Tax Law Update 2012-02-01Tax Law Update 2012-02-01

IRS issues new proposed regulations regarding alternate valuation date — The Internal Revenue Service has published new proposed Treasury regulations under Internal Revenue Code Section 2032 (REG-112196-07, 76 Fed. Reg. 71491 (Nov. 18, 2011)). Under IRC Section 2032, a decedent's property is valued on the date of death for estate tax purposes, unless the estate executor elects alternate valuation. If the executor elects alternate valuation, the decedent's property is valued on the date that's six months after the date of death, or for property that's distributed, sold, exchanged or otherwise disposed of before the six month alternate valuation date (AVD), the date of such distribution, sale, exchange or disposition.

The proposed regulations expand the listed examples of what constitutes a distribution, sale, exchange or disposition that will require valuation on the date of such distribution. For example, an exchange of an interest in a corporation, partnership or other entity for a different interest (for example, a different class of stock) in the same entity or in an acquiring or resulting entity is an exchange or disposition. In addition, a change in ownership structure or the assets of a corporation, partnership or other entity that causes the property after the change to no longer reasonably represent the property at the decedent's date of death, is also an exchange that requires valuation on the date of exchange or disposition. Examples include: (1) a dilution of the decedent's ownership interest in the entity due to the issuance of additional ownership interests in that entity; (2) an increase in the decedent's ownership interest in the entity due to the entity's redemption of the interest of a different owner; (3) a reinvestment of the entity's assets; and (4) a distribution or disbursement of property by the entity (other than expenses, such as rents and salaries, paid in the ordinary course of the entity's business), with the effect that the fair market value (FMV) of the entity before the occurrence doesn't equal the FMV of the entity immediately thereafter.

However, the proposed regulations describe two exceptions to the valuation-on-distribution-date rule: (1) an exchange of an interest in an existing corporation, partnership or entity if the FMV of the interest exchanged equals the FMV of the interest received, and (2) a distribution or disbursement from a business entity (such as a partnership or corporation) or trust (including retirement savings accounts and plans such as individual retirement accounts, Roth IRA, 403(b) and 401(k) accounts), if the value of the interest immediately before the distribution equals the value of the distributed property on the date of distribution, plus the FMV of the remaining interest immediately after the distribution. If either of these exceptions apply, the interests in the entities or trusts are valued on the six month AVD (the distribution received in the latter case is valued on the date of distribution).

The regulations include an “aggregation rule” for valuing each portion of property that's been disposed of during the six month period. Under this rule, if a portion of an asset is disposed of, the value of that portion is determined by multiplying the total value of the asset as of the date of disposition by the fraction disposed. As a result, no minority interest discount is taken into account.

In addition, the regulations provide that with regard to property that's includible in a decedent's gross estate because of his right to an annuity, unitrust or other payment under IRC Section 2036, if the AVD is elected, the value of each payment or distribution during the six month alternate valuation period must be determined as of the date of distribution and added to the value of the property generating the annuity, unitrust or payment, determined as of the AVD. This value is then used to calculate the amount includible in the decedent's gross estate under IRC Section 2036.

IRS confirms that a grantor's right to reacquire an insurance policy creates a grantor trust without inclusion in gross estate — In Revenue Ruling 2011-28 (Dec. 5, 2011), the IRS applied the holding of Rev. Rul. 2008-22 to a trust that owned a life insurance policy on a grantor's life. Rev. Rul. 2008-22 explained that a grantor's right to substitute trust assets of equivalent value wouldn't risk estate tax inclusion if certain requirements were met. Now, with the issuance of Rev. Rul. 2011-28, it's clear that an insured grantor's retained right to reacquire trust property by substituting assets of equivalent value won't be considered an incident of ownership over insurance policies on his life held by the trust.

The requirements under both revenue rulings are as follows: First, the trustee must have a fiduciary obligation (under local law or the trust instrument) to ensure the grantor's compliance with the terms of the power by satisfying itself that the properties acquired and substituted by the grantor are, in fact, of equivalent value. Second, the substitution power can't be exercised in a manner that can shift benefits among the trust beneficiaries. This second requirement is met if either: (1) the trustee has both the power (under local law or the trust instrument) to reinvest the trust corpus and a duty of impartiality with respect to the trust beneficiaries, or (2) the nature of the trust's investments or the level of income produced by the trust's investments doesn't impact the respective interests of the beneficiaries (such as when the trust is administered as a unitrust or when distributions from the trust are limited to discretionary distributions of principal and income).

If the grantor retains the power to substitute trust assets, which include an insurance policy, and the above requirements are met, the trust is considered a wholly-owned grantor trust for income tax purposes, but the insurance policy wouldn't be included in the grantor's gross estate under IRC Section 2042 because of this substitution power.

IRS issues final regulations regarding value of property subject to retained interests included under IRC Section 2036 — The IRS issued final regulations regarding the estate tax treatment of retained interest trusts, such as grantor retained annuity trusts (GRATs), when the grantor dies during the reserved term (T.D. 9555, Nov. 8. 2011, 76 Fed. Reg. 69126 (Nov. 8, 2011)). The regulations provide rules on how to calculate what portion of property subject to a retained interest is includible in certain situations, such as when: (1) the grantor and another person are entitled to trust income jointly; (2) the grantor retains the right to a payment that succeeds another beneficiary's right to payments; and (3) the grantor is entitled to increasing payments (such as in a “backloaded” GRAT). The regulations include examples to illustrate the calculations.

In the first situation, in which a decedent and another individual were joint income beneficiaries, the following is included in the grantor's estate according to the example: (1) the value of half of the trust property; plus (2) the value of the other half of the trust property reduced by the value, as of the grantor's death, of the present value of the survivor's interest.

In the second situation, in which a grantor's beneficial interest succeeds another individual's interest, the value of the trust fund necessary to produce the grantor's annuity or unitrust payment had he survived the current recipient, less the present value of the current recipient's remaining annuity or unitrust interest, is included in the decedent's estate. The amount includible, however, can't be less than the amount of corpus required to produce the annuity or unitrust payment the grantor was entitled to in the year of his death.

In the third situation, in which the decedent is entitled to increasing payments, the following is included in the decedent's estate: (1) the value of the trust fund necessary to produce the decedent's annuity or unitrust payment for the year of death (for example, the annuity amount due in the year of death, divided by the IRC Section 7520 rate in effect on the date of death); plus (2) the value of the trust fund necessary to produce the incremental amount resulting from the increased annuity in each of the future years, discounted to reflect the delay in the decedent receiving this additional amount.

The regulations also clarify that if Section 2036 applies to include the value of trust property in a decedent's estate, any payments payable to the grantor's estate after his death won't be included under IRC Section 2033, to avoid double inclusion.

Family limited partnership assets includible in gross estate — In Liljestrand v. Commissioner, T.C. Memo. 2011-259 (Nov. 2, 2011), the Tax Court once again held that assets owned by a family limited partnership (FLP) were includible in a decedent's estate under IRC Section 2036. Dr. Paul H. Liljestrand became involved in real estate management after his retirement from the medical profession when he exchanged a Hawaii hospital building for a number of income-producing properties in California, Florida and Oregon. Liljestrand's revocable trust took title to all the real estate properties and Liljestrand's son, Robert, managed the real estate according to a management agreement. Robert also handled his father's financial affairs and was a co-trustee of Liljestrand's revocable trust.

Liljestrand created the Paul H. Liljestrand Partners Limited Partnership (the partnership) in 1997. Liljestrand, through his revocable living trust, contributed real estate holdings with a net value of approximately $5.9 million. Liljestrand was the sole general partner with the exclusive right to make all distributions and owned 99.98 percent of the interests in the partnership. Robert owned one Class B unit (.02 percent), even though it didn't appear that Robert made any contribution to the partnership. None of Liljestrand's children contributed any property to the partnership, and none of the children other than Robert were involved in the partnership's formation.

Over the next two years, Liljestrand made gifts of Class B limited partnership units to irrevocable trusts for his four children. Interestingly, the IRS didn't appear to raise any issues with valuation of the gifts under IRC Section 2701, even though Liljestrand gave away junior equity interests (Class B units) while retaining senior equity interests (the general partnership units and Class A units), along with the remaining Class B units, in the partnership.

However, from the very beginning, Liljestrand didn't respect partnership formalities. The partnership didn't open a bank account until August 1999. For the first two years, Liljestrand reported real estate income and expenses on his own individual income tax returns. Disproportionate distributions from the partnership were made to Liljestrand and his personal expenses, as well as the personal expenses of his children, were paid out of the income from partnership assets. Finally, the partnership refinanced some property and used the proceeds to pay Liljestrand's estate tax liability after his death.

The IRS issued a notice of deficiency, stating that the assets of the partnership were includible in Liljestrand's estate under IRC Section 2036. The estate appealed, arguing that the transfer of property to the partnership was a bona fide sale for adequate and full consideration and therefore outside of IRC Section 2036. Under Bongard v. Commissioner, 124 T.C. 95, 111 (2005), the “bona fide sale” exception requires that the formation and funding of an FLP be “motivated by a legitimate and significant nontax purpose.” The Liljestrand court rejected the estate's several alleged non-tax purposes for forming the partnership. First, the estate argued that the partnership was created to secure Robert's employment as manager of the property. However, before the partnership was established, Robert was already guaranteed long-term employment as property manager by virtue of his position as trustee and the terms of the management agreement. Second, the estate argued that Hawaii law would subject the real estate to partition or division without the partnership. However, the court wasn't convinced that this was true, because most of the real estate was located outside of Hawaii. In addition, pursuant to Liljestrand's revocable trust, the property would have been owned by the trustees and not subject to partition by his children anyway. Lastly, the court wasn't convinced that protecting the property from the claims of creditors was an actual motivation for establishing the partnership (the estate cited the litigious environment in Hawaii as a concern motivating the formation of the partnership).

In addition to the court's finding that there was no legitimate, significant non-tax reason motivating the establishment of the partnership, the court noted other facts indicating that the transfers weren't bona fide. The court highlighted the considerable disregard of partnership formalities, including no regular partnership meetings, commingling of funds, a two-year failure of income tax reporting for the entity and the failure to maintain capital accounts. Moreover, the transaction was one-sided: all capital contributions came from Liljestrand, and there were no indicia of an arm's length deal. Lastly, Liljestrand retained enjoyment of the partnership assets: He lacked sufficient funds outside of the partnership, relied on partnership distributions to cover his personal expenses and received disproportionate distributions.

Estate may be able to avoid late filing and payment penalties by reliance on advice of counsel — In Estate of Liftin v. United States, 2011 WL 5395546 (Ct. Fed. Cl. Nov. 8, 2011), the Court of Federal Claims denied the IRS' motion for judgment on the pleadings because the estate had alleged facts sufficient to show reasonable reliance on advice of counsel regarding a late filed estate tax return. Morton Liftin died in 2003, appointing his son as executor and leaving a surviving spouse. His surviving spouse, Anna G. Lavandez Liftin, was a U.S. resident and a citizen of Bolivia. The estate timely filed for a six month extension to file the estate tax return and made a payment of over $870,000. In the meantime, Anna decided to apply for U.S. citizenship to allow the estate to take advantage of the marital deduction. The executor consulted with an attorney, who was experienced in estate and gift tax planning, to ask whether the estate could wait to file the estate tax return until after Anna obtained citizenship. The attorney advised the executor that the estate could file its return after the due date and preserve the marital deduction and, further, that no penalties would be triggered as long as the return was filed within a reasonable time. The executor found this advice reasonable, since the estate had already made a payment. In addition, the executor requested confirmation from the attorney on multiple occasions that no penalties would accrue.

The estate ultimately filed the estate tax return almost two years after the extended deadline. The return showed an overpayment of almost $200,000. However, the IRS issued a Notice of Adjustment reflecting penalties of just under $170,000. The estate then sued for a refund of the late filing penalties.

To avoid a late filing penalty, a taxpayer must prove that the failure was due to reasonable cause and that the taxpayer exercised ordinary business care and prudence, but was unable to file the return within the prescribed time. Reasonable cause may exist when a taxpayer files a return after the due date in reliance on an expert's erroneous advice regarding a substantive question of tax law (relying on an expert for merely filing a tax return doesn't constitute reasonable cause). Because the estate had consulted with an attorney on multiple occasions on substantive questions regarding the potential for penalties in its situation, the court held that the estate may be able to prove facts that show its failure to timely file was due to reasonable cause.