Estate Wise Planning Newsletter, Vol 1, No. 7, July 2005

Knowledge promotes understanding . . . understanding breeds creativity. . . .

ESTATE WISE PLANNING TM

Since 1979

By: Doug H. Moy

Consulting Specialist in Estate and Gift Taxation and Planning
Member, National Association of Tax Professionals (NATP)
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Published by: Doug H. Moy, Inc., P.O. Box 254, Lake Oswego, OR 97034
(503) 636-5855
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Vol. I, No. 7. July 2005
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Qualified Tuition Programs: Any contribution to a qualified tuition program (QTP) on behalf of any designated beneficiary is treated as a completed gift to such beneficiary, is a gift of a present interest for purposes of the gift tax annual exclusion under IRC Section 2503(b), but is not a qualified transfer under IRC Section 2503(e) [IRC Sec. 529(c)(2)(A)]. If the aggregate amount of contributions during the calendar year by a donor exceeds the gift tax annual exclusion (presently $11,000 per donee per calendar year), the donor may elect to treat such aggregate amount ratably over a five-year period beginning with the calendar year in which the contribution is made [IRC Sec. 529(c)(2)(B)]. Thus, for one donee, the donor may contribute $55,000 to a qualified tuition program and take advantage of the gift tax annual exclusion ratably over a five-year period without using-up any of the donor’s lifetime federal gift tax exemption amount of $1.0 million.


As a general rule, upon the donor’s decease, the value of the QTP established for the beneficiary is not includable in the decedent donor’s gross estate [IRC Sec. 529(c)(4)(A)]. However, in certain cases, amounts distributed on account of the death of a beneficiary are includable in the deceased beneficiary’s gross estate [IRC Sec. 529(c)(4)(B)]. With respect to a donor who elects to treat excess contributions ratably over a five-year period, and who dies before the close of the five-year period, the gross estate of the donor includes the portion of such contributions properly allocable to periods after the date of death of the donor [IRC Sec. 529(c)(4)(C)]. For example, if the aggregate amount is $55,000, and if the donor died after the end of the first ratable year, the donor’s gross estate would include $44,000 of the initial $55,000 amount contributed to the QTP. If the donor had created QTPs for five beneficiaries, then, $220,000 ($44,000 x 5 = $220,000) would be includable in the deceased donor’s gross estate for purposes of determining the federal estate tax.


Like-Kind Exchange: The IRS has ruled that a testamentary trust may hold replacement property received in a like-kind exchange of real property within the meaning of IRC Section 1031(a), notwithstanding that the trust must terminate by its own terms and, thus, distribute all of its properties, when the like-kind exchange is independent of the impending termination. With respect to the proposed exchange, the taxpayer had two concerns: (1) that the proposed transfer of the replacement property to a single-member limited liability company (LLC) not taxed as a corporation would violate the holding requirement of IRC Section 1031(a) (i.e., that the replacement property must be held by the taxpayer for productive use in a trade or business or for investment) as applied in Revenue Rulings 75-292 and 77-337; and (2) that, as a result of the Trust’s terminating distribution of membership interests in the LLC to multiple beneficiaries, which would then result in a de facto partnership between the beneficiaries for federal income tax purposes, the holding requirement of IRC Section 1031(a) as applied to the revenue rulings would be violated with respect to the replacement property. As to the first concern, the IRS has ruled that, because the Trust intends to hold the replacement property for investment purposes, the transfer by the Trust of the replacement property to the LLC will not violate the holding requirement of IRC Section 1031(a). Finally, as to the second concern, the like-kind exchange is wholly independent from the distribution of the properties from the Trust under the Plan of Termination, the date of which was fixed by the date of the decedent’s death and cannot be modified or changed. Thus, the facts of this exchange are distinguishable from those in Revenue Rulings 75-292 and 77-337 [Ltr. Rul. 200521002 (Feb. 24, 2005)].

Lifetime Estate Management Plan: Taxes should not become the tail that wags the dog. Estate planning is not just about minimizing or eliminating estate tax. A well-designed comprehensive estate plan includes a lifetime estate management plan that addresses how the estate owner’s financial affairs are to be managed in the event of physical or mental incapacity. In this regard, if the estate owner does not have such a plan and becomes physically and/or mentally incapacitated, a proper court of jurisdiction will appoint a guardian (of the person) or a conservator (of the person’s financial affairs) to manage the estate owner’s personal needs and financial affairs. On the other hand, the estate owner may choose not to involve the courts and be subject to a personally humiliating, degrading, emotionally traumatic and financially expensive court-supervised process to determine whether he or she is legally incapacitated. Only the following options are available for the protection and management of a person’s property and financial affairs: (1) ownership of property (real or personal property [tangible or intangible] as joint tenants with right of survivorship. The co-tenant not incapacitated may continue to manage the incapacitated co-tenant’s interest in the property; however, the court may require the entire property owned as joint tenants with right of survivorship to come under the umbrella of the court; or (2) designation of an immediate family member or close trusted friend as attorney-in-fact under either a durable general or special power of attorney; or (3) creation of a well-designed and correctly funded revocable (or irrevocable) living trust; or (4) implementation of a combination of these options.


Disclaiming Vow of Poverty: When making a charitable bequest intended to qualify for the unlimited charitable estate tax deduction, such gift must be made to the qualified charity—not to an individual member of the charity. Where there is a decedent’s residuary bequest to a beneficiary who is a member of a religious order and who has taken a vow of poverty prior to the effectuation of the bequest, such bequest does not qualify for the charitable estate tax deduction under IRC Section 2055(a). In this particular case, the decedent’s Last Will provided: "I direct that all the rest, residue and remainder of my estate, both real and personal property, of whatsoever kind, nature and description and wheresoever the same may be situated shall be given to [Beneficiary]. If [Beneficiary] predeceases me, it shall be given to [Order]." Decedent’s estate consisted primarily of securities and cash. Beneficiary, serving in her capacity as executrix (i.e., personal representative) of the decedent’s estate, transferred title to the securities to the name of the Order and transferred cash to the Order.


In effect, the Beneficiary, as executrix of the decedent’s estate, renounced the gift by transferring it to the Order. However, such renunciation is not a qualified disclaimer under IRC Section 2518 and is not recognized for claiming the charitable estate tax deduction. In this regard, a bequest to an individual, where the individual is required to transfer to a religious order pursuant to a vow of poverty in effect at the time of the decedent’s death, does not qualify for an estate tax charitable deduction under IRC Section 2055. Under these circumstances, the property does not pass from the decedent to the religious order pursuant to the terms of the testamentary instrument. Rather, the property passes to the religious order from the individual (i.e., in this case, the Beneficiary who served as the executrix) subject to the vow of poverty pursuant to the contractual arrangement between the individual and the Order [Rev. Rul. 68-459, 1968-2 C.B. 411; Rev. Rul. 55-759, 1955-2 C.B. 607; Estate of Callaghan v. Comm’r, 33 T.C. 870 (1960); See also, Estate of Lamson v. United States, 338 F.2d 376 (Ct. Cl. 1964); Estate of Barry v. Comm’r, 311 F.2d 681 (9th Cir. 1962); Cox v. Comm’r, 297 F.2d 36 (2nd Cir. 1961); Estate of Pickard v. Comm’r, 60 T.C. 618 (1973); Estate of McGuire v. Comm’r, 59 T.C. 361 (1972)].


Relying on the court’s holding in Callaghan and other cases cited above, the IRS ruled that, under the terms of the decedent’s Last Will, the residuary estate passed to the Beneficiary and not to the Order. The residuary estate was distributed to the Order pursuant to the Beneficiary’s obligation under the vow of poverty. Thus, in accordance with the cited cases and revenue rulings, the IRS ruled that the decedent’s residuary bequest did not qualify for the unlimited estate tax charitable deduction under IRC Section 2055 [TAM 200437032]. Had the decedent named the Order directly as the beneficiary, instead of the beneficiary indirectly, then, the bequest would have qualified for the estate tax charitable deduction.


Pre-1977 Jointly-Owned Property: Under present law, property owned by married spouses as joint tenants with right of survivorship (including tenants by the entirety with right of survivorship) is deemed to be owned one-half by each spouse (spouse’s joint property rule). Thus, only one-half the fair market value of the property owned by the spouses as JTWROS is includable in the gross estate of the first spouse to die—no matter who had provided the consideration for the purchase of the property [IRC Sec. 2040(b)]. However, with spousal joint interests (i.e., property owned by the spouses as JTWROS) created by the spouses before 1977 ("pre-1977"), 100 percent of the value of the property is includable in the gross estate of the first spouse to die, if that spouse provided the sole consideration for the property (consideration furnished test or the Gallenstein rule) [M. Lee Gallenstein v. United States, 92-2 U.S. Tax Cas. (CCH) ¶ 60,114 (6th Cir. 1992), aff’g (D.C. E.D. Kentucky, September 16, 1992)].


Requiring inclusion of the full value of the property owned as JTWROS in the estate of the first spouse to die can generate an income tax advantage for the surviving spouse, since the basis of the property will be stepped-up to 100 percent of its fair market value as of the date of the decedent spouse’s death (or the alternate valuation date). Combining this result with the unlimited estate tax marital deduction in the decedent spouse’s gross estate, in conjunction with a credit shelter trust to be funded with assets having a value of up to the federal estate tax exemption amount in the year of the decedent’s death (presently, $1.5 million), would allow the surviving spouse to receive the property free of federal estate tax, sell it at the decedent spouse’s date-of-death (or alternate-valuation-date) value free of capital gain tax, and minimize or entirely eliminate federal estate tax on the value of the surviving spouse’s taxable estate upon his or her subsequent death, provided the value of the surviving spouse’s taxable estate is less than or equal to the federal estate tax exemption amount in the year of his or her decease.
IRC Section 2040(b) does not require absolutely that the spouse’s joint property rule must always apply. Except for Field Service Advice 1998-332, which only addressed the issue of the noncontributing spouse predeceasing the contributing spouse, to my knowledge, the IRS has not issued any other rulings regarding the Gallenstein rule. Conceivably, a husband and wife could take ownership of real property as tenants by the entirety (or securities as JTWROS) with, say, either spouse providing 100 percent of the consideration from his or her separate funds. If the 100 percent consideration furnished by either spouse is designated in the instrument evidencing ownership, then, 100 percent of the value of the property may be includable in the value of the first decedent spouse’s gross estate. Such a designation on the deed of real property may be indicated as follows: "John Smith and Mary Smith, husband and wife, as tenants by the entirety with right of survivorship and with the following interests in the property: John Smith, 100 percent; Mary Smith, zero percent." The same allocation may apply for any fractional interest, provided the spouses designate the amount in the instrument evidencing ownership of the property. This may be an important income tax saving benefit for the surviving spouse.

Caution: The benefit of owning property as JTWROS created by spouses before 1977 ("pre-1977") may be lost if the title to such property is conveyed to the trustee of a revocable living trust. Once title to the property previously owned as JTWROS is conveyed to the trustee, the property is no longer deemed owned by the spouses as JTWROS; instead, each spouse holds a beneficial undivided one-half interest as a tenant in common in the property. In effect, upon the decease of the first spouse to die, only one-half the fair market value of the property on the date of the decedent spouse’s death, or the alternate valuation date, will be included in the first decedent spouse’s gross estate for federal estate tax purposes. Accordingly, only that one-half interest will receive a step-up (or step-down) in basis to the fair market value of the property in the hands of the trustee or the surviving spouse. Of course, the spouse who furnished 100 percent of the consideration for the pre-1977 jointly-owned property created by the spouses may, with the noncontributing co-tenant spouse’s agreement, convey 100 percent of his or her interest in the property to the trustee of his or her revocable living trust.


Question of the Month: I want to give the trustee of my revocable living trust a power not specifically addressed under state statute (local law); does this mean that such a power is not permissible in the revocable living trust? Answer: Not necessarily, unless the trustor resides in the state of Louisiana, whose laws are based on the Napoleonic Code. At the risk of oversimplification, in Louisiana, if the law is not part of the statutes, then, it is illegal to do what is not covered by the law. This may be a flagrant interpretation, but it is done purposely to emphasize the caution needed when designing a revocable living trust for a trustor who resides in Louisiana. In most other states, however, any fiduciary power is probably acceptable, so long as it does not violate public policy.


AFR: The July Applicable Federal Rate, under IRC Section 7520, for determining the present value of an annuity, an interest for life or a term of years or a remainder or reversionary interest is 4.6 percent (Rev. Rul. 2005-38, 2005-27 IRB 6). This bodes well for the grantor retained annuity trust (GRAT), charitable lead annuity trust (CLAT), charitable transfer of remainder interest in residence or farm and private annuities but not well for the qualified personal residence trust (QPRT), grantor retained income trust (GRIT) and charitable remainder annuity trust (CRAT). Lower AFRs have no impact on grantor retained unitrust (GRUT), charitable remainder unitrust (CRUT), charitable lead trust (CLT) and pooled income funds.


Copyright 2005 by Doug H. Moy. All rights reserved. Without limiting the rights under copyright reserved above, no part of this publication may be reproduced, stored in or introduced into a retrieval system or transmitted, in any form or by any means (electronic, mechanical, photocopying, recording or otherwise), without the prior written permission of the author and copyright holder of this material. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is made available with the understanding that neither the author nor Doug H. Moy, Inc. and/or employees is/are engaged in rendering legal or accounting services. If legal advice or accounting assistance is required, the services of a competent professional should be sought.