Estate & Gift
Tax
Bogdanski
Fall 2012
Sample Answers to Question 3
Exam No. 3947
There's no GST issue in this problem because there are no skip persons.
NOTE: Unified credit exclusion amount is indexed for inflation up to $5,120,000, but this problem seems to be written as though it's still $5 million, so I'm going with that. But there's be extra floating around if this is some sort of trick...
Under §2010(c), there is portability between spouses of remaining unified credit. So after X died in 2012, J would have $1 million in unified credit left (his own $5 million is gone, but X's remaining $1 million can be added to J's, IF HE ELECTS). The election would require filing an estate tax return, even if one is not otherwise required. So in 2013 when he remarries, T has zero and J has $1 million in unified credit.
T and J enter into a prenuptial agreement. The valuation of the stock would be made with the market approach, which is mandated in the Regs. for §2031 since they are publicly traded. If the value fluctuated on the date on the gift, it would be the average of the high and low on that day. From the facts given, it's $2,000,000. Generally, a gift is the amount by which the FMV of the property transferred is greater than any consideration received by the transferor. The issue then becomes whether the release of marital rights to J's property in the future if they ever (or, realistically, when) they get divorced is consideration. This is answered firmly "no" by Reg. §25.2512-8. A prenuptial agreement transfer is a gift for federal gift tax purposes. A consideration not reducible to a value in money or money's worth, as promise of marriage, etc. is "wholly disregarded" and the entire value of the property transferred constitutes the amount of the gift. This is also said in Estate of Copley. So this is a gift. If this had been made after the marriage, it would have been reduced by the unlimited marital deduction. Unfortunately for them, they made the transfer before the wedding. Under §2523, the spouses must be married at the time of the transfer. Therefore, this is just a gift. It is completed because J has given up dominion and control, so it's a gift of $2,000,000 in 2013 (or whenever the actual transferred happened). This can be reduced by the annual exclusion in §2503(b), but only by $13k. The rest will be subject to gift tax. Assuming his death is within three years of this (hard to tell from the dates given), this gift tax will be included in his gross estate under §2035(b).
The holding company was likely valued using the asset/balance sheet income approach. The appraiser likely looked at the company as a container with individual assets in it and rather trying to figure out the future income of the whole operation, it was likely valued by looking at the individual FMVs of each of the assets, and then adding that up and subtracting out liabilities and debt. This would have to be discounted back to present value. The assets in the "box" would still have to be valued using some method, possible the capitalization approach if it holds other businesses, or a market or cost approach if it has stock or equipment.
For a gift to be complete, the donor must give up dominion and control. This has not happened with this trust. J has the power to change the amounts that S and T can take, plus he has the power to revoke. So this give is not complete. Even though control over just timing is still considered a complete gift, here he can control not only timing, but also the disposition of the money. Reg. §25.2511-2(d). Therefore, there aren't gift tax consequences when this is initially funded. However, the right to withdraw the $8k is probably a "Crummey" power, where the possibility of possession/withdraw is equal to the immediate possession and enjoyment of the property. This will also a present interest annual exclusion, assuming the IRS considers this to be a meaningful opportunity to exercise the power. Therefore, J can take two $8k annual exclusions. As each distribution is made, J will be entitled to take an annual exclusion up to $13k for each person who receives the money. Once it's actually distributed, that portion of the gift is considered complete.
This would not count for §2503(c) creation of a present interest due to it being a transfer to minor. We don't know how old the kids are, but we know they're under 25. §2503(c) creates a present interest in property and is used as an alternative to Crummey trusts. However, the amount not distributed must pass to the kids when they reach 21, not 25.
The trust would get added back into J's gross estate under §2036. §2036 requires inclusion of property in the decedent's estate of property that was transferred but that the decedent retained an interest in. There is a three-part test that must be met. The decedent must have transferred property, while retaining a prescribed interest, for a prescribed period of time. He transferred property when he set up the trust. He retained a prescribed interest because he could designate who shall receive the income because he could say which son and in what amount would get income from the trust. He had this power presumably up until his death, although the fact pattern doesn't quite specify this. The amount included would be the extent of the interest held by J at the time of death. So here, it would be the value of the trust on the date on J's death. Because the grantor is the trustee, under §2036(a)(2), the retained power to choose among beneficiaries, even if only exercisable in capacity of trustee, will usually trigger inclusion. There may also be inclusion under §2038. Under §2038, there's inclusion if the transferor retains power to revoke or materially change a wealth transfer, then the transferor still has sufficient control over the property such that it is fair to say that he still "owns" it at death. §2038(a)(1) requires inclusion of the interest to be included in the gross estate if, at decedent's death, enjoyment of interest was subject to power held by decedent to alter, amend, revoke, or terminate. Here, J had the power to revoke the trust completely. However, because Sam had a substantially adverse interest to the revocation, this may not be met here. This is the case if there's a general power of appointment, but it's not expressly stated for §2038.
The promissory note is a below market gift loan under §7872. There are two transfers created: imputed amount is transferred from lender to borrower, interest payment is imputed passing from borrower to lender. The basic result is that the gift amount will equal the amount of unpaid interest. First, we must determine if it's a gift or demand loan under §7872(e)(1). The facts specify that this is a demand loan, meaning it is payable in full at any time if J demands. Demand loans qualify as below market loans if the interest rate is less than the applicable federal rate: §7872(e)(1)(A). Here, that is the case because the interest rate is zero but the applicable federal rate is 2% a year. §7872 applies to "gift loans," which is any loan where foregoing interest is in the nature of gift. This doesn't qualify for the $10k de minimis exception. For gift demand loans, the gift tax consequences are that that transfer from J to S is the amount of foregone interest: §7872(a)(1). Time of transfer occurs on the last day of the year. The foregone interest calculated using the applicable rate. So here, it'd be $20k/year. So every year that this gift demand loan exists, J is treated as making a $20k gift to S. This can be offset by the $13k annual exclusion, resulting in $7k gift, assuming there aren't other gifts that are using up the exclusion. Further, husband and wife can elect to "split gifts." So if they make this election, during J's life they could count $26k as excluded, which would mean the $20k/year foregone interest to S would be written off. Any gift tax paid in the three years prior to death will be added back into his gross estate under §2035(b) (if they don't make the gift splitting election, for example.)
The bequests to his wife are subject to the unlimited marital deduction, so his estate won't pay any gift tax on transfers to his wife. The rest in his gross estate will be taxable, assuming he really did use up the remaining $1 million unified credit he brought with him into the marriage. It's a shame that the trust will be included in his estate because it was only worth $3 million when it was established. But because it's included in his gross estate (discussed above), the full amount will be included in his gross estate, off set for any gift tax already paid on it. His estate will also be able to deduct administrative expenses, funeral expenses, claims against the estate, certain debts, possibly mortgages, etc.
Exam No. 3271
No GST tax b/c there are no skip ppl in this problem.
2012, DSUE
J is married to X when she dies. Her unified credit is portable btwn spouses. 2010(c)(2)(B). J gets to take X's DSUE equal to 1.12mil. J gets to use it even if he's remarried, so long as his second spouse is alive.
2013, Prenup
When the donor parts w/ dominion and control as to leave him no power to change its disposition, the gift is complete. 25.2511-1(b). When J made a binding agrmt to give 2mil in stock to T, he made a completed gift. J became legally bound to make the gift when he made the agmt. But since it's a prenup, the obligation is not triggered until T and J are married. Therefore, J could have taken a marital deduction to offset the entire gift once the two are married. 2523. However, J might have messed up his marital deduction. He gave her the stock before the wedding. If they were not legally married at the time of the transfer, J probably can't take a marital deduction for the gift and owes gift tax on the gift of 2mil = 700k. J could use his DSUE unified credit against this transfer so his gift tax due = 2mil - 1.12mil = 880k x .35 = 308k.
The fact that T releases legal claims against J doesn't make the transfer not a gift. Therefore, T's release has no impact on J's gift tax burden.
2014, Trust
J set up a trust for his sons.
The income interest is not a present gift at this time. J has the power to choose how much S or T will get, not subject to an ascertainable standard. Therefore, the income interest is undetermined, and not present. 25.2503(c) Example 3. Therefore, J can't take an annual exclusion for this gift and cannot split the gift w/ T to get two annual exclusions. However, every time the trust actually pays S or T, that's a completed gift of a present interest of the amount paid to each. J can take an annual exclusion against each years' transfer. If J and T choose to split gifts, J and T can each take an annual exclusion of the amounts paid to S and T, doubling their potential exclusion amount.
Furthermore, J has reserved the right to move the hose. Under 2036(a)(2), the entire trust is includible in J's GE when he dies in 2016 b/c J retained some enjoyment from the income interest. Therefore, when J dies in 2016 and still has this power, J must include in his GE the 4mil FMV of the trust corpus. I assume that J still has the power to move the hose since the trust is not terminated before his death.
When the younger one turns 25, they trust corpus is distributed. This trust doesn't qualify as a present interest under 2503(c) since the beneficiaries can't get the $ at 21.
The remainder is not a present interest, thus not subject to 2503(b) annual exclusions. Also, there would be no benefit in gift splitting due to the lack of annual exclusions. 2513.
If J has a legal obligation to support S and T, then the amount of the trust going to S and T during this obligation is not a gift; instead, it's a retained interest by J and also triggers 2036. 20.2036-1(b)(2).
J has reserved the right to revoke the trust w/ S's permission. J has retained the right to alter the remainder interest. When J dies in 2016, the entire remainder of the trust goes back into J's estate, 2038. 2038 doesn't care who's permission you have to get to change the interest. However, the corpus is already included under 2036, so 2038 is redundant here.
In contrast, for gift tax purposes, the gift of the remainder is complete as to half of the remainder and all of the income interest. S is an adverse party as to half the remainder and potentially all of the income interest. J has to get S's permission to revoke the trust. Since J has to get S's permission, the gift is partially complete. 25.2511-2(c).
J owes gift tax on the setup of the trust up to the amount that S's adverse interest makes the gift complete. J can use his DSUE from X to offset his gift tax due if he has any left after the transfer to T.
2014, Crummey power
J gave S and T the right to w/draw 8k cash w/in 30 days of funding the trust. J can take an annual exclusions for S and T's interest, so long as he told S and T about the right. If the beneficiary has the power to demand $ for a limited time, then that interest is enough to transform the gift of the right to w/draw into a present interest and subject to an annual exclusion. Therefore, J can take a 16k exclusion from his gift tax due. However, when S and T let the power lapse, it's a lapse of a GPOA. 2514. That's taxable pro rata to each interest holder. Lapse of powers are subject to a de minimus exception equal to 5k or 5% of the corpus of the trust. Since the trust is worth 3 mil, 5% of 3 mil is 150k, well above 8k. Therefore, the lapse of power is ignored. 2514(e).
There is one snag w/ the Crummey power: since the trust is partially revocable, J might not be able to take the annual exclusion as to T's right to w/draw. Most Crummey trusts are irrevocable. If the trust were revocable, then the right to w/draw would never be a present interest b/c it could be wiped out at any time by the grantor. Here, S must give permission, so S's right to w/draw probably meets the Crummey requirements. However, T doesn't have the same power as S, so his 8k right to w/draw might not meet the Crummey requirements.
2015, Loan to S
J loaned S 1mil in exchange for a note. Since J and S both expect to have the note repaid in full, this is not a gift to S. However, lending $ for free is a gift of the value of the interest, 7872. The amount of the gift is equal to the amount of federal interest minus the amount of interest paid. Since this is a demand loan, the gift of interest amount will be calculated as a gift each year. In 2015 and 2016, the federal interest amount is 2% and S paid 0 interest. Therefore, in each year, J made a gift to S of 20k (1mil x 2%). J can split this gift with T to use two annual exclusions against this gift and wipe out the gift tax amount due. J has no unified credit left.
2016, J dies
J left 2mil cash and S's note to T. All transfers to spouses are subject to the marital deduction. 2056. Therefore, all transfers to T are completely offset. The note isn't a terminable interest since no one else gets the value of the note after T. But so long as T has the note, she's making annual gifts to S determined by the contemporary effective federal rate.
All left to S and T is subject to estate tax. See how I handled the trust corpus w/ 2036 above.
Any gift tax J paid in the past three years goes back into J's GE. 2035(b). This includes the gift tax on the transfer to T in 2013 (if it's w/in 3 years and not subject to the marital deduction), the setup of the trust for S and T in 2014, and any gift tax on the interest to S in 2015 and 2016.
J's estate can choose an alternate valuation date of 6 months after DOD, 2032, if the date will produce a lower estate tax due and the depreciation is not due to the mere lapse of time.
Exam No. 3286
To simplify calculations, I'm assuming a unified credit of $5 mil instead of $5,120,000 (b/c I don't know how to use the darn calculator in softest or even where the thing is).
1. Xaviera Death.
When Xaviera dies, because she didn't use any of her unified credit during life and only used $4 mil of it at death, under 2010(c), Jim can get the benefit of the portability option with respect to the remaining $1 mil left over. Jim, in effect, gets the DSUE which is the lower of the basic exclusion amount of $5,000,000 or the unused exclusion amount of the deceased spouse. In order for Jim to get the use of this, Xaviera's estate must have timely filed its estate tax return and the executor (if it wasn't Jim) needs to have made an election to allow the remaining unified credit of Xaviera to be portable to Jim. This extra $1 mil that Jim gets will work for Jim until his second spouse dies, and then he'll be relegated to whatever leftovers his second spouse has.
2. Marriage to Terri.
When Jim enters into a Prenuptial Agreement with Terri, and promises to transfer stock FMV $2 mil to her in exchange for a release of all claims she may have to his property in the future, this transaction seems fishy. For one thing, is a release of all claims under state law for marital purposes in exchange for $2 mil really adequate consideration? It turns out that it's not adequate and full consideration. Merrill v. Fahs was a case that passed on this issue and that court used Section 2043 of the estate tax to analogize to the gift tax context to arrive at the conclusion that a release of marital rights in exchange for property in the context of a Prenuptial Agreement is NOT adequate consideration. Therefore, we have to analyze this to figure out if it's a gift. First, there was property ($2 mil worth of stock) transferred to Terri (facts say it was transferred) and it was pursuant to a K. Pursuant to Rev. Rul. 84-25, a gift takes place at the time a legally binding obligation is created provided the gift is susceptible of valuation at that time. Because there was a valid and binding K (prenups can be valid and binding), the gift was complete when the K was signed. Further, because the K was signed before the wedding, there's no possibility for Jim to use a marital deduction for this gift. However, Jim can use the annual exclusion for the gift, so the value of the gift will really be at $2 mil minus $13K (there's not a concern here that the stock may not be a gift of a present interest b/c it's publicly traded and publicly traded stock is basically liquid so she could sell it and presently use the cash). Reg. 25.2512-8 provides that if a consideration is not reducible to money or money's worth (promise of marriage isn't), then the entire value of the property transferred constitutes the amount of the gift. Thus, the gift is 1,987,000. Jim can use the $1 mil of unified credit he has left from his first wife's death against this gift, thus paying tax on only $987,000.
3. Trust fbo S and T.
The question here is whether the establishment of the Trust for S and T is a completed gift or not. If S and T are minors and thus Jim has a legal obligation to support them, then the establishment and funding of the trust is not going to be a completed gift. Assuming that they are NOT minors, I will analyze for completed gift.
First, there is property - $100K cash and $2.9 mil of holding company shares. Second, the property is transferred - it is contributed to the trust according to the facts. I note also that there is no consideration - it is a gratuitous transfer to the kids. So, the next issue is whether the gift is complete. A gift is complete when the donor has so parted w/ dominion and control as to leave in him no power to change its disposition. If the donor reserves any power over its disposition, the gift may be wholly incomplete or may be partially complete and partially incomplete. Reg 25.2511-2. The issue here is that Jim has retained the right to revoke the trust, which is a reservation of the power over the disposition of the trust funds. The regs provide that a right to revoke is an incomplete gift (a gift is incomplete in every instance in which a donor reserves the power to revest the beneficial title to the property in himself). Because the right to revoke can only be exercised in connection with Sam, who is a beneficiary of the trust it seems like maybe this saves the gift. However, depending on what kind of trust this is (a two fund trust, or a one fund trust), I think that Jim could technically exercise the right to revoke Tim's portion (and why wouldn't Sam agree to that if it doesn't affect him?), so the gift to Tim may be incomplete. However, because Sam is adverse to the exercise of a right to revoke his portion, then I would argue that it's a completed gift as to Sam. For ease of analysis, I'm going to assume that it is one trust fund. Assuming this, Reg 25.2511-2(e) is on point and states that if the trustor has to get permission from someone who has an adverse interest (who will lose out) if you exercise your power, you are treated as not having the power. Therefore, because Sam has to consent to Jim's right to revoke, then the funding of the trust is a completed gift to S and T. Note the fact that J can reserve the manner or time of enjoyment of the trust property by accumulating income or distributing income doesn't make the gift incomplete (but it will screw with us in the estate tax analysis).
The value of the gift is the value of the property placed into the Trust, so it's a gift of $3 mil total to S and T ($1.5 mil apiece). Normally, the annual exclusion wouldn't apply because the gift is not a gift of a present interest (it would be a gift when S and T got income each year), but on initial funding, J gave the boys a right of withdrawal (Crummey power). Because they have the right to withdraw $8K from the trust for 30 days (which has been determined by the courts to be reasonable), then the funding of the trust is considered a gift of a present interest as to $8K for each of S and T. Therefore, Jim can utilize $8K of the annual exclusion to exclude the first $8K of each boy's $1.5 mil from his gift tax liability. No other deduction appears to apply.
4. Loan to S
When Jim loans S money to start up his business, even though the note is valid and payable in full on demand, because the note bears no interest, then there is a deemed gift of interest from Jim to Sam and a deemed payment of interest from Sam to Jim (so Jim has interest income AND he is liable for gift tax on the deemed interest. 7872(a)(1) provides that there is a below market loan (which can be a loan that is a demand loan w/ interest payable at a rate less than the AFR - here we have a demand loan with interest less than AFR because there is zero interest whatsoever), then the foregone interest is treated as transferred from lender to borrower (as a gift) and then back from borrower to lender (as interest income). So the deemed gift of interest and deemed interest income on this loan will be 2% per year.
5. Jim's Death.
Jim's estate will include the $2 mil cash under 2033. It will also include the promisory note that is assigned to Terri (which will be worth $2 mil plus interest), and any other property he has at his death.
The corpus of the trust ($4 mil) fbo Sam and Tim will be included in Jim's estate and I believe it is included under 2036 because Jim has the right to distribute income in whatever amounts and at whatever times he determines. Further Jim is the trustee himself. Those two powers combined seem to me to be Jim's right to designate who shall receive. 2036 is very sensitive to a Grantor-Trustee having the power to do things with a trust he establishes. Further, Jim retains the power effectively up to his death b/c when he dies he can no longer serve as trustee. Further, his powers aren't limited by an ascertainable standard. Even if 2036 doesn't pick up the corpus of the trust, 2038 will pick up the value of the property where enjoyment is subject to a power of the trustor/grantor to revoke, alter, amend, or terminate. Here, Jim can alter the flow of income, he can revoke with the consent of only one son (this may be enough of an adverse interest so that 2038 wouldn't apply if that were the only power that Jim had), and he is himself the Trustee and there appears to be no ascertainable standard limiting his Trustee duties. However, as I said, I think 2036 is more likely to apply here and include the entire trust corpus in his estate.
He will get to take the marital deduction for the cash to Terri and for the current PV of the note that Terri gets. He won't get a deduction as to property that goes to his boys. He may not actually end up paying tax on the trust corpus b/c the formula for calculating estate taxes will account for taxes he paid on the lifetime gift. He doesn't get the unified credit b/c he used up the rest of the unified credit from Xaviera when he did the prenuptial agreement.
I don't have time to do this but note that he also made gifts within 3 years of his death, so we'd have to analyze whether 2035 is going to pull any of those back in. For sure it will pull back in the gift tax he paid in the 3 years prior to his death (so on the prenup, trust, and loan).