• Internal Revenue Service grants extension of filing deadline for certain estates to make portability election — Notice 2012-21 (Feb. 17, 2012) grants executors of certain estates a six month extension to file a federal estate tax return (Form 706) to make the portability election. The extension is only applicable to estates in which: (1) the decedent died in the first six months of 2011 and was survived by a spouse, and (2) the gross estate was no greater than $5 million. The IRS granted the extension because many executors of such estates didn't file the Form 706 if the value of the estate was under the federal estate tax exemption, because they were unaware that filing the Form 706 was required to make the portability election.

    The extension will be granted as long as the executor files a Form 4768 (with a notation of “Notice 2012-21, Extension of Good Cause Shown” or other sufficient notice) and the Form 706 within 15 months of the date of death. The executor may file the Form 4768 at the same time as the Form 706, as long as both are filed on or before the date that's 15 months after the date of death.

    Notice 2011-82, mentioned in Notice 2012-21, provides that the estate of a decedent who's survived by a spouse will be deemed to elect portability by timely filing a complete and properly prepared Form 706, which will, in turn, be deemed to contain the computation of the decedent's spousal unused exclusion amount, until the Form 706 is revised to include specific provisions for the calculation. To date, no regulations have been issued to implement the portability provisions and, while Notice 2012-21 grants an extension to file a return, it doesn't contain any substantive rules regarding the portability election.

  • Tax Court rules in estate's favor on family limited partnership (FLP) — In Estate of Stone v. Commissioner, T.C. Memo. 2012-48 (Feb. 22, 2012), the Tax Court made a somewhat surprising ruling in favor of the taxpayer, that the assets contributed to an FLP shouldn't be included in the gross estate of the decedent under Internal Revenue Code Section 2036.

    Joanne Harrison Stone was a resident of Tennessee when she died in 2005, at the age of 81. The Stone family owned and operated a well-known publishing company, was prominent locally and had held significant amounts of real estate in the area for several generations. Joanne owned, either wholly or in part, approximately 30 parcels of real property in Cumberland County in 1997. Nine of these parcels (totaling approximately 740 acres) were mostly undeveloped woodlands, without utilities or roads and were owned jointly by Joanne and her husband.

    Joanne and her husband wanted to make gifts of the property to their children and grandchildren and consulted with an estate-planning attorney who suggested forming an FLP. On Dec. 29, 1997, they formed Stone Family Limited Partnership of Cumberland County, each signing as general partner (1 percent each) and limited partner (49 percent each). They quitclaimed the woodland parcels to the FLP on Dec. 30; these were the only assets of the FLP. An appraiser valued the combined parcels, and Joanne and her husband used the appraisal value as the value of the FLP. On Dec. 31, 1997, they gave limited partnership (LP) interests to their children, the spouses of their children and grandchildren. The Stones didn't apply any discounts when valuing the LP interests given to their family members (that is, the value of the gift was a pro rata share of the value of the combined parcels). By 2000, as a result of their gifts over the three years, Joanne and her husband each owned only the 1 percent general partnership interests and their other family members held the remaining 98 percent LP interests.

    The parcels held by the FLP weren't developed, and the FLP generated no income. The only expenses incurred were property taxes, which Joanne and her husband paid.

    The FLP agreement provided that the FLP's purpose was to hold and manage property for the family members. The FLP could be terminated by written agreement of limited partners owning 67 percent of the FLP or upon sale of all FLP property and distribution of proceeds therefrom. The partners' ability to transfer their partnership interests was restricted, and the FLP could purchase a partner's interest on his death.

    As general partners, Joanne and her husband had considerable powers, including the rights to: (1) determine whether properties would be sold; (2) manage the day-to-day business of the FLP; and (3) determine the amounts of any distributions to partners. The limited partners owning interests representing 67 percent of the FLP could dismiss a general partner.

    The IRS issued a notice of deficiency, stating that the assets of the partnership were includible in Joanne's estate under IRC Section 2036. The estate argued that the transfer of property to the partnership was a bona fide sale for adequate and full consideration and, therefore, qualified for the exception to IRC Section 2036. UnderBongard v. Comm'r, 124 T.C. 95, 111 (2005), the “bona fide sale” exception requires that the formation and funding of the FLP be “motivated by a legitimate and significant nontax purpose.”

    The Tax Court held that the transfer of the property to the FLP was a bona fide sale and, therefore, the parcels weren't included in Joanne's estate under IRC Section 2036. The court found that the Stones formed the FLP to facilitate gift giving and to manage the parcels as a family asset. This latter purpose was a legitimate and significant non-tax reason that satisfied the Bongard test. Further, the court explained that even though the Stones stood on both sides of the transaction, the bona fide sale exception could still apply if mutual legitimate and significant non-tax reasons existed for the transaction, and the transaction was carried out in a way in which unrelated parties to a business transaction would deal with each other. The court held that the Stones' non-tax reason, coupled with the receipt of interests in the FLP proportional to the property contributed, satisfied this requirement.

    The court acknowledged that the family failed to respect certain partnership formalities, for example, by paying property taxes out of personal funds, failing to transfer actual FLP interests among the children and their spouses during divorce settlements and using bills of sale to make gifts of FLP interests. However, it noted that there was no commingling of funds (because the FLP had no funds) and that the Stones didn't rely on distributions from the FLP (because it made no distributions). Lastly, while there was no active management of the parcels, the court held that since there was a legitimate and actual non-tax purpose for transferring the parcels, forming the FLP wasn't merely an attempt to change the form of property ownership.

    The facts of Stone aren't as egregious as some of the recent “bad fact” FLP cases. However, it does seem surprising that the Tax Court upheld an FLP that owned only non-income-producing woodlands requiring no active management and that didn't respect some formalities.

    The court seemed heavily influenced by the fact that the Stones didn't apply discounts when making their gifts of FLP interests to their family; this appears to be strong evidence of their non-tax-related motivation to form the FLP. The court noted several times that the “total value of the [FLP] interests was equal to the appraised value of the woodland parcels.” This case shows that the outcomes in FLP cases are fact-specific and not always predictable.

  • Chief Counsel Advice (CCA) memorandum finds that testamentary limited power of appointment (POA) doesn't preclude a completed gift; gifts don't qualify for annual exclusion — In CCA 201208026 (Sept. 29, 2011), the taxpayers (apparently spouses) made gifts to an irrevocable trust and designated one of their children as sole trustee. The trustee was given absolute discretion to distribute trust property to the taxpayers' descendants and their spouses. The taxpayers reserved testamentary POAs and, in default of exercise, the trust property would be distributed to their children after both taxpayers' deaths.

    The trust agreement gave the beneficiaries the right to withdraw gifts made to the trust up to the annual exclusion amount, but the trustee could void this power for any additions made to the trust. The trust provided that its construction, validity and administration were to be determined under relevant state law, but all questions and disputes concerning the trust must be submitted to an “Other Forum” charged with enforcing the trust. Any beneficiary who filed or participated in a civil proceeding to enforce the trust was to be excluded as a beneficiary of the trust in the future. The Chief Counsel held that this provision prevented transfers to the trust from qualifying for the annual exclusion under IRC Section 2503(b). The CCA stated:

    To be a present interest, a withdrawal right must be legally enforceable. For example if a trust provides for withdrawal rights, and the trustee refuses to comply with a beneficiary's withdrawal demand, the beneficiary must be able to go before a state court to enforce it.

    Because the beneficiaries couldn't enforce their withdrawal rights in court without losing the entitlement to those same rights and any other distributions in the process, gifts to the trusts subject to such withdrawal rights weren't present interests that qualified for the annual exclusion.

    The taxpayers asserted that their gifts to the trust were incomplete because of their testamentary limited POAs. Treasury Regulations Section 25.2511-2(c) provides, in part, that a gift is incomplete to the extent that the donor reserves a power to name new beneficiaries or to change the interests of the beneficiaries as among themselves (unless the power is a fiduciary power limited by a fixed or ascertainable standard). The relinquishment or termination of a power to change the beneficiaries of transferred property, occurring otherwise than by the death of the donor (the statute being confined to transfers by living donors), completes the gift and causes the tax to apply.

    The CCA determined that since the POA was testamentary, it related only to the remainder of the trust and not the preceding term interest, citing Chanler v. Kelsey, 205 U.S. 466 (1907). Since the retained POA couldn't affect the trust beneficiaries' rights and interests during the trust term (that is, prior to the taxpayers' deaths), the taxpayers made a completed gift of the term interests. In addition, the Chief Counsel noted that IRC Section 2702 applied to the transfer. Under Section 2702, the value of any retained interest that's not a qualified interest is treated as having no value. Therefore, the value of the gift may equal the entire value of property transferred, without any reduction for the retained interest. In this case, the retained testamentary powers would be valued at zero, so the taxpayers would be treated as making a completed gift of all the property transferred to the trust. Lastly, the Chief Counsel advised that since the sole trustee was a beneficiary of the trust, and, as a result, an “adverse party” under IRC Section 672 and the related grantor trust rules, the trust would be a non-grantor trust.

    This CCA's conclusion of a completed gift is consistent with Revenue Ruling 54-537, which held that a gift is incomplete to the extent the donor may revest beneficial title to the property in himself, unless such power is subject to a condition that's outside the donor's control. The gift would also be incomplete if the donor retained the power to name new beneficiaries or to change the interest of the beneficiaries among themselves. In this CCA, the taxpayers' powers to change the interests of the beneficiaries, through their POAs, were subject to a condition they couldn't control: their deaths.

    There are several private letter rulings that came to the opposite conclusion and held that the donor's testamentary limited POA was a retention of dominion and control over the trust property that prevented transfers to the trust from being completed gifts. These rulings (PLRs 200148028 (Aug. 29, 2001), 200247013 (Aug. 14, 2002) and 200502014 (Sept. 17, 2004)) all involved trusts a donor established for the benefit of himself and his family. A distribution committee managed trust distributions. The committee consisted of beneficiaries that were “adverse parties” under IRC Section 672(a) with respect to the donor, and the trusts' provisions were otherwise structured to avoid grantor trust status. In these rulings, the IRS determined that no taxable gift would be made until either a distribution was made to a beneficiary (other than the donor), or the donor released the testamentary POA.

    The trusts in all of these prior rulings were drafted to avoid a completed gift (and, therefore, the property transferred to the trust would be includible in the donor's gross estate), but establish the trust as a separate taxpayer for income tax purposes (the so-called “Delaware incomplete non-grantor trusts” or “DING trusts”). When a taxpayer lives in a state where the income tax rates are high (New York, for example), it may be beneficial to establish a non-grantor trust that “resides” in another state to avoid state income tax on the trust's income and gains, especially for a large portfolio or assets on which the taxpayer would otherwise recognize income. This strategy, however, won't be viable if the transfer to the trust is now subject to gift tax.

    One distinction between the prior rulings and CCA 201208026 is that the donor wasn't a beneficiary of the trust in the CCA. However, the legal analysis applied to reach the conclusion suggests that wouldn't have made a difference. Moreover, the CCA is consistent with many prior rulings (PLRs 8727031 (April 3, 1987), 8849067 (Sept. 15, 1988), 9112007 (Dec. 20, 1990), 9049033 (Sept. 10, 1990) and 199908022 (Nov. 25, 1998)), which held a testamentary POA doesn't make a gift incomplete when the assets could be distributed to other beneficiaries before the grantor's death. The rulings on this subject aren't consistent, but if the CCA's approach holds up, this could be the end of DING trusts.