Once again, we’re at an appropriate juncture to look back at some notable developments in estate planning that occurred during a just-concluded year and ahead at some of what may be in store during the coming year and beyond.
The President’s Green Book
On April 10, 2013, the Department of the Treasury issued its 2013 Green Book (officially called General Explanations of the Administration’s Fiscal Year 2014 Revenue Proposals). The Green Book, published annually, essentially amounts to the Administration’s wish list for changes in the Internal Revenue Code.
Anyone who’s not living under a rock knows that the current political climate in Washington is about as toxic as, if not more so than, it’s ever been. Thus, the chances of any meaningful tax legislation finding its way to the President’s desk this year seem small. However, there’s a chance that enough bi-partisan bargaining could produce a viable tax bill. The 2013 Green Book reveals, among many other things, changes in the tax law relating to estate planning matters that the President would favor. A few (but by no means all) of these proposed changes are summarized below:
Estate, gift and generation-skipping transfer (GST) tax rates and exemptions. For decedents dying and transfers made after 2017, the Administration proposed to restore the estate, gift and GST tax rates and the applicable exclusion amounts and GST exemption amount that were in effect in 2009. Accordingly, the top tax rate would be 45 percent, and the applicable exclusion amount would be $3.5 million for estate tax purposes and $1 million for gift tax purposes. The GST exemption would be $3.5 million. The applicable exclusion and GST exemption amounts wouldn’t adjust due to inflation.
Coordination of income and transfer tax treatment for grantor trusts. The Administration proposed that if a person who’s a deemed owner of a trust under the grantor trust rules engages in a sale, exchange or similar transaction with that trust that’s disregarded for income tax purposes due to the grantor trust status of the trust, then the portion of the trust attributable to property received by the trust in such transaction (including income and appreciation on such property) would be: (1) subject to estate tax on the deemed owner’s death; (2) subject to gift tax at any time during the deemed owner’s life when grantor trust status is terminated; and (3) subject to gift tax with respect to any distribution made from the trust to any person other than the deemed owner (except in discharge of the deemed owner’s obligation to the distributee) during the life of the deemed owner. The trust would be liable for the gift and estate taxes arising from such transfers.
Increasing risk associated with grantor retained annuity trusts (GRATs). The Administration made proposals that, according to the Treasury, would require some “downside risk” in using so-called zeroed-out, short-term GRATs. The Treasury noted that taxpayers often minimize the risk of a GRAT by establishing it for a for a very short term (for example, two years) and causing the taxable gift on funding the GRAT to be zero or close to zero by structuring the annuity so that its actuarial value is virtually equivalent to the value of the property used to fund the GRAT. The Administration would require that a GRAT: (1) have a minimum term of 10 years; and
(2) have a remainder interest with a value greater than zero at the time such interest is created.
Limiting duration of GST exemption. Due to many states’ having repealed or significantly reduced the applicability of the rule against perpetuities and the expanding GST exemption (which is up to $5.34 million for 2014), the Administration is concerned that the GST tax currently isn’t accomplishing the objective for which it was enacted: preventing the avoidance of estate tax through the use of dynasty trusts.
The Green Book proposal would require that, on the 90th anniversary of the creation of a trust, the inclusion ratio of the trust would be increased to one, effectively eliminating any GST exemption allocated to the trust. Trusts that are decanted and trusts transferred under the rule for pour-over trusts under IRC Section 2653(b)(2) would be deemed to have the same date of creation as the initial trust. This limitation on the GST exemption would also apply to taxable terminations and taxable distributions that occur after the 90th anniversary of the creation of the trust, with an exception for certain trusts established under IRC Section 2642(c)(2).
The Administration would apply this rule to trusts created after enactment and to the portion of any pre-existing trust attributable to additions to such a trust made after that date.
In floating the idea of a rollback of the applicable exclusion amount and GST exemption to 2009 levels, the President would seem to be facing a strong headwind. A reduction in the applicable exclusion amount (formerly known as the “unified credit exemption equivalent”) has been proposed in Congress a few times, but has never come close to being enacted.
On the other hand, clamping down on the use of one or more estate planning strategies that might be characterized as facilitating an end run around the intent of applicable law (for example, zeroed-out, short-term GRATs, perpetual GST-exempt dynasty trusts or installment sales to grantor trusts) might stand a chance on Capitol Hill if the President were to give something (for example, some sort of income tax relief) in return.
Defined Value Clauses
A defined value clause (DVC) is a provision that may be included in a document implementing a gift or sale of an asset. Such a clause is designed to ensure that a particular donee or purchaser shall receive the property that’s the subject of the gift or sale but only to the extent the value of such property doesn’t exceed a stated amount. DVCs often state that any excess value above and beyond the stated amount shall pass to a tax-exempt charity. In some of those circumstances, DVCs provide that the values of property passing to the target donee or purchaser, on the one hand, and a charity, on the other hand, shall be arrived at by reference to values as finally determined for federal gift tax purposes. In other such cases, the value of what the donee or purchaser receives and the value of what the charity receives are fixed pursuant to a “confirmation agreement” entered into between the donee or purchaser and the charity.
The Internal Revenue Service has fared poorly in the past several years in litigating the efficacy of DVCs.1 In fact, in all the cases that have been handed down in the last 10 years (eight in all—counting trial court and appellate decisions), the IRS is zero for eight.
There are, however, insidious danger signs. First, it’s obvious from the litigation history that the IRS detests DVCs, and, given how effectively such clauses can discourage the IRS from examining gift tax returns, the IRS’ reaction isn’t surprising. Second, in the latest of the IRS’ losses, Wandry,2 the IRS filed a Notice of Appeal to the U.S. Court of Appeals for the 10th Circuit on Aug. 28, 2012. The IRS dropped that appeal on Oct. 16, 2012, but, on Nov. 13, 2012, the IRS issued an action on decision indicating its nonacquiescence,3 seemingly indicating they haven’t abandoned the fight. Third, the Ninth Circuit, in the last sentence of its opinion in Petter, quoting Mayo Found. for Med. Educ. & Research v. United States,4 ominously said “[W]e expressly invite [ ] the Treasury Department to ‘amend its regulations’ if troubled by the consequences of our resolution of th[is] case.” In light of the IRS’ numerous unsuccessful attacks on DVCs in the courts, it would seem to be only a matter of time, perhaps a short time, before the IRS accepts the Ninth Circuit’s invitation in Petter.
Portability and QTIP Trusts
One of the most important aspects of The American Taxpayer Relief Act of 20125 for estate planning professionals is that it made portability permanent (to the extent anything emanating from Washington can be said to be permanent). The term “portability” is shorthand among estate planners to refer to the ability of a predeceased spouse’s executor to transmit to the surviving spouse whatever is left of the predeceased spouse’s applicable exclusion amount (the deceased spousal unused exclusion amount). When portability was introduced into the law,6 it was hailed as a concept that would greatly simplify estate planning for married couples. No longer would it be necessary for each spouse to own sufficient assets and have an estate plan in place that would facilitate use of the predeceased spouse’s applicable exclusion amount, regardless of which spouse died first (the traditional approach).
By now, attentive estate planners have come to realize that portability hasn’t resulted in simplification. If anything, portability has complicated estate planning by introducing yet another option that a married couple must consider.
Examining the tip of the iceberg reveals that implementing portability, unlike the traditional approach, enables the assets that would have passed to a credit shelter trust at the death of the first spouse to die instead to be owned by the surviving spouse at his death, thereby generating a full step-up in basis with respect to all such assets.7 A few advantages, however, are forfeited by employing portability in this manner. First, the GST exemption,8 unlike the applicable exclusion amount, may not be transmitted to a surviving spouse. Second, all assets owned by a surviving spouse are fully exposed to claims of his creditors. Third, any post-predeceased spouse’s death growth in the value of the assets that would have passed to a credit shelter trust at the death of the first spouse to die using the traditional approach, and so would have been excluded from the gross estate of the surviving spouse, will be included in the surviving spouse’s gross estate.
A possible way to solve the first two of those portability disadvantages would be to structure the spouses’ estate plan so that, at the death of the first spouse, everything owned by that spouse passes to a qualified terminable interest property (QTIP) trust, instead of outright to the surviving spouse. A so-called “reverse QTIP election”9 could be made, thereby enabling the predeceased spouse’s GST exemption to be used, and the assets and income of the QTIP trust, for so long as such assets and income remained in the trust, would be exempt from the claims of the surviving spouse’s creditors.
The fly in the ointment, though, is Revenue Procedure 2001-38,10 in which the IRS indicated that a QTIP election that isn’t necessary to reduce estate tax liability to zero will be disregarded and treated as “null and void.” In the portability context, of course, a QTIP election wouldn’t be necessary to reduce the estate tax to zero when the amount with respect to which the QTIP election would be made is equal to or less than the amount of the predeceased spouse’s applicable exclusion amount remaining at his death. Rev. Proc. 2001-38 was issued long before portability came into the law and, by its terms, appears to operate only when a taxpayer invokes it to avoid the future application, when a QTIP election had been made inadvertently, of IRC Section 2044 or IRC Section 2519. There is, however, enough concern about Rev. Proc. 2001-38 blocking the use of portability when a QTIP trust, rather than an outright disposition, is used that both the American College of Trust and Estate Counsel and the American Bar Association Section of Real Property, Trust and Estate Law asked the IRS to initiate a project clarifying that Rev. Proc. 2001-38 can be used only to invalidate an unintended QTIP election at the request of a taxpayer and not to negate portability when a QTIP trust is used. The Treasury-IRS 2013-2014 Priority Guidance Plan, issued on Aug. 9, 2013, indicates that the IRS intends to issue a revenue procedure under IRC Section 2010(c) regarding the validity of a QTIP election on an estate tax return filed only to elect portability.11
On June 26, 2013, the U.S. Supreme Court, in a 5-4 decision, handed down its ruling in Windsor.12 The Supreme Court held that Section 3 of the Defense of Marriage Act (DOMA) violated the Equal Protection Clause of the Fifth Amendment in that, by defining marriage as a union between a man and a woman, it mandated impermissible discrimination against same-sex couples whose marriages were valid under state law. In so holding, the Supreme Court stated that Congress, by enacting Section 3 of DOMA, had intruded into an area (the definition of marriage) traditionally and appropriately left to the states and wrongly sought to injure a class of persons the State of New York sought to protect. The court seemed strongly to imply that the definition of marriage would continue to be left to the states. Windsor impacts the interpretation and implementation of laws that give rise to federal tax consequences and federally conferred benefits, but it doesn’t expressly purport to affect state tax consequences or benefits arising under state law.
Despite the court’s implicit acknowledgement that its decision is intended to leave the states as the ultimate arbiters in determining who’s considered to be married for state law purposes, one wonders how long this position can hold. It would appear to stretch logic beyond the breaking point to maintain that a state law version of Section 3 of DOMA is valid under the U.S. Constitution while Section 3 of DOMA itself is not. Same-sex couples can be expected to use the very same arguments that were used in Windsor, and Windsor itself as controlling precedent, to overturn state law versions of Section 3 of DOMA.
In Rev. Rul. 2013-17,13 the IRS indicated, among other things, that same-sex spouses would be allowed (but not compelled) to file amended tax returns to claim married status, so long as the applicable limitations period under IRC Section 6511 hasn’t expired.14 What about a tax return with respect to which applicable limitations period under Section 6511 has expired? Couldn’t a same-sex married couple forcefully argue that the Supreme Court’s decision in Windsor supersedes the statute of limitations? The reasoning would be that Section 3 of DOMA didn’t become unconstitutional on June 26, 2013. The determination that Section 3 is unconstitutional was handed down on June 26, 2013. Section 3 has been unconstitutional from the moment it was enacted. Can a statute of limitations preclude a citizen from pursuing a claim emanating from a statute that was essentially an illegitimate enactment? We should expect litigation this year challenging the enforcement of Section 3 of DOMA for any period of time from and after the date of its enactment. (For more information on the effect of the Supreme Court’s DOMA ruling, see “Ding Dong, Is DOMA Dead?” by Joshua S. Rubenstein and Jason J. Smith, in this issue, p. 40.)
On April 23, 2013, the Seventh Circuit in In re Heffron-Clark, held that an inherited individual retirement account, as contrasted with an IRA owned by the individual who established it, isn’t protected from creditors’ claims in bankruptcy.15 The court examined the provisions of the Bankruptcy Code that may cause an IRA to be exempt from inclusion in a debtor’s bankruptcy estate.16 The requirements set out in these virtually identical provisions are two-fold. First, the IRA must be exempt from taxation under IRC Sections 401, 403, 408, 408A, 414, 457 or 501(a). Second, the IRA must be comprised of “retirement funds.” These requirements must be satisfied regardless of whether the debtor in bankruptcy is using federal exemptions or state exemptions.
The Seventh Circuit determined that, while the inherited IRA in question was indeed exempt from taxation under Section 408, the IRA didn’t, in the hands of the beneficiary, constitute retirement funds. The court acknowledged that an IRA owned by the person who established it qualifies as retirement funds because, presumably, that person is using the IRA as a vehicle to save for retirement but stated that an IRA beneficiary can’t be said to use an IRA as a means of saving for retirement.
Before Heffron-Clark, two other federal circuit courts of appeal had addressed this same issue and had concluded that an inherited IRA met both tests for exclusion from the beneficiary/debtor’s bankruptcy estate.17 Each of these courts, essentially, adopted the view that whether an IRA currently constitutes funds intended to be used for an individual’s retirement is irrelevant. What matters, according to these courts, is that when the IRA was established, the funds comprising it were set aside for the eventual retirement of the person who created it.
On Nov. 26, 2013, the Supreme Court announced it was granting certiorari in Heffron-Clark.18 Thus, the split in the circuits regarding this important question, represented by Chilton and Nessa, on the one hand, and Heffron-Clark, on the other, will be resolved this year.
The crystal ball is never quite as clear as we would like, but 2014 certainly has the potential to be a year of several developments important to estate planners. Don’t blink or you may miss something!
1. Wandry v. Commissioner, T.C. Memo. 2012-88; Estate of Petter v. Comm’r, T.C. Memo. 2009-280, aff’d, 2001-2 U.S.T.C. par. 60,623 (9th Cir. 2011); Hendrix v. Comm’r, T.C. Memo. 2011-133; Estate of Christiansen v. Comm’r, 130 T.C. 1 (2008), aff’d, 586 F.3d 1061 (8th Cir. 2009); Succession of McCord v. Comm’r, 120 T.C. 358 (2003), aff’d, 461 F.3d 614 (5th Cir. 2006).
2. Wandry, ibid.
3. Action on Decision 2012-04, 2012-46 I.R.B. (Nov. 13, 2012).
4. Mayo Found. for Med. Educ. & Research v. United States, 131 S.Ct. 704, 713 (2011).
5. P.L. 112-240 (Jan. 2, 2013).
6. Section 302(a)(1) of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (P.L. 111-312), amending Internal Revenue Code Section 2010(c).
7. IRC Section 1014(a).
8. IRC Section 2631.
9. IRC Section 2652(a)(3).
10. 2001-38 I.R.B.
11. The Treasury-IRS 2013-2014 Priority Guidance Plan indicates that numerous other projects are also in the pipeline, some of which have been there for several years.
12. United States v. Windsor, 133 S.Ct. 2675 (2013).
13. 2013-38 I.R.B.
14. Revenue Ruling 2013-17 says in pertinent part:
… affected taxpayers may … rely on this revenue ruling for the purpose of filing original returns, amended returns, adjusted returns … provided the applicable limitations period for filing such claim under section 6511 has not expired.
15. In re Heffron-Clark, 714 F.3d 559 (7th Cir. 2013).
16. 11 U.S.C. Section 522(b)(3)(C) and (d)(12).
17. In re Chilton, 674 F.3d 486 (5th Cir. 2012); In re Nessa, 426 B.R. 312 (BAP 8th Cir. 2010).
18. Clark v. Rameker, No. 13-299 (cert. granted Nov. 26, 2013).