Estate & Gift Tax
Bogdanski
Fall 2008

Sample Answers to Question 1

Exam No. 9510

There are no GST implications because there are no skip person benefiting from any of Mildred’s property.

 

Creation of the Trust

 

            When M sets up the trust, it is irrevocable but her power to invade the corpus for the benefit of O with no ascertainable standard means she has retained sufficient dominion and control that there is no gift of the remainder to S.  Reg §25.2511-2.  M has reserved the power to change the interest of the beneficiaries because she could give all of the corpus to O and S would get nothing.  This is true even though she has limited her personal invasion to an ascertainable standard.  Incomplete gift since you can turn hose on and off, but you can’t move the hose around.  It does not matter that she never exercised those rights, just that she had them.

 

Renouncing rights to invade corpus for herself and O

 

            When M renounces her rights, there is a completed gift to S of the remainder.  S has no present interest in the trust since he must wait until the end of the term.  M cannot take the annual exclusion under 2503 because gifts of future interest do not qualify.  Since M and S  are “family members” under 2702 and M has set up a grantor retained interest trust the value of M’s retained interest is valued at zero for gift tax purposes and she has made a gift of the full value of the trust.  The only way she could avoid this valuation would be under a GRAT or a GRUT where she is to receive a fixed amount or a fixed percentage each year.  It is possible that the company will have no income or make no dividends and therefore her income interest will be zero.

 

            Gift tax valuation is based on the fair market value of the property.  Since the trust consists of publicly traded stocks and bonds the value can be easily ascertained from the actual market.  Stock prices are valued price per share as the mean between the highest and lowest quoted selling price on the date of the transfer.  No discount for lack of marketability since they are traded on public markets.  The common stock in Pubco may get a blockage discount because the large block of stock would depress the market if sold.  They must actually prove that the sale would depress the market.

 

            M can use her gift tax unified credit (if she hasn’t already) to the extend that it will cover the value of the gift to S.

 

Death of M

 

Her gross estate under 2033 will include any property owned at death (the rest of the estate passing to S and O).  Any unused portion of the gift tax unified credit of $1mil can be combined with the estate tax unified credit for a total credit of $2million.  Since she did not own the trust when she died, the corpus will not be included under 2033.  However, 2036 will grab it.

 

When M dies, she dies holding an income interest in the trust because the 25 year term has no expired.  Under 2036(a) if you set up a trust and have the right to enjoy or hold or have right to income from property until you die, then the entire property gets dragged back into the estate.  M never cut the strings and this is very bad news if the stocks/bonds have appreciated since 2008.  Of course the same valuation rules will apply here that applied for valuing the trust for gift tax.

 

            Under 2035(b) any gift tax paid by M on the gift in June 2008 will be dragged back into the gross estate because it occurred within 3 years of her death.  Thus the tax-exclusive nature of the federal gift tax is lost for near-death gifts.

 

Deductions

 

            2053(a)(1) allows administration expenses to be deducted if they are necessary and reasonable.  The broker’s commission for selling off the real estate will not be allowed unless necessary.  For example if there was no cash in the estate and things had to be paid, then sales commissions would be necessary expenses for the benefit of the estate.  Under 2058 state death taxes can be deducted from the gross estate (used to be a credit).  Attorney’s fees can also be deducted if they are necessary expenses for the benefit of the estate.

 

            2053(a)(3) allows a deduction for claims against the estate.  The claim must be enforceable and represent a personal obligation of the decedent at death.  Circuits are split on how to value a contingent claim against the estate.  The 9th circuit and majority rule is that valuation is determined at death by figuring out how much estate would have to pay if it loses and the probability that the estate loses.  The minority rule followed by the 8th circuit is that you wait and see what happens with the claim up until the point that the statute of limitations on taxes runs.  The minority rule is similar to proposed reg §20.2053-4.  The attorney fees for litigating the case could probably be deducted as a necessary expense or if not, then they could probably be included in the valuation of the claim (both result in a deduction for the estate).

 

 

Exam No. 9091

 

            Generally, when you set up an irrevocable trust, that is a gift to the interest holders in the trust, however, if the power to invade the corpus is large enough, that would not be a gift to S. M can invade the corpus for her own “health, comfort, or well-being.” If you can invade the trust for you, your creditors, your estate, or creditors of your estate, that is a general power of appointment, unless it is limited by an ascertainable standard. If it is a general power of appointment, it is not really a gift, because the power holder can still control who gets the money. “Health, comfort or well-being” are not the magic words usually used to make an ascertainable standard, but they are close, so it could go either way. The fact that she must get the trustee’s approval will not affect the answer, because a trustee without an adverse interest will approve whatever M wants to do. M can also invade the corpus for O, there does not seem to be any standard for her invading the corpus for O, so the gift to S is not complete at the time of the formation of the trust, and there will be no gift tax.

 

            On June 1, 2008, when M renounces her rights to invade the corpus for herself and O, that is when there is a taxable gift to S, because M (the transferor) finally relinquishes her control over the trust. Reg. § 25.2511-2(b); Estate of Sanford.

 

            Now that we have a completed gift, we need to value the gift. Normally, we would value the income interest and the remainder interest separately, but no here because M kept the income interest for herself, but not as an annuity or unitrust interest. So, M’s interest will be valued at $0. IRC § 2702.

 

            The corpus of the trust consists of publicly traded stocks and bonds, so the valuation will be easy, because we can just look at what they were trading at on June 1, 2008. More specifically, we will take the average between the high and the low for each stock on that day. However, because the trust has such a large amount of stock in Pubco, M will get a lack of marketability discount, because if they put them all on the market at the same time it would flood the market and lower the price. There will not be a control premium, because this is not a controlling share of the stock. This discount might be 15%, but will need to be appraised by an expert. If M has not used up her unified credit, then the first $1 million worth of the gift will be tax free.

 

            At M’s death her gross estate will include all of the property she owns. It will also include the trust, under sections 2035 and 2036. She retained an income interest, which she still had when she died, so the whole trust goes back into her estate under 2036. Also, she cut the string of her right to invade the trust within 3 years of her death, so it will go into her estate under 2035 (a). This does not mean that she will be taxed twice on it, but it does mean that there will be two taxable events, so M’s estate will get taxed on the appreciation of the trust from 2008 to 2010.  Also, the gift tax paid in 2008 will go back into her estate under 2035(b).

 

Under § 2032, the estate can be valued on the date of death, or exactly 6 months after the date of death. The entire estate must be valued at whichever date they choose. M’s estate will also have $2 million of unified credit to use, so the first $2 million in the estate will be tax free. The rest will be taxed at 45%, under the current rate structure. However, there will be some deductions to take before that.

 

M estate cannot deduct the broker’s commission from selling off M’s real estate, because they are not administrative expenses under 2053. Administrative expenses must be necessary under state law to be deductible; selling the real estate was for the benefit of the beneficiaries, not for the estate, so it is not deductible.  This is similar to selling the sculptures in Estate of Smith, where the deduction for the commissions was not allowed.

 

Estate taxes imposed by M’s home state are deductible under § 2058. Attorney’s fees dealing with the administration of the estate are deductible under § 2053.

 

M’s estate can also deduct for the defamation claim against her, under § 2053(a)(3) Estate of O’Neal, an 11th Circuit case, says that you can deduct an estimated value for the claim. This is the 9th Circuit rule, and the majority rule. The proposed regulations, however, say that the estate cannot make a deduction until the claim is actually settled, and then they can revise the estate tax return.  The attorney’s fees for defending this lawsuit would be deductible as well.

 

There are no generation skipping transfer tax (GST) implications of this problem, because there are no skip people.

 

 

Exam No. 9263

 

            This question presents several gift and estate tax issues, which are discussed below.  No generation-skipping-transfer tax issues are presented, because all the transfers are occurring between Mildred and her sons.  None of the transfers are generation-skipping under Internal Revenue Code (IRC) §§ 2601, 2611, et. seq.

 

Gift Tax Consequences

 

For gift tax purposes, a gift is a transfer for less than adequate consideration in money or money’s worth, under IRC 2512.  In July 2007, when Mildred set up the irrevocable trust, with income to herself or her estate for 25 years and remainder to Shane, that was an incomplete gift of the remainder, because Mildred retained the right to invade the corpus for her own “health, comfort or well-being” or for the benefit of Oscar.  Because this is a transfer in which Mildred, the grantor, retained an interest, § 2702 applies.  Typically, when a power to invade is limited by an ascertainable standard (that is, the power is limited to as needed for health, support, maintenance), then the transfer is considered a completed gift despite the existence of that power to invade.  (Reg. 25.2511-1).  However, here her power to invade for herself is limited by the ascertainable standard, but the facts do not indicate that her power to invade for Oscar is limited by that standard.   If her power to invade for Oscar’s benefit was limited by that ascertainable standard, then this would be a completed gift of the remainder to Shane.  Because her power to invade the corpus for Oscar’s benefit is not limited by an ascertainable standard, the gift of the remainder to Shane is incomplete, and thus not yet subject to gift tax.  Her retention of a life estate is not considered a gift, because it is to herself.

 

            On June 1, 2008, when Mildred renounced her rights to invade the corpus of the trust, the gift of the remainder to Shane became a completed gift.  At that point, she no longer had any rights to invade for herself or for Oscar, and thus no longer had any control.  Under Reg. § 25.2511-2, the gift was then complete to Shane, and subject to gift tax.  The next question, then, is what amount or value of the property is subject to gift tax?  Under § 2702, because Mildred retained an interest that is not a qualified retained interest (that is, she is not entitled to a fixed amount or fixed percentage of the income annually), the value of the transfer for gift tax purposes is 100% of the transfer.  Her retained interest is valued at $0.  Therefore, upon establishing the irrevocable trust, the full value of the property that she transferred into the trust is taxable under the gift tax. 

 

            Because the trust property consists of publicly traded stocks and bonds, it should be fairly easy to value by looking at the fair market value of the stocks and bonds on the day the gift was completed: June 1, 2008.  The property is most likely not eligible for any minority or lack of marketability discounts, nor will it be subject to a control premium; as those adjustments apply to holdings of closely held companies.  The property does include 1,000,000 shares of Pubco (which is the largest block of the stock held by any one shareholder).  Because that is such a large block, it may be eligible for a “blockage discount,” if Mildred’s block is so large that if it were sold all at once, it would depress the price.  If her 1,000,000 share block is greater than 2 weeks worth of trading volume, it should probably get the discount; but we would need an expert opinion to be certain, and to calculate the size of the discount.  No matter what, we start with the fair market value (FMV) of the property.

 

            Thus, the value of the gift to Shane is 100% of the transfer, valued at FMV (less any blockage discount) on the date the gift was completed.  Mildred will not get any annual exclusion for this transfer because it is a remainder—a future interest.  To get the annual exclusion, the gift has to be of a present interest.  If the total value is greater than the $1 million unified gift tax exclusion, or if she had given gifts in the past that, together with this gift, exceed that exclusion, then Mildred will owe gift tax.  Either way, she must file a gift tax return to facilitate record-keeping of the exclusion and previous gifts.  No other gift tax issues appear to be raised by these facts.

 

Estate Tax Consequences

 

            When Mildred dies in August 2010, the estate tax comes into play.  First, we must determine what property is included in her gross estate (GE).  § 2033 includes in her GE all property in which she had an interest at the time of death.  This includes anything of value that she had an interest in.  If she owned homes or cars, those certainly are included in her GE under § 2033.  The trust property is not included in her GE under § 2033 but may be included under the IRC’s “string provisions,” despite the fact that she had made a completed transfer of the property prior to her death.  First, § 2035(b) applies here to include in Mildred’s GE an amount equal to the gift tax paid on any completed (gift) transfers made within 3 years of death.  Because Mildred’s completed gift to Shane was made in June 2008, just over 2 years before her death, the gift tax Mildred paid on that transfer should be included in her GE.

 

            Next, § 2036 applies because Mildred retained “beneficial interests” in the trust property for a term of years that did not end before her death.  Her income interest was a beneficial interest because she retained the possession or enjoyment of the property under § 2036(a)(1); and § 2036 applies even when the grantor did not have a life estate but instead had a retained interest of a term of years, if that term did not end before the grantor’s death.  Therefore, under § 2036, the entire value of the transferred property must be included in Mildred’s GE. 

 

            Other string provisions (like § 2037, 2038, 2035(a), etc.) do not necessarily apply under these facts, and even if they did, they would be duplicative because § 2036 already applies to include the full value of the transferred property in Mildred’s GE.

 

            The property in the gross estate is normally valued at the moment of death under § 2031, unless the personal representative chooses the § 2032 alternate valuation.  Under § 2031 valuation, the value of the property is the FMV at the moment of death.  Publicly traded stock is valued by averaging the high and low trading prices of the stock on the day of death, adjusted for any blockage discount (as discussed above under the Gift Tax Consequences).  Other property such as bonds, etc. may be valued by their FMV market prices or by the income/cash flow method or by the balance sheet/asset approach to valuation.  Income-producing property is often better to value under the income approach.  If, however, the value of Mildred’s GE is decreasing, then the § 2032 alternate valuation may be appropriate (if the value of the GE is decreasing and if alternate valuation will decrease the overall estate tax imposed).  If the alternate valuation election is made, then the property is valued at its actual date-of-disposition value; or if it is not disposed of within 6 months of Mildred’s death, then it is valued at 6 months after death. 

 

            Several deductions will likely be allowed to Mildred’s GE.  Administrative expenses necessary for administering the estate are deductible under § 2053, as are claims against the estate.  The defamation claim against her is likely deductible in the amount eventually settled for and paid.  To be deductible, administrative expenses must be actually and necessarily incurred.  The attorneys fees likely would be deductible, the broker’s commissions in selling off her real estate probably are not, because the real estate likely could have just been distributed to heirs instead. If Mildred had any unpaid recourse mortgages against property in the estate, those would also be deductible.   State estate taxes are also deductible under § 2058.

 

Finally, the estate tax would be actually computed by finding the tentative tax (her GE – deductions, multiplied by the applicable § 2001 (c) tax rate based on the size of the estate.  Then, we would subtract out Mildred’s lifetime gift tax payable, resulting in a tentative estate tax figure.  The unified estate tax credit ($2 million in 2008, or $780,000 tax exemption amount) is then applied to that tentative estate tax figure.  If the tentative estate tax amount is less than the unified credit, no estate tax is due; if it is more, then estate tax is due in the amount of the excess.  No other issues appear to be presented by these facts.