• Tax Court rules in favor of Internal Revenue Service on “marital deduction mismatch” issue and Internal Revenue Code Section 2036—In Estate of Clyde Turner v. Commissioner, 138 T.C. No. 14 (March 29, 2012), the Tax Court analyzed the marital deduction mismatch that may occur when assets are included in the taxable estate under IRC Section 2036, and the estate is allocated using a marital deduction formula.
Clyde Turner Sr. resided in Georgia when he died intestate on Feb. 4, 2004. Two years before his death, Clyde and his wife, Jewell H. Turner, established Turner & Co., a Georgia limited liability partnership, funding it with cash, Regions Bank common stock, shares of other banks, certificates of deposit and assets held in securities accounts, such as preferred stock and bonds (Clyde and Jewell each contributed $4,333,671 for a total value of $8,667,342). In exchange, Clyde and Jewell each received a 0.5 percent general partnership (GP) interest and a 49 percent limited partnership (LP) interest. Clyde then gifted LP interests (21.7446 percent) to family members. On the date of his death, he owned a 0.5 percent GP interest and a 27.7554 percent LP interest.
The parties agreed that as of the date of Clyde’s death, the partnership’s net asset value was $9,580,520. The estate applied discounts for lack of marketability and lack of control and valued the 0.5 percent GP interest at $30,744 and the 27.7554 percent LP interest at $1,578,240.
In a 2011 ruling, Estate of Turner v. Commissioner, T.C. Memo. 2011-209, the Tax Court held that the assets transferred to the partnership were includible in Clyde’s estate under IRC Section 2036(a) because: (1) there was no legitimate and significant non-tax reason for forming the partnership, (2) Clyde retained an interest in the transferred assets, (3) the purpose of Turner & Co. was primarily testamentary, (4) none of the assets contributed to Turner & Co. required active management or special protection, and (5) Clyde didn’t have a distinct investment philosophy that he hoped to perpetuate. (For more information on that ruling, see the synopsis in our October 2011 “Tax Law Update,” p. 10).
The estate moved for reconsideration, arguing that the Tax Court didn’t consider that even if IRC
Section 2036 applies, the estate has no estate tax deficiency, because it’s entitled to an increased marital deduction equal to the increased value of the gross estate.
Of the 27.7554 percent that Clyde owned on the date of his death, the estate reported that an 18.8525 percent LP interest was allocated to Jewell and an 8.9029 percent interest was allocated to a bypass trust. Clyde’s estate claimed a marital deduction of $1,820,435, of which $1,072,000 pertained to the 18.8525 percent interest in Turner & Co. that passed to Jewell. The court noted that the IRS allowed a marital deduction based on the net asset value of the partnership, rather than a reduced marital deduction based on the discounted value of the partnership interests transferred, so there was no “marital deduction mismatch” problem with respect to these interests.
However, the estate claimed a marital deduction for the value of the assets representing the partnership interests gifted to the other family members (not Jewell) during Clyde’s life that were included in his estate under IRC Section 2036, arguing that the will’s formula marital deduction clause required the estate to increase the value of the marital gift. The estate argued that Section 2036
imposes “a legal fiction for purposes of calculating the gross estate, and, for consistency, the marital deduction should also be increased to reflect that fiction.”
The Tax Court disagreed. First, it reasoned that the property gifted to the other family members during Clyde’s life wouldn’t qualify for the marital deduction, because it didn’t “pass from the decedent to his surviving spouse,” as required under IRC Section 2056 and the Treasury regulations. In addition, allowing the marital deduction for such property would violate the public policy behind the marital deduction, which is to defer transfer taxes until the death of the surviving spouse. In this case, if the marital deduction were allowed, the property included in Clyde’s estate would escape tax at his death, but wouldn’t be included in Jewell’s estate at her death. As a result, the court explained, it would “allow the assets to leave Clyde and Jewell’s marital unit without being taxed, thereby frustrating the purpose and the policy underlying the marital deduction.”
• Treasury adopts final regulations regarding income tax consequences of charitable payments—On
April 13, 2012, in T.D. 9582, the Treasury adopted as final proposed regulations under IRC Sections 642 and 643 (specifically, 1.642(c)-3 and 1.643(a)-5, which were published in 2008). These regulations confirmed that a provision in a trust or will, or a provision of local law that specifically indicates the source out of which amounts are to be paid, permanently set aside or used for a purpose specified in Section 642(c), must have economic effect independent of income tax consequences to be respected for federal tax purposes. Otherwise, if the provision governing payment sources doesn’t have economic effect independent of income tax consequences, the income will consist of the same proportion of each class of the items of income as the total of each class bears to the total of all classes. Generally, these regulations apply to charitable lead trusts and trusts and estates making payments or permanently setting aside amounts for a charitable purpose.
• Tax Court holds for IRS regarding dissolution of family limited partnership—In Estate of Lois L. Lockett v. Comm’r, T.C. Memo. 2012-123 (April 25, 2012), the Tax Court assessed whether transfers made by a partnership were bona fide loans and whether the partnership itself was in existence on the date of death.
Lois Lockett and her husband, Robert Sr., were descendants of pioneer families with deep roots in Arizona. In 2000, 15 years after Robert Sr. died, Lois moved into an assisted living facility because her own health was declining. Around that time, Lois and several members of her family (her sons and a former daughter-in-law who was a financial planner), on the advice of an accountant and an estate-planning attorney, decided she should establish a family partnership. However, it took quite a while for the family to implement the plan.
In March 2002, Lois and her sons, in various capacities, established Mariposa Monarch LLLP (Mariposa) by signing a partnership agreement and filing the other necessary documents. Lois’ sons signed the partnership agreement and certificate as general partners. Lois, individually, and Lois and her sons, Joseph and Robert Jr., as trustees of a trust established under the will of Robert Sr. (the trust), signed as limited partners.
Within a few months, Lois and the trustees of the trust began funding the partnership, primarily with cash. Joseph and Robert Jr. made no contributions to Mariposa. A year later, the trustees terminated the trust and distributed the trust assets to Lois, its sole beneficiary. After the termination, Lois was the sole owner of LP interests in Mariposa.
From 2002 until her death in 2004, Lois reported all of the income and deductions of the partnership on her personal income tax return. Lois’ sons, as general partners, signed the annual reports and Forms 1065 and attached Schedule K-1. During these years, the partnership transferred assets to Lois’ sons and a grandchild; promissory notes were executed in return for some (but not all) of the transfers.
Lois died in 2004. Her estate tax return reported Lois as the 100 percent owner of the partnership, but applied discounts for lack of control and marketability. After the estate tax return was filed, the IRS issued notices of deficiency for gift tax and estate tax, asserting that the distributions to the sons and grandchild were taxable gifts, not loans, and that Mariposa wasn’t a valid partnership, so the assets should be includible in Lois’ estate.
The Tax Court analyzed the facts and certificates of each transfer from the partnership and determined that certain of the transfers were in fact gifts, but others were bona fide debts, because the partnership had a real expectation of repayment and an intention to enforce the debts.
Regarding the partnership, however, the Tax Court held that Lois’ sons, who were described in the partnership documents as general partners, weren’t, in fact, general partners. The sons didn’t contribute assets to the partnership, and the court wasn’t convinced by the estate’s arguments that the sons received GP interests in return for services performed (because the level of services they provided was minimal) or by gifts. Therefore, the only initial partners of the partnership were Lois and the trust. When the trust terminated, Lois was the sole owner and, under Arizona law and the partnership agreement itself, this caused the partnership to dissolve. Therefore, on the date of her death, 100 percent of the assets of the partnership were includible in her gross estate.
• Private letter ruling on grantor trust status when a person other than the grantor can substitute trust property—In PLR 201216034 (Jan. 11, 2012), a trust was created for the benefit of an individual, who also served as trustee. The grantor intended to transfer S corporation stock and requested a ruling on whether the trust would be a grantor trust to the beneficiary, whether the trust could, therefore, hold S corporation stock and whether the trust property would be includible in the beneficiary’s estate.
The beneficiary had a withdrawal right over the entire value of each contribution. The withdrawal right was cumulative and lapsed each year only to the extent of $5,000 or 5 percent of the value of the trust principal for that year.
The beneficiary, as trustee, could make distributions to himself, subject to ascertainable standards. In addition, he could, in a nonfiduciary capacity, acquire the trust property by substituting other property of an equivalent value as determined by an independent appraiser selected by the trustee.
The grantor wasn’t a beneficiary of the trust. Neither the grantor nor the grantor’s spouse could act as a trustee. Neither the grantor nor any “nonadverse party” (as defined in IRC Section 672(b)) had power to purchase, exchange or otherwise deal with or dispose of all or any part of the principal or income of the trust for less than adequate consideration in money or money’s worth, or to enable the grantor or the grantor’s spouse to borrow all or any part of the corpus or income of the trust, directly or indirectly, without adequate interest or security.
IRC Section 675(4)(C) provides that the grantor of a trust is treated as the owner of any portion of a trust with respect to which a power of administration is exercisable in a nonfiduciary capacity by any person without the approval or consent of any person in a fiduciary capacity. The term “power of administration” includes a power to reacquire the trust corpus by substituting other property of an equivalent value.
IRC Section 678(a) provides, in general, that a person other than the grantor shall be treated as the owner of any portion of a trust with respect to which such person: (1) has a power exercisable solely by himself to vest the corpus or the income therefrom in himself, or (2) has previously partially released or otherwise modified such a power and, after the release or modification, retains such control as would, within the principles of IRC Sections 671 to 677, inclusive, subject a grantor of a trust to treatment as the owner thereof. Section 678(b) provides that Section 678(a) shall not apply with respect to a power over income, as originally granted or thereafter modified, if the grantor of the trust or a transferor (to whom Section 679 applies) is otherwise treated as the owner under the provisions of subpart E, other than Section 678.
The PLR concluded that, under Section 678(a)(1), the beneficiary will be treated as the owner of that portion of the trust over which his withdrawal right hasn’t lapsed. Further, to the extent that the beneficiary fails to exercise a withdrawal power and the power lapses, the beneficiary will be treated as having released the power, while retaining a power of administration to acquire trust corpus by substituting other property of equivalent value. The PLR held that facts and circumstances of the trust administration would determine whether that power of administration was exercisable in a fiduciary or nonfiduciary capacity. If the power was held in a nonfiduciary capacity, the PLR concluded that under Section 678(a)(2), the beneficiary would be treated as the owner of the trust over which his powers had lapsed, making the trust a grantor trust to him entirely. If the entire trust was treated as owned by him, it would be a permitted shareholder of an S corporation, and the amounts subject to his withdrawal right on his death would be includible in his gross estate because his withdrawal rights constituted a general power of appointment.
The PLR on the grantor trust status is surprising. It appears that the trust should be treated as grantor trust to the grantor under Section 675(4)(C), because of the beneficiary’s power of substitution. That provision applies if the power is held “by any person” in a nonfiduciary capacity. Further, under Section 678(b), if the grantor is treated as the owner of the trust, then Section 678(a) doesn’t apply to make the trust a grantor trust to the beneficiary. It appears that the IRS didn’t correctly interpret how 675(4)(C) and 678(b) would apply in this case.
In the charitable lead annuity trust (CLAT) context, other rulings have reached the opposite conclusion, holding that the grantor is treated as the owner of the trust when another individual who isn’t the grantor, the trustee or an adverse party, holds the power to acquire and substitute trust property in a nonfiduciary capacity. For example, Revenue Procedure 2007-45 contains a form CLAT. In the comments to the form CLAT, it notes that when a person other than the donor, the trustee (who would hold it in a fiduciary capacity) or disqualified person holds a power to substitute trust assets, the CLAT is a grantor CLAT to the grantor under 675(4). In PLR 201216034, the person holding the power was both the trustee and the beneficiary, but held the substitution power in a nonfiduciary capacity.