Significant recent developments in estate planning.

• Author: Zysik, Jeffrey C.

The estate planning area continues to be a "hotbed" of IRS activity. During the period Sept. 1, 1996 through Apr. 30, 1997, significant developments occurred in the areas of charitable gifts, Chapter 14, entity discounts and deduction of estate administration expenses.

This article is presented to assist estate planning professionals attempting to stay abreast of these and other controversial developments in the estate planning area. The article begins by examining the period's most significant items, followed by highlights of additional court decisions and IRS rulings, regulatory developments and other authoritative pronouncements.

Highlights

The period's highlights included:

* The release of proposed regulations terminating the viability of the short-term charitable remainder trust (CRT) as a capital gains elimination technique, and publication of the IRS's position on built-in gains on assets contributed to a CRT.(1) However, the proposed regulations now allow "flip" CRTs that meet imposed requirements.

* A technical advice memorandum (TAM) officially reversed the IRS's previous ruling that a spouse's revocable interest in a grantor retained annuity trust (GRAT) is not a "qualified interest."

* The Supreme Court issued a long-awaited, pro-taxpayer decision on administration expenses that guarantees additional litigation.

* A TAM set forth the IRS's position on the availability of discounts for interests in family limited partnerships (FLPs).

CRT Prop. Regs.

Generally, a CRT provides for a specified periodic distribution to one or more noncharitable beneficiaries for life or a term of years, coupled with an irrevocable remainder interest held for the benefit of charity. If the CRT has no unrelated business taxable income (UBTI), it is exempt from income tax.

Sec. 664(d) specifies two types of CRTs: a charitable remainder annuity trust (CRAT) pays a sum certain at least annually to one or more noncharitable beneficiaries; a charitable remainder unitrust (CRUT) pays a fixed percentage of the net fair market value (FMV) of the trust's assets valued annually (the fixed percentage method) to one or more noncharitable beneficiaries. Alternatively, a CRUT may be structured to pay the lesser of (1) the fixed percentage method amount or (2) the trust's net income (the net income method). The unitrust amount could also be the amount determined under the fixed percentage method, plus (to the extent trust income exceeds the current year's fixed percentage), the unitrust amount can be increased to "make up" for any shortfall in distributions from prior years when trust income was less than the fixed percentage amount (the net income with makeup charitable remainder trust (NIMCRUT) method).

The proposed regulations attempt to clarify issues and halt use of various techniques deemed abusive. The proposed regulations address (1) flip CRUTs; (2) the timing of the CRAT or CRUT payment; (3) appraisals for "unmarketable assets" (i.e., assets that are not cash, cash equivalents or marketable securities); (4) the application of Sec. 2702; and (5) the allocation of an asset's precontribution gain between CRT principal and income.

Flip CRUTs: Prop. Regs. Sec. 1.664-3(c) sanctions the use of "flip" CRUTs under certain conditions. A flip CRUT is a CRUT initially structured as a NIMCRUT, but that later becomes a fixed percentage method CRUT. Prop. Regs. Secs. 1.664-3(c)(1)-(4) allow donors to use flip CRUTs, if all of the following are met: 1. At least 90% of the FMV of the assets held in the trust immediately after the initial contribution (or any subsequent contribution) consists of "unmarketable assets." 2. The governing instrument provides that the change in method will be triggered on the earlier of (a) the sale or exchange of a specified unmarketable asset or group of assets initially contributed to the CRUT or (b) the sale or exchange of unmarketable assets if, immediately after the sale or exchange, the FMV of remaining CRUT assets is 50% or less of the FMV of all CRUT assets. 3. After flipping, the CRUT will use only the fixed percentage method of calculating all remaining unitrust payments. 4. Any remaining makeup amount (as described in Sec. 664(d)(3)(B)) will be forfeited as of the beginning of the next trust year.

An amendment procedure is provided for flip trust agreements that do not contain these provisions. According to Prop. Regs. Sec. 1.664-3(f)(iv)(b), these rules are effective for CRUTs created on or after the date final regulations are published in the Federal Register.

Timing of CRAt/CRUT payment: Under Regs. Secs. 1.664-2 and -3, for administrative convenience, a trustee must pay a CRUT or CRAT amount within a reasonable period following the close of the trust's tax year. Prop. Regs. Secs. 1.664-2(a)(1)(i) and -3(a)(1)(i) require that such amount determined under the fixed percentage method be paid by the close of the tax year in which due. These rules are proposed to be effective for tax years ending after Apr. 18, 1997. Nevertheless, the IRS will continue to challenge the purported tax consequences of accelerated CRUTs, as described in Notice 94-78.(2)

The requirement that payment be made by the end of the CRT's tax year effectively eliminates the viability of the accelerated, CRT technique. Under the income ordering rules, if highly appreciated property is transferred to a CRT in year 1 and sold at the beginning of year 2, a payment to the donor in year 2 in satisfaction of the CRT's first-year obligation does not consist of any capital gain generated by the sale of the asset (because the capital gain did not occur until year 2). Thus, if the payout percentage is set at an extremely high level (e.g., 90%), and the trust term is short (e.g., two years), the vast majority of capital gain realized on the CRT's sale of an appreciated asset will never be recognized. This planning opportunity is eliminated by Prop. Regs. Secs. 1.664-2(a)(1)(i)`s and -3(a)(1)(i)'s requirement that the payment be made by the close of the tax year in which due.

Although the new timing requirement is an effective method of ensuring that a CRT donor is taxed on the trust's capital gains, it is administratively unworkable. The preamble to the proposed regulations states that "[t]hese proposed amendments should not require the amendment or reformation of governing instruments of existing [CRTs]...[t]he trustees of such trusts can comply with the proposed regulations by actually paying the annuity or unitrust amount within the time permitted by the proposed amendments." In the case of many CRUTs, this statement is naive. If a CRUT's valuation date is the last business day of its year, as a practical matter, it is impossible for the trustee to pay the CRUT amount prior to the end of the year. Thus, the IRS and Treasury will be forced to reconsider this requirement, or to provide a reformation procedure for existing CRUTs with year-end valuation dates.

Appraising unmarketable assets: Prop. Pegs. Sec. 1.664-1 (a)(7) provides that if a CRT holds unmarketable assets and the trustee is the CRT's grantor, a noncharitable beneficiary, or a related or subordinate party to the grantor or the noncharitable beneficiary, the trustee must use a current qualified appraisal from a qualified appraiser to value those assets. Arguably, this rule is supported by congressional intent as indicated in the legislative history accompanying Sec. 664.(3) The provision is proposed to be effective for trusts created on or after the date final regulations are published in the Federal Register.

Application of Sec. 2702: Currently, Sec. 2702 does not apply to CRUTs or CRATs. Sec. 2702 provides special rules to determine the value of a gift when an individual makes a transfer in trust to or for the benefit of a family member, and the donor or donee retains an interest in the trust.(4) Prop. Regs. Sec. 25.2702-1 (a)(3)(i) provides that the unitrust interest in a NIMCRUT retained by the donor or any applicable family member will be valued at zero if someone other than the donor and/or the donor's spouse is a noncharitable beneficiary of the trust.

As a result, if someone other than the donor or the donor's spouse receives a unitrust interest in the NIMCRUT, the value of such interest received (i.e., the donor's gift to the interest holder) will be the FMV of all the property transferred to the CRUT, less the value of the remainder interest that will be transferred to charity. Thus, for gift tax purposes, the value of the interest retained by the donor or his spouse is zero. This provision is proposed to be effective for transfers in trust made on or after May 19, 1997.

No allocation of precontribution gain to trust income: Prop. Regs. Sec. 1.664-3(a)(1)(i)(b)(3) clarifies that the proceeds from the sale or exchange of assets contributed to a NIMCRUT by the donor must be allocated to principal and not to trust income, at least to the extent of the FMV of those assets on the date of contribution. In addition, the preamble to the proposed regulations indicates that, for sales and exchanges occurring prior to the effective date (Apr. 18, 1997), the IRS will continue to challenge any attempt to allocate precontribution gain to trust income as being fundamentally inconsistent with applicable local law and with the charitable deduction claimed.

However, the proposed regulations do not explicitly require that a NIMCRUT's contingent liability generated by previously unpaid unitrust amounts (because trust income was less than the required unitrust payment) be taken into account when calculating a unitrust amount. In previous rulings,(5) the Service had required the liability to be taken into account in performing the calculation.

Spouse's Revocable GRAT Interest

The Service ruled in Letter Ruling (TAM) 9707001(6) that a spouse's revocable contingent right to receive annuity payments in a GRAT is not a qualified interest for Sec. 2702(b) purposes; thus, the interest...