Significant recent developments in estate planning.

• Author: Gardner, John H.

The past year has produced a number of key estate planning developments, including some long-anticipated legislative changes. This article will examine court decisions, IRS rulings and regulations, and changes in the tax law significantly affecting estate planning that occurred between Apr. 1, 1995 and Aug. 31, 1996. The article begins by examining the period's most prominent and controversial developments, including new statutory provisions important to estate planners followed by a discussion of other developments, organized by topic.

Highlights

The past year's highlights included:

* Controversial proposed regulations were issued requiring trust agreements to prohibit certain individuals and entities from purchasing a residence held in a qualified personal residence trust (QPRT).

* The IRS attacked the use of notes to satisfy annuity payments from a grantor retained annuity trust (GRAT).

* Final regulations barred "zeroed-out" GRATs.

* The IRS restricted the allocation of precontribution capital gains to trust accounting income (TAI) of a charitable remainder unitrust (CRUT).

* The IRS attacked the use of Crummey powers to create present interests.

* New legislation was enacted.

QPRT Prop. Regs.

The IRS issued proposed regulations amending Regs. Secs. 25.2702-5 and -7, dealing with QPRTs.(1) Under Prop. Regs. Secs. 25.2702-1(b)(1), (c)(9) and -7, for trusts created after May 16, 1996, a QPRT's governing instrument must prohibit the grantor, his spouse or an entity controlled by either from purchasing the residence from the trust both during and after the retained term. While the proposed regulations will not apply retroactively, if the facts and circumstances indicate a preplanned purchase, the IRS may challenge pre-effective date QPRTs.

Prop. Regs. Sec. 25.2702-5(a)(2) addresses reformation of QPRT documents. A QPRT that does not include the provision discussed above is deemed to comply if the trust is reformed judicially or nonjudicially (if effective under state law) within a prescribed time period.

The IRS justification for the repurchase prohibition is to prevent a grantor from "baiting and switching," so that at the end of the trust term, beneficiaries receive assets other than the residence, while the requirements for a GRAT or grantor retained unitrust (GRUT) are avoided.

Under Rev. Rul. 85-13,(2) if a QPRT is structured to remain as a grantor trust after the term holder's interest expires, and the grantor purchases the residence from the trust at that time, no gain is recognized. If the grantor subsequently the owning the residence (or a residence with a substituted basis), the beneficiaries receive the residence with a stepped-up basis; gain on the residence thus escapes taxation in the grantor's generation. (This is not a valuation issue properly the subject of the Sec. 2702 regulations.) In addition, the repurchase of a residence from a QPRT is not always the result of a prearranged plan; rather, it is an option that grantors are typically very concerned with, due to the possibility of changed circumstances (e.g., the death of a remainder beneficiary).

Use of Notes to Make GRAT Payments Rejected

Letter Ruling (TAM) 9604005(3) held that a GRAT did not meet the requirements of Sec. 2702 because, from its inception, there was a plan to satisfy the annuity payments with notes.

In the TAM, each of 25 trusts was funded with class A voting stock in Company, a closely held corporation that had no history of paying cash dividends on such stock; thus, the GRATs would lack sufficient cash flow to make the required annuity payments. If, as an alternative, payments were made in kind, frequent appraisals of the stock would be necessary. To avoid the need for frequent appraisals, the donors devised the following plan:

* Separate "administrative trusts" would be established to coordinate the GRAT payments.

* The donors would loan the respective administrative trust an amount necessary to make the annuity payments.

* The trustee of the administrative trust would execute a separate promissory note for each GRAT.

* The proceeds of each loan would be used to satisfy each required annuity payment.

The trustee was required to pay each promissory note no later than Dec. 31, 2004, the last day of the year in which the longest GRAT terminated. The notes initially carried zero interest, paying interest only after a trust with respect to which the note was issued ceased to be a grantor trust.

Although the GRATs' express terms satisfied the technical requirements of Sec. 2702 and the regulations thereunder, the IRS concluded that the trusts did not qualify as GRATs because the retained interests were not qualified annuity interests. The IRS found that, based on the company's dividend-paying history, the GRATs would generate insufficient cash flow to pay the annuities. Further, the trustee would never willingly distribute stock in satisfaction of the annuity payments, because such a distribution would clearly defeat the purpose of creating the GRATs.

TAM 9604005, in combination with Letter Ruling 9515039,(4) illustrates the Service's hostility toward the use of notes to satisfy a GRAT's required annuity payments. Thus, while after these things, it may be possible for a GRAT to continue using notes to satisfy annuity payments, taxpayers should be wary of such arrangements, particularly when the notes are noninterest-bearing and the GRAT property is not likely to produce sufficient income to fund the payments. Also, if the IRS were to conclude on audit that the use of notes to satisfy annuity payments caused the GRAT to fail to meet Sec. 2702, the full value of the transferred property would be a taxable gift.

"Zeroed-out" GRAT Prohibited

Final Regs. Sec. 25.7520-3(b)(2)(i)(5) adopts the IRS position set forth in Rev. Rul. 77-454,(6) that a GRAT may not be valued using a standard Sec. 7520 annuity factor if the annuity is expected to exhaust the trust before the last payment date; the Tax Court rejected this position in Shapiro.(7) In light of the regulations, taxpayers wishing to rely on Shapiro have the burden of proving those rules are unreasonable, a burden that did not exist with respect to Rev. Rul. 77-454.

Precontribution Capital Gain Not Allocable to

CRUT's Income

In Letter Ruling 9609009,(8) the taxpayer sought to establish a CRUT funded with common stock. The taxpayer and another person would be the trust's lifetime income beneficiaries. The trust was established as a net-income only CRUT with a make-up provision. The trust instrument provided that any gain realized on the disposition of the specific assets contributed to the trust was to be treated as principal, but all other capital gain would be allocated to TAI. In addition, when calculating the CRUT's payments each year, the fair market value (FMV) of the assets was to be reduced by any deficiency in payments for prior years.

The IRS ruled that the trust was a valid CRUT because it allocated certain capital gains from post-contribution assets to income and treated the unitrust deficiency as a liability in valuing the trust's assets. Letter Ruling 9609009, along with recent statements by IRS personnel (discussed below), demonstrates the new IRS position that precontribution capital gain cannot be allocated to a CRUT's TAI. This is contrary to previous rulings; Letter Rulings 9511007(9) and 9511029(10) held that the allocation of precontribution capital gain to TAI does not violate the CRUT requirements, provided that applicable local law allows allocation of capital gain to TAI.

In an attempt to prevent manipulation of TAI, Regs. Sec. 1.643(b)-1 states that trust provisions that depart fundamentally from the concepts of local law in the determination of what constitutes income are not recognized. A possible interpretation of this regulation is that capital gain may not be allocated to TAI unless applicable local law so provides; however, state principal and income acts generally allow a trust instrument to control allocation of receipts between income and principal.(11) Consequently, because the states allow capital gain to be relocated to TAI if specified in the trust document, such a provision in the trust instrument should not depart fundamentally from local law concepts; thus, the Service's position in Letter Ruling 9609009, that precontribution capital gain cannot be allocated to TAI, appears inconsistent with Regs. Sec. 1.643-1.

Unfortunately, the IRS has signaled its intent to rule contrary to the regulation. Frances Schaefer, Senior Technical Reviewer in Branch 4, Office of Assistant Chief Counsel and the drafter of Letter Ruling 9609009), indicated during a telecast sponsored by the American Law Institute and the American Bar Association that the IRS will not allow income-only CRUTs to allocate precontribution appreciation to income for trust accounting purposes.(12) MS. Schaefer indicated that the Service's business plan for 1996 includes the issuance of guidance on CRUTs, particularly those that limit the annuity payment to TAI and have a make-up provision. The IRS has also indicated that a regulations project had been opened on income-only CRUTs.(13)

Purported Withdrawal Powers Did Not Create

Present Interests

The IRS continued its attack on Crummey(14) powers in its acquiescence in result only(15) to Cristofani(16) and its issuance of Letter Ruling (TAM) 9628004.(17) In Cristofani, an individual created an irrevocable inter vivos trust, and made annual contributions to the trust in the year of death and the immediately preceding year. The decedent's two adult children were the primary beneficiaries; her five minor grandchildren were contingent remainder beneficiaries.

The trust contained a Crummey withdrawal power, granting each of the two primary and five secondary beneficiaries an unrestricted right to withdraw up to $10,000 for 15 days after a contribution. While allowing the donor's Sec. 2503(b) annual gift tax exclusions...