Tax Year In Review 2017

Attorneys

Butler v. LeBouef*

Gifts to a drafting attorney subject to additional scrutiny 

The drafting attorney in Butler v. LeBouef (248 Cal.App.4th 198 (Ct. App. Calif. 2016)), was the principal beneficiary of the decedent’s $5 million estate. The evidence showed the attorney’s intent to enrich himself and, therefore, the court invalidated the will and trust and removed the trustee.

Charitable Trusts

Private Letter Ruling 201730012

CLAT converts from non-grantor trust to grantor trust

In PLR 201730012 (May 1, 2017), a taxpayer established a charitable lead annuity trust (CLAT). The taxpayer sought to amend the CLAT under state law to allow the grantor’s sibling (who wasn’t a trustee) to have the power to substitute trust property under the meaning of Internal Revenue Code Section 675(4), which would convert the trust from a non-grantor trust to a grantor trust.

The grantor of the trust requested three rulings: (1) the conversion from a non-grantor trust to a grantor trust wasn’t a taxable transfer of property to grantor, (2) the conversion wasn’t an act of self-dealing under IRC Section 4941, and (3) the grantor would be entitled to an income tax charitable deduction in the year of conversion.

The Internal Revenue Service ruled that converting the trust from a non-grantor trust to a grantor trust wouldn’t be treated as a transfer of property to the grantor under any income tax provision. It referred to Revenue Ruling 77-402, which dealt with the income tax consequence of relinquishing grantor trust status or other lapse of grantor trust status. This ruling wasn’t applicable here because the conversion was to grantor trust status, rather than from grantor trust status. While Rev. Rul. 85-13 related to a transaction that was in the right “direction” (the grantor who acquired trust property in exchange for a promissory note caused grantor trust status by “borrowing” the trust corpus), it didn’t conclude that the action was an income recognition event for the grantor. The IRS therefore held that because Rev. Rul. 85-13 didn’t treat conversion of a non-grantor trust to a grantor trust as an income tax realization event and there was a lack of authority imposing such consequences, conversion of the trust to a grantor trust wouldn’t be treated as a transfer of property to the grantor for income tax purposes. 

On the self-dealing issue, the IRS noted that the self-dealing rules in Section 4941 apply to the CLAT as if the trust were a private foundation (PF). The IRC defines “self-dealing” as any direct or indirect transfer to a disqualified person, including a substantial contributor, a manager or certain family members of those persons. The family members who are included as disqualified persons don’t include siblings. Therefore, because the power to substitute trust assets was given to the grantor’s sibling and the sibling wasn’t a disqualified person, holding or exercising such power wasn’t an act of self-dealing.

While the taxpayer received favorable rulings on the first two issues, he wasn’t so fortunate with the last. The IRS ruled that the grantor was unable to take an income tax deduction under IRC Section 170(a). Applying Section 170(a), the IRS reasoned that when the trust converts from a non-grantor trust to a grantor trust, the owner of a grantor trust can only claim a federal income tax deduction if there’s a property transfer to the grantor trust for income tax purposes, and because the conversion isn’t treated as a transfer of property for income tax purposes per the first ruling, no deduction was allowed. 

PLR 201714002

PLR holds that improperly administered CRUT is a PF 

In PLR 201714002 (Dec. 12, 2016), a beneficiary of a charitable remainder unitrust (CRUT) requested guidance on the tax implications of terminating a CRUT gone wrong. On the advice of his lawyer, a taxpayer established a CRUT in part to avoid capital gains tax on sale of low-basis assets. The CRUT provided for a unitrust payment to the taxpayer, and certain other persons, with a net income make-up provision. The lawyers preparing the trust incorrectly advised the taxpayer/beneficiary that he would be guaranteed a certain percentage unitrust payment every year; however, the trust limited the payment to the lesser of the unitrust amount or the trust’s net income (a NICRUT). As it turned out, the trust’s net income actually was often less than the unitrust amount.

Several other errors were made. The lawyers advised the taxpayer that funding the trust wouldn’t be a completed gift because the taxpayer would retain the right to change the successor beneficiaries, but they didn’t include such a provision in the document, and the taxpayer failed to file a gift tax return. The trust was administered by including capital gains in the calculation of the trust’s net income so the payments to the income beneficiary were incorrectly inflated. The taypayer also made additions to the trust after the initial funding, based on the incorrect advice from his lawyer that the trust property was excludible from his taxable estate (which it wasn’t due to his retained interest). The taxpayer died, and a successor unitrust recipient petitioned a local court to terminate the trust. The court issued a declaration that the trust was void ab initio, contingent on a ruling from the IRS that there wouldn’t be additional federal income tax consequences, otherwise the court would declare the trust terminated.

The IRS held that the trust wasn’t void ab initio. It found that while it wasn’t operated properly as a CRUT (because it made distributions to the income beneficiary in excess of what should have been paid), it should be treated as a PF. As a PF, if the trust were to distribute its assets to the unitrust beneficiary, it would be a taxable expenditure and, as the beneficiary was a disqualified person, an act of self-dealing and, further, possibly justify an involuntary termination by the IRS and assessment of further tax and transferee liability. To avoid the various excise taxes, the trust could terminate its PF status under IRC Section 5701(a)(1) by giving notice and paying the required tax. In addition, the trust was required to correct prior year income tax returns.

Digital Assets

Ajemian v. Yahoo

Massachusetts case addresses digital assets

In Ajemian v. Yahoo (478 Mass. 169 (2017)), the Massachusetts Supreme Judicial Court addressed whether the personal representatives of a decedent’s estate had a right to access the decedent’s personal email account managed by Yahoo.

John Ajemian died at a young age in a bicycle accident. His brother and sister were appointed as the personal representatives of his estate and sought access to his Yahoo account. Yahoo agreed to turn over certain limited information to them when presented with a court order, but refused to provide them unfettered access to the account.  

The estate and Yahoo each filed for summary judgment.  John’s siblings claimed that as personal representatives of the estate, they were entitled to access the email account because it was an asset of the estate. Yahoo claimed that it was prohibited from permitting access to the account under the federal Stored Communications Act (the SCA) and, in the alternative, it wasn’t obligated to allow them access under the terms of service (TOS) that John agreed to when opening the account.

The court held that the SCA didn’t prohibit Yahoo from disclosing John’s emails. The SCA allows disclosure with the “lawful consent” of the originator. The court determined that a personal representative of the estate could lawfully consent to the disclosure under the SCA. The court reasoned that to find otherwise would result in a preemption of state law and concluded that Congress intended for lawful consent to encompass certain forms of implicit consent. It also noted that general purposes of the SCA were to prevent unauthorized access by law enforcement and private parties, not personal representatives of estates working to manage estate assets. As a result, Yahoo couldn’t claim that it was prohibited from providing access.

Then, the court remanded to the lower court on the issue of whether the TOS constituted a binding contract. Therefore, there was no resolution as to whether the TOS allowed Yahoo to refuse to grant access.

In summary, the case acknowledges that John’s email account is an estate asset of which the personal representative may seek access and control.  While the SCA doesn’t preclude a personal representative from accessing the account, it isn’t clear if the fine print relating to the email account in this case would give Yahoo authority to prevent access.

While state law on digital assets is evolving (and the interplay with federal law is complicated), estate planners should consider including provisions that authorize fiduciaries to handle digital assets even though there’s currently no guarantee that such provisions will be effective.  Such provisions should be discussed with clients, as many might not want to give family members access to certain digital assets, such as emails, following their death.

Estate & Gift Tax

Estate of Nancy H. Powell v. Commissioner

Tax Court rules on consequences of deathbed FLP transfer

In Estate of Nancy H. Powell v. Comm’r (148 T.C. 18 (May 18, 2017)), the Tax Court ruled on summary judgment motions relating to the estate tax consequences of certain deathbed transfers of decedent Nancy Powell’s assets made by her son, Jeffrey, under her durable power of attorney (POA).

On Aug. 6, 2008, Jeffrey formed NHP Enterprises LP, a Delaware family limited partnership (FLP). The opinion doesn’t say whether Jeffrey contributed assets to the FLP, but he was designated the general partner. The FLP could be dissolved with the consent of all partners. Two days later, just over $10 million in cash and securities were transferred from Nancy’s revocable trust to the FLP in exchange for a 99 percent FLP interest. On the same day (Aug. 8), using Nancy’s durable POA, Jeffrey transferred the 99 percent FLP interest to a CLAT. (Query why the FLP interests weren’t held by the revocable trust and transferred to the CLAT by the trustee.) Under the terms of the CLAT, an annuity was to be paid to the Nancy H. Powell Foundation, a Delaware nonprofit, for the remainder of Nancy’s life and, on her death, the assets to be split among her children. Nancy died one week later, on Aug. 15.

The estate filed a gift tax return for 2008, reporting the gifts relating to the CLAT, along with its estate tax return. The IRS issued a notice of deficiency disputing the value of the gift and included the value of the partnership assets in the estate.

The Tax Court held that the value of the cash and securities transferred to the FLP were includible in Nancy’s taxable estate under two alternative grounds. The first was based on the ability to dissolve the partnership and IRC Section 2036(a)(2). If Nancy had remained the owner of the 99 percent interest in the FLP on the date of her death, the court concluded that she had the ability to dissolve the FLP with the cooperation of her sons (the court didn’t go into detail regarding the revocable trust’s ownership of the interest versus Nancy individually and didn’t state explicitly whether Nancy was the sole trustee). The court held that this ability to dissolve the FLP was a right to designate who would possess or enjoy the property she transferred to the FLP, which would have caused inclusion of the cash/securities in her estate under IRC Section 2036(a)(2) had Nancy held it on the date of her death.  

The estate argued that Nancy didn’t hold this power on the date of her death because the FLP interest had been transferred to the CLAT. However, transferring that 99 percent FLP interest days before her death didn’t change matters, because IRC Section 2035 applied. Section 2035 includes in the estate certain property: (1) transferred, or (2) subject to a power if that transfer is made or that power is relinquished within three years of date of death, if that property would have otherwise been includible in the decedent’s estate.

The second ground for inclusion was based on the right to direct partnership distributions. In its analysis, the court analogized to the foundational case, Strangi v. Comm’r (417 F.3d 468 (5th Cir. 2005)), and noted that even in the absence of the dissolution power, the assets should still be includible under Section 2036(a)(2) because Jeffrey was acting as Nancy’s agent under her POA and was, in his individual capacity, the general partner of the FLP. In effect, Nancy’s attorney-in-fact had the power to make distribution decisions, although in his individual capacity. Unlike the holding in the well-known case
U.S. v. Byrum (408 U.S. 125 (1972)), which held that a decedent, as a majority shareholder, held fiduciary duties to minority shareholders that precluded inclusion under Section 2036(a)(2), the court in Powell found that any fiduciary duties allegedly held by Jeffrey were illusory because his duties were nearly exclusively to Nancy (or to her revocable trust) as the 99 percent limited partner.

The court then applied IRC Section 2043, in concert with Sections 2036 and 2035, to determine that the value includible in the estate was the excess of the value of the cash and securities over the value of the partnership interest. This, essentially, negated the benefit of any purported valuation discounts for lack of control and/or marketability. IRC Section 2043 (titled “Transfers for insufficient consideration”) provides that if a transfer is made for consideration but isn’t a bona fide sale for adequate and full consideration in money or money’s worth, and such property is included under Sections 2035 to 2038, only the excess of the fair market value at the time of death over the consideration paid is included in the gross estate. In this case, the estate didn’t challenge the IRS determination that the sale wasn’t bona fide so the court held that Section 2043 applied, and the value of the assets in excess of the value of the partnership interest was includible.

The court also found that Nancy’s gift of her FLP interest to the CLAT was void under California law (and therefore revocable under Section 2038(a)) because the POA gave Jeffrey only the authority to make annual exclusion gifts to Nancy’s children and not to charities, as required under state law. There was therefore no gift to the CLAT and no gift tax deficiency. However, because no gift occurred, Nancy was treated as owning the FLP interest on the date of her death, and it was includible in her estate.

All together, the end result is that the value of the cash and securities was still includible in Nancy’s estate, and there was no estate tax benefit from the transactions executed by Jeffrey.

The application of Section 2043 in this case is interesting because it’s so unusual. In prior cases, the factual scenario usually involved a decedent who continued to own an FLP interest until his date of death, and the IRS included the value of the assets held in the FLP in lieu of including the partnership interest under Section 2036. Several judges on the Tax Court acknowledged this and concurred in the result only. The concurring opinion held that the same result may be reached more simply by just applying Section 2036(a)(2) as the “string” that pulls the value of the assets transferred to the partnership back into the taxable estate. It argued that the application of Section 2043 simply wasn’t necessary.

Based on Powell, clients who create FLPs and family limited liability companies (LLCs) would be wise to not own any interest at death and not have any voting powers, including any vote on distributions or dissolution. 

Center of Budget and Policy Priorities

Report issued on estate tax facts

In light of the proposals to repeal the estate tax at the time this is written, the following facts may be of interest. According to a report published by the Center on Budget and Policy Priorities on May 5, 2017: 

• Only about 0.2 percent of estates are federally taxable.

• While the top statutory federal estate tax rate is 40 percent, the average effective federal tax rate is about 17 percent, after taking into account the federal estate tax exemption and estate-planning techniques, such as valuation discounts.

• While the estate tax would generate less than 1 percent of federal revenue over the next decade, the Joint Committee on Taxation estimates that repealing the estate tax may cost $269 billion over the same time frame.

Pfannenstiehl v. Pfannenstiehl*

Husband’s right to trust distributions not included in marital estate 

The Massachusetts Supreme Judicial Court reversed the appellate court’s ruling in Pfannenstiehl v. Pfannenstiehl, (475 Mass. 105 (Mass. 2016)) and held that a husband’s right to trust distributions based on ascertainable standards was too speculative and thus wasn’t included in the marital estate. In determining whether an irrevocable trust should be included in the marital estate for division on divorce, the court will closely examine the trust instrument, along with the facts and circumstances of each case to make its decision. When a court determines that an interest in trust property is too speculative, the court may consider the expectancy as a possible future asset or source of income in determining how to divide the marital estate. In other words, the spouse-beneficiary may end up with a smaller share of the marital estate.

Estate Tax Return 

IRS Notice 2017-12 

How to confirm closing of an examination of an estate tax return

On Jan. 6, 2017, the IRS issued Notice 2017-12. The notice provides guidance on the methods available to confirm the closing of an examination of a decedent’s estate tax return. Specifically, the notice announces that an account transcript issued by the IRS can serve as the “functional equivalent” of an estate tax closing letter (Letter 627), in that each of these documents may serve to provide estates and their representatives notice that the IRS has closed a decedent’s estate tax return. Importantly, the IRS stated it will no longer automatically issue estate tax closing letters for estate tax returns filed after June 30, 2015 (with the exception of those returns that were filed solely for the purpose of electing portability, and the portability election was denied) but one can be requested. Therefore, going forward, the account transcript will likely be the primary means by which estates and their representatives are provided notice that the IRS has closed an estate tax return. 

An account transcript is a computer-generated report, available free of charge, that provides current account data such as payment history, refund history, penalties assessed and the date on which the examination was closed. An account transcript presents this data by including numerical codes and descriptions of what each of these codes indicates. For example, code “421” indicates “closed examination of estate tax return.” Therefore, an account transcript showing a transaction code of “421” can independently serve the same purpose as an estate tax closing letter.

Typically, after the issuance of a closing letter or the entry of transaction code “421” on an account transcript, the IRS examination of the corresponding estate tax return is closed. However, the IRS may reopen the examination of an estate tax return after the issuance of a closing letter or the entry of transaction code “421” on an account transcript for the purpose of determining the estate tax liability of a decedent under circumstances described in the closing letter, Revenue Procedure 2005-32 and Rev. Proc. 2005-1.   

Rev. Proc. 2005-32, Rev Proc. 2005-1 and the estate tax closing letters state that an estate tax closing letter doesn’t prevent the IRS from reopening or re-examining the estate tax return to determine estate tax liability if there’s: (1) evidence of fraud, malfeasance, collusion, concealment or misrepresentation of a material fact, (2) a clearly defined, substantial error based on an established IRS position, or (3) another circumstance indicating that a failure to reopen the case would be a serious administrative omission. Additionally, in the case of the estate of a decedent (survived by a spouse) who elects portability of the deceased spousal unused exclusion (DSUE) amount, the issuance of an estate tax closing letter doesn’t prevent the IRS from examining the estate tax return of that decedent for the purpose of determining the transfer tax liability of the surviving spouse of that decedent (specifically, the DSUE amount to be included in the applicable exclusion amount of the surviving spouse).    

Estates and their authorized representatives may request an account transcript by filing Form 4506-T, Request for Transcript of Tax Return via mail or facsimile (per the instructions on the form). Account transcripts for estate tax returns aren’t currently available through the IRS’ automated online system, but the IRS website will have current information should an automated online method become operational. Those who wish to receive an estate tax closing letter may call the IRS at 866-699-4083 to request one. Requests for either document should be made no earlier than four months after filing the estate tax return.  

Estate of Esther M. Hake

U.S. district court finds estate executor’s reliance on erroneous advice on filing deadlines was reasonable

In Estate of Esther M. Hake, No. 1:15-CV-01382 (M.D. Pa. March 9, 2017), the estate filed an action for an abatement of penalties relating to the late filing of its federal estate tax return. The valuation of estate assets was in dispute, and the estate was unable to file its return on time. The executors retained counsel who filed the Form 4768 to extend the due date of the return and payment of tax. As a result, the estate was granted a 1-year discretionary extension of the deadline for payment. With regard to filing, the Form 4768 permits an automatic 6-month extension of the due date. However, the attorneys advised the family incorrectly that the estate had a 1-year extension to file. Based on this advice, the executors made an estimated estate tax payment of $900,000 prior to the extended payment deadline, in an amount of $100,000 more than the actual tax liability. Then, they filed the federal estate tax return on the date they thought it was due, according to advice of counsel, which was actually six months late. The IRS notified the estate that penalties and interest had been assessed for failure to file a timely return.

The court held that the estate’s reliance on their attorneys’ advice was reasonable cause to avoid the assessment of late filing penalties and interest. When a taxpayer fails to file a tax return by the due date, including any extensions of time, a late penalty applies unless it’s shown that such failure is due to reasonable cause and not due to willful neglect. The court held for the estate on its motion for summary judgment because the executors filed the return objectively late, but within the time instructed by their attorneys, and had paid the estate taxes in advance of the payment deadline. The executors exercised ordinary business care and prudence, making their reliance reasonable.

Fiduciary Liability

U.S. v. McNicol*

Decedent’s wife personally liable for unpaid federal tax liabilities

The decedent in U.S. v. McNicol (829 F.3d 77 (1st Cir. 2016)) died owing over $340,000 in unpaid federal income tax liabilities. The decedent’s wife was appointed as executrix, who chose not to pay the tax and instead transferred assets to herself. The court held that the wife, as fiduciary, was personally liable for the unpaid federal tax liabilities following her transfer of estate assets to herself without first paying the estate’s federal tax debts. 

Incomplete Gifts

George Fakiris v. Comm’r 

Restrictions in contract of sale render gift incomplete; income tax charitable deduction denied

In George Fakiris v. Comm’r (T.C. Memo. 2017-126, (June 28, 2017)), George, a real estate developer who owned a 60 percent interest in a real estate development company (the Company), deducted on his personal income tax returns for several years the value of a property that the Company had donated to a charity. The IRS issued a notice of deficiency denying the initial deduction and carryforwards.

The Company purchased an old theater in Staten Island, N.Y., in 2001, planning to build a high-rise development on the property. The community surrounding the historical theater opposed the plan and ultimately a local community dance ensemble expressed interest in the property. The Company decided to make a charitable donation of the theater. However, the dance ensemble hadn’t yet obtained tax-exempt status. So, the Company made a bargain sale to a different charitable organization (the Charity), which already had tax-exempt status. As part of the deal, the Charity agreed to transfer the theater to the dance ensemble once it received tax exempt status from the IRS.

In the summer of 2004, the Company and the Charity signed a contract of sale. Two provisions of the contract were particularly important to the IRS.  First, the Charity was prohibited from transferring the theater property for five years after the conveyance, other than to the dance ensemble. Second, the Company was permitted to transfer the premises to the dance ensemble once the dance ensemble received its tax-exempt status. This second provision was inconsistent with the rest of the contract because the Company no longer had title to the premises after conveyance but the court interpreted it to mean that the Company retained the right to direct the Charity to transfer the property to the dance ensemble.

On the same date that the contract was signed, the theater property was conveyed by deed to the Charity. In addition, the individual who established the dance ensemble and orchestrated the transfer paid the Company $470,000 for the property. The Charity didn’t pay anything to the Company for the theater. An appraisal of the theater property at the time of transfer estimated its value to be about $5 million.

The Company’s income tax return for 2004 shows a sale for $470,000 and a related capital gain. George, however, claimed a noncash charitable contribution of $3 million, which was 60 percent of the $5 million appraised value of the theater (as he owned 60 percent of the Company). The appraised value wasn’t reduced by the consideration paid of $470,000. In 2004 and for the next four years, George claimed charitable deductions related to the contribution and its carryforwards. The IRS disallowed the income tax deductions for three years and issued a notice of deficiency. 

The Tax Court interpreted the contract of sale and held that under New York law, the Company had retained the right to direct the Charity to transfer the theater to the dance ensemble.  The court held that the Company therefore retained “dominion and control” over the property, causing the transfer to be an incomplete gift. A critical part of the opinion analyzed New York state law and concluded that the problematic provisions of the contract of sale didn’t merge with the deed because the contract specifically stated that those provisions survived the transfer of title. As a result, the restrictions were still operative and prevented completion of the gift.

Because the gift was incomplete, the value of the charitable contribution was zero. Due to the disparity between the value of the property claimed on the return and as determined by the court, the court then applied accuracy-related penalties, noting that the accuracy-related penalties don’t distinguish between a valuation misstatement due to legal error versus a valuation error.

Portability

Rev. Proc. 2017-34

IRS simplifies procedures for portability extensions

The IRS issued Rev. Proc. 2017-34, which provides a simpler method for extending the time to file for portability elections.

In 2010, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act amended Section 2010 of the IRC to allow a “portability” election for the estates of persons who died leaving a surviving spouse. The election permits the DSUE to be used by a spouse, subject to certain rules. To take advantage of portability, the executor of the first spouse to die must make an election on a timely filed estate-tax return.

In 2012, the IRS finalized regulations regarding portability, providing that estates under the federal filing threshold could obtain an extension of time to file the portability election. An estate could initially file for the extension by requesting a PLR under Treasury Regulations Section 301.9100-3 and showing that: (1) the estate acted reasonably and in good faith, and (2) the extension wouldn’t prejudice the interests of the government.

In 2014, the IRS published Rev. Proc. 2014-18, which provided a method for obtaining an extension to make a portability election, but it was only available until Dec. 31, 2014. 

Since the end of December 2014, due to the numerous PLRs issued under Treas. Regs. Section 301.9100-3 granting extensions, the IRS determined that it needed to implement a simplified extension process again. Rev. Proc. 2017-34 provides that process for the 2-year period after the decedent’s death, or prior to Jan. 2, 2018 (for those decedents who died more than two years ago).

Under the revenue procedure, estates may make the portability election by filing Form 706 within the necessary time frame (that is, before the later of two years after the decedent’s date of death or Jan. 2, 2018) by making a special note that it’s filed pursuant to Rev. Proc. 2017-34 on the top of the form. To be eligible, the decedent must have died after Dec. 31, 2010, be survived by a spouse and be a citizen or resident of the United States. The estate must be under the filing threshold and not have filed any prior estate tax return.

Form 706 will be considered complete if it’s prepared according to the portability regulations under IRC Section 2010 (these regulations allow exceptions for valuing certain property eligible for the marital and/or charitable deduction). If the filing is made properly, the DSUE will be available for the surviving spouse’s transfers during lifetime or at death. However, the surviving spouse may not use the DSUE obtained through the extension process to claim a credit or refund of gift or estate tax if the statute of limitations for the claim has expired. (However, the spouse could make a protective credit or refund claim within the statute of limitations period, pending the filing of the portability return.)

If a PLR was pending on June 9, 2017, the IRS will close its file and refund the fee paid. The estate should follow Rev. Proc. 2017-34 to obtain an extension.

Estate of Sower v. Comm’r

Tax Court upholds review of return for portability of DSUE

In Estate of Sower v. Comm’r (149 T.C. No 11. (Sept. 11, 2017)), the Tax Court ruled against an estate and held that the IRS was able to review the estate tax return of a decedent’s predeceased spouse for purposes of adjusting the DSUE applicable to the decedent’s return.

After Frank Sower’s death, his estate filed an estate tax return but didn’t use his entire basic exclusion amount. His return showed the remaining amount (the DSUE) to be over $1.2 million. After submitting the return, Frank’s estate received a letter from the IRS stating that the estate tax return was accepted as filed.

Frank’s wife, Minnie, survived him. On her death, her estate filed an estate tax return using Frank’s DSUE. However, as part of its examination of Minnie’s return, the IRS reviewed the calculation of the DSUE on Frank’s estate tax return. It determined that the DSUE wasn’t calculated properly because taxable gifts were omitted from the calculation. After reducing the amount of the DSUE available for Minnie’s estate to just over $282,000, the IRS found that estate tax was due, and it issued a notice of deficiency to her estate for $788,165.

Minnie’s estate filed a petition disputing the deficiency. First, the estate argued that the letter from the IRS to Frank’s estate should be treated as a closing agreement that binds the IRS. However, the court held that only particular IRS forms qualify as closing agreements. In the absence of the proper form, courts have held certain agreements reached between the IRS and an estate have bound the IRS as closing agreements but only when reached through a process of negotiation. In this case, the “accepted as filed” letter sent to Frank’s estate was neither one of the requisite forms nor an agreement obtained after negotiations.

In addition, Minnie’s estate argued that reviewing Frank’s estate tax return for the calculation of the DSUE was an improper second examination. However, the court again disagreed. First, it held there was no examination because an “examination” means a request for further facts. The IRS didn’t request any additional information from Frank’s estate, it just reviewed the returns already filed and in its possession. Second, if there were any such second examination, it was of Frank’s estate tax return, not Minnie’s. Minnie’s estate couldn’t use a purported second examination of Frank’s estate tax return to its own advantage.

The estate made several other unconvincing arguments based on statutory interpretation. It argued that the effective date of the statute didn’t allow the IRS to adjust the DSUE for gifts made before 2010. Lastly, it suggested that when the IRS applied the portability statute, it overrode the statute of limitations on assessment under IRC Section 6501, which violated due process. The court ruled against the estate on both claims.

This case is a reminder that if your clients use the DSUE, the IRS may review and examine the deceased spouse’s return with respect to the calculation of the DSUE when the surviving spouse files his gift or estate tax return, regardless of the statute of limitations under IRC Section 6501. However, under temporary regulations, the IRS may only assess additional tax on the deceased spouse’s estate within the statute of limitations period.

Private Foundations

Rev. Proc. 2017-53

Updates to PF procedures

Rev. Proc. 2017-53 updates the procedure that PFs follow to make good faith determinations that a foreign grant recipient qualifies as a public charity.

Generally, PFs are restricted to making grants to charitable organizations. However, if a PF plans to make a grant to a foreign organization that doesn’t have U.S. charitable status, it may assess whether that grant recipient is the equivalent of a public charity. If it makes a good faith determination that the organization is the equivalent of a U.S. public charity, then distributions to that foreign organization won’t require “expenditure responsibility” under IRC Section 4945, and the grant may count as a “qualifying distribution” under IRC Section 4942. This determination by the PF is often referred to as an “equivalency determination.”

In 2015, final regulations regarding equivalency determinations were issued. These 2015 regulations provide that a PF’s determination will be considered made in good faith if it’s based on written advice that’s current and from a qualified tax practitioner concluding that the grant recipient is a qualifying public charity.  

This new standard, which is elaborated under Rev. Proc. 2017-53, makes several changes to the rules under prior regulations. First, it broadens the class of qualified tax practitioners who can prepare the written advice. Second, it eliminates the special prior rule that allowed a PF to rely solely on grantee affidavits. Third, it now provides a rule for the period during which the PF can rely on that written advice.

Under the revenue procedure, the written advice qualifies as “current” if the law relating to the advice hasn’t changed, and the factual information on which the advice is based is from the current or prior taxable year. As a result, written advice can remain current for two years.

A “qualified tax practitioner” is an attorney, CPA or enrolled agent. A PF may reasonably rely on the written advice in good faith. The standard isn’t met if the PF knows or should know that a qualified tax practitioner lacks knowledge of U.S. tax law relating to charities, or the practitioner wasn’t fully informed as to relevant facts or is otherwise relying on incorrect assumptions.

To meet the standard, written advice should show that the foreign grant recipient meets the general standards of a U.S. charity by including (among others):

• The grant recipient organization’s articles of organization, bylaws or other organizing document;

• The tax-exempt purposes of the organization;

• Confirmation that if the organization terminates or dissolves, its assets will be distributed to another charitable organization;

• Confirmation that the organization has no shareholders or members who have an ownership interest in its assets or income; 

• Confirmation that the organization doesn’t attempt to lobby or influence legislation;

• A description of the past, current and future activities of the organization;

• Confirmation that the organization hasn’t been designated as a terrorist organization; and

• Financial information and demonstration that the organization satisfies any applicable financial/support test.

Same-Sex Spouses

IRS Notice 2017-15

IRS issues guidance on applicable exclusion amount and generation-skipping transfer (GST) tax exemption for same-sex spouses

To apply the U.S. Supreme Court decision in United States v. Windsor and Rev. Rul. 2013-2017, the IRS has issued Notice 2017-15. This notice outlines administrative procedures for taxpayers and their estates to recalculate the remaining applicable exclusion amount and GST tax exemption to the extent that an allocation of that exclusion or exemption was made to certain transfers while the taxpayer was married to a person of the same sex. 

If a taxpayer made a gift to his same-sex spouse prior to Windsor and the limitations period with respect to filing an amended return hasn’t yet expired, then the taxpayer may file an amended gift tax return or supplemental estate tax return to claim the marital deduction (if it would have qualified) and restore the applicable exclusion amount and GST tax exemption allocated to that transfer. However, if the limitations period has expired, pursuant to Notice 2017-15, the taxpayer can recalculate his remaining applicable exclusion amount as a result of the recognition of the taxpayer’s same-sex marriage as if a marital deduction applied. Importantly, Notice 2017-15 doesn’t permit the change in value of the transferred interest or any other change in position concerning a legal issue after the limitations period has expired. Additionally, no credit or refund of tax paid on the marital gift can be given after the expiration of the period for credit or refund.

Following Windsor, generation assignments of a same-sex spouse and that spouse’s descendants made for GST tax purposes are established based on the familial relationship between the same-sex spouses and not their age difference. Regardless of whether the IRC Section 6511 limitations period has expired, if a taxpayer had previously allocated GST tax exemption by filing a return or by operation of law before the date Notice 2017-15 was issued, and such transfer was based on a same-sex spouse’s age-based generation assignment, the exemption allocated to such transfer is void. Therefore, the taxpayer is permitted to restore GST tax exemption allocated to transfers that were made for the benefit of transferees whose generation assignment subsequently changed pursuant to the Windsor decision, so that such transfer was now deemed to be made to a non-skip person.   

To recalculate the remaining applicable exclusion amount or the taxpayer’s remaining GST tax exemption accordingly, the taxpayer should use a Form 709, an amended Form 709 if the limitations period hasn’t expired or Form 706 for the taxpayer’s estate if the gift isn’t reported on a Form 709. The taxpayer should include the statement “FILED PURSUANT TO NOTICE 2017-15” on the form filed. To recalculate an applicable exclusion amount pursuant to a marital deduction, the taxpayer should attach a statement supporting the claim for a marital deduction. If a taxpayer is making a qualified terminable interest property or qualified domestic trust election to obtain the marital deduction, the taxpayer must also file a separate request for relief in accordance with Treas. Regs. Section 301.9100-3. For recalculations of GST tax exemption, the taxpayer should attach a statement that the allocation of GST tax exemption in a prior year is void pursuant to Notice 2017-15 and a computation of the resulting exemption allocation(s) and the amount of the taxpayer’s remaining exemption amount.  

State Income Tax

Bank of America, N.A. v. Comm’r*

Bank was subject to Massachusetts fiduciary income tax 

Bank of America sought an abatement from the Massachusetts Department of Revenue for tax incurred during the 2007 tax year, asserting that because it wasn’t a natural person, it wasn’t an inhabitant of the commonwealth for income tax purposes. The Supreme Judicial Court in Bank of America, N.A. v. Comm’r (SJC-11995 (Mass. July 11, 2016)) reaffirmed that despite having its principal place of business in Charlotte, N.C., the bank nonetheless qualified as an “inhabitant” and accordingly was subject to Massachusetts’ fiduciary income tax. The court’s decision narrowed the prior 2015 ruling to state that to be subject to the Massachusetts fiduciary income tax, a corporate trustee must act in a material fashion within the Commonwealth.

Tax Reimbursement Clause

PLR 201647001

PLR permits addition of tax reimbursement clause

In PLR 201647001 (released Nov. 18, 2016), Grantor 1 and Grantor 2 created an irrevocable grantor trust for the benefit of their children. Due to unforeseen circumstances, payment by the grantors of the income taxes on the trust became unduly burdensome.  

The trustee sought court approval to modify the trust, including a modification allowing the trustee, in his discretion, to reimburse the grantors for tax liability either of them might incur because part or all of the trust’s income was reportable by him to the trust’s status as a grantor trust.    

This clause was in conformance with Situation 3 of Rev. Rul. 2004-64. That ruling states that a reimbursement clause won’t cause inclusion of the value of the property of a trust in the settlor’s gross estate under IRC Section 2036, even when the trustee exercises his discretion to make the reimbursement, so long as this isn’t done by pre-arrangement. The disbursement won’t be deemed pre-arranged if there’s no express or implied agreement between the settlor and the trustee regarding the trustee’s exercise of his discretion. Also, the trustee must be independent, as the trustee was here. 

The IRS held that the foregoing modifications to the trust were administrative in nature, complied with the requirements of the revenue ruling and didn’t result in a deemed transfer of any property by the grantors or their children for federal gift tax purposes. Furthermore, the foregoing modifications wouldn’t result in the inclusion of any trust property in the gross estates of the grantors or their children under Section 2036.  

Trust Accountings

Hilgendorf v. Estate of Coleman*

Court denies request for trust accounting

In Hilgendorf v. Estate of Coleman (41 Fla. L. Weekly D2402 (Fla. 4th DCA Oct. 26, 2016)), a beneficiary requested trust accountings for the period that the settlor was living. The court held that an estate or beneficiary of a revocable trust can’t compel the trustee to render an accounting of transactions that occurred while the settlor was living when: (1) the trust didn’t require accountings during the settlor’s life; (2) the settlor never requested accountings; and (3) there’s no showing of any breach of fiduciary duty.

Valuations

Estate of Eva Kollsman

Court upholds IRS valuation of paintings

In Estate of Eva Kollsman, T.C. Memo. 2017-40 (Feb. 23, 2017), the IRS assessed a deficiency related to the valuation of two paintings. The estate owned two paintings, one known as Maypole, by Pieter Brueghel the Elder, and the other known as Orpheus, the artist of which was in some dispute (it was believed to be painted by Jan Brueghel the Younger, Jan Brueghel the Elder or a Brueghel studio). Under Eva’s estate plan, the executor was also the residuary legatee and therefore due to inherit the paintings.

After Eva’s death, Sotheby’s gave an estimate of the paintings’ values in an opinion letter based on personal inspection: $500,000 for Maypole and $100,000 for Orpheus. These values were ultimately used as the estate tax values, and the opinion letter was attached to the estate tax return. At the same time, Sotheby’s and the executor entered into an agreement giving Sotheby’s the exclusive right to auction the paintings for a 5-year time period.  

The executor hired a restoration company to remove layers of dirt from the paintings. The restoration company insured the artwork while it had the paintings under its custody. The amount of insurance was determined based on recommendations by the executor: $2 million for Maypole and $500,000 for Orpheus. The cleanings were relatively low risk and very successful.

Three and a half years after the valuation date, Maypole was auctioned by Sotheby’s and sold for a hammer price of $2.1 million.   

The IRS determined a deficiency, asserting a higher value for the paintings ($2.1 million for Maypole and $500,000 for Orpheus), and the estate petitioned the court for a redetermination. The estate’s expert from Sotheby’s explained the discrepancy in his valuation date value and sale price of Maypole as a result of the unexpected improvement in condition due to the cleaning and a change in market conditions that had increased demand for paintings of this type. However, the court wasn’t convinced. It found that Sotheby’s’ conflict of interest rendered its opinion unreliable and that the opinion exaggerated the risk that cleaning posed to the painting. It also was unpersuaded by the valuation report, which didn’t include analysis of any sales of comparable paintings. Instead, it accepted the government’s expert’s valuation of Maypole at the sale price and accepted the government’s expert’s value of Orpheus. It found the analysis of comparable sales and reasoning of the government’s valuations convincing and ultimately accepted its initial values, making some adjustments for the uncertainty of the artist and the paintings’ condition. The court settled on a value of $1.995 million for Maypole and $375,000 for Orpheus.

This case demonstrates the importance of a thorough, independent, substantive and well-reasoned valuation report.

Estate of John F. Koons, III, et al. v. Comm’r

Estate denied deduction for Graegin loan

The estate of John F. Koons, III was denied a deduction of $71,419,497 for interest payable on a loan made to John’s revocable trust to pay estate taxes (Estate ofJohn F. Koons, III, et al. v. Comm’r, T.C. Memo. 2013-94). 

The estate held about $19 million of liquid assets, and John’s revocable trust owned 50.5 percent of Central Investment LLC (CI LLC), which included a 46.94 percent voting interest and a 51.59 percent non-voting interest. The estate tax liability was approximately $21 million, and the revocable trust was subject to a GST tax liability of approximately $5 million. On audit, the estate tax and GST tax liability were determined to be $64 million and $20 million, respectively. The deficiency was related to the valuation of the interest in CI LLC owned by the revocable trust and a denial of the deduction for the interest on the loan made to the estate by CI LLC, described below.

To pay the taxes, on Feb. 28, 2006, CI LLC loaned the estate $10.75 million with interest accruing at 9.5 percent. Interest and principal were payable in 14 equal installments, with payments due between 2024 and 2031. At the time, CI LLC owned two operating companies and more than $200 million of liquid assets. CI LLC was the successor, in part, to a family business that bottled and distributed soft drinks and operated a vending machine business.

Before John’s death, agreements had been signed in which CI LLC agreed to redeem the interests of John’s children (these redemptions didn’t close until after John’s death). Prior to the redemptions, John’s revocable trust owned a 49.64 percent voting interest. After the redemptions, John’s revocable trust owned a 70.42 percent voting interest. In addition, before John’s death, pursuant to a settlement and sale agreement with PepsiAmericas, CI LLC revised its operating documents to include certain restrictions, including requirements to hold at least $40 million in assets and a vote of the majority of the members to permit discretionary distributions.

The Tax Court held that the estate couldn’t deduct the interest payable on the loan. Interest on a so-called “Graegin loan” to pay estate taxes must be “actually and necessarily incurred in the administration of the decedent’s estate” to be deductible under Treas. Regs. Section 20.2053-3(a).
(A Graegin loan is named after the case Estate of Cecil Graegin, T.C. Memo. 1988-477, which held that interest on a loan taken out by an estate to pay its estate taxes because it has insufficient liquid assets may be a deductible expense for estate tax purposes.) The Tax Court held that the loan wasn’t necessary because, at the time of the loan, after the children’s interests were redeemed, the revocable trust held a 70.42 percent voting interest in CI LLC, which allowed it to force distributions to the members of CI LLC. The estate’s assets were not only insufficient to pay the estate tax, but also were insufficient to pay the required principal and interest on the loan, which would have required future distributions from CI LLC as well. Because CI LLC would have needed to eventually make distributions to the revocable trust to pay back the loan, there was no reason to make the loan, rather than an initial distribution to the revocable trust.

The Tax Court also agreed with the IRS’ expert on valuation, applying only a 7.5 percent discount for lack of marketability (the estate had applied a 31.7 percent discount) due to the highly liquid nature of the company.

This case shows that a deduction won’t be allowed if the loan isn’t necessary and reasonable. CI LLC’s loan to the estate for a little over $10 million generated interest payments and a claimed deduction of over $70 million, all while the estate controlled a limited liability company with over $200 million in liquid assets. The estate’s position was too good to be true.

Treasury Report in Response to Executive Order 13789 

Treasury to withdraw IRC Section 2704 proposed regulations 

On Oct. 2, 2017, the Treasury issued a report (the October report) to Presidential Executive Order 13789, which directed the Treasury to identify proposed, temporary and final regulations for withdrawal, revocation or modification because they are unnecessary, unduly complex or excessively burdensome or fail to provide clarity and useful guidance.

The October report recommended that the proposed regulations under Section 2704 be withdrawn, finding them to be a “web of dense rules and definitions” that are “unworkable.” The proposed regulations were an attempt to counteract state statutes and case law that, over time, have reduced the ability of Section 2704 to curtail artificial valuation discounts for interests in family controlled entities. The proposed regulations required an interest in an entity to be valued as if certain restrictions on withdrawal or liquidation didn’t exist, either in the entity’s governing documents or state law, without exception for active or operating businesses. Commenters noted that it wasn’t feasible to value an entity in a vacuum, as if there were no restrictions on liquidation or withdrawal. The Treasury agrees, and it plans to publish a withdrawal of the proposed regulations shortly.

The IRS published a notice on Oct. 20, 2017 withdrawing the proposed regulations (REG-163113-02).

2018 Inflation & Other Adjustments

Rev. Proc. 2017-58

IRS sets certain inflation-adjusted tax items for 2018

In Rev. Proc. 2017-58, the IRS published the inflation adjustments for tax items for 2018.  

For an estate of any decedent dying in calendar year 2018, the basic exclusion amount is $5.6 million for determining the amount of the unified credit against estate tax under IRC Section  2010. The exemption for GST tax, which is determined by reference to the unified credit, will also be $5.6 million. 

The annual exclusion is also (finally) increased.  In 2018, the first $15,000 of qualifying gifts to any person are excluded from the calculation of taxable gifts under IRC Section 2503 made during that year.

For calendar year 2018, the first $152,000 (up from $149,000) of qualifying gifts to a non-citizen spouse who isn’t a U.S. citizen (other than gifts of future interests in property) are excluded from the total amount of taxable gifts under IRC Sections 2503 and 2523(i)(2) made during that year.

*Cases denoted with an asterisk originally appeared in the discussion by Joshua S. Miller and Michael Sneeringer in “Fiduciary Law Trends” (Trusts & Estates, May 2017, at p. 25). 

David gratefully acknowledges the assistance of his colleagues in the trusts and estates group at Kirkland & Ellis LLP in preparing this report. They are: partners Angelo F. Ties, Patricia Ring and Anna Salek; and associates Joe Higgins, Kristen Curatolo and Thomas Norelli. He also gratefully acknowledges Alison E. Lothes, an attorney at Gilmore, Rees & Carlson P.C. in Wellesley, Mass.