Estate & Gift Tax
Bogdanski
Fall 2010

Sample Answers to Question 2

Exam No. 6993

Doris

 

Gift Tax — Family Trust

 

            The trust is a completed gift and will be taxable at the time of creation to D. Although D retained the ability (via directing the trustee) to accumulate income for up to 10 years (until A, the income beneficiary, reaches 35), it would still be paid out to A eventually. Under Reg. 25.2511-2(b), this power to change timing does not render the gift incomplete. This is notably different than § 2036, however, and will affect the calculations at that point.

 

            Because the gift is complete, it will need to be valued. It will probably come to something less than 40% of the $100,000,000 corpus. D will argue vigorously for various discounts. She will begin by noting that Rev. Rul. 93-12 states that interests are valued without regard to family attribution or other factors like that — instead, it is a purely hypothetical buyer and seller. Thus D can claim a minority discount, as B owns a majority 60% share of the trust. Additionally there is an argument for blockage, under the theory that selling off 40% of the trust all at once would negatively affect the price. There may also be an argument for lack of marketability, depending on the type of business Corp. is. The facts note that only that it is a “closely held operating company”, indicating that it should probably go for something less than publicly traded shares of similar companies. There is always a premium paid for the ability to get your investment in and out of a company quickly.

 

            After the valuation battle is over, D will be taxed on the transfer. If D has not used her unified credit (the gift portion), she could and probably should do so now. She will also attempt to take an annual exclusion for the gift. Corp. historically pays annual dividends, which means there should be a present interest for A, unlike in Hackl. However, the IRS will counter that D’s retained power to accumulate A’s income makes it too contingent to be a present interest. They will likely win on this argument, as this appears to fall under the terms of Reg. 25.2503-3(a).

 

            D made no other gifts during her lifetime. Her failure to exercise her power to accumulate income is not an gift (indeed, that gift was already taxed).

 

Estate Tax — Family Trust

 

            The entire Family Trust will be pulled back into D’s gross estate upon her death due to § 2036(a).  Although this section appears to only apply when the decedent retains possession or enjoyment, or the ability to designate who does get possession or enjoyment, the courts have ruled that this includes the right to designate when someone gets possession or enjoyment. Although it may seem counterintuitive, D’s ability to accumulate A’s income (even though it would be paid out in 10 years, at the most), falls under this. Because D retained this power for her entire life, § 2036 will be triggered and will drag the entire trust corpus at the time of her death back into her estate. Once again, the fact that D never exercised this power is irrelevant to the application of § 2036.

 

            The same valuation battle that took place before will need to take place again, with the same arguments being made over the 40% interest, although more is at stake now given the value of the Corp. stock doubling (§ 2036 will value the property at the time of death). An interesting twist here is that the stock value drops immediately after D’s death. The estate may want to consider using the alternate valuation date under § 2032. Under this section, if the estate elects to use it, the entire estate will be valued 6 months after the death of the decedent, instead of at the time of death. Note that this would not apply to any property which depreciates merely due to the passage of time (e.g. annuities or patents), but there is no indication of such property in D’s estate. The election is “all or nothing” — that is, the estate must elect to value everything 6 months after D’s death, including (for reasons stated below) the Charity Trust. Doing so must lower both the gross estate and the estate tax (no basis-only games here). This will be a job for the accountants and the like, as it will have to be determined whether it is beneficial given all the property in the estate. The size of the trust, however, likely will be a deciding factor.

 

Estate Tax — Charity Trust

 

            The entire $8,000,000 trust will be taxed to D’s estate. D clearly attempted to set up a charitable trust, and did, just not sufficient to merit a deduction under § 2055. That section requires that the donation go to a charitable organization, and churches certainly qualify. However, under § 2055(e), interest split in time (such as this one) between the charity and a non-charitable entity, are only deductible if they fit into the limited exceptions laid out. This is clearly not a pooled income trust, as the charity does not have control over the funds on the facts given (although the trustee actually is not named, the decedent would need to specifically set it up this way). This is an attempted charitable remainder trust, with the remainder spilling out to the non-charitable entity (G) after 20 years. This would only work if it were an annuity (CRAT) which paid out a fixed amount each year, or a unitrust (CRUT) which paid out a fixed percentage each year.

 

            Because this trust pays out an income interest each year, none of it will qualify for the charitable deduction. The policy behind this is to prevent games with income producing assets (or lack thereof) — for example, the trustee here may invest in all growth, non-income producing property, resulting in little or no actual money going to the charity for those 20 years, despite an attempted deduction taken based on actuary tables. To prevent this, Congress created the strict limitations of § 2055(e), none of which D’s trust falls into.

 

Generation Skipping Transfer Tax

 

            There is only one possible skip person here: Gary. G is a lineal descendant of D’s grandparent under § 2513 and § 2651, and is more than one generation away from D. Since D still has children, and G still has parents, neither of the exceptions of § 2651(e) apply. Neither trust is a skip person, because there are non-skip beneficiaries in it, so there will be no direct skips.

 

            The gift to G in the initial Family Trust is a future interest, so it cannot be a direct skip. Since it will pay out at the termination of the trust, it will be a taxable termination under § 2512(a). This is taxable to the trustee, not the settlor, so D and D’s estate will not pay GST for this transfer.

 

            The gift in the Charity Trust is likewise a taxable termination, and will also be paid by the trustee at the time of termination.

 

            In both cases D was free to assign her GST exemption to the trusts at creation. It is up to the taxpayer to assign the exemption (although there is a default scheme). If it is done in a trust like this, the excluded amount will be the proportional share, or the “exclusion ratio” under § 2631. This is determined by 1 – (GST exemption allocated / total value of property). The property is valued at the time of creation, which allows for significant savings when the trust property appreciates (such as the Corp. stock, which doubled in value). Although both trusts appear to be too large for D to apply her exemption to cover the entire trust (unless some seriously good arguments are made in valuing the Family Trust Corp. shares), it will still pay off when they terminate. Any amount applied now will effectively mean more money distributed to G, as the trustee will pay the tax out of the trust upon its termination to G.

 

Abby

 

            There are no transfer tax consequences for A due to the Family Trust or the income paid out of it. She had no power or control over any of the interests contained in it. Likewise, she is not even involved in the Charity Trust.

           

Gary

 

            Gary will not be liable for any tax consequences. I’m beginning to regret this organization scheme I chose.

 

Shawn

 

            Shawn will be liable for the GST tax when the Family Trust terminates. The GST will be determined as noted above.

 

            I am unsure who the trustee of the Charity Trust is, but if it’s S, she is liable there as well for the taxable termination to G.

 

 

Exam No. 6727

 

Year 1

 

            When D sets up the trust, there is no GST consequences because the trust is not a skip person because not all interests are held by skip people or no one holds an interest and at no time may a distribution be made to a non-skip person.  The income gift to her daughter will be complete at the time the trust is set up.  A gift is not considered incomplete just because the donor reserves the power to change the manner or time of the enjoyment of the gift.  D can direct the trustee to retain all or part of the income but Abby will still get it eventually.  SO the income gift will be complete and the gift will be value at the time the trust is set up using the actuarial tables.  Because the trustee has the power under the direction of D to hold back income this makes the gift a future interest so there will be no annual exclusion.  Because the gift is an income interest, D will have show that income is actually distributed.  There is evidence that the Corp has issued dividends so this shouldn’t be problem.  Doris could argue for a minority discount for the stock.   The gift to Gary would be complete at the time the trust is created.  Because it is a future interest it will not qualify for the annual exclusion.  D can use the Unified credit if she has any left towards the gifts in trust. 

 

Year 5

 

            D dies in year 5.  Any gift tax paid by her in the last three years will be brought back into her estate.  Because D retained the right to retain income in the trust it will be considered a string for 2036 and as a retained power to alter the interest under 2038.  2036 would include the whole value of the trust in the gross estate whereas 2038 will only include the income interest.  Because 2036 is the larger inclusion that code section will apply.  It does not matter that D never actually exercised the power.  2036 will apply even if the power is never exercised, there only needs to be a possibility that it could have bee.  The value of the trust is 200 million when D dies, the date of death value is the default value for the value of assets.  However, because the value of the stock drops shortly after D’s death, the estate should elect to use the alternate valuation date.  This can only be used if it lowers the gross estate and the estate tax.  Because the whole value of trust is included in the estate, this will most likely be the case. 

 

            Normally charitable bequests are allowed an unlimited deduction.  The transfer must be directly to the charity or in trust for the charity.  The charity must be an eligible one under 2055 and 2522.  The IRS is fairly lenient so I am sure that Chapel will qualify.  The charity trust in the will is a split interest transfer, meaning that one interest is charitable and the other is not.   Under 2055, if a charitable interest is also subject to an interest that is not charitable, there is no deduction unless the remainder interest is a charitable remainder annuity trust, charitable unitrust, or a pooled income fund.  To be an annuity trust one beneficiary must get a fixed amount or fixed percentage of the FMV of the trust corpus at the time it was created, not less than 5% annually.  It can be either a lead or remainder trust.  This trust is not one of these.  To be a unitrust, the income beneficiary is entitled to receive an annual payment equal to a specified percentage of the trust corpus valued annually and not less than 5%.  It can be a lead or remainder trust.  This trust is not one of these.  To be a pooled income fund usually a trust or fund is maintained by a charitable organization to which donors transfer property.  This is not one of these.  There is no way for the IRS to guarantee that Chapel will ever actually get any income.  So D will not get a charitable deduction for the trust.  The estate will have to pay estate tax on the full value of the trust.  When the trust terminates in 20 years and is distributed to Gary, this will be a taxable termination because Gary is a skip person.  Gary is a skip person because he is a lineal descendent that is two or more generations below D.  Gary’s mother is still alive so the orphan rule will not apply.  The GST will be valued at the time of termination so when the trust terminates and the base of the tax will be the value of all the property in the trust minus a deduction for administration expenses.  The trustee of the trust must pay the tax.  The tax is treated as an estate tax on the intermediate generation so there is a tax on the tax. The estate can choose to allocate the GST exemption of 3.5$ towards this taxable termination if there is any left after the family trust terminates.  When the allocation happens it will lock in the value of that asset.  Depending on how much it chooses to allocate will determine how much tax will be paid.  If they don’t choose to allocate the Code will do it for them with allocations going to direct skips first and then to trusts in the order created.   The applicable rate for the GST will be maximum federal rate at the time times the inclusion ration.  The inclusion ratio is 1- applicable fraction.  The applicable fraction is GST exemption allocated to the trust / value of the property transferred.

  

D’s estate will be able to use any deductions for administration expenses, funeral expenses, unpaid mortgages or claims against the estate.  It will also be able to use any unified credit that is left over.   When calculating the estate tax the taxable gift that was paid at the time the property was gifted will not go into the adjusted taxable gifts because the property was included in the estate.  This prevents D from being taxed twice. 

 

Year 16

 

            When the family trust terminates the distribution of stock to Gary will be another taxable termination for the GST in which the trustee (Shawn) will have to pay tax on.  The base of the tax will be 40% of the 300 million of the stock in Corp minus deductions for admin expenses.  There would be marketability discount and a lack of control discount that could apply.  There is no set discount so it would depend on the facts.  The estate can choose to allocate the GST exemption of 3.5$ towards this taxable termination.  Depending on how much it chooses to allocate will determine how much tax will be paid.  If they don’t choose to allocate the Code will do it for them with allocations going to direct skips first and then to trusts in the order created.   The applicable rate for the GST will be maximum federal rate at the time times the inclusion ration.  The inclusion ratio is 1- applicable fraction.  The applicable fraction is GST exemption allocated to the trust / value of the property transferred. 

 

 

Exam No. 6776

 

Year 1

D sets up irrevocable trust, income to daughter Abby for 15 years, remainder to D’s grandson Gary. Trustee is Shawn- who has the power to accumulate income but must eventually distribute accumulated income to Abby upon Abby reaching age 40. Doris can compel Shawn to accumulate income during this time.

Shawn does not have a general power of appointment since she can only accumulate income for a limited time, this is not exercised in favor of herself/her estate / her creditors/ her estate’s creditors. This is a specific power of appointment. The power to accumulate income (turning the hose on / off) by itself does not defeat the completeness of a gift. Doris’ power to compel Shawn to do this also does not defeat the completeness of the gifts to Abby (income interest) and Gary (remainder interest). However, this power does mean that Abby’s income interest is not a “present” interest. Gary’s remainder interest is a future interest. D. has retained a “string” over the trust (has not relinquished all “dominion and control.”) Doris’ decision (and Shawn’s decision) to NOT accumulate income is NOT treated as a “lapse” of those powers. Thus, because the gifts are “complete” but not “present,” D must pay gift tax but cannot apply her annual exclusion / $13K.

D. will have to pay gift tax immediately on the value of the first 10 years of Abby’s income interest (using the present value of future earning projections of the corpus) and may not allocate any annual gift exclusion to that amount (but D. can use her available unified credit / $1M so may avoid paying actual tax but must still file). D. CAN allocate annual gift exclusion (+ any unified credit remaining) to the remaining 5 years of income interest, since upon Shawn’s termination of withholding powers Abby’s income interest becomes a “present” interest.

Doris has made a completed gift to Gary, however, this is a future interest (a remainder interest) and she will thus have to pay gift tax immediately (or use annual $13K exclusion / remaining unified credit). The remainder interest is valued using the 15 year term of the trust and present value of that estimated amount.

The trust is funded with 40% of stock in Corp. Since the Corp. pays a dividend each year, it is “productive property” and Abby’s present interest to the income won’t be scrutinized (possibly knocking it into a “future interest” category per Maryland / Hackl). Since this is a closely held company, it is tricky to establish the value of this 40% interest (no market comparisons as with publicly traded stock). The base starting point at the valuation of the trust upon transfer is $1M x 40%. However, this $400,000 may be reduced by valuation discounts: lack of marketability discount (since closely held company / who would want to buy in and for how much?), and also minority discount since 40% is not a controlling share of the company. It does not matter that the other shareholder is D’s brother- for purposes of valuation, there is no “family attribution” (the hypothetical willing buyer / willing seller are presumed strangers) per Rev. Rul 93-12. Thus- D. owes gift tax (minus annual exclusions, etc.) for Abby’s present interest based on some computation of the term of income’s present value. The Service may be suspicious of this valuation (and any discounts) and may challenge the gift amount.

No GST tax in Year 1.

Gary, as Doris’ grandson, is a “skip person”: he is a natural person, lineal descendant of D’s grandparents, and two generations lower than Doris. The trust itself is not a skip person, so its set-up does not trigger GST tax immediately. It looms until the trust terminates at year 16 and a taxable termination is made to Gary (see below). Doris can, however, choose to allocate her $3.5 GST exemption to Gary’s remainder interest now. This is generally a smart thing to do, especially since the trust corpus is stock and has 16 years to appreciate, and upon allocation the value of the property is “locked in.” If Doris does not allocate now, her estate can allocate later (but again, only locking in the property value at point of allocation).

Year 5

Doris dies. Any gift tax paid on account of gifts made by D. in the last three years will be pulled back into D’s gross estate. 2035. Because she died with a Sec. 2036 “string” (the power to compel Shawn to accumulate income meddles with Abby’s right to the present income), with no ascertainable standard to exclude the string, the entire value of the trust might be dragged back into Doris’ gross estate. However, mere accumulation of the income might be considered an “administrative” power- akin to a fiduciary duty or management of the trust. If so, Doris’ string does not trigger Sec. 2038 / Sec. 2036 inclusion of the full value of the trust into her gross estate. If the Service finds this was not akin to an administrative power, the value of the 40% share of $200,000,000 (minus minority / lack of marketability discounts) will be dragged back into Doris’ gross estate. Given the drop in the stock market, Doris’ estate would likely want to elect Alternative Valuation per 2032 and wait for valuation 6 months after Doris’ death. Likewise, if she didn’t already do so, Doris’ estate may want to WAIT to allocate her GST exemption until it feels that the market has bottomed out.

Because the Charity trust is a time-divided interest (income to Chapel for 20 years, remainder to grandson Gary), the testamentary trust set up for benefit of Chapel will only qualify as a charitable donation (and thus be exempt from inclusion in D’s gross estate) if it is a proper charitable remainder annuity trust, unitrust, or pooled income trust. It does not meet such requirements here; Gary might elect to make a “qualified disclaimer” per 2518 of his remainder interest (within 9 months of D’s death, in writing). If so, D’s estate can take the deduction (which will probably benefit Gary in the end).

Year 16

Termination of the trust triggers a “taxable termination” for GST Tax purposes on top of a gift to Gary. The base of the GST tax is the valuation of the interest upon termination. Sec. 2612. If D. allocated any of her $3.5M GST exemption, it will be factored into the GST tax due per 45% x inclusion ratio of (1- GST exemption over value of property at transfer.) Again, similar valuation problems here for what the value of 40% of the closely held stock is (minus valuation deductions, etc.). The trustee (Shawn) must pay the tax on this amount, and the value is not reduced by the GST tax paid (tax inclusive).