Tax Law Update 2010-06-01 (1)Tax Law Update 2010-06-01 (1)

House passes bill to restrict GRAT terms — On March 24, the House passed H.R. 4849, the Small Business and Infrastructure Jobs Tax Act of 2010, which includes an amendment to Internal Revenue Code Section 2702 imposing a minimum term of 10 years for grantor retained annuity trusts (GRATs). Under IRC Section 2702, if an individual transfers an interest in a trust to a family member while retaining an interest in the same trust, the value of the retained interest is zero, causing the full value of the trust to be treated as a gift to the family member. However, retained interests that meet the definition of “qualified interests” under Section 2702(b) will not be valued at zero, but instead will be valued under IRC Section 7520. The bill amends IRC Section 2702(b) to redefine a “qualified interest.” The bill says that a retained annuity interest will only be a qualified interest if the term of the interest is “not less than 10 years,” the annuity payments don't decrease from one year to the next, and the remainder interest in the GRAT is greater than zero. The law would apply to GRATs created after its enactment. It wouldn't apply retroactively. If passed, this law would eliminate the estate-planning benefit of establishing a GRAT that's zeroed out, pays decreasing annuities or has a term of less than 10 years. However, the bill doesn't require a minimum remainder value so it's not clear whether a de minimis remainder (for example, $1) would suffice. As we went to press, the Senate had taken up the bill and there was some talk of it passing before Memorial Day, although no one knows for sure what will happen. For more information, see Wealth Watch E-letters, “A Last Bite at the GRAT Apple?” and “Transfer Opportunities in Advance of GRAT Legislative Change” on our website, www.trustsandestates.com.

IRS releases 2009 IRS Data Book — The Internal Revenue Service has released its 2009 Data Book. The Data Book provides summaries and statistical data on the returns filed, taxes collected and other IRS activities. A few estate and gift tax highlights:

An electronic version of the 2009 Data Book is available on the IRS website, www.irs.gov. According to the IRS website, printed copies of the Data Book, Publication 55B are available from the U.S. Government Printing Office. To get a copy, write to the Superintendent of Documents, P.O. Box 371954, Pittsburgh, PA 15250-7954. You may also order by calling (202) 512-1800 or faxing a request to (202) 512-2250.

Estate's transfer of IRA to satisfy charity's claim to residuary share doesn't trigger gain under IRC Section 691(a)(2) — In Private Letter Ruling 201013033, the decedent failed to name a beneficiary of an individual retirement account. Accordingly, under applicable state law, the decedent's estate was deemed the default beneficiary of the IRA. The decedent's will left his estate to a revocable trust, which provided for several pecuniary bequests and allocated the residue among several charities. The executor of the estate planned to transfer the IRA to the revocable trust that would then transfer it to one of the charities as part of the charity's share of the trust residue. The estate sought a ruling regarding the income tax consequences of the transfer.

IRC Section 691 governs income in respect of a decedent (IRD). Under Section 691(a)(2), certain transfers (that is, sales, exchanges or satisfactions of installment obligations) of IRD will cause the transferor to recognize the value of the IRD as income. However, transfers to a person who is entitled to the IRD because of the death of a decedent will not cause income to be recognized under Section 691(a)(2). Further, the Treasury regulations provide that if an estate transfers IRD to a specific or residuary legatee, only the legatee recognizes income as a result of the transfer.

The issue in this ruling was whether the estate's transfer of the IRA to the charity in satisfaction of the amount to which the charity was entitled pursuant to the trust agreement would be considered a sale or exchange and cause the estate to recognize income under IRC Section 691(a)(2). The IRS held that the transfer of the IRA to the charity wasn't a transfer under Section 691(a)(2) so the estate didn't recognize income upon transfer of the IRA. Instead, under the regulations, the charity, as the legatee, would recognize income (if the charity was not tax-exempt) when it actually received distributions from the IRA. This ruling is consistent with the general rule that funding a pecuniary bequest is treated as a sale and should trigger gain but allocation of property to residuary beneficiaries should not.

Wisconsin Supreme Court refuses to establish equitable apportionment; pay-on-death accounts not required to reimburse estate for estate tax — James F. Sheppard died on July 2, 2007 without a will, with an estate valued at approximately $12 million. In Estate of James F. Sheppard v. Jessica Schleis, No. 2009AP1021 (Wisc. May 4, 2010) at issue was whether Jessica Schleis, his goddaughter, was required to reimburse the estate for estate taxes attributable to two pay-on-death (POD) accounts worth approximately $3.8 million payable to her. As POD accounts, the assets in the accounts were non-probate assets but were includible in James' gross estate for tax purposes.

Jessica was 17 when James died. The attorney for James' estate discussed the accounts with Jessica's mother and told her that the accounts would be subject to federal and Wisconsin estate taxes. After consulting their own attorney and without Jessica's knowledge, Jessica's parents signed an “Estate Tax Withholding Agreement” providing that 50 percent of the accounts would remain in the accounts for paying “required estate taxes.” Since Jessica was still a minor, her parents were required to establish a guardianship. During the process, the guardian ad litem appointed for Jessica advised the family and the estate's attorney that the POD accounts weren't liable for any estate taxes or required to reimburse the estate for any portion of estate taxes. After Jessica's parents were appointed guardian, they withdrew all the funds from the accounts. The estate brought suit, seeking reimbursement for estate taxes from Jessica and her parents.

The circuit court granted summary judgment to Jessica and her parents and the Supreme Court of Wisconsin upheld its decision. First, the court noted that under IRC Section 2002, the executor of an estate is responsible for paying all estate taxes from the probate estate, regardless of any other non-probate assets.

In certain limited circumstances (regarding life insurance, property over which the decedent has a power of appointment, certain marital deduction property and property in which the decedent retained an interest), the IRC provides that the executor may seek reimbursement from others. IRC Section 2207B allows the executor to recover a pro rata share of the estate tax from property which is included in the gross estate of a decedent due to IRC Section 2036. The estate argued that the POD accounts were included in James' estate under IRC Section 2036 and therefore Section 2207B should apply.

The court disagreed. It held that funding a POD account and naming Jessica as beneficiary of the account was not a “transfer” under Section 2036, noting that the account remained in James' sole and individual name and that James could have removed all the assets from the account at any time. Refusing to interpret “transfer” broadly, the court held that Section 2207B didn't apply. Instead, the account was included in his estate under Section 2033 for which there is no right of recovery under the IRC. Further, under Wisconsin common law, the residue of the estate is responsible for estate taxes unless the decedent provides otherwise, and Wisconsin doesn't have an apportionment statute. Therefore, in the case of a decedent who dies intestate, the residuary probate estate must pay the taxes attributable to all property, including non-probate property. The court declined to adopt a new equitable apportionment rule and invited the Wisconsin legislature to adopt new laws if it wished. Lastly, the court held that the agreement signed by Jessica's parents didn't require any reimbursement of estate taxes because the agreement was vague. First, there were no “required estate taxes” with respect to the POD account and no federal or state withholding procedures for the accounts. Second, Jessica's parents didn't have the ability to bind Jessica by signing in their individual capacities before being appointed guardian.

The court was unconvinced by the estate's pleas that Jessica's windfall produced an unfair result. Sheppard shows the consequences of failing to execute a will and the importance of understanding the client's assets and drafting apportionment clauses carefully.

Tax Court respects bargain sale by S corporation; charitable deduction allowed for bargain sale portion — In this Tax Court case, Klauer v. Commissioner, T.C. Memo 2010-65 (April 5, 2010), the taxpayer prevailed against the IRS' assertion of the step-transaction doctrine. The taxpayer, Klauer Manufacturing (Klauer), an S corporation that operated a sheet metal business in Iowa, began acquiring land in New Mexico in 1919. By 2001, Klauer owned approximately 9,800 acres of land in Taos County, N.M., a portion of which (about 2,500 acres) was known as the Taos Valley Overlook.

In 1999, the Trust for Public Land (the Trust), a charity established to preserve open space and conserve natural resources by purchasing land to sell to public agencies (essentially acting as a third-party facilitator for acquiring property for public agencies) approached Klauer about purchasing the Taos Valley Overlook property. The Trust was interested in purchasing the property because the New Mexico office of the Bureau of Land Management had identified the property as one of its top priorities. Klauer didn't engage an appraiser to value the property but believed that the Taos Overlook was worth between $20 million and $21 million. Due to the limited resources of the Trust, it couldn't offer to purchase all the property for fair market value. The Trust was funded almost exclusively from Congressional appropriations, which weren't steady, predictable or guaranteed. The Trust was also hoping to arrange a bargain sale, knowing that Congress would be more likely to make an appropriation to the Trust if the sale was a bargain sale.

After negotiations, Klauer sold an option to the Trust for $10,000 in January 2001. Pursuant to the terms of the option agreement, Klauer granted the Trust three successive options, each to purchase a different (but approximately equal in size) parcel of the property. The options were exercisable at different times between January 2001 and February 2003. The Trust had one year to exercise its option to purchase the first parcel for $4 million. If the Trust purchased the first parcel, it had another year in which it could elect to purchase the second parcel for $5 million, and if the second purchase was made, it had another year to exercise an option to purchase the last parcel for $5.5 million. At the end of three years, if the Trust exercised each successive option, it would have purchased the entire property for $14.5 million. The option agreement provided that the purchase price was significantly less than the fair market value and that Klauer intended to take a charitable deduction for the difference between the purchase price and the fair market value.

The Trust exercised all of its options. However, due to a lack of funds, the option agreement was renegotiated extensively during the three years, extending the time for exercising of the options and subdividing the parcels to allow the Trust to purchase even smaller portions of the property as funds became available. The purchase price was also increased by $500,000 during the exercise of the second option.

Each time an option was exercised, Klauer obtained an appraisal for the parcel sold. To the extent the appraised value exceeded the purchase price, Klauer claimed a charitable contribution deduction. Klauer claimed a charitable contribution deduction of over $2.9 million in 2001, $1.2 million in 2002 and $1.6 million in 2003. The charitable deduction flowed through to Klauer's stockholders who each claimed a proportionate share of the claimed deduction. The IRS issued notices disallowing the charitable deductions and alleging that the step-transaction doctrine applied to cause the sales made over the course of several years to be treated as having all occurred in January 2001. At trial, the parties agreed that the fair market value of the whole property as of January 2001 was $15 million (even though Klauer, at the time, had believed that the value of the property was between $20 million and $21 million). As a result, if the sales were collapsed, the Trust would be treated as purchasing the land for fair market value without any bargain or charitable element. If the sales were treated as occurring over several years, the value of certain parcels sold exceeded the purchase price and would result in a charitable deduction for the bargain sale element.

The Tax Court held that the step-transaction doctrine didn't apply and upheld Klauer's and the shareholders' charitable deductions. The step-transaction doctrine combines the steps in more than one transaction and treats them as having occurred in a single transaction. It applies if any of three different tests are met. The first test (the binding commitment test) asks whether each step in a series of transactions is a binding commitment to the next step. The second test (the end result test) asks whether the steps were designed and executed as part of an overall plan to achieve a particular end result. The last test (the interdependence test) asks whether the individual steps had independent significance or whether each step only had meaning as part of the larger transaction.

The Tax Court held that none of the tests were met. First, the binding commitment test wasn't met because the Trust's exercise of one option with respect to one parcel never obligated it to exercise any other option for another parcel. Because the Trust's funding wasn't predictable, the entire goal of the option agreement was to allow the Trust to avoid being bound to purchase parcels for which it didn't have the available funds. The end result test was not met for the same reasons. Because there were no guarantees that the Trust would receive funding for the land, the option agreement was specifically designed to address the Trust's concerns that it may not want to or be able to exercise all of the options to purchase all of the property. In fact, the location of the parcels of land subject to each option was specifically designed so that the exterior portions were sold first, allowing Klauer to retain the interior of the property if the Trust didn't decide to exercise the options. Lastly, the interdependence test wasn't met because each of the purchases had its own independent effect and value — the Trust's exercise of any one option wouldn't have been fruitless.