Developments from Heckerling Institute, Pt. I

Paul T. Fabiano, Esq., of Cornerstone Advisors in Allentown, PA, attended the annual Heckerling Institute, held January 14-18, 2008, in Orlando, Florida. For background about the Institute, see: PA EE&F Law Blog posting, "Heckerling Institute 2008 Revs Up" (01/11/08).

Afterwards, Paul volunteered to write his impressions of highlights he noted at the Institute for posting on this Blog in multiple parts. This is Paul's first installment, with more to come. I thank him and Cornerstone for this contribution. Contact information for Paul is found at the end of his article.

2008 Heckerling Highlights, Part I

by Paul T. Fabiano, JD, LLM, of Cornerstone Advisors

709 Fundamentals

1. Definition of Taxable Gifts: The Supreme Court in Dickman (1984) used a very broad definition of taxable gifts by analogy to the income tax definition of “all income from whatever source derived.”[1] This opens the door to bringing in obscure transfers as gifts. Although they may not ordinarily be reported as taxable gifts, consider whether such things as paying for a wedding or taking the family on vacation could be viewed as a taxable gift by the Service. It may be relevant if the payor is in attendance in determining if there was a gift transfer.

2. Community Property Gifts: Transfers of community property are automatically deemed one-half by each spouse even without a gift splitting election. Thus status as community property dictates, and titling or elections are otherwise irrelevant. Additionally, gifts made from community property may qualify for a valuation discount. When advising a client who moved from a community property state, be careful to consider these consequences before making any change.

3. Adequate Disclosure: In order to get the statute of limitations running on a gift transfer made after August 5, 1997, the return must adequately disclose it. Among other requirements for adequate disclosure, there must be a detailed description of the method used to determine the fair market value of the property transferred or a written appraisal.

Requirements. The description has detailed requirements, including financial data, restrictions considered and discounts used. [2] If an entity is gifted, the description must include the value of 100 percent of the underlying assets, without regard to the discounts. The requirement of the detailed description is very notable because it essentially requires a formal written appraisal or the return preparer to provide a substantive justification for the value used.

Income Tax Returns. Disclosure of a transfer on an income tax return can start the gift tax statute, but the disclosure must include an explanation why the transfer is not a gift. Transfers made in the ordinary course of business (e.g., salary to an employee-family member) do not need the explanation as long as otherwise reported properly.[3]

Incomplete Transfers. It seems to make sense to err in favor of reporting transfers as completed gifts. If a gift is reported as completed and the statute runs, the gift value used will be final even if later determined not to be a complete gift. In contrast, a gift reported as incomplete will not start the statute even if later found to be complete.[4]

Recent Developments

4. Priority Guidance Hit List: The following items appear among others on the Service’s Priority Guidance Plan

Swap Power. The application of IRC §2036 to a grantor’s retained power to substitute assets in a trust is on the Service’s most recent priority guidance. This power is often used to trigger grantor trust status under IRC §675(4)(c). It will be interesting to see their position. If the transaction is done at fair market value, it does not seem as if there is any retained enjoyment.

Restricted Management Accounts: It does not look like restricted management accounts are a good family limited partnership alternative after all. The IRS priority guidance provides that the application of IRC §2703 to such accounts will be addressed.

5. GST Grandfathering: There is a split in circuits whether a beneficiary’s exercise, release or lapse of a general power of appointment at death ends the GST grandfathering of a trust (pre- September 25, 1985). The Eighth and Ninth Circuits maintained grandfathering, with only the Eighth Circuit being subsequent to contradictory Regulations.[5] A recent Tax Court case, which will go to the Sixth Circuit, held the Regulations were valid and the subject trust would lose its grandfathered status when a beneficiary exercised a general power of appointment at death. [6]

6. Tax Apportionment: A recent case highlights the importance of a well thought out tax apportionment clause. In Matter of Lee, a New Jersey court found a vague tax clause apportioned estate taxes to a residual charitable beneficiary despite state law which would exonerate it.[7] A circular calculation, therefore, ensued and caused additional estate taxes. Make sure the tax apportionment clauses specifies the tax payers and coordinates (or overrides) IRC §2207A properly, especially when there is a charitable beneficiary following a QTIP trust. Additionally, it is important to specify whether proportional residuary gifts are determined before estate taxes are calculated or after, as this will change the amount going to each beneficiary.

7. Estate Deductions: Proposed Regulations under IRC §2053 significantly change the way estate deductions are taken into account. In general, deductions are limited to amounts actually paid, and for future payments, the estate must take into account post-death events.[8] There is great concern that this does not coordinate with marital or charitable deductions which are determined as of the date of death. This could lead to an inadvertent estate tax and must be addressed by the IRS before the Regulations are final and effective. If these rules are not changed, most returns with contingent claims will likely be accompanied with a protective claim for a refund.

8. Investment Management Fees: This is a recurring discussion for the past few years at Heckerling, probably because of all the trust companies in attendance. The Supreme Court affirmed the Second Circuit’s holding that fees for investment management services paid by a trust were subject to the two-percent floor for miscellaneous itemized deductions.[9] This position is also provided for under the IRC 67(e) Regulations, which states that any cost that is not unique to an estate or non-grantor trust is subject to the two-percent floor. Although trustees must unbundle their fees for this purpose, there may be some flexibility available in allocating the amounts. [See also: PA EE&F Law Blog posting "IRS Wins Rudkin Case in U.S. Supreme Court" (01/17/08).]

9. Single Member LLC: A method used to avoid certain state’s estate taxes on out-of-state real estate is to put it in an LLC or partnership, thereby changing it’s character to an intangible. Recently, some states have ignored a single member LLC for this purpose, namely New York and Massachusetts.

10. Distribution Committees: Over recent years at Heckerling the use of multiple trustees with defined duties or working as committees has been touted. IRS New Release 2007-127 announced the IRS was reconsidering private letter rulings it has issued on the application of IRC §2514 (the gift tax general power of appointment) to such committees where trust beneficiaries serve and distribute with full discretion.[10]

11. Transfer for Value Ruling: Revenue Ruling 2007-13 helped clarify some uncertainty regarding whether certain non-gift transfers to grantor trusts are excepted from the transfer for value rule of IRC §101(a)(2). Specifically, a transfer between two grantor trusts is ignored for income purposes, so no transfer for value has occurred. If only the transferee trust is a grantor trust (not the transferor), the transfer will meet the transfer to insured exception of IRC §101(a)(2)(B) and the policy proceeds will maintain the exclusion from income tax. In this latter scenario, however, the parties still need to be careful about triggering a gain if the consideration exceeds the policy basis.

12. Charitable Lead Trust: A Private Letter Ruling on charitable lead annuity trusts provided that a trust instrument cannot alter the source ordering rules with regard to annuity payments.[11] In other words, income will always come out worst character first.

13. Built-In Gain Effect on Valuation: The 11th Circuit reversed a Tax Court case in regard to the methodology used to reduce the estate tax value of a closely-held C corporation with built-in gain.[12] The Tax Court had attempted to project a future sale date and discount the built-in gain liability. The 11th Circuit held the sale should be taken into account as if it occurred at the time of death, resulting in no discounting of the reduction. In a partnership situation using this logic, one would have to weigh the value of an IRC §754 election step-up on inside basis (which would eliminate the impact) versus taking an immediate estate tax reduction. [See also: PA EE&F Law Blog posting "Jelke Ruling re Company's Value for FET" (12/06/07.]

14. Form 706 Line for Disclosing Discount: Form 706 now asks on line 10a if the decedent owned any interest in a partnership, an unincorporated association, or limited liability company, or owned a fractional interest in real estate. Line 10b follows up by asking if the value of any interest owned under line 10a was discounted. This could be viewed as the IRS recognizing the existence of fractional interest discounts. Although this should produce additional caution regarding discounts generally, it could also inadvertently sanction the ability to take fractional interest discounts.

15. GRAT Inclusion: Proposed Regulations were released that provide the included estate tax value of an annuity, unitrust, or other payment retained by a grantor in a CRT or GRT is governed by IRC §2036 only and not IRC §2039. Instead of the entire value of the trust being included in the grantor’s estate, therefore, only the calculated amount needed to satisfy the remaining retained payments is included.[13] Drafters should address the resulting IRC § 2207B right of reimbursement from the GRAT for estate taxes under the grantor’s will, and specifically waive it if desired.

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[1] Dickman v. Comm., 465 U.S. 330 (1984).

[2] Treas. Reg § 301.6501(c)-1(f).

[3] Treas. Reg §301.6501(c)-1(f)(4).

[4] Treas. Reg §301.6501(c)-1(f)(5).

[5] Simpson v. U.S., 183 F.3d 812 (8^th Cir. 1999); Bachler v. U.S., 281 F.3d 1078 (9^th Cir. 2002).

[6] Treas. Reg. §26.2601-1(b)(1)(i). Estate of Eleanor R. Gerson v. Comm., 127 T.C. 139 (2006).

[7] 389 N.J. Super. 22, 910 A.2d 634 (App. Div.).

[8] Treas. Reg. §20.2051-1.

[9] Michael J. Knight, Trustee v. Commissioner, 552 U.S. ___ (No. 06-1286, Jan. 16, 2008).

[10] PLRs 200731019, 200715005, 200647001, 200647001, 200637025, 200612002 and 200502014.

[11] PLR 200648025.

[12] Estate of Frazier Jelke, III, 2007 U.S. App. Lexis 26477.

[13] REG-119097-05, IRB 2007-28.

You may contact Paul at Cornerstone Advisors, 1802 Hamilton Street, Allentown, PA 18104 (Ofc: 610-437-1375; Fax: 610-437-4575; Email: pfabiano@cornerstone-companies.com).

Update: 02/18/08:

For Part II of Paul's observations from the Heckerling Institute, see: PA EE&F Law Blog posting "Developments from Heckerling Institute, Pt. II" (02/18/08).

Update: 02/25/08:

For Part III of Paul's observations from the Heckerling Institute, see: PA EE&F Law Blog posting "Developments from Heckerling Institute, Pt. III" (02/25/08).