In an ever eagerly anticipated annual tradition, Ronald Aucutt, a McGuireWoods partner and co-chair of the firm’s private wealth services group, has identified the following as the top ten estate planning and estate tax developments of 2015. Ron is a past president of The American College of Trust and Estate Counsel, an observer and frequent participant in the formation of tax policy and regulatory and interpretive guidance in Washington, D.C., and the editor of the Recent Developments materials that are presented each year at the Heckerling Institute on Estate Planning.
Number Ten: The Meaning of “Of,” Another “Investor Control” Case: Webber v. Commissioner, 144 T.C. No. 17 (June 30, 2015)
In this case, Jeffrey T. Webber, venture capital investor and private equity fund manager, created a grantor trust that bought “Flexible Premium Restricted Lifetime Benefit Variable Life Insurance Policies” on the lives of his aunt and step-grandmother-in-law. The trust was held for the benefit of Webber and his descendants, with a corporate trustee with “uncontrolled discretion” to distribute trust assets to the beneficiaries, and with Webber’s attorney (in the U.S.) as trust protector.
The policies stated that Webber had no power to direct investments. But the investment manager always followed Webber’s investment directions. Nearly all of the investments were non-publicly traded securities, and Webber admitted that the investment manager could not have had access to these investments except through him. In many cases, Webber negotiated a deal directly with a third party, then “recommended” that the investment manager implement the deal that he had already negotiated. “In reality,” as the Tax Court (Judge Lauber) bluntly put it, “the Investment Manager selected no investments but acted merely as a rubber stamp for petitioner’s ‘recommendations,’ which we find to have been equivalent to directives.” Webber was taxed on the income from the policies’ investments, under the “investor control” doctrine.
In the most basic of income tax analysis, the court pointed out that section 1 of the Internal Revenue Code imposes a tax on the taxable income “of” every individual and quoted the Supreme Court’s elaboration that “[t]he use of the word ‘of’ denotes ownership.” Poe v. Seaborn, 282 U.S. 101, 109 (1930). As to “ownership,” again quoting the Supreme Court, “taxation is not so much concerned with the refinements of title as it is with actual command over the property taxed – the actual benefit for which the tax is paid.” Corliss v. Bowers, 281 U.S. 376, 378 (1930). The “investor control doctrine” is derived from Revenue Rulings 77-85 (1977-1 C.B. 12), 80-274 (1980-2 C.B. 27), 81-225 (1981-2 C.B. 12), 82-54 (1982-1 C.B. 11), and 2003-91 (2003-2 C.B. 347). Making an important jurisprudential point that might apply in other contexts, the court noted that it was not bound by these revenue rulings, but that under Skidmore v. Swift & Co., 323 U.S. 134, 140 (1944), they may be given weight on the basis of “their persuasiveness and … consistency” over 38 years.
The outcome in Webber, based on de facto control despite the governing trust documents, is reminiscent of SEC v. Wyly, Number Nine in the 2014 Top Ten.
As wealth becomes more concentrated – or at least as increases in the federal estate tax exemption focus estate planning more on the very wealthy – the hazard of talented and strong-willed individuals’ seeking to maintain control even after making gifts may be encountered more frequently.
Number Nine: Developments with Crummey Powers: Mikel v. Commissioner, T.C. Memo 2015-64 (April 6, 2015); Administration’s Budget Proposals (Feb. 2, 2015)
In Chief Counsel Memorandum 201208026 (dated Sept. 28, 2011, and made public Feb. 24, 2012), the IRS Chief Counsel’s office stated that the gift tax annual exclusion would not be available for contributions to “Crummey trusts” by reason of the beneficiaries’ right to withdraw contributed amounts, because the trust document provided that questions and disputes concerning the trust had to be submitted to an “Other Forum,” widely assumed to be some form of arbitration, and because a beneficiary who filed or participated in a civil proceeding to enforce the trust would be excluded from any further participation in the trust (a “no contest” or “in terrorem” clause). Under those circumstances, the Chief Counsel’s office viewed the withdrawal rights as “unenforceable and illusory.” It turns out that this memorandum apparently was issued with respect to the facts of the Mikel case, which rejected the position taken by the memorandum.
The Mikel opinion reveals that in 2007 a husband and wife jointly gave property they claimed to have a value of $3,262,000 to a trust in which 60 beneficiaries had “Crummey” withdrawal rights. If those transfers thereby qualified for 120 $12,000 gift tax annual exclusions, the taxable gifts would have been reduced to $911,000 for each spouse, less than the $1 million gift tax exemption. The trust agreement provided that any dispute regarding the interpretation of the agreement “shall be submitted to arbitration before a panel consisting of three persons of the Orthodox Jewish faith.” Such a panel in Hebrew is sometimes called a “beth din” (pronounced “bet deen”).
The Tax Court (Judge Lauber) held that the transfers created present interests that qualified for the annual gift tax exclusion. The court stated that “it is not obvious why the beneficiary must be able to ‘go before a state court to enforce that right.’ … A beneficiary would suffer no adverse consequences from submitting his claim to a beth din, and respondent has not explained why this is not enforcement enough.” Moreover, the court held that the specific in terrorem provision in this case would not apply to a beneficiary’s withdrawal right because it applied only to actions to oppose or challenge discretionary trust distributions.
There may be at least three more developments relating to the issues in Mikel. In the first development, Judge Lauber denied the taxpayers’ request for payment of attorney’s fees under section 7430, finding that the position of the IRS, although unsuccessful, was substantially justified, in that it had a reasonable basis in fact and law and was justified to a degree that could satisfy a reasonable person. Mikel v. Commissioner, T.C. Memo 2015-173 (Sept. 8, 2015).
In the second development, apparently still to come, it must be determined, either by a decision of the court or by a settlement between the Mikels and the IRS, whether the withdrawal rights of all 60 beneficiaries justify annual exclusions and whether the $3,262,000 value of the contributions to the trust is accurate.
And as a third possible development, although it wouldn’t affect the Mikels’ 2007 gifts, the Obama administration’s budget-related revenue proposals would significantly limit the effectiveness of Crummey withdrawal powers. The “General Explanations of the Administration’s Fiscal Year 2015 Revenue Proposals” (March 4, 2014), at pages 170-71, and the “General Explanations of the Administration’s Fiscal Year 2016 Revenue Proposals” (Feb. 2, 2015), at pages 204-05, include a proposal to “Simplify Gift Tax Treatment for Annual Gifts.” The General Explanations (popularly called the “Greenbooks”) note the compliance costs of Crummey powers, including the costs of giving notices, keeping records, and making retroactive changes to the donor’s gift tax profile if an annual exclusion is disallowed, as well as the enforcement costs to the IRS. They also lament the IRS’s lack of success in combating the proliferation of Crummey powers, especially in the hands of persons not likely to ever receive a distribution from the trust, in Estate of Cristofani v. Commissioner, 97 T.C. 74 (1991), and Kohlsaat v. Commissioner, T.C. Memo 1997-212. If its 60 Crummey powers are ultimately upheld, Mikel is likely to be added to this list.
Although the proposal states that it “would eliminate the present interest requirement for gifts that qualify for the gift tax annual exclusion,” what it actually proposes is to limit the annual exclusion (currently $14,000 per donee) to outright gifts, gifts to “tax-vested” trusts exempt from GST tax under section 2642(c)(2), and “a new category of transfers” that some interpreted in 2014 to be allowed, up to $50,000 per donor per year, without tapping into the donor’s $14,000-per-donee annual exclusions. That interpretation was repudiated by a new sentence in the 2015 Greenbook: “This new $50,000 per-donor limit would not provide an exclusion in addition to the annual per-donee exclusion; rather, it would be a further limit on those amounts that otherwise would qualify for the annual per-donee exclusion.” Thus, the compliance burdens of identifying donees would not be eliminated after all, and drafting to take advantage of the $50,000 (indexed) category could be more complex, not less. (The 2015 Greenbook also added that the proposed limit of $50,000 would be indexed for inflation.)
Although there is little reason to expect this Greenbook proposal to be enacted, the proposal, along with the Mikel decision, does illustrate the frustration of Treasury and the IRS with at least some uses of Crummey powers.
Number Eight: Continued Erosion of the Power of States to Tax Trust Income:Kimberly Rice Kaestner 1992 Family Trust v. North Carolina Department of Revenue, 12 CVS 8740 (N.C. Sup’r Ct. April 23, 2015), and Residuary Trust A u/w/o Kassner v. Director, Division of Taxation, 2015 N.J. Tax LEXIS 11, 2015 WL 2458024 (N.J. Sup’r Ct. App. Div. May 28, 2015), aff’g 27 N.J. Tax 68 (N.J. Tax Ct. Jan. 3, 2013)
In Kaestner, discussed in more detail in our Legal Alert of May 1, 2015, the Superior Court of Wake County, North Carolina, held North Carolina’s income tax on the taxable income of a trust for the benefit of a North Carolina resident unconstitutional as applied to a trust created by a New York resident for the benefit of his descendants. One of the beneficiaries had moved to North Carolina. But a New York resident was the trustee, all trust records were maintained in New York, the custodian of the trust investments was in Boston, the trust tax returns were prepared in New York, the trustee did not travel to North Carolina, the trustee did not make any distributions to the North Carolina beneficiary, and the beneficiary could not compel the trustee to make a distribution. The court held that the tax, as applied to this trust in which the trustee had no connections with North Carolina, violates both the due process and commerce clauses of the U.S. Constitution.
The trust in Kassner was created by the will of a New Jersey resident who died in 1998. New Jersey law defines a resident trust for income tax purposes to include “a trust, or a portion of a trust, consisting of property transferred by the will of a decedent who at his death was domiciled in this state.” During the tax year at issue (2006), the sole trustee resided in New York and administered the trust outside of New Jersey. The trustee filed a return and paid New Jersey tax only on income of S corporations attributable to the corporations’ activity in New Jersey. The New Jersey Tax Court rejected the New Jersey Division of Taxation’s contention that the trust was taxable on all undistributed income because it held assets in New Jersey, holding that the trust cannot be deemed to own assets in New Jersey merely because it was a shareholder in S corporations that own New Jersey assets.
The Appellant Division affirmed the New Jersey Tax Court. It did so using the New Jersey square corners doctrine that requires the government to deal fairly with its citizens and engage in equitable practices. It noted that the Division of Taxation’s official guidance in 1999 in the State Tax News (which the court noted is a “bi-monthly newsletter published by the Division itself”) gave taxpayers unequivocal advice that undistributed trust income would not be taxable if the trustee was not a New Jersey resident and the trust had no New Jersey assets. In fact, the position that a trust was subject to taxation of its retained income if it had any New Jersey income had first been announced only in 2011, five years after the year at issue. The court noted that it was fundamentally unfair for the Division of Taxation to announce in its official publication that under a certain set of facts a trust’s income will not be taxed, and then retroactively apply a different standard years later.
These decisions are limited. Kaestner is being appealed by the North Carolina Department of Revenue. Further, while the trust sought a determination that the statute is unconstitutional on its face, the court ruled only that it is unconstitutional as applied to this trust. In Kassner, the appellate court relied as much on New Jersey’s published advice as on constitutional grounds, leaving open the possibility that the result would be different if the instructions and advice had been different. But these cases still represent a continuation of, not a retreat from, the recent trend of limiting a state’s power to tax nonresident trusts. See, for example, Linn v. Department of Revenue, 2013 Ill. App. 4th 121055 (Dec. 18, 2013), and McNeil v. Commonwealth of Pennsylvania, Pa. Comm. Court, No. 651 F.R. 2010, 173 F.R. 2011 (May 24, 2013).
Number Seven: More Flexibility in the Support and Administration of Charities: “Protecting Americans from Tax Hikes Act of 2015,” Notice 2015-62, 2015-39 I.R.B. 411, Green v. United States, 116 AFTR 2d 2015-6668 (W.D. Okla. Nov. 4, 2015)
Legislation: Part of the Consolidated Appropriations Act, 2016 given final approval by the House and Senate and signed into law by President Obama on December 18, 2015, was the Protecting Americans from Tax Hikes Act of 2015 (PATH Act). The core of the PATH Act (56 of 127 sections) was the nearly annual “extenders” of a variety of temporary provisions. Twenty-two of those sections made some of those temporary provisions permanent. Included were five provisions described as “Incentives for Charitable Giving.” These now-permanent provisions include the closely watched ability of individuals over 70½ years old to make charitable distributions from individual retirement accounts (IRAs), up to $100,000 per year, without including those amounts in gross income (section 112 of the Act). Others include donor-favorable rules for contributions of real property for conservation purposes, especially for farmers and ranchers and Alaska Native Corporations (section 111), and for certain contributions of food inventory (section 113), and the special rule that the basis in an S corporation shareholder’s stock is not reduced by the unrealized appreciation in property contributed to charity by the S corporation (section 115).
Continuing to react to “scandals” regarding IRS handling of applications for recognition of tax exemption, Congress has also included in the PATH Act requirements that the IRS allow administrative appeals of adverse exemption determinations to the Office of Appeals (section 404 of the Act); a streamlined recognition process for section 501(c)(4) social welfare organizations (section 405); extension of the availability of declaratory judgment relief under section 7428 to all organizations described in section 501(c), not just section 501(c)(3) and explicitly including section 501(c)(4) (section 406); and the exemption from gift tax of gifts to section 501(c)(4), (5), and (6) (social welfare, labor, agricultural, horticultural, and business league, etc.) organizations (section 408). In related provisions of more general application, the Act codifies a “taxpayer bill of rights” (section 401); allows taxpayers who have been victimized by the IRS, such as by unauthorized disclosure of private tax information, to learn the IRS’s reaction, such as whether the case is being investigated or referred to the Justice Department for prosecution (section 403); and requiring the termination of an IRS employee who performs, delays, or fails to take any official action for personal gain or political purposes (section 407). It is hard to say how these changes will encourage charitable giving, but they will provide modest reassurance to some anxious taxpayers that Congress is attentive to their concerns.
Administrative Guidance: Notice 2015-62 clarifies the circumstances in which certain investments for mixed charitable and income purposes will not be treated as investments that jeopardize charitable purposes under section 4944. Section 4944(c) exempts “program-related investments,” defined as “investments, the primary purpose of which is to accomplish one or more of the purposes described in section 170(c)(2)(B), and no significant purpose of which is the production of income or the appreciation of property.” Some investments, however, often called “mission-related investments,” are intended to produce both a social benefit and an investment return and therefore do not meet the definition of a program-related investment. Notice 2015-62 provides that such an investment will not be considered a jeopardizing investment if, in making the investment, the foundation’s managers exercise ordinary business care and prudence. The notice specifically acknowledges that the managers may include in their evaluation of an investment “all relevant facts and circumstances, including the relationship between a particular investment and the foundation’s charitable purposes.” The Notice concludes that “a private foundation will not be subject to tax under section 4944 if foundation managers who have exercised ordinary business care and prudence make an investment that furthers the foundation’s charitable purposes at an expected rate of return that is less than what the foundation might obtain from an investment that is unrelated to its charitable purposes.” Mission-related investments and Notice 2015-62 are discussed in more detail in our Legal Alert of December 18, 2015.
Case Law: Meanwhile, a judicial development may simplify and enhance the charitable contribution deduction for certain contributions of appreciated property by trusts. Green v. United States, 116 AFTR 2d 2015-6668 (W.D. Okla. Nov. 4, 2015), involved charitable donations of appreciated real estate in 2004 by The David and Barbara Green 1993 Dynasty Trust, which owned a 99 percent limited partnership interest in Hob-Lob Limited Partnership, which in turn owned or operated many Hobby Lobby stores. The trust deducted the adjusted basis of the properties on its 2004 federal income return and then amended the return exactly three years later to deduct the full fair market value of the properties. The IRS disallowed the refund, stating, a bit simplistically, that “[t]he charitable contribution deduction for the real property donated in 2004 is limited to the basis of the real property contributed.”
The District Court (Judge DeGiusti) granted summary judgment to the trust. Citing opinions of other courts, it stated that “[t]he purpose of Congress in enacting [charitable contribution provisions] was to encourage charitable gifts” and that “statutes regarding charitable deductions … are not matters of legislative grace, but rather ‘expression[s] of public policy.’” As such, “[p]rovisions regarding charitable deductions should … be liberally construed in favor of the taxpayer.” The government argued that section 642(c) limits the deduction to “any amount of the gross income … paid.” The court was persuaded by the fact that the properties had been bought with gross income. The government also argued that gross income does not include unrealized appreciation, but the court found no limitation to basis in section 642(c).
The result in Green might be surprising to some, because, as the government argued, gross income indeed does not include unrealized appreciation. But allowing a deduction of fair market value puts the trust in the same position as if it had sold the property and donated the cash proceeds, while allowing the charitable donees to receive the property, which in at least some cases was evidently going to be used by the donee for its charitable purposes.
Number Six: New Uniform Acts: Trust Decanting; Digital Assets (July 2015)
Decanting. A new Uniform Trust Decanting Act (UTDA) was approved by the National Conference of Commissioners on Uniform State Laws (“Uniform Law Commission”) at its annual conference in Williamsburg, Virginia, July 10-16, 2015. The Act generally allows decanting whenever the trustee has discretion to make principal distributions, or even if the trustee does not have such discretion if it is appropriate to decant into a special-needs trust. UTDA imposes no duty to decant, but requires that, if decanting is done, it must be done in accord with fiduciary duties. Decanting requires notice to beneficiaries, but not court approval, although a fiduciary or beneficiary may ask a court to provide instructions or relief. Generally decanting may not add beneficiaries, and it may not increase the trustee’s compensation without approval of beneficiaries or a court. In addition, UTDA includes extensive explicit safeguards, called “tax-related limitations,” to prevent decanting from jeopardizing any intended beneficial tax treatment of the trust.
The 2011-2012 Treasury-IRS Priority Guidance Plan included, as item 13 under the heading of Gifts and Estates and Trusts, “Notice on decanting of trusts under §§2501 and 2601.” This project was new in 2011-2012, but it had been anticipated for some time, at least since the publication at the beginning of 2011 of Rev. Proc. 2011-3, 2011-1 I.R.B. 111, in which new sections 5.09, 5.16, and 5.17 included decanting among the “areas under study in which rulings or determination letters will not be issued until the Service resolves the issue through publication of a revenue ruling, revenue procedure, regulations or otherwise.” Rev. Proc. 2015-3, 2015-1 I.R.B. 129, §§5.01(14), (20) & (21) continues this designation. On December 20, 2011, the IRS published Notice 2011-101, 2011-52 I.R.B. 932, asking for comments from the public on the tax consequences of decanting transactions. Notice 2011-101 also “encourage[d] the public to suggest a definition for the type of transfer (‘decanting’) this guidance is intended to address” and encouraged responses to consider the contexts of domestic trusts, the domestication of foreign trusts, and transfers to foreign trusts. The Notice also said that the IRS “generally will continue to issue PLRs with respect to such transfers that do not result in a change to any beneficial interests and do not result in a change in the applicable rule against perpetuities period.” There were extensive public comments, and there is no doubt that Treasury and the IRS have continued to study decanting. But decanting was omitted from the 2012-2013 Plan and has been omitted again from the 2013-2014, 2014-2015, and 2015-2016 Plans.
The publication of UTDA should now pave the way for the long-awaited tax guidance. And because of the care to avoid tax problems that UTDA exhibits, that guidance should not be as hard to complete or as harsh in its application as many might have feared.
Digital Assets. In January 2012, the Uniform Law Commission authorized the formation of a drafting committee to write model legislation authorizing fiduciaries to access, manage, copy, and delete digital assets. The committee developed a Uniform Fiduciary Access to Digital Assets Act (UFADAA), which the ULC approved at its July 2014 annual meeting in Seattle. Despite introductions and discussions of UFADAA in many states, Delaware is the only state that adopted that version of UFADAA. Indeed, the Delaware legislature had enacted the final draft version of UFADAA even before the July 1014 ULC meeting, and the governor of Delaware signed it into law later in 2014. In other states, enactment of UFADAA was opposed and effectively blocked by a coalition of internet providers and advocates for personal rights and privacy, in many cases by the use of exaggerated horror stories of the breaches of privacy that UFADAA would allow. Some internet service providers even developed and promoted their own very harsh alternative to UFADAA, the Privacy Expectation Afterlife Choices Act (PEAC Act, pronounced “peace act”).
Renewed informal discussions among members of the ULC committee, internet providers, and privacy advocates resulted in a Revised Uniform Fiduciary Access to Digital Assets Act (RUFADAA), which original Internet service provider opponents of UFADAA found acceptable and agreed not to oppose. At its Williamsburg meeting in July 2015, the ULC approved RUFADAA, which generally allows a fiduciary full access to digital assets other than the content of electronic communications (unless the user or the court directs otherwise). RUFADAA also sets forth its own recapitulation of fiduciary duties, so as to reassure, within the corners of the Act, service providers and others who might otherwise not have any reason to know or appreciate the scope and seriousness of those duties and the safeguards of privacy those duties entail.
As RUFADAA catches on among the states, it will behoove estate planners and other advisers to structure estate plans and draft estate planning documents, as well as recommend user actions with respect to service contracts, that will be consistent with RUFADAA and will ensure the orderly transition of necessary access when a user dies or becomes incapacitated or missing.
Number Five: Final Portability Regulations, T.D. 9725, 80 Fed. Reg. 34279 (June 16, 2015)
Section 303 of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, Public Law 111-312 (“the 2010 Tax Act”), signed into law on December 17, 2010, authorized the portability of the federal estate tax and gift tax unified credit between spouses. Temporary regulations (T.D. 9593, 77 Fed. Reg. 36150 (June 18, 2012)) and identical proposed regulations (REG-141832-11, 77 Fed. Reg. 36229) were released on Friday, June 15, 2012, just barely 18 months after the enactment of the 2010 Tax Act. Section 7805(b) generally prohibits such regulations from being retroactive, with an exception, in section 7805(b)(2), for regulations issued within 18 months of the statute to which they relate, so these temporary regulations just made it and were retroactive to January 1, 2011, when portability took effect. Public comments on the proposed regulations were invited by September 17, 2012, and a public hearing, if requested, was scheduled for October 18, 2012, but no one asked for a hearing and the hearing was cancelled. The final regulations, very similar to the temporary and proposed regulations, were released on June 12, 2015. T.D. 9725, 80 Fed. Reg. 34279 (June 16, 2015). Under section 7805(e)(2), the temporary regulations would have expired after three years, on June 15, 2015, so again the final regulations just made it.
As a result of the perseverance of Treasury and the IRS in meeting these deadlines – it isn’t always easy – a number of very favorable clarifications in the regulations are now confirmed to have been available without interruption since portability first took effect on January 1, 2011. These include confirmation that if an estate tax return is not otherwise needed for estate tax purposes (if, for example, the gross estate plus adjusted taxable gifts is less that the basic exclusion amount) but is filed solely to elect portability, a simplified method of reporting values on the return is permitted, and if such a portability-only return is not timely filed, “9100 relief” is available to permit a late portability election. The rules also provide, for all estates, ordering rules that permit a surviving spouse, by making gifts, to benefit from the unified credit of more than one predeceased spouse.
The regulations do not address the availability of a QTIP election on a portability-only return in light of Rev. Proc. 2001-38, 2001-24 I.R.B. 1335, in which the IRS announced that it “will disregard [a QTIP] election and treat it as null and void” if “the election was not necessary to reduce the estate tax liability to zero, based on values as finally determined for federal estate tax purposes.” That issue is the subject of a pending Treasury-IRS guidance project to produce a clarifying revenue procedure (Item 4 of the 2015-2016 Priority Guidance Plan). It is understandable that there is concern about the validity of a QTIP election in a context in which the IRS has used the phrase “null and void.” But the forthcoming guidance will almost certainly be favorable, although it may use the occasion to address general concerns, not unique to the portability scenario, that Rev. Proc. 2001-38 may seem to encourage an inappropriate use of “hindsight” to in effect postpone the real QTIP election to the due date of the estate tax return of the surviving spouse.
It is clear that in the intended target case of a married couple with a home, modest tangible personal property, bank account, and perhaps an investment account – all possibly jointly owned – and life insurance and retirement benefits payable to the survivor, the requirements for electing portability have been made relatively manageable, especially considering that the surviving spouse is likely to be the “non-appointed executor” in possession of all the property and therefore the right person to make the portability election. What may be a surprise to the original advocates of portability, including the lawmakers who voted for it, is the degree of “portability planning” in much larger estates.
Number Four: Same-Sex Marriage Recognized as a Constitutionally Protected Right: Obergefell v. Hodges, 576 U.S. ___, 135 S. Ct. 2584 (June 26, 2015)
In a 5-4 decision, the United States Supreme Court held that the Fourteenth Amendment protects the right of two persons of the same sex to marry, and therefore no state could refuse to allow such a marriage or to recognize such a marriage performed elsewhere. This came exactly two years after the court’s 5-4 decision in United States v. Windsor, 570 U.S. ___, 133 S. Ct. 2675 (2013), that federal law may not refuse to recognize such a marriage validly performed or recognized under the law of any state.
The social implications of Obergefell are greater than this short discussion and even its Number Four placement would indicate, and there are complex open issues related to the intersection of the Obergefell result with other liberties, such as religious liberty, and also testamentary freedom. Some of these are included in the discussion of Windsor as item Number Two in the 2013 Top Ten and in our Alert of July 8, 2015, on the Obergefell decision. The two principal implications for estate planning are a short-term acceleration of the transitional issues, including retroactivity, that emerge whenever there is a change like this from one definition to another, and a long-term increase in uniformity and thus in simplification.
Number Three: Consistency-of-Basis Legislation: Sections 1014(f) and 6035; Notice 2015-57, 2015-36 I.R.B. 294
On July 31, 2015, the day that funding for the Highway Trust Fund was scheduled to expire, President Obama signed into law the Surface Transportation and Veterans Health Care Choice Improvement Act (Public Law 114-41), extending that infrastructure funding for three months, with the $8 billion cost funded by various tax compliance measures. One of those compliance measures is section 2004 of the Act, labelled “Consistent Basis Reporting Between Estate and Person Acquiring Property from Decedent,” which added new sections 1014(f) and 6035 to the Code.
Section 1014(f) requires in general that the basis of property received from a decedent may not exceed the value as finally determined for estate tax purposes, or, if there is no final determination (as in the case of property sold while an estate tax audit is still in progress or, within the statutory period for assessments, has not begun), the value reported on the estate tax return.
Section 6035 imposes reporting requirements on every executor (or person in possession of property with the statutory duties of an executor) who is required to file an estate tax return – that is, in general, if the gross estate plus adjusted taxable gifts exceeds the applicable filing threshold, but also, apparently, under Reg. §20.2010-2(a)(1), if a return is filed only to elect portability. Such a person is required to furnish to the IRS and to the recipients of property interests included in the decedent’s gross estate a statement setting forth the value of those property interests reported on the estate tax return. This statement is due 30 days after the due date (including extensions) of the estate tax return. Every such statement must be supplemented if a value is adjusted, for example, on audit.
Penalties apply for failure to file a required statement and for reporting basis inconsistently with such a statement.
This legislation resembles legislative proposals in the Obama administration’s Treasury Department’s annual “General Explanations” of revenue proposals associated with President Obama’s budget proposals (“Greenbooks”), including a proposal on pages 195-96 of the 2015 Greenbook. Unlike the Greenbook proposals, however, what Congress enacted applies only to property acquired from a decedent, not to gifts, and, under section 1014(f)(2), applies “only … to any property whose inclusion in the decedent’s estate increased the liability for the tax imposed by chapter 11 (reduced by credits allowable against such tax) on such estate.” In other words, these new rules apparently do not apply to property that passes to a surviving spouse or to charity, or to property that does not pass to the surviving spouse but is reported on an estate tax return filed only to elect portability. (Oddly, there is no corresponding exception to the reporting requirement of section 6035.)
In addition, while the Greenbook proposals would have been effective for transfers – that is, for decedents dying – on or after the date of enactment, section 1014(f) as enacted is applicable to property with respect to which an estate tax return is filed after the date of enactment. This produces a significant acceleration of the application of the statute. A return filed after the date of enactment might have been due, and filed, on August 1, 2015, making the first statements under these rules due on August 31, 2015. Apparently in recognition of that accelerated application, Notice 2015-57, released on August 21, 2015, extended to February 29, 2016, the due date of any statements required by section 6035 that otherwise would be due before that date. The Notice cites section 6081(a), which allows extensions of time only for up to six months except in the case of taxpayers who are abroad. February 29, 2016, is the closest date the calendar allows to six months after August 31, 2015. So the Notice signals that this will be the only extension.
Notice 2015-57 also states that “[t]he Treasury Department and the IRS expect to issue additional guidance to assist taxpayers with complying with sections 1014(f) and 6035.” We should expect this guidance by February 29, 2016; it affects too many estates to be deferred beyond that date. Among the guidance that might be appropriate, certain regulations are explicitly contemplated and authorized or even directed by the statute. Section 1014(f)(4) states that “[t]he Secretary may by regulations provide exceptions to the application of this subsection.” And section 6035(b) states that “[t]he Secretary shall prescribe such regulations as necessary to carry out this section, including regulations relating to (1) the application of this section to property with regard to which no estate tax return is required to be filed, and (2) situations in which the surviving joint tenant or other recipient may have better information than the executor regarding the basis or fair market value of the property.” Guidance on other subjects, including the dilemma of how to even know 30 days after filing the estate tax return which beneficiaries will receive which property, will likely also be considered.
A draft Form 8971 for reporting the necessary information was released on December 18, 2015. It contains space for listing five beneficiaries, and Schedule A (to be given to each beneficiary, like a K-1) with space for listing six assets. Clearly the liberal use of continuation sheets is contemplated. For each asset, the executor is to answer whether the asset increases estate tax liability and provide the valuation date and value. Schedule A includes the following:
Notice To Beneficiaries:
You have received this schedule to inform you of the value of property you received from the estate of the decedent named above. Retain this schedule for tax reporting purposes. If the property increased the estate tax liability, Internal Revenue Code section 1014(f) applies, requiring the consistent reporting of basis information. For more information on determining basis, see IRC section 1014 and/or consult a tax professional.
This notice looks like about the best that could be done in the form to permit the blast of value information to all beneficiaries long before the recipients of particular assets are identified that the statute seems to require, without unnecessarily alarming or misleading the beneficiaries.
It is less clear that such guidance will or can address what many observers consider the fundamental flaw of the statute – it has the potential, especially when an estate tax return is audited, to pit family members and other beneficiaries against each other in an intolerable tension. Van Alen v. Commissioner, T.C. Memo 2013-235, discussed as Number Seven in the 2013 Top Ten, describes how an estate tax audit “went back and forth” and the low value of a ranch could have been a trade for higher values of three other properties. Indeed, the court said: “The bottom line was that the IRS got an increase in the total taxable value of the estate … and an increase in the estate tax.” To bind heirs who do not participate in that audit seems quite unfair, and to give the heirs a role in the audit would be monstrously impractical. Yet, enchanted by the siren song of “consistency” – not to mention the temptation of a conjectural revenue gain – Congress seems not to have thought this through.
Number Two: The Political Climate in Washington
The suggestion that Congress might not think some things through is a comparatively mild comment in today’s political environment. Even as, from year to year, it seems that really significant federal tax developments suitable for a compilation like this are in decline, we can always count on the Washington political climate in general to be anything but dull. In addition, in 2015 and 2016, the impact of the presidential election campaign simply defies analysis.
But new leadership in the House of Representatives seems to have had at least a modest effect. The Consolidated Appropriations Act, 2016, enacted on December 18, 2015, and mentioned in the discussion of Number Seven, is an example. There seemed to be more “regular order” participation of lawmakers and committees than we have seen in recent years, and the spending appropriations remained on the basis of the regular fiscal year, rather than ad hoc “fiscal cliffs.” Perhaps as a result, the votes were more bipartisan than we are accustomed to. In the Senate, the final vote was 65-33, with 27 Republicans and 38 Democrats (including one Independent) in favor. The final vote in the House of Representatives was 316-113, with 150 Republicans and 166 Democrats in favor. The final vote, however, included spending that some Republicans had resisted; a vote in the House the day before, focusing on the tax provisions, was 318-109, with 241 Republicans and only 77 Democrats in support. The overall impression was one of some compromise, leaving almost everyone unenthusiastic about something; not as robust a compromise as may have been expected a few decades ago, but providing some reason for optimism for the budget process in 2016 – possibly with a budget resolution early in the year and “reconciliation” of the input of many committees later in the summer or early fall.
The 127 sections of the Protecting Americans from Tax Hikes Act of 2015, including the charitable and other tax-exempt provisions mentioned in the discussion of Number Seven, are not fundamental tax reform or even a reliable predictor of tax reform in the near future. But the provision-by-provision attention reflects a somewhat thoughtful and policy-based deliberation, albeit sprinkled with an ample portion of political trading. As examples, some of the expiring “extender” provisions were made permanent, including both middle-class relief like the child tax credit (section 101 of the Act), American Opportunity Tax Credit (section 102), and earned income credit (section 103), and business provisions like the research and development tax credit (section 121) and the reduction from 10 to five years of the period in which a newly converted S corporation’s built-in gains are subject to a corporate-level tax (section 127). And the Act makes permanent the option to claim an itemized deduction for state and local sales taxes rather than income taxes (section 106), which is especially important, of course, to residents of states with no income tax.
Significant elements of the changes in House leadership include a Speaker, Congressman Paul Ryan (R-WI), who had briefly been the chair of the Ways and Means Committee, and a new chair of the Ways and Means Committee, Congressman Kevin Brady (R-TX), who has been outspoken about his opposition to the estate tax. It was Congressman Brady who had introduced the Death Tax Repeal Act of 2015 (H.R. 1105), which the House of Representatives approved by a largely party-line vote on April 16, 2015, permanently repealing the estate and GST taxes, retaining the gift tax with a 35 percent rate and an exemption of $5 million indexed for inflation, and retaining a date-of-death-value basis for transfers at death (despite the absence of an estate tax). Certainly his assumption of the chair of the committee somewhat increases the chances of estate tax repeal, but it would be wrong to jump to conclusions about that. Estate tax repeal remains a politically complex issue, and it is not at all clear that the present or future House leadership would be willing to spend its political capital on this objective rather than others, whether in packaging a repeal to avoid a presidential veto or in positioning it to get 60 votes for a Senate cloture motion.
Number One: The Administration’s Present and Future Assaults on Estate Planning Techniques: Estate of Davidson v. Commissioner , Tax Court Docket No. 13748-13 (stipulated decision entered July 6, 2015); Estate of Donald Woelbing v. Commissioner, Tax Court Docket No. 30261-13 (filed Dec. 26, 2013); Estate of Marion Woelbing v. Commissioner, Tax Court Docket No. 30260-13 (filed Dec. 26, 2013); Administration’s Budget Proposals (Feb. 2, 2015); 2015-2016 Treasury-IRS Priority Guidance Plan (July 31, 2015)
In the Davidson case, the decedent had engaged in estate planning transactions, including gifts, substitutions, a five-year GRAT, sales for five-year balloon notes at the applicable federal rate, and sales for five-year balloon self-canceling installment notes (SCINs). The decedent at that time was 86, and his actuarial life expectancy was about five years. He lived for 50 days after making the last transfer and received no payments on the sales. Addressing the sales both in Chief Counsel Advice 201330033 (Feb. 24, 2012), and in its answer in the Tax Court, the IRS believed the notes should be valued, not under section 7520, but under a willing-buyer-willing-seller standard that took account of the decedent’s health. The IRS assessed combined gift and estate tax deficiencies and penalties of about $2.6 billion. On July 6, 2015, the case was settled for just over $550 million.
In the Woelbing cases, the decedent had sold nonvoting stock for a promissory note with a principal amount of $59 million (the appraised value of the stock) and interest at the applicable federal rate (AFR). The purchaser was a trust that owned insurance policies under a split-dollar arrangement with the company. Two of the decedent’s sons, who were beneficiaries of the trust, gave their personal guarantees, apparently for 10 percent of the purchase price. The sale agreement provided for the number of shares sold to be adjusted if the IRS or a court revalued the stock. In its notice of deficiency, the IRS basically ignored the note, essentially treating it as equity rather than debt, and doubled the value of the stock to about $117 million. The IRS ignored the note for estate tax purposes too, but included the value of the stock, which it then asserted to be about $162 million, in the decedent’s gross estate under sections 2036 and 2038. Finally, the IRS asserted gift and estate tax negligence and substantial underpayment penalties. After a rumored settlement apparently fell through, the Tax Court rescheduled the trial for February 29, 2016. Thus, among other things, if the case does not settle, the Tax Court might be obliged to address the effectiveness of the value adjustment clause, the substance of the notes, the appropriate interest rate and value for the notes, and the possible reliance on life insurance policies and/or guarantees to provide “equity” in the trust to support the purchase.
Meanwhile, the “General Explanations of the Administration’s Fiscal Year 2016 Revenue Proposals” (Feb. 2, 2015) (“Greenbook”), at pages 197-99, include a legislative proposal to tighten the tax treatment of all sales to grantor trusts, as did the 2012, 2013, and 2014 Greenbooks. The current proposal would subject to gift or estate tax the portion of any grantor trust that is attributable to property received from a person in “a sale, exchange, or comparable transaction that is disregarded for income tax purposes by reason of the person’s treatment as a deemed owner of the trust.”
Finally the Treasury-IRS Priority Guidance Plan for the 12 months beginning July 1, 2015 (released on July 31, 2015), contains 277 projects (down from 317 in 2014), including 12 projects under the heading of “Gifts and Estates and Trusts” (up from 10 in 2014). Four of those projects (an ambitious number) are new in 2015. Item 1 is “Guidance on qualified contingencies of charitable remainder annuity trusts under §664.” Item 3 is “Guidance on basis of grantor trust assets at death under §1014.” Item 5 is “Guidance on the valuation of promissory notes for transfer tax purposes under §§2031, 2033, 2512, and 7872.” And Item 8 is “Guidance on the gift tax effect of defined value formula clauses under §§2512 and 2511.” The objective of Item 1, regarding charitable remainder trusts, is not clear. Item 3, regarding basis, might be aimed at trusts created by non-U.S. persons, but it might also have implications for domestic grantor trusts. Items 5 and 8, regarding promissory notes and defined value clauses, sound almost tailored to the facts of Davidson and Woelbing.
The point is that grantor trusts, including transactions with promissory notes and even defined value clauses, have received a lot of attention from the IRS in recent years, highlighted by the addition this year of multiple guidance projects in the Priority Guidance Plan. On top of that, regulations under section 2704(b)(4) − affecting valuation discounts for transfers in closely held corporations, partnerships, and similar entities − have been the subject of an unprecedented amount of attention and speculation in 2015, even though section 2704(b)(4) has been in the Code since 1990 and this regulations project has been in the Priority Guidance Plan since 2003. No lawyer or other observer has seen all the variations of estate planning techniques using grantor trusts, promissory notes, and valuation formulas. But the IRS has seen many of them. And this surge of IRS interest and activity probably means the IRS sees a lot of variations it does not like.