Estate & Gift Tax
Bogdanski
Fall 2014

Sample Answers to Question 1

Exam No. 9856

There may be no gift tax consequences to the $80K and partition to tenancy in common made from David to Xena depending on the date the agreement was made relative to the divorce. § 2516 provides that transfers made pursuant to a divorce agreement when the agreement is entered into within 3 years of the divorce will be considered transfers for full and adequate consideration (and therefore not a gift), if the transfers are for settlement of property rights. It appears from the facts that both the $80K and partition of the originally common property house would be transfers as settlement of property rights such that §2516 applies, but even if that were not the case it is doubtful that any gift tax would be owed under the Harris court decision, since the $80K is pursuant to a divorce decree. The only possible issue under Harris is that the partition may have been done simply by mutual agreement (though more likely by operation of law): it still would probably not be a gift since it was bought as community property (they both own 1/2) and thus a partition is just their fair amount.

The trust created in 2013 implicates both GST and gift tax in the year it is created. For gift tax, the $6 million value (there do not appear to be any marketability issues, since the securities appear to be publicly traded: a blockage discount could potentially be involved) of the trust is a completed gift to Gina since David has sufficiently parted with the dominion over the property (it is irrevocable, he is not a trustee with any powers to change beneficiaries or the amounts going to beneficiaries). Even though David has retained the power to compel payments from the corpus to Gina (thus controlling which beneficiary enjoys the property), this power is exercisable ONLY with the consent of an adverse party -namely the main beneficiary, Gina. Since it is essentially never in Gina's financial interest to agree to this power, the gift is considered fully complete.

Although this gift is in substance a future interest, the trust instrument seems to provide "Crummy Powers" such that Gina could, theoretically, demand $14K from it. Even though she certainly won't do this, the bare legal right is enough to establish a present interest of $14K, and thus an allowance of the $14K exclusion to it. If David has any unified credit he can elect to apply some or all of it to the remaining amount of the gift, but some tax will be owed in either case.

GST tax would be due immediately since the trust would qualify as a "skip person:" everyone with an interest in the trust is at least two generations removed from David and all qualify as lineal descendants. This tax is applied in addition to gift tax. The GST unified credit is in addition to the estate/gift unified credit, and David could apply whatever amount he has left of it to the gift. It should be noted that if David pays the GST tax on this the payment of that tax is also considered a gift subject to tax.

David's death in 2015 triggers an array of unfortunate estate tax consequences. For one, his death occurred within 3 years of the gift of the trust in 2013, such that any gift tax he paid on that transfer gets brought back into the estate under § 2035 (effectively removing the benefit of the tax exclusive base of gift tax). Worse, however, is that David retained an interest in the trust that would trigger §2036(a)(2) inclusion in his gross estate. David retained a right to determine who could enjoy the income from the corpus of the property (in this case Olivia). Unlike the analysis of a completed gift, § 2036 applies even if the power is held in conjunction with another person. Furthermore, he retained the right for a period of time that did not lapse until his death, and thus was considered to be possessed regardless of the fact that the contingency had not occurred. Therefore, the entire value of the income interest in the trust (i.e. the power that David retained) would be pulled back into the estate. It would not be "double taxed" since it would be taken out of the adjustible gifts equation, but the appreciation on the property would be taxed.

Finally, the Blackacre property would also be taxed to David's estate, though likely at a value of less than 1/2 of $1.5 million (i.e. one half the full value of the home, representing one half undivided ownership). The valuation would see a discount because of the lack of control over the property, which makes it less desirable (and thus worth less) to a potential buyer.

It should also be noted that the facts do not indicate who the property is passed to when David dies. If he passed it all to Gina or Olivia, GST would be implicated again. There is no chance for a marital deduction since he is not presently married, and the facts make it clear that he would not have enough unified credit to cover all of the transfers of property (i.e. the earlier trust and the home), such that he would certainly be due for the application of 40% tax rates on some portion of the money (depending in part on the valuation of the home held as tenants in common).

Exam No. 9389

David and Xena's Divorce Settlement:

David will not have any gift or estate tax consequences for the divorce settlement. 26 USC §2516 provides statutory consideration for transfers made pursuant to a divorce. There is a three year safe-harbour for transfers made within that time from a divorce. Although the transfers in this case continue beyond that time period, they will have no problem (under Harris v. Commissioner) showing that the payments are being made pursuant to a divorce settlement. They have a divorce decree which shows that the transfer is being made pursuant to divorce. The transfer is being made pursuant to a court decree. That is not a gift.

Gift Tax for the 2013 Trust:

David will have gift tax due upon creation of the 2013 Irrevocable trust. David has effectively severed his control over the property contained in the trust. The trust is irrevocable, and the beneficiary may only be changed with the consent of a person who has an adverse economic interest. 26 CFR §20.2511-2(e) says that "a donor is considered as himself having a power if it is exercisable by him in conjunction with any person not having a substantial adverse interest in the disposition of the transferred property." In this case, David's power to elect to have income distributed to Olivia is exercisable only in conjunction with Gina, who has an adverse interest, because otherwise she would receive that money. Additionally, there is the fact that the power is contingent upon Olivia's graduation from Business School. This is not something within David's control. There is therefore a completed gift of a future interest in 2013. That future interest is the value of $6 million in 10 years. Depending on the current federal interest rates, David will have gift tax owing of some amount over 6 million, minus his Unified Credit of $5.34 million.

Additionally, he will be able to subtract $14,000 from the gift amount, because he has successfully created a Crummey trust, because Gina has the right to withdraw 14,000 immediately from the trust. This counts as a present interest, and counts for the annual exclusion. It does not appear that Gina has any kind of actual agreement with David not to withdraw the income. Instead, she is merely going along with what she thinks David wants. Courts have been friendly towards this (and even more aggressive) Crummey style giving.

Generation Skipping Tax Due When Trust is Created:

David will have an additional generation skipping tax for the 2013 trust. There is no Orphan exception under these facts. 26 USC §2651(e) provides an exception for cases where the middle generation is dead. However, this only applies where the descendants of the transferor are dead. In this case, David still has a Son, Sonny. Therefore, David will not be able to use the Orphan exception. Indeed, it is unclear whether Gina is even an orphan. We know that her mother Nancy died in 2010, but the status of her father is unclear.

The trust is a "skip person." Under 26 USC §2613(a)(2) all the interests in the trust are held by skip persons. That is, Gina, and Olivia. They are both skip persons because they are descendants of David's Grandfather, and are more than 1 generation removed from David. 26 USC §2613. Gina has a present right to $14,000 of income. This is a generation skipping gift, and unless David uses part of his generation skipping gift credit on this transfer, he will have generation skipping gift tax due on top of the regular gift tax he will owe. The default rule, however, if no election as to exclusion amount is made, is that trusts receive exclusions in the order they are created. Presumably, then, the $14,000 GST will be excluded. If David did pay that GST, then under 26 USC §2515 he would also have to pay gift tax on the GST tax that he paid. This has the effect of accurately mimicking the taxes which would have been paid had the intermediary generation received the gift, and then given it to the skip person.

The bulk of the GST will be due when the taxable distributions are made to Gina in 2023.

David's Death in 2015:

When David dies in 2015, the entire corpus of the trust will be dragged into his gross estate by 26 USC §2036. That section provides that where the grantor retained the right, either alone, or in conjunction with any person, the right to designate the persons who shall possess or enjoy the property or income therefrom, that property will be included in the grantor's gross estate. In this case, David retained the right, which did not end before his death, to designate the persons who shall possess the income from the trust (namely Olivia or Gina). The fact that he needed Gina's permission to exercise this right does not, unlike it did for gift tax purposes, get David out of §2036. As such, his gross estate will include the full $7,200,000, along with his half of Blackacre. Of course, Under §2036, David will get a credit for any gift tax which he paid on the property in 2013. Any untaxed appreciation, however, will, upon his death, be taxed.

The value of Blackacre will be discounted, because of the fact that it is owned as a tenancy in common. This lack of control discount is provided because people do not want to deal with the hassle of owning property as TIC. They may have to go through the legal expense, and headache of splitting the property up.

The amount of the estate tax due will depend upon the gift tax paid originally, which will depend on the federal interest rates used to determine the present value of the future interest given to Gina. Also, the gross estate will depend on the discount given for shared control of Blackacre. The estate would then have to pay a tax of 40% on that amount.

Exam No. 9008

Transfers incident to David and Xena's divorce

First, there is no taxable gift in the conversion of the interest in Blackacre to a tenancy in common because David and Xena already owned undivided one-half interests in the property because they held Blackacre as community property. David's one-half interest in Blackacre is included in his gross estate under § 2033, subject to a valuation discount for the lack of control over the property, given that David shares control over Blackacre with Xena.

The property settlement payments are also not taxable gifts from David to Xena, either under the Harris case or under § 2516. Although the relinquishment of marital rights is not full and adequate consideration under Reg. § 25.2512-8, transfers made pursuant to written property settlements upon divorce are considered to be made for full and adequate consideration and are not taxable gifts. The divorce decree that directs David to pay Xena is presumably a court-ordered division of property that would be considered to be made for full and adequate consideration under the Harris case.

The irrevocable trust

Under § 2036(a)(2), the entire value of the trust is included in David's estate because he transferred the property and retained a string, namely the right to direct the trustee to distribute income to Olivia. This is a retained right to designate income that triggers inclusion of the value of the trust under § 2036(a)(2). For inclusion under § 2036(a)(2), it is immaterial that David's power to direct income to Olivia is contingent on Olivia's completion of business school, an event that is outside David's control. It is also irrelevant that David can only exercise this power in conjunction with Gina, an adverse party who would incur an economic detriment by agreeing to distribute income to Olivia.

For gift tax purposes, however, David has made a completed gift of the trust corpus to Gina because, although David retains the ability to direct income to Olivia, he can only exercise this power with the consent of Gina, who is an adverse party. Under the Camp case, a donor's retained power to distribute income that can only be exercised in conjunction with an adverse party will not preclude the transfer from being treated as a completed gift. David therefore must pay gift tax on the value of the securities transferred into the trust in excess of the unified credit amount. David's estate can receive credit for the gift tax paid on this transfer when the estate computes its estate tax owed.

David may be entitled to exclude $14,000 of the gift to Gina because of the Crummey power that he has bestowed on Gina. The allowability of the deduction depends on whether there was an implied agreement between Gina and David that Gina would not exercise her power, whether Gina was given notice of her withdrawal power, and whether the lapse after 15 days was a reasonable period of time. The lapse of Gina's power has no tax consequences because it is a lapse of a power over less than 5% of the trust corpus and ignored for gift tax purposes under § 2514(e).

David will also owe generation skipping transfer tax on the transfer into the trust because the trust is a skip person under § 2613. At the time of the trust's creation, no one holds a present interest in the trust, but no distributions may be made to non-skip persons because both Olivia and Gina are skip persons. Olivia is a skip person because she is a lineal descendant of David's grandparent, and she is two generations below David. Gina is also a skip person as to David, even though her parent is dead, because she is not a lineal descendant of David and David has surviving lineal descendants on the date of the transfer, see § 2651(e)(2). If David does not elect to allocate any of his GST exemption amount to the trust, then when the trust ends and distributes the income and corpus to Gina in ten years, a taxable termination will occur and the trust will have to pay 40% of the fair market value of the corpus. If David does elect to allocate his GST exemption, he can shield some of the appreciation in value of the trust from the GST tax. Assuming he allocates all of his GST exemption to this transfer, which is $5.34 million in 2014, then on distribution the trust will be subject to a GST tax rate 40% times the inclusion ratio, which is 1 minus 5.34 million divided by 6 million.