Significant recent developments in estate planning.

• Author: Ransome, Justin P.

EXECUTIVE SUMMARY

* The Small Business and Work Opportunity Tax Act of 2007 extended the preparer penalties under Sec. 6694 to cover preparers of estate and gift tax returns.

* The Supreme Court ruled in Knight that a trust's investment advisory fees are deductible if they are of a type that would be "uncommon (or unusual, or unlikely)" to be incurred by a hypothetical individual investor.

* The Tax Court issued several rulings on the tax treatment of family limited partnerships.

* The IRS issued final and proposed regulations regarding qualified severances for generation-skipping transfer tax purposes.

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This article examines developments in estate, gift, and generation-skipping transfer tax planning and compliance between June 2007 and May 2008. It discusses legislative developments, cases and rulings, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) changes taking place in 2008, and the annual inflation adjustments for 2008 relevant to estate and gift tax.

Legislative Developments

President Bush signed the Small Business and Work Opportunity Tax Act of 2007, P.L. 110-28 (SBWOTA), on May 25, 2007. There are two changes that will be of significance to estate planners. First, for tax years beginning after December 31, 2006, an electing small business trust (ESBT) is allowed to deduct interest it incurs on debt to purchase S corporation stock. (1) This puts ESBTs on similar footing with qualified subchapter S trusts (QSSTs) and other entities in relation to the deductibility of interest. Second, SBWOTA raised the standards for avoiding preparer penalties under Sec. 6694 and extended these standards to all returns, including estate and gift tax returns. (2)

Significant Cases and Rulings Deduction of Investment Advisory Fees

The Supreme Court settled a split among the circuit courts of appeal and put to rest the issue of whether investment advisory fees are fully deductible under Sec. 67(e) or are deductible under Sec. 212 subject to the 2% adjusted gross income (AGI) limitation. In Knight, (3) the Court ruled that investment advisory fees similar to those that would have been incurred by a "hypothetical" individual investor are deductible under Sec. 212.

In general, trusts are subject to the same rules for calculating AGI that apply to individuals, with one exception. A trust's costs are fully deductible, rather than subject to the 2% AGI limitation, if they satisfy the requirements found in Sec. 67(e): (1) they are paid or incurred in connection with the administration of the trust, and (2) they would not have been incurred if the property were not held in such trust.

The courts have split on the issue of whether investment advisory fees incurred by a trust satisfy the second requirement in Sec. 67(e). The Sixth Circuit in O'Neill (4) held that investment advisory fees paid by a trust were unique to the trust's administration because the trustees of the trust required the expertise of an investment adviser in order to satisfy their fiduciary duties and comply with the prudent investor standard of the state in which the trust was administered. The Second Circuit in Rudkin (5) (from which Knight was appealed), the Fourth Circuit in Scott, (6) and the Federal Circuit in Mellon Bank (7) held (applying different tests) that the investment advisory fees were not unique to a trust because such fees are similar to fees routinely incurred by individuals in the management of their assets.

The Supreme Court framed the test of whether a cost would not have been incurred if the property were not held in such trust as whether such cost is "uncommon (or unusual, or unlikely)" for a hypothetical individual investor to incur. The Supreme Court then determined that in the case before it, investment advisory fees were not so unusual or uncommon that an individual investor with the same objectives as the trust would not have incurred such fees if the property were held by such individual.

Prior to Knight, Treasury issued proposed regulations (8) providing that costs incurred by a trust that are unique to trusts are deductible under Sec. 67(e)(1). A cost is unique to trusts if an individual could not have incurred the cost in connection with property not held in trust. The proposed regulations also provide that a trust may not circumvent the 2% AGI limitation by bundling costs subject to the limitation into a trustee fee. If a trust bundles such costs, it must "unbundle" them using a reasonable method to allocate the single fee between costs subject to and those not subject to the 2% AGI limitation. The Supreme Court's decision in Knight rejected the definition of "unique" the IRS incorporated in the proposed regulations, but it did not address the issue of unbundling trustees' fees.

In response to Knight, the Service released Notice 2008-32, (9) which provides that trusts and estates will not be required to determine the portion of unbundled fiduciary fees for any tax year beginning before January 1, 2008. Instead, for each such tax year, trusts and estates may deduct the full amount of the bundled fiduciary fee without regard to the 2% AGI limitation. However, payments by a trustee or executor to third parties for expenses subject to the 2% AGI limitation must be treated separately from the otherwise bundled trustee fee.

FLPs

The IRS has successfully argued for including the assets transferred to a family limited partnership (FLP) in a transferor's gross estate under Sec. 2036(a)(1). The Service victories invariably involve cases in which the facts surrounding the transfer of property and the subsequent use of the property show that the transferor implicitly retained the right to enjoy the property (or its income). Transferring substantially all of one's assets to an FLP, coupled with relying on substantial disbursements from the FLP to meet living expenses, commingling FLP and personal funds, and failing to respect partnership formalities, are factors that the courts have cited as evidence of the retention of the right to enjoy the property.

In Bigelow, (10) the Ninth Circuit became the latest circuit court of appeals to accept the Sec. 2036(a)(1) argument. (11) In affirming the Tax Court decision, the Ninth Circuit noted that the decedent's transfer of her major asset--a piece of rental property--left her with insufficient funds to meet her living needs without access to FLP funds as evidenced by an analysis of her monthly income and expenses. Further, the court noted that even though the decedent did not transfer to the FLP the debt secured by the rental property (i.e., she continued to be personally liable for the debt), the FLP made the monthly payments on the debt, and the FLP property continued to secure the decedent's personal debt.

The Tax Court held for the IRS in two other cases. In Rector, (12) the Tax Court ruled that Sec. 2036(a) applied, noting that (1) the decedent retained insufficient assets to meet her living needs, (2) the FLP directly paid the decedent's living expenses and gift and estate tax liabilities; and (3) the partners failed to observe partnership formalities (there was no business plan or investment strategy, no financial statements were issued, and there were no formal meetings of the partners).

In Erickson, (13) the Tax Court cited the delay in funding the FLP; although the agreement called for asset contributions concurrent with the execution of the FLP agreement, manY of the assets were not transferred until four months later (just two days before the decedent's death). In addition, the IRS cited the substantial disbursements to the estate to meet its liabilities; although the disbursements were for the purchase of the decedent's home and the redemption of FLP units, the estate received funds at a time when no other partner did.

While case law has created a clear list of factors that are evidence of the retention of the right to enjoy the property, there are inconsistencies between the courts (and between Tax Court judges) as to what is required to meet the bona fide sale exception.

In theory, the Sec. 2036(a)(1) inquiry is a two-step process:

1. Does the bona fide sale exception apply?

2. If not, did the transferor retain the right to enjoy the property (or the income from it)?

   In practice, the same factors that are probative of the application of Sec. 2036(a)(1)--commingling of funds, failure to follow partnership formalities, retention of insufficient funds by the transferor to meet living needs--heavily influence the court's decision on whether the bona fide sale exception applies. Thus, in cases that involve commingling of funds (for example), the courts invariably find that the bona fide sale exception does not apply. But instead of using the third prong of the test developed by the Fifth Circuit in Kimbell (14)--which demands an examination of the facts that would confirm or deny the taxpayer's assertion that the transfer is a bona fide sale--to reach the correct conclusion, the courts continue to cite factors that are not only inconsistent with existing law but also unnecessary to reach the intended result. In Rector, the Tax Court cited "mere recycling," "lack of legitimate negotiations," "pooling of assets," and "legitimate and significant business reasons" in reaching its conclusion that the exception did not apply. These concepts were rejected by the Fifth Circuit (and even by the Tax Court majority in Bongard) (15) because they place undue emphasis on the taxpayer's subjective motives.

   Thus, where there is no evidence of the retention of the right to enjoy the property (e.g., no commingling of funds, no failure to follow FLP formalities, etc.), the presence of some potential benefit other than estate tax advantages--a benefit that fits the facts of the case---constitutes a significant and legitimate nontax reason sufficient to meet the bona fide sale exception. Where there is evidence of the retention of the right...