Significant recent developments in estate planning.

• Author: Ransome, Justin P.

EXECUTIVE SUMMARY

* The fate of the estate and generation-skipping transfer taxes remains in doubt after 2009; currently both taxes are scheduled to be repealed for 2010 and then to be reinstated in 2011, under pre-EGTRRA law.

* The Supreme Court held in the Knightcase that investment advisory fees paid by trust are subject to the 2% of adjusted gross income floor under Sec. 67(a). The IRS has issued two notices addressing the unbundling of trustee fees.

* The IRS issued final and proposed guidance on the qualified severance of a trust for generation-skipping transfer tax purposes under Sec. 2642.

* The Sixth Circuit, joining the Fifth Circuit and the Tax Court, reversed a district court and held that a decedent's remaining lottery prize installments were an annuity that should be valued using the Sec. 7520 tables.

* The IRS issued proposed guidance on private trust companies and a procedure for pursuing a declaratory judgment in the Tax Court under Sec. 7477.

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This article examines developments in estate, gift, and generation-skipping transfer tax planning and compliance between June 2008 and May 2009. It discusses legislative developments, cases and rulings, 2009 changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001 (1) (EGTRRA), and the annual inflation adjustments for 2009 relevant to estate and gift tax.

Legislative Developments

Under EGTRRA, the estate tax and the generation-skipping transfer (GST) tax are scheduled to be repealed effective January 1, 2010, but due to the act's sunset provisions they will be reinstated January 1, 2011, under pre-EGTRRA law (e.g., $1 million applicable exclusion amount; 55% top rate).

There is a strong possibility that Congress will enact legislation this year to address the fate of the estate tax going forward. In its budget proposal, the Obama administration's "Baseline Projection of Current Policy" assumes that the estate tax would be maintained at its 2009 parameters--with a $3,500,000 per decedent exclusion and a top tax rate of 45%--for 2010 and beyond. Numerous bills introduced in the 111th Congress propose to maintain the estate tax at its 2009 parameters, although with modifications (primarily to index the applicable exclusion amount for inflation and allow portability of the applicable exclusion amount between spouses).

In addition to the fate of the estate tax, there could be other sweeping changes to estate tax planning if other proposals contained in either the Obama administration's fiscal year 2010 tax proposals or proposed legislation tied to estate tax reform are enacted. Provisions affecting estate and gift taxes in the FY 2010 tax proposals include:

* Imposing a reporting requirement on executors and donors to provide both the IRS and the recipient of property with accurate basis information and also requiring both parties to report basis consistently;

* Disallowing valuation discounts in valuing transfers of family-controlled entities if the discounts are a result of certain restrictions; and

* Imposing a minimum term of 10 years for grantor retained annuity trusts (GRATs).

Proposed legislation tied to estate tax reform has been introduced in Congress to limit the discounts for transfers of family-controlled entities that hold nonbusiness assets.

Trusts

Deduction of Investment Advisory Fees

Sec. 212 allows individuals to take a deduction for expenses incurred in connection with property held for investment. Sec. 67(a) limits this deduction (along with other miscellaneous deductions) to amounts that exceed 2% of adjusted gross income (AGI). Sec. 67(e)(1) provides that the AGI of a trust or an estate is to be computed in the same manner as an individual's AGI except that deductions that (1) are paid or incurred in connection with the administration of the trust or estate and (2) would not have been incurred if the property were not held in such trust or estate shall be treated as allowable in arriving at AGI (i.e., deductible above the line).

In Knight, (2) 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. 67(a), making them subject to the 2% AGI floor. The Supreme Court ruled that investment advisory fees were not "uncommon (or unusual, or unlikely)" for a hypothetical individual to incur. Therefore, the Court ruled that the second requirement of Sec. 67(e)(1) (that the expense "would not have been incurred if the property were not held in the trust") had not been met.

Prior to the Supreme Court's decision in Knight, the IRS published Prop. Regs. Sec. 1.67-4, in which it addressed expenses of a trust or an estate that it believed to be deductible under Sec. 67(a) or Sec. 67(e)(1). The IRS also addressed for the first time the issue of bundled trustee fees. The Service is concerned that trustees are combining into one amount fees that may not all be deductible under Sec. 67(e) (1). The proposed regulations require trustees to unbundle or break down these fees and then deduct them under Sec. 67.

Although the Supreme Court was aware of Prop. Regs. Sec. 1.67-4, it did not address the regulation in its decision. Specifically, the Court did not address the issue of bundled trustee fees. This left many practitioners who specialize in fiduciary income tax accounting in the uncomfortable position of deciding whether to take a taxpayer-unfavorable position and abide by Prop. Regs. Sec. 1.67-4 or a taxpayer-favorable position contrary to such regulation on returns filed for a trust's 2007 tax year.

In response to this uncertainty, the IRS released Notice 2008-32, (3) which provided that trusts and estates would 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 trustee fee without regard to the 2% AGI floor. There is one exception: Payments by a trustee or executor to third parties for expenses subject to the 2% AGI floor are readily identifiable and must be treated separately from the otherwise bundled trustee fee.

The IRS had anticipated issuing final regulations in 2008. Realizing that it would not have this guidance issued by the end of the year, it issued Notice 2008116, (4) which provides that the guidance in Notice 2008-32 has been extended to tax years beginning before January 1, 2009.

Allocation of Income to Payment to Charity

In general, Sec. 642(c) allows an estate or trust a deduction for payments to charity in lieu of the charitable deduction allowed an individual under Sec. 170. The deduction, however, is limited to the gross income of the estate or trust for the year in which the payment is made to the charity.

Regulations under Sec. 642(c) provide special rules for computing the amount of an estate's or trust's charitable deduction. In particular, Regs. Sec. 1.642(c)-3(b)(2) provides that in determining whether an amount of income paid to a charitable beneficiary includes particular items of income not included in gross income (for example, tax-exempt income), provisions in the trust's or estate's governing instrument will control if they specify the source out of which amounts are to be paid to the charitable beneficiary. In the absence of specific provisions in the governing instrument or in local law, the amount of income distributed to each charitable beneficiary is deemed to consist of the same proportion of each class of the items of income of the estate or trust as the total of each class bears to the total of all classes.

Sec. 643(a) provides rules for determining an estate's or trust's distributable net income (DNI) deduction. Regs. Sec. 1.643(a)-5(b) provides rules for reducing the amount of tax-exempt interest includible in DNI when tax-exempt interest is deemed to be included in a payment to charity. Similar to Regs. Sec. 1.642(c)3(b), the regulation provides that if the estate's or trust's governing instrument provides as to the source out of which payments are to be made to a charity, the specific provisions control. In the absence of specific provisions, the amount of income distributed to each charitable beneficiary is deemed to consist of the same proportion of each class of the items of income of the estate or trust as the total of each class bears to the total of all classes.

The IRS has generally taken the position in private letter rulings that Regs. Secs. 1.642(c)-3(b)(2) and 1.643(a)-5(b) require that if an estate's or a trust's governing instrument or local law has a specific provision addressing the sourcing of payments to be made to a charity, that provision must have economic effect independent of income tax consequences. REG-101258-08 (5) incorporates this position into these regulations. The proposed regulations require that a provision in a governing instrument or in local law that specifically provides the source out of which amounts are to be paid to charity must have economic effect independent of income tax consequences in order to be respected for federal tax purposes. If such a provision does not have economic effect, income distributed for a charitable purpose will consist of the same proportion of each class of the items of income as the total of each class bears to the total of all classes.

The primary target of the proposed regulations is charitable lead trusts (CLTs) and the ordering rules generally contained in a CLT's governing instrument. Many CLT governing instruments provide that the annuity or unitrust payment is to consist of the following classes of items until such class has been exhausted: (1) ordinary income, (2) capital gain, (3) other income (including tax-exempt income), and (4) corpus. These ordering rules allow for the maximum benefit of the charitable deduction under Sec. 642(c). Because a CLT is a taxable entity...