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 December issue, concern estate planning developments from Apr. 1, 1994 to Mar. 31, 1995. The article begins with "Headlines," which represent the year's most important or controversial developments; the discussion of other developments is then organized by topic. The summaries of developments will be supplemented by editorial comments.

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 S corporation issues. In general, no developments occurring after Mar. 31, 1995 are included, unless a case or ruling issued thereafter affected a development covered in this article.

Headlines

The estate and gift tax issues that have attracted the most controversy and attention over the past year include:

* High-payout charitable remainder unitrusts (CRUTs) attacked by the IRS.

* Trust's payment of grantor's income tax on undistributed grantor trust income may constitute a taxable gift.

* Uncertainty created concerning powers of substitution.

* "Swing vote" premium valuation argument launched by the IRS.

* Family partnerships escaped anti-abuse regulations.

* High-payout CRUTs attacked

In July 1994, the IRS issued Notice 94-78,(1) challenging the use of high-payout CRUTs.(2) In the IRS's view, some taxpayers have used CRUTs to convert appreciated assets into cash, while substantially avoiding capital gains tax. The example in the notice assumes that capital assets having a $1 million value and a zero basis are contributed to a trust on january 1, the assets generate no income and a two-year CRUT payment is set at 80% of the annually redetermined fair market value of the trust's assets. Although the year 1 required CRUT payment is $800,000, no actual distributions are made until shortly after year-end, when the assets are sold for $1 million; $800,000 is distributed in year 2 before April 15. The year 2 unitrust amount, $160,000 (0.80 ($1,000,000 - $800,000)) is paid by year-end and the trust terminates, distributing $40,000 to a charitable organization.

Proponents of this technique characterize the year 1 $800,000 CRUT payment as a tax-free corpus distribution under Sec. 664(b)(4), because no income was earned nor assets sold or distributed to the donor during year 1. The year 2 $160,000 CRUT payment is characterized as capital gain, because the property is sold in that year. After capital gains tax of $44,800 ($160,000 x 28%), the donor has a total of $915,200 (($800,000 + $160,000) - $44,800). Had the donor sold the assets directly, there would have been $280,000 of capital gains tax and only $720,000 remaining.

Some commentators believe that the technical arguments in favor of the desired treatment are beyond challenge (i.e., that the transaction and related consequences flow from a literal reading of Sec. 664(b) and Regs. Sec. 1.664-1(d)(4)). Although CRUTs have been permitted for decades, and Sec. 664(d)(2)(a) specifies a 5% minimum payout, the IRS has not previously specified a maximum payout.

Nevertheless, in Notice 94-78, the IRS expressed an intent to challenge the transaction using one or more legal doctrines, depending on the particular facts of each case. Possible challenges include (1) recharacterizing the form of the transaction as a sale by the grantor, due to possible prearrangement by the grantor and trustee,(3) (2) applying the assignment of income doctrine to include the gain in the donor's gross income,(4) (3) challenging the trust's exempt status under Regs. Sec. 1.664-1(a)(4) by asserting that such status was sought solely for the donor's benefit, so that the trust did not operate exclusively as a CRUT from the date of creation and (4) imposing self-dealing and other penalties.

Because Form 5227, Split-interest Trust Information Return, explicitly requires disclosure of the CRUT's payout percentage, it should be easy for the IRS to identify high-payout CRUTs for examination. Due to the substantial tax savings potential when using CRUTs, the authors expect the IRS to challenge such CRUTs vigorously. Taxpayers contemplating using the technique should be prepared for an extended contest and should recognize the potential for a deficiency, interest and sizable penalties if the IRS can convince the courts that high-payout CRUTs are too good to be true.

* Payment of tax on grantor's income may be taxable gift

In Letter Ruling 9444033,(5) the IRS concluded that the grantor of a grantor retained annuity trust (GRAT) was the owner of both principal and income for income tax purposes under Sec. 677(a). The governing instrument required the trust to reimburse the grantor for any income tax liability incurred with respect to trust income received by the trust but not distributed to the grantor. In the ruling, the IRS stated, "[u]nder this provision, a grantor will not make an additional gift to a remainderperson in situations in which a grantor is treated as the owner of a trust under [Sec.] 671 through [Sec.] 679, and the income of the trust exceeds the amount required to satisfy the annuity payable to the grantor .... If there were no reimbursement provision, an additional gift to a remainderperson would occur when the grantor paid tax of [sic] any income that would otherwise be payable from the corpus of the trust."

Although equivalent language may be found in other rulings,(6) the IRS does not cite any authority for its position. It seems bizarre that a taxable gift will occur when an individual pays a tax liability imposed by statute, particularly when nonpayment can lead to civil, and possibly criminal, penalties. Apparently, the IRS now refuses to issue GRAT qualification rulings absent a reimbursement provision. The only apparent rationale for refusing GRAT recognition is obstinacy, since neither Sec. 2702 nor the regulations thereunder require reimbursement. Fortunately, for those who wish to comply, the IRS has ruled that the reimbursement right is not a retained interest resulting in estate inclusion under Sec. 2036(a).(7) Finally, the stakes can grow still higher--imputed gifts can be constructive additions for generation-skipping tax purposes.

* Power of substitution

Taxpayers often require certainty that a trust (e.g., a qualified personal residence trust or qualified subchapter S trust (QSST)) will be treated as a wholly grantor trust under Sec. 671. Until recently, the IRS issued letter rulings that unilaterally concluded, based on the document's language, that a Sec. 675(4) power of substitution of trust property held in a nonfiduciary capacity resulted in wholly grantor status.(8) The IRS has now tightened its ruling policy. In Letter Ruling 9352004,(9) the IRS ruled that the mere existence of such a power in a trust document was insufficient to allow the usual "wholly grantor" conclusion. Rather, grantor trust status could be confirmed only by field examination, which would determine, based on the facts and circumstances, whether the power actually was held in a nonfiduciary capacity. Of course, no indication was provided as to the type of facts that might outweigh the document's clear language. The IRS subsequently ruled on this issue without the field examination proviso.10 However, more recently, the IRS refused to rule on the subject, stating only that the matter is under extensive study.(11)

Regs. Sec. 1.675-1(b)(4)(iii) states that if a power is exercisable by a person as trustee, it is presumed that the power is held in a fiduciary capacity; if a power is not exercisable by a trustee, the determination of whether the power is exercisable in a fiduciary or nonfiduciary capacity is based on the trust terms and the circumstances surrounding trust creation and administration. Therefore, although the IRS has the right to hedge in this manner, it has created uncertainty where none previously existed.

* IRS "swings both ways" on minority stock discounts

It seems like only yesterday that the IRS curtailed its decade-long effort to limit minority interest discounts (MIDs) on intrafamily gifts of stock interests, with the issuance of Rev. Rul. 93-12.(12) In Letter Ruling (TAM) 9449001,(13) the National Office rebuffed an agent's attempt to disallow MIDs when a donor simultaneously gave approximately 9% of a corporation's stock to each of his 11 children...