It'd be easy to write off 2004 as a year of much talk and little action when it comes to trusts and estates law — easy, but misleading. While it's true that Congress failed to enact estate tax legislation, a major tax law it did pass, the American Jobs Creation Act, includes important provisions for trusts and estates practitioners. Charities bills didn't move forward in Washington, but new statutory structures for private foundations came up in some key state legislatures.

The Internal Revenue Service also issued rules affecting grantor trusts, and the courts decided a number of cases involving family limited partnerships. All told, there were a number of important themes to track.


Congress, of course, did not resolve the most pressing trusts and estates issue: the fate of the estate tax. In fact, 2004 was the first year since 1998 that Congress did not vote for a single bill with provisions mandating either a temporary or a permanent repeal of estate taxes. This inaction did not reflect any new-found enthusiasm for the existing estate tax regime. Congress, like most practitioners, is clearly unhappy with the one-year repeal of estate and generation skipping transfer taxes scheduled for 2010, the compromise enacted by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). The sticking point for lawmakers has been whether estate and GST taxes should be repealed permanently or reformed significantly through increased exemptions and decreased rates.

At the heart of this impasse are Senate budget rules requiring a 60-vote majority. This hurdle must be cleared whether the Senate is voting on permanent extension of EGTRRA's provisions or on any stand-alone legislation that would reduce revenue without corresponding spending offsets. In 2002 and 2003, the 60-vote threshold thwarted passage of legislation seeking permanent extension of EGTRRA's estate tax provisions. No one believed that the necessary votes could be mustered in the Senate during the contentious election year of 2004.

November's results gave the Republicans a 55-vote majority in the Senate, and this has encouraged proponents of estate tax repeal. We are likely to soon know if their optimism is justified. The House strongly supports permanent repeal and seems poised to introduce a bill to this effect early in the next session. What will happen in the Senate is uncertain.


Estate taxes were not the only issue that the last Congress failed to address. Despite the overwhelming passage of charities bills in both the House and Senate in 2003, Congressional leaders failed to pass a conference bill that could be sent to the President. As a result, such popular measures as direct distributions from individual retirement accounts to charities and above-the-line deductions for charitable contributions have not been enacted. For trusts and estates practitioners, probably the most important proposals in the 2003 bills involved changes in private foundation rules — particularly new restrictions on what constitutes a qualified distribution.

But Congress did not ignore charities in 2004. During the summer, the Senate Finance Committee issued a discussion paper recommending changes to exempt-organization laws, including a five-year review of an exempt organization's status and greater regulation of donor-advised funds (DAFs). Legislative aides have recently indicated that this discussion paper may be the basis for a new charities bill that will create more stringent reporting requirements for exempt organizations and new rules for DAFs, while also incorporating many provisions from the 2003 bills.

There also was considerable activity at the state level regarding charities. New York State Attorney General Elliot Spitzer recommended passage of a charities bill that would enforce new governance standards for not-for-profit organizations. Spitzer's bill focuses on creating new rules for determining executive compensation and establishing more stringent governance practices. A bill similar to New York's was passed in California in September. Like the New York bill, the California Nonprofit Integrity Act of 2004 creates strict rules governing compensation and reporting.

These developments suggest that charities may face significant changes in the near future on both the state and federal level.


In October, Congress passed the American Jobs Creation Act (AJCA). Purportedly designed to eliminate European Union sanctions by repealing the Internal Revenue Code's extra-territorial income exclusion provisions, AJCA included a potpourri of tax provisions. The two most relevant to trusts and estates practitioners are new rules for deferred compensation and revised rules for individual expatriation.

AJCA created a new section in the IRC, Section 409A, establishing restrictions on non-qualified deferred compensation plans, including voluntary deferral plans, executive retirement plans, stock appreciation rights, restricted stock units, phantom stock and deferred severance packages. The law, which took effect Jan. 1, generally applies to amounts deferred after 2004. Key restrictions limit when distributions can occur, when election deferral must be made, and what kind of rabbi trusts are allowed.

In general, apart from distributions made at a specified time or on a fixed schedule established at the time of deferral, distributions are allowable only under these conditions: separation from service, disability, death, a change of ownership or an unforeseeable emergency. These events are further restricted in some cases. For instance, a key employee of a public company may not receive a distribution within six months of separation from service. Finally, acceleration of distributions is no longer allowed, including so called “haircut distributions” that allowed early payments subject to a penalty.

Elections for deferrals must generally be made 12 months before the taxable year in which the service being compensated occurs. There is an exception for performance-based compensation, which can be deferred up to six months before the end of the deferral period. In addition, springing and offshore rabbi trusts are now prohibited as vehicles for non-qualified deferred compensation. Section 409A also establishes severe penalties for failing to comply with the new regime. Treasury regulations addressing many of the issues raised by the new rules are expected soon.

Meanwhile, the expatriation rules in AJCA resolve a longstanding division between the House and Senate regarding revision of expatriation law. Eschewing the Senate's approach of establishing a mark-to-market capital gains tax on assets when an individual expatriates, AJCA revised IRC Section 877 by introducing objective standards for determining if former citizens or long-term residents are subject to the expatriation tax regime. Long-term residents and former citizens are subject unless they can establish that they have had annual income of less than $124,000 and net worth of less than $2 million, and that they complied with all federal tax obligations for the five years preceding expatriation. Taxpayers caught in the expatriation regime will remain subject to U.S. income tax and U.S. estate tax on U.S. source income and U.S. assets for a period of 10 years following expatriation as if they were still U.S. taxpayers. Expatriated persons subject to the expatriation regime who spend more than 30 days in the U.S. in any year during the 10-year period will be subject to U.S. taxes on their worldwide income and assets for that year.

The new law also eliminates the current practice of ruling requests for exceptions to the alternative tax regime, although it does provide for certain exceptions (most notably for dual citizens and minors).


The Internal Revenue Service provided some long-awaited and welcome guidance on July 6 when it released Revenue Ruling 2004-64 stating that the payment of a grantor trust's income tax by the grantor does not constitute a taxable gift for transfer tax purposes. The ruling also states that if, pursuant to the trust's governing instrument or applicable local law, the grantor must be reimbursed for income tax attributable to trust income, the full value of the trust's assets is includible in the grantor's gross estate. However, if either local law or the trust instrument provides the trustee with discretion regarding reimbursement of income taxes, this discretion will not cause the value of the assets to be included in the estate.


There was also some new case law regarding FLPs in 2004. By now, all practitioners are aware that the Service has successfully litigated a number of FLP cases in which Section 2036 was used to undermine discounts taken on transferred assets. The Service continued to be successful in making these arguments in a number of cases: Hillgren, T.C. Memo 2004-46; Abraham, T.C. Memo 2004-3; Turner v. Comm'r, 3d Cir., No. 03-3173, Sept. 1, 2004. But each of these cases seems to rest on a bad fact pattern — as did earlier FLP cases.

A more interesting decision was the decision last year by the U.S. Court of Appeals for the Fifth Circuit in Kimbell. The appeals court found that the decedent's transfer of property to a FLP constituted a bona fide sale for full and adequate consideration. The Fifth Circuit also set a fairly broad standard for establishing the business purpose of a partnership, making the “adequate and full” exception standard easier to attain. Kimbell, of course, does not eliminate the 2036 argument against FLP discounts, but it does tend to reinforce the impression that properly constructed and executed FLPs remain viable estate-planning tools.

It is important to note that the Strangi case, perhaps the most important of the recent FLP cases, is still working its way through the appellate process. Should the IRS position in Strangi be upheld, the possible impact on FLP cases may be litigated well into the future. Of course, insofar as these rulings are based upon the particular fact patterns at hand, such impact may be limited.

Recent cases do make it clear, though, that certain practices should be followed regarding FLPs. For instance, the transferor should be sure to retain sufficient assets outside of the FLP for his support. A transferor also should not commingle partnership assets with personal assets. Because a partnership is a distinct business entity, the court will look to determine whether it has been respected as such. For example, a partnership must maintain financial records, keep records of regular meetings, provide all partners with financial statements and make distributions in accordance with the provisions of the partnership agreement.

An individual creating an FLP for estate-planning purposes should be sure these practices are followed. Basically, courts are looking to make sure that the transferor has given up sufficient control of the transferred assets and does not treat them as personal assets.


We await further clarification in 2005 on the use of FLPs as an estate-planning technique. Though the Fifth Circuit in Kimbell gave an important boost to this technique, it remains to be seen what will happen as Strangi and other cases reach final adjudication.

We are likewise awaiting further developments in the other key areas — in particular, the fate of the estate and GST tax, and the new requirements for charitable organizations and private foundations.