income interest through the exercise of a limited power of appointment did not result in a gift. In reaching its conclusion, the court found support in Walston,(6) in which the Fourth Circuit expressly disagreed with the predecessor to Regs. Sec. 25.2514-1(b)(2). It was this regulation that the IRS relied on in asserting the gift in Self. In Letter Ruling 9419007, the IRS noted that it had previously announced its decision not to follow Self in Rev. Rul. 79-327.(7)

The IRS argued that characterizing the grandchild's relinquishment as a "limited power of appointment" did not change the economic substance of the transaction. The grandchild was the beneficial owner of the income and contingent interests and had gratuitously transferred them.

The IRS drew considerable support from the Supreme Court's decision in Jewett,(8) which principally dealt with a disclaimer's timeliness under pre-Sec. 2518 law. However, the IRS noted that there, the taxpayer asserted that his disclaimer was the equivalent of the exercise of a limited power of appointment, since it could benefit only a limited class of beneficiaries, which excluded the disclaimant, his estate and creditors. The Supreme Court in Jewett disposed of this argument, stating that "a disclaimant's control over property more closely resembles a general power of appointment, the exercise of which is a taxable transfer ... Unlike the holder of a special power ... a disclaimant may decide to retain the interest himself."(9) (Emphasis in original.) In light of the above, the IRS stated that the interests and powers held by the taxpayer in Jewett were identical to those possessed by the taxpayer in Letter Ruling 9419007. As such, the IRS concluded that Jewett effectively eliminated whatever precedential value Self may previously have had.

The IRS clearly dislikes possessors of lifetime limited powers of appointment effecting at any time tax-favored transfers of their interests when the same cannot be achieved through a disclaimer. However, the IRS has sought to "correct this abuse" through the questionable technique of an administrative pronouncement. The authors believe that the IRS's interpretation of the Supreme Court's decision in Jeweet is at best misleading, and at worst disingenuous. In fact, the Supreme Court never opined on the gift tax impact of an exercise of a limited power of appointment. It simply stated that the disclaimer made by Jewett could not be recharacterized as a limited power. The Supreme Court analogized the disclaimer to a general power, because of the taxpayer's ability to wait out the life tenancy and receive a remainder interest. However, this analogy does not mean that the Court would find a clearly expressed limited power of appointment to be the same as a general power whenever the power holder possessed a contingent remainder interest. It is difficult to speculate where the IRS is going in Letter Ruling 9419007. Is it possible that it is setting the groundwork for denying the existence of all limited powers for transfer tax purposes?

Planning hints: The IRS has aggressively "thrown down the gauntlet" on this issue. It is clear that it will not follow Self and will challenge the tax-free status of exercised limited powers of appointment, particularly when the power holder possesses a current income interest and/or a contingent remainder. Estate planners should inform clients of the potential consequences of such exercise. Hopefully, this issue will reach the courts and be ruled on definitively.

* Receipt of voting shares and employment contract a gift

In Letter Ruling (TAM) 9352001,(10) the taxpayer owned the following assets: $1.661 million of stocks and bonds; $906,000 of bank deposits and Treasury bills; 1,829.5 acres of ranch land, plus cattle and equipment with a total value of $643,000; and 500 shares of a shell corporation. In 1990, the taxpayer's daughter, under a power of attorney, recapitalized the corporation, authorizing the issuance of 10,000 shares each of voting and nonvoting common stock. Shortly thereafter, the taxpayer's 500 voting shares were exchanged for 500 nonvoting shares and the balance of his assets were conveyed to the corporation in exchange for the remaining 9,500 nonvoting shares.

A few days later, an employment contract was entered into...