Recent Developments Affecting Estate and Business Succession Planning

RECENT STATUTORY DEVELOPMENTS

ADMINISTRATION’S 2015 BUDGET AND TREASURY EXPLANATION

The Administration’s 2015 Budget and the Treasury Department’s “General Explanations of the Administration’s Fiscal Year 2015 Revenue Proposals,” (March, 2014), include various proposals of significance to trust and estate lawyers, including the following (many of which have been in prior revenue proposals):

• Restoring estate, gift, and GST rates and exemptions to 2009 levels beginning in 2018;

• Requiring GRATs to have at least a 10 year term and requiring the remainder to have some value;

• Limiting protection from allocation of GST exemption to 90 years;

• Treating a sale or exchange to a grantor trust as an incomplete transfer for gift and estate tax purposes;

• Requiring use of average basis for all identical shares of portfolio stock held by a taxpayer that has a long-term holding period;

• Limiting to $50,000 per year the annual exclusion for gifts to most trusts, for gifts of interests in pass-through entities, for gifts of interests subject to a prohibition on sale, and for other transfers of property that cannot be liquidated immediately by the donor;

• Modifying certain rules that apply to sales of life insurance contracts;

• Requiring non-spouse beneficiaries of a decedent’s IRA or retirement plan to take inherited distributions over no more than five years;

• Prohibiting a taxpayer who has accumulated amounts within an IRA, qualified plan or other tax-favored retirement plan in excess of the amount necessary to provide the maximum annuity permitted for a tax-qualified defined benefit plan (currently $210,000 per year payable as lifetime joint and 100% survivor benefit commencing at age 62) from making additional contributions or receiving additional accruals.

BILL TO REFORM AND RAISE ESTATE, GIFT & GST TAXES INTRODUCED BY WAYS AND MEANS MEMBER

H.R. 4061, 113^th Cong., 2d Sess. (Feb. 14, 2014), captioned “The Sensible Estate Tax Act of 2014,” introduced by House Ways and Means Committee member Jim McDermott (D-Wash.), would reduce the estate tax exclusion amount to $1 million, raise the top estate and gift tax rate (and the sole GST tax rate) to 55% (on amounts over $10 million), adjusted for inflation after 2000, restore the state death tax credit, eliminate the minority discounts for interests in entities to the extent that they hold passive assets, require consistent income tax reporting of adjusted basis in accordance with estate tax return values, require a 10-year minimum term for GRATs, and limit the effect of the allocation of GST exemption to 90 years.

ESTATE TAX DECISIONS

ESTATE OF RICHMOND V. COMMISSIONER, TC MEMO 2014-26 (FEB 11, 2014)—TAX COURT USES DISCOUNTED NET ASSET VALUE TO VALUE SHARES IN HOLDING COMPANY; VALUATION UNDERSTATEMENT PENALTY IMPOSED

Helen P. Richmond, the decedent, a Pennsylvania resident died December 10, 2005. At death, she owned 23.44% of a family owned investment company (“the company”); she was one of the three largest shareholders, who together owned 59.20%. The company was a C corporation. The company’s assets consisted primarily of publicly traded stocks. The value of the company’s assets exceeded $50 million dollars, 87.5% of which was attributable to untaxed appreciation. The “built-in capital gains tax” on the appreciation was in excess of $18 million dollars.

There was no “put” or “call” rights with respect the to the decedent’s interest; as a minority stockholder, she had no ability to control distributions, determine investments or make an S election. The stated policy of the company was to preserve capital and maximize dividend income and the company had consistently paid dividends that had also consistently increased by slightly more than 5% a year from 1970 through 2005.

The value of the decedent’s interest in the company as reported on the federal estate tax return was determined using a capitalization of dividends method.

The Tax court held that the capitalization of dividends method was not the appropriate method, suggesting that capitalization of dividend methodology is generally appropriate for an operating company or when the company’s assets were difficult to value. Since this company was an investment company that held publicly traded securities, the dividend capitalization method ignored the most concrete and reliable data available—the value of the assets less liabilities, i.e. net asset value.

With respect to a discount from net asset value for built-in capital gains, there was no controlling Circuit Court decision (which would also be true for a 10^th Circuit case). The estate cited the 5^th and 11^th Circuit decisions that would require a dollar for dollar discount from net asset value. Instead, the court looked to the 2^nd and 6^th Circuit cases and tax court cases and determined that the discount should be the present value of the built-in capital gains tax.

In determining the present value of the built-in capital gains tax, the court did not use the company’s very low historical turn-over (it would have taken 70 years to recognize the tax using the historical data) and looked to what a rational hypothetical investor would have expected. The “likely” turn-over was 20-30 years.

The court considered the approaches of the experts with respect to discounts for lack of marketability and control; the IRS expert had provided an inadequate basis for his lower proposed discounts. The court used a discount for lack of marketability of 32.1% (an average of the general range of marketability discounts) and a discount for lack of control of 7.75% (a mean after removing the two highest values and the lowest of the set of data). Both of these were slightly less than the estate’s expert proposed.

Because the value on the estate tax return of $3,149,767 was less than 65% of the final value determined by the court of $6,503,804, the court held there was a substantial estate tax valuation understatement, resulting in a 20% penalty of $1,141,892. The estate argued that the penalty should not apply because the taxpayer had acted in good faith and with reasonable cause. The court was unpersuaded. The estate had used an accountant who had experience doing appraisals but no appraisal certifications to determine the value reported on the estate tax return, and had relied on his unsigned draft report without further consultation with him. The accountant was not used as an expert in the tax court case; the value of the expert the estate did use was over $2 million dollars higher than the value reported on the estate tax return.

ESTATE OF OLSEN V. COMMISSIONER, TC MEMO 2014-58—DETERMINATION OF ASSETS INCLUDED IN ESTATE OF SURVIVING SPOUSE WHEN TRUSTEE/SURVIVING SPOUSE HAD FAILED TO DIVIDE TRUST INTO MARITAL TRUSTS AND FAMILY TRUST

Grace Olsen died in 1998. Her revocable trust named her husband, Elwood Olsen, who was a lawyer, as trustee. Three separate trusts were to be created at her death under the terms of her revocable trust, two Marital Trusts and a Family Trust. The Marital Trusts were qualifying terminable interest trusts, and the federal marital deduction election was made with respect to both. The values of the trusts on the federal estate tax return were:

Marital Trust A $1,000,000

Marital Trust B $ 504,695

Family Trust $ 600,000.

The terms of the Marital Trusts during Mr. Olsen’s life were identical. In addition to requiring all income to be distributed to him, principal could be distributed to him, based on an ascertainable standard. At Mr. Olsen’s death, Marital Trust A passed to a generation-skipping trust; Marital Trust B was to be distributed as part of the Family Trust.

The Family Trust provided for distributions of income and principal to Mr. Olsen based on an ascertainable standard. Mr. Olsen also had a lifetime power of appointment over the Family Trust principal, exercisable in favor of children, grandchildren and 501(c) organizations. He also had a testamentary limited power. At Mr. Olsen’s death, absent exercise of the power, the trust was to be distributed to children outright, with a share of any deceased child to pass to the child’s issue.

Mr. Olsen withdrew $1,474,780 before his death without having divided the assets in his wife’s trust into the three separate trusts and without designating which trust was the source of the withdrawal. (This was in addition to some distributions of income and some smaller distributions). At his death in 2008 at age 92, there was $1,001,906 still held in the undivided trust.

The estate took the position that all of the $1,001,906 was attributable to the Family Trust and reported no trust assets on Mr. Olsen’s federal estate tax return. The IRS took the position that the entire amount was includable. The court held that $607,927 was includable. The basic rationale of the court was that the withdrawals that went into Mr. Olsen’s own account could not have properly been made from the Family Trust and the withdrawals that Mr. Olsen distributed to charity could not have been properly made from the Marital Trusts, in effect “tracing” the withdrawals to determine the assets of the respective trusts at Mr. Olsen’s death.

ESTATE OF SAUNDERS V. COMMISSIONER, 113 AFTR 2D 2014-1273 (9th Cir. March 12, 2014)—NINTH CIRCUIT AFFIRMS TAX COURT DECISION LIMITING ESTATE TAX DEDUCTION TO AMOUNT ACTUALLY PAID ON LEGAL MALPRACTICE CLAIM

William Saunders, an attorney, died November 2, 2003, survived by his wife, Gertrude, who died November 27, of the next year. A lawsuit was filed against Mr. Saunders’ estate alleging legal malpractice, breach of confidence, breach of the duty of loyalty and fraudulent concealment, and seeking damages of over $90 million. Mrs. Saunders’ executors deducted $30 million for the value of the claim; the claim was later settled for a payment of $250,000 and waiver of $289,000 in costs. Treasury regulations applicable at Mrs. Saunders’ death (not the current regulations under IRC § 2053) permitted the estate to deduct an estimated value of a claim if it was ascertainable with reasonably certainty and if the amount “will be paid.” Because the claim was not ascertainable with reasonable certainty, post-death events were considered in determining the deduction and the amount paid was allowed.

TRUST INCOME TAX

FRANK ARAGONA TRUST V. COMMISSIONER, 142 T.C. NO. 9—ACCORDING TO TAX COURT, TRUSTEES MATERIALLY PARTICIPATED IN RENTAL REAL ESTATE ACTIVITIES

The trust held rental real estate and was involved in other real estate business activities. Some of the real estate business activities were through entities that were wholly owned by the trust or that the trust controlled. The IRS had disallowed losses from rental activities as passive activity losses. The IRS contended a trust could not satisfy the material participation requirements under IRC § 469(c)(7) because that provision was not intended to apply to individuals. The court’s analysis, in part, was that the statute used the word “taxpayer” instead of “natural person” and held that a trust can materially participate. The court further held that the services to be considered were both the services of the trustees in their capacity as trustees and the services of the trustees as employees, reasoning that the trustee/employees still had fiduciary duties under applicable state law. This case is particularly significant given the 3.8% tax on net investment income and given this and related unresolved issues that relate to rental real estate held in a trust. The court did not determine whether a trust could materially participate through agents other than the trustees. For a relatively recent discussion of the passive activity limitations on deductions and other issues that relate to rental real estate held in trust, see Lawson, “Tax Planning for Rental Real Estate Owned by a Trust,” Estate Planning Journal, Volume 40, Number 09, September 2013.

PLR 201410001 THROUGH PLR 101410010—INCOMPLETE GIFT; NON-GRANTOR TRUST

In this series of 10 private letter rulings, the IRS approved key elements of a technique that potentially shifts investment income to family members who are in lower income tax brackets, reduces state income tax, avoids an immediate gift, does not eliminate obtaining a step-up in basis at the grantor’s death and leaves open the possibility of distributions to the grantor. To accomplish these goals, the taxpayer transfers assets to an irrevocable trust that is not taxed as a grantor trust. The taxpayer’s contributions to the trust also must not be treated as completed gifts (distributions from the trust to any person other than the grantor would result in a completed gift). Because Treas. Reg. § 1.677(a)-1(d) provides that a trust is a grantor trust if trust assets can be used to discharge the legal obligation of the grantor (such as if a creditor can reach the trust assets) and state laws often provide a creditor of a grantor of a trust can reach assets transferred into trust if those assets are available for the grantor, this type of trust is generally created in a state that recognizes self-settled asset protection trusts.

MISCELLANEOUS

REV. PROC. 2014-18, 2014 IRB 513—PORTABILITY

The executor of the estate of a U.S. citizen or resident person who died after Decmber 31, 2010, and on or before December 31, 2013, may elect portability under IRC § 2010(c)(5)(A) as described in this revenue procedure on a later return without filing a private letter ruling asking for an extension of time and with no user fee. The complete federal estate tax return must be filed by December 31, 2014. The estate must not have been required to file a federal estate tax return under IRC § 6018(a). If a taxpayer does not qualify under Rev. Proc. 2014-18, the taxpayer may file a letter ruling asking for an extension of time to make the election under Treas. Reg. § 301-9100-3.

FRANK SAWYER TRUST AS OF MAY, 1992, TRANSFEREE, CAROL S. PARKS, TRUSTEE, TC MEMO 2014-59)—TRUST FOUND TO HAVE LIABILITY AS A TRANSFEREE OF A TRANSFEREE

Four C corporations owed federal tax liability and penalties in excess of $24.3 million but had no funds to pay the tax. The trust owned 100% of the corporations when the corporations were incurring large capital gains tax, but liquidated the assets of the companies, satisfied all non-tax liabilities leaving the companies with cash and tax liabilities, then sold the companies. The companies were solvent at the time of the sale. Two were taxi companies; they had $39.6 million in cash and $14.3 million of contingent income tax liabilities. The purchaser paid the trust $32.4 million. The other two companies were real estate corporations. They had cash of $27.5 million and contingent income tax liabilities of $10.5 million. The purchaser paid $23.4 million.