This examination consists of three essay questions, each of which will be given equal weight in determining grades. Three hours will be permitted for this examination. At the end of the three hours, these questions and your answers to them will be collected. All answers must be entered in the bluebooks you have been provided (or, for those typing or operating computers, on separate sheets of plain white paper). No credit will be given for anything written on this set of questions.

Pay close attention to the final portion, or "call," of each question. Failure to respond to the matters called for will result in a low score for the question. On the other hand, discussion of matters outside the scope of the call of the question will not receive credit.

Be sure to explain as thoroughly as possible your answers to the questions posed. Your reasoning, discussion and analysis are often as important as any particular conclusion you reach.

The suggested time limit for each question is one hour. Experience has shown that failure to budget one's time according to this limit can result in a drastic lowering of one's overall grade on this examination.

References to "the Code" mean the Internal Revenue Code of 1986, as amended. For purposes of this examination, assume that at all times, the interest rate described in section 7520(a) of the Code is 8.0 percent per annum. Unless otherwise expressly instructed, assume that all individuals described in the questions are U.S. citizens and U.S. residents.
 
 

Derek is a single man, age 60, with two children: Art, age 35, and Barb, age 37. On December 2, 1996, Derek establishes an irrevocable trust, to which he transfers $1,000,000 cash. The trustee is a bank. Derek retains no power to replace the trustee, and the trust prohibits Derek himself from ever serving as the trustee.

Under the terms of the trust, its income is to be distributed annually, one half to Art and one half to Barb, for the life of Derek. On Derek's death, the trust is to terminate, and the corpus is to be distributed one half to Art's son, Mike, age 15, or Mike's estate; and the other half to Barb's daughter, Nancy, age 16, or Nancy's estate.

The trust instrument gives the trustee the power, for the first 10 years of the trust's operation, to pay all of the income to Barb (rather than half to her and half to Art) if the trustee "finds it necessary for Barb's well-being, comfort, or happiness." In order to exercise this power, the trustee must obtain permission from Derek. In fact, the trustee never exercises the power, and it expires, in accordance with its terms, on December 2, 2006.

The trust documents also give Nancy the right to withdraw $50,000 in cash from the trust immediately upon its establishment. Nancy and Barb are informed of this right by a phone call from the trustee on December 2, 1996. Nancy decides not to withdraw the funds, and her right to do so expires, in accordance with its terms, on December 12, 1996.

In 2005, Derek and Barb buy a parcel of real estate, Blackacre. They take title as equal tenants in common. Of the $500,000 purchase price, Derek contributes $300,000 in cash and Barb contributes $200,000 in cash. Part of Barb's contribution consists of income from the trust Derek established.

Derek dies in 2007 at age 71. On the date of his death, Blackacre has a fair market value of $750,000. Under the terms of Derek's will, Derek's half-interest in Blackacre passes to Art. The trust corpus is worth $2,000,000, and it is distributed half to Mike and half to Nancy.

What are the federal gift, estate, and generation-skipping-transfer tax consequences -- to Derek, Derek's estate, Art, Barb, Mike, Nancy, and the trustee -- of each of the transactions and events just discussed, with and without all available tax elections? Be sure to discuss the amount and timing of each item.

Explain.

Margaret, a single, self-employed caterer, has a son, Sergio. On July 1, 1996, Margaret lends Sergio $200,000 pursuant to a legally binding loan agreement. The loan is repayable on demand; however, Sergio's obligation to repay by its terms bears no interest.

Margaret dies on June 30, 1997. At the time of her death, Margaret is the trustee of a sizeable trust established by her late brother, Billy. Under the terms of the trust, Margaret had the power, up until the time of her death, to appoint the corpus of the trust to her own creditors. So long as Billy was alive, Margaret could exercise the power only with Billy's consent; after Billy's death, she was free to exercise the power unilaterally. Billy died on September 1, 1994. When Margaret dies nearly three years later, her power of appointment expires; by its terms, it cannot be exercised by her will.

Margaret's will forgives the loan that she made to Sergio. At the time of Margaret's death, Sergio had not repaid any of the principal on the loan.

Margaret's probate estate includes the following assets: her principal residence; a household full of personal effects; several parcels of commercial real estate, which Margaret has rented out on long-term leases; and equipment that she used in her catering business. All of Margaret's assets pass to Sergio, who promptly puts them up for sale. The catering business is discontinued.

Answer each of the following questions:

A. Assuming that the "applicable Federal rate" under section 1274(d) of the Code is 8.0 percent per annum, what are the federal gift, estate and generation-skipping-transfer tax consequences to Margaret and her estate of each of the transactions and events just discussed, with and without all available tax elections? Be sure to discuss the amount and timing of each item.

B. Which methods are likely to be used to value the assets in Margaret's estate for federal estate tax purposes?

Discuss.

Hubert and Wendy, husband and wife, have been married to each other since 1991. They have no children.

In 1996, at age 60, Hubert sets up Trust No. 1 -- an irrevocable trust with a bank trustee. Funded with publicly traded stock worth $1,000,000, Trust No. 1 provides that all of the income from the trust is to be paid to Hubert for life. On Hubert's death, the trust is to terminate and the corpus is to be paid to his nephew, Nick, or Nick's estate.

Also in 1996, Hubert takes out a whole-life life insurance policy on his own life, naming Nick as the sole beneficiary. The face amount of the policy is $1,000,000. Hubert pays a single premium of $700,000 for it. A few weeks after he buys the policy, Hubert transfers ownership of it to Nick; at the time of this transfer, the policy's cash surrender value is $650,000. Thereafter, Hubert retains no right to borrow against the policy, withdraw its cash value, add or change beneficiaries, or otherwise affect its enjoyment.

In 1997, at age 61, Hubert sets up Trust No. 2, another irrevocable trust with a bank trustee. Funded with an interest-bearing investment account worth $2,000,000, Trust No. 2 provides that all of the income from the trust is to be paid to Wendy for her life. On the date the trust is established, Wendy is 60 years old.

Under Trust No. 2, all income received by the trust in any given calendar year is to be paid to Wendy on January 15 of the immediately following calendar year. On Wendy's death, the trust is to terminate and the corpus is to be paid to Nick or Nick's estate. On Wendy's death, any income earned since the immediately preceding January 1 shall also be distributed to Nick or Nick's estate.

Hubert dies unexpectedly in 1998. The corpus of Trust No. 1 has a value of $1,200,000 on the date of his death. The insurance company pays the $1,000,000 face amount of the policy to the beneficiary, Nick.

Wendy dies in 2005. The corpus of Trust No. 2 has a value of $1,800,000 on the date of her death.

What are the federal gift, estate and generation-skipping-transfer tax consequences -- to Hubert, Hubert's estate, Wendy, and Wendy's estate -- of each of the transactions and events just discussed, with and without all available tax elections? Be sure to discuss the amount and timing of each item.

Discuss.