Significant recent developments in estate planning.

• Author: Pye, Nicholas I.
• Position: Part 1

EXECUTIVE SUMMARY

* The Hubert proposed regulations appear to be more restrictive than the Supreme Court's holding.

* The IRSRRA '98 clarified the QFOBI provisions enacted by the TRA '97.

* The much-celebrated Alaska self-settled spendthrift trust may have passed its first major test last year.

This article--the first of two parts--examines recent developments in estate, gift and generation-skipping transfer (GST) tax planning. Specifically, the article discusses, among other items, the Hubert proposed regulations; the Sec. 6501 (c)(9) "adequate disclosure" proposed regulations; the Sec. 2057 "qualified family owned business interest" deduction; the indexing of the GST tax for inflation; and recent rulings on deathbed planning, family limited partnerships, Alaska creditor protection trusts and the annual gift tax exclusion.

During the period from May 1998--May 1999, there were many interesting (and in some cases, dramatic) estate planning developments. For example, Congress, in key tax legislation, made certain significant statutory changes (including amendments to the Sec. 2033A qualified family-owned business interest (QFOBI) exclusion included in the IRS Restructuring and Reform Act of 1998 (IRSRRA '98) and the permanent extension of Sec. 170(e)(5)). The IRS released several key regulatory projects (including Hubert proposed regulations, Sec. 6501(c)(9) "adequate disclosure" proposed regulations and charitable remainder trust final regulations). In addition, the Service and the courts issued some important rulings (including a Tax Court decision allowing a valuation discount for built-in capital gains tax liability and an IRS ruling invoking a novel "gift on formation" argument to impose gift tax on the routine creation of a family limited partnership (FLP)).

Because a detailed analysis of all of these important estate planning developments is beyond the scope of this article, the discussion below focuses only on the most influential statutory changes, regulations, cases and rulings from the period covered. The first part of this two-part article, below, examines recent developments in estate, gift and generation-skipping transfer (GST) tax planning. The second part, in the September issue, will focus on income tax planning, valuation issues and proposed legislation.

Estate Tax Planning

Although recent estate tax developments pale in comparison to those made by the Taxpayer Relief Act of 1997 (TRA '97), the period covered witnessed some important regulations and rulings, as outlined below.

Hubert Prop. Regs.

In response to its loss in the Supreme Court's decision in Est. of Hubert,(1) which sought to interpret the definition of "material limitation" in Regs. Sec. 20.2056(b)-4(a), the Service issued proposed regulations.(2) The Court in Hubert was confronted with whether an executor's use of estate income attributable to marital property to pay administration expenses was a "material limitation" on the surviving spouse's right to the income, and thus, reduced the marital deduction. The Court found that the regulations failed to define material limitation and that the Service failed to present sufficient evidence of one. A divided Court concluded that the marital and charitable deductions would not be reduced, despite the fact that the estate administration expenses were paid from income derived from the property passing to the spouse and charity. A concurring opinion suggested that the IRS publish regulations on this issue.

The Service and Treasury gave careful consideration in establishing a rule to define material limitation that could be administered in the context of the Court's directive. After reviewing practitioner comments, the Service concluded that the definition of "materiality" was not workable given the cost and administrative burden associated with such a test; thus, it abandoned the concept of materiality and substituted two new concepts: estate "transmission" and "management" expenses, which, according to the Service, will have uniform application to all estates, be simple to administer and reflect the realities of estate administration.(3)

Estate transmission expenses are defined by Prop. Regs. Sec. 20.2056(b)-4(e) (1) as all estate administration expenses that are not estate management expenses, including expenses incurred in collecting the decedent's assets, paying debts and death taxes and distributing the decedent's property to those entitled to receive it. These types of expenses, whether charged to income or principal under state law or the governing instrument, reduce the marital and charitable deductions. Estate management expenses are defined by Prop. Regs. Sec. 20.2056(b)-4(e)(2)(i) as those expenses incurred in connection with the investment of the estate assets and with their preservation and maintenance during the administration period. These expenses do not reduce the marital or charitable deductions in most circumstances, although the Service has proposed adopting a special rule that will reduce the marital deduction for estate management expenses deducted on the Federal estate tax return.

Observation: The Service and Treasury deserve praise for their efforts to develop a simplified approach to defining material limitation, a term with no statutory meaning. However, the proposed regulations fail to provide an immediate solution. Although the preamble indicates that the proposed regulations simplify estate administration, it is uncertain whether that objective has been achieved, because the special new administration expense classification serves to create a "Federal tax/fiduciary accounting law" disparity that will complicate estate administration. The concepts introduced by the proposed regulations will lead to disputes with Service field examiners and Appeals officers, based on differing interpretations. Further, the proposed regulations appear to be more restrictive than the Supreme Court's holding in Hubert, because their effect is the same as the IRS's position in that case, which a plurality of the Court rejected.

QFOBIs

IRSRRA '98 Section 6007(b) replaced Sec. 2033A, which had been added by TRA '97 Section 502, with new Sec. 2057. As originally enacted, Sec. 2033A allowed an estate an exclusion for the lesser of (1) the adjusted value of the decedent's QFOBIs or (2) the excess of $1.3 million over the applicable exclusion amount of the estate's unified credit. The IRSRRA '98 converted this benefit from an exclusion to a deduction, and made the following other technical changes:

* Better coordination with the applicable exclusion amount. Prior to the IRSRRA '98, the QFOBI exclusion decreased as the applicable exclusion amount increased; their combined benefit never exceeded $1.3 million. New Sec. 2057(a)(3) coordinates the increase in the applicable exclusion amount through 2006 by calculating the estate tax as if the estate was allowed a $675,000 maximum QFOBI deduction and a $625,000 applicable exclusion amount.

* Added a requirement under Sec. 2057(b)(2) that the deducted QFOBI pass to a qualified heir or a trust,(4) all of the beneficiaries of which are qualified heirs.

* Clarified (in Sec. 2057(e)) that an individual's interest in property used in a trade or business may qualify for the QFOBI deduction as long as such property is used in a trade or business by the individual or a member of his family. In addition, property leased on a cash-lease basis between family members will not be treated as a passive asset or reduce the amount of the business interest eligible for QFOBI treatment.

* Clarified that the QFOBI deduction is not available for GST tax purposes.

* Clarified (in Sec. 2057(f)(2)) the calculations needed to compute the recapture tax on a disposition event that occurs within 10 years of the decedent's death and before the qualified heir's death.

Observation: The IRSRRA '98 corrections are much-welcomed, because they removed much of the ambiguity in QFOBI planning. QFOBI owners should now seriously consider redrafting their wills to take advantage of this deduction.

Final QTIP Regulations

In March 1994, the Service published final Regs. Sec. 20.2056(b)7(d)(3), which provided that an income interest (or life estate)...