How much do estate and gift taxes contribute to funding the federal government? A March 19, 2008, Congressional Research Service report said that combined revenues from estate and gift taxes were $26 billion in 2007, constituting 1 percent of total federal revenue. The Congressional Budget Office projects that, if the estate tax were to be reinstated in 2011 as scheduled, “revenue from the estate and gift taxes would climb steadily by about $7 billion per year.”
CRT can split unitrust payments between a grantor and a charity. In Private Letter Ruling 200813023 (issued Nov. 21, 2007 and released March 28, 2008), a taxpayer proposed to established a charitable remainder unitrust (CRUT) under which 50 percent of the unitrust amount would be paid to the taxpayer and 50 percent would go according to a special trustee's discretion to the taxpayer and/or any charities. Under the CRUT's terms, the taxpayer could not act as special trustee, but could remove and appoint successors to the position, as long as the successor was not related or subordinate to the taxpayer, within the meaning of Internal Revenue Code Section 672(c).
Treasury Regulations Section 1.664-1(a)(4) provides that a trust that otherwise qualifies as a CRUT will be treated as a CRUT at the earliest time that neither the grantor nor any other person is treated as the owner of the entire trust under the grantor trust rules. Internal Revenue Code Section 674(a) generally provides that the grantor of a trust is treated as the owner of any portion of the trust of which the grantor or a non-adverse party controls the beneficial enjoyment. But Section 674(a) doesn't apply if the power to control beneficial enjoyment is exercisable only by the trustees, and no more than half of the trustees are related or subordinate to the grantor.
PLR 200813023 held that, because the special trustee was neither related nor subordinate to the grantor, the special trustee's power to allocate 50 percent of the unitrust between the taxpayer and charities did not cause the taxpayer to be treated as the owner of the trust; therefore, the arrangement did not prevent the trust from qualifying as a CRUT. But note — the IRS did say that such a trust would qualify as a CRUT only if a portion of the unitrust must be paid to non-charitable beneficiaries each year, which portion is not de minimis under the facts and circumstances.
A “backwards” QPRT qualifies as a QPRT. In PLR 200814011 (issued Dec. 6, 2007 and released April 4, 2008), the Service found a transfer of a residence to a trust qualified as a personal residence trust (QPRT) even though the QPRT was backwards. Usually, the grantor of the QPRT retains the right to use the residence for a period of a year, and the donee/remainderman receives the residence after that term. In this ruling, the donee received the use of the residence for a term, and the grantors received the residence back after the term.
A mother transferred her residence to a QPRT that ended after 10 years, leaving her children owning the residence and leasing it back to her. The children proposed transferring the residence to a new QPRT with a one-year term. The QPRT would provide that the mother would have the right to use and possess the residence for one year, or until both of the children died, whichever came first. At the end of the year, the residence would revert back to the children. The Service ruled that, assuming the residence meets the requirements of a personal residence under Treas. Regs. Section 25.2702-5(c)(2), the trust qualifies as a QPRT.
This PLR seems to identify a method by which the mother can continue to live in the residence without paying rent and without the children incurring a significant gift tax liability. They made a gift of the right to use the residence for one year, the value of which was determined under the Section 7520 tables. Of course, the gift would have a very small value because the term is so short. For example, if the house was worth $500,000, the 7520 rate was 4 percent and the children 40-years-old, the gift would be only about $19,000. Moreover, the gift would qualify for the gift tax annual exclusion. Treas. Regs. Section 25.2503-3(b) provides that the right to use, possess, or enjoy property for a term is a present interest that qualifies for the annual exclusion.
IRS releases proposed regulations on time extensions for GST exemption allocations. The IRS issued proposed regulations on April 17, 2008 to provide guidance on the application of IRC Section 2642(g)(1). These regs describe when a time extension will be granted to: (1) allocate generation skipping transfer (GST) tax exemption (as defined in IRC Section 2631(a)) to a transfer; (2) elect under Section 2632(b)(3) not to have the deemed allocation of GST exemption apply to a direct skip; (3) elect under Section 2632(c)(5)(A)(i) not to have the deemed allocation of GST exemption apply to an indirect skip or transfers made to a particular trust; and (4) elect under Section 2632(c)(5)(A)(ii) to treat any trust as a GST trust for purposes of IRC Section 2632(c).
In 2001, the IRS issued Notice 2001-50 announcing that transferors may seek an extension of time to make an allocation of GST tax exemption. The notice provides that relief will be granted under Section 301.9100-3 of the Procedure and Administration Regulations (1) if the taxpayer satisfies the requirements of those regulations; (2) if the taxpayer acts reasonably and in good faith; and (3) if granting the requested relief won't prejudice the government's interests. If relief is granted under Section 301.9100-3 and the allocation is made, the amount of GST tax exemption allocated to the transfer is the federal gift or estate tax value of the property as of the transfer date and the allocation is effective as of the transfer date.
In 2004, the IRS issued Revenue Procedure 2004-46 (2004-2 CB 142), which provides a simplified, alternate method to obtain an extension of time to allocate GST exemption in certain situations. Generally, this method is available only for inter vivos transfers to a trust if each of the following requirements is met: (1) the transfer qualifies for the gift tax annual exclusion under Section 2503(b); (2) the sum of the amount of the transfer and all other gifts by the transferor to the donee in the same year do not exceed the applicable annual exclusion amount for that year; (3) no GST exemption is allocated to the transfer; (4) the taxpayer has unused GST exemption to allocate to the transfer as of the filing of the request for relief; and (5) no taxable distributions or taxable terminations have occurred as of the filing of the request for relief.
Under the proposed regulations, Section 301.9100-3 will be amended to provide that relief under Section 2642(g)(1) cannot be obtained through the provisions of Sections 301.9100-1 and 301.9100-3 (rendering Notice 2001-50 obsolete). Relief under Section 301.9100-2(b) (the automatic six-month extension) will continue to be available to transferors or transferor's estates that qualify. In addition, Rev. Proc. 2004-46 will remain effective for transfers that meet the requirements of that revenue procedure.
The amount of GST tax exemption that may be allocated to a transfer pursuant to an extension granted under Section 2642(g)(1) is limited to the amount of the transferor's unused GST tax exemption under Section 2631(c) as of the date of the transfer. Thus, if the amount of GST tax exemption has increased since the date of the transfer, no portion of the increased amount may be applied by reason of the grant of relief under Section 2642(g)(1) to a transfer taking place in an earlier year and prior to the effective date of that increase (Prop. Regs. Section 26.2642-7(c)).
Requests for relief under Section 2642(g)(1) will be granted when the taxpayer establishes to the IRS' satisfaction that the taxpayer acted reasonably and in good faith, and that the grant of relief will not prejudice the government's interests. (Prop. Regs. Section 26.2642-7(d)(1)). The following nonexclusive list of factors will be used to determine whether a transferor or the executor of a transferor's estate acted reasonably and in good faith (Prop. Regs. Section 26.2642-7(d)(2)):
- a demonstration of the intent of the transferor or the executor of the transferor's estate to allocate the GST tax exemption or make an election under Sections 2632(b)(3) or (c)(5) in a timely fashion — as evidenced in the trust instrument, instrument of transfer or contemporaneous documents (such as federal gift or estate tax returns or correspondence);
- if intervening events beyond the control of the transferor as defined in Section 2652(a), or of the executor of the transferor's estate as defined in Section 2203, caused a failure to allocate GST tax exemption to a transfer or a failure to elect under Section 2632(b)(3) or (c)(5);
- if the transferor or the executor of the transferor's estate is unaware of the need to allocate GST tax exemption to a transfer after exercising reasonable diligence (taking into account the experience of the transferor or the executor of the transferor's estate and the complexity of the GST issue);
- evidence of consistency by the transferor in allocating (or not allocating) the transferor's GST tax exemption, although evidence of consistency may be less relevant if there is evidence of a change of circumstances or change of trust beneficiaries that would otherwise support a deviation from prior GST tax exemption allocation practices; and
- reasonable reliance by the transferor or the executor of the transferor's estate on the advice of a qualified tax professional retained or employed by either (or both) of them, and the failure of the transferor or executor, in reliance on or consistent with that advice, to allocate GST tax exemption to the transfer or to make an election described in Section 2632(b)(3) or (c)(5).
For purposes of Section 2642(g)(1), the following non-exclusive list of factors will be used to determine whether the interests of the government would be prejudiced (Prop. Regs. Section 26.2642-7(d)(3)):
- the grant of requested relief would permit the use of hindsight to produce an economic advantage or other benefit that would not have been available had the allocation or election had been made in a timely fashion, or that results from the selection of one out of a number of alternatives (other than whether to make an allocation or election) available at the time the allocation or election could have been made in a timely fashion;
- if the transferor or the executor of the transferor's estate delayed the filing of the request for relief with the intent to deprive the IRS of sufficient time (by reason of the expiration or impending expiration of the applicable statute of limitations or otherwise) to challenge the claimed identity of the transferor; the value of the transferred property that is the subject of the requested relief; or any other aspect of the transfer that is relevant for transfer tax purposes; and
- a determination by the IRS that a grant of relief under Section 2642(g)(1) would be unreasonably disruptive or make it difficult to adjust the GST tax consequences of a taxable termination or a taxable distribution that occurred between the time for making a timely allocation of GST exemption or a timely election described in Section 2632(b)(3) or (c)(5) and the time at which the request for relief under Section 2642(g)(1) was filed.
The standard of reasonableness, good faith and lack of prejudice to the interests of the government will not be met, and relief will not be granted, in the following situations (Prop. Regs. Section 26.2642-7(e)):
- the transferor or the executor of the transferor's estate made an allocation of GST exemption as described in Section 26.2632-1(b)(4)(ii)(A)(1) or made an election under Sections 2632(b)(3) or (c)(5) on a timely filed federal gift or estate tax return — and the relief requested would decrease or revoke that allocation or election;
- the transferor or the transferor's executor delayed in requesting relief in order to preclude the IRS, as a practical matter, from challenging the identity of the transferor, the value of the transferred interest on the federal estate or gift tax return, or any other aspect of the transaction that is relevant for federal estate or gift tax purposes;
- the action or inaction that is the subject of the request for relief reflected or implemented a decision regarding the allocation of GST exemption or an election described in Section 2632(b)(3) or (c)(5) that was made by the transferor or executor of the transferor's estate who had been accurately informed in all material respects by a qualified tax professional retained or employed by either (or both) of them; and
- the IRS determines that the transferor's request is an attempt to benefit from hindsight.
Lastly, if the relief granted under Section 2642(g)(1) results in a potential tax refund claim, no refund will be paid or credited to the taxpayer or the taxpayer's estate if, at the time of filing the request for relief, the period of limitations for filing a claim for a credit or refund of federal gift, estate, or GST tax under Section 6511 on the transfer for which relief is granted has expired. (Prop. Regs. Section 26.2642-7(g))
Score one highly favorable FLP decision for taxpayers. In Estate of Anna Mirowski v. Commissioner, T.C. Memo 2008-74 (March 26, 2008), the Tax Court held that assets Anna Mirowski transferred to her family's limited liability company (LLC) and the LLC interests she gifted to trusts for her daughters' benefits were not includible in her estate — despite the fact that she'd executed the operating agreement and funded the LLC less than two weeks before her unexpected death. Because such decisions are very fact-driven, here are the details of that case:
In the late 1990s, Mirowski had begun to consolidate management of her investment portfolio with Goldman Sachs. At that time, her portfolio consisted primarily of U.S. treasuries held in 84 accounts in 10 institutions. Over time, she diversified into other types of investments based on Goldman's advice.
Mirowski also owned patents developed by her late husband and rights to royalties on those patents under a license agreement. The royalty payments dramatically increased after 1990, generating millions of dollars each year.
The Tax Court went to great lengths to note that Mirowski “was a careful, deliberate and thoughtful decision maker” who met with a representative from Goldman Sachs at least three to five times a month and, as the court put it, “actively made every decision regarding the purchase of securities by Goldman Sachs.” At no time did her daughters make any financial decisions for her.
In May 2000, Mirowski and one of her daughters met with a representative from U.S. Trust who suggested forming an LLC. She discussed this option with her attorney, who sent Mirowski and her daughters a draft of the operating agreement a few months later. Mirowski had meetings with her daughters once a year at their vacation home to discuss family finances and she planned to wait until the next family meeting in August 2001 (a year later) to discuss the LLC operating agreement. However, in August 2001, Mirowski's daughters held the annual meeting with the attorney but without Mirowski. On Aug. 27, 2001, Mirowski received the final documents from her attorney and signed the articles of organization and the operating agreement.
On Aug. 31, 2001, at the age of 74, Mirowski was admitted to the hospital for a foot ulcer, but was otherwise in good health. No one — not Mirowski, her physicians or her daughters — expected her to die at this time. Her daughters were frequently in touch with her and not overly concerned about her health. Indeed, one of her daughters, who was a physician, left for a trip to France on Sept. 6, 2001.
During the first week of September 2001, Mirowski transferred the patents and her rights under the license agreement and $62.5 million of securities held in the Goldman Sachs account to the LLC. On Sept. 7, 2001, Mirowski gifted a 16 percent interest in the LLC to each of three trusts, one for the benefit of each daughter, retaining a 52 percent interest. After these transfers, she retained assets worth just over $7 million in her own name, only $3.3 million of which was liquid. While she had enough assets to meet her living expenses, she did not have enough assets to pay the gift tax that would be due on the gifts of the 16 percent interests made to the trusts.
Mirowski was the general manager of the LLC. The timing and amount of distributions was determined by the members holding a majority of the LLC, subject to other provisions of the operating agreement. These “other provisions” required:
- approval of all members to sell or otherwise dispose of any assets of the LLC, liquidate or dissolve the LLC, or admit additional members;
- cash flow to be distributed to the members in proportion to their percentage interests within 75 days of year-end;
- capital proceeds and profits and losses with respect to capital transactions to be paid in proportion to the members' capital accounts; and
- other profits and losses to be allocated according the members' percentage interests. The death of a member caused dissolution of the LLC — unless the remaining members unanimously elected otherwise.
On Sept. 10, 2001, Mirowski's condition unexpectedly and quickly deteriorated due to an infection related to the foot ulcer. On Sept. 11, 2001, she died. On Sept. 16, 2001, her daughters held a meeting and elected to continue the LLC and elected officers. Afterwards, her daughters, as officers, held regular meetings three to four times a year. In 2002, the LLC made distributions to Mirowski's estate totaling over $36 million to pay the estate and gift taxes and other obligations; the other members did not receive a proportionate amount of this distribution. The LLC has been operating since then, managing the investments and litigation concerning the patents and royalty rights.
The Tax Court concluded that the assets Mirowski transferred to the LLC were not includible in her estate under IRC Section 2036 because the bona fide sale exception applied. Section 2036 will not apply to property transferred in a bona fide sale for an adequate and full consideration in money or money's worth. In the family limited partnership (FLP) or LLC context, this test is satisfied when there is a legitimate and significant non-tax reason motivating the formation of the entity.
Based on the daughters' testimony, the court found that legitimate non-tax reasons were a crucial motivation for forming the LLC: so that family members could jointly manage family assets; maintain the family's assets in a single pool to allow for certain investment opportunities that would not otherwise be available; and provide for the daughters and grandchildren on an equal basis.
Mirowski had received a proportionate interest to the assets she'd transferred and her capital account was properly credited with the value of the assets contributed. The LLC continued to function after her death, managing business matters relating to the patents and license agreements as well as litigation regarding the license agreement.
The court noted that the activities of the LLC do not have to rise to the level of a business under the federal income tax laws.
In addition, the court concluded that the gifted LLC interests were not includible under IRC Section 2035 because the gifted property would not be “otherwise included” under Sections 2036(a)(1), (a)(2) or 2038. Regarding IRC Section 2036(a)(1), the court held that Mirowski's powers and discretion as the general manager and majority member were sufficiently limited by the operating agreement to prevent her from retaining the right to possess or enjoy the right the income from the property. The court focused on provisions requiring that all cash be distributed out within 75 days of the end of the year and that capital proceeds be distributed to members in proportion to their interests. It also noted that Mirowski, as general manager, was subject to fiduciary duties imposed by Maryland law. Based on the daughters' testimony, the court also found no evidence of an express or implied agreement between Mirowski and her daughters that she would retain the possession or enjoyment of the property transferred. For the same reasons, the court held that the gifted LLC units were not includible in Mirowski's estate under Section 2036(a)(2) or Section 2038.
Mirowski is an unusual departure from the string of recent cases that have found FLP interests includible in the estate of a decedent who'd established the entity. The facts of this case at first seem to be like those other cases: an elderly person set up an LLC at the request of her children or upon the suggestion of their tax advisor just days or months before her death, hoping to obtain a valuation discount on the assets transferred. A few particular facts here were helpful in winning relief for the taxpayer: Mirowski's thorough and detailed involvement with her investments, her good health until 24 hours before her death, and the diversified assets transferred to the LLC that required active management (that is to say, the royalty rights under the licensing agreement).
Nevertheless, many facts appeared to be on the IRS' side:
- Mirowski was a 52 percent owner and general manager of the LLC.
- She was the sole contributor to the LLC (the daughters did not contribute any assets, although they could have contributed their interests in the patent license agreement).
- The LLC was formed just two weeks before her death.
- Gifts of the LLC interests were made one week after funding the LLC.
- Mirowski did not retain enough personal assets outside the LLC to pay the gift or estate tax.
- The gift and estate taxes were paid with a non-pro rata distribution to the estate.
In spite of these facts, the Tax Court's application of the law and interpretation of the facts were friendly to the taxpayer. First, regarding the bona fide sale exception to Section 2036 for the property sold to the LLC, the Tax Court used the rule applied in Bongard, 124 T.C. No. 6141 (March 15, 2005) — the existence of a legitimate, significant non-tax reason that was a significant and not merely theoretical motivation to create the LLC and a receipt of LLC interests in proportion to the value of the property transferred. While Mirowski understood there were certain tax benefits in forming the LLC, the court held that these potential benefits were not the most significant factor in her decision to form the LLC. The stated non-tax purposes for forming the LLC were:
- joint management of the family's assets by the daughters and eventually the grandchildren;
- maintenance of the bulk of the family's assets in a single pool of assets to allow for investment opportunities that would not be available if Mirowski were to make separate gifts of her assets to her daughters or to their trusts; and
- providing for her daughters on an equal basis (that is to say, not having to select different assets to give to each of them that might grow at different rates or return).
There are several interesting developments in the opinion:
- The Tax Court held that ensuring joint management of the family's assets was a significant, legitimate non-tax purpose to form the LLC, and that, standing alone, sufficed to satisfy that requirement. Interestingly, even though joint management of the family's assets was the primary non-tax purpose, the daughters did not contribute their interest in the patent license agreement to the LLC.
- The court stated that facilitating lifetime gifts could qualify as a significant non-tax reason for forming a family partnership or LLC. The court stated that, while the record in Bongard did not show that the facilitation of lifetime gifts was a reason for forming the family partnership in that case, it did not hold that such a reason could never be a significant purpose sufficient for Section 2036 purposes.
- The court stated that the fact that Mirowski was the sole transferor to the LLC, which was initially a single member LLC (so she was on both sides of the transaction creating the LLC), did not preclude application of the bona fide sale exception.
- In its analysis of whether Mirowski retained any right to the possession or enjoyment of or income from the gifted LLC interests within Section 2036(a)(1), the court disregarded the fact that she lacked sufficient assets outside of the LLC to pay her gift tax liability, let alone her future estate tax liability. The court pointed out that (a) she could have used distributions from the LLC or borrowed against the personal assets she retained or her LLC interests to pay the gift tax; and (b) the estate tax was not Mirowski's personal obligation, but an obligation of her executor, which if not paid in full, results in a lien upon the estate.
- The distributions to the estate of more than $36 million to pay the state and federal gift and estate taxes a year later (while the other members of the LLC did not receive a proportionate distribution) still did not lead the court to conclude that there was an implied agreement between Mirowski and the LLC members that she would retain the possession or enjoyment of, or the right to the income from the LLC.
- Even though Mirowski was a 52 percent owner and general manager of the LLC, the court held that she did not retain the right to designate or control the possession or enjoyment of the gifted interests under Section 2036(a)(2). As majority owner, she had the power under Section 5.1.2 of the LLC agreement to determine the timing and amount of distributions to the members, subject to other provisions of the LLC agreement. The court found that those other provisions of the LLC agreement, as well as her fiduciary duties owed to the LLC members, modified that power sufficiently such that she did not have the authority to determine the timing and amount of distributions of the cash flow and capital proceeds to its members, either as the general manager or the majority member.
Those other provisions required:
- cash flow for each taxable year to be distributed to the members within 75 days of the end of the taxable year;
- capital proceeds to be distributed each year proportionally to the LLC owners after payment of any debts and liabilities in the establishment of any reserves that the general manager deems necessary for the liabilities and obligations of the LLC;
- consent of all members of the LLC to sell or otherwise dispose of any assets of the LLC, other than in the ordinary course of operations; and
- consent of all members of the LLC to liquidate or dissolve the LLC, after which assets were to be distributed to interest holders in accordance with the balances of their capital accounts.
Mirowski is an extremely taxpayer friendly decision that departs significantly from other recent cases in this area. But, given the sensitivity of the cases to the specific facts and circumstances, it does not signal that FLPs are safe from attack. It does indicate, however, that a client's bona fide reasons for establishing an FLP or LLC should be well-documented and the more the operating agreement proscribes what can or will be distributed, the more likely one can avoid inclusion of interests under Sections 2036(a)(1) and (a)(2).