Clik here to view.
One of the most potent and useful tools in an estate planner’s toolbox is language by which property being gifted, sold, exchanged, swapped, disclaimed, appointed or distributed is precisely described in relation to its identity and value or just in relation to its value (formula language). Using formula language facilitates taking maximum advantage of, without exceeding, various tax-driven, dollar amount-limited exemptions and exclusions.
The Internal Revenue Service has accepted and, in some cases, explicitly sanctioned, the use of formula language in certain contexts1 but has shown great hostility to it in others.2 In the last several years, taxpayers, when challenged, have generally been successful in defending formula language,3 but there have been a few notable exceptions. A couple of very recent examples follow.
Nelson v. Commissioner
Nelson4 involved a gift and an installment sale of limited partner (LP) interests in Longspar Partners, Ltd. The documentation effectuating the transactions contained formula language stating that what was being gifted/sold were LP interests each having a fair market value (FMV) of $X as of [date], as determined by a qualified appraiser within [number] days of the effective date.
The IRS asserted that the donor/seller had gifted/sold LP interests representing Y% of the value of Longspar and that such interests were worth more than $X as of the effective date. In sustaining the IRS’ position, the Tax Court noted that the formula language of the gifting/sale documents “hang[s] on the determination by an appraiser within a fixed period; value is not qualified further, for example, as that determined for Federal estate tax purposes.”5 The court cited and favorably discussed cases in which the efficacy of formula language defining FMV as that “finally determined for federal [estate][gift] tax purposes” was upheld.6 The court stated it wouldn’t ignore the “by a qualified appraiser within [a fixed period]” language of the gifting/sale documents and replace it with “for federal estate and gift tax purposes.”7
In affirming the decision of the Tax Court, the U.S. Court of Appeals for the Fifth Circuit didn’t add substance to the Tax Court’s analysis but noted:
The transfer documents clearly and unambiguously state that [the donor/seller] was gifting and selling the percentage of limited partner interests that an appraiser determined to have a fair market value equal to a stated dollar amount. The transfer agreements must be interpreted as written. The [donor/seller] therefore transferred what the plain language of their transfer instruments stated—$2,096,000 and $20,000,000 of limited partner interests in Longspar as determined by a qualified appraiser to be 6.14% and 58.65% of such interests.8
It seems clear that the donor/seller’s effort to cap the value of the gifted/sold LP interests crashed and burned because the formula language used was seriously flawed. Those who design and use formula language should closely follow the models provided in the several cases in which the taxpayers have been victorious.9
PLR 202206008
Private Letter Ruling (PLR) 20220600810 analyzes various aspects of a settlement agreement to be consummated on the issuance of a favorable PLR. Pursuant to the proposed settlement agreement, a trustee would modify a trust’s governing instrument by adding formula language giving a beneficiary a testamentary power to appoint trust property to the beneficiary’s estate. The formula language specified that what the beneficiary could appoint would consist of the largest portion of the trust property that could be included in the beneficiary’s estate without increasing the total amount of all inheritance, estate and other death taxes, plus all federal and state generation-skipping transfer taxes, over and above the amount that would have been actually payable in the absence of such provision.
The IRS ruled, as requested, that modification of the trust instrument pursuant to the proposed settlement agreement wouldn’t cause trust property to be includible in the beneficiary’s gross estate under Internal Revenue Code Section 2041(a)(2) and would result in only the trust property subject to the beneficiary’s testamentary power of appointment (POA) being included in the beneficiary’s gross estate under
IRC Section 2041(a)(2).11
Largely as a result of enactment of the 2017 Tax Act,12 not only do many clients anticipate having no estate tax issues, but also they reasonably believe their children and grandchildren will have no such issues. It’s possible to design trusts for such clients’ descendants in a manner that will cause the value of the assets in such trusts to be included in their respective gross estates just up to the point beyond which estate tax would be incurred. The point of causing inclusion in the gross estate of the value of property while not generating estate tax liability is to obtain a cost-free stepped-up basis with respect to such property for income tax purposes.13
The most common and popular method so to design such trusts is to confer on trust beneficiaries a testamentary general POA of the type described and ruled on favorably in PLR 202206008.14 Whether the holder of a testamentary general POA chooses to exercise it, the property that was subject to the power will be deemed to have been acquired from the deceased powerholder and will, therefore, qualify for the step-up in basis.15 Although PLRs can’t be used as precedent by taxpayers at large,16 it’s heartening to see the IRS issue a ruling on the estate tax effect of formula language granting a general POA that’s consistent with what estate-planning professionals would expect.
Endnotes
1. See, e.g., Treasury Regulations Sections 1.664-2(a)(1)(iii); 20.2056(b)-7(b)(2) and (h), Example 7 and Example 8; 25.2518-3(d), Example 20; 25.2702-3(b) and (c).
2. See, e.g., Action on Decision, 2012-46 IRB 543, in which the Internal Revenue Service indicated its disagreement with the result in Wandry v. Commissioner, T.C. Memo. 2012-88.
3. See, e.g., Wandry, ibid.; Hendrix v. Comm’r, T.C. Memo. 2011-133; Estate of Petter v. Comm’r, T.C. Memo. 2009-280, aff’d 653 F.3d 1012 (9th Cir. 2011); Estate of Christiansen v. Comm’r, 130 T.C. 1 (2008), aff’d 586 F.3d 1061 (8th Cir. 2009).
4. Nelson v. Comm’r, 17 F.4th 556 (5th Cir. 2021).
5. Nelson v. Comm’r, 2020 WL 3077357, at *7 (U.S. Tax Ct. 2020).
6. Estate of Christiansen, supra note 3; Estate of Petter, supra note 3.
7. Nelson, supra note 5.
8. Nelson, supra note 4, at p. 563.
9. Supra note3.
10. Private Letter Ruling (PLR) 202206008 (Feb. 11, 2022).
11. The ruling is a bit muddled in that it includes the following statement:
“However, the exercise by [beneficiary] of [beneficiary]’s testamentary general power of appointment will result in the appointed property being includable in [beneficiary]’s gross estate under
§ 2041(a)(2).” This statement is clearly incorrect. Internal Revenue Code Section 2041(a)(2) addresses the estate tax treatment of general powers of appointment created after Oct. 21, 1942. Under IRC Section 2041(a)(2), merely the possession of such a power at death, regardless of whether it was exercised, causes inclusion in the gross estate of the powerholder of the value of all property subject to the power.
12. An Act To Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018, Pub. L. No. 115-97 (Dec. 22, 2017).
13. See IRC Section 1014(a) and (b)(9).
14. The formula language approved in PLR 202206008 could be further refined in such a way so as to have effect only with respect to certain assets in a trust or to subject to such power, first, those trust assets having a cost basis for federal income tax purposes as of the day before the powerholder’s date of death that’s the smallest percentage of fair market value as of the powerholder’s date of death and, then, cascading, in order, to each asset having a cost basis for federal income tax purposes as of the day before the powerholder’s date of death that’s the next smallest percentage of fair market value as of the powerholder’s date of death until holding the power would no longer not cause any imposition of estate tax.
15. See Treas. Regs. Section 1.1014-2(a)(4) and (b)(2).
16. IRC Section 6110(k)(3).