Estate & Gift Tax
Bogdanski
Fall 2010

Sample Answers to Question 1

Exam No. 6072

There are no GST consequences present.

Year 1 Trust

When Hollis transfers the stock to the trust he is making a gift. A gift occurs when property is transferred for less than full and adequate consideration in money or money’s worth. The gift is complete because H no longer has dominion and control over the stock as to change its disposition either for himself or another. The value of the gift will based on its fair market value at the time the gift is complete. FMV is the price at which the property would change hands between a willing buyer and a willing seller, neither under any compulsion to buy and all have the relevant facts. Because the stock is a publically traded the valuation based on its market value will be absolutely controlling. Here the value of the stock is 1.5 million. H will have to pay GT at the time the trust is created. H will be able to use his annual exlusion towards the GT on the stock for both the income interest to W and S because they are both present interests. The code allows gifts, other than gifts of future interests, made to nay person by the donor in a year, the first 13K are ignored. H and W can also choose to split the gift to Sandy and use a double annual exclusion. Because they are income interests, H will have to prove the trust will receive income, that some portion of the income will flow steadily to W and S and the portion of the income flowing to W and S is ascertainable. Here the stock is publically traded so this shouldn’t be a problem. To value the income interest, H will have to use the actuarial tables put out by Congress to value Sandy’s remainder interest and subtract that from the trust corpus. The remainder interest to Sandy is a future interest so it will not qualify for the annual exclusion. There is also a Gift tax marital deduction which allows a deduction for the full value of gifts to a spouse but only to the extent that this property is not treated as a nondecutible terminable interest. A terminable interest is only where the property passes both to the spouse and to a third person, the spouse’s interest will terminate upon the laps of time or contingency and the third person will enjoy the property on the termination without paying full and adequate consideration. H has given spouse a life interest which qualifies a terminable interest. The only way for H to get the marital deduction would be if he elects to treat it as a QTIP. If the election is made when W dies or when W gives it to someone else it will be treated as if W gave the entire property or the entire trust corpus will be in W’s estate. If H makes the election the interest to W will be tax free under the marital deduction as long as the marriage was valid under state law. If not, then H can only use the annual exclusion towards the gift to W. The power of appt that H gave to W is a special power because W can’t appt to herself, her estate or creditors of either. There are no estate tax consequences for a special power or for letting a special power lapse. Also there are no gift tax consequences if she chooses to exercise the power. H will be able to use his GT unified credit towards whatever is left over after the annual exclusions on the present interest and towards the remainder interest to Sandy.

Lilco

When H forms Lilco, and transfers an interest to Sandy, he is making a gift because the transfer is complete because he has no dominion and control. A gift occurs when the property is transferred for less than full and adequate consideration. Sandy did pay H 10K for the interest so the gift will be whatever is the excess in value of the interest over 10K. It is possible to pay partial consideration and have that taken out of the gift. The value of the gift will be the time the gift is complete, the transfer. It will be valued using either the cost, market, or income methods. H will be able to use Minority discount because he is transferring a non-controlling interest. However the IRS will probably challenge the discount on the grounds that H has kept a 2036 string. H and W continue to use the residence and under 2036 retention of the use or enjoyment of property requires inclusion in H’s estate. It won’t matter that Sandy is a family member, the discount is calculated as if between strangers. Also when valuing the gift the anti abuse rule under 2703 will apply meaning the value of the stock will determined without regard to the restriction on the rights to sell because the transaction is between family members. This wouldn’t apply if it was a bona fide business arrangement, which it isn’t or if it wasn’t a device to get the property to members of H’s family, which it is. So the stock will be valued without the restriction on the sale and the value would be the value of the stock at the time of transfer. H will be able to use annual exclusion that he didn’t use for the trust transfer to Sandy towards the gift or if split with W any left over from the double exclusion left over and any portion of the UC that is left over.

Life Insurance

The value of the gross estate includes any amount received by the executor on a life insurance policy and any amount that the insured holds any incident of ownership over. When H first has the policy, if he can change the beneficiaries then the gift is not complete. If he can’t change the beneficiary then the gift is complete to Sandy. Because Sandy changes the ben later, I will assume that H could too so when the policy is taken out, that is an incomplete gift and no tax at that time. When he assigns the policy to Sandy this is a completed gift to Sandy and the value will be computed at the time of transfer. Because it is a term policy on a healthy person and the premiums are still being paid the policy probably isn’t worth much. As H gets older or ill, it will be worth more. In valuing a policy from the case law, Ryerson says if the policy was issued recently, the value is most likely what H paid for it. If the policy is older you have to look at all attributes of the policy. The regs say you must use the interpolated terminal reserve value while Ryerson says to use the replacement cost. Because the policy is fairly fresh and we don’t look at how long the person actually lives the gift value will be what H paid for the policy. Because it is a new year, he will get a fresh annual exclusion of 13K to use towards the gift or a double exclusion from H and W of 26K. Making the ben. of the policy the owner is the most option for tax purposes. After H assigns the policy, he is making a gift of a present interest every time he pays a premium for Sandy. He can take the annual or double exclusion for this as well as long as there is some left over. He can also use whatever Unified Credit he has left over from the Year 1 and Year 2. Because Sandy can change the beneficiary of the policy it is not a completed gift even when she changes it to Curt. When H dies, this will complete the give and the value of the gift will be the value at H’s death, which is the full proceeds of the policy. Sandy will have to pay gift tax at this time. She can use her annual exclusion towards this gift or her unified credit. She should have kept herself as the beneficiary to avoid the gift tax.

Hollis Dies

When H dies the value of the gross estate will be the FMV of everything owned on the date of death – any deductions. Or the estate can use the alternate valuation date with is 6 months after the date of death but it must be used for all of H’s assets. When H dies, this will complete Sandy’s gift of the life insurance as mentioned above. Because H did not hold any incidents of ownership over the policy at his death 2042 will not include it in his estate. However because he transferred the incidents of ownership within the last three years of his death 2035 will include it in his estate. Under 2033, the ownership interest in Lilco will be in his estate and he will not get a minority discount. His estate could argue for a lack of marketability discount because there is no ready market. As mentioned above, when H dies the life insurance gift to Curt by Sandy will be complete and she will have to pay GT on the full proceeds of the policy which she can put the gift tax annual exclusion towards and any portion of the unified credit. H will get a marital deduction for all the assets he left to W. W will have 9 months to disclaim the property if she so chooses, which might be a good idea if there is any unified credit left over. Beachacre will also be included in the estate because H held a 2036 string over it by retaining the use and enjoyment of it without paying rent. When calculating his estate tax the taxable gift that was paid at the time the property was gifted will not go into his adjusted taxable gifts because the property was included in his estate. This prevents him from being taxed twice. He will only be taxed on the appreciation. Any gift tax paid by H in year 1,2, or 3 on any gift made by H or W will be pulled back into the estate under 2035. W holds a special POA over the trust corpus and transfers that to Sandy. The exercise of a special POA is not a gift unless it is to create a new power, discharge a legal obligation, or if the trustee alos has an interest. Because Wren is also an income interest holder in the trust, this would be an exception to exercising a special power is not a gift. She is also not limited by an ascertainable standard so she would be considered giving a gift because when she terminates the trust she no longer gets income. W will have to pay gift tax on the value of the income that she is no longer getting because of the termination. It would be a gift of a present interest because she is just speeding up S’s interest in the income so she will get the annual exclusion for this.

Exam No. 6776

No GST tax implications, since there are no “skip persons” involved in any transactions.

Note: any use of “Wendy” means “Wren” (I don’t know why I started doing that)

Year 1

H sets up irrevocable trust, retains no powers. This constitutes a “completed” gift of both income and remainder interests (a transfer of property into the trust, in which H. has given up all “dominion and control” and H. can’t change the subsequent disposition per Reg. 25.2511(2)(b).

The trust grants Wren (as wife) a terminable interest per Sec. 2056(b) since she and Sandy share the income, and Sandy gets the remainder interest upon Wren’s death. This is a “completed” gift to Wren of 1/2 of the income interest, a completed gift to Sandy of 1/2 the income interest. The remainder interest to Sandy is also a “completed” gift.

Wren has an unlimited specific power of appointment in this trust. She can appoint corpus to Sandy or Sandy’s estate. Normally, the gifts and estate tax ignores specific powers of appointment. However, since Wendy is also an income beneficiary, her power to invade is considered relinquishing her own property, and thus every time she invades she will be making a “gift” to Sandy / Sandy’s estate.

Because Wren has this power to invade, neither her nor Sandy’s income interests are “present interests.” A present interest is an “unrestricted right to the immediate use, possession, or enjoyment of the property or income from the property “ per Reg. 25.2503(b). Wendy could presumably invade the entire corpus at once. Sandy’s remainder interest is a “future interest.”

Thus- Hollis may not use any of his annual gift exclusion ($13K/year/person), nor could he combine with Wren to make split gifts ($26K instead of $13K) of the income interests. Unless Hollis had unified credit / $1M lifetime gifts to spare (or combined $2M with Wren if so elected), he will need to pay gift tax on the completed 1/2 income interest gift to Sandy (based on the estimated present value of $750K of the stock), and also gift tax on Sandy’s remainder interest (based on federal actuarial tables of life expectancy of Wren for the present value of the remainder interest). These are publicly traded stocks, so the valuation baseline is the average market value of the securities on the date of transfer. But, If Hollis’ estate elects to treat this trust as a QTIP trust, his unlimited marital deduction applies and he will not have to report any gift tax for Wren’s 1/2 income interest. This trust qualifies as a QTIP trust because, while Wren’s interest is a terminable interest, she has a right to 50% of the interest income for life, no one can take that away from her, and Hollis controls who gets the remainder interest. If this trust does not qualify as a QTIP (I’m not sure if Wren’s own power to invade corpus destroys that) then Hollis will be making an additional gift to Wren of her 1/2 income interest.

Upon Hollis’ death, the entire value of the trust will be deducted from his gross estate, and will be included in Wren’s gross estate upon her death.

Hollis also sets up an FLLC (Family Limited Liability Co.) in year 1. The Service scrutinizes FLLCs as potential tax avoidance vehicles (and transfers of property between family members are presumed gifts). Hollis transfers the only property in the FLLC, Beachacre. This is a vacation home, and even though the FLLC does not have a specific business purpose, the investment accrual value of a Hawaiian home should be sufficient to find this FLLC valid (Biz Purpose Doctrine). Hollis transfers a 10% non-managing membership interest to Sandy, for which Sandy pays $10,000. This may or may not be be “adequate and full consideration in money or money’s worth” per Sec. 2512(b) for this 10% interest. If the 10% interest is worth more, the difference is a completed gift to Sandy. Valuation of this 10% interest will be tricky. Since the interest is non-managing, the share may qualify for a minority discount (20% or so likely). While there is a restriction on liquidation of shares, under Sec. 2704(b) this may or may not qualify for an additional valuation discount. The liquidation restriction is among family members, who control the company, but- if no one has power to remove the liquidation restriction, it may be ok as an additional deduction. Assume that Hollis does not pay any gift tax in Year 1 for the interest transfer to Sandy.

Year 2

Hollis makes a gift of the life insurance proceeds (valued at $3M) to Sandy in year 2 by naming him the policy beneficiary. This gift is probably not “complete” until Hollis assigns the policy ownership to Sandy (if Hollis could have changed the beneficiary prior to that). Hollis will owe gift tax on the $3M assignment. At this point, Hollis has transferred all “incidents of ownership” to Sandy per Sec. 2042 (Hollis’ continued payments of the premiums do no qualify as an “incident of ownership”).

Year 3

Sandy changes the beneficiary to his cousin Curt. If Sandy is not able to change the beneficiary again, this is a “completed” gift, and he will owe gift tax on $3M (which he can apply a $13K annual exclusion, and if he has unified lifetime gift credit use that as well). However, if Sandy continues to maintain “incidents of ownership” in the ability to change the beneficiary, the gift is not “completed” and he does not have to pay gift tax yet.

Year 4

Hollis dies. $3M of the insurance proceeds are paid to Curt- this definitely “completes” the gift if it wasn’t already in Year 3 and Sandy will owe gift tax on the $3M (w/ annual excl, etc. if available, see above). However- the entire value of the proceeds will be pulled back into Hollis’ gross estate per Sec. 2035, since Hollis cut his “incidents of ownership” within three years of his death. Sec. 2035 also pulls back into Hollis’ gross estate the value of all gift tax paid on gifts transferred by Hollis within 3 years of his death.

Provided that Hollis’ other assets are not “terminable interests,” Hollis’ estate should be able to use the unlimited marital deduction to exclude the value of these assets. As such, Hollis’ 90% share in the FLLC should pass to Wren with no gift or estate tax implications. However- if the Service finds that Sandy only paid “partial consideration” for his 10% share (less that “adequate & full...”), then the difference of: FLLC value at date of Hollis’ death - Sandy’s $10K payment will be dragged back into Hollis’ gross estate. Likewise, if the service finds that the FLLC was a sham (in particular since Hollis continued to use the vacation property and Sandy never did), then it may drag the entire value of the FLLC back into Hollis’ gross estate per Sec. 2036 (and “Substance over Form” doctrine).

When Wren appoints the entire corpus of the trust to Sandy, she is making a completed gift to Sandy of $2M (valued at the date of transfer). Since Hollis is dead (and the Code treats marital status as your status at the end of the tax year) Wendy will not be able to use the split gift annual deduction. She can apply max. $13K / annual exclusion to this gift, and use any remaining unified credit (also singular, $1M).

If the $3M value of the life insurance proceeds are the only assets in Hollis’ gross estate (defined as the value of Hollis’ property interests held at death per 2033), his estate will not need to file an estate tax return and thus can not elect to use Alternative Valuation in determining the value of the estate per 2032. However, if the Service pulls in the FLLC value into Hollis’ gross estate, his estate might opt for the Alternate Valuation / 6 mo. (especially if home property values are dropping). This election applies to all “included” property (what H. had at date of death).

Exam No. 6015

The trust that H set up in yr 1, was a completed gift when the trust was set up, since H parted with dominion and control as to leave him no power to change its disposition § 25.2511-2(b). Since the gift is complete, H must pay gift tax. The value of the trust will be subject to gift tax, valued on the date of gift. However, since H did give ½ of the income stream to his wife, W, he could take a marital deduction under § 2523 for the value of her life estate in the trust, which can be calculated from the actuarial tables as prescribed by § 7520, if H took a QTIP election and the trust could be a QTIP. In this case, interest given to the wife is a terminable interest, however, W’s income stream from the trust does not qualify for a QTIP, because she does not have all the income from the trust during her life. Therefore H cannot take a marital deduction for the value of W’s interest in the trust. However, since both W and S have a present interest in the trust due to their income interest, H is able to take an annual deduction of $13,000 for each of them. H can also choose to use any or all of his unified credit of $1,000,000 if he hasn’t used it up in the past to offset the gift tax the trust is subject to.

The LLC that H formed in yr 1 might be a gift to S if 10% of Beachacre (BA) was worth more than the $10,000 S paid for 10% of the LLC. If 10% of BA was worth $10,000, then there is no gift from H. If 10% of BA was worth more than $10,000, then S did not pay full and adequate consideration for their share, and H has made a gift to S. There would be gift tax at time of the transfer since the gift of the LLC interest is complete, the gift tax base would be the value of S’ 10% share less his $10,000 contribution.

In yr 2 when H purchased the life insurance policy on his life, and makes S the beneficiary of the policy, there is an incomplete gift since H still has the ownership interest and can change the beneficiary. However, a few months later when H assigns the ownership interest to S, then there is a completed gift to S subject to gift tax. The gift tax base is the value of the replacement cost of the policy or the interpolated terminal reserve (basically the present value of the policy) that can be requested from the insurer. Also, since H will be making annual payments of the premium, there is a completed gift every time H makes a payment. H’s payment of the life insurance premium is considered a gift of a present interest in property, and thus is eligible for an annual exclusion. Here since we are in yr 2, H has another annual exclusion and can use it to offset the gift tax here, in fact since H is married, they can elect under § 2513, that the gift be considered as made ½ by H and ½ by W. Thus, they would be able to take a $26,000 annual exclusion, therefore the $15,000 annual premiums being paid will also be covered under the annual exclusion. Otherwise, since the premium exceeds the $13,000 annual exclusion, H would have to pay gift tax on $2,000 every year he made a gift of the premium by paying it.

In yr 3, when S changes the beneficiary on the policy to C, there is no completed gift since S still retains the power to change the beneficiary.

In yr 4 when H dies, S’ ability to change the beneficiary is extinguished and S has made a completed gift to C at the time of H’s death. Unfortunately, S is now responsible for gift tax on the $3,000,000 face value of the life insurance policy.

H’s estate will also have to include his 90% interest in the LLC that he formed in yr 1 under § 2033, and . There might be a § 2036 issue here since it looks like H retained enjoyment of the property in excess of his 90% since S never went to the BA. In this case, § 2036 would require the full value of BA at date of H’s death (or 6 months out if they elect the alternate valuation date) into H’s gross estate. Additionally, since there are limitations over the LLC interest that restrict liquidity, H’s estate might argue for a discount. However, § 2703 prevents the restriction on the right to sell from affecting the value. Unfortunately, 2035 will pull back the value of the life insurance because H transferred it less than 3 years before his death. H’s estate will also have to include any gift taxes paid in the last three years in his gross estate under § 2035. The trust was a completed gift in yr 1, and it does not look like there are any strings that H kept for it to be put back into his gross estate at death. Since H’s will left everything to his wife W outright with no terminable interest, then H should be able to take a marital deduction of his estate tax for property given to W. However, since H did not take advantage of his unified credit by using the marital deduction, W can choose to disclaim some of H’s bequest to her, to use up the unified credit. W would just have to do this in writing and make sure that the writing was received within 9 months of H’s death, prior to receiving any interests or benefits from the property being disclaimed, and the property passes without direction of W.

W’s exercise of her special power of appointment to appoint the entire corpus of the trust to S in yr 4 is not a taxable event, because W did not have a general power of appointment for it to be included in her gross estate or be subject to gift tax. No GST issues here, because no skip persons.