Significant recent developments in estate planning.

AuthorNager, Ross W.
PositionPart 3

Part I of this article, published in October, covered gifts; disclaimers; debts, claims and administration expenses; powers of appointment; retained interests; and charitable deductions. Part II, published in November, covered valuation, special use valuation and the marital deduction. Part III, below, includes cases and rulings on fiduciary income tax, generation skipping transfer tax, the Chapter 14 special valuation rules and miscellaneous estate tax issues.

Fiduciary Income Taxation

* Joint educational trust was a grantor trust.

* SCINs triggered cancelation of debt income.

* License to publish books did not create IRD.

* Option exercisable on decedent's death will not trigger IRD.

* No gain generated on merger of trusts.

* Basis step-up denied after like-kind exchange of deferred annuity contracts.

* S corporation was a qualified CRUT donor.

* Rulings on QSSTs.

* Joint educational trust deemed owned by grantors under Sec. 676

In Letter Ruling 9333028,(112) pursuant to their 1989 divorce, former spouses (grantors) created an educational trust for their son. Their joint contributions were segregated into two equal subaccounts and separate contributions would be added to the particular grantor's sub-account. Distributions were to be withdrawn equally from each sub-account. On the son's attaining age 35, amounts remaining in the sub-accounts were to be distributed to the respective grantors.

By written instrument signed by both grantors, a grantor could revoke or amend the trust in whole or in part with respect to either subaccount. The IRS ruled that (1) the sub-account's income was taxable to the respective grantor, (2) each undistributed sub-account balance will be includible in the respective grantor's estate and (3) no gift occurs until distributions are made to the son.

Critique: Sec. 676(a) directs that a grantor will be treated as the owner of any portion of a trust over which he, either alone or in conjunction with a nonadverse party, possesses a power to revoke. The IRS found that each grantor held a beneficial interest only in his respective sub-account. Since neither grantor had any beneficial interest in the other's sub-account, they were not adverse parties under Regs. Sec. 1.672(a)-1(a).

Planning hints: Sec. 676(a) could have been avoided if the son had a veto power over the grantors' power to revoke. Clearly, the son possessed an income interest in the trust that would have been adversely affected by the exercise of such power. Obviously, such a provision would have changed the transaction's economics by reducing each grantor's ability to undo the transfer. Notwithstanding Sec. 676(a), the grantors also could be deemed owners under Sec. 673(a) if their reversionary interests, at inception, had values in excess of 5% of the amount transferred. This issue was not addressed by the IRS.

* Note's self-canceling feature causes debt forgiveness income

In Frane,(113) the decedent sold stock in the family business to his four sons. Each son executed a self-canceling installment note (SCIN) requiring the payment of principal and interest over 20 years. The SCINs provided that any balance remaining unpaid at the seller's death would be deemed canceled and extinguished as though paid. As compensation for the self-canceling feature, the SCINs contained a higher-than-market interest rate.

At the time of sale, the decedent's life expectancy exceeded 20 years. However, his death occurred after only two payments had been made. The SCINs were excluded from the decedent's gross estate and no income was reported because of the cancelation. On the corporation's subsequent liquidation, the sons reported as basis the principal actually paid, rather than the SCINs' face amounts. The Eighth Circuit held that the debt forgiveness income to be recognized in the estate's income tax return equalled the unrecognized gain at the time of death.

Critique: Sec. 453B(f) requires income recognition when an installment obligation between family members is canceled or otherwise becomes unenforceable. The taxpayer argued that Sec. 453B is directed exclusively at cancelations extraneous to, and independent of, the note establishing the obligation. In Frane, the self-canceling feature was an integral part of the obligation, for which additional consideration had been paid.

The Eighth Circuit disagreed. It noted no statutory distinction between an independent cancelation act and a cancelation triggered under the obligation's provisions. In each instance, the cancelation relieves the obligor of any further obligations. The court stated that Congress's intent to impose income recognition regardless of the reason for cancelation was amply demonstrated by the legislative history behind Sec. 453B(f).(114) The taxpayer's argument also was undermined by the SCINs' clear language, which described the extinguishment as a cancelation.

Although the Tax Court had required the debt forgiveness income to be reported in the decedent's final income tax return, the Eighth Circuit disagreed. It noted that Sec. 691(a)(5)(A)(iii) unambiguously provides that cancelation of an installment obligation occurring at death is a transfer by the estate of the decedent. Thus, the Eighth Circuit required the gain to be recognized in the estate's income tax return. Finally, the sons' basis was determined by reference to the SCINs' face amount, not the amount of installments actually paid prior to death.

Planning hints: Although a self-canceling feature may eliminate estate tax on the unpaid SCIN balance at death, advisers must consider the source of funds available to the estate to pay the associated income tax. This issue becomes particularly difficult if the residuary heirs differ from the installment note obligors.

* Book royalty agreements do not generate IRD

In Letter Ruling 9326043,(115) the decedent authored various copyrighted literary works, and during his life, entered into agreements with third parties concerning publication. The agreements characterized the transactions as publishing licenses giving rise to royalties, rather than as sales. Although they were community property, the copyrights and agreements were held individually by the decedent or by a revocable trust established by the decedent and his spouse. The IRS ruled that the agreements were licenses, rather than sales. Thus, the royalty interests did not constitute income in respect of a decedent (IRD).

Critique: For estate tax purposes, the copyrights were valued by reference to the discounted present value of the income streams expected to arise under the royalty agreements. At issue were the Federal income tax consequences of the eventual receipt of these royalties. If the agreements were sales, the copyrights' entire value would be IRD. However, if the agreements were true licenses, no IRD would result and the estate would receive a Sec. 1014(a) basis step-up equal to the estate tax value. In the latter event, the estate could depreciate(116) the entire new basis as royalties were received.

Payments received pursuant to a contract granting a third party an exclusive right to exploit a copyrighted work throughout the copyright's life are generally treated as sales proceeds. It is irrelevant that the payments are designated as "royalties" under the contract.(117) However, such agreements are treated as licenses if the copyright holder receives an interest resembling a royalty and retains other rights in the property. In Letter Ruling 9326043, the IRS ruled that the following types of limited licenses avoided IRD treatment:

* An exclusive right to publish a work for the length of the copyright, but limited to the British Commonwealth.

* An exclusive right to publish a work throughout the world, but limited to trade editions in the Spanish language.

* An Exclusive right, for five years, to make a television program based on a specific work.

* Option exercisable at death does not result in IRD

In Letter Ruling 9325029,(118) the taxpayer created an option to sell real estate at a certain price that could not be exercised before the taxpayer's death. The taxpayer also reserved the right to terminate the option and return the consideration received, if she failed to obtain an IRS ruling stating that (1) any sales proceeds from the option's exercise were not IRD and (2) the optioned real estate was entitled to a basis step-up at her death. The IRS ruled favorably on both counts.

Critique: Citing Rev. Rul. 71-265,(119) the IRS stated that the option in question did not give rise to IRD because prior to death, there could be no transfer of the rights and burdens of ownership. The optionee held nothing until the taxpayer's death. Further, on the taxpayer's death, the optionee was under no obligation to exercise the option, and the estate could not force a sale. If the option was exercised, the parties were then required to execute a sales contract and convey title. While the taxpayer's termination right was not a factor in the IRS's favorable determination, it did provide an insurance policy allowing the taxpayer, or her estate, to undo the deal if an adverse ruling was received.

The IRS came to a similar conclusion in Letter Ruling 9319005,(120) which involved a "short-sale-against-the-box" option strategy. The decedent's revocable trust entered into a short sale of publicly traded stock. The short sale was collateralized by cash and the same company's shares already held by the trust (the "long" shares). Citing Rev. Rul. 73-524,(121) the IRS permitted the basis of the long shares to be stepped up and concluded that there would be no IRD.

Planning hints: Subject to transaction costs, these rulings illustrate an excellent way to liquify highly appreciated assets, while delaying capital gains tax (and potentially avoiding it on the short seller's later death).

* Merger of two trusts does not trigger gain

In Letter Ruling 9338020,(122) the decedent created an inter vivos trust for the...

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