Estate Wise Planning Newsletter, Vol. 1, No. 9, September 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. 9. September 2005
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Savings Clause Against Public Policy: Taxpayer and his spouse formed a family limited partnership (“FLP”). According to the FLP Agreement, taxpayer held both general and limited partnership interests in the FLP. Taxpayer executed an Assignment, which reads: “Assignor (Taxpayer) desires to transfer as a gift to Assignee (a trust) that fraction of Assignor’s Limited Partnership Interest in Partnership which has a fair market value on the date hereof of $X.” Pursuant to this assignment, Trust received a percentage interest in the FLP from Taxpayer. Taxpayer filed a United States Gift (& Generation-Skipping Transfer) Tax Return (Form 709). On the return, Taxpayer reported the value of the gift, the Trust percentage interest, as $Y, an amount equal to $5,000 less than $X.




As in Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944), the Fourth Circuit Court of Appeals concluded that such a provision is a condition subsequent and void because it was contrary to public policy. The court of appeals explained that the condition was contrary to public policy because: (1) it has a tendency to discourage the collection of the tax by the public officials charged with its collection, since the only effect of an attempt to enforce the tax would be to defeat the gift; (2) the effect of the condition would be to obstruct the administration of justice by requiring the courts to pass upon a moot case. If the condition were valid and the gift was subject to tax, the only effect of the holding would be to defeat the gift so that it would not be subject to tax; and (3) the condition is to the effect that the final judgment of a court is to be held for naught [Commissioner v. Procter, 142 F.2d at 827].

The Tax Court reached a similar conclusion in Ward v. Commissioner, 87 T.C. 78 (1986). In that case, a husband and wife transferred 85 shares of stock in a closely-held corporation to each of their three sons. The donors and donees executed a gift adjustment agreement, providing that, if it should be finally determined for federal gift tax purposes that the fair market value of each share of stock transferred exceeded or was less than $2,000, an adjustment will be made in the number of shares constituting each gift so that each donor will give to each donee the maximum number of shares, the total value of which will be $50,000 from each donor to each donee and a total of $150,000 from each donor to each donee. The court concluded that the gift adjustment clause was void as contrary to public policy [see also, Estate of McClendon v. Commissioner, T.C. Memo 1993-459].

The Service reached a similar conclusion in Rev. Rul. 86-41, 1986-1 C.B. 300. In that ruling, “A” transferred an interest in a tract of income-producing real property to “B.” Under the deed, “B” received a one-half undivided interest in the property. The deed provided that, if, for federal gift tax purposes, the Service determined that the value of the one-half interest was more than $10,000, then, “B’s” interest would be reduced so that its value equaled $10,000. Under local law, the adjustment clause operated as a condition subsequent. Thus, if the Service determined the gift was more than $10,000, the adjustment clause would effectively reconvey to “A” a fractional share of the property sufficient to reduce the value of “B’s” interest to $10,000 as of the date of the gift. The revenue ruling concludes that the adjustment clause will be disregarded for federal tax purposes; and, consequently, the value of the gift will be determined without regard to the adjustment clause.

The “savings” clause language in the Assignment regarding the gift of the Taxpayer’s FLP interest to the Trust is similar to the clauses in Ward and Rev. Rul. 86-41. In the instant case, Taxpayer transferred a certain percentage interest in the FLP to Trust pursuant to the Assignment. However, if the Service determines that the value of the percentage interest transferred is greater than $Y, and the “savings” clause in the Assignment is given effect, then, pursuant to the “savings” clause, the percentage interest in the FLP which exceeds the value of $Y would be retransferred to Taxpayer. Such a clause is void as contrary to public policy [TAM 200337012].




Disclosure of Gifts: Whether the federal estate tax and generation-skipping transfer tax is repealed, the federal gift tax will remain. Presently, the lifetime federal gift tax exemption amount (applicable exclusion) is $1.0 million and will remain such after 2009; and the maximum gift tax rate will be 35 percent after 2009. Under the Taxpayer Relief Act of 1997 (“TRA ’97”), a gift made after August 5, 1997, for which the limitations period of gift tax assessment has passed, cannot be revalued for purposes of determining the applicable estate tax bracket and available federal estate tax unified credit, provided the gift has been adequately disclosed [IRC § 2001(f)(1); Reg. § 301.6501(c)-1(f)(2)]. A gift is adequately disclosed on the Form 709 only if it is reported in a manner adequate to apprise the IRS of the nature of the gift and how the value of the gift was determined. The information needed to adequately disclose the gift on the Form 709 is found in Reg. § 301.6501(c)-1(f)(2)]. Though gifts qualifying for the gift tax annual exclusion, presently $11,000, are not required to be reported on Form 709 (since such gifts are not taxable gifts), nevertheless, if the value of such a gift is subject to interpretation (or valuation adjustment; e.g., closely-held stock, real property, works of art, an interest in an FLP or LLC, etc.), then, the donor would be well-advised to disclose such a gift on Form 709. By doing so, the IRS may be precluded (or estopped) from revaluing the gift at its value on the date of the donor’s death for federal estate tax purposes. Adequate disclosure is required if the donor wants to commence the running of the period of limitations on assessment with respect to a gift made before August 5, 1997 [Rev. Proc. 2000-34, 2000-2 C.B. 186, § 5(7)].

No Discount for Retirement Accounts: For federal estate tax purposes, valuation discounts are highly prized; and some estates will push the envelope as far as possible in an effort to minimize the payment of federal estate tax. Such was the case with the claim made by the decedent’s estate that it was entitled to a partial refund of federal estate taxes because it overvalued certain retirement accounts held by decedent in calculating his total gross estate and, therefore, overpaid its federal estate taxes. According to the estate, the retirement accounts at issue should have been valued at a discounted amount to reflect the federal income tax liability triggered upon distribution to beneficiaries [this tax liability resulted from the fact that the retirement accounts at issue were not taxable to decedent at or before his death. As a result, the accrued income was taxable to the beneficiary of the accounts as income in respect of a decedent (“IRD”)].

In contrast, the government moved for summary judgment on the sole ground that the decedent’s estate was not entitled to a federal estate tax refund and argued that the potential federal income tax liability of the beneficiaries of the decedent’s retirement accounts should not be considered in valuing such retirement accounts for federal estate tax purposes. The government argued the estate’s refund claim was based upon an erroneous valuation method in that the retirement accounts should not be discounted to account for the income tax liability generated upon distribution of the securities contained in the accounts.

The Court ruled that the fair market value of the retirement accounts was properly reported by the estate in its initial federal estate tax return [the estate valued the decedent’s Thrift Plan at $725,550.00 and the decedent’s Stock Plan at $42,808.00]. This valuation reflected the value of the securities held in the decedent’s retirement accounts as determined by reference to applicable securities exchange rates on the date of decedent’s death but did not include a discount for the IRD taxed to the beneficiaries of the retirement accounts [Estate of Louis R. Smith v. United States, 2004 TNT 31-49 (DC SD Tex., Jan 20, 2004)].

Quid Pro Quo Trusts: When a trust or a series of trusts are made quid pro quo for one another, the reciprocal trust doctrine apples. This doctrine dates back to 1940 to the case of Lehman v. Commissioner [109 F2d 99 (1940)]. The doctrine came about in response to estate tax situations where estate owners created reciprocal (“crossed”) irrevocable trusts to hold their property that, in form, removed the value of the property from their gross estates but left the estate owner some control over the transferred property through retained powers as trustee of the trust. In reality, therefore, each estate owner had the same lifetime enjoyment of his or her property; albeit, the property was in the other estate owner’s trust, which he or she would have enjoyed had he or she simply reserved the same entitlements in his or her own trust.

The doctrine was developed to deal with this situation by “uncrossing” the trusts and treating each trustor (creator of the trust) as if the trustor had created his or her own trust. As a result, a decedent was treated as the “transferor” of the property, which the other trustor had in form transferred, causing the value of the trust property to be taxed in his or her estate at death. In the majority of cases following Lehman v. Commissioner, the issue was whether the creation of one trust had been induced by, and represented a quid pro quo for, the creation of the other trust.

Finally, in 1969, the U.S. Supreme Court ruled on the issue of reciprocal trusts in the area of intrafamily transfers. In United States v. Grace [395 U.S. 316 (1969)], the Supreme Court held that application of the reciprocal trust doctrine requires only that the trusts be interrelated, and that the arrangement, to the extent of mutual value, leave the settlors in approximately the same economic position as they would have been in had they created trusts naming themselves as life beneficiaries.

The U.S. Tax Court has noted that [t]he reciprocal trust doctrine covers not only husband and wife, but brother and sister, parent and child, and very possible two complete strangers [Krause v. Commissioner, 57 T.C. 890 (1972), at 901, f.n. 8]. In view of the Supreme Court’s ruling, the IRS has taken the position that, with regard to gift tax, when two donors (related or unrelated, married or unmarried) establish similar trusts under circumstances such that the beneficial interests are matching, the transfers may be treated as reciprocal, whether or not the transfers were actually in consideration for each other [Rev. Rul. 85-24, 1985-1 C.B. 329; Ltr. Rul. 8813039].

Either the reciprocal trust doctrine or the reciprocal transaction doctrine has been used regarding reciprocal gifts qualifying for the gift tax annual exclusion (presently $11,000). In these regards, either doctrine is an application of substance over form for purposes of inclusion of the gifted property in the donors’ gross estates [See United States v. Estate of Grace, 395 U.S. 316, 321 (1969)]. In Sather v. Commissioner, T.C. Memo. 1999-309, the Tax Court applied the reciprocal trust doctrine to reduce the number of present interest annual exclusions for gift tax purposes [Estate of Robert V. Schuler v. Commissioner, 2001-1 U.S. Tax Cas. CCH ¶ 60,432, aff’g T.C. Memo 2000-392; see also, Furst v. Commissioner, T.C. Memo 1962-221; Schultz v. United States, 493 F.2d 1225, 1226 (4th Cir. 1974)].




Buy-Sell Agreement Disregarded: A major concern of many owners of closely-held businesses is how to maintain continuity of business ownership and management in the event one or more of the owners becomes disabled, decides to make a lifetime sale of his or her interest in the business or dies. In some cases, qualified family members are already active in the business and can carry on the company operations or an unrelated key employee may continue to manage the business or obtain ownership of the business or the business may be sold to a competitor. In any event, some mechanism is needed so that the closely-held business or its surviving shareholders or partners can acquire a disabled, departing or decedent shareholder’s, partner’s or sole proprietor’s interest in the business. Moreover, a well-designed buy-sell agreement can “peg” the value of the decedent’s interest in the closely-held business includable in the decedent’s gross estate for federal estate tax purposes, thus, dampening the Service’s efforts to assign unrealistic and unreasonable value to property includable in the decedent business owner’s gross estate.

Under present law, for purposes of federal estate and gift taxes, an enforceable buy-sell agreement must satisfy three requirements: (1) the option, agreement, right or restriction involving the business interest must be a bona fide business arrangement; (2) not be a device to transfer the business interest to members of the decedent’s family for less than full and adequate consideration in money or money’s worth [IRC §§ 2703(b)(1) and (2)]; and (3) the terms of the option, agreement, right or restrictions be comparable to similar arrangements entered into by persons in an arm’s length transaction [IRC § 2703(b)(3)].

The special valuation rules governing buy-sell agreements apply to agreements, options, rights or restrictions entered into or granted after October 8, 1990. The same rules apply to agreements, options, rights or restrictions amended or modified after October 8, 1990 [see, e.g., Estate of G. Blount v. Commissioner, T.C. Memo 2004-116], even though the original agreement, option, rights or restrictions were entered into or granted before October 9, 1990 [Revenue Reconciliation Act of 1990, Pub. L. No. 101-508, § 11602(e)(1)(A)(ii) (Nov. 5, 1990)].

In Blount v. Commissioner, cited above, the court held: (1) the modified agreement was disregarded for purposes of determining the value of decedent’s shares for federal estate tax purposes because the decedent had the unilateral ability to modify the agreement, rendering the agreement not binding during the Decedent’s lifetime, as required by Regulation Section. 20.2031-2(h); (2) IRC Section 2703 applies to the modified agreement because the modification, which occurred after October 8, 1990, was a substantial modification; and (3) the modified agreement was also disregarded because its terms were not comparable to similar arrangements entered into by persons in an arm’s-length transaction.

Question of the Month: Do I have to use a bank as trustee of my revocable living trust?

Answer: No. In some cases, a bank or an independent trust company is named as the ultimate successor trustee in the event of the resignation or inability of an individual successor trustee to serve. By naming a bank or independent trust company as successor trustee, the beneficiaries do not have to turn to a proper court of jurisdiction to appoint a successor trustee in the event none of the individual successor trustees can serve. Moreover, a corporate trustee may be better able to interface and handle a difficult beneficiary, such as an infamous or difficult child. A corporate trustee can be a formidable opponent in the event a difficult beneficiary becomes bent on overturning a subtrust established under the revocable living trust agreement for that beneficiary.

AFR: The September 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 5.0 percent (Rev. Rul. 2005-57, 2005-36 IRB 1). 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.

Contact Doug H. Moy at dougmoy@msn.com or at (503) 636-5855 in regard to:

Referrals — always welcome
Initial consultation appointment
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Doug H. Moy, President
Doug H. Moy, Inc.
PO Box 254
Lake Oswego, OR 97034-0030
Telephone: (503) 636-5855
Fax: (503) 697-7749

dougmoy@msn.com

Available at most book stores for $39.95: Moy, Doug H., Living Trusts, Third Edition. John Wiley & Sons, Inc., 2003. Or visit http://www.wiley.com/WileyCDA and enter “Doug Moy” in Product Search “by Author.”

This is an extremely accessible work, written in a clear,
conversational tone....This is a very commendable work,
equally appropriate in the professional’s office library
or at home on the den bookshelf.... Highly recommended.
Nancy Shurtz, “Estate Planning,” July 2004, Vol. 31/No.7,
p. 357.