Despite her “sole discretion” over a trust, a decedent did not possess at the time of her death a general power of appointment over property in the trust. In Technical Advice Memorandum 200847015 (July 30, 2008), the decedent's husband's will created a testamentary trust of which decedent was sole trustee. The terms of the trust said the decedent as trustee had the power to distribute income to herself “as the Trustee in its sole discretion reasonably exercised … deems necessary and appropriate to provide for [her] health, support and maintenance … in the manner to which she is accustomed.” The trust also provided that the decedent as trustee could, in her “sole discretion” distribute principal to “maintain and support [herself] in the station in life to which she is accustomed” if she determined that the income of the trust was not sufficient.
Yet the Internal Revenue Service concluded that the decedent, as trustee, did not possess a general power of appointment (GPA) over the property held in the trust at the time of her death. As such, the IRS said, the trust property was not included in the decedent's gross estate under Internal Revenue Code Section 2041(a)(2).
Under IRC Section 2041(b)(1)(a), a power that is limited by an ascertainable standard relating to the health, education, support or maintenance of the decedent is not a GPA. Treasury Regulations Section 20.2041-1(c)(2) further provides that a power exercisable to support the holder in her accustomed manner of living is a power limited in the manner required by IRC Section 2041(b)(1)(a).
Because the decedent's power to distribute income and principal to herself was limited by ascertainable standards relating to the decedent's “health, support, and maintenance” and to amounts necessary to “maintain and support” herself in her accustomed manner of living, the IRS concluded that the decedent's power to distribute income and principal to herself did not constitute a GPA.
Although not discussed in the TAM, the fact that the trustee was given “sole discretion” whether to make the distributions did not cause the power to be a GPA. Presumably, this is because all of the distributions had to be for health, support and maintenance. That is, distributions could be made only for health, support and maintenance, but then the trustee was given “sole discretion” to determine whether to make a distribution for those purposes.
The trust also provided that “to carry out the spirit and purpose” of the trust's spendthrift clause, the trustee had the power to discontinue payment to any beneficiary and instead expend such payment “for the account of such beneficiary and for his or her support, comfort, happiness and welfare.”
Despite this power to make payments for “comfort, happiness and welfare” (which are not ascertainable standards under Section 2041(b)(1)(a)), the IRS concluded that this provision did not result in the decedent possessing a GPA at the time of her death. Treas. Regs. Section 20.2041-3(b) says a power that by its terms is exercisable only upon the occurrence during the decedent's lifetime of an event or contingency that did not in fact take place or occur during such time, is not a power in existence on the date of the decedent's death. The IRS reasoned that the decedent's power to discontinue payments to a beneficiary and expend them instead on the beneficiary's account for his or her “support, comfort, happiness and welfare” was exercisable only if the beneficiary triggered the spendthrift provision, for example, by attempting to assign the trust interest or if a third party attempts to garnish or execute against the trust interest, or the beneficiary otherwise becomes financially distressed in some manner.
The decedent did nothing to violate the spendthrift provision and trigger this power. As her power was conditioned on an event that did not take place during her lifetime, she did not hold a GPA when she died.
A grantor's substitution power did not cause a trust to fail to qualify as a grantor retained annuity trust. In Private Letter Ruling 200846001 (released Nov. 14, 2008 but issued July 31, 2008), the taxpayer (the grantor) created a grantor retained annuity trust (GRAT.) When the GRAT terminates, if the grantor and her husband are alive, the trust property is to be distributed to a family trust. If the grantor is not living but her husband is, the remainder would pass to him. If neither are alive, the remainder will pass to the grantor's descendants. The grantor's husband served as the GRAT's initial trustee and was to serve as trustee of the family trust. The PLR states that the present value of the right to receive trust corpus on the termination of the GRAT term exceeded 10 percent of the initial fair market value (FMV) of the property transferred to the trust. But it's unclear whether this was present value of the family trust's right to the remainder, or all of the potential remaindermen's rights.
The trust agreement provides the grantor the right to acquire any property of the GRAT by substitution of other property of equivalent value, exercisable only in a fiduciary capacity. Action in a fiduciary capacity means action that is undertaken in good faith and in the best interests of the trust and its beneficiaries, and subject to fiduciary standards imposed under applicable state law.
The IRS held that the grantor's substitution power did not disqualify the grantor's annuity interest as a qualified interest under IRC Section 2702(b)(1).
IRC Section 2702(a) provides that when individuals make transfers to a member of their families, the value of any interest retained by the transferor is zero, unless the interest is a “qualified interest.” After noting that the substitution power in this case was exercisable only in a fiduciary capacity, the IRS held that neither the existence nor the exercise of the power disqualified the grantor's annuity interest from being a qualified interest.
The power to substitute property — in a non-fiduciary capacity — often is included in trust agreements to make the trust a grantor trust under IRC Section 675(4). But this power was specifically held in a fiduciary capacity. It is not clear from the ruling whether that impacted the IRS' conclusion.
Further, the IRS held that the substitution power would not result in the recognition of any gain or loss by the grantor, the GRAT or the family trust for income tax purposes, because both the GRAT and the family trust were grantor trusts. The IRS concluded that because the grantor's husband had the power to distribute income and principal as trustee of the family trust, the family trust was treated as being owned by the grantor under IRC Section 674(a).
Interestingly, the IRS further concluded that the exception in IRC Section 674(b)(2) would not apply. Under this section, a power to control beneficial enjoyment will not make a trust a grantor trust when the power only applies after the occurrence of an event, such that the grantor would not be treated as the owner under Section 673 if the power were a reversionary interest (that is to say, if the power controlled less than 5 percent of the value of the property initially contributed to the trust).
In this ruling, the husband's power to control beneficial enjoyment would not occur until the GRAT term ended. Had the husband's power been a reversionary interest, it would have caused the family trust to be a grantor trust, because it was worth more than 5 percent of the value of the trust at inception. Therefore, the fact that the husband's power did not apply until after the occurrence of an event did not invoke Section 674(b)(2) because the present value of the remainder that would pass to the family trust was greater than 5 percent of the value of the property initially contributed to the GRAT.
Assignment of an inherited IRA from an estate to charities is not a transfer under IRC 691(a)(2). In PLR 200850004 (issued Sept. 8, 2008), the sole designated beneficiary of a decedent's individual IRA disclaimed his interest in the IRA, causing it to pass under the decedent's will. The executor of the decedent's estate filed and the court approved a motion to reform the decedent's will to designate the IRA as the funding source for charitable bequests made to three different charities in the decedent's will.
The IRS stated that the estate's assignment of the IRA to the charities was not a “transfer” within the meaning of IRC Section 691(a)(2). This section provides that if a right to an item of income in respect of a decedent (IRD) is transferred by the estate of a decedent, the fair market value (FMV) of the item of IRD at the time of transfer (plus any consideration received in excess of FMV) is included in the estate's gross income. The term “transfer” includes sale, exchange or other disposition, or the satisfaction of an installment obligation at other than face value, but does not include transmission at death to the estate of the decedent or a transfer to a person pursuant to the right of such person to receive such amount by reason of the death of the decedent or by bequest, devise or inheritance from the decedent.
Treas. Regs. Section 1.691(a)-4(b)(2) provides that if a right to IRD is transferred by an estate to a specific or residuary legatee, only the specific or residuary legatee must include the IRD in gross income when received.
Based on these facts, the IRS concluded that the assignment of the IRA from the decedent's estate to the charities was not a transfer under IRC 691(a)(2). As such, only the charities had to include the distributions from the IRA in their respective gross incomes when received.
IRS provides interim guidance regarding application of the 2 percent floor to investment advisory fees. In Notice 2008-116 (released Dec. 11, 2008 and published Dec. 29, 2008), the IRS announced that taxpayers will not be required to determine what portion of a “bundled fiduciary fee” is subject to the 2 percent floor under IRC Section 67 for any taxable year beginning before Jan. 1, 2009.
In Knight v. Commissioner, 128 S. Ct. 782 (2008), the U.S. Supreme Court held that costs paid to an investment advisor by a non-grantor trust or estate are subject to the 2 percent floor for miscellaneous itemized deductions under IRC Section 67(a). The IRS has not yet issued regulations to address the issue raised when a non-grantor trust or estate pays a “bundled fiduciary fee” to a fiduciary for costs incurred by the fiduciary, some of which are subject to the 2 percent floor (that is to say, investment advisory fees) and some of which are fully deductible.
Notice 2008-32 provided that taxpayers were not required to “unbundle” a bundled fiduciary fee to determine what portion of the fee was subject to the 2 percent floor for any taxable year beginning before Jan. 1, 2008.
Notice 2008-116 extended the guidance provided in Notice 2008-32 to taxable years that begin before Jan. 1, 2009.
- IRC Section 2701(a) does not apply to reverse qualified personal residence trusts. In PLRs 200848003 and 200848007 (released Nov. 28, 2008 and issued Aug. 18, 2008, and Aug. 19, 2008, respectively), a parent transferred a residence to Trust 1, a qualified personal residence trust (QPRT), of which the parent was the grantor and trustee. Upon the expiration of the parent's retained term interest, the trust was liquidated and distributed to the children. The children planned to create another irrevocable trust (Trust 2) under which the parent would have the right to use the residence for a term of years, with the children retaining the reversion interest (a “backwards QPRT.”)
IRC Sections 2702(a)(1) and (a)(2) provide that when an individual makes a transfer to a member of his or her family, the value of any interest retained by the transferor is zero unless the interest is a “qualified interest.” But Treas. Regs. Section 25.2702-5(c)(5) provides that Section 2702(a) does not apply to a trust meeting the requirements of a QPRT.
Although a grantor typically uses a QPRT to gift the remainder interest in a residence while retaining use of the residence for a term of years, the IRS held that a trust can qualify as a QPRT when the grantor gifted the use of the property for a term of years and retained the reversion. Thus, for purposes of Section 2702(a), it is immaterial whether the interest gifted is a term of years or a remainder interest, so long as the trust instrument is substantially similar to the sample in Section 4 of Revenue Procedure 2003-42, the trust operates in a manner consistent with the terms of the trust instrument and the residence qualifies as a personal residence under Section 25.2702-5(c)(2) of the Gift Tax Regulations.
PLR 200814011 reached the same conclusions on similar facts.
Payments to charities by a trust were not deductible. In PLR 200848020 (released Dec. 3, 2008, issued July 28, 2008), a testamentary trust provided for annual distributions to the decedent's children and several charities. The trustees and beneficiaries obtained a court order modifying the trust so that a certain percentage of the trust value would be paid to the charities, with the balance remaining in trust solely for the children's benefit.
The IRS held that the trust was not allowed to deduct the payments made to charities under IRC Section 642(c), because the payments were not made pursuant to its governing instrument but instead rather to a court order reforming the trust.
IRC Section 642(c)(1) and Treas. Regs. Section 1.642(c)-1(a)(1) provide that any part of the gross income of a trust that, pursuant to the terms of the governing instrument, is paid during a taxable year for a charitable purpose will be allowed as a deduction to the trust.
In Middleton v. United States, 99 F. Supp. 801 (D.C. Pa. 1951), a district court held that amounts distributed to a charity pursuant to an agreement compromising a will contest were made “pursuant to the terms of the will.” Similarly, in Emanuelson v. United States, 159 F. Supp. 34 (D.C. Conn. 1958), the decedent left two conflicting wills: one left two-thirds of the residue of decedent's estate to certain charities; the other will left the entire residue to non-charitable legatees. The conflict was resolved in a written compromise agreement between the two sets of beneficiaries, under which 52/480 of the residue passed to the charities named in one of the wills. Payments made to the charities under the written compromise agreement were held to be made pursuant to the will.
Revenue Ruling 59-15, 1959-1 C.B. 164, citing Emanuelson, held that a settlement agreement arising from a will contest qualifies as a governing instrument. But, in this ruling, there was no conflict with respect to the trust. In both the original trust and in the modified trust, the charities were entitled to a percentage of the trust property.
The purpose of the court order in PLR 200848020 was not to resolve a conflict in the trust, but to obtain the tax benefits that would ensue if the trust were to qualify as a “designated beneficiary” under IRC Section 401(a)(9). The IRS noted in this PLR that neither Rev. Rul. 59-15 nor Emanuelson hold that a modification to a governing instrument will be construed to be the governing instrument when the modification does not stem from a conflict.
Moreover, both Crown Income Charitable Fund v. Comm'r, 8 F.3d 571 (7th Cir. 1993) and Brownstone v. United States, 465 F.3d 525 (2d Cir. 2006) have a narrow interpretation of what qualifies as “pursuant to a governing instrument.”
Therefore, the IRS held in PLR 200848020 that the accelerated payments to the charities were not considered to be made pursuant to the governing instrument; the trust therefore was not entitled to a deduction for such payments under IRC Section 642(c).
Bequest of remaining GST exemption is a pecuniary bequest. In PLR 200848009 (released Dec. 3, 2008, issued Aug. 19, 2008), the decedent created a revocable trust. Following the decedent's death, after paying all debts and estate taxes, the trustee was to distribute “an amount equal to decedent's generation-skipping transfer (GST) tax exemption not allocated to lifetime direct skips” to a trust (the GST trust.) The amount of the decedent's GST exemption remaining at his death was allocated to the GST trust on the federal estate tax return. Because it was not possible to immediately satisfy the outstanding debts, the trustee administered the revocable trust for a number of years, during which time the trust assets substantially increased.
A ruling was requested to the effect that the GST trust was entitled to receive a fractional portion of the trust's assets, thereby sharing the assets' post-death appreciation. If such a ruling were granted, the GST exemption allocated to the GST trust also would apply to a pro rata portion of the trust's post-death appreciation, thus shielding that portion from GST tax liability.
But the IRS held that the bequest to the GST trust was clearly a pecuniary bequest under governing state law, not a fractional share bequest. A pecuniary bequest does not share in post-death appreciation, while a bequest of a fraction of an estate does. Accordingly, the GST exemption allocated to GST trust was limited to the decedent's GST exemption that had been allocated on the estate tax return.
In addition, because the funding of the GST trust was treated as a transfer in satisfaction of a pecuniary bequest for federal tax purposes, the trust realized gain (or loss) under IRC Section 1001(a) to the extent it was funded with assets that appreciated post-death.
What not to do in an estate plan: The U.S. Tax Court spells it out in a decision dealing with the fortune of a former Hunt Oil president. Thelma Hurford's husband was Gary T. Hurford, a former president of Hunt Oil Company. Gary died on April 8, 1999, and was survived by Thelma and their three children, Michael, David, and Michelle. His gross estate reported on his estate tax return was about $14.2 million. His will divided his estate into a family trust to receive his estate tax exemption and a marital trust. Thelma was the executor of Gary's estate and the trustee of both trusts.
After her husband's death, Thelma decided she was dissatisfied with the attorney who had drafted her husband's estate plan. She hired a new lawyer, Joe Garza, to draft her own estate plan. This attorney proposed to separate the assets of Thelma, the marital trust, and the family trust into three different asset groups: (1) cash, stocks, and bonds; (2) Hunt Oil “phantom stock”; and (3) farm and ranch properties. Then he would create three family limited partnerships (FLPs), one to receive each group of assets, giving an interest in each to Thelma, the marital trust, the family trust, and Thelma's children. Finally, Thelma was to sell her interest and the interests of Gary's estate in each FLP to the three children through a private annuity agreement.
The attorney purported to execute his plan starting in February 2000. Thelma died in February 2001. Thelma's estate received a notice of deficiency with respect to her 2000 gift tax return and her federal estate tax return.
In considering what property should be includible in Thelma's estate, the U.S. Tax Court, in Estate of Thelma G. Hurford v. Comm'r, T.C. Memo 2008-278 (Dec. 11, 2008) first examined whether Thelma's interests in the FLPs that she purported to transfer to her children in exchange for the private annuity were includible in her estate under IRC Sections 2036(a) or 2038. Under IRC Section 2036, the value of any property transferred by Thelma during her life (except in the case of a bona fide sale for an adequate and full consideration in money or money's worth) would be included in her estate if she retained either (1) the possession or enjoyment of, or the right to the income from, the property; or (2) the right, either alone or in conjunction with any person, to designate the persons who will possess or enjoy the property or the income therefrom. Thus, under Section 2038, the value of any property transferred by Thelma during her life (except in case of a bona fide sale for an adequate and full consideration) would be included in her estate when the enjoyment of the property was subject at the date of death to Thelma's power to revoke or alter the transfer.
The court first concluded that the transfers of Thelma's own FLP interests, as well as the interests she purportedly held via Gary's estate, to the children for the private annuity were not bona fide. In so holding, the court noted that Thelma's children did not use (nor could they have afforded to use) their own assets or even income from the FLP assets to make the annuity payments. Rather, they simply used the FLP's assets (in the same form in which they were contributed by Thelma) to make the payments.
Moreover, formalities were disregarded with respect to the transfers of assets in the marital and family trusts as well as assets that were still titled in the name of the Gary Hurford Estate. When forming the FLPs, the attorney had named “The Gary T. Hurford Trust” (rather than the marital and family trusts) as the owner of a 48 percent limited partnership interest in each of the FLP agreements.
At trial, explaining how Thelma was able to accomplish a sale of a 96.25 percent interest in each FLP to her children, Joe Garza claimed that Thelma, in her capacity as trustee, transferred the marital and family trust assets to herself as beneficiary, then simultaneously transferred these assets to her children. There was nothing in writing to memorialize these transfers other than letters to Chase Bank of Texas, N.A., requesting that it transfer the marital and family trust accounts (as well as an account in Thelma's name and an account that was in the name of the Gary Hurford Estate) into the name of the Hurford Investments 1 (HI-1) FLP.
In response to this letter, Chase opened three new accounts for the FLP, using the same names as the old accounts except each was preceded by the name of the FLP (for example, “HI-1 Marital Trust” account, “HI-1 Family Trust” account and “HI-1 Thelma G. Hurford Investment Management Agency” account). The account in the name of the Gary Hurford Estate was transferred into another account bearing the name “Thelma G. Hurford, Executrix of The Estate of Gary T. Hurford, Deceased #1.”
These accounts remained titled in this manner until the month Thelma died. At that point, Chase emptied the HI-1 Marital Trust, HI-1 Family Trust, and the Gary Hurford Estate account into the HI-1 Thelma G. Hurford Investment Management Agency account.
This series of mishaps and transfers certainly cast doubt on the bona fide nature of this transaction.
The court next held that the transfer of Thelma's interest in the FLPs for the private annuity was not for adequate and full consideration. The attorney had never arranged for appraisals of the FLP interests and the basis for the valuation discounts he had taken for the partnership interests was unclear from the record. Judge Mark K. Holmes, writing for the Tax Court, stated that not only had the attorney “conjured the partnership discounts out of the air,” but also that he had undervalued each FLP interest sold for the private annuity by using outdated and/or inaccurate valuations of the underlying partnership assets. In many instances, he had simply used underlying asset values as reported on Gary's estate tax return — despite the fact that the private annuity transaction purportedly took place one year after Gary's death.
Having concluded the transfers of the FLP interests to the children were not bona fide or for full and adequate consideration, the court held that Thelma retained enjoyment of the FLP interests within the meaning of IRC Section 2036(a)(1). The court relied on the fact that Thelma's monthly annuity payments were paid directly from an FLP account, rather than from the children directly. Moreover, Thelma continued to make deposits into and retained signature authority over the various FLP accounts. She even withdrew money from one of the FLP accounts to pay her personal income taxes. The court pointed out that she never resigned as president of the limited liability companies acting as the general partner of the FLPs.
Further, although Thelma intended that each of her three children own one-third of the FLPs, only two of Thelma's three children (Michael and Michelle) signed the private annuity agreement purporting to purchase the interests in the FLPs. This action was apparently done to avoid giving the third child, David, “managerial signature rights” over the property in the FLPs. But the court found that Thelma had made it clear to Michael and Michelle that David was to be treated as a co-owner of the FLPs. Not only did the court state that this arrangement indicated that the private annuity transaction was not bona fide, but also, the court held that Thelma had exercised a right under IRC Section 2036(a)(2) to designate the persons who would posses or enjoy the FLP interests. Moreover, the court found that Thelma had exercised a power to alter or amend the enjoyment of the FLP interests in violation of IRC Section 2038. Therefore, the court held that the sale in exchange for the private annuity must be disregarded and the FLP interests must be included in Thelma's estate under IRC Sections 2036(a)(1), 2036(a)(2), and 2038.
Having disregarded the sale of the FLP interests to the children in exchange for the private annuity, the court next considered whether IRC Section 2036(a)(1) also would operate to include the full value of the underlying assets of the FLPs in Thelma's estate.
The court found that the transfer of the assets to the FLPs was not bona fide, because the court found no legitimate non-tax reason for the transfer. The court rejected the estate's argument that transferring the assets to the trust provided a greater degree of asset protection or any advantages from consolidated management. The court also pointed to several other factors that indicated that the transfer to the FLPs was not bona fide, including that:
- Thelma transferred nearly all of her liquid assets to one of the FLPs such that she relied on assets of the FLP to make an estimated income tax payment;
- Thelma commingled her own funds with the funds of the FLPs; and
- there was a significant delay between the formation of the FLPs and the transfer of the assets into the FLPs.
The court also pointed to the family's lack of even minimal involvement in the management of the assets of the FLP as evidence of the FLPs' lack of meaningful economic activity.
As if that weren't enough, the court found that the transfers to the FLPs were not for full and adequate consideration because the partners did not receive partnership interests proportionate to the fair market value of the assets they contributed. The children neither contributed assets in exchange for the 1 percent interests they received, nor did Thelma report gifts to each of them of partnership interests. Thus, Thelma and Gary's estate received partnership interests worth less than the assets they contributed.
Having concluded that the transfer to the FLPs was not bona fide or for full and adequate consideration, the court next held that Thelma retained possession and enjoyment of the assets transferred to the FLPs in violation of IRC Section 2036(a)(1). Because Thelma had contributed most of her assets to the FLPs, she needed to use FLP assets to pay her living expenses. Moreover, the private annuity arrangement allowed Thelma to receive the very same assets that she had contributed to the FLPs back in the form of annuity payments. As such, the court stated that there was plenty of evidence of an implied agreement that Thelma would continue to be able to enjoy the property after its contribution to the FLPs.
Finally, the court concluded that even if Thelma relinquished the IRC 2036(a)(1) retained interest in the FLP assets by transferring the FLP interests to her children in exchange for the private annuity, the value of the assets Thelma transferred to the FLPs would still be included in her estate under IRC Section 2035 because the relinquishment was within three years of Thelma's death.
The court also held that the property contributed to the FLPs by both the marital and the family trusts must be included in Thelma's estate. Although the family trust only gave Thelma a limited power of appointment, the court found that Thelma in fact exercised a general power of appointment over the family trust assets when she “distributed” all of the trust assets to herself and sold them to her children in exchange for the private annuity, such that they then became subject to her full control and individual ownership.