Estate Planning Practical Solutions

Publication Date: July 2021

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Estate Planning Practical Solutions

By

Danny C. Santucci

The author is not engaged by this text, any accompanying electronic media, or lecture in the render-ing of legal, tax, accounting, or similar professional services. While the legal, tax, and accounting issues discussed in this material have been reviewed with sources believed to be reliable, concepts discussed can be affected by changes in the law or in the interpretation of such laws since this text was printed. For that reason, the accuracy and completeness of this information and the author's opinions based thereon cannot be guaranteed. In addition, state or local tax laws and procedural rules may have a material impact on the general discussion. As a result, the strategies suggested may not be suitable for every individual. Before taking any action, all references and citations should be checked and updated accordingly.

This publication is designed to provide accurate and authoritative information in regard to the sub-ject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert advice is required, the services of a competent professional person should be sought.

—-From a Declaration of Principles jointly adopted by a committee of the American Bar Association and a Committee of Publishers and Associations.

Copyright July 2021

Danny Santucci

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TABLE OF CONTENTS

CHAPTER 1 - Estate Planning .................................................................. 1-1 Build, Preserve & Distribute ...................................................................................................................... 1-2 Legal Documents ....................................................................................................................................... 1-3 Estate Planning Team ................................................................................................................................ 1-4

Attorney ............................................................................................................................................... 1-5 Accountant ........................................................................................................................................... 1-5 Insurance Agents ................................................................................................................................. 1-6 Financial Planner .................................................................................................................................. 1-6

Estate Administration ................................................................................................................................ 1-6 Probate Court....................................................................................................................................... 1-6 Executor ............................................................................................................................................... 1-7 Internal Revenue Service (IRS) ............................................................................................................. 1-9 Trustee ................................................................................................................................................. 1-9 Family Members .................................................................................................................................. 1-9

Things to Be Done When Death Occurs ........................................................................................ 1-9 Estate Planning Techniques & Devices ...................................................................................................... 1-10

Transfers within Probate ..................................................................................................................... 1-10 Disposition of Property without a Will ......................................................................................... 1-10 Disposition of Property with a Will ............................................................................................... 1-11

Transfers Outside Probate ................................................................................................................... 1-11 Joint Tenancy with Right of Survivorship ...................................................................................... 1-11 Tenancy in Common ..................................................................................................................... 1-12 Retirement Plan & Individual Retirement Accounts ..................................................................... 1-12 Life Insurance ................................................................................................................................ 1-12 Gifts ............................................................................................................................................... 1-12 Payable on Death Accounts (POD) ................................................................................................ 1-12

Transfers Using a Trust ........................................................................................................................ 1-13 Special Planning Tools .......................................................................................................................... 1-13

Spending ....................................................................................................................................... 1-13 Annual Gift Tax Exclusion .............................................................................................................. 1-13 Applicable Exclusion Amount ....................................................................................................... 1-15

Spousal Portability of Unused Exemption Amount ................................................................. 1-15 2010 Special Election .............................................................................................................. 1-16

Unlimited Marital Deduction ........................................................................................................ 1-16 Family Business Deduction - Expired ............................................................................................ 1-16 Installment Payment of Estate Taxes - §6166............................................................................... 1-16 Private Annuities ........................................................................................................................... 1-17

Regs Restrict Private Annuity Tax Benefits ............................................................................. 1-17 Installment Sale to Family Member .............................................................................................. 1-17

Self-Canceling Installment Notes ............................................................................................ 1-17 Irrevocable Life Insurance Trust ................................................................................................... 1-17 Special Valuation of Farms and Businesses - §2032A ................................................................... 1-20 Crummey Trusts ............................................................................................................................ 1-20 Charitable Remainder Trusts ........................................................................................................ 1-20 Minor Trusts ................................................................................................................................. 1-21 Family Limited Partnerships ......................................................................................................... 1-21

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Grantor Retained Income Trusts .................................................................................................. 1-21 Qualified Personal Residence Trusts (QPRTs) ......................................................................... 1-21 Grantor Retained Annuity Trusts (GRATs) .............................................................................. 1-22 Grantor Retained Unitrusts (GRUTs) ....................................................................................... 1-22

Buy-Sell Agreements ..................................................................................................................... 1-22 Estate Planning Facts ................................................................................................................................. 1-22

Family ................................................................................................................................................... 1-22 Property ............................................................................................................................................... 1-23

Domicile ........................................................................................................................................ 1-23 Objectives ............................................................................................................................................ 1-23 Existing Estate Plan .............................................................................................................................. 1-23

CHAPTER 2 - Estate & Gift Taxes ............................................................. 2-1 Federal Estate Tax...................................................................................................................................... 2-1

Changing Legislative Landscape ........................................................................................................... 2-2 Spousal Portability of Unused Exemption Amount - §2010(c)(2) ................................................. 2-3

Persons Subject to Federal Estate Tax ................................................................................................. 2-4 Applicable Exclusion Amount, Basic Computation & Rates ................................................................. 2-4

Progressive or Flat Rate ................................................................................................................ 2-4 2010 Special Election .................................................................................................................... 2-7

State Inheritance Tax ........................................................................................................................... 2-7 State Death Tax Credit Turns into Deduction – §2011 & §2058 ................................................... 2-7

Taxable Estate - §2051 ......................................................................................................................... 2-8 Gross Estate - §2031 ..................................................................................................................... 2-9

Owned Property - §2033 ......................................................................................................... 2-11 Interests Terminating At Death - Life Estates & Joint Tenancies ........................................ 2-11 Interests Created After Death............................................................................................. 2-12 Remainder Interests ........................................................................................................... 2-12

Dower & Curtsey - §2034 ........................................................................................................ 2-13 Community Property Comparison ...................................................................................... 2-13

Gifts within Three Years of Death - §2035 .............................................................................. 2-13 Transfers from Revocable Trusts ........................................................................................ 2-13

Retained Life Interest - §2036 ................................................................................................. 2-14 Retained Voting Rights ....................................................................................................... 2-15

Lifetime Transfers With Reversionary Interests - §2037 ......................................................... 2-15 Revocable Transfers - §2038 ................................................................................................... 2-16 Annuities - §2039 .................................................................................................................... 2-16 Joint Interests - §2040 ............................................................................................................. 2-17

Qualified Joint Interests Between Spouses - §2040(b) ....................................................... 2-17 Powers of Appointment - §2041 ............................................................................................. 2-18

Ascertainable Standard - The Safe Harbor Limitation ........................................................ 2-18 5/5 Power ........................................................................................................................... 2-19

Life Insurance - §2042 ............................................................................................................. 2-19 Incidents of Ownership ....................................................................................................... 2-21 Community Property Issue ................................................................................................. 2-21

Deductions from Gross Estate ...................................................................................................... 2-23 Estate Expenses & Claims - §2053 .......................................................................................... 2-24

Inclusion of Administrative Expenses on Non-Probate Assets ........................................... 2-24 Casualty & Theft Losses during Administration - §2054 ......................................................... 2-24 Charitable Transfers - §2055 (§170 & §2522) ......................................................................... 2-24

Immediate Contributions .................................................................................................... 2-25 Split-Interest Contributions ................................................................................................ 2-25

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Charitable Remainder Trusts .......................................................................................... 2-27 Charitable Lead Trusts .................................................................................................... 2-35

Insurance Related Contributions ........................................................................................ 2-35 Unlimited Marital Deduction - §2056 ..................................................................................... 2-35

Requirements ..................................................................................................................... 2-35 Net Value Rule .................................................................................................................... 2-36 Non-Citizen Spouse ............................................................................................................. 2-36

Qualified Domestic Trust ................................................................................................ 2-38 Gifts to Non-Citizen Spouses .......................................................................................... 2-39

Valuation .............................................................................................................................................. 2-42 IRS Valuation Explanation - §7517 ................................................................................................ 2-42 Alternate Valuation - §2032.......................................................................................................... 2-42 Special Valuation - §2032A ........................................................................................................... 2-42

Estate Tax Return & Payment - §6018 ................................................................................................. 2-43 Installment Payment of Federal Estate Taxes - §6166.................................................................. 2-43

Computation ........................................................................................................................... 2-43 Eligibility & Court Supervision............................................................................................. 2-44

Closely Held Business .............................................................................................................. 2-44 Acceleration of Payment ......................................................................................................... 2-44

Flower Bonds ................................................................................................................................ 2-45 Tax Basis for Estate Assets - §1014 ...................................................................................................... 2-45

Community Property Cost Basis ................................................................................................... 2-46 Basis of Property Under the 2010 Special Election ....................................................................... 2-46

Property to Which the Modified Carryover Basis Rules Apply ................................................ 2-46 Limited Basis Increase for Certain Property ............................................................................ 2-47

GST Tax - §2601 ......................................................................................................................................... 2-48 Predeceased Parent Exception ..................................................................................................... 2-49 Exemption ..................................................................................................................................... 2-50

Allocation ................................................................................................................................ 2-50 Retroactive Allocation ........................................................................................................ 2-52

Gift Taxes - §2501 to §2524 ....................................................................................................................... 2-54 Gift Tax Computation ........................................................................................................................... 2-54 Calculation Steps .................................................................................................................................. 2-54 Applicable Exclusion............................................................................................................................. 2-55 Application ........................................................................................................................................... 2-55

Entity Rule ..................................................................................................................................... 2-55 Valuation .............................................................................................................................................. 2-55

Real Property ................................................................................................................................ 2-56 Stocks & Bonds ............................................................................................................................. 2-56 Annuities, Life Estates, Terms for Years, Remainders, & Reversions ............................................ 2-56

Split Gifts - §2513 ................................................................................................................................. 2-56 Community Property States.......................................................................................................... 2-57

Annual Exclusion .................................................................................................................................. 2-57 Per Donee/Per Year ...................................................................................................................... 2-58 Gifts in Excess of the Annual Exclusion ......................................................................................... 2-58 No Gift Tax .................................................................................................................................... 2-58 Gifts within 3 Years of Death ........................................................................................................ 2-58 Uniform Gifts to Minors Act ......................................................................................................... 2-59 Exception for Minor’s Trusts - §2503(b) & (c) ............................................................................... 2-59

Medical & Tuition Exclusion - §2503(e) ............................................................................................... 2-62 Qualifying Transfers ...................................................................................................................... 2-62

Interest-Free or Below-Market Loans .................................................................................................. 2-62 Gift Tax Marital Deduction ................................................................................................................... 2-62

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Nondeductible Terminable Interests ............................................................................................ 2-62 Gift Tax Charitable Deduction .............................................................................................................. 2-63

Partial Interests ............................................................................................................................. 2-64 Selecting Gift Property ......................................................................................................................... 2-65 Gift Advantages .................................................................................................................................... 2-65 Gift Disadvantages ............................................................................................................................... 2-66 Gift Tax Returns ................................................................................................................................... 2-66 Includibility of Gifts in the Estate ......................................................................................................... 2-66 Shifting Income & Gain ........................................................................................................................ 2-68

Gifts before Sale ........................................................................................................................... 2-68 Transfers into Trust Prior to Sale ............................................................................................ 2-68

Installment Obligations ................................................................................................................. 2-68 Transfer to Obligor at Death ................................................................................................... 2-69 Income in Respect of a Decedent ........................................................................................... 2-69

Reporting of Foreign Gifts - §6039(f) ............................................................................................ 2-70

CHAPTER 3 - Wills & Probate .................................................................. 3-1 What Is A Will? .......................................................................................................................................... 3-1

Provisions & Requirements .................................................................................................................. 3-1 Specific & General Bequests ......................................................................................................... 3-2 Residual Bequests ......................................................................................................................... 3-2 Conditional Bequests .................................................................................................................... 3-2 Executor ........................................................................................................................................ 3-2 Guardian ....................................................................................................................................... 3-3

Types of Wills ....................................................................................................................................... 3-3 Title Implications .................................................................................................................................. 3-4

Individual ...................................................................................................................................... 3-4 Joint Tenancy ................................................................................................................................ 3-5 Tenants in Common ...................................................................................................................... 3-7 Tenants by the Entirety................................................................................................................. 3-7 Community Property .................................................................................................................... 3-7

Tax Basis Advantage ................................................................................................................ 3-7 Untitled Assets .............................................................................................................................. 3-8

Changes to a Will ................................................................................................................................. 3-8 Advantages of a Will .................................................................................................................................. 3-8

Intestate Succession ............................................................................................................................ 3-9 Periodic Review .................................................................................................................................... 3-10 Continuing Business Operations .......................................................................................................... 3-11

Simple Will ................................................................................................................................................. 3-12 Probate ...................................................................................................................................................... 3-13

Advantages .......................................................................................................................................... 3-14 Disadvantages ...................................................................................................................................... 3-14 Probate Avoidance ............................................................................................................................... 3-15

Joint Tenancy ................................................................................................................................ 3-15 Community Property .................................................................................................................... 3-15 Totten Trust Accounts .................................................................................................................. 3-17 Life Insurance & Employee Benefits ............................................................................................. 3-17 Living Trusts .................................................................................................................................. 3-17

CHAPTER 4 - Trusts ................................................................................. 4-1 What is a Trust? ......................................................................................................................................... 4-1

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Why a Trust? .............................................................................................................................................. 4-1 Types of Trusts ........................................................................................................................................... 4-3

Common Elements ............................................................................................................................... 4-3 Revocable Trust ................................................................................................................................... 4-3 Irrevocable Trusts ................................................................................................................................ 4-3 Testamentary Trust .............................................................................................................................. 4-4 Foreign Trusts - §679 ........................................................................................................................... 4-4 Family Trusts ........................................................................................................................................ 4-4 Medicaid Trust ..................................................................................................................................... 4-5 Living Trust ........................................................................................................................................... 4-5

Reversion ...................................................................................................................................... 4-5 Advantages of a Living Trust ......................................................................................................... 4-5 Disadvantages ............................................................................................................................... 4-6 Priority .......................................................................................................................................... 4-6

Pour-Over Will ......................................................................................................................... 4-6 Trust Taxation ............................................................................................................................................ 4-6

Income Tax ........................................................................................................................................... 4-6 Grantor Trusts - §671 to §678 ...................................................................................................... 4-6

Grantor Retained Income Trust .............................................................................................. 4-8 Revocable Trusts Included in Estate - §646 & §2652(b)(1) ........................................................... 4-9

Election for Income Tax Purposes ........................................................................................... 4-9 Irrevocable Trust Taxation ............................................................................................................ 4-10

Throwback Rules ..................................................................................................................... 4-10 Capital Gains ................................................................................................................................. 4-11 Deduction of Estate Planning Expenses ........................................................................................ 4-11 Deductibility of Death Expenses ................................................................................................... 4-11

Gift Tax ................................................................................................................................................. 4-11 Estate Tax ............................................................................................................................................. 4-12

Unlimited Marital Deduction ........................................................................................................ 4-12 Outright to Spouse .................................................................................................................. 4-13 Marital Deduction Trust .......................................................................................................... 4-13 Qualified Terminable Interest Property (QTIP) Trust .............................................................. 4-13

“A-B” Format................................................................................................................................. 4-15 “A-B-C” (QTIP) Format .................................................................................................................. 4-17 Valuation & Tax Basis .................................................................................................................... 4-18 Alternate Valuation....................................................................................................................... 4-20

Fundamental Provisions - Revocable Living Trust ..................................................................................... 4-22 Identification Clause ............................................................................................................................ 4-22 Recital Clause ....................................................................................................................................... 4-22 Property Transfer Clause ..................................................................................................................... 4-22 Income & Principal Clause ................................................................................................................... 4-23 Revocation & Amendment Clause ....................................................................................................... 4-23 Trustee Clause ...................................................................................................................................... 4-23

Trustee’s Acceptance .................................................................................................................... 4-23 Choice of a Trustee ....................................................................................................................... 4-23 Factors for Corporate Trustees ..................................................................................................... 4-23 Factors for Individual Trustees ..................................................................................................... 4-24

Trust Termination Clause ..................................................................................................................... 4-25

CHAPTER 5 - Entities & Title .................................................................... 5-1 Basic Entity Formats .................................................................................................................................. 5-1

Individual & Sole Proprietorship .......................................................................................................... 5-1

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Marital Property ........................................................................................................................... 5-3 Timing & Domicile ................................................................................................................... 5-3

Corporate ............................................................................................................................................. 5-3 Categories of C Corporations ........................................................................................................ 5-4

Personal Holding Company - §541 .......................................................................................... 5-4 Attribution Rules ................................................................................................................. 5-4 Penalty Tax .......................................................................................................................... 5-4

Regular C Corporation ............................................................................................................. 5-4 Corporate Tax Rate ............................................................................................................. 5-4 No Pass Through ................................................................................................................. 5-5 Getting Money Out of the C Corporation ........................................................................... 5-5 Passive Loss Restrictions ..................................................................................................... 5-7 Partnership vs. Corporation ................................................................................................ 5-10

Personal Service Corporation - §269A .................................................................................... 5-10 S Corporation - §1361 ................................................................................................................... 5-10

Minors as Shareholders .......................................................................................................... 5-11 Bequests & Estate Ownership ................................................................................................. 5-12 Trusts as Shareholders ............................................................................................................ 5-12 S Corporation Assets ............................................................................................................... 5-15

Built-In Gains Tax - §1374 ................................................................................................... 5-15 Incorporation of a Farm ................................................................................................................ 5-16

Land Partnership Advantage ................................................................................................... 5-17 Leasebacks .................................................................................................................................... 5-17

Trusts ................................................................................................................................................... 5-18 Title Holding .................................................................................................................................. 5-18 Business Trusts ............................................................................................................................. 5-18

Co-Tenancy .......................................................................................................................................... 5-18 Taxation ........................................................................................................................................ 5-19 Percentage Interests ..................................................................................................................... 5-19 Partition ........................................................................................................................................ 5-20

Partnership .......................................................................................................................................... 5-22 Partnership Taxation ..................................................................................................................... 5-22

Allocation of Income & Deduction .......................................................................................... 5-22 Partnership Recapitalization ......................................................................................................... 5-22

Two Class Format .................................................................................................................... 5-23 Valuation ............................................................................................................................. 5-23

Guaranteed Payment ..................................................................................................... 5-23 Control & Management ...................................................................................................... 5-24 Estate Issues ....................................................................................................................... 5-24

Family Partnerships ...................................................................................................................... 5-24 Estate Savings.......................................................................................................................... 5-25 Income Tax Savings ................................................................................................................. 5-25 Family Partnership Requirements ........................................................................................... 5-25

Recognizing a Partner ......................................................................................................... 5-26 Control ............................................................................................................................ 5-26 Transferability................................................................................................................. 5-26

Donee as a Partner ............................................................................................................. 5-27 Trusts as Partners ............................................................................................................... 5-27 Minor as a Partner .............................................................................................................. 5-27 Purchased Interests ............................................................................................................ 5-28 Capital Interest in the Partnership ...................................................................................... 5-28 Capital as a Material Income-Producing Item .................................................................... 5-29

Source of Capital............................................................................................................. 5-29

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Family Partnerships Not Within §704(e) ............................................................................ 5-29 Real Estate Family Partnerships .......................................................................................... 5-29 Business Family Partnerships .............................................................................................. 5-29 Structuring the Family Partnership ..................................................................................... 5-30

Limited Liability Company .................................................................................................................... 5-30 Outside Basis & Debt Share Advantage ........................................................................................ 5-31

Substantial Economic Effect Rules .......................................................................................... 5-32 Discharge of Indebtedness Income ......................................................................................... 5-32

Suggested Uses ............................................................................................................................. 5-32 Professional Firms ................................................................................................................... 5-32 Joint Ventures ......................................................................................................................... 5-33 Substitute for Family Limited Partnership .............................................................................. 5-33

Retirement Plan ................................................................................................................................... 5-33 Employer Costs ............................................................................................................................. 5-34 Profit-Sharing Plan ........................................................................................................................ 5-36 Money Purchase Pension Plan ...................................................................................................... 5-36 Defined Benefit Pension Plan ....................................................................................................... 5-36

Custodianship ...................................................................................................................................... 5-37 Estate ................................................................................................................................................... 5-37

CHAPTER 6 - Life Insurance, Annuities & Buy-Sell Agreements ............... 6-1 Purpose ...................................................................................................................................................... 6-1 Tax Overview ............................................................................................................................................. 6-3

Income Tax ........................................................................................................................................... 6-3 Transfer for Value Rule ................................................................................................................. 6-3 Employee Death Benefit - §101(b) (Repealed) ............................................................................. 6-4 Premiums ...................................................................................................................................... 6-4 Lifetime Benefits ........................................................................................................................... 6-4

Section 72 ................................................................................................................................ 6-4 Estate Taxes - §2042 & §2035(a) ......................................................................................................... 6-5

Ownership ..................................................................................................................................... 6-6 Gift Taxes ............................................................................................................................................. 6-6

Community Property Gift Danger ................................................................................................. 6-6 Types of Life Insurance .............................................................................................................................. 6-8

Term Insurance .................................................................................................................................... 6-8 Whole Life (Permanent) Insurance ...................................................................................................... 6-8

Straight Life v. Limited Payment ................................................................................................... 6-8 Modified v. Preferred ................................................................................................................... 6-9

Endowment Insurance ......................................................................................................................... 6-9 Universal Life........................................................................................................................................ 6-9

Charges ......................................................................................................................................... 6-9 Premium Payment ........................................................................................................................ 6-9

Variable life .......................................................................................................................................... 6-10 Investment Accounts .................................................................................................................... 6-10 Taxation ........................................................................................................................................ 6-10

Survivor Life ......................................................................................................................................... 6-10 Single Premium Whole Life .................................................................................................................. 6-10 Dividends ............................................................................................................................................. 6-11

Life Insurance Trust ................................................................................................................................... 6-11 Considerations ..................................................................................................................................... 6-12

Annuities .................................................................................................................................................... 6-14 Deferred Annuity ................................................................................................................................. 6-14

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Private Annuity .................................................................................................................................... 6-14 Unsecured Promise ....................................................................................................................... 6-15 Regulations Restrict Private Annuity Income ............................................................................... 6-15

Buy-Sell Agreements .................................................................................................................................. 6-17 Definition ............................................................................................................................................. 6-17

Contractual Format ....................................................................................................................... 6-19 Funding ......................................................................................................................................... 6-19

Life Insurance Funding ............................................................................................................ 6-19 Term vs. Whole Life ............................................................................................................ 6-20 Policy Ownership & Premium Payment .............................................................................. 6-20

Entity & Cross-Purchase Agreements .................................................................................................. 6-20 Tax Consequences - Cross-Purchase Agreements ........................................................................ 6-20

Non-Deductible Premiums ...................................................................................................... 6-20 No Dividend Danger ................................................................................................................ 6-21

Tax Consequences - Entity Purchase Agreements ........................................................................ 6-21 Non-Deductible Premiums ...................................................................................................... 6-21 Dividend Danger - §302........................................................................................................... 6-21 Exception to Dividend Treatment ........................................................................................... 6-22

Constructive Ownership (Attribution) Rules ....................................................................... 6-22 “Estate/Beneficiary” Rule ............................................................................................... 6-22 “Family/Trust/Corporation” Rule ................................................................................... 6-22

No Gain on Sale ............................................................................................................................. 6-24 Estate Tax Valuation ..................................................................................................................... 6-24

Using the Buy-Sell Agreement to Set Value ............................................................................ 6-24 Enforcement of Contract Price ..................................................................................................... 6-25

Purchase Price & Terms ....................................................................................................................... 6-25 Valuation ....................................................................................................................................... 6-25

Community Property ........................................................................................................................... 6-25 Professional Corporations .................................................................................................................... 6-26

Marketability Problems ................................................................................................................ 6-26 Controlled Disposition .................................................................................................................. 6-26

S Corporations ..................................................................................................................................... 6-26 Sole Shareholder Planning ................................................................................................................... 6-26

Complete Liquidations .................................................................................................................. 6-27 Alternative Dispositions .......................................................................................................... 6-27 Use of Life Insurance ............................................................................................................... 6-27 Estate Valuation ...................................................................................................................... 6-27

One-Way Buy-Outs ....................................................................................................................... 6-27

CHAPTER 7 - Special Business Issues ....................................................... 7-1 Business Valuation ..................................................................................................................................... 7-1

Relevant Facts ...................................................................................................................................... 7-2 Revenue Ruling 59-60 .......................................................................................................................... 7-2 Tangible Assets .................................................................................................................................... 7-3

Special Real Estate Election - §2032A ........................................................................................... 7-3 Limitations............................................................................................................................... 7-6 Related Party Cash Lease ........................................................................................................ 7-6

Intangible Assets & Goodwill ............................................................................................................... 7-6 R.R. 68-609 .................................................................................................................................... 7-6

Qualified Family-Owned Businesses - §2057 (Repealed) ..................................................................... 7-7 Deduction Amount ....................................................................................................................... 7-7 Definitions ..................................................................................................................................... 7-8

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Requirements ............................................................................................................................... 7-8 Material Participation ................................................................................................................... 7-9 Determining 50+% of AGE ............................................................................................................ 7-9 Interests Acquired From the Decedent ........................................................................................ 7-9 Recapture...................................................................................................................................... 7-9 Trade or Business Requirement .................................................................................................... 7-10 Sunset Provision ........................................................................................................................... 7-10

Land Subject To Conservation Easement - §2032A(c)(8) ..................................................................... 7-13 Family Member ............................................................................................................................. 7-13 Indirect Ownership of Land .......................................................................................................... 7-13 Qualified Conservation Easement ................................................................................................ 7-13

Qualified Real Property Interest ............................................................................................. 7-13 Qualified Organization ............................................................................................................ 7-14 Conservation Purpose ............................................................................................................. 7-14

No Additional Income Tax Deduction ........................................................................................... 7-14 Valuation Discounts ............................................................................................................................. 7-14

Minority Interests ......................................................................................................................... 7-15 Special Valuation Plus Minority Discount ............................................................................... 7-16

Fractional Interests ....................................................................................................................... 7-16 Lack of Marketability .................................................................................................................... 7-17 Swing Vote Premium .................................................................................................................... 7-17

Buy-Sell Agreements ............................................................................................................................ 7-17 Redemptions Under §303 .......................................................................................................................... 7-18

Requirements ....................................................................................................................................... 7-19 Corporate Accumulation For §303 Redemption .................................................................................. 7-20 Accumulation in Anticipation of Shareholder’s Death ......................................................................... 7-20

Death of a Spouse ...................................................................................................................................... 7-21 Bypass Trust ......................................................................................................................................... 7-21

Lifetime Dispositions ................................................................................................................................. 7-22 Stock Redemptions Under §302 .......................................................................................................... 7-22

Substantially Disproportionate Redemption - 80/50 Rule ............................................................ 7-22 Redemptions Not Essentially Equivalent to a Dividend ................................................................ 7-22 Complete Redemptions ................................................................................................................ 7-23 Constructive Ownership - §318 .................................................................................................... 7-23

Double Attribution .................................................................................................................. 7-23 Stock Attribution in Complete Redemptions .......................................................................... 7-23

Stock Recapitalization .......................................................................................................................... 7-24 Section 306 Taint .......................................................................................................................... 7-25

Deferred Compensation Agreements .................................................................................................. 7-25

CHAPTER 8 - Estate Freeze Rules ............................................................ 8-1 Application ................................................................................................................................................. 8-3 Corporations & Partnerships - §2701 ........................................................................................................ 8-3

Definitions ............................................................................................................................................ 8-3 Member of the Family .................................................................................................................. 8-3 Applicable Family Member ........................................................................................................... 8-3 Applicable Retained Interest ........................................................................................................ 8-5 Control .......................................................................................................................................... 8-8

Exceptions To §2701 ............................................................................................................................ 8-8 Zero Value Rule .................................................................................................................................... 8-10

Qualified Payment Exception to Zero Value Rule ......................................................................... 8-10 Valuation of Qualified Payments - Lowest Value Rule ............................................................ 8-10

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Cumulative but Unpaid Distributions - Compounding Rules .................................................. 8-11 Taxable Events .................................................................................................................... 8-11 Amount of Increase ............................................................................................................ 8-12 Limitation ............................................................................................................................ 8-12

Applicable Percentage .................................................................................................... 8-12 Transfer Tax Adjustment .................................................................................................... 8-13

Election into Qualified Payment Treatment ........................................................................... 8-13 Election Out of Qualified Payment Treatment ........................................................................ 8-13

Minimum Valuation of a Junior Interest ....................................................................................... 8-14 Definitions ............................................................................................................................... 8-14

Junior Equity Interest .......................................................................................................... 8-14 Equity Interest .................................................................................................................... 8-14

Value of Other Rights .................................................................................................................... 8-14 Capital Contributions, Redemptions, & Recapitalizations ................................................................... 8-17 Attribution Rules .................................................................................................................................. 8-18

Corporation ................................................................................................................................... 8-18 Partnership ................................................................................................................................... 8-19 Estate & Trust ............................................................................................................................... 8-19 Siblings & Lineal Descendants ...................................................................................................... 8-20

Transfer Tax Adjustments .................................................................................................................... 8-20 Splitting Retained Interests .................................................................................................................. 8-21 Subtraction Method ............................................................................................................................. 8-21

Three-Step Computation .............................................................................................................. 8-22 Valuation Adjustment ................................................................................................................... 8-23

Transfers of Interests in Trust - §2702 ....................................................................................................... 8-25 Definitions ............................................................................................................................................ 8-25

Applicable Family Member ........................................................................................................... 8-25 Member of the Family .................................................................................................................. 8-25 Transfer in Trust ............................................................................................................................ 8-25 Term Interest ................................................................................................................................ 8-25 Retained ........................................................................................................................................ 8-25

Zero Value Rule .................................................................................................................................... 8-26 Qualified Interest .......................................................................................................................... 8-26

Exceptions to §2702 ............................................................................................................................. 8-27 Incompleted Gift ........................................................................................................................... 8-27

Term Interests ...................................................................................................................................... 8-27 Successive v. Concurrent .............................................................................................................. 8-27 Leasehold ...................................................................................................................................... 8-28

Joint Purchases .................................................................................................................................... 8-28 Term Interests in Tangible Property ............................................................................................. 8-29 Transfers of Interest in Portion of Trust ....................................................................................... 8-30

Buy-Sell Agreements & Options - §2703 ................................................................................................... 8-30 Exceptions to §2703 ............................................................................................................................. 8-30 Arm’s Length Bargain ........................................................................................................................... 8-30 Substantial Modifications .................................................................................................................... 8-31

Exceptions ..................................................................................................................................... 8-31 Lapsing Rights & Restrictions - §2704 ........................................................................................................ 8-31

Definitions ............................................................................................................................................ 8-32 Member of the Family .................................................................................................................. 8-32 Lapse ............................................................................................................................................. 8-32 Voting Right .................................................................................................................................. 8-32 Liquidation Right ........................................................................................................................... 8-32 Control .......................................................................................................................................... 8-33

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Amount of Transfer .............................................................................................................................. 8-33 Restrictions on Liquidations Disregarded ............................................................................................ 8-33 Attribution Rules .................................................................................................................................. 8-34

CHAPTER 9 - Elderly & Disabled Planning ................................................ 9-1 Managing the Estate .................................................................................................................................. 9-1

Joint Tenancy ....................................................................................................................................... 9-1 Conservatorship ................................................................................................................................... 9-2 Durable Power ..................................................................................................................................... 9-2 Revocable Living Trust ......................................................................................................................... 9-3

Catastrophic illness .................................................................................................................................... 9-3 Medicare .............................................................................................................................................. 9-4 Medicaid .............................................................................................................................................. 9-4

Countable Assets .......................................................................................................................... 9-6 Non-Countable Assets .................................................................................................................. 9-6

Personal Residence ................................................................................................................. 9-7 Gifting the Residence - General Rule .................................................................................. 9-7

Exceptions ...................................................................................................................... 9-8 Inaccessible Assets ........................................................................................................................ 9-8

Gifts ......................................................................................................................................... 9-8 Spousal Transfers ................................................................................................................ 9-9 Spousal Allowance .............................................................................................................. 9-9

Medicaid Trusts ....................................................................................................................... 9-10 Limited Trust Exceptions ..................................................................................................... 9-11

Criminalization of Medicaid Asset Transfers ................................................................................ 9-11 Private Insurance ................................................................................................................................. 9-12

Health Care Decisions ................................................................................................................................ 9-12 Supplemental Security Income .................................................................................................................. 9-14

Income ................................................................................................................................................. 9-15 Unearned Income ......................................................................................................................... 9-15 Earned Income .............................................................................................................................. 9-15 Exempt Income ............................................................................................................................. 9-15

Assets ................................................................................................................................................... 9-16 Countable Assets .......................................................................................................................... 9-16 Non-Countable Assets .................................................................................................................. 9-16

Disability Benefits ...................................................................................................................................... 9-16 Blind ..................................................................................................................................................... 9-17 Kidney Disease ..................................................................................................................................... 9-17 AIDS ...................................................................................................................................................... 9-18

CHAPTER 10 - Post-Mortem Planning & Tax Return Requirements ......... 10-1 After Death Planning ................................................................................................................................. 10-1

Alternate Valuation Election ................................................................................................................ 10-1 Special Use Valuation ........................................................................................................................... 10-1 Election to Defer Payment ................................................................................................................... 10-1 Final Medical Expenses ........................................................................................................................ 10-2 Administration Expenses ..................................................................................................................... 10-2 QTIP Election ........................................................................................................................................ 10-2 Disclaimers ........................................................................................................................................... 10-2

Federal Returns ......................................................................................................................................... 10-3 Form 1040 - Decedent’s Income Tax ................................................................................................... 10-3

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Form 1041 - Estate’s Income Tax ......................................................................................................... 10-3 Form 706 - Decedent’s Estate Tax ....................................................................................................... 10-3 Carryover Basis Election & Information Return For 2010 .................................................................... 10-3

Decedent’s Estate Tax - Form 706 ............................................................................................................. 10-4 Filing Requirements ............................................................................................................................. 10-4 Paying the Estate Tax ........................................................................................................................... 10-5

Section 6161 ................................................................................................................................. 10-5 Section 6166 ................................................................................................................................. 10-6 Section 6163 ................................................................................................................................. 10-6

Overview of Form 706 ......................................................................................................................... 10-6 Definitions ..................................................................................................................................... 10-8

Preparing Form 706 ............................................................................................................................. 10-10 Form 706, Part 1, Page 1 - Decedent & Executor ......................................................................... 10-10 Form 706, Part 3, Page 2 - Elections by the Executor ................................................................... 10-10 Form 706, Part 4, Pages 2 & 3 - General Information ................................................................... 10-10 Schedule A, Page 5 - Real Estate ................................................................................................... 10-10 Schedule A-1, Pages 6 thru 9 - Section 2032A Valuation .............................................................. 10-11 Schedule B, Page 10 - Stocks and Bonds ....................................................................................... 10-11 Schedule C, Page 11 - Mortgages, Notes, and Cash ...................................................................... 10-11 Schedule D, Page 12 - Insurance on Decedent’s Life .................................................................... 10-12 Schedule E, Page 13 - Jointly Owned Property ............................................................................. 10-12 Schedule F, Page 14 - Other Miscellaneous Property .................................................................. 10-12 Schedule G, Page 15 - Transfers During Decedent’s Life .............................................................. 10-12 Schedule H, Page 15 - Powers of Appointment ............................................................................ 10-13 Schedule I, Page 16 - Annuities ..................................................................................................... 10-13 Schedule J, Page 17 - Funeral and Administration Expenses ........................................................ 10-13 Schedule K, Page 18 - Debts of Decedent, and Mortgages and Liens ........................................... 10-14 Schedule L, Page 19 - Net Losses During Administration and Expenses Incurred in Administering Property Not Subject to Claims .......................................................................................................................... 10-14 Schedule M, Page 20 - Bequests to Surviving Spouse................................................................... 10-14 Schedule O, Page 21 - Charitable Gifts and Bequests ................................................................... 10-14 Schedule P, Page 22 - Credit for Foreign Death Taxes .................................................................. 10-14 Schedule Q, Page 22 - Credit for Tax on Prior Transfers ............................................................... 10-14 Schedules R & R-1, Pages 23 thru 27 - Generation-Skipping Transfer Tax ................................... 10-15 Old Schedule T Gone - Qualified Family-Owned Business Interest .............................................. 10-15 Schedule U, Page 28 - Qualified Conservation Easement Exclusion ............................................. 10-15 Form 706, Part 5, Page 3 - Recapitulation .................................................................................... 10-15 Form 706, Part 6, Page 4 - Portability of Deceased Spousal Unused Exclusion (DSUE) ................ 10-15 Form 706, Part 2, Page 1 - Tax Computation ................................................................................ 10-15 Schedule PC, Pages 29 - 31 - Protective Claim for Refund ............................................................ 10-16

Discharge from Personal Liability......................................................................................................... 10-16 Estate Income Tax Return - Form 1041 ..................................................................................................... 10-18

Filing Requirements ............................................................................................................................. 10-18 Schedule K-1 ................................................................................................................................. 10-19

Tax Computation .................................................................................................................................. 10-19 Exemption Deduction ................................................................................................................... 10-20 Contributions ................................................................................................................................ 10-20

Statute of Limitations........................................................................................................................... 10-20 Accounting Methods ............................................................................................................................ 10-20 Taxable Year ......................................................................................................................................... 10-20 Double, Split & Solo Deductions .......................................................................................................... 10-20

Decedent’s Final Income Tax Return - Form 1040 ..................................................................................... 10-23 Preceding Year Return ......................................................................................................................... 10-23

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Filing Requirements ............................................................................................................................. 10-23 Refund .......................................................................................................................................... 10-23 Form 1310 ..................................................................................................................................... 10-23 Joint Return with Surviving Spouse .............................................................................................. 10-24

Request for Prompt Assessment.......................................................................................................... 10-24 Included Income .................................................................................................................................. 10-24

Partnership Income ...................................................................................................................... 10-25 S Corporation Income ................................................................................................................... 10-26 Self-Employment Income.............................................................................................................. 10-26 Community Income ...................................................................................................................... 10-26 Interest & Dividend Income .......................................................................................................... 10-26

Exemptions & Deductions .................................................................................................................... 10-27 Medical Expenses ......................................................................................................................... 10-27

Election for Decedent’s Expenses ........................................................................................... 10-27 Making the Election ............................................................................................................ 10-27 AGI Limit ............................................................................................................................. 10-28

Medical Expenses Not Paid By Estate ..................................................................................... 10-28 Insurance Reimbursements .................................................................................................... 10-28

Deduction for Losses..................................................................................................................... 10-28 At-Risk Loss Limits ................................................................................................................... 10-28 Passive Activity Rules .............................................................................................................. 10-29

Gift Tax Return - Form 709 ........................................................................................................................ 10-31 Penalties ............................................................................................................................................... 10-31 Filing ..................................................................................................................................................... 10-31

Extension of Time to File .............................................................................................................. 10-32 Extension of Time to Pay .............................................................................................................. 10-32

Split Gifts .............................................................................................................................................. 10-32 Special Applications & Traps ................................................................................................................ 10-33

Bargain Sales ................................................................................................................................. 10-33 Below Market Loans ..................................................................................................................... 10-33

Exception ................................................................................................................................. 10-34 Net Gifts ........................................................................................................................................ 10-34 Promises to Make a Gift ............................................................................................................... 10-34 Checks ........................................................................................................................................... 10-35 Stock Certificates .......................................................................................................................... 10-35 Promissory Notes .......................................................................................................................... 10-35 Powers of Appointment ................................................................................................................ 10-35

Appendix A - Sample Revocable Living “A-B” Trust Agreement ............... A-1 A. RIGHT TO ADD PROPERTY TO TRUST ........................................................................................ A-2 B. RIGHT TO AMEND OR REVOKE TRUST ...................................................................................... A-2 C. RIGHT TO DIRECT TRUSTEE RE INVESTMENTS, ETC .................................................................. A-3 A. DURING THE JOINT LIFETIMES OF BOTH TRUSTORS. ............................................................... A-3 B. UPON THE DEATH OF EITHER TRUSTOR SURVIVED BY THE OTHER. ......................................... A-3 C. SIMULTANEOUS DEATH OF BOTH TRUSTORS ........................................................................... A-7 D. TERMINATION OF TRUST .......................................................................................................... A-7 E. CONTEST OF TRUST ................................................................................................................... A-7 A. GENERAL POWERS .................................................................................................................... A-9 B. NO PHYSICAL DIVISION REQUIRED ........................................................................................... A-10 C. PAYMENTS TO MINORS OR INCOMPETENTS ............................................................................ A-10 D. ADDITION OF ASSETS TO TRUST ............................................................................................... A-10 E. RETENTION OF ASSETS .............................................................................................................. A-11

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F. TRANSACTIONS WITH ESTATE OF TRUSTOR ............................................................................. A-11 G. LOANS TO TRUST ESTATE ......................................................................................................... A-11 H. ENUMERATION OF POWERS NOT LIMITATION ........................................................................ A-11 I. PURCHASE OF TREASURY BONDS .............................................................................................. A-11 J. POWERS CONSISTENT WITH MARITAL DEDUCTION .................................................................. A-12

Appendix B - Family Limited Partnership Agreement .............................. B-1

Appendix C - Buy & Sell Agreement ........................................................ C-1

Appendix D - Care Documents ................................................................ D-1 GUIDELINES AND DIRECTIVE ......................................................................................................... D-1 GUIDELINES FOR SIGNERS ............................................................................................................ D-1

SUMMARY AND GUIDELINES FOR PHYSICIANS .................................................................................... D-3 INTRODUCTION ............................................................................................................................. D-3 SIGNATURE AND WITNESSES ........................................................................................................ D-4 EFFECT OF A DIRECTIVE ................................................................................................................ D-4 REVOCATION ................................................................................................................................. D-4 OTHER RIGHTS .............................................................................................................................. D-5 PRECAUTIONS ............................................................................................................................... D-5 SUMMARY ..................................................................................................................................... D-5

Recording Requested By: ..................................................................................................................... D-6 When Recorded Return To: ................................................................................................................. D-6 RECORDING REQUESTED BY ................................................................................................................ D-8 AND WHEN RECORDED MAIL TO ......................................................................................................... D-8 WARNING TO PERSON EXECUTING THIS DOCUMENT* ....................................................................... D-8 STATEMENT OF WITNESSES ................................................................................................................. D-12 REQUIREMENTS ................................................................................................................................... D-13 RECORDING REQUESTED BY ................................................................................................................ D-14 AND WHEN RECORDED MAIL TO ......................................................................................................... D-14

Learning Objectives

After reading Chapter 1, participants will be able to:

1. Identify basic estate planning elements recognizing the importance of well-drafted legal documents and specify the key team participants including their roles in the estate plan-ning process.

2. Determine the major steps in the probate process, identify ways to make transfers out-side the probate system including the use of a trust, specify estate tax techniques that save death taxes while retaining maximum control, and identify estate-planning facts.

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CHAPTER 1

Estate Planning

Everyone needs to do estate planning. Whether a person is a business owner or an employee, young or retired, wealthy or poor, people should plan their estate. Even those without assets need to deal with old age, possible conservatorship, health care directives, and funeral arrangements. Estate plan-ning is for everyone.

Since death is uncertain, everyone, young or old, should be ready for the contingency of death at any time. Even with the great advances in modern medicine, not everyone is lucky enough to grow old gracefully. None of us can, with certainty, predict the timing of our deaths. In estate planning, to-morrow may instantly become today.

Estate planning is more than just planning for death. It includes building an estate during a lifetime, then seeing that those assets are protected in an estate that can be passed to the next generation. It allows you the opportunity to control your success both during life and on death.

Thus, estate planning has three economic elements:

(1) Building the estate;

(2) Preserving the estate; and

(3) Distributing the estate.

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Build, Preserve & Distribute

Estate planning is designing a program for effective wealth building, preservation, and disposition of property at the minimum possible tax cost. This process is much more than just planning for death. It is a commitment to yourself and your family.

Estate planning tries to encourage wealth building for everyone. Building an estate throughout life is part of estate planning.

When you start building an estate, you must preserve it at the same time. Preservation is the process of looking at the income and gift tax to minimize the overall tax burden for the total family unit.

Finally, once you have made and preserved an estate, you must determine how to distribute it to your heirs with the least possible death tax cost.

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Legal Documents

For an estate plan to be effective, suitable and proper legal documents must be executed. The im-portance of well drafted legal documents cannot be overemphasized. Poor drafting and improper documentation will destroy any estate plan.

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Legal instruments must be drafted by a competent attorney who knows estate planning techniques. Not all attorneys are qualified for estate planning work. For example, a specialist in real estate may not be knowledgeable on the latest estate planning developments.

Estate planning documents must be periodically reviewed due to tax and legal changes and to ascer-tain whether they continue to express the objectives of the estate owner. Such a review could bring about a modification in the plan that would produce significant benefits to the estate owner, while the neglect of such a review could be very costly.

Estate Planning Team

In estate planning, many professional skills are useful and a team effort will work best. Normally, the professionals most often involved in the estate planning process are:

(1) The attorney,

(2) The accountant,

(3) The insurance agent, and

(4) The financial planner.

There is one goal - the development of a comprehensive plan to accomplish the client’s financial and family objectives. Each member of the team has a job to do.

Estate Planning Team Assignments

Action Qualified Persons

Convincing a person to do estate planning

You (i.e., client or individual)

Spouse\

Attorney

Accountant

Financial Planner

Insurance Agent

Family Members

Friends

Analysis of Assets

Attorney

Accountant

You

Review of Present Plan

Attorney

Accountant

Financial Planner

Insurance Agent

Action Qualified Persons

Tax Analysis

Attorney

Accountant

Insurance Agent

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Liquidity Requirements

Attorney

Accountant

Financial Planner

Insurance Agent

Legal Consequences Attorney

Changes in Estate Plan

You

Attorney

Accountant

Financial Planner

Insurance Agent

Putting Plan into Effect

Attorney

Accountant

Financial Planner

Insurance Agent

Follow Up

You

Attorney

Accountant

Financial Planner

Insurance Agent

Attorney

The attorney should decide whether suggestions, recommendations, and phases in the plan have legal substance and merit. A competent attorney must draft the legal documents that are the frame-work of an effective estate plan. Only a lawyer may legally practice law.

Note: Many people mistakenly believe that the attorney named in the estate planning documents must be used as the estate attorney at death. Even if the estate planning documents name an at-torney, most states deem this only a suggestion and not a requirement. There’s no reason to hire a lawyer if he or she is not the best choice.

Accountant

The accountant should know the financial affairs of the taxpayer, recognize the client’s need for po-tential estate planning1, and be knowledgeable with respect to income and estate tax laws. The ac-countant should also be able to advise on valuation problems and family income needs.

An accountant should file the final income tax return on behalf of the decedent. In addition, the estate will generally require an income tax return, as will any trusts formed under the estate plan. These are important functions for a good accountant.

1 The accountant is often the person on the team who has the responsibility to initiate the estate process.

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Insurance Agents

Insurance agents are great motivators in getting persons involved in the estate planning process and can provide excellent advice and ideas. The agent should have specialized knowledge of the many forms of life insurance and know what various policies can and cannot do.

Financial Planner

The financial planner should be able to advise on investment return, asset management, and cash flow analysis. The financial planner should also know enough about insurance, estate taxes, and law to suggest possible solutions for the client to discuss with his or her accountant and attorney.

Estate Administration

There are other players in the total process of estate planning besides the “estate planning team.” These other participants can include:

(1) The Probate Court,

(2) An executor,

(3) The Internal Revenue Service, and

(4) A trustee.

Probate Court

The probate court is an important participant. It functions to:

(i) Oversee the executor and conserve the decedent’s assets,

(ii) Interpret the will, and

(iii) If there is no will, apply the laws of intestate succession.

The "probate estate" refers to any property subject to the authority of the probate court. Often it is good planning to avoid probate and there are several estate planning devices to do so.

Note: When one dies without a will, this is called dying intestate and the state writes a will for you by statute. Thus, under intestate succession, the probate estate is distributed to heirs based on a statutory distribution scheme.

Intestacy vs. Will

Intestacy Will

No expense of a will Appointment of guardian for mi-nors

No need to think about death Appointment of executor

Expense of a probate proceeding with an administrator

Potential expense of probate with an executor

Potential litigation Allocation of death taxes to heirs

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Assignment of powers to executor to carry on business, sell assets

and make tax decisions

Elimination of bond for executor

Creation and exercise of powers of appointment

Bequests to relatives, heirs, and charities

Establishment of a testamentary trust

Can be used together with a living trust to avoid probate

Executor

An executor (man) or executrix (woman) is designated by the will to manage the assets and liabilities of the decedent. Normally, the executor is the surviving spouse or a close relative.

Being an executor is time consuming and often complex. The job may last from nine months up to several years. The duties of the executor include searching for assets, publishing notices to creditors, filing estate and income tax returns, paying expenses and liabilities, and distributing remaining assets (if any) to the beneficiaries. The executor is only in control of the probate assets.

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Internal Revenue Service (IRS)

Obviously, the Internal Revenue Service is an interested participant. As many as four federal tax re-turns may be required after a person dies:

(1) An income tax return (Form 1040),

(2) An estate tax return (Form 706),

(3) An estate income tax return (Form 1041), and

(4) A gift tax return (Form 709).

Note: The tax departments of your state or local government may also have a role, depending on the inheritance tax laws of your domicile.

Trustee

If a trust has been created during the decedent’s lifetime (called inter vivos) or at death (called tes-tamentary), there will be a trustee named in the trust agreement to carry out the terms of the trust.

Family Members

The most immediate duties arising from the decedent’s death often fall on the shoulders of close family members. They have to deal with the practical and necessary tasks created when a loved one dies.

Things to Be Done When Death Occurs

1. Notify funeral parlor, funeral society, or other institution responsible for removing the body from the hospital.

Note: Request at least 10 death certificates. The funeral directors will usually handle such requests as a part of their duties.

2. Obtain and begin to implement any instructions the decedent left regarding his or her dispo-sition, including anatomical gifts or special funeral instructions.

3. Contact appropriate religious officials and proceed with funeral services or other planned dis-position.

4. Locate the Will, if any, and notify the executor.

Note: This may require access to safe deposit boxes. In many states, the next of kin may legally enter each box in the presence of a bank officer to retrieve legal papers such as wills, trusts, deeds, and burial instructions.

5. The executor should select and/or contact the estate lawyer.

6. Notify the immediate family, close friends, employer, and business colleagues of the death.

Note: When contacting relatives and friends confirm their addresses and telephone numbers.

7. Decide on an appropriate memorial for the decedent and notify acquaintances if flowers are to be omitted.

8. Prepare and deliver obituary to local newspapers, giving time and place of services.

9. Notify concerned persons too far away to attend the funeral.

10. Arrange for care of members of the family.

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Note: This is a particular concern where there are minor children, an elderly spouse, a disabled dependent, or animals.

11. Determine if the decedent’s credit cards should be canceled.

12. Check carefully all death benefits.

13. Promptly check all debts and installment payments.

14. Notify utilities and landlord, if any.

15. Tell the post office where to send mail.

16. Determine the location of decedent’s vehicles and who has access to them.

Note: No one should be permitted to use the decedent’s vehicles except his or her surviving spouse. As legal owner, the decedent’s estate may be held liable for any accidents.

Estate Planning Techniques & Devices

While it is difficult to list all estate planning techniques and devices, the most popular can be cate-gorized by common use and objective rather than by tax code section. In fact, first approaching es-tate planning in this way will actually help your later understanding of the related tax issues that gave birth to most of these devices.

Transfers within Probate

Probate is the process through which legal title to property contained in the probate estate is trans-ferred from the decedent to the decedent’s heirs and beneficiaries. When a person dies with a will (testate), the probate court determines if the will is valid, hears any objections to the will, provides for the payment of creditors, and supervises the distribution of property by the personal representa-tive or executor according to the terms of the will. When an individual dies without a will (intestate) the probate court appoints an administrator who receives all claims, pays creditors, and distributes any remaining property according to the laws of the state in which the decedent died.

The “probate estate” refers to any property subject to the authority of the probate court. This prop-erty includes all solely owned property plus any other property that does not pass to someone else by operation of law.

Disposition of Property without a Will

If there’s no will, property in the probate estate is distributed according to the state law of intes-tacy. When an individual dies intestate, the probate court chooses a person responsible for ad-ministering the estate and distributing the probate assets. This person, called the administrator, may or may not have been the person you would’ve chosen. If there’s family bickering regarding the appointment of the administrator, the court often appoints a neutral party whose services must be paid from estate funds.

In addition, the probate estate is distributed to heirs based upon a statutory distribution scheme. While state laws vary greatly, most provide an allowance to be set aside for the surviving spouse and/or children. After this spousal set aside or if there is no spouse, the remaining probate estate, after payments of claims against the estate or debts of the decedent, is distributed in a variety of ways depending upon marital status, surviving heirs, and nature of the property.

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Note: When there is a will, many states give the surviving spouse the ability to renounce the will and elect to take her intestate share provided by state law. Usually, the surviving spouse can take about one-third to one-half of the probate estate. This election procedure is meant to protect the surviving spouse from being disinherited by the predeceasing spouse.

Disposition of Property with a Will

A will is typically a written document that provides instructions for disposing of a person’s prop-erty upon his or her death. Upon the decedent’s death, the will must go through the probate process in order to have the instructions carried out. There are many reasons for having a will, including:

(1) The ability to dispose of your property other than through intestate succession;

(2) Nomination of your personal representative;

(3) Making specific bequests to individuals and charities;

(4) Appointment of guardians for minor children; and

(5) Apportionment of death taxes among heirs.

Transfers Outside Probate

There are many devices for the transfer of property or money outside of the probate system. Typi-cally, these arrangements produce no state or federal death tax savings. Their primary rationale is avoidance of probate and transfer convenience.

Note: The probate estate does not equate with the definition of “estate” for federal estate tax purposes. Avoiding probate is not the same as avoiding federal estate tax. In addition, avoiding probate does not necessarily avoid state inheritance tax.

These techniques are very popular. However, there can be traps for the unaware. Using probate avoidance techniques also avoids any disposition provisions given in the will. This is because a will has no control over any property outside of probate. Probate avoidance techniques operate independently of one’s will. These devices determine who gets property at the estate owner’s death regardless of the owner’s will or trust.

Note: A trust only disposes of property that has been transferred to it. If no assets have been trans-ferred to a trust either during life or at death by the decedent’s will, no property will be controlled by the terms of trust.

Joint Tenancy with Right of Survivorship

When an asset is held in joint tenancy with right of survivorship, each joint tenant has an equal, undivided interest in the whole asset. In addition, a decedent’s share automatically shifts to the surviving joint tenant(s) at the moment of death by operation of law. In most situations, no fed-eral estate tax is saved. Fifty percent of any property held in such a manner with a spouse is included in the decedent’s estate. If the surviving joint tenant(s) is not the decedent’s spouse, 100% of the jointly held property is included in the decedent’s taxable estate, unless the surviving joint tenant(s) can prove actual contribution to the property.

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Tenancy in Common

Tenancy in common is an arrangement in which each tenant takes an interest in the property. The interests owned by each co-tenant do not have to be equal. Each tenant can sell or bequeath his or her portion of the asset independent of the other tenant(s). Tenancy in common is fre-quently used for joint ownership of property among family members who are not spouses.

Retirement Plan & Individual Retirement Accounts

Naming a beneficiary to your retirement plan or individual retirement account (IRA) permits the benefits to go directly to the named beneficiary, bypassing probate. While at one time these funds enjoyed a special exclusion from the decedent’s estate, they are now generally includible in the decedent’s estate for federal estate tax purposes.

Note: Income tax planning has generally favored naming a spouse as the beneficiary even if the individual has a living trust. The spouse can take advantage of a variety of tax provisions which essentially treat the funds as the spouse’s own retirement account.

Life Insurance

When there is a named beneficiary other than the decedent’s estate, life insurance proceeds “spring” outside of probate. Proceeds from an insurance policy owned by the decedent that go to a named person as beneficiary are excluded from income tax. However, if the decedent owned the policy (or had any incidents of ownership), the proceeds are includible in the decedent’s fed-eral taxable estate even though the proceeds were payable to someone else.

Note: Frequently, an irrevocable insurance trust is used to avoid inclusion of the insurance proceeds in the decedent’s estate.

Gifts

Completed gifts made during one’s life avoid probate and in most cases federal estate tax. Essen-tially what has been given away is gone and is not includible in either the probate or federal estate. If a gift is given to a minor child, the transfer is typically made under the Uniform Transfers to Minors Act (UTMA) or the Uniform Gifts to Minors Act (UGMA). In such a case, the donor placing the asset in the name of a person called the “custodian” makes a gift of property or money. Legal title is actually held by the minor. However, the custodian manages the asset until the minor becomes an adult at which time the property is turned over to the minor.

Note: If funds in such an account can be used to pay parental obligations for support, this may be considered taxable income to the parents. In addition, if a parent serves as custodian, such funds may be included in the parent’s estate should he or she predecease the child.

Payable on Death Accounts (POD)

Payable on death bank accounts are often referred to as “Totten” trusts. In either event, the account owner names a beneficiary (or payee) who automatically receives the account balance on the death of the owner. Until the owner dies, the beneficiary has no right to the account. In addition, the owner of the account can change the beneficiary or close the account at anytime. While such an account may be convenient and avoids probate, it saves no federal estate tax.

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Transfers Using a Trust

A trust is a legal contract in which one party, the trustor, transfers property to a trustee for the ben-efit of one or more beneficiaries. While there are numerous types of trusts with a variety of charac-teristics, for estate planning purposes the most popular is the living revocable trust.

While a simple living trust will avoid probate, it does not necessarily save any federal income or es-tate taxes. From an income tax standpoint, it is typically classified as a “grantor” trust and the person creating the trust is taxable on its income. In addition, since the trust is typically revocable by the trustor, on the trustor’s death all assets in the trust are included in the trustor’s federal taxable es-tate.

For married couples, a popular type of trust is the “A-B” marital deduction trust. These trusts not only can avoid probate but also can reduce or avoid federal income and estate tax. This is accom-plished through the effective use of the marital deduction and the applicable exclusion amount. For example, such a trust can transfer tax-free to the couples’ heirs up to twice the applicable exclusion amount ($11,700,000 in 2021) plus the growth in up to one-half of their estate.

Note: Testamentary trusts are created by will at the time of the decedent’s death. As a result, tes-tamentary trusts require probate. This is a severe drawback with few offsetting advantages.

Special Planning Tools

The motivation to pass more wealth to survivors and save death taxes while retaining maximum control where possible has generated a variety of specialized estate planning tools. While many of the techniques listed below are more appropriately used for larger estates (i.e., those well in excess of the applicable exclusion amount), given the proper circumstances, they should be considered re-gardless of the size of the estate.

Spending

You may wish to simply spend and use up your estate for your own benefit. You earned it; you spend it. You do not have to leave it to anyone. However, most people are not so aggressive in reducing their estates.

Annual Gift Tax Exclusion

Up to $15,000 (in 2021) per donee per year can be given without gift tax consequences to each of an unlimited number of recipients. This amount is adjusted for inflation. In addition, an unlim-ited amount may be transferred free of gift tax for qualified tuition and medical expenses. Such gifts do not reduce the donor’s gift tax applicable exclusion amount ($5,000,000 in 2011; $5,120,000 in 2012; $5,250,000 in 2013; $5,340,000 in 2014; $5,430,000 in 2015; $5,450,000 in 2016; $5,490,000 in 2017; $11,180,000 in 2018; $11,400,000 in 2019; $11,580,000 in 2020; and $11,700,000 in 2021) and do not result in income tax to the recipient.

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Gifting Tips

• Avoid Gifts of Future Interests

• Use Gift Splitting

• Make Direct Tuition or Medical

Expense Payments

• Don’t Give Appreciated Property

Shortly Before Death

• Don’t Give Property That May Drop in

Value

• Beware of Kiddie Backfire Tax

• Careful of Gifts of Mortgaged

Property

• Don’t Delay Lifetime Gifts

• Consider Crummy Trusts

• Beware of Generation Skips

• Beware of Transfers With Retained

Interests

• Watch COD on Life Insurance

• Give Power to Make Gifts in POA

• Careful of Donor as Trustee

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The estate planning benefit of such gifts is a reduction in the taxable federal estate by both the original gift and any subsequent appreciation. For large estates, a pattern of gifts should be initi-ated early in order to transfer any substantial funds.

Applicable Exclusion Amount

The applicable exclusion amount is the size of an estate that can pass estate tax-free to one’s heirs. As a result of recent tax law, this amount has gradually risen over several years. In 2009, individuals could transfer a total of $3,500,000 in assets either during their lives or at death with-out paying any federal estate or gift tax. After applying this applicable exclusion amount the es-tate tax rate began at 45%. In 2010, the estate and generation-skipping transfer taxes were re-pealed.

However, in December of 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“TRUIRJCA”) reinstated (subject to a special election for 2010) the es-tate and generation-skipping transfer taxes effective for decedents dying and transfers made af-ter December 31, 2009.

Note: This reenactment of the estate tax is in a complicated section of TRUIRJCA that sunsets cer-tain provisions of EGTRRA as if they had never been enacted.

For 2010 and 2011, the estate tax applicable exclusion amount was $5 million: for 2012 the ex-clusion was inflation indexed to $5.12 million. Amounts exceeding this exclusion amount were taxed at 35%. ATRA kept the inflation-indexed exclusion ($11.7 million in 2021) but, permanently increased the top estate, gift, and GST rate from 35% to 40% for transfers over the exclusion.

Spousal Portability of Unused Exemption Amount

Under TRUIRJCA, any applicable exclusion amount that remains unused as of the death of a spouse who dies after December 31, 2010 (the "deceased spousal unused exclusion amount"), is available for use by the surviving spouse, as an addition to such surviving spouse's applicable exclusion amount.

Note: The Act does not allow a surviving spouse to use the unused generation-skipping transfer tax exemption of a predeceased spouse.

If a surviving spouse is predeceased by more than one spouse, the amount of unused exclu-sion that is available for use by such surviving spouse is limited to the lesser of $11.7 million (in 2021) or the unused exclusion of the last such deceased spouse. This last deceased spouse limitation applies whether or not the last deceased spouse has any unused exclusion or the last deceased spouse's estate makes a timely election. A surviving spouse may use the pre-deceased spousal carryover amount in addition to such surviving spouse's own $11.7 (in 2021) million exclusion for taxable transfers made during life or at death.

Note: A deceased spousal unused exclusion amount is available to a surviving spouse only if an election is made on a timely filed estate tax return (including extensions) of the predeceased spouse on which such amount is computed, regardless of whether the estate of the predeceased spouse otherwise is required to file an estate tax return.

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2010 Special Election

For a decedent who died during 2010, TRUIRJCA allowed the executor of such a decedent's estate to elect to apply the Code as if the TRUIRJCA estate tax and fair market value basis step-up rules had not been enacted. When such an election was made, the estate would not be subject to estate tax but, the basis of assets acquired from the decedent would be deter-mined under the modified carryover basis rules of §1022.

Comment: Estates not covered by the applicable exclusion amount should have made this election. However, the executor would have had to consider a variety of factors, particularly, the estate tax savings vs. the gain that would be subject to tax on a future sale of assets.

Unlimited Marital Deduction

Since 1981, transfers between spouses during lifetime or at death are not taxed. An individual’s total gross estate at death is reduced by the marital deduction for any property passing directly to, or in trust for, the individual’s surviving spouse. Thus, property transferred outright to the surviving spouse qualifies for the unlimited marital deduction.

In addition to outright transfers, property payable to a marital deduction trust for the sole benefit of the surviving spouse can also qualify for this unlimited estate tax deduction. In order to qualify, the marital deduction trust must pay all of the income it generates to the spouse and only the spouse is eligible for principal distributions during his or her lifetime. The surviving spouse must also be given the right to convert unproductive property to income-producing property.

Family Business Deduction - Expired

Prior to 2004, a Qualified Family-owned Business Interest (QFBI) could receive an estate tax value deduction of $1.3 million less the applicable exclusion amount. In order to receive the deduction, a variety of complex requirements had to be met, including the following:

(1) Decedent must have been a U.S. citizen or resident;

(2) The qualified business’s principal place of business must be in the U.S.;

(3) Ownership of the business must be held at least 50% by the decedent and the decedent’s family, or 70% by two families or 90% by three families;

Note: In the latter two cases, the decedent and the decedent’s family must own at least 30%.

(4) The value of the decedent’s interest passing to qualified heirs must exceed 50% of the decedent’s adjusted gross estate;

(5) In the year of the decedent’s death no more than 35% of the adjusted ordinary gross income of the business can be personal holding income;

(6) The decedent or a member of the decedent's family must have owned and materially participated in the business; and

(7) The business’s stock must not have been publicly traded within three years of the dece-dent's death.

Installment Payment of Estate Taxes - §6166

Federal estate taxes are normally payable in full within nine months of the decedent’s death. However, certain qualified business interests can qualify for the installment payment of federal

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estate taxes over a period of up to 15 years. This deferral of federal estate taxes is available for the tax attributable to the first $1,590,000 (for 2021) in taxable value of the closely held business. The annual interest rate on such installments can be as low as 2%.

Private Annuities

A private annuity is where one person transfers property to another (who is not in the business of selling annuities) for that person’s unsecured promise to make fixed periodic payments to the other for life. The property must be transferred for full and adequate consideration. The results can be similar to a self-canceling installment note, however, under a private annuity, the pay-ments never stop so long as the annuitant is alive. An annuity can also reduce the transferor’s estate and spread out the gain on the transferred property over the annuitant’s life expectancy.

Regs Restrict Private Annuity Tax Benefits

The IRS has issued proposed regs that would eliminate the income tax advantages of selling appreciated property in exchange for a private annuity. Under the new rules, the property seller's gain would now be recognized in the year the transaction occurs rather than as pay-ments are received ((Prop. Reg. § 1.72-6, Prop Reg § 1.1001-1)).

The regs generally would apply for transactions entered into after Oct. 18, 2006. However, certain transactions effected before Apr. 19, 2007 would continue to be subject to the current rules.

Installment Sale to Family Member

While there are restrictions on the use of the installment sale method among family members and related entities, it can be used very effectively as an estate planning tool. When selling an asset to a family member on the installment method, the potential appreciation of the asset is shifted to the purchasing family member. The installment note can be secured by the property sold. In addition, any gain on the sale can be spread out over the term of the installment note or perhaps enjoy the §121 exclusion. However, the promissory note will be part of the seller’s estate and receives no step up in basis on death.

Self-Canceling Installment Notes

The self-canceling installment note is a device that arose to prevent the inclusion of the in-stallment note in the seller’s estate. This type of installment sale uses a promissory note that by its terms expires on the death of the payee. As a result, the unpaid balance of the note is reduced to zero at death and there is arguably nothing included in the payee’s estate at death. Since the note may expire before the payee receives all payments, an additional “premium” must be paid for the self-canceling provision. Determining the amount of the premium with any certainty is extremely difficult.

Note: Self-canceling installment notes are frequently referred to as death terminating notes.

Irrevocable Life Insurance Trust

While life insurance proceeds are generally not income taxable, they are included in the insured’s federal estate. To prevent this inclusion an irrevocable life insurance trust can be used. This is a

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specific type of trust in which you give up all ownership rights. The trust is made the owner and beneficiary of the life insurance to remove the proceeds from the estate of the insured and the insured’s spouse. Strict formalities are required to set up such a trust.

To avoid estate taxation, the insured must avoid all incidents of ownership in the policy. Obvi-ously, the insured should not own the policy outright. Unfortunately, the concept of “incidents of ownership” is not clearly defined and courts have been inconsistent in applying the term. As a result, the IRS looks for any strings or links between the insured and the policy.

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Estate Tax Reduction

• Spend & Use Up the Estate

• Make Effective Gifts

– Annual Exclusion

– Use of Appreciating Property

– Value-Discounted Interests

• Minority & Fractional Interests

– Gifts in Trust

• Irrevocable Life Insurance Trust

• Charitable Remainder Trusts

• GRIT, GRAT, GRUT & QPRT

• Buy-Sell Agreements

• Installment Sales

– Death Terminating Notes (SCINs)

• Private Annuities

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Special Valuation of Farms and Businesses - §2032A

In general, the value of real estate must be determined based upon its highest and best use. However, an executor may, when certain requirements are met, elect to value, for estate tax purposes, real estate used as a farm or other closely held business based upon its actual use rather than its highest and best use (§2032A). Thus, farmland and real property used in a closely held business can be valued at less than fair market value.

The election cannot result in a reduction of more than $1,190,000 (in 2021) in fair market value. If the real property is later sold to non-qualified heirs or the qualified use of the property ceases, then the tax savings are recaptured and the amount of the additional tax which would have been payable if the election had not been made is then required to be paid.

Crummey Trusts

This concept takes its name from a court case lost by the IRS. In this case, the taxpayer wanted to set up a trust for several beneficiaries and take advantage of the $15,000 (in 2021) annual exclusion. While the taxpayer could have simply made outright gifts, he or she wished to do it through a trust that would discourage the beneficiaries from spending the gifts immediately.

However, making gifts to a trust presents problems when one also wants to take advantage of the annual exclusion. The annual exclusion requires that any excluded gifts must be present in-terests, not future - as in a trust. A Crummey trust is meant to overcome this problem.

Under this estate planning tool, gifts are made to an irrevocable trust. The beneficiaries are given only a short period of time each year to withdraw the gift from the trust. If they do not make such a withdrawal the funds remain in the trust and are administered pursuant to its terms. The result is hopefully the use of the annual exclusion with subsequent control of the funds by the trust.

Charitable Remainder Trusts

A charitable remainder trust can provide substantial annual payments to one’s heirs and a tax deduction to the grantor while at the same time benefiting a charity. The heirs can receive pay-ments during their lifetime or during a fixed term of up to 20 years. In general, the payments to the heirs must be at least 5% of the value of the trust’s assets. They cannot exceed 50%, and the present value of the amount going to the charity must be at least 10% of the amount contributed. On the death of the heirs, the remainder must pass to the charity.

Note: The grantors of the trust can also be life or term beneficiaries and receive payments.

Charitable remainder trusts are tax-exempt and do not pay any income taxes. However, the ben-eficiaries who receive payments are taxed on income that is distributed to them.

There are three basic types of charitable trusts:

(1) Charitable remainder annuity trusts,

(2) Charitable remainder unitrusts, and

(3) Charitable lead trusts.

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Minor Trusts

Minor trusts under §2503 are similar in purpose to Crummey trusts. However, unlike Crummey trusts, minors' trusts are based on a federal statute, not written court opinion. If properly struc-tured these trusts qualify in whole or in part for the annual gift tax exclusion by law.

Minor trusts come in two variations. In the §2503(c) trust, the annual income may be accumu-lated, however, the trust must provide that both income and principal can be used for the minor’s benefit. Unfortunately, all trust assets must be distributed when the beneficiary turns age 21. In the §2503(b) trust, the annual income cannot be accumulated, however, the trust can continue past age 21. Trust principal is not required to be distributed to the income beneficiary and can actually go to someone else.

Family Limited Partnerships

A family limited partnership can be a great income, estate, and gift tax savings device. Senior family members can control property transferred to such a partnership while discounted gifts of limited partnership interests are made to the remaining family members. During its operation, partnership income can be split among family members through their ownership of interests in the partnership. In the meantime, senior family members can continue to exercise control of the partnership assets through their retention of general partnership interests. Finally, on the death of a senior family member, an estate tax discount may be in order because of the minority inter-est held at death.

Grantor Retained Income Trusts

A grantor retained income trust is an estate planning tool in which a grantor transfers certain property to an irrevocable trust for the benefit of his or her heirs while retaining an income or beneficial right in the property. In the estate and gift tax setting, the retention of an income or beneficial right in the property arguably reduces the value of the initial transfer to the trust. As a result, this discounted transfer would absorb less of the applicable exclusion amount. The longer the grantor has a right to the income generated by the trust property, the lower the value of the remainder interest.

If the grantor dies before his or her benefits are terminated under the terms of the trust, the trust assets are subject to estate taxes in the grantor’s estate. However, if the grantor outlives his or her right to receive benefits under the trust, the trust assets are excluded from his or her estate.

Over the years, Congress has limited the use of this tool to very specific types of trusts.

Qualified Personal Residence Trusts (QPRTs)

A qualified personal residence trust (QPRT) is a grantor retained income trust still permitted under federal law. In this variation of the tool, a grantor transfers his or her primary personal residence to a trust that allows the grantor to continue to reside in the home for a designated time. When the designated time expires, the property passes to the grantor’s heirs.

While the gift to the grantor’s heirs is subject to federal gift tax, the value of the present gift is determined under IRS tables after considering the term of the grantor’s retained interest,

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the grantor’s age, and the applicable interest rate published by the IRS monthly. The reduc-tion in value can be substantial.

Grantor Retained Annuity Trusts (GRATs)

Grantor retained annuity trusts (GRATs) have similar rules to those of charitable remainder annuity trusts. The grantor transfers assets to a trust and retains a right to annuity payments. GRATs allow the gift of remainder interests that are discounted for gift-tax purposes under the IRS valuation tables. Longer terms produce lower remainder values.

Grantor Retained Unitrusts (GRUTs)

Grantor retained unitrusts (GRUTs) have similar rules to those of charitable remainder unitrusts. The grantor transfers assets to a trust and retains a right to unitrust payments. GRUTs are not considered as effective as GRATs where the trust’s assets are expected to ap-preciate.

Buy-Sell Agreements

Whenever two or more people are in business together it is an absolute necessity that they have a buy-sell agreement. Buy-sell agreements have a number of benefits, including:

(1) Liquidity for the deceased owner’s family,

(2) The ability to set the value of a business interest for estate tax purposes,

(3) Providing funds for retirement, and

(4) Lifetime transfer restrictions.

Estate Planning Facts

Garbage in - garbage out. Only accurate facts can serve as the basis for designing and implementing an estate plan. In many cases, this is the most challenging part of the estate planning process. The facts can be classified into three categories:

(i) Family

(ii) Property, and

(iii) Objectives.

Family

The estate planning team must gather family information. These facts should at the very least include the names, birth dates, and general health of all family members, prior marriages, and adoptions. The character of the spouse and other heirs and their business abilities must be considered. The financial needs of the family and the attitudes of individual heirs toward each other will also be im-portant.

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Property

A property inventory must be gathered. The inventory should include stocks & bonds, insurance pol-icies, real property owned separately and jointly, business interests, and retirement and death ben-efits. Information about personal debts, business debts, installment contracts, and all other debts, including contingent liabilities should be obtained.

Note: Valuation problems are often caused by ownership of business interests. Generally, such in-terests must be valued under R.R. 59-60.

Domicile

Domicile determines many estate related factors, including:

(1) Title to property (e.g., community property versus separate property and joint tenancy versus a tenancy in common),

(2) The law that will govern the validity of the will and its provisions, and

(3) What state(s) will try to tax your assets.

Objectives

Estate goals must be formulated. Some people want their heirs to have unrestricted use of the assets they inherit. Others fear entrusting their heirs with substantial money, especially in one lump sum. In this environment, human considerations will supersede tax considerations. Basic estate planning objectives include:

(1) A valid will and trust that are periodically reviewed and revised when necessary,

(2) Flexibility to permit family members and heirs to meet changing needs and emergencies,

(3) Cash liquidity at death to cover final expenses and taxes,

(4) A business succession plan,

(5) The integration of insurance and retirement benefits with other estate assets,

(6) Maximization of income, gift, and estate tax savings devices,

(7) Providing for a comfortable retirement, and

(8) Financial independence.

Most estate planning is primarily for the benefit of the heir. In fact, as a result of the unlimited marital deduction, with minimal estate planning, all assets can pass to the surviving spouse without any fed-eral estate tax. Since there is no federal estate tax until the surviving spouse dies, only the benefi-ciaries save death taxes by detailed planning.

Existing Estate Plan

People have an estate plan that may have been developed consciously or accidentally. Intestate suc-cession will become their estate plan, even when they have signed no estate documents.

Information on this “plan” must be gathered and analyzed. If estate planning documents exist, they should be obtained and reviewed.

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Date: ___________

Short Form Estate Planning Questionnaire

Please supply the following information so that we may prepare a proposal for your consideration. Be sure to print clearly! When completed, please return to our office for review.

Personal Information

1. a. Name: Date of Birth:

b. Spouse2 (if any): Date of Birth:

c. Date of Marriage: Place:

d. Date Came to California -Client: Spouse:

2. a. Residence Address:

Street City County Zip

b. Business Address:

Street City County Zip

c. Business Phone: ( ) ______________ Home Phone: ( )_____________

3. Prior Marriages (if any)3: Client:

Spouse:

4. Children4 (including deceased children):

Name Birth Date Name of Parents Name of Spouse

5. Grandchildren (including deceased grandchildren):

Name Birth Date Name of Parents Name of Spouse

Assets

6. If you are married:

a. Is all your property community property? yes no

2 If you are living with someone please indicate such and give date cohabitation began. 3 Indicate how marriage was terminated (e.g., death, divorce, etc.) and approximate date of termination. 4 Include adopted as well as natural.

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b. Does the husband own separate property? yes no

c. Does the wife own any separate property? yes no

7. Do you (or your spouse) have a retirement plan? yes no

8. a. What is the total amount of insurance on your life? $

b. If married, what is the total amount of insurance

on your spouse’s life? $

9. a. Estimated net total of cash and notes: $

b. Estimated net value of real property: $

c. Estimated net value of stocks & bonds: $

d. Estimated net value of my business: $

e. Estimated net retirement plan benefits: $

f. Estimated net value of miscellaneous assets: $

Total estimated net worth: $

Estate Objectives

10. Who do you want to receive your personal effects?

Husband:

Wife:

11. Do you want to leave money or specific items to anyone or charity? If so, please specify what and to whom:

12. How do you wish the balance of your estate to be distributed?

13. Please list any further information or comments concerning the disposition of your estate:

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Review Questions

1. When considering income, gift, and, ultimately, death taxes, taxpayers should attempt to re-duce the overall tax load for the whole family unit. What is this process called?

a. building the estate.

b. distribution of the estate.

c. estate planning.

d. preservation of the estate.

2. An accountant, an attorney, a financial planner, and an insurance agent are the professionals most often on an estate planning team. Of these professionals, whose responsibilities include being familiar with the client’s financial affairs and being well-informed on income and estate tax laws?

a. accountant.

b. attorney.

c. financial planner.

d. insurance agent.

3. Individuals create wills to instruct how they would like their possessions to be disposed of upon their death. What must a will go through in order for an executor to carry out the decedent’s instructions?

a. probate avoidance.

b. the intestacy process.

c. the probate process.

d. the transfer process.

4. Life insurance proceeds are included in a decedent’s estate where the decedent retained inci-dents of ownership over the policy. What planning device can taxpayers use to avoid this inclu-sion?

a. a payable on death account.

b. a private annuity.

c. a self-canceling installment note.

d. an irrevocable insurance trust.

5. Crummey trusts are based on a court case in which a taxpayer wanted to make present interest gifts through a trust. What is a characteristic of such a Crummey trust?

a. The taxpayer makes gifts to a revocable trust.

b. If funds are not withdrawn, they are administered according to the trust’s terms.

c. Making gifts to it presents problems when one wants to take advantage of the annual ex-clusion.

d. The beneficiaries may withdraw the gift from the trust at any time.

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6. For their heirs, grantors may transfer some assets to an irrevocable trust and, for themselves, they may keep an income or beneficial right in the transferred property. What is such an estate-planning device often called?

a. buy-sell agreement.

b. family limited partnership.

c. grantor retained income trust.

d. minor trust.

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Learning Objectives

After reading Chapter 2, participants will be able to:

1. Identify potential death taxes including federal estate tax as it applies to various size estates, specify the principal taxes that impact death taxation, and determine the expira-tion of the death tax credit.

2. Determine what constitutes a taxable estate under §2501 specifying what assets are included in a gross estate using basic categories of property and transfers.

3. Specify estate deductions allowed under federal estate tax law stating their tax ad-vantages and disadvantages.

4. Determine the value of a decedent’s assets using permitted elections, recognize the use of Form 706 to pay any estate tax due, select the tax basis of estate assets stating how common transactions affect property basis under §1014.

5. Recall the advantages of gift planning including estate reduction recognizing the impact of the GST, specify the steps to compute gift tax identifying the gift tax exclusion amount, and determine the value of gifts including those that are split.

6. Identify the various gift tax exclusions, specify the tax treatment of below-market loans, recall the gift tax marital deduction requirements, determine the tax consequences of giv-ing various assets specifying factors to consider when gifting, and recognize the use of Form 709 to compute and pay federal gift tax.

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CHAPTER 2

Estate & Gift Taxes

There are not one but eight potential death taxes that may apply at death:

• FEDERAL ESTATE TAXES: Taxes imposed by the Federal Government on the transfer of assets on death (Form 706).

• STATE INHERITANCE TAXES: Taxes imposed by many (but not all) states on the right of heirs to receive assets on death.

• FEDERAL INCOME TAXES: No one ever dies on December 31 while mailing his or her in-come tax return early, so a return is due for the period January 1 to date of death (Form 1040).

• STATE INCOME TAXES: Most states (e.g., California Form 540) have his or her own income tax and require a return for the decedent’s income to date of death.

• FEDERAL GIFT TAXES: If the decedent made taxable gifts during his or her lifetime but failed to pay gift taxes these taxes plus interest and penalty must be paid by the executor (Form 709).

• STATE GIFT TAXES: Some states duplicate the Federal Gift Tax structure and impose a gift tax of his or her own.

• FEDERAL FIDUCIARY INCOME TAXES: If your estate has any income after your death it must also pay taxes on any such funds (Form 1041).

• STATE FIDUCIARY INCOME TAXES: Most states (e.g. California Form 541) also tax income received by your estate after your death.

Federal Estate Tax

Federal estate tax is a death tax imposed on the fair market value of taxable assets, less liabilities, owned at death. Taxable assets include the home, all life insurance (even though paid to someone else), and property owned jointly with someone else. Gift tax is imposed on transfers by gift during life, and the estate tax is imposed on the taxable estate at death.

Federal estate tax is not a property tax. It is an excise or privilege tax - i.e., it is imposed upon property transfers, not on property itself. This difference has constitutional significance. Article 1, section 9, clause 4 of the Constitution requires direct (property) taxes to be apportioned among the states according to population.

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Note: Despite popular belief, a person does not have a right to have his or her property transferred to others at death. This is a privilege granted by the state and not a right.

However, indirect (transfer) taxes need only be uniform (New York Trust Co. v. Eisner, 256 U.S. 345 (1921)).

Historical Note: The revenue needs of World War I generated the first federal estate tax under the Revenue Act of 1916. However, the end of the war did not end the tax. While refined over the years, the essential elements of that estate tax continue today in §2001 through §2209 of the Internal Revenue Code.

While substantial dollars are raised by the federal estate tax, the percentage of federal revenue it collects is small. Initial supporters of the tax saw the federal estate tax as a way to limit the accumu-lation of wealth rather than an income resource.

Changing Legislative Landscape

Changes made by the Economic Growth and Tax Relief Reconciliation Act of 2001 greatly affected estate planning repealing the 5% surtax (which phased out the benefit of graduated rates) and rates in excess of 50%. In addition, in 2002, the applicable exclusion amount (for both estate and gift tax purposes) was $1 million.

Note: The applicable exclusion amount is the size of an estate that can be passed free of federal estate tax. Everyone is entitled to the applicable exclusion amount.

In 2003, the estate and gift tax rates in excess of 49% were repealed. In 2004, the estate and gift tax rates in excess of 48% were repealed, and the applicable exclusion amount for estate tax purposes became $1.5 million.

Note: Until 2011, the applicable exclusion amount for gift tax purposes remained at $1 million as increased in 2002. However, for gifts after December 31, 2010, the exclusion amount was $5 million in 2011 and was $5.12 million in 2012.

In 2005, the estate and gift tax rates in excess of 47% were repealed. In 2006, the estate and gift tax rates in excess of 46% were repealed, and the applicable exclusion amount for estate tax purposes was increased to $2 million. In 2007, the estate and gift tax rates in excess of 45% were repealed. In 2009, the applicable exclusion amount was increased to $3.5 million. In 2010, the estate and gener-ation-skipping transfer taxes were repealed. However, in December of 2010, TRUIRJCA reinstated (subject to a special election for 2010) the estate and generation-skipping transfer taxes effective for decedents dying and transfers made after December 31, 2009. This reenactment of the estate tax was in a complicated section of TRUIRJCA that sunseted certain provisions of EGTRRA as if they had never been enacted.

Note: The Tax Relief Act of 2001 gradually phased out the state death tax credit between 2002 and 2004, with the credit repealed in 2005. Since 2005, the state death tax credit is replaced by a de-duction for state death taxes paid. TRUIRJCA continued this deduction through 2012 (§2058). ATRA made the state death tax deduction permanent for decedents dying after December 31, 2012.

For 2010 and 2011, the estate tax applicable exclusion amount was $5 million: for 2012 the exclusion was inflation indexed to $5.12 million. Amounts exceeding this exclusion amount were taxed at 35%. ATRA kept the inflation-indexed exclusion ($11.7 million in 2021) but, permanently increased the top

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estate, gift, and GST rate from 35% to 40% for transfers over the exclusion. As a result, the applicable exclusion amounts and their credit equivalents are as follows:

Year of death Exclusion Amount Credit Equivalent

2012 5,120,000 1,772,800

2013 5,250,000 2,045,800

2014 5,340,000 2,081,800

2015 5,430,000 2,117,800

2016 5,450,000 2,125,800

2017 5,490,000 2,141,800

2018 11,180,000 4,360,200

2019 11,400,000 4,505,800

2020 11,580,000 4,577,800

2021 11,700,000 4,625,800

Note: The exclusion amounts apply to cumulative transfers. Thus, a taxpayer who made $1,000,000 of taxable gifts in 2021 could not then transfer $11,700,000 upon death in 2021 without paying wealth transfer tax. The taxpayer could transfer only $10,700,000 free of tax upon death ($11,700,000 estate tax exclusion amount minus $1,000,000 taxable lifetime gifts).

The generation-skipping transfer tax exemption for a given year is equal to the applicable exclusion amount for estate tax purposes. In addition, the generation-skipping transfer tax rate for a given year will be the highest estate and gift tax rate in effect for such year.

Spousal Portability of Unused Exemption Amount - §2010(c)(2)

Under TRUIRJCA, any applicable exclusion amount that remains unused as of the death of a spouse who dies after December 31, 2010 (the "deceased spousal unused exclusion amount"), is available for use by the surviving spouse, as an addition to such surviving spouse's applicable exclusion amount.

Note: The Act does not allow a surviving spouse to use the unused generation-skipping transfer tax exemption of a predeceased spouse.

If a surviving spouse is predeceased by more than one spouse, the amount of unused exclusion that is available for use by such surviving spouse is limited to the lesser of $11.7 million (in 2021) or the unused exclusion of the last such deceased spouse. This last deceased spouse limitation applies whether or not the last deceased spouse has any unused exclusion or the last deceased spouse's estate makes a timely election. A surviving spouse may use the predeceased spousal carryover amount in addition to such surviving spouse's own $11.7 million (in 2021) exclusion for taxable transfers made during life or at death.

Note: A deceased spousal unused exclusion amount is available to a surviving spouse only if an election is made on a timely filed estate tax return (including extensions) of the predeceased spouse on which such amount is computed, regardless of whether the estate of the predeceased spouse otherwise is required to file an estate tax return.

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Persons Subject to Federal Estate Tax

The federal estate tax applies to all property owned by a citizen or resident of the United States without regard to its location (§2031). Likewise, gift tax applies to all property transferred by a citizen or resident (§2501). In the case of nonresident aliens, only property located in the United States is subject to the federal estate tax (§2103).

Applicable Exclusion Amount, Basic Computation & Rates

In 2021, the first $11,700,000 of a person’s estate who died is not taxable – this is called the applica-ble exclusion amount. The law is written so that the first $4,625,800 (in 2021) of estate taxes (i.e., the credit equivalent) is not paid, which translates into a taxable estate of about $11,700,000. There-after, the tax rate is a flat 40% for taxable estates over $11.7 million.

Note: A single set of deductions, exemptions, and graduated rates apply to a decedent’s estate. It makes little difference how many heirs share in the estate, or who they are.

Progressive or Flat Rate

Federal estate and gift taxes are technically progressive. However, as a result of increased appli-cable exclusion amounts, both impose a flat (or top) rate on all taxable amounts in excess of his or her applicable exclusion amounts. Below are the technically progressive and unified estate and gift tax rates after 2012.

“Technically Progressive” Estate & Gift Tax Rates – Years After 2012

If the amount is: Tax is: Over But not over Tax +% Excess Over 0 $10,000 0 18 $0 $10,000 $20,000 $1,800 20 $10,000 $20,000 $40,000 $3,800 22 $20,000 $40,000 $60,000 $8,200 24 $40,000 $60,000 $80,000 $13,000 26 $60,000 $80,000 $100,000 $18,200 28 $80,000 $100,000 $150,000 $23,800 30 $100,000 $150,000 $250,000 $38,800 32 $150,000 $250,000 $500,000 $70,800 34 $250,000 $500,000 $750,000 $155,800 37 $500,000 $750,000 $1,000,000 $248,300 39 $750,000 $1,000,000 ------------ $345,800 40 $1,000,000

However, even though above the table shows a progressive application of estate tax rates, the size of the applicable exclusion amount negates his or her effect and resulted in a 45% flat estate tax from 2007 to 2009, a 35% flat estate tax from 2010 through 2012, and a 40% flat estate tax for years after 2012.

Likewise, the maximum gift tax rate also fluctuated. In 2010, the maximum gift tax rate was scheduled to equal the highest marginal individual income tax rate then in effect (35%). However,

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for gifts made after December 31, 2010, the gift tax was reunified with the estate tax, with the same applicable exclusion amount and the top estate and gift tax rate was 35%. In 2013, the American Tax Relief Act (“ATRA”) permanently increased the gift rate from 35% to 40% for trans-fers over the applicable exclusion amount.

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Estate & GST Tax Chart

Year Rate RangeEstate & GST

Exclusion

2008 Flat 45% $2 million

2009 Flat 45% $3.5 million

2010 0% or Flat 35% $5 million

2011 Flat 35% $5 million

2012 Flat 35% $5.12 million

2013 Flat 40% $5.25 million

2014 Flat 40% $5.34 million

2015 Flat 40% $5.43 million

2016 Flat 40% $5.45 million

2017 Flat 40% $5.49 million

2018 Flat 40% $11.18 million

2019 Flat 40% $11.4 million

2020 Flat 40% $11.58 million

2021 Flat 40% $11.7 million

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Note: The gift tax imposed for each calendar year is an amount equal to the excess of (1) a tentative tax, computed using the rate schedule above, on the aggregate sum of the taxable gifts for such calendar year and for each of the preceding calendar periods, over (2) a tentative tax, computed using the rate schedule above, on the aggregate sum of the taxable gifts for each of the preceding calendar periods.

2010 Special Election

For a decedent who died during 2010, TRUIRJCA allowed the executor of such a decedent's estate to elect to apply the Code as if the TRUIRJCA estate tax and fair market value basis step-up rules had not been enacted. When such an election was made, the estate would not be subject to estate tax but, the basis of assets acquired from the decedent would be determined under the modified carryover basis rules of §1022.

State Inheritance Tax

There are two fundamental types of death taxes:

(1) Estate taxes, and

(2) Inheritance taxes.

Estate tax is basically a tax upon the value of all property owned at death which is transferred to heirs. Inheritance tax is a tax upon property received by heirs.

Many states impose inheritance taxes on the amounts received by heirs. Most inheritance tax sys-tems apply separate exemptions and rates to the share received by each heir. Typically, the rates and exemptions vary depending upon the relationship of the heir.

State inheritance taxes are often tied to the federal estate tax. However, even where there is no direct tie, state inheritance taxes are often similar to federal estate tax concerning the property and transfers subject to tax. Thus, federal estate tax planning should achieve suitable state inheritance tax results as well.

State Death Tax Credit Turns into Deduction – §2011 & §2058

Prior to 2005, the maximum allowable state death tax credit was based on the size of the "ad-justed taxable estate," which, for purposes of the credit, was the taxable estate reduced by $60,000 (§2011). The chart below shows the maximum credit formerly available for state death taxes.

Death Tax Credit

Column #1 Column #2 Column #3 Column #4

Adjusted Taxable Es-tate* Equal to or

More Than:

Adjusted Taxable Estate* Less Than:

Credit on Amount in Column (1):

Rate of Credit on Ex-cess over Amount in

Column (1)

0 40,000 0 None

40,000 90,000 0 0.8

90,000 140,000 400 1.6

140,000 240,000 1,200 2.4

240,000 440,000 3,600 3.2

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440,000 640,000 10,000 4.0

640,000 840,000 18,000 4.8

840,000 1,040,000 27,600 5.6

1,040,000 1,540,000 38,800 6.4

1,540,000 2,040,000 70,800 7.2

2,040,000 2,540,000 106,800 8.0

2,540,000 3,040,000 146,800 8.8

3,040,000 3,540,000 190,800 9.6

3,540,000 4,040,000 238,800 10.4

4,040,000 5,040,000 290,800 11.2

5,040,000 6.040,000 402,800 12.0

6,040,000 7,040,000 522,800 12.8

7,040,000 8,040,000 650,800 13.6

8,040,000 9,040,000 786,800 14.4

9,040,000 10,040,000 930,800 15.2

10,040,000 — 1,082,800 16.0

*"Adjusted taxable estates" equals taxable estate minus $60,000.

The Tax Relief Act of 2001 gradually phased out the state death tax credit between 2002 and 2004, with the credit being repealed in 2005. Since 2005, the state death tax credit has been replaced by a deduction for state death taxes paid (§2058). ATRA made this deduction permanent (§2058).

Prior to 2005, the state death tax credit was reduced as follows:

(1) 25% in 2002,

(2) 50% in 2003, and

(3) 75% in 2004.

Thus, the maximum state death tax credit allowable for:

(1) 2002 was $812,100 plus 12% of the excess of over $10,040,000,

(2) 2003 was $541,400 plus 8% of the excess of over $10,040,000, and

(3) 2004 was $270,700 plus 4% of the excess over $10,040,000.

Many states used a “credit estate tax” calculation, which meant that since the Federal govern-ment allowed a credit for presumed state death taxes, rather than permitting this credit to go unused, most states imposed a tax equal to the allowed credit as their state inheritance tax (e.g., California). With the expiration of the federal credit, many states have had to modify this calcu-lation.

Taxable Estate - §2051

Federal estate tax is applied to the “taxable estate” (§2001). Under §2051, the “taxable estate” is defined as the “gross estate” less any allowable deductions. Thus, before estimating estate tax, one must know:

(1) What assets are included in the gross estate,

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(2) The value of those assets, and

(3) Any and all allowable deductions.

The estate planner is helpless without knowledge of these three things.

Gross Estate - §2031

Under §2031, the gross estate includes the value of all real or personal, tangible or intangible property, owned by the decedent in whole or in part at the time of death, wherever situated.

Section 2033 further provides that: “The value of the gross estate shall include the value of all property to the extent of the interest therein of the decedent at the time of his or her death.” This includes any real property located outside the United States.

Note: Because the gross estate includes the value of all property owned at death, ownership is important to determine the gross estate. Generally, state law will control the issue of ownership for tax purposes.

Section 2033 through §2046 list four basic categories of property and transfers included in the gross estate:

1. Owned Property - Under §2033 and §2034, all property owned at death is included in the gross estate.

2. Lifetime Transfers - Under §2035 through §2038, even lifetime transfers of property may be included in the gross estate under certain circumstances.

3. Interests, Rights & Powers - Some interests, rights, or powers while not technically “prop-erty” or “transfers” do transfer value upon death. Section 2039 through §2042 handle four such types of property:

(a) Annuities (§2039),

(b) Joint tenancies (§2040),

(c) Powers of appointment (§2041), and

(d) Life insurance (§2042).

4. Gratuitous Transfers - Under §2043 gratuitous transfers are subject to the estate tax. These are sales or exchanges not for full consideration.

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Federal Gross Estate

Interests Owned At Death:

– §2033 - property owned outright

– §2034 - dower & curtsey

– §2039 - survivor annuities

– §2040 - joint interests

– §2041 - powers of appointment

– §2042 - life insurance

Transfers With Retained Interest:

– §2036 - retained life interests

– §2037 - reversionary interests

– §2038 - revocable transfers

Transfers within 3 years of death of

interests includable under §2036, 2037,

2038 & 2042 (§2035)

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Owned Property - §2033

A decedent’s gross estate is composed of a wide variety of “owned” property. All types of property are subject to federal estate tax whether real or personal, tangible or intangible. This includes notes or other claims, contract rights, accrued salary, rent, interest, and divi-dends.

When a person has a note or claim against another, the amount thereof is taxable under §2033 even if the obligation is canceled in the will. The cancellation is treated as if the decedent had transferred the amount of the debt to the debtor (Reg. §20.2033-1(b)).

Note: The result is different for self-canceling installment notes. In Moss v. Commissioner, 74 T.C. 1239 (1980), the decedent sold stock taking back an installment note that canceled on his death. The Tax Court held that the obligation was extinguished by the decedent’s death and any unpaid balance was not includible in the decedent’s estate.

The “ownership” required by §2033 is beneficial ownership. Mere legal title is not included in an estate (Reg. §20.2033-1). Thus, if Dan holds title to property as trustee for Daphne but he has no beneficial interest, the property is not included in Dan’s estate.

Note: A transfer that is void under local law does not convey beneficial ownership and the property remains taxable in the transferor’s estate under §2033 (City National Bank v. United States, 383 F. 2d 341 (5th Cir. 1967)).

A mere expectancy is not an interest in property. The possibility that a decedent may receive property under a will or under the laws of intestate succession is not includible in his or her estate as property.

Interests Terminating At Death - Life Estates & Joint Tenancies

Interests that terminate upon death (e.g., a life estate) are not taxable under §2033 (Wil-liams v. United States, 41 F. 2d 895 (Ct. Cl. 1930) and Helvering v. Rhodes’ Estate, 117 F. 2d 509 (8th Cir. 1941))1. However, if a person’s life estate is measured by the life of another and he or she dies before the end of the measuring life, the remaining term of that life estate is includible in the decedent’s gross estate. A similar result applies to future inter-ests not contingent upon survival (R.R. 67-370) and the remaining portion of a term of years (Millard v. Malony, 121 F. 2d 257 (3d Cir. 1941)).

Note: While interests terminating on death are not taxable, this rule only applies to interests conveyed to the decedent by another. Transfers by the decedent with a retained life estate are taxable in the decedent’s estate under §2036.

Joint tenancies with right of survivorship are also interests that terminate at death. As a result, there is no “transfer” from a deceased joint tenant to the survivor and §2033 does not apply. However, §2040 does tax this form of ownership.

Note: Tenancies in common do not carry survivorship rights and are taxable under §2033 be-cause the interest of a deceased co-tenant is inheritable (Harvey v. United States, 185 F. 2d 463 (7th Cir. 1950)).

1 Similarly, a life interest under an annuity contract (purchased by the decedent or another) having no refund or survivor

feature is not included in the gross estate because all rights end on death.

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Interests Created After Death

Lawsuits - For many years the Service insisted that wrongful death actions were taxable under §2033. However, in R.R. 75-127, the Service reversed itself and agreed that the value of wrongful death claims (or the proceeds) is not taxable.

Note: Any claims or causes of action owned by the decedent at the time of death and which survive death are includible in the gross estate under §2033 (Maxwell Trust v. Commissioner, 58 T.C. 444 (1972)).

Insurance Contracts - While insurance proceeds are subject to special rules under §2042, an insurance contract is brought into the policy owner’s gross estate under §2033 if the owner is not the insured. This can happen where one spouse owns an insurance contract on the other.

If the insured is alive when the policy owner dies, only the value of the policy (at replace-ment cost) is includible in the policy owner’s estate (DuPont’s Estate v. Commissioner, 233 F. 2d 210 (3d Cir. 1956)). However, if the insured is dead when the policy owner dies, then any proceeds remaining at death are taxable.

Income - If income property (e.g., rental property, stocks, or bonds) is owned at death, §2033 includes, in the estate, both the value of that property and the income therefrom which has accrued at the date of death (Reg. §20.2033-1(b)). However, income accruing after death is not included but is income taxable to the estate or heirs.

The present value of a right to receive income in the future owned at death is included in the gross estate. This value is determined by discounting the amount of the expected pay-ments using tables specified by Reg. §20.2031-7.

Note: Future interests that are contingent on survival are terminated at death and are not included in the estate under §2033.

Remainder Interests

Under §2033, a remainder interest or other future interest in property is included in the gross estate, unless the interest is a contingent remainder or terminates on the death of a decedent. Thus, if a decedent transfers property and retains an interest in the property, but that interest is contingent on the person remaining alive, §2033 does not apply.

A contingent remainder is an interest that:

(i) Does not come into enjoyment or possession unless a future condition occurs, or

(ii) Can end on the occurrence (or nonoccurrence) of a future event.

A vested remainder is included in the estate of a remainder person who dies before ob-taining such property interest. However, a remainder interest is limited to the remainder person’s life.

Example

Husband transfers assets to a trust with income to his wife, for life, with remainder to his son (if living), and any remainder to his nephew. If the son dies survived by wife, nothing is included in the son’s estate since the interest ended at his death. However,

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the nephew’s interest vests on the son’s death. If the nephew now dies (i.e., after the son is dead), survived by the wife, his interest is included in his estate.

Dower & Curtsey - §2034

Dower and curtsey are not vested interests, but mere expectancies in the property. A dower (to the wife) or curtsey (to the husband) is a statutory provision in a common-law state that directs a certain portion of the estate to the surviving spouse. Section 2034 includes in the decedent’s gross estate “the value of all property to the extent of any interest therein of the surviving spouse, existing at the time of the decedent’s death as dower or curtsey, or by virtue of the statute creating an estate in lieu of dower or curtsey." Thus, property owned at death is included at its full value without reduction for the surviving spouse’s marital interests therein (Reg. §20.2034-1).

For example, a husband without a will dies, with an estate of $1,200,000. Under state law, the wife is entitled to one-third of the husband’s estate. As a result, the $400,000 that the wife receives is included in the husband’s estate under §2034.

Community Property Comparison

In community property states each spouse owns a present, undivided one-half interest in the community assets. On the death of either spouse, only his or her one-half is includible in his or her estate.

Gifts within Three Years of Death - §2035

Formerly, estate tax law automatically included in the donor’s estate any gifts made within three years of the donor’s death (§2035(a)). However, the Economic Recovery Tax Act of 1981 eliminated most outright gifts from inclusion in the donor’s gross estate under this rule. Nev-ertheless, §2035 was not repealed and continues to have two important effects:

(i) Any gift taxes paid or payable on such gifts are included in the donor’s estate, and

(ii) If the decedent holds an interest under §2036, §2037, §2038, or §2042 and attempts to transfer or release it within three years of death it will still be included in the decedent’s estate.

Transfers from Revocable Trusts

In the past, there was significant litigation as to whether these rules required that certain transfers made from a revocable trust within three years of death be includible in the gross estate. See, e.g., Jalkut Estate v. Commissioner, 96 T.C. 675 (1991) (transfers from revoca-ble trust includible in gross estate); McNeely v. Commissioner, 16 F. 3d 303 (8th Cir. 1994) (transfers from revocable trust not includible in gross estate); Kisling v. Commissioner, 32 F. 3d 1222 (8th Cir. 1994) (acq.) (transfers from revocable trust not includible in gross es-tate).

The TRA ‘97 codified the rule set forth in the McNeely and Kisling cases to provide that a transfer from a revocable trust (i.e., a trust described under §676) is treated as if made directly by the grantor. Thus, an annual exclusion gift from such a trust is not included in the gross estate.

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Retained Life Interest - §2036

A transfer with a retained life interest is included in the gross estate. Section 2036 imposes a tax upon any lifetime transfer made by a decedent “under which he has retained for his life or any period not ascertainable without reference to his death or for any period which does not in fact end before his death - (1) the possession or enjoyment of, or the right to income from, the property, or (2) the right either alone or in conjunction with any person, to desig-nate the persons who shall possess or enjoy the property or the income therefrom.”

Section 2036(a) specifies four requirements for taxation:

(1) There must have been a lifetime transfer of property;

(2) Decedent retained interests in or powers over the property;

(3) The retained interests or powers must be either:

a. The possession, right to income, or other enjoyment of the property (§2036(a)(1)); or

b. The right to designate who shall possess or enjoy the property or its income (§2036(a)(2)); and

(4) The taxable interest or power is retained:

a. For life; or

b. For a period other than life if the period cannot be determined without reference to the transferor’s death; or

c. For a period of time other than life if in fact, the decedent dies before the end of that period.

The enjoyment of the property is considered as having been retained by the decedent if it is to be applied to discharge any legal obligations, including the support of a dependent.

Section 2036 does not apply to a power held solely by a person other than the decedent, such as an independent trustee. However, if the decedent reserved the power to remove a trustee and appoint himself or herself as trustee, the decedent is considered as having the powers of the trustee.

Example

Dan creates a trust naming an independent trustee. Trust income is used to support his three minor children. Dan dies while all his children are still minors. Because the trust income was being used to satisfy his legal obligation of support, the trust assets would be included in his estate under §2036.

The entire value of property subject to a retained interest or power is taxable under §2036. The tax is not limited to the value of the specific interest or power2.

2 However, where the retained right relates only to a portion of the property, only that portion is taxed.

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Example

Dan transfers property in trust for Alice for life and remainder to Ralph, retaining the power to substitute other income beneficiaries. While Dan’s power affects only the income interest, (not the remainder), the full value of the property is taxable in Dan’s estate.

Retained Voting Rights

Directly or indirectly retained voting rights in stock of a controlled corporation is the re-tention of the enjoyment of the stock under §2036(a). Control is ownership of, or the right to vote, stock possessing at least 20% of the total voting power of all classes of stock.

Lifetime Transfers With Reversionary Interests - §2037

The estate includes the value of any property transferred by the decedent in any way, except for full consideration, when two (perhaps three?) requirements are met:

(1) Possession or enjoyment of the property could only have been obtained by surviving the decedent (§2037(a)(1)); and

Note: However, for estate tax to apply the property must be “owned” by the decedent at death and it must be “transferred” from the decedent to another. If a decedent’s death is merely instrumental in someone acquiring an interest in property that is not enough to sup-port imposition of the estate tax - e.g., a discretionary bonus granted to an employee after his or her death and paid to his or her executor is not taxable in the employee’s gross estate (R.R. 65-217).

(2) The decedent retained a reversionary interest in the transferred property valued at more than 5% of the value of the transferred property (§2037(a)(2)).

Note: A reversionary interest is a possibility that property transferred by the decedent may return to the decedent or his or her estate or be subject to a power of disposition by the decedent (§2037(b)). The value of a reversionary interest is determined using mortality tables and actuarial principles.

The last sentence of §2037(b) imposes a final “negative requirement”:

“Notwithstanding the foregoing, an interest so transferred shall not be included in the decedent’s gross estate under this section if possession or enjoyment of the property could have been obtained by any beneficiary during the decedent’s life through the exercise of a general power of appoint-ment (as defined in §2041) which in fact was exercisable immediately before the decedent’s death.”

Example

Dan (decedent) transfers property to a trust. The income is payable to his wife for life and with the remainder payable to Dan or, if he is not living at his wife’s death, to his brother or his estate. The brother cannot obtain possession or enjoyment of the prop-erty without surviving Dan. If Dan’s reversionary interest immediately before his death exceeded 5% of the value of the property, the value of the property, less the value of the wife’s outstanding life estate, is includable in the decedent’s gross estate under §2037.

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Thus, under §2037, the property must have been transferred by the decedent during life. Sec-tion 2037 does not apply to property transferred by another. In addition, a reversionary in-terest must be “retained” by the decedent.

Revocable Transfers - §2038

Under §2038, the gross estate includes the value of any property that decedent transferred during lifetime, in trust or otherwise, where at the date of death the transfer was subject to a power to alter, amend, revoke or terminate, exercisable by the decedent alone or in con-junction with any other person.

The tax is imposed upon transfers where enjoyment of the transferred property is subject, at the date of the transferor’s death, to any change through the exercise of a power by the decedent (§2038(a)). The power must either be possessed or exercisable by the decedent at the time of death.

However, a contingent power is not a taxable power if:

(i) The contingency is not within the control of the decedent, and

(ii) The contingency has not occurred at the time of the decedent’s death (Reg. §20.2038-1(b)).

Example

Dan put property into a trust directing that income be paid to Ralph for life, remainder to Mary. Dan can name additional income beneficiaries or remaindermen if he survives Ralph. If Dan dies before Ralph, the trust property is not taxable under §2038 since Ralph’s death is not within Dan’s control and the condition did not occur by the time of Dan’s death. However, such a contingent power will be estate taxable under §2036(a)(2).

Annuities - §2039

There is included in the estate of the decedent the value of amounts receivable by a benefi-ciary under a contract or agreement where the decedent, during life, was receiving or had a right to receive payments under the contract or agreement (§2039).

Section 2039(a) taxes the value of an annuity or other payment receivable by any beneficiary by reason of surviving the decedent under any form of contract or agreement entered into after March 3, 1931, other than as insurance under policies on the life of the decedent.

Payments to the survivor that are in the nature of life insurance proceeds are not taxable under §2039. However, if the decedent retained “incidents of ownership” in the policy, life insurance payable under an annuity may be taxed in the decedent’s estate under §2042.

Section 2039 applies if the decedent was actually receiving payments or had a right to receive payments in the future. For example, if the decedent could receive a pension upon retire-ment, with a death benefit payable to a designated survivor, and he or she died before re-tirement, the survivor’s benefit is includible in decedent’s estate under §2039.

Note: The payments to the beneficiary after the decedent’s death must be “by reason of sur-viving the decedent.” If payments are made at a scheduled time or upon the happening of an

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event, whether the decedent is alive or dead, they are not taxable under §2039 (Reg. §20.2039-1(b)).

The estate tax is on the value of the survivor’s benefit that is proportionate to contributions made by the decedent (§2039(b)). It is not always the entire value of the survivor’s benefit that is includible. Only the amount proportionate to decedent’s contributions is taxed.

Valuation is made as of the date of the decedent’s death. When a lump-sum payment, the value is the amount of the survivor’s benefit. If an annuity or other deferred payments, the benefit is the present value of the right to receive these payments, determined actuarially.

Joint Interests - §2040

Under §2040, co-tenancies with a “right of survivorship” (e.g., joint tenancies, tenancies by the entirety, joint bank accounts, etc.) are included in the gross estate of the first joint tenant to die. Co-ownership without survivorship rights (e.g., tenancies in common, community property, etc.) are not taxable under §2040. However, the interest of the decedent in such property is taxable under §2033.

The inclusion is not limited to the value of the decedent’s undivided interest. It applies to the full value of the joint tenancy property except any part shown to have originally belonged to the survivor and never to have been received or acquired by the survivor from the decedent for less than full consideration (§2040(a)). Thus, to the extent the property originally be-longed to the survivor, or the survivor furnished consideration for its acquisition, the property is not includible in the decedent’s estate.

Note: The amount excluded from the decedent’s estate is not the amount that the survivor contributed. It is an amount proportionate to the survivor’s contribution.

A gift made to a noncitizen spouse before July 14, 1988, toward the creation of a joint tenancy is the surviving noncitizen spouse’s consideration in determining the value of the tenancy includible in the gross estate of the first spouse to die. The RRA ‘90 retroactively provided that the transfer creating a joint tenancy is consideration belonging to the surviving spouse. This rule, however, only applies if the transfer would have constituted a gift had the donor been a U.S. citizen. The transfer, therefore, proportionately reduces the amount of the joint tenancy property includible in the gross estate of the first spouse to die.

Qualified Joint Interests Between Spouses - §2040(b)

Section 2040(b) provides a special rule for husband-and-wife joint tenancies. In the case of such “qualified joint interests,” only one-half of the value of the property will be in-cluded in the estate of the first to die, without regard to which co-tenant furnished the consideration at the time of the joint tenancy’s creation.

Note: The qualified joint interest rule does not apply where the surviving spouse is not a U.S. citizen, unless (1) the surviving spouse becomes a U.S. citizen before the estate tax return is filed, and (2) the spouse was a U.S. resident at all times after the decedent’s death and before becoming a U.S. citizen (§2056(d)).

A “qualified joint interest” is any interest held by a decedent and the decedent’s spouse that is either:

(i) A tenancy by the entirety, or

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(ii) A joint tenancy with right of survivorship, but only if the decedent and his or her spouse are the only joint tenants.

Note: In community property states, each spouse has a present, vested one-half interest in all community assets. Thus, on the death of either spouse, only the deceased spouse’s one-half of the community property is taxable under §2033.

Powers of Appointment - §2041

A “power of appointment” is a power granted by one person to another to dispose of prop-erty even though it is “owned” by another. Section 2041 includes in the gross estate of the holder of such a power the value of the property subject to a general power of appointment.

Note: Under §2041(a), a general power of appointment is “a power which is exercisable in favor of the decedent, his estate, his creditors, or the creditors of his estate . . .” (§2041(b)(1)).

Ascertainable Standard - The Safe Harbor Limitation

Section 2041 provides an exception for a power to consume, invade, or appropriate prop-erty for the benefit of the decedent which is limited by an ascertainable standard relating to health, education, support, or maintenance of the decedent (§2041(b)(1)(A)). Even though such a limited power enables the decedent to appoint the property to himself or herself or his or her creditors, it is not a general power. Where an ascertainable standard is used, anyone, including the trust beneficiary, may be the trustee.

Example

Dan dies having set up a trust for his wife, Daphne, in which she is the sole trustee, receives all income, and can use trust principal for her “health, support, maintenance, and education.” On Daphne’s death, she is not considered the owner of the trust as-sets, and they are not taxed in her estate.

The terms “health, support, maintenance, and education” are important:

1. “Health” would include medical treatment such as hospital, doctor, convalescent hos-pital, prescription drugs, nursing care, etc.

2. “Education” refers to payments to an educational institution such as a private sec-ondary school, college or university, graduate school, and even trade school, together with related expenses such as room and board, transportation, books, etc.

3. “Support” and “maintenance” mean the normal standard of living that the individual enjoys at the time the trust is created or the trustor dies. It includes the cost of housing, utilities, transportation, clothing, and other reasonable, related expenses.

If a “nonascertainable standard,” such as “joy or comfort” is used, there may be problems. If the surviving spouse is the beneficiary and trustee and can take out the principal of the trust for his or her “joy,” then the entire trust could be revoked. Under §2041, this would be a general power. However, it is possible to use a broad, nonascertainable standard when there is an independent trustee.

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5/5 Power

An individual can also be given the right to withdraw a portion of the trust each year. Un-der §2041(b)(2), one can withdraw up to 5% of the value of the trust or $5,000, whichever is greater, each calendar year. This right cannot be accumulated and must be used each year or lost.

Example

Dan creates a trust for his wife, Daphne, and gives her the right to withdraw the greater of 5% of the value of the trust or $5,000. If the trust has a $600,000 value, she can withdraw up to $30,000 (5% of $600,000, which is greater than $5,000).

There is a disadvantage to this right. In the year the beneficiary dies, the beneficiary’s estate will be taxed on this right if it is not used. If no withdrawal in the year of death occurred, then 5% of the value of the trust will be added to the beneficiary’s estate (R.R. 79-373).

Example

For example, assume that A transferred $200,000 worth of securities in trust providing for payment of income to B for life with the remainder to B’s issue. Assume further that B was given a noncumulative right to withdraw $10,000 a year from the principal of the trust fund (which neither increased nor decreased in value prior to B’s death). In such case, the failure of B to exercise his right of withdrawal will not result in estate tax with respect to the power to withdraw $10,000 which lapses each year before the year of B’s death. At B’s death, there will be included in his gross estate the $10,000 which he was entitled to withdraw for the year in which his death occurs less any amount which he may have taken during that year (Reg. §20.2041-3(d)(3)).

Life Insurance - §2042

Under §2042, the proceeds from life insurance on the decedent’s life are includible in the gross estate if the proceeds are:

(i) Payable to (or for the benefit of) decedent’s estate; or

(ii) Payable to any other beneficiary, but only if the decedent possessed “incidents of own-ership” in the policy at the time of death.

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Incidents of OwnershipIncidents of Ownership

The Code does not define “incidents

of ownership.” However, regulations

(e.g., Reg. §20.2042-1(c)(2)) apply

the phrase to any right or interest in

the policy where the insured has the

power, directly or indirectly, to:

(a) control the existence of the

policy,

(b) rearrange the economic

interests therein, or

(c) affect the benefits payable

thereunder.

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Incidents of Ownership

The Code does not define “incidents of ownership.” However, regulations (e.g., Reg. §20.2042-1(c)(2)) apply the phrase to any right or interest in the policy where the insured has the power, directly or indirectly, to:

(a) Control the existence of the policy,

(b) Rearrange the economic interests therein, or

(c) Affect the benefits payable thereunder.

If the insured makes a complete and effective gift of all ownership and beneficial interests in the policy, the proceeds are normally not taxable in the estate. However, if the insured transfers incidents of ownership within three years of death, the proceeds will be taxed in his or her estate by reason of the interaction between §2035 and §2042.

Community Property Issue

Where insurance is purchased with community property funds, it is treated as a commu-nity asset. Each spouse is deemed to have an existing, one-half interest in the policy. Thus, if the insured spouse dies first one-half of the proceeds are taxable in the insured’s estate under §2042. If the uninsured spouse dies first, the deceased spouse’s one-half interest in insurance on the other spouse’s life is “property owned by the decedent” and taxable un-der §2033.

The value of this property would be one-half of the present value of the insurance (meas-ured by its replacement cost). When the insured subsequently dies, all of the proceeds attributable to premiums paid by the insured are taxable.

Example

If 60% of premiums are paid with community funds while husband and wife are alive (30% attributable to each spouse), and 40% of the premiums are paid by the insured husband after the uninsured wife’s death, then 70% of the proceeds are taxed in the insured’s estate when he later dies (Scott v. Commissioner, 374 F. 2d 154 (9th Cir. 1967)).

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Review Questions

7. Upon a decedent’s death, numerous tax forms must be filed. Which form is due for the period of January 1 to the date of the decedent’s death?

a. Form 706.

b. Form 709.

c. Form 1040.

d. Form 1041.

8. Federal estate tax is one of eight potential death taxes. What is a distinguishing characteristic of the federal estate tax?

a. It is not a privilege tax.

b. It is a tax on a property transfer.

c. It is not an excise tax.

d. It is a tax on property.

9. Estate and inheritance taxes are the two basic types of state death taxes. What is a character-istic of the estate tax used by many states?

a. Distinct exemptions and rates apply to amounts received by each heir.

b. It applies to the value of property that heirs receive.

c. It applies to the value of all assets that the decedent owned at death and is transferred to heirs.

d. It is similar to federal estate tax concerning the property and transfers subject to tax.

10. Section 2033 provides that when an interest terminates at death, said interest is excluded from taxation. Under R.R. 75-127, what has also been excluded from taxation?

a. any insurance proceeds remaining at death if the insured is dead when the policy owner dies.

b. income accruing from rental property after death.

c. income accruing from stocks or bonds after death.

d. the proceeds from wrongful death claims.

11. If a remainder person dies prior to obtaining a decedent’s property interest, it can be included in the remainder person’s estate. In such a case, what is this interest called?

a. a contingent remainder.

b. a curtsey.

c. a dower.

d. a vested remainder.

12. Section 2036(a) imposes four requirements for taxation of transfers with a retained life inter-est. What is one of those requirements?

a. An independent trustee solely holds a power over the property.

b. Interests in the property are retained by the decedent.

c. The tax is limited to the value of the specific interest or power.

d. The decedent did not make a lifetime transfer of property.

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Deductions from Gross Estate

Four basic deductions from the gross estate are allowed under federal estate tax law:

(1) Expenses of and claims against the estate (§2053);

(2) Casualty & theft losses during estate administration (§2054);

(3) Charitable transfers (§2055); and

(4) The marital deduction (§2056).

Deductions From GrossDeductions From Gross

EstateEstate

The following deductions are allowed

from the gross estate:

(1) expenses of and claims against

the estate (§2053),

(2) casualty & theft losses during

estate administration (§2054),

(3) charitable transfers (§2055),

and

(4) the marital deduction (§2056).

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Estate Expenses & Claims - §2053

Certain expenses incurred by the estate and various types of claims against the estate, includ-ing debts and taxes owed by the decedent, are deductible. Section 2053(a) lists four catego-ries of deductible items:

(i) Funeral expenses;

(ii) Administration expenses;

(iii) Claims against the estate; and

(iv) “Unpaid mortgages on, or any indebtedness in respect of, property where the value of the deceased’s interest therein, undiminished by such mortgage or indebtedness, is in-cluded in the value of the gross estate . . .”

Note: Expenses are only deductible when paid before expiration of the statute of limitations relating to the estate tax return.

Inclusion of Administrative Expenses on Non-Probate Assets

Section 2053(b) also provides a deduction for administration expenses on property that is not part of the decedent’s probate estate but is part of the federal gross estate, i.e., prop-erty includable under §2035 through §2042.

Casualty & Theft Losses during Administration - §2054

Section 2054 provides a deduction for casualty or theft losses that are not compensated for by insurance or otherwise. While such losses are deductible against the estate’s income tax return (§165) or the gross estate (§2054), no double deductions are allowed and the executor must elect the treatment (§642(g)).

Note: Losses on the sale of property during administration may be deducted for income tax purposes, but are not deductible for estate tax purposes.

Charitable Transfers - §2055 (§170 & §2522)

Taxpayers can have numerous reasons for making charitable contributions, including reli-gious, educational, psychological, and social agendas. In addition, there are substantial tax reasons to make a charitable contribution.

There are three basic formats for charitable contributions in the federal tax system:

(1) An income tax deduction under §170,

Note: Depending on the type of charity receiving the contribution, the available income tax deduction is limited to 20%, 30%, or 50% of the taxpayer’s AGI.

(2) A gift tax deduction under §2522, and

(3) An estate tax deduction under §2055.

Section 2055 provides for an estate tax deduction for a charitable contribution made by an individual’s estate. While income tax provisions place percentage AGI limitations on

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contributions, the estate regulations permit an unlimited charitable deduction if the property is passed by will or other testamentary means.

Under §2055, a deduction is allowed for property transferred by a decedent for charitable purposes. The contribution must be to an organization operated exclusively for a recognized religious, scientific, literary, educational, or other charitable purpose (Reg. §20.2055-1(a)). Sections 501 and 170 define, in detail, the qualifications organizations must meet to be con-sidered charitable. In addition to the definitions found in the Code, the IRS publishes an an-nual report, Publication 78, listing organizations that qualify for federal tax-deductible contri-butions.

There are three primary ways to make a charitable contribution:

(1) Immediate,

(2) Split-interest, or

(3) Insurance-related.

Immediate Contributions

If a taxpayer wishes to make a charitable contribution, he or she can give cash, write a check, or transfer property to a charitable organization. The organization receives the cash or prop-erty and the transaction is complete.

Note: When property is transferred or willed directly to a charity (and not by trust), deductions are easier to determine since the property value is the current fair market value.

Split-Interest Contributions

In a split-interest contribution, interests in the same property are given to both charitable and noncharitable beneficiaries. Examples would be an income interest to an individual for life with the remainder to a charity (“charitable remainder gift”) or income to a charity for a term of years with the remainder to an individual (“charitable lead gifts”).

Note: The charitable deduction is only the value of the interest transferred to the charity (§2055(a)). Special IRS tables, used together with published monthly rates, are used to deter-mine the specific value of the charitable deduction.

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Sections 170 and 2055(e) require a split gift be in the form of:

(1) Annuity trust,

(2) Unitrust, or

(3) Pooled income fund.

Charitable Remainder Trusts

A deductible contribution can be made by a taxpayer in trust to a charity and that tax-payer can keep (or give to another person or persons) the right to receive regular pay-ments from the trust, for life or a period of years, before the charity receives any amount (§170(f)(A)).

Under a charitable remainder trust, the taxpayer contributes property to a trust for the “split” benefit of the taxpayer and a charity. The charity does not receive the full benefit of the contributed property until some future time.

However, the taxpayer receives a current income tax deduction in the year of the con-tribution for the value of the future interest passing to the charity. The amount of the charitable deduction is the present value of the contributed property less the income interest retained by the taxpayer.

The contributed property is, then, typically sold and the proceeds invested to pay an annual income to the taxpayer.

Note: If the taxpayer is one of the income beneficiaries, the value of the charitable trust assets will be included in his or her gross estate. However, since the interest passes to a charity on death, there should be an offsetting estate tax deduction.

Example

Years ago Danny purchased some land for $10,000, which is now worth $100,000. Danny, now age 70, establishes a 7% charitable remainder trust and transfers the land into the trust. The trustee sells the land and invests the entire $100,000. Since the trust is a tax-exempt entity, it pays no tax on the sale of the land. Danny will now receive $7,000 per year for the remainder of his life. Without the charitable trust, the $90,000 would have been taxed at 28% and Danny would only have $74,800 after tax. Danny would have had to invest this $74,800 at an annual rate of approx-imately 9% to receive the comparable $7,000 annually.

Danny is entitled to an income tax deduction for the actuarial present value of the charitable remainder interest on the $100,000. The tables in IRS Publication 1457 are used to determine the amount of the deduction. In addition, the land has been re-moved from Danny’s estate. If he wishes to replace the value of the land for the benefit of his heirs, Danny could purchase life insurance with the cash savings generated.

The Code narrowly defines these trusts and several points should be observed:

(a) Any individual beneficiaries must be alive when the trust is created;

(b) The contribution must be of real property or intangibles; and

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(c) A contribution of a remainder interest in tangible personal property is deductible only when all intervening interests have expired or are held by parties unrelated to the donor (§170(a)(3); Reg. §1.170A-5(a)(1)).

Charitable Remainder Unitrust

This is a trust where the trustee must distribute annually the lesser of:

(i) A fixed percentage (at least 5%) of the trust estate (determined annually), or

Note: The payout must be a fixed percentage of not less than 5% of the net fair market value of the trust assets.

(ii) All trust income (§664(d)).

Note: The trust instrument may limit the payout to the net income of the trust, with any deficiency to be made up in later years. This is commonly referred to as a net income unitrust.

Thus, a charitable remainder unitrust provides the noncharitable beneficiary a varia-ble payout based on the annual valuation of the trust assets. Because the trust is val-ued annually, the donor may make additional contributions to the trust. In addition, the trust must be irrevocable.

The payout term may extend for a period of up to a maximum of 20 years, or if the beneficiary is an individual, for life (or the lives of more than one beneficiary), after which time the remainder assets pass to the charity. However, no payments other than those described may be made to anyone other than a qualified charity. Upon the termination of all payments, the remainder interest is passed to the charity or is re-tained by the trust for the benefit of the charity (§664(d)(2) and (3)).

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Life Insurance Funding

Since a unitrust is permitted to receive additional contributions, it is an excellent device to be funded with life insurance. The life insurance can be transferred to the trust and the trust named as beneficiary of the policy. The trust beneficiaries will be the charity and the heirs. The cash value of the policy can be used as a source of income payments to the heirs. The benefit amount that passes to the charity will generate a charitable deduction.

Note: The benefit amount that passes to the charity will depend on actuarial calculations based on the life expectancies of the heirs.

Charitable Remainder Annuity Trust

This is a trust where the trustee must annually distribute to the noncharitable benefi-ciary at least five percent of the original value of the trust assets (§664(d); Reg. §1.664-1(a)(1)). Because the payout amount is fixed at the inception of the trust, valuation occurs only once and the payout cannot be limited to the net income of the trust. The donor cannot make additional payments to the trust and it must be irrevocable. Again, the payout term may extend for up to 20 years or, if the beneficiary is an individual, for life (or the lives of more than one beneficiary). On termination of the payments, the remainder interest is transferred to the charity or retained by the trust for the benefit of the charity (§664(d)(1)).

Note: In both the annuity and unitrust formats the annuity can be cumulative. Thus, if the investment return is insufficient to pay the full annuity, the trust can make up the deficiency in subsequent years.

50% & 10% Annuity Restrictions - §664(d)

Since 1997, a trust cannot be a charitable remainder annuity trust if the annuity for any year is greater than 50% of the initial fair market value of the trust’s assets or be a charitable remainder unitrust if the percentage of assets that are required to be distributed at least annually is greater than 50%. In addition, tax law requires that the value of the charitable remainder with respect to any transfer to a qualified charitable remainder annuity trust or charitable remainder unitrust be at least 10% of the net fair market value of such property transferred in trust on the date of the contribution to the trust. There are special rules that deal with revocations and reformations of trusts created after that date that do not meet the 10% require-ment.

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Note: The 10% requirement does not apply to trusts created by will or other testamentary instrument if the settlor dies before January 1, 1999, and the will or other testamentary instrument is not changed after June 28, 1997, or the settlor is under a mental disability on that date.

Finally, tax law provides that additional contributions made after July 28, 1997, to a charitable remainder unitrust created before July 29, 1997, that does not meet the 10% requirement with respect to the additional contribution, is treated, under the regulations as if those contributions were made to a new trust that does not affect the status of the original unitrust as a charitable remainder trust.

Pooled Income Fund

A pooled income fund is a trust maintained by the charity into which each donor trans-fers property and from which each named beneficiary receives an income interest. Donors contribute property to the trust reserving a life estate in a share of the total property. The public charity must be the irrevocable remainder (§642(c)). The remain-der interest ultimately passes to the charity that maintains the fund.

All contributions to a pooled income fund are commingled, and all transfers to it must meet the requirements for an irrevocable remainder interest. The pooled income fund cannot accept or invest in tax-exempt securities, and no donor or beneficiary of an income interest can be a trustee of the fund. The income to the beneficiaries is determined by the rate of return earned by the trust each year (§642(c)(5); Reg. §1.642(c)-5).

A pooled default income fund is similar to a mutual fund since it maintains a portfolio of investments and provides the taxpayer with a rate of return comparative to stock market funds. By pooling assets into a common fund, taxpayers have less risk of loss and greater diversity.

Taxation of Charitable Trust Beneficiaries - §664

Amounts paid to a beneficiary of a charitable remainder trust retain his or her char-acter when received. While a regular trust characterizes its payments according to the trust’s annual income, a charitable remainder trust characterizes payments based on the entire history of the trust.

Multi-Tiered Structure

Section 664(b) sets forth a multi-tiered structure for taxing distributions to in-come beneficiaries of a charitable remainder trust. Distributions paid to a chari-table remainder trust beneficiary are first taxed as ordinary income to the extent of the trust’s current and prior undistributed income.

Once all the ordinary income is exhausted, remaining distributions are character-ized as follows:

(1) Short-term capital gain to the extent of current and past undistributed short-term capital gains;

(2) Long-term capital gain to the extent of current and past undistributed long-term capital gains;

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(3) Other income, such as tax-exempt income, to the extent of the trust’s cur-rent and past undistributed income of such character; and

(4) Tax-free distributions of principal (§664(b)(1) through (4)).

Generation-Skipping Transfer Tax

Even though the generation-skipping transfer (GST) tax does not apply to charitable gifts, the impact on the GST tax should be considered if the donor’s grandchild (or another skip person) is an income beneficiary of the charitable remainder trust. In such a situation, the donor must plan the allocation to the trust so that it (together with other assets transferred) does not exceed the GST exemption. The generation-skipping transfer tax exemption for a given year is equal to the applicable exclusion amount for estate tax purposes. In addition, the generation-skipping transfer tax rate for a given year will be the highest estate and gift tax rate in effect for such year.

Example

Danny transfers $600,000 to a charitable remainder unitrust. The value of the remain-der interest is $375,000. Danny has $450,000 of his GST tax exemption still available. He could allocate $225,000 [$600,000 total value - $375,000 charitable remainder value] of the remaining GST tax exemption to the trust. The trust would have an inclu-sion ratio of zero, and no GST tax.

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HEIRS

CHARITY

CHARITABLE LEAD TRUST

FOR TERM OF YEARS

TAXPAYER'S ASSETS

END OF TRUST

GIFT TAX ON

REMAINDERGIFT

Charitable Lead Trust

INCOME

REMAINDER

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Charitable Lead Trusts

A deduction is also permitted for a gift of an income interest, generally referred to as a charitable lead trust (§170(f)(2)(B)). A charitable lead trust is where the donor gives an income interest to the charity, with the remainder reverting to the donor (or named beneficiaries). It is essentially the reverse of a charitable remainder trust.

The gift of the income interest will be deductible if the interest is in the form of:

(a) A “guaranteed annuity interest,” or

Note: A guaranteed annuity interest is an irrevocable right to receive at least an annual payment of a determinable amount. A guaranteed annuity may be made to continue for the shorter of a term of years or lives in being plus a term of years (R.R. 85-49).

(b) A “unitrust interest” (§170(f)(2)(B)).

Note: A unitrust interest is an irrevocable right to receive payment at least annually of a fixed percentage of the fair market value of the trust assets, determined annually.

In either case, payments may be made to the charity for a term of years or over the life or lives of an individual (who is living at the date of the transfer to the trust). After ter-mination of the income interest, the remainder interest in the property goes to children or other designated remainder beneficiaries.

Insurance Related Contributions

Life insurance can be used to fund charitable contributions by:

(1) Assigning ownership of an existing policy to a charity,

(2) Making a charity beneficiary of an existing policy,

(3) Assigning a split-interest in a policy to a charity, and

(4) Making a charity an irrevocable beneficiary of a new policy.

Unlimited Marital Deduction - §2056

A deduction is allowed for property passing unconditionally to the surviving spouse of the decedent’s death. Section 2056(a) provides that this deduction shall be an “amount equal to the value of any interest in property which passes or has passed from the decedent to his surviving spouse . . .”

Requirements

The marital deduction has six basic requirements:

(1) The decedent must have been a citizen or resident of the United States (§2056(a));

(2) Property passing to the surviving spouse must have been included in the decedent’s estate (§2056(a));

(3) The decedent must have been married at the time of death;

Note: State law determines marital status (R.R. 67-442).

(4) The spouse survived the decedent;

Note: Survival is determined using the presumptions under the Uniform Simultaneous Death Act (Reg. §20.2056(e)-2(e)).

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(5) Property must have “passed” from the decedent to the surviving spouse - by will, by operation of law, or otherwise; and

(6) The property must be a “deductible interest.” Nondeductible interests include inter-ests:

(a) Not included in the gross estate,

(b) Deductible under §2053 or §2054, and

(c) Some (but not all) “terminable interests.”

Note: Section 2056(b)(1) defines a terminable interest as one where “on the lapse of time, on the occurrence of an event or contingency, or on the failure of an event or contingency to occur, an interest passing to the surviving spouse will terminate or fail . . .”

Net Value Rule

The marital deduction is restricted to the net value of property passing to the surviving spouse. When property going to the surviving spouse is subject to a mortgage (which has not been paid off by the estate), the value of the property under the marital deduction is reduced by that debt (§2056(b)(4)(B)).

The value of the property must also be reduced by any death taxes payable by the spouse or payable out of property passing to the spouse (§2056(b)(4)(A)).

Non-Citizen Spouse

When a foreign-born spouse is a United States resident but not a citizen, he or she is still taxed in the same manner as a United States citizen for federal income tax purposes. Like-wise, if such a spouse makes a gift of property abroad (outside the United States), he or she would be subject to gift tax like any United States citizen. Should the foreign-born spouse be the first to die, his or her estate would be entitled to the marital deduction for bequests and transfers to the surviving citizen spouse. However, if the foreign-born spouse is the survivor, there are important estate tax implications.

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Marital Deduction ElementsMarital Deduction Elements

1. Decedent was a US citizen or resident;

2. Property was included in the decedent’s

estate;

3. Decedent was married at death;

4. Spouse survived the decedent;

5. Property “passed” from decedent to

surviving spouse by will, operation of law,

or otherwise; and

6. Property was a “deductible interest.”

Nondeductible interests include interests:

(a) not included in gross estate,

(b) deductible under §2053 or §2054, and

(c) some (but not all) “terminable interests.”

Note: A terminable interest is where on the lapse of

time, on the occurrence of an event or contingency,

an interest passing to the surviving spouse will

terminate or fail

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Example

Dan’s spouse was born in France, and even though she has established permanent residence in California, she has never given up her French citizenship to become a United States citizen. She is considered a non-citizen or alien.

Under §2056(d)(1), no marital deduction is allowed if the surviving spouse is not a citizen of the United States, even though the decedent is a citizen. Thus, if a citizen spouse dies, assets passing to a surviving non-citizen spouse will not qualify for the unlimited estate tax marital deduction that is available to United States citizens.

Note: The marital deduction is allowed if the surviving spouse becomes a citizen before the estate tax return is filed, and was a resident of the U.S. at all times after the decedent’s death and before becoming a citizen.

This denial of the marital deduction for non-citizen spouses has an important exception. If assets, otherwise qualifying for the marital deduction, are transferred into a qualified do-mestic trust (QDT), the marital deduction will be available without limit (§2056(d)(2)).

Qualified Domestic Trust

Under §2056A(a), a QDT means a trust:

(a) That requires that at least one trustee be an individual U.S. citizen or a domestic corporation,

Note: Under Prop. Reg. §20.2056A-2(c), a domestic corporation would be defined as a cor-poration that is created or organized under the laws of the U.S. or under the laws of any state or the District of Columbia.

(b) That provides that no distribution (other than a distribution of income) may be made from the trust unless a trustee who is an individual U.S. citizen or domestic cor-poration has the right to withhold the tax imposed by §2056A,

Note: The tax imposed by §2056A is the amount by which the citizen-decedent’s estate tax would have been increased if the amount taxable (the amount of the distribution or amount remaining in trust at the survivor's death) had been included in the citizen-decedent’s tax-able estate. For this purpose, any previous taxable distribution must be taken into account. All distributions from a qualified domestic trust except distributions of income or distribu-tions to the surviving spouse on account of hardship are subject to the tax imposed by §2056A. The tax imposed because of a distribution during the surviving spouse’s life is due on the 15th day of the fourth month following the calendar year in which the distribution occurs.

The tax is also imposed on the value of any property remaining in the trust on the date of the surviving spouse’s death (§2056A(b)(1)(B)).

The trustee is personally liable for the amount of tax imposed. In addition, there is a lien against the property giving rise to the tax for 10 years after the taxable event.

Some relief for this tax cost is also offered through a credit provision. If property is be-queathed to a non-citizen spouse and that property transfer is subjected to estate tax but would not have been taxed if the surviving spouse had been a citizen, a credit will be avail-able to the surviving spouse’s estate on his or her death. This percentage credit will be for

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the tax paid by the first spouse’s estate on the earlier transfer to the non-citizen spouse that did not qualify for the marital deduction.

(c) Which meets such requirements as the Treasury Secretary may by regulations pre-scribe to ensure the collection of the tax, and

Note: The IRS has exercised the authority given by this section to issue proposed regula-tions. A sample of these regulations follows.

Under Prop Reg. §20.2056A-2(d)(1), if the fair market value of the assets passing to the QDT, determined as of the date of the decedent’s death, exceeds $2,000,000, the trust in-strument would have to require that either:

(1) At least one U.S. trustee be a bank, as defined in §581, or

(2) The U.S. trustee furnish a bond or security in an amount equal to 65% of the fair market value of the trust corpus determined as of the date of the decedent’s death.

If the fair market value of the assets passing to the QDT is $2,000,000 or less, the trust instrument would either have to meet requirement (1) or (2), above or require that no more than 35% of the fair market value of the trust assets, determined annually on the last day of the tax year of the trust, may consist of real property located outside of the U.S. that is owned by the trust.

When the U.S. trustee of a QDT is an individual U.S. citizen, the individual would have to have a tax home in the U.S. (Prop. Reg. §20.2056A-2(d)(2)).

A QDT would have to provide that all trust assets must be physically located in the U.S. (Prop. Reg. §20.2056A-2(d)(3)). However, this rule would not apply when the requirements for QDTs with assets in excess of $2,000,000 apply.

The U.S. trustee of a QDT would have to file a statement annually with IRS. The statement would have to be attached to the fiduciary income tax return (Form 1041) filed by the QDT (Prop Reg. §20.2056A-2(d)(4)(i)).

(d) With respect to which the citizen-decedent’s executor elects to have the trust qualified as a qualified domestic trust.

Note: The executor must make an irrevocable election on the estate tax return with respect to the trust. However, the executor is not required to make such an election. The executor’s right to make this election should appear in the will or the QDT trust.

An executor may make a protective election if there is a bona fide legal controversy that would render the making of the election at the time of the estate tax return not feasible (Prop. Reg. §20.2056A-3(c))). Partial QDT elections are not permitted.

If property passes to a trust that otherwise would qualify for the marital deduction ex-cept that the surviving spouse is not a U.S. citizen, the property can be treated as passing to a qualified domestic trust if the trust is reformed to meet the QDT requirements. The revision may occur pursuant to the decedent’s will, trust, or a judicial proceeding (Prop. Reg. §20.2056A-4(a)).

Gifts to Non-Citizen Spouses

The gift tax provisions specify that the unlimited marital deduction is not available for gifts to non-citizen spouses. However, since July 14, 1988, a gift of up to $100,000 (in-dexed for inflation) per year can be made to a non-citizen spouse without incurring a

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gift tax (§2523(i)). To qualify, the gift must be one of a present interest. Under this pro-vision, substantial assets can be transferred to a non-citizen spouse during lifetime to effect estate planning objectives.

Example

Dan, a U.S. citizen, is married to Maria, a resident alien. Dan transfers to Maria 100 shares of X Corporation stock valued for federal gift tax purposes at $130,000. The transfer is a gift of a present interest and is a deductible interest for gift tax purposes. Accordingly, $100,000 of the $130,000 gift is not included in the total amount of gifts made by Dan during the calendar year for federal gift tax purposes. Dan must include $30,000 on his annual gift tax return, Form 709, as a taxable gift.

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Review Questions

13. According to the author, taxpayers may make charitable contributions in three basic ways. In which method are property interests received by both charitable and noncharitable beneficiar-ies?

a. immediate.

b. insurance-related.

c. pledge.

d. split-interest.

14. A taxpayer can make a deductible contribution in trust to a charity. What is a planning con-sideration in establishing a charitable remainder trust?

a. The taxpayer may deduct a contribution of a remainder interest in tangible personal prop-erty only when related parties hold all intervening interests.

b. The taxpayer may deduct a contribution of a remainder interest in intangible real property only upon the expiration of all intervening interests.

c. When the taxpayer establishes the trust, all individual beneficiaries must be over 18 years of age.

d. The taxpayer must contribute real property or intangibles.

15. Under §§170 and 2055(e), split gifts can be in three formats. In which format does the charity maintain the trust?

a. a charitable lead trust.

b. a charitable remainder annuity trust.

c. a charitable remainder trust.

d. a pooled income fund.

16. In a charitable remainder trust, a taxpayer makes a contribution of property to a trust for the immediate benefit of the taxpayer and the future benefit of a charity. What is fundamentally the opposite of a charitable remainder trust?

a. a charitable lead trust.

b. a charitable remainder annuity trust.

c. a charitable remainder unitrust.

d. a pooled income fund.

17. Upon the decedent’s death, a marital deduction can be allowed for assets that pass com-pletely to the surviving spouse. When is said deduction denied for assets?

a. when they pass to a marital deduction trust for the survivor’s benefit.

b. when they pass to a qualified domestic trust of which a noncitizen surviving spouse is a beneficiary.

c. when they pass to a surviving spouse as an outright transfer.

d. when they pass to a surviving spouse who is a non-U.S. citizen.

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Valuation

Determination of the estate tax begins with the value of the decedent’s assets at death (or the alter-nate valuation date). The estate tax is measured by the fair market value of the property transferred. Since estate tax attaches at the instant of death, the value of estate assets is his or her value imme-diately after death, not the instant before death.

Note: Sections 2031 (gross estate) and 2512(a) (valuation of gifts) use “value” without elaboration. Reg. §20.2031-l(b) defines FMV as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” Reg. §25.2512-1 provides a similar definition for gift tax purposes.

The estate and its representatives have the burden of proof as to the fair market value of the estate assets.

IRS Valuation Explanation - §7517

Under §7517, the estate can request that the IRS furnish a written statement explaining its pro-posed or actual valuation. This statement must:

(i) Describe the basis of the valuation,

(ii) Show any computation, and

(iii) Enclose a copy of any appraisal.

Alternate Valuation - §2032

Under §2032, the executor is given an election to value the estate assets either at:

(i) The date of the decedent’s death, or

(ii) At the “alternate valuation date.”

When the alternate date is elected3, all assets in the estate are valued as of six months after the decedent’s death. However, any assets sold, exchanged, or otherwise disposed of during the six months after death are valued as of his or her disposition.

Assets included in the estate because of §2035 through §2038 are valued as of decedent’s death (or alternate date) not as of the transfer date. This is true even if the donee has sold or exchanged the property.

Special Valuation - §2032A

Farmland and real property used in a closely held business can be valued at less than fair market value (§2032A). Farmland can be valued by dividing the net average annual gross cash rental for comparable land (gross cash rental less real estate taxes) by the average annual effective interest rate for all new federal land bank loans (§2032A(e)(7)). Business real property can be valued by several methods that primarily rely upon a capitalization of earnings (§2032A(e)(8)). In any event, the decrease in value for estate tax purposes cannot exceed $1,190,000 in 2021.

3 The election must be made on the estate tax return - Form 706.

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Estate Tax Return & Payment - §6018

Under §6018(a), the executor is responsible for filing the federal estate tax return, Form 706. A return is required only if the amount of the gross estate exceeds the applicable exclusion amount (e.g., $11,700,000 in 2021)4 (§6018(a)(1)). The return must be filed within nine months of the decedent’s death (§6075(a)). However, a filing extension of up to six months can be granted (§6018(a)).

The executor is also personally responsible for the payment of the estate tax (§6151(a)). This liability continues until he or she has been discharged upon application to the IRS (§2204). If the tax is not paid, the persons who received the property that was in the estate are liable for the tax to the extent of the value of the property received (§6324).

Payment of the estate tax is due at the same time as the estate tax return itself - i.e., within nine months of death. Extensions for payment of the tax5 can be granted (after showing reasonable cause) for up to ten years (§6161).

Installment Payment of Federal Estate Taxes - §6166

Estates of individuals whose major assets are interests in a closely held business may elect to pay the estate tax in installments if the value of the closely held business interest relative to the gross estate or taxable estate is large enough.

Where the estate is substantially (35% of the adjusted gross estate) made up of an interest in a closely held business, §6166 permits installment payment of the tax associated with the business. Under §6166, the tax is deferred for five years (interest only is due) and then paid in ten annual installments. For years 6 through 15 after the decedent’s death, the tax is payable in equal in-stallments.

Computation

For estate taxes that are deferred under §6166, the tax attributable to the first $1,000,000 (indexed for inflation) in taxable value of the closely held business (i.e., the first $1,000,000 in value in excess of the effective exemption provided by the applicable exclusion amount and any other exclusions) is subject to interest at a rate of 2%. The remainder of such taxes is subject to interest at a rate equal to 45% of the rate applicable to underpayments of tax, and all taxes paid under §6166 are made nondeductible.

Note: Interest paid on estate taxes deferred under this provision is not deductible for estate or income tax purposes.

Example

Dan died in 2011 when the applicable exclusion amount was $5,000,000. He owned a business that qualified for the $1 million deferral of tax payments for qualified family-owned business interests. If his executor so elected, the amount of estate tax

4 A return is required for estates of nonresident aliens if that part of the gross estate that is situated in the United States

exceeds $60,000. 5 Interest still accrues.

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attributable to the value of the closely held business between $6,000,000 and $5,000,000 was eligible for the 2% interest rate.

Eligibility & Court Supervision

If an estate never qualified or ceases to qualify for the installment payment of estate taxes, the total amount of deferred estate tax is immediately due. However, taxpayers are given access to the courts to resolve disputes over an estate’s eligibility for the §6166 election. The U.S. Tax Court is authorized to provide declaratory judgments regarding initial or con-tinuing eligibility for deferral under §6166.

Closely Held Business

A closely held business is:

(a) A sole proprietorship,

(b) An interest as a partner in a partnership where 20% or more of the total capital interest in such partnership is included in determining the gross estate of the decedent or the part-nership has 45 or fewer partners, or

(c) Stock in a corporation where 20% or more is included in the gross estate or the corpo-ration has 45 or fewer shareholders (§6166(b)(1)).

An estate with an interest in a qualifying lending and financing business is eligible for install-ment payment of the estate tax. However, an estate with an interest in a qualifying lending and financing business must make installment payments of estate tax (including both princi-pal and interest) over five years.

Only the stock of holding companies, not that of operating subsidiaries, must be nonreadily tradable to qualify for installment payment of the estate tax. However, an estate with a qual-ifying property interest held through holding companies must also make all installment pay-ments over five years.

Acceleration of Payment

Section 6166(g) provides for acceleration of installments upon default or the disposition or with-drawal of more than fifty percent in value of the business interest.

Deferred Payment of Federal Estate Tax

Section 6161 Section 6166

Maximum Period of Tax Payment

10 Years 15 Years

(Interest only for first 5 years)

Amount of Tax Af-fected

Total Federal Estate Tax Tax Allocable to Qualifying Business

Interest Rate Same as for Deficiencies 2% on the portion of tax allocable to the first $1 million (indexed for inflation) of

the business, remaining tax is 45% of defi-ciency rate

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Requirements Show Reasonable Cause 1. Business value is greater than 35% of Adjusted Gross Estate

2. Businesses can be combined if decedent owned 20% or more of each

3. Business has 45 or fewer shareholders or partners or 20% or more ownership in-terest

Flower Bonds

Formerly, certain Treasury bonds owned by a decedent at death could be redeemed at par value (plus accrued interest) to pay federal estate taxes. These bonds could be turned into the Treasury as payment and represented an excellent method of paying some or all or the estate tax liability at a substantial discount. However, these “flower” bonds can no longer be purchased directly from the government, but might still be obtained through stockbrokers for a limited time. The government accepts them at par to pay death taxes. The author is not aware of any such bonds still being available. The last of such bonds matured in 1998.

Tax Basis for Estate Assets - §1014

Under §1014, heirs receive a stepped-up basis in estate assets and take as his or her income tax basis the fair market value of the property included in the estate.

Property Basis

Property Basis in Common Transactions

Type of Transaction Basis Holding Period Starts

Purchase Cost of property plus improve-

ments Date of purchase

Gift Later Sold At Gain Donor’s basis Date donor’s holding period

started

Gift Later Sold At Loss

Lesser of:

Donor’s basis, or FMV on date of gift

Date donor’s holding period started on date of gift

Seller Repossession

Adjusted basis of the debt due, plus gain from the reposses-

sion, plus any repossession ex-penses

The holding period includes the period before and after the

seller repossession

Tax-deferred Exchange Original basis of property given up, plus “boot” given, plus any

net increase in debt

The holding period includes the period before and after the ex-

change

Inheritance FMV on date of death or 6

months thereafter

Generally, date of decedent’s death but, automatically

deemed more than one year for C/G

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Community Property Cost Basis

Holding title as community property can have significant cost basis advantages. When property is held as “community property,” the decedent’s and the surviving spouse’s respective commu-nity shares of an asset receive a complete “stepped-up” basis at the decedent’s death. This is true even though only the decedent’s share is included in the estate (R.R. 87-98).

This could result in a substantial income tax advantage over couples holding property in other forms of joint ownership. Here only the portion of an asset included in the decedent’s estate will be eligible for a “step-up” in basis.

Basis of Property Under the 2010 Special Election

For a decedent who died in 2010, TRUIRJCA allowed the executor of such a decedent's estate to elect to apply the Code as if the TRUIRJCA had not been enacted. Without the enactment of TRUIRJCA, the 2010 repeal of the estate, gift, and generation-skipping transfer taxes would have eliminated the step-up basis rules and imposed a modified carryover basis regime. Thus, when such an election was made, the estate was not subject to estate tax but, the basis of assets ac-quired from the decedent was determined under the modified carryover basis rules of §1022.

Under this modified carryover basis regime, recipients of property transferred at the decedent’s death received a basis equal to the lesser of:

(1) The adjusted basis of the decedent, or

(2) The fair market value of the property on the date of the decedent’s death.

The modified carryover basis rules applied to property acquired by bequest, devise, or inher-itance, or by the decedent’s estate from the decedent, and property passing from the decedent to the extent such property passed without consideration.

Property acquired from a decedent was treated as if the property had been acquired by gift. Thus, the character of gain on the sale of property received from a decedent’s estate was carried over to the heir. For example, real estate that had been depreciated and would be subject to recapture if sold by the decedent would be subject to recapture if sold by the heir.

Property to Which the Modified Carryover Basis Rules Apply

The modified carryover basis rules applied to property acquired from the decedent. Property acquired from the decedent was:

(1) Property acquired by bequest, devise, or inheritance,

(2) Property acquired by the decedent’s estate from the decedent,

(3) Property transferred by the decedent during his or her lifetime in trust to pay the in-come for life to or on the order or direction of the decedent, with the right reserved to the decedent at all times before his or her death to revoke the trust,

(4) Property transferred by the decedent during his or her lifetime in trust to pay the in-come for life to or on the order or direction of the decedent with the right reserved to the decedent at all times before his or her death to make any change to the enjoyment thereof through the exercise of a power to alter, amend, or terminate the trust,

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(5) Property passing from the decedent by reason of the decedent’s death to the extent such property passed without consideration (e.g., property held as joint tenants with right of survivorship or as tenants by the entireties), and

(6) The surviving spouse’s one-half share of certain community property held by the dece-dent and the surviving spouse as community property.

Limited Basis Increase for Certain Property

The modified carryover basis rules allowed an executor to increase the basis of assets owned by the decedent and acquired by the beneficiaries at death. Under this rule, each decedent’s estate generally was permitted to increase (i.e., step up) the basis of assets transferred by up to a total of $1.3 million.

The $1.3 million was increased by the amount of unused capital losses, net operating losses, and certain “built-in” losses of the decedent. In addition, the basis of property transferred to a surviving spouse could be increased by an additional $3 million.

Thus, the basis of property transferred to surviving spouses could have been increased by a total of $4.3 million. Nonresidents who were not U.S. citizens were allowed to increase the basis of property by up to $60,000. The $60,000, $1.3 million, and $3 million amounts were to be adjusted annually for inflation occurring after 2010.

Example

Danny died in 2010 leaving an estate consisting of stock worth $6,000,000 with a basis of $1,000,000 and his executor made the special election. If Danny left his estate to his surviving spouse, the executor could increase the total basis in the stock to $5,300,000 ($1,000,000 carryover basis + $1,300,000 million general basis and $3,000,000 spousal basis.) If Danny left his estate to a beneficiary other than his spouse, the executor could increase the total basis in the stock to $2,300,000.

In general, the basis of property could be increased above the decedent’s adjusted basis in that property only if the property was owned, or was treated as owned, by the decedent at the time of the decedent’s death. In the case of property held as joint tenants or tenants by the entireties with the surviving spouse, one-half of the property was treated having been owned by the decedent and was thus eligible for the basis increase.

In the case of property held jointly with a person other than the surviving spouse, the portion of the property attributable to the decedent’s consideration furnished was treated as having been owned by the decedent and was eligible for a basis increase. The decedent also was treated as the owner of property (which was eligible for a basis increase) if the property was transferred by the decedent during his or her lifetime to a revocable trust that pays all of its income during the decedent’s life to the decedent or at the direction of the decedent. The decedent also was treated as having owned the surviving spouse’s one-half share of commu-nity property (which will be eligible for a basis increase) if at least one-half of the property was owned by, and acquired from, the decedent.

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The decedent was not, however, treated as owning any property solely by reason of holding a power of appointment with respect to such property.

Property not eligible for a basis increase included:

(1) Property that was acquired by the decedent by gift (other than from his or her spouse) during the three-year period ending on the date of the decedent’s death;

(2) Property that constitutes a right to receive income in respect of a decedent;

(3) Stock or securities of a foreign personal holding company;

(4) Stock of a domestic international sales corporation (or former domestic international sales corporation);

(5) Stock of a foreign investment company; and

(6) Stock of a passive foreign investment company (except for which a decedent share-holder had made a qualified electing fund election).

Basis increase was allocable on an asset-by-asset basis (e.g., basis increase could be allocated to a share of stock or a block of stock). However, in no case could the basis of an asset be adjusted above its fair market value. If the amount of basis increase was less than the fair market value of assets whose bases were eligible to be increased under these rules, the ex-ecutor determined which assets and to what extent each asset received a basis increase.

GST Tax - §2601

The 1976 Tax Reform Act introduced a completely new and entirely separate6 transfer tax - the “Gen-eration-Skipping Transfer Tax.” It is a tax on the value of property at the time an interest shifts from one generation to a succeeding generation (§2601). The generation-skipping transfer tax was a flat rate of 45% (in 2009) on cumulative generation-skipping transfers in excess of $3.5 million (in 2009). While this tax was repealed in 2010, it was reinstated by TRUIRJCA for 2010 through 2012 at a flat (or top) rate of 35% for amounts exceeding its exemption. In 2013, ATRA permanently increased the top GST rate from 35% to 40% for transfers over the exemption

Note: The generation-skipping transfer tax exemption for a given year is equal to the applicable exclusion amount for estate tax purposes.

The generation-skipping transfer tax is imposed on transfers, either directly or through a trust or similar arrangement, to a “skip person” (i.e., a beneficiary in a generation more than one generation below that of the transferor). Under §2611, the tax applies to the following types of transfers:

1. Taxable Terminations - This is defined as any termination (by death, lapse of time, release of a power, or otherwise) of an interest in property held in trust, unless:

(a) Immediately after such termination, a non-skip person has an interest in such property, or

(b) At no time after such termination may a distribution be made from such trust to a skip person (§2612(a)).

6 Nonetheless, the generation-skipping transfer tax is related to the estate tax. It is designed to produce a tax result for

generation-skipping transfers as would have occurred had the property passed through successive generations.

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Note: A skip person may be a natural person or certain trusts. All persons assigned to the second or more remote generation below the transferor are skip persons (e.g., grandchildren and great-grandchildren). Trusts are skip persons if (1) all interests in the trust are held by skip persons, or (2) no person holds an interest in the trust and at no time after the transfer may a distribution (includ-ing distributions and terminations) be made to a non-skip person (§2613(a)(1)).

2. Taxable Distributions - This means any distribution from a trust to a skip person (§2612(b)).

3. Direct Skips - This is a transfer subject to gift or estate tax but which is made to a skip person (§2612(c)).

Note: A transfer to a grandchild is exempt if the parent of the grandchild is dead (§2612(c)(2)).

The tax is computed by multiplying the “taxable amount” by the “applicable rate” (§2602). The tax-able amount differs with the type of transfer. For taxable terminations, it is the value of all property that was the subject of the taxable termination reduced by expenses under §2053(b) (§2622). In the case of taxable distributions, it is the value of the property received by the transferee reduced by expense related to the determination of the tax (§2621(a)). For direct skips, it is the value of the property received (§2623).

The applicable rate is the maximum federal estate tax rate in effect on the date of the transfer mul-tiplied by the “inclusion ratio.” This ratio is the reciprocal of a fraction that has, as its numerator, the amount of the exclusion allocated to the subject property and, as its denominator, the value of all property transferred less any federal estate taxes (§2642).

In short, the GST is imposed at a flat rate of 40% (i.e., the top rate of estate and gift taxation in 2021) on cumulative generation-skipping transfers in excess of an exemption amount ($11,700,000 in 2021).

Predeceased Parent Exception

Under the “predeceased parent exception”, a direct skip transfer to a transferor’s grandchild is not subject to the generation-skipping transfer (“GST”) tax if the child of the transferor who was the grandchild’s parent is deceased at the time of the transfer (§2612(c)(2)). This “predeceased parent exception” to the GST tax is not applicable to:

(1) Transfers to collateral heirs (e.g., grandnieces or grandnephews), or

(2) Taxable terminations or taxable distributions.

The predeceased parent exception applies to transfers to collateral heirs, provided that the de-cedent has no living lineal descendants at the time of the transfer. For example, the exception applies to a transfer made by an individual (with no living lineal heirs) to a grandniece where the transferor’s nephew or niece who is the parent of the grandniece is deceased at the time of the transfer.

Example

Dan is a granduncle with no children. Rocko, his sister’s son (his nephew) is deceased. A transfer from Dan to his grandniece (nephew’s daughter) is excluded from the GSTT because of the predeceased parent exception. However, the transfer is subject to gift and estate taxes.

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In addition, the predeceased parent exception (as modified by the change in the preceding par-agraph) also applies to taxable terminations and taxable distributions, provided that the parent of the relevant beneficiary was dead at the earliest time that the transfer (from which the bene-ficiary’s interest in the property was established) was subject to estate or gift tax. For example, where a trust was established to pay an annuity to a charity for a term of years with a remainder interest granted to a grandson, the termination of the term for years is not a taxable termination subject to the GST tax if the grandson’s parent (who is the son or daughter of the transferor) is deceased at the time the trust was created and the transfer creating the trust was subject to estate or gift tax.

Exemption

The generation-skipping transfer tax exemption for a given year is equal to the applicable exclu-sion amount for estate tax purposes. In addition, the generation-skipping transfer tax rate for a given year will be the highest estate and gift tax rate in effect for such year. The exemption can be allocated by a transferor (or his or her executor) to transferred property.

Allocation

If an individual makes a skip during his or her lifetime, any unused generation-skipping trans-fer tax exemption is automatically allocated to a skip to the extent necessary to make the inclusion ratio for such property equal to zero. Lifetime direct skips (gifts) use up the GST exemption first. Since 2001, allocation of the exemption is also made for transfers to a GST trust. A GST trust is a trust that could have a GST.

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An individual can elect out of the automatic allocation for lifetime skips. The election out of the automatic allocation for lifetime direct skips must be made on a timely filed gift tax return Form 709. The automatic allocation of the exemption is irrevocable after the due date for Form 709.

Retroactive Allocation

The GST exemption can be allocated retroactively when there is an unnatural order of death. If a lineal descendant of the transferor predeceases the transferor, then the trans-feror can allocate any unused generation-skipping transfer exemption to any previous transfer or transfers to the trust on a chronological basis. A transferor may retroactively allocate a generation-skipping transfer exemption to a trust when a beneficiary:

(a) Is a nonskip person,

(b) Is a lineal descendant of the transferor's grandparent or a grandparent of the trans-feror's spouse,

(c) Is a generation younger than the generation of the transferor, and

(d) Dies before the transferor.

An exemption is allocated under this rule retroactively, and the applicable fraction and inclusion ratio is determined based on the value of the property on the date that the prop-erty was transferred to a trust.

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Review Questions

18. The property basis for an asset can vary based on how it was acquired. In what type of trans-action is the basis the lesser of the original owner's basis or the fair market value on the transac-tion date?

a. a gift later sold at a gain.

b. a gift later sold at a loss.

c. a purchase.

d. a tax-deferred exchange.

19. The start of a holding period for an asset can also depend on how it was acquired. In which of the events below does the holding period for an asset commence on the date of someone's death?

a. a reversion.

b. a gift.

c. an inheritance.

d. a repossession.

20. Under the 2010 special estate election, property received from a decedent was subject to the modified carryover basis rules. According to this legislation, what qualified as an asset obtained from the decedent?

a. property obtained by gift.

b. property obtained by the decedent’s estate from the surviving spouse.

c. property passed from the decedent to joint tenants of said property as a right of survivor-ship.

d. the entire community property that passes to a surviving spouse.

21. Six types of property were ineligible for a modified basis increase under the 2010 special election. However, what property qualified for a basis increase?

a. property that establishes an entitlement to receive income in respect of a decedent.

b. property transferred during the decedent’s lifetime to a revocable trust that pays all of its income to the decedent during the decedent’s life.

c. stock shares of a foreign investment company.

d. stock or securities of a foreign personal holding company.

22. The generation-skipping transfer tax (§2601) applies to three basic types of transfers. Which of these transfer types is considered an outright transfer to a second generation family member?

a. a nontaxable distribution.

b. a direct skip.

c. a taxable distribution.

d. a taxable termination.

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Gift Taxes - §2501 to §2524

The gift tax applies to any transfer of property by gift whether made directly or indirectly and whether made in trust or otherwise. A transfer is a transaction where property is passed to or con-ferred upon another regardless of the means or device employed. Gift taxes were not repealed in 2010.

Gifting is a method of reducing or eliminating growth in estate value and consequent future potential estate tax liability. Each completed gift made over a donor’s lifetime removes not only the current value of the property gifted from the estate but any appreciation in the property as well.

However, there is a price to pay for making gifts. This price is the federal gift tax. This tax has two purposes:

(1) To discourage the avoidance of federal income taxes by giving away income-producing assets to those in lower income tax brackets, and

(2) To limit avoidance of federal estate taxes by lifetime gifts that remove property from the donor’s estate.

The present gift tax had its roots in the Revenue Act of 1932 and persists today in §2501 through §2524.

Gift Tax Computation

Lifetime gifts and transfers at death are taxed on a tax schedule that has cumulatively progressive rates. Each taxable transfer, including the final transfer at death, begins in the tax bracket attained by the prior gift.

For gifts made in 2010, the applicable exclusion amount for gift tax purposes was $1 million, and the gift tax rate was 35%. However, for gifts made after December 31, 2010, the gift tax was reunified with the estate tax, with the same applicable exclusion amount of $11.70 million (in 2021) and a top gift tax rate that has risen from 35% to 40% for transfers that exceed this exclusion.

Note: The applicable exclusion amount can be used during lifetime or at death, not both.

Calculation Steps

The following schedule is an outline of the basic gift tax calculation steps:

Federal Gift Tax

1. Gross value of current gift $___________ 2. Less: 50% of line 1 if spouse splits gift $___________ 3. Less: Annual exclusion ($15,000/per donee in 2021) $___________ 4. Less: Marital deduction if gift is to spouse $___________ 5. Less: Charitable deduction if gift is to charity $___________

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6. Equals: Current taxable gift (line 1 less lines 2-5) $___________ 7. Sum of all prior taxable gifts $___________ 8. Add lines 6 and 7 $___________ 9. Tax on line 8 $___________ 10. Less: Tax on line 7 $___________ 11. Equals: Tentative tax on current taxable gift $___________ 12. Less: Exclusion credit equivalent for year of gift $___________ 13. Plus: Any exclusion credit equivalent previously used $___________ 14. Gift tax due and payable $

Applicable Exclusion

Under the Tax Reform Act of 1976, a single or unified set of graduated gift and estate tax rates applied to both lifetime and death transfers. However, the Tax Relief Act of 2001 changed this unified struc-ture. Under the 2001 Act, the applicable exclusion amounts differed for estate and gift taxes. The estate tax exclusion rose to $3.5 million but, the gift tax exclusion amount stayed at $1,000,000.

However, for gifts made after December 31, 2010, the gift tax is again reunified with the estate tax, using an applicable exclusion amount and a top tax rate.

Application

Under §2501, the gift tax is imposed on the transfer of property by gift by any individual7. The tax applies whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible (§2511(a)).

Note: Nonresident aliens pay gift tax on transfers of property located in the United States (§2511(a)). However, gifts of intangible property by nonresident aliens are exempt from gift tax (§2501(a)(2)).

Entity Rule

When a gift is made to an entity, the gift is deemed made to the individuals who own beneficial interests in the entity. Thus, a gift to a trust is not treated as a single gift to the trustee, but a gift to each of the trust beneficiaries. The same rule applies to corporations and partnerships.

Valuation

The value of a gift is the fair market value of the property on the date the gift is made. There is no alternate valuation date for the federal gift tax as there is for the federal estate tax.

The fair market value is the price at which the property would change hands between a willing buyer and a willing seller when neither one is under any compulsion to buy or to sell, and both have reasonable knowledge of all relevant facts.

Note: Fair market value is not determined by a forced sale price, or by the sale price of the item in a market other than that in which that item is most commonly sold to the public.

7 This language implies that gift tax cannot apply to entities. However, the regulations state that a gift by an entity is

taxable to the persons owning a beneficial interest in the entity (Reg. §25.2511-1(h)).

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A valuation understatement occurs if the value of any property claimed on the gift tax return is 66 2/3% or less of the amount determined to be the correct valuation. If there is an underpayment of the gift tax because of this understatement, an addition to tax of up to 30% of the underpayment may be assessed. The addition to tax will not apply if the underpayment is less than $1,000. The IRS may waive all or part of this addition to tax if it can be shown that there was a reasonable basis for the valuation claimed and that it was made in good faith.

Real Property

Generally, the best indication of the value of real property is the price paid for the property in an arms-length transaction on or before the valuation date.

Note: Unimproved real property is defined as land without significant buildings, structures, or any other improvements that contribute to its value.

If the property has not recently been the subject of an arms-length transaction, the best method of estimating value is by using the market data or comparable sales approach. This approach uses arms-length sales of properties that are as similar as possible to the property being valued.

Stocks & Bonds

The value of stocks and bonds is his or her fair market value per unit (share or bond) on the date of the gift. If there is a market for stocks and bonds on a stock exchange, in an over-the-counter market, or otherwise, the fair market value per unit is the mean (midpoint) between the highest and lowest quoted selling prices on the date of the gift.

Annuities, Life Estates, Terms for Years, Remainders, & Reversions

The value of all annuities, life estates, terms for years, remainders, or reversions is generally the present value on the date of the gift determined by IRS tables. The tables and factors used depend on the date of the transfer.

However, the value of an annuity, or of a life insurance policy issued by a company regularly engaged in the selling of such contracts, is the amount that the issuing company would charge for a comparable contract on the date of the decedent’s death.

Split Gifts - §2513

If a married individual makes a gift of his or her own separate property to someone other than the spouse, and the donor’s spouse consents8 to “split-gift,” it may be regarded as made one-half by each spouse (§2513). The net effect of this gift-splitting provision is to make the gift tax exclusions and credit of the spouse available to the donor. Thus, the first $30,000 ($15,000 X 2 in 2021) of gifts of present interests is excluded when the non-donor spouse consents to split the gift.

This privilege of “splitting” gifts is extended only to separate property given away by a husband or wife.

Note: The spouses must be married when the gift is made and the consent must be applied to all gifts made by each spouse during the year (Reg. §25.2513-1).

8 The consent is made on the gift tax return.

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Community Property States

For gifts of community property, there is no need to “split” the gift since each spouse actually owns his or her one-half interest in the property. Thus, persons with community property have the ad-vantage of not having to file a gift tax return on a gift of $30,000 ($15,000 X 2 in 2021) worth of community property to a given donee.

Annual Exclusion

Section 2503 provides an annual exclusion of $15,0009 for gifts (other than” future interests”) made to any donee. Tax law provides for annual indexing for inflation of the $15,000 (in 2021) annual ex-clusion for gifts.

Indexing the annual exclusion permits donors to give more property without transfer tax costs and without using part of his or her applicable exclusion amount. Lifetime transfers deliver deeper tax savings because the post-transfer appreciation in the value of the gifts shifts to the recipient of the gift, instead of the donor’s estate.

The annual gift tax exclusion applies only to “present interests.” No exclusion is allowed for a “future interest in property” (§2503(b)).

Note: Under Reg. §25.2503-3, a future interest is any interest or estate, whether vested or contin-gent that is:

(1) Limited to commence in use, possession, or enjoyment at a future date, or

(2) Subject to the will of some other person.

Future interests include reversions, remainders, and other interests or estates that are to commence in use, possession, or enjoyment at some future date. On the other hand, an unrestricted right to the immediate use, possession, or enjoyment of property or the income from the property is a present interest in property.

Example

Dan created a trust under the terms of which his son was to receive for life the entire income from the property, with the remainder going to Dan’s grandson at the death of his son. There is a gift of a present interest to the son and of a future interest to the grandson. However, if Dan directed the trustees to pursue an investment policy that results in future increases in the value of the trust, rather than current income, his son would not have a present interest, and the annual exclusion would not be allowed for Dan’s gift to his son.

Although treated as a gift to its shareholders, a gift to a corporation generally is a gift of a future interest, not qualifying for the annual exclusion.

9 Annual exclusion was $13,000 but in 2021 is $15,000.

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Per Donee/Per Year

The annual exclusion is available with respect to gifts made to each donee, irrespective of the number of donees. For instance, if $15,000 (in 2021) is given to each of 10 individuals (a total of $150,000), the annual exclusion applies to each, and there is no gift tax liability. Moreover, the annual exclusion is available year after year, and gifts made within three years of the donor’s death are not brought back into the donor’s estate, as are pre-1982 gifts in excess of the annual exclusion.

Note: For a gift in trust, each beneficiary of the trust is treated as a separate person for purposes of the annual exclusion.

A gift to a corporation is a gift of a future interest to its stockholders and does not qualify for the annual exclusion. If the donor’s spouse is a shareholder, such a gift qualifies for the marital de-duction in proportion to the interest of the donor’s spouse in the corporation.

Gifts in Excess of the Annual Exclusion

Gifts in excess of the annual exclusion can be made without having to pay gift taxes, provided the remaining applicable exclusion amount is sufficient to offset the “tentative gift tax.” The applica-ble exclusion amount offsets the gift tax liability otherwise due with respect to the gift. The max-imum gift applicable exclusion amount may be used to offset gift taxes on lifetime transfers and, to the extent not so used, to offset estate taxes upon death.

Despite this reduction of the applicable exclusion amount available for estate tax purposes, it may still be advantageous to make certain gifts during one’s lifetime. For instance, if a gift of appreciating property is made prior to death, neither the donor nor the estate incurs any transfer tax liability on the appreciation amount (i.e., the appreciation is removed from the donor’s estate without tax liability to the donor).

No Gift Tax

If gifts are made within the annual exclusion amount, assets can be transferred to one’s eventual heirs without any gift tax liability. Thus, if a gift does not exceed $15,000 (in 2021), no gift tax return must be filed. However, if the gift to any donee is less than $15,000, the balance of the annual exclusion is lost. There is no carry over to other donees. If the gift to any donee is over $15,000, only the excess is taxed.

Gifts within 3 Years of Death

Since 1982 the old rule that gifts made within three years of death were included in the dece-dent’s estate no longer applies. However, a special provision applies to life insurance.

If the insured transferor dies within three years of the transfer of a policy, the entire policy pro-ceeds will be included in the insured’s gross estate even though the value of the policy on the date of the gift was less than $15,000 (in 2021). But if any premiums paid after the transfer are paid by the donee rather than by the insured, only proceeds in the ratio of premiums-paid-by-donor to total-premiums-paid should be includable in the donor’s estate.

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Uniform Gifts to Minors Act

Most states have adopted the Uniform Gifts to Minors Act to provide a simple and inexpensive method of making gifts to minors, which will qualify as a “present interest” for the annual gift tax exclusion. The asset is placed in the name of an adult as “Custodian under the Uniform Gifts to Minors Act.” Legal title, however, vests in the minor. The custodian is to use the assets during the child’s minority for support, education, and maintenance of the minor.

The custodianship terminates when the child reaches his or her majority, which is 18 in most states. Assets that can be conveyed under the Uniform Gifts to Minors Act are (i) money, (ii) securities, (iii) life insurance, and (iv) annuity contracts. Income on the assets is taxable to the minor, whether distributed or accumulated. If the donor is the custodian, the assets will be part of his or her estate should he or she die before distribution to the minor. To remove the asset from the gross taxable estate a third party should be named as custodian.

Note: Many states have adopted the Uniform Transfer to Minors Act. This Act permits a wider va-riety of assets to be transferred.

Exception for Minor’s Trusts - §2503(b) & (c)

Making an outright gift of a present interest to a minor is dangerous, even though state law may require the appointment of a guardian. It would be safer to make gifts to a trust with discretion-ary distributions of income and transfer of the trust principal to the child when he or she is more mature. However, such a transfer into trust is a future interest and no annual exclusion would be allowed.

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Fortunately, §2503(b) and §2503(c) provide an exception to this rule and permit certain transfers into trust to qualify under the annual exclusion as a present interest.

Medical & Tuition Exclusion - §2503(e)

In addition to the annual exclusion of $15,000 (in 2021), the law provides unlimited gift tax exclusion for amounts paid for a donee’s medical expenses or school tuition (§2503(e)). Technically, these transfers are not treated as a transfer of property by gift.

Qualifying Transfers

Qualifying transfers are amounts paid on behalf of any individual to:

(1) A qualified educational institution (defined in §170(b)(A)(ii)) as tuition for such individual, or

(2) Any person providing medical care (defined in §213) with respect to such individual.

The statutory language refers to “tuition” without further definition. The Committee report indi-cates that the exclusion applies to tuition for both full and part-time students. However, it is limited to “direct tuition costs (i.e., no exclusion is provided for books, supplies, dormitory fees, etc.).”

Interest-Free or Below-Market Loans

In Dickman 465 U.S. 330 (1984), the Supreme Court held that an interest-free or below-market in-terest-rate demand loan was a gift. The Court held that the right to use money is a valuable right, and the failure to demand repayment over time passes wealth.

After Dickman, §7872 was passed providing that certain loans bearing a below-market rate of inter-est result in:

(1) The borrower being treated as if he or she paid interest to the lender, and

(2) The lender being treated as if he or she made an annual gift of the foregone interest to the borrower.

Gift Tax Marital Deduction

The value of gifts made to a spouse may be deducted from the total amount of gifts made during the calendar year. The amount of this marital deduction is unlimited. However, to qualify for the marital deduction, the following conditions must be met at the time the gift is made:

(1) The spouses must be married; and

Note: A gift to a person who becomes the donor’s spouse after the gift has been made does not qualify for the marital deduction.

(2) The spouse receiving the gift must be a U.S. citizen.

Note: The spouse making the gift does not have to be a U.S. citizen or resident.

Nondeductible Terminable Interests

Not all interests qualify for the gift tax marital deduction. Nondeductible interests include prop-erty interests transferred to a spouse that are terminable interests. A terminable interest in

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property is an interest that will end or fail after a period of time or when some contingency occurs or fails to occur. Examples of terminable interests are life estates, annuities, estates for a term of years, and patents.

For purposes of the marital deduction, there is a distinction between “property” and an “interest in property.” “Property” refers to the underlying property in which various interests exist. How-ever, interests in property are not considered “property.”

For purposes of the marital deduction, terminable interests fall into three categories:

(a) Terminable interests that qualify for the marital deduction without the need for an elec-tion;

Note: If the donor transfers a property interest to his or her U.S. citizen spouse and the two spouses are the only joint tenants, the donor is not considered to have retained an interest in the property and the marital deduction is allowed even if the donor may receive the property because his or her spouse dies or the tenancy is severed. Likewise, if the donor makes a transfer of a life estate with power of appointment that meets certain conditions, the donor is considered to have made a trans-fer to his or her spouse that qualifies for the marital deduction.

(b) Terminable interests that do not qualify for the marital deduction unless the donor makes an election to treat the interest as qualified terminable interest property; or

Note: If the donor gives his or her spouse a life interest in property, the gift generally is a terminable interest and does not qualify for the marital deduction. However, the donor may elect to treat the life interest as a qualified terminable interest for which the marital deduction is allowed. The elec-tion is made on the gift tax return for the calendar year in which the interest was transferred. You must make the election on or before the due date, including extensions, for filing the return (§2523(f)(4)(A)). This election is irrevocable and may be made for any property in which the spouse has a qualifying income interest for life.

(c) Terminable interests that cannot qualify for the marital deduction.

Gift Tax Charitable Deduction

A donor may deduct from the total amount of gifts made during the calendar year all gifts (included in that total) that were made to or for the use of:

(1) The United States, a state, a political subdivision of a state, or the District of Columbia, exclu-sively for public purposes,

(2) Any corporation, trust, community chest, fund, or foundation organized and operated exclu-sively for religious, charitable, scientific, literary, or educational purposes, including the encour-agement of art,

Note: Organizations that foster national or international amateur sports competitions also qualify, but only if none of his or her activities involve providing athletic facilities or equipment, unless they are qualified amateur sports organizations, and organizations for the prevention of cruelty to chil-dren or animals are included. These organizations qualify as long as no part of his or her net earnings benefits any private individual and no substantial activity is undertaken to carry on propaganda, or otherwise attempt to influence legislation or participate in any political campaign on behalf of any candidate for public office.

(3) A fraternal society, order, or association operating under the lodge system, if the transferred property is to be used exclusively for religious, charitable, scientific, literary, or educational

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purposes including the encouragement of art, and the prevention of cruelty to children or ani-mals, or

(4) Any war veterans’ organization organized in the United States or any of its auxiliary depart-ments or local chapter or posts, as long as no part of the net earnings benefits any private indi-vidual.

Partial Interests

When an interest in property is transferred for both charitable and noncharitable purposes, a charitable deduction is allowed for the interest passing to the charity only if the transfer is:

(a) An undivided portion of the donor’s entire interest;

Note: An undivided portion of the donor’s entire interest in property must consist of a fraction or a percentage of each interest or right the donor owns in the property, and it must extend over the entire term of his or her interest in that property or in other property into which the donated prop-erty is converted.

(b) A remainder interest in a personal residence;

Note: If the donor transfers for a charitable purpose the remainder interest, not in trust, in his or her personal residence, the value of the interest is a deductible charitable contribution.

(c) A remainder interest in a farm;

Note: If the donor transfers the remainder interest, not in trust, in a farm to a qualified charity, the value of that interest is deductible.

(d) A qualified conservation contribution;

Note: If the donor transfers a qualified real property interest to a qualified organization exclusively for conservation purposes, the value of that interest is deductible.

(e) A remainder interest, charitable remainder trust, or pooled income fund; or

Note: A charitable remainder annuity trust is a trust from which a specified amount is paid at least annually to one or more persons who were living at the time the trust was created. The amount must be at least 5% of the initial fair market value of the property placed in trust. At the death of the last noncharitable beneficiary, or at the end of a term of up to 20 years, the remainder interest must be paid to or held for the benefit of a qualified charitable organization.

A charitable remainder unitrust is a trust from which a fixed percentage of the net fair market value of its assets, valued annually, is paid at least annually to one or more persons who are living at the time of the creation of the trust. The percentage must be at least 5%. At the death of the benefi-ciaries or at the end of a term of up to 20 years, the remainder interest is paid to or held for the benefit of a qualified charitable organization.

A pooled income fund is a trust maintained by a charity to which donors transfer property and contribute the remainder interest in the property to charity. You either keep an income interest for life for your part of the trust property or create an income interest in that property for the life of one or more beneficiaries who are living at the time of the transfer.

(f) A guaranteed annuity interest or unitrust interest (i.e., a lead interest).

Note: A guaranteed annuity interest is the right to receive a determinable amount for a specified term or for the life of an individual living at the date of the gift. The annuity may also qualify if the instrument of transfer provides for a term of years or a period of lives plus a term of years. The amount must be paid at least annually.

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A unitrust interest is the right to receive payment at least annually of a fixed percentage of the net fair market value, determined annually, of the property that funds the unitrust.

Selecting Gift Property

The following factors should be considered when selecting gift property:

1. If property in excess of the annual exclusion is transferred and the primary reason for the transfer is to reduce estate taxes, the donor should transfer property with a low gift value relative to estate value (i.e., property with a high appreciation potential).

2. When the property will be sold by the donee, highly appreciated property may not be a good selection, since large capital gains may be incurred by the donee. In addition, if retained by the owner, the property should obtain a full step-up in basis at death.

3. If one of the objectives of the gift is to transfer income to a lower income tax bracket, high-yielding income property would be appropriate.

4. Property that may present problems of valuation, division, or sale for the personal representa-tive of the estate should be considered. For instance, art objects, antiques, and jewelry are apt to be good for lifetime giving, since they often present valuation problems. In addition, there are sometimes questions as to whether they are to be sold or retained, and if retained, to whom they should be given if not the subject of a specific legacy.

5. Assets that shrink in value with age such as copyrights, patents, leaseholds, mineral rights, and the like are not usually good for gifts. These are known as shrinking or wasting assets.

Gift Advantages

1. $15,000 (in 2021) may be transferred free of any transfer tax to any donee, each and every year; the amount may be $30,000 if spouses join in the gifts.

2. The future growth in the value of property given away can be removed from the donor’s estate and be transferred to the donee. Better to pay transfer taxes at the lower current value, rather than at the higher value that will exist at the time of death.

3. Giving income-producing property shifts the income tax consequences from the donor to the donee, who may be in a substantially lower income tax bracket. The income tax savings occur each year, and so the beneficial effect will be cumulative over the donor’s lifetime.

4. Gifts from one spouse to the other are completely free of gift tax (§1041).

5. Giving low basis property to a spouse or other person who may die before the donor, and who wills the property back to the donor can sometimes qualify that property for basis advantages.

6. In a community property state, a gift of low basis separate property to the community (a gift of one-half to the non-owning spouse) may ensure that upon the death of either spouse, the entire property will qualify for basis advantages.

7. Gifts may adjust the ownership percentages among the component parts of an owner’s estate, perhaps making it possible to qualify for long-term installment payments of estate taxes, or for §303 redemptions to pay death taxes and expenses.

8. Gift payments of medical and tuition expenses for a donee are gift tax-free.

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Gift Disadvantages

1. Donor loses control over, and income from, the property given away. It is therefore not avail-able for his or her future security, or to meet unexpected emergencies. In an uncertain world, this could be disastrous.

2. Gifts can make the donee wealthier than the donor, thus making the ultimate tax burdens even higher, and shifting the obligation to pay those taxes from the donor to the donee.

3. Gifts can have an adverse effect on the donee’s personality, his or her family relationships, and his or her attitudes toward life. They could conceivably turn the donee into a sloth. They might cause a rift in his or her marriage or other personal relationships.

4. Gifts to a minor child, where the minor gets his or her hands on the property before he or she has reached financial maturity, are potentially the most dangerous of all. In the hands of a nor-mally rebellious teenager, they could break his or her relationship with his or her own parents.

5. Even though the list of disadvantages is not as long as that of advantages that does not mean that the disadvantages might not be the most important, and might not tip the scales in favor of not making a contemplated gift.

6. Weigh the disadvantages very carefully before making any gift that is motivated solely by po-tential tax savings.

Gift Tax Returns

Any individual who makes gifts to any one donee during a calendar year that are not fully excluded under the $15,000 (in 2021) annual exclusion must file a gift tax return, i.e., Form 709 (the Short Form 709-A is now obsolete and should not be filed). However, no return is required to report a qualified transfer for educational or medical costs (§6019(a)).

The return is due on April 15 of the year following the year the gifts were made (§6075).

Includibility of Gifts in the Estate

Since 1982, gifts made within three years of death are no longer considered in the computation of the taxable estate. If they exceed the annual exclusion, however, they may be added to the taxable estate as “adjusted taxable gifts.” However, the appreciation on the asset from the date of gift until the date of death is not brought into the computation.

Gifts of life insurance policies, however, are still included if made within three years of death. Certain incomplete transfers (e.g., retained life estates, revocable transfers, etc.) will also be included in the gross estate without regard to when they were made.

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All transfers made within three years (except those qualifying for the annual gift tax exclusion) will be included for purposes of determining whether an estate qualified for §303 redemption, §2032A valuation, or §6166 deferral of tax payment.

Shifting Income & Gain

One of the valuable benefits of making lifetime gifts is that the donor can shift tax on the income to a donee who is in a lower income tax bracket. The gift tax exclusion of $15,000 (in 2021) a year per donee provides a substantial opportunity for a high-earning taxpayer to reduce his or her income tax burden without using up any part of his or her unified gift and estate tax credit. Not only can he or she make outright gifts of up to $15,000 a year which, if the property earns 10%, would shift $1,500 a year from the donor’s income tax bracket to that of each donee.

Gifts before Sale

When a high bracket family member holds substantially appreciated property, a gift of all or a portion of that property to low bracket family members should be considered prior to any taxable sale (See R.R. 78-197). Upon completion of the gift, the low bracket family member would then make the actual sale.

Note: A transfer to a child under age 18 will not accomplish the desired result since the child will be taxed at the parents’ top rate.

Transfers into Trust Prior to Sale

Transfers into a trust in advance of a sale can be extremely dangerous. Section 644 provides that when appreciated property is transferred to a trust and then sold within 2 years, the trust will be taxed as if the transferor had made the sale.

Note: Even when the sale is not treated as made by the transferor, recent changes in income tax rates for trusts make this format costly.

Installment Obligations

The use of installment sales can have interesting and controversial gift and estate planning as-pects. For purposes of gift tax, senior family members may wish to installment sell property to younger generation family members. While such a sale can result in gain to the seller, the gain can be reported under the installment method pursuant to §453. In addition, loan principal can be forgiven using the gift tax annual exclusion.

In this context, the installment sale has several advantages:

(1) The property sold should only need to be valued at the time of the original sale;

Note: A pattern of gifts involving annual percentages of a substantial property (i.e., valuable real property) would require annual appraisal of the property in order to ensure that each gift was within the annual exclusion amount.

(2) The buyers of the property should have a tax basis equal to the sales price;

Note: Buyer can use this new basis for purposes of depreciation and calculating gain or loss on sale.

(3) The buyers should not have cancellation of indebtedness income since this is a gift made out of detached generosity; and

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(4) The buyers should have immediate possession and enjoyment of the entire property.

However, there are also several disadvantages:

(1) The amount forgiven is treated as a payment received by the seller for income tax pur-poses;

(2) The note may still be in the seller’s estate at his or her death and would get no step-up in basis;

(3) Such an installment obligation must bear at least the applicable federal interest rate or it will be imputed; and

(4) If the buyers resell the property within 2 years of the original installment sale, it can ac-celerate the original installment note and cause all gain to be recognized on that original note.

In making the sale to a younger family member, the seller might elect out of the installment method. While this would result in the immediate recognition of gain, the seller could argue a substantial discount on the current value of the installment obligation. Such a discount would reduce the immediate gain. In addition, when the seller dies, the estate may also argue a discount on the note if it is still part of the decedent’s estate.

Note: If the seller receives payments equal to the discounted fair market value of the note, any additional payments would constitute ordinary income. Likewise, if the estate or beneficiary re-ceived payments in excess of the discounted value of the note at death, such payments would be income.

When an installment obligation passes from the decedent to his or her estate and then from the estate to the beneficiary, there is no disposition of the installment obligation requiring all gain to be immediately recognized (§453B(c)). However, if the executor sells property during administra-tion using the installment method, distribution of the installment obligation is a disposition of the note and the entire amount of gain is recognized to the estate at the time of distribution (Shannon, 29 T.C. 702 (1958))).

Note: If an executor intends to sell property using the installment method, he or she should first consider a preliminary distribution of the property to a beneficiary. The beneficiary using the in-stallment method could then make the installment sale without risk of acceleration.

Transfer to Obligor at Death

When a seller sells property using the installment method and the installment obligation is later transferred at death to the obligor (buyer or person legally obligated to pay the install-ments), a taxable transfer occurs (§691(a)(5)(A)). The amount included in the income of the transferor (the estate or beneficiary) is the greater of the amount received or the fair market value of the installment obligation at the time of transfer, reduced by the basis of the obliga-tion. The basis of the obligation is the decedent’s basis, adjusted for all installment payments received after the decedent’s death and before the transfer.

Note: If the decedent and obligor were related persons, the fair market value of the obligation cannot be less than its face value.

Income in Respect of a Decedent

Uncollected installment obligations held by the decedent and disposed of on the decedent’s death result in income in respect of a decedent to the estate or beneficiary (§691). When an

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installment note is transferred from the decedent to any other person at death, an amount equal to the excess of the face amount of the note over its basis to the decedent is considered income in respect of a decedent (Reg. §1.691(a)-5(a)). The installment obligation receives no step-up in basis.

Note: All gross income that the decedent had a right to receive and that is not properly includible on the decedent’s final return is called income in respect of a decedent.

Thus, if a decedent had sold property using the installment method and an heir receives the right to collect the payments after the date of death, the payments the heir collects are in-come in respect of the decedent. The heir will use the same gross profit percentage that the decedent used to figure the part of each payment that represents profit. The heir includes in income the same profit the decedent would have included had death not occurred.

Note: The character of the income received in respect of a decedent is the same as it would have been to the decedent if he or she were alive. Thus, if the income would have been a capital gain to the decedent, it will be a capital gain to the estate or beneficiary.

Income that a decedent had a right to receive is included in the decedent’s gross estate and is subject to estate tax. This income in respect of a decedent is also taxed when received by the estate or beneficiary. However, an income tax deduction is allowed to the person (or estate) receiving the income.

Reporting of Foreign Gifts - §6039(f)

Section 6039(f) generally requires any U.S. person (other than certain tax-exempt organizations) who receives gifts or bequests from foreign sources totaling more than $16,815 (in 2021) during the taxable year to report them to the Treasury Department. The threshold for this reporting requirement is indexed for inflation.

The definition of a gift to a U.S. person for this purpose excludes amounts that are qualified tui-tion or medical payments made on behalf of the U.S. person, as defined for gift tax purposes (§2503(e)(2)), and amounts that are distributions to a U.S. beneficiary of a foreign trust if such amounts are properly disclosed under the reporting requirements.

If the U.S. person fails, without reasonable cause, to report foreign gifts as required, the Secretary of the Treasury is authorized to determine the tax treatment of the unreported gifts. In addition, the U.S. person is subject to a penalty equal to 5% of the amount of the gift for each month that the failure continues, with the total penalty not to exceed 25% of such amount.

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Review Questions

23. Most gifts are subject to gift tax. However, under §2501, what type of transfer is not subject to gift tax?

a. a gift by any entity.

b. a gift if the transfer is in trust.

c. an indirect gift.

d. an intangible gift.

24. A gift’s value must be determined for federal gift tax purposes. For which of the following items are IRS tables used to determine present value on the date that the gift is completed?

a. life insurance.

b. real property.

c. remainders and reversions.

d. stocks and bonds.

25. The portion of a property interest that is transferred to a charity, when the transfer is for combined charitable and noncharitable purposes, may qualify for a charitable deduction. Under what circumstance is this deduction allowed for said portion of the interest?

a. if the transfer is a qualified conservation contribution.

b. if the transfer is a divided portion of the donor’s partial interest.

c. if the transfer is a farm in trust.

d. if the transfer is a personal residence in trust.

26. Six disadvantages of giving gifts are provided in the course material. What is one of these disadvantages?

a. Spousal gifts are excessively taxed.

b. A donor may transfer only $5,000 tax-free to any donee.

c. the result could mean even higher tax burdens to the recipient.

d. Upon the death of either spouse, none of the property qualifies for basis advantages.

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Learning Objectives

After reading Chapter 3, participants will be able to:

1. Specify types of wills citing the functions a will can perform, identify types of bequests, determine the duties of executors and guardians, and recall ways to hold title and their tax ramifications.

2. Identify advantages of a properly drafted will, determine the distribution flow of simple wills, and specify the pros and cons of probate proceedings.

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CHAPTER 3

Wills & Probate

What Is A Will?

A will is a legal document executed by any competent person according to the prescribed statutes of his or her state and contains instructions to be followed at death. It is an important vehicle for the transfer of property and is often the first step taken in estate planning. Everybody needs a properly executed will.

If one does not have a will, the state will draft one for them under the laws of intestacy. Each state has enacted such laws that divide the decedent’s assets on death if there is no will.

A will can perform many functions. For example, it can:

(1) Dispose of decedent’s assets to any individual, association, corporation, group, or government entity,

(2) Name an executor to handle estate assets on death,

(3) Provide for the disposition of the decedent’s body or leave funeral instructions,

(4) Disinherit a spouse, child, or anyone else, or

(5) Designate a guardian for minor children.

Provisions & Requirements

Before a will is accepted for probate, the probate court determines whether the will is legal in sub-stance and form. The testator must be at least 18 years old, competent, and not under the undue influence of another.

Most wills have certain fundamental provisions. First, there is a statement identifying the individual and stating that the document is the person’s will. Normally, the county of residence is also stated.

All prior wills and codicils should be revoked. In some states, unless a will specifically revokes a prior will or codicil, the prior document is not canceled.

The will should identify all family members, even if the intent is to disinherit them. Many states re-quire that the testator name his or her:

(1) Spouse,

(2) All living children, and

(3) Any children of a deceased child.

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Failure to mention or provide for them is presumed to be a mistake and they are entitled to a share they would have received if the testator had died without a will.

Example

Dan puts in his will that his entire estate goes to his son, Ralph, and his daughter, Daphne. No mention is made of his third child, Rocko. In many states, Rocko automat-ically receives one-third of Dan’s estate. Dan should have mentioned Rocko in his will and provided that he did not wish to leave him anything.

The will should effectively distribute your assets. This can be done with style and very simply, for example, “I leave my entire estate to my worthless, ‘peace at any price’ son, Rocko, if he is lucky enough to survive me.” A number of specific or general bequests can also be made.

Specific & General Bequests

A specific bequest (called a specific devise when real property) is the distribution of a specific asset, for example, “my apartment house located at 2222 Marina Drive, Newporche Beach, Cali-fornia, to my good and faithful son, Ralph.” However, if the apartment house is not owned, the recipient gets nothing in its place.

A general bequest is actually a cash bequest, for example, “I leave $50,000 to the local chapter of the Small Animal League for research.” If there is not $50,000 cash in the estate on death, the executor must sell assets to raise the funds.

Residual Bequests

Even if the testator believes he or she has distributed everything, there still should be a clause that covers the “residue” of the estate. For example, after several small bequests, put at the end of your will “I leave the residue of my estate to Dan Santucci.” This means that everything that is not specifically itemized will go to someone who really deserves it.

Conditional Bequests

Some people add specific conditions to their will. This frequently cannot be done. For example, one may want to leave money to his or her daughter, but not want any of it to later go to her derelict spouse. Unfortunately, once you will something outright, you cannot add conditions to it. Unless the assets are put into a trust, you must leave it outright and hope the recipient will later carry out your wishes.

Executor

The will should name an executor (executrix if female) to handle the estate at death. In general, the executor’s job is to take possession of the assets subject to the will, pay all of the debts and any taxes, and distribute assets in accordance with the will. Some states place restrictions on the appointment of an executor. Generally, the executor must be at least 18 years of age, not con-victed of certain crimes, and agree to serve. Several people can serve together, or several people can serve in order so that if one cannot serve, the next named takes over.

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Normally, the will “waives bond” for the executor. As a result, the executor does not have to obtain a bond to protect the estate if the executor were to steal assets. Most people trust their executor enough to waive this requirement. The executor is often given the “power to sell estate assets.” This gives the executor flexibility if estate assets, particularly real property, need to be sold during probate.

Guardian

When there are minor children, the will should name a guardian. There are two types of guardian:

(1) A guardian of a minor’s estate is the person who handles the minor’s assets until the child attains 18, and

(2) A guardian of the person raises the child until he or she turns 18.

In general, anyone can be named as guardian of the estate even if the other parent is living. Many people name close friends as guardians. If all children are over age 18, no guardians are needed.

Example

Dan is divorced and wants to leave his assets to his six-year-old son, Ralph. He can name his biker brother, Ron, guardian of Ralph’s estate. However, parents have the first right to custody. When Dan dies, his attractive but vicious ex-wife (Ralph’s mother) has the right to raise Ralph.

Types of Wills

Most states recognize several types of wills. First is the handwritten or holographic will. The majority of states allow a handwritten will if entirely in the decedent’s handwriting, dated and signed by the decedent. Normally, witnesses are not required.

Note: There is frequent litigation over interpreting handwritten wills.

The second type of will is a regular witnessed will. Two or three people must witness the will1. The witnesses have to see the will signed by the testator. The testator then declares the document to be his or her will and asks the witnesses to attest to it by also signing the will. The witnesses should not receive any assets under the will.

Note: A copy of the will should be kept outside the safe deposit box. If the only copy is inside, it may be impossible for the heirs or executor to get at it without a lot of time-consuming legal pro-cedures.

A joint will is when two people (usually husband and wife) sign one will disposing of both of their assets. This can be dangerous since there is some question whether such a will can be changed after the death of one of the parties.

Some states (e.g., California) have introduced a type of will called a statutory will. A statutory will is exactly that - a simple preprinted form established by statute. Normally, you cannot change any pro-vision.

1 California requires two witnesses to a will.

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Title Implications

One of the most important aspects of estate planning is determining how title is held on assets. When stock is bought, a bank account opened, a car or home purchased, title is recorded on the asset. This title will determine what happens to the asset at death.

Title can be taken in a number of different ways. Four fundamental ways to hold title are:

(1) Individual

(2) Joint tenancy

(3) Tenancy in common, and

(4) Marital - i.e., tenancy by the entirety or community.

Each of these forms of title has different ramifications that are important to know before taking title.

To find out how title is held, obtain the transfer or purchase documents and see how title is recorded. Here are some guidelines:

1. For real estate, look at the original deed. When real estate is purchased, the buyer receives a deed called a “grant deed” or a “quitclaim deed,” or in some states a “warranty deed.” If the original deed can’t be found, a copy can normally be obtained from the County Recorder’s office for a small fee. Sometimes a copy can be obtained from a title company if it handled the purchase.

2. For bank accounts look on the saving passbook, certificate of deposit, or other document evi-dencing the account.

Note: If the bank doesn’t type how title is held on these documents, check the signature card for the account.

3. For securities look at the stock or bond certificate.

4. For automobiles, check the “pink slip” or certificate of ownership2.

5. Federal law governs U.S. saving bonds or government securities. If registered with an “or,” it is referred to as “co-ownership” which is equivalent to joint tenancy. At death, the asset will go to the surviving party.

Individual

Assets in decedent’s individual name are controlled by the decedent’s will. If the decedent is single, the will controls everything in the decedent’s individual name. However, if the decedent is married, the will may not control all property in the individual’s name since it could be com-munity property. In such a case, the will can only control the decedent’s one-half interest in the community asset.

Example

Dan has a brokerage account and accumulates $500,000 in bonds. The account is in his name alone but is community property. Since the property is community property,

2 In California, the Department of Motor Vehicles does not use the words “joint tenants” or “tenants in common.” Instead

they use “or” to mean joint tenancy and “and” or a slash “/” to mean tenants in common.

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at his death only one-half of the account will be subject to his will, the other one-half belongs to his surviving spouse.

Even in a community property state, if the asset is a separate property asset (i.e., acquired either before marriage or during marriage by gift, inheritance, or earnings from a separate property), then the will can control all of it.

Joint Tenancy

Joint tenancy is when two or more people take title to an asset and at death, the asset automat-ically goes to the survivor or survivors. It is a simple and inexpensive way to pass property. There is no probate or other legal proceeding involved. A will does not affect joint tenancy property because the joint tenancy title supersedes the will. However, where there is no intent to transfer the property to the survivor, complications can arise.

Example

Dan has set up a will and a testamentary trust for the benefit of his son, Ralph. Using his will, Dan intends to put his property into trust at death. However, Dan has taken title to all his property as joint tenants with his girlfriend Suzy. On Dan’s death, his property automatically passes to Suzy as the surviving joint tenant. Nothing passes by his will, and nothing goes into his trust.

Example

Dan has $300,000 he wants to pass to his three nephews at death. He puts $120,000 in joint tenancy bank account with one nephew. This will permit that nephew to handle Dan’s financial affairs before death. Dan’s will leaves everything equally to the three nephews. On Dan’s death, the $120,000 passes to the one nephew as the surviving joint tenant, the remaining $180,000 is divided up three ways. Although Dan could have put a provision in his will to take joint tenancy or other assets into account in dividing up an estate, this is rarely done. Unless the nephew quickly disclaims the joint tenancy, he could be estate or inheritance taxed on it. If the nephew equalizes his share with the other two nephews, it could also then be a taxable gift.

Most people use joint tenancy to avoid probate. However, probate avoidance does not neces-sarily eliminate or reduce federal estate taxes. In short, joint tenancy avoids probate, but not federal death taxes. Section 2040(a) presumes that joint tenancy property belonged entirely to the decedent unless the survivor can prove his or her contribution3.

3 This presumption does not apply to husband and wife.

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Example

Dan puts $800,000 into a joint tenancy bank account with his girlfriend, Suzy, to “prove his love” and then dies. The Service will presume it was all Dan’s unless Suzy can prove that part of the cash belonged to her.

Often the creation of a joint tenancy can itself be a gift (Reg. §25.2511-1). For example, it is a gift to put real estate or any form of securities into joint tenancy.

Example

Dan puts one of his children on title to his home as a joint tenant. Each joint tenant now has an equal interest in the property. Dan has made a gift of 50% of his home by putting it into joint tenancy. Even if Dan files a gift tax return, it will not reduce his taxable estate at death.

While establishing a U.S. savings bond or bank account in joint tenancy is not a gift, it becomes a gift when the other joint tenant withdraws funds. Thus, if Dan puts $100,000 in a joint tenancy bank account with his ex-wife, Jane, and she runs off with the money, he has made a gift to her of $100,000 at the time of withdrawal.

If the transfer of an asset into joint tenancy is a gift, then the other joint tenant(s) own a propor-tionate share of the assets and will be taxed on its income. The following list shows those assets that become gifts when put into joint tenancy.

Asset Gift?

Real Property Yes

Bank Account No

Credit Union Account No

Stocks & Bonds Yes

Mutual Funds Yes

Brokerage Account No

Money Market Funds Yes

U.S. Savings Bonds No

U.S. Treasury Bills Yes

U.S. Treasury Notes Yes

Vehicles No

Joint tenancy can be severed without the knowledge of the other joint tenant. For example, if Dan and his son, Ralph own a house in joint tenancy, either can deed the property to a third party who then deeds it back. Dan and Ralph would no longer be joint tenants but would become ten-ants in common. Their wills now pick up their one-half of the property.

Note: A surviving spouse is often shocked to discover that his or her spouse severed the joint ten-ancy and left his or her half to someone else.

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Tenants in Common

Tenancy in common is frequently used when several people go together to buy real property. When two or more people hold title as “tenants in common,” they own an undivided interest in the property. A person’s will controls only his or her share of assets held as tenants in common. Unlike joint tenancy, their interests do not have to be equal4.

Example

Dan and his brother, Ron purchase a house. Dan puts up 60% of the money and Ron puts up 40%, taking title as tenants in common to reflect their unequal interests. Ten-ants in common title will also allow their wills to transfer their respective shares.

Tenants in common can partition property so that if one tenant wants it sold, they can require the other co-owners to either divide it (if possible) or sell it.

Tenants by the Entirety

Some states5 use a form of title called “tenants by the entireties.” This is basically a joint tenancy registration between husband and wife. However, it differs from a true joint tenancy in several ways. Its survivorship feature can only be broken with the consent of both spouses, while in a joint tenancy any co-owner can cause a severance and undo survivorship. Originally, only the husband had control of property held as tenants by the entirety, and he was entitled to all income from the property. While some states have modified this, in those that have not, it also differs from joint tenancy where each co-owner is entitled to an equal share of the income.

Community Property

Community property has a dual meaning:

(1) It refers to assets that have been acquired in a community property state during marriage; and

(2) It is a manner of holding title for a married couple.

In either event, each spouse has the right to convey one-half of the total community property at death. Thus, when the home is in the husband and wife’s names as community property and the wife dies, her will picks up one-half of the home.

Tax Basis Advantage

Community property title has a tax basis advantage. Under §1014(b)(9), when assets are in the husband and wife’s names as joint tenants and one dies, only half the assets get a new basis. However, §1014(b)(6) provides that when community property title is used all assets get a full stepped-up basis on the first spouse’s death.

4 However, if no percentage difference is stated, the presumption is equal shares. 5 California does not recognize such registration.

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Example

Dan and Daphne buy a house for $50,000 and it increases in value to $200,000. If the house is held as joint tenancy and Dan dies, Dan’s one-half gets a stepped-up basis of $100,000 (half of the $200,000). However, Daphne keeps her original basis of $25,000 (half of the original $50,000). As a result, Daphne’s new basis in the house is $125,000 ($100,000 for Dan’s half and $25,000 for her half). If Daphne sells the house for $200,000, the gain will be $75,000. On the other hand, if the house were held as com-munity property, Daphne would step up her basis to $200,000 ($100,000 for Dan’s half and $100,000 for her half). Now, if Daphne sells the house for $200,000, there is no gain and no tax.

To gain this basis advantage, a community property agreement is often signed. This is a doc-ument stating that regardless of how a husband and wife have taken title to property, some or all of their assets are to be treated as community property (R.R. 87-98). Normally, the agreement6 lists each spouse’s separate property and provides that everything else the cou-ple owns shall be community property. Any separate property not listed will become com-munity property.

Untitled Assets

Furniture, jewelry, art objects, coin and stamp collections, etc. often have no recorded title. Such untitled assets are subject to the will of the decedent owner.

Changes to a Will

People often wish to change their will. When the change is simple, such as adding a cash bequest, it is usually done with a codicil. A codicil is a document that changes a will. It is the same as if the will had been retyped with the changes.

Note: In fact, with the rise of word processors, many attorneys prefer retyping the entire will with the changes in lieu of a codicil.

In any event, the original will should not be written on after it is signed. Going through the will cross-ing out language or making other changes is dangerous. This is referred to as “obliteration” and can completely cancel the will. The will should not be marked in any way after it is signed.

Note: Handwritten changes can be made on the will before it is signed. However, even here the testator and all the witnesses should initial the change to show that it was made before the will was signed.

Advantages of a Will

1. Intestacy is avoided.

2. Guardians can be appointed for the minor children.

6 In California, such an agreement has the same effect as if the couple had recorded the property as community property.

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3. Bequests to relatives, individuals, and charities can be made.

4. Selection of executor.

5. Executor can be authorized to continue a business and make tax decisions.

6. Death taxes can be allocated and apportioned.

7. Probate bond may be waived.

8. Tax savings through trusts and the marital deduction.

9. Delayed distributions to minors and other heirs.

10. Sale of assets during estate administration.

11. Funeral instructions.

12. Protecting children by a previous marriage.

13. Disinheritance of potential heirs.

14. Grant life estates.

15. Avoid estate litigation.

Intestate Succession

When one dies without a will, the state laws direct how the assets will be distributed, i.e., a will by default. If there is no will, in effect the state drafts a will for the decedent. The county or state pro-bate court will appoint an administrator7.

The intestate succession is time-consuming and costly8. It is better to make a will and determine who will receive the assets.

Intestate Succession - Typical Community Property State

PERSONS LEFT SURVIVING:

DECEDENT’S SHARE OF COMMUNITY PROPERTY

DECEDENT’S SEPARATE PROPERTY

SPOUSE & ONE CHILD

All to surviving spouse One-half to spouse & one-half to child

SPOUSE & CHILDREN

All to surviving spouse One-third to spouse & two-thirds to children

ONLY CHILDREN No community property All to children

ONLY SPOUSE All to surviving spouse One-half to spouse, one-half to decedent’s parent’s if living,

otherwise to brothers & sisters

ONLY PARENTS No community property All to parents equally

7 Good luck! This person will have little or no knowledge of your family or assets. 8 Lawyers often get the bulk of the assets.

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NO SPOUSE NOR CHILDREN NOR PARENTS

No community property All to brothers & sisters equally

Most state laws favor the surviving spouse, child, or grandchildren. As a result, assets could go to children of a previous marriage, or even distant nephews and nieces! In addition, state laws assume that family members (and not friends) are the natural objects of one’s bounty. Furthermore, most states do not recognize a “living together” relationship. Thus, for unmarried couples living together, dying without a will can have catastrophic consequences.

Periodic Review

A will is only as good as it is up to date. Wills and estate plans are not once-in-a-lifetime documents. Yet, once a will is signed, it is often put in a safe deposit box and forgotten for 10-20 years. People outgrow their estate plan, and new laws make revision essential. Estate planning is a lifelong process. Thus, it is important that the will be periodically reviewed at least every 3-5 years.

This does not necessarily mean meeting with an attorney. Frequently, just carefully reading over the will to review the disposition of assets and the people named as guardian, executor, or trustee can be satisfactory.

Changes Requiring Estate Planning Review

Change Married Person Single or Divorced Person

Family Relation Divorce or Separation

Death of Spouse or Child

Birth, Adoption, Illness, Marriage or Divorce of a Child

Marriage or Living Together

Death of Child or Heir

Birth, Adoption, Illness, Marriage or Divorce of a Child

Economic & Per-sonal Conditions

Asset Values: Increase or Decrease

Change in Insurability

Change in Employment

Change in Business Interests:

New Partnership, Corporation or

Co-Venture

Death of a Business Associate

Property Acquired Out of State

Retirement, Illness or Disability

Inheritance or Gift

Asset Values: Increase or Decrease

Change in Insurability

Change in Employment

Change in Business Interests: New Partnership, Corporation or Co-Ven-ture

Death of a Business Associate

Property Acquired Out of State

Retirement, Illness or Disability

Inheritance or Gift

External Change in Law

Change in Residence

Death of an Heir

Change in Law

Change in Residence

Death of an Heir

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Death or Relocation of Executor, Trustee, Guardian, or Advisor

Death or Relocation of Executor, Trustee, Guardian, or Advisor

Continuing Business Operations

If a person runs a business, mention should be made in the will about the operation of the business after death. In some states, an executor cannot lawfully continue a business without specific author-ization. The business operation may come to halt, the building may deteriorate, or the business may have to be liquidated if proper authority is not given. Thus, key issues in the will should cover valuation of the business, succession, or disposal.

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Simple Will

Married couples with small estates may wish to have a simple “I love you will.” Here each spouse leaves all of his or her assets to the surviving spouse. Even in such cases, however, it is necessary that a legal arrangement is made for the assets to be left in a trust for any minor children in case both parties die simultaneously (such as in a plane accident). In legal terms, a holographic will is in one’s own handwriting, and a nuncupative will is oral. An oral will is seldom valid.

Simple Will

On Husband’s Death Wife Owns 100% of Estate

Unlimited Marital Deduction Protects Wife

From Federal Death Taxes

On Husband’s Death Wife Owns 100% of Estate

Unlimited Marital Deduction Protects Wife

From Federal Death Taxes

Property Owned

by Husband

Property Owned

by HusbandProperty Owned

by Wife

Property Owned

by Wife

R.I.P.

Death

of

Wife

R.I.P.

Death

of

Wife

R.I.P.

Normally

Husband

Dies First

R.I.P.

Normally

Husband

Dies First

Federal Estate Taxes

If Wife’s Estate

Exceeds AEA

Remainder to

Children or Other

Heirs

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Probate

Probate is a method of transferring assets as provided in a will, or, if a person dies without a will, of transferring assets to his or her heirs in accordance with state law. Assets in the decedent’s name alone must be probated to transfer title. Community property must be probated if it is left by will to someone other than the surviving spouse. Assets that cannot be controlled by a person’s will are not subject to probate.

Normally, a probate is handled by the superior court in the county where the individual lived at the time of death. Real property must be probated in the state where it is located. Thus, if real property is owned in another state, there may be an ancillary or secondary probate in that state. The probate will occur in the county where the real property is located.

If the decedent left a valid will, the will is offered on his or her death for probate and the court appoints an executor; if the decedent left no will, the court appoints an administrator to serve. The executor or administrator must collect assets subject to probate, pay debts and death taxes, and request court approval to transfer assets to the decedent’s heirs or to the persons named in the will. State law determines the fees charged by executors or administrators and their attorneys.

The estate pays tax due on the income of probate assets until the assets are distributed or the estate is closed. The usual duration of probate is from nine months to several years. The size and complexity of the probate estate determine the duration of probate.

The court grants the executor or administrator approval for transfer of probate assets to the heirs or to persons named in the will. On final distribution and transfer of all probate assets, the court dis-charges the executor or administrator.

Outline of an Average Probate

Action Usual Time Period

File Petition for Probate of will 0-30 Days After Death

Notice to Creditors Upon Granting Probate Petition

Family or Widow’s Allowance, or Probate Homestead

Upon Granting Probate Petition

Marshall Assets & Prepare Inventory; Present to Appraiser if Required

Soon After Executor Assumes Office

Creditor Period Elapses Varies Widely; Normally From 2 to 6 Months After First Publication or Posting

Liquidate Property to Raise Cash for Taxes & Distributions

Promptly After Executor is Appointed

Preliminary Distributions Normally After Creditor Period Elapses

File State Inheritance Papers Normally from 6 to 9 Months After Appoint-ment of Executor

Alternate Valuation Date for Federal Estate Tax Purposes

6 Months After Date of Death Unless Property Has Been Sold Earlier

When No Federal Estate Tax Return is Required - Make Final Accounting & Distribution, and

Close Estate

Roughly One Month After Creditor Period Elapses and State Taxes Paid

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File Federal Estate Tax Return and Pay Tax 9 Months After Date of Death, Unless Exten-sion is Granted

If No Wish to Wait for Audit of Federal Estate Tax Return - Make Final Accounting & Distribu-

tion and Close Estate

Approximately One to Two Months After Es-tate Tax Paid

Keep Estate Open Until Federal Estate Tax Re-turn is Audited or Audit Period Elapses

3 Years After Form 706 is Filed

When Audit Period Elapses - Make Final Ac-counting & Distribution and Close Estate

One to Three Months After Audit Period Elapses

Large or Extraordinarily Complex Estates May Stay Open for Many Years

Advantages

The advantages claimed for probate proceedings are:

(a) The court protects the heirs and beneficiaries;

(b) Probate cuts off the claims of creditors after a period, determined by state law (e.g., 4 months in California), following the first date of publication of notice to creditors of the decedent’s death;

(c) The transfer of title is a public record that prevents problems with title companies;

(d) Questions and disputes are settled under the protection of the court;

(e) The estate is a separate taxpayer and some tax planning may result; and

(f) The costs are deductible for income tax purposes if properly planned and for death tax pur-poses if properly planned.

Disadvantages

The disadvantages asserted against probate proceedings are:

(a) They are expensive;

(b) They are time-consuming; the delays are excessive; and

(c) Court proceedings are inherently inflexible.

Sample California Statutory (Probate Code §901 & §910) Probate Fees

Probate Estate Executor’s Commission (Same as Attorney Fees)

% On Next Dollar

15,000 600 3%

50,000 1,650

100,000 3,150

2%

150,000 4,150

200,000 5,150

300,000 7,150

400,000 9,150

500,000 11,150

600,000 13,150

700,000 15,150

3-15

800,000 17,150

900,000 19,150

1,000,000 21,150

1,250,000 23,650

1%

1,500,000 26,150

2,000,000 31,150

3,000,000 41,150

4,000,000 51,150

Additional amounts are subject to the 1% rate.

Probate Avoidance

Most people want to avoid probate. Probate is complex, time-consuming, and costly. If you can rea-sonably avoid it, do so. Assets can be passed in several different ways to avoid probate.

Joint Tenancy

Joint tenancy assets avoid probate and pass at death to the surviving joint tenant. No legal pro-ceedings are necessary.

Community Property

In some community states, it is necessary to probate the decedent’s portion of community assets when one spouse dies. In California, for example, in lieu of probate, a simplified proceeding called a “Community Property Set Aside Proceeding” is available. This proceeding can transfer commu-nity property outright to the surviving spouse. While there is no statutory fee involved, legal costs are greater than a simple termination of joint tenancy.

If a spouse dies without leaving his or her community property to the surviving spouse, then his or her half of the assets will be subject to probate.

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Totten Trust Accounts

In most states, it is possible to open an account in an individual’s name as trustee for someone else - called a “Totten Trust.” This is not a formal trust, but a bank account. When an account is opened in the name of “Dan, trustee for Ralph,” the account is Dan’s sole account during his lifetime. Only Dan can withdraw funds, deposit funds, or change the account around at his op-tion. On Dan’s death, the funds in the account automatically go to Ralph, without probate. Gen-erally, only a death certificate is needed to obtain the funds.

An account opened in the name of “Dan and Daphne, Trustees for Ralph” is a joint tenancy ac-count. If Dan or Daphne dies, the account passes to the survivor, not to Ralph. Only when both Dan and Daphne are dead does the account pass to Ralph.

A POD account is payable on death to a named beneficiary and is treated like a “Totten trust.” This type of account can be used for bank accounts and federal obligations, such as U.S. Treasury notes, U.S. Treasury bonds, and U.S. savings bonds.

Life Insurance & Employee Benefits

Policies and benefit programs that permit the decedent to name a beneficiary such as life insur-ance, retirement plans, and employee benefits bypass probate and go directly at death to the beneficiary.

Living Trusts

A funded (i.e., have been placed in the trustee’s name during lifetime) living trust can avoid pro-bate. If assets are not placed in the trust during the decedent’s lifetime, they will be probated at death.

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Review Questions

27. A bequest can be used to dispose of assets at death. What type of bequest is actually a dis-position of cash?

a. a conditional bequest.

b. a general bequest.

c. a residual bequest.

d. a specific bequest.

28. Two individuals, typically spouses, may sign one will in which they dispose of both of their assets. What is such a will called?

a. a living will.

b. a joint will.

c. a statutory will.

d. a witnessed will.

29. When certain assets are put into a joint tenancy, the transaction can be treated as a gift. Which of the following assets become gifts when put into joint tenancy?

a. bank accounts.

b. credit union accounts.

c. money market funds.

d. vehicles.

30. Rather than making changes directly on an original will, a separate document can be created. What is the name of such a document?

a. a codicil.

b. a community property agreement.

c. a will.

d. an obliteration.

31. Individuals can choose from a variety of types of wills. What is a holographic will?

a. a handwritten will.

b. an oral will.

c. a will that leaves all assets to a surviving spouse.

d. a will that is executed when a testator faces imminent death.

32. According to the author, there are at least three disadvantages in having an estate go through probate. What is one of these disadvantages?

a. Probate costs are nondeductible for income tax or death tax purposes.

b. The proceedings are intrinsically rigid.

c. The court does not look after heirs or beneficiaries.

d. Title transfers are not publicly recorded.

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Learning Objectives

After reading Chapter 4, participants will be able to:

1. Identify the relationship of parties in a trust, reasons to establish a trust, and types of trusts specifying their estate planning function.

2. Specify recommended living trust provisions, identify the application of gift and income tax including the use of a grantor trust and an unlimited marital deduction, and determine what constitutes an “A-B” and “A-B-C” trust format.

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CHAPTER 4

Trusts

One of the most valuable and flexible estate planning tools is a trust. Trusts evolved and became popular during the thirteenth century in England. In the wars of that period, wealthy people often wound up on the wrong side and lost all of their property. To avoid this result, assets were trans-ferred to a neutral person for the “use” of one’s family. These “uses” became the predecessor of modern trusts.

What is a Trust?

A trust is a legal relationship in which one person transfers property to a “trustee” for the benefit of a third person. The creator of the trust is the “grantor.” The person having legal title to the trust property is the “trustee” and has the responsibility of carrying out the terms of the trust. The person for whose benefit the trust is created is the “beneficiary.”

Note: One person can be a grantor, trustee, and beneficiary all at the same time.

Why a Trust?

Individuals establish trusts for a variety of reasons. Here are some of those reasons:

1. Management - Assets can be transferred to a trustee (corporation, individual, or both) who is skilled in managing and investing the trust property.

2. Protection - Certain trusts help insulate one’s assets from the claims of creditors. Others are established to protect against the grantor’s (or a beneficiary’s) incapacity, improvidence, or in-competence.

3. Tax Savings - Trusts are frequently created to afford the grantor and his or her family the opportunity to save current income taxes or future transfer taxes.

Example

When Dan dies, he can shelter up to $11.7 million (in 2021) in a trust. At the death of his surviving spouse, the assets in the trust are not taxed for federal estate tax pur-poses. If the surviving spouse also has an estate of $11.7 million, the use of a trust can

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shelter up to $23.4 million from federal estate tax. While there is no limit on the assets which Dan can pass to his spouse on death, without a trust only $11.7 million (in 2021) might be passed tax-free on the surviving spouse’s death assuming no portability. Thus, $11.7 million more could be transferred estate tax-free using a trust.

4. Timed Disposition - People often want to put restrictions on the disposition of their assets. The primary way to do this is by use of a trust. If children are to receive assets at age 30, instead of age 18, a trust is an alternative to an outright transfer of the property.

Example

If Dan and Daphne die without an estate plan when their children are young, their assets will go to a court appointed guardian to hold for the children. When each child attains age 18, they receive their share of the assets outright. If Dan and Daphne set up a trust, the assets can be retained and used for the children’s benefit until each child reaches a more mature age.

5. Flexibility - Trust provisions can be established to complement almost any situation. Twenty-twenty foresight via the trustee can be invaluable, especially in today’s complex society. For ex-ample, two beneficiaries may be equal in every way today; but ten years from today one benefi-ciary may have a greater need for trust income than does the other beneficiary.

6. Privacy - Unlike a will, which becomes part of the public record after the probate process, the details of an inter vivos (“living”) trust can be kept confidential. In some cases, this confidentiality factor can be very important.

7. Probate Avoidance - Most people want to avoid probate because of the delays, the hassles, and the costs. Trusts, particularly living trusts, avoid probate. While there are some costs at death with a living trust, it can avoid 90-95% of probate costs.

8. Long-Term Care & Conservatorship Avoidance - Trusts can be used for long-term care. Physi-cally or mentally handicapped relatives need to be cared for financially. Assets left outright to these people will often require a conservatorship to manage the assets. However, a trust can leave assets with a trustee to be used for such a person.

Example

Dan dies and leaves his assets in trust for his son, Ralph. The trustee must pay the income to Ralph for life and in an emergency invade the trust principal for Ralph’s benefit. If Ralph marries and divorces, his ex-wife does not get the assets. If he goes bankrupt, his creditors cannot get the trust assets. Ralph can’t give the trust assets away during his lifetime.

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Types of Trusts

The basic types of trusts break down into “living” trusts (trusts created during the lifetime of the grantor), and “testamentary” trusts (trusts created under the terms of one’s will). Living trusts can be either revocable (i.e., the grantor can amend or destroy the trust at any time), or irrevocable (unamendable or fixed). During one’s lifetime, a testamentary trust is also “revocable” in the sense that one can always change its terms through the formal procedure of changing the will of which it is a part. Living and testamentary trusts become irrevocable at the death of the grantor.

Common Elements

Every trust has four common elements:

(1) A grantor or donor (creator of the trust),

(2) A trustee (manager of the trust assets),

(3) A beneficiary or beneficiaries (person or persons receiving the trust income and/or principal), and

(4) The property or funds (corpus) that go into the trust.

Revocable Trust

While the trustor is alive, most trusts are revocable - i.e., it can be changed or terminated. Normally, when a person sets up a living trust, he or she wants the power to change the trust during his or her lifetime. Testamentary trusts are also revocable since one can always change his or her will before death. After death, the trust is irrevocable and cannot be changed.

When one has the right to revoke a trust, that person is its owner for estate (§2038) and income (§671 through §679) tax purposes.

Example

Dan sets up a revocable living trust for his son, Ralph. Since Dan can revoke the trust, he will be taxed on all the trust income and capital gains during his lifetime, and the trust assets will be included in Dan’s estate on death.

Irrevocable Trusts

An irrevocable trust cannot be changed or canceled. The term applies to living trusts, for with a tes-tamentary trust the trustor is dead and by definition cannot change the trust. Thus, most trusts be-come irrevocable at death.

Example

Dan sets up a trust for his wife, Daphne. If Dan does not wish the assets in the trust taxed on Daphne’s death, the trust must become irrevocable after Dan’s death. If Daphne can revoke the trust, she will be taxed on the trust assets at her death.

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A living trust is made either revocable or irrevocable by the terms of the trust agreement. Some states provide that a trust is revocable unless it is expressly stated to be irrevocable. This seems wise since it prevents one from unintentionally creating an irrevocable trust. However, many states say that to be revocable the trust agreement must expressly state that it is revocable. Because of these differences, one should clearly declare the revocable or irrevocable nature of the trust in the trust agreement.

Sometimes, an irrevocable trust is set up during lifetime. For example, an irrevocable trust could be established for children or others. However, to avoid estate and income tax, the grantor cannot:

(1) Act as trustee,

(2) Receive income or other benefit from the trust, or

(3) Receive the assets from the trust (§2036 & §2043).

There are forms of irrevocable trusts, such as charitable trusts, §2503(b) & (c) trusts, insurance trusts, and trusts with “Crummey” provisions.

Testamentary Trust

Trust provisions can be contained in the will. In this event, the trust is referred to as a testamentary or court trust. However, since the trust does not come into existence until the time of death, property cannot be put into such a trust while the testator is alive. Property must go through probate to fund this type of trust. After death, there is no difference between a living trust and a testamentary trust.

Foreign Trusts - §679

Formerly, it was popular (among the “rich and famous”) and profitable to establish a trust in a foreign “tax haven” country. This loophole was closed with the passage of §679. A foreign trust can still be set up, but little if any taxes will be saved.

Under §679, a U.S. citizen or permanent resident, who sets up a foreign trust which can make any payments to a beneficiary in the United States, is the owner for income and estate tax purposes and is taxed on all of the income and capital gains.

Family Trusts

This is a popular term with no particular meaning. In recent years, unscrupulous individuals have promoted the idea that it is possible to set up a “family trust” that has the ability to avoid all federal taxes. This arrangement has been called “The American Birthright Trust,” “The Family Estate Trust,” “The Constitutional Trust” and other titles. Using such a device an individual sets up an irrevocable trust and appoints a committee to run it. The individual then assigns all his or her income (including future income) to the trust. The trust income is then either accumulated or distributed among spouses, children, or other relatives. The trust also pays for and deducts any expenses of the grantor. Supposedly, the grantor is taxed on only what he or she is paid by the trust.

There is no merit to such a trust.

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Medicaid Trust

A Medicaid trust is a planning tool to help older people protect their assets from nursing homes. When done correctly, money and property put into such trusts will not be depleted by long-term health care costs.

Transfers to Medicaid trusts must generally be made at least 60 (formerly 36) months before a per-son enters a nursing home. In addition, the transferor must give up control of the transferred assets.

OBRA ‘93 changed this area dramatically and should be consulted before adopting any such trust.

Living Trust

If a trust is created during the trustor’s lifetime, rather than in his or her will, it is an inter vivos or living trust. When the trustor retains the right to dissolve the trust arrangement it is a revocable living trust.

A living trust is established by a written trust agreement, sometimes called a trust declaration. A living trust can be set up by a husband and wife, or by a single person. In addition to signing the trust agreement, it is necessary to transfer assets into the trust1. Transferring title to the trustee of the trust does this2.

Example

Dan set up a living trust and signs the trust agreement. Dan wants his home in the trust. The deed would transfer title from Dan to “Dan Santucci, Trustee of the Santucci Living Trust, under Trust Agreement dated October 7, 2009.”

Reversion

A living trust may be designed to benefit a person or persons other than the grantor for a limited period of time, thereafter the trust assets are returned to the grantor. Such a return of trust assets is a “reversion.” A reversion may be certain to occur or it may be contingent on a future event.

Advantages of a Living Trust

1. Assets in the trust are not subject to probate administration.

2. Professional Management is available if the trustor becomes incompetent, disabled, or wants to be free of the worries of management.

3. Should the trustor die, the successor trustee can step in and manage the estate without delay or “red tape.”

4. Annual Court accountings, with accompanying legal fees, are not required.

5. The trustee can collect life insurance proceeds immediately after the trustor.

6. A successor trustee can be in another state without complications.

1 Assets transferred into a living trust avoid probate at death, but must be transferred before death. 2 Recording may or may not be required to legally transfer title to the trustee.

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7. Avoiding ancillary (secondary) administration.

8. Avoiding statutory restrictions on bequests of property.

9. Avoiding inheritance taxes.

10. Avoiding will contests.

10. Management uninterrupted by the incapacity of the grantor.

11. Uninterrupted income and access to principal for family beneficiaries.

Disadvantages

1. Creditors may not be cut off as quickly as they are in probated estates (i.e., four to six months).

2. A separate tax return is necessary if and when the living trust becomes irrevocable.

3. Assets must be transferred into the trust.

4. An attorney charges more for a living trust compared to a testamentary trust.

Priority

A living trust has priority over a will. If there is a will leaving specific property to an heir and later a living trust is created and the trustor transfers the same property into it, the trust takes prece-dence and the property will go to the trust beneficiary. However, this is the result most people want. In fact, people use a “pour-over” will together with their living trust to ensure that all assets are controlled by the trust.

Pour-Over Will

Many people who have a living trust also have a will to pick up any assets that are not in the trust at death. This will takes assets left out of the pre-existing living trust and “pours” them into the living trust at death. Such “poured-over” assets would be subject to probate.

Trust Taxation

As a legal entity, a trust can be subject to both income and estate tax. When taxed, trusts are required to file their own returns apart from the tax returns of their beneficiaries.

Income Tax

A trust may be treated as a separate taxpayer for federal income tax purposes, thus requiring the trustee to file a federal income tax return (i.e., Form 1041) for the trust. Whether a trust is treated as a separate taxpayer depends on the nature of the trust. A trust is not treated as a separate tax-payer for income tax purposes when the grantor is considered the substantial owner of the trust under the grantor trust rules contained in §671 through §678.

Grantor Trusts - §671 to §678

A grantor trust is a trust that a grantor can revoke or terminate. Trusts that fall into this category are not required to pay income tax or file an income tax return (§671 through §678). The reason-ing of the grantor trust rule is that if one can revoke a trust, he or she is the owner of the trust

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assets for income tax purposes. Since the grantor has retained the power to revoke, he or she is treated as the beneficial owner of the trust, and therefore the trust income is taxable to him or her whether or not it is payable to him or her under the trust terms.

Under the grantor trust rules, the grantor will be treated as the owner of the trust and be taxed on the trust income if:

(1) The grantor, his or her spouse, or a nonadverse party has powers of disposition over the corpus or income (§674(a));

Note: Powers of disposition mean control over who gets the corpus or income or when he or she gets it (§674). Nevertheless, the following powers are deemed reasonable controls and will not cause the trust income to be taxed to the grantor, even if retained by the grantor:

(a) The power to invade corpus for the benefit of a designated beneficiary, if limited by a rea-sonably definite standard (§674(b)(5));

(b) The power to postpone payments of income to a beneficiary who is under age 21 or a legal disability (§674(b)(7));

(c) The power to change the distribution of income by will (§674(b)(3));

(d) The power to either distribute or accumulate income provided the accumulated income is certain to be paid to the person who would have received it (§674(b)(6)).

(2) The corpus will revert to the grantor or to the grantor’s spouse at any time and the rever-sionary interest is worth at least 5% of the value of the corpus as of the inception of the trust (§673, §672(e));

(3) The grantor, his or her spouse, or a nonadverse party has the power to revoke the trust and revest all or a portion of the corpus in the grantor (§676);

(4) The administrative control of the trust is, or may be, exercisable primarily for the benefit of the grantor or his or her spouse (§675);

(5) In the discretion of the grantor or any nonadverse party, trust income is, or may be:

(a) Distributed to the grantor or his or her spouse,

(b) Accumulated for future distribution to the grantor or his or her spouse,

(c) Used to buy insurance on the life of the grantor or his or her spouse, or

(d) Used to support other dependents, but only to the extent the income is actually so used (§677).

Generally, every fiduciary (e.g., a trustee of a trust) must make a return of income on Form 1041. This return lists the trustor’s name and address, the social security number, and the trust’s in-come or deductions. The trust must obtain a separate tax identification number. In addition, if any portion of trust income, loss, deduction, or credit is treated as owned by the grantor or an-other person, the trustee must show such items on a separate statement attached to Form 1041. However, there are two exceptions to the above rule and no Form 1041 need be filed where:

(1) The same individual is both grantor and trustee (or co-trustee) and that individual is treated as the owner of the entire trust under the grantor trust rules (Reg. §1.671-4(b)(1)); or

(2) Husband and wife are the sole grantors, one or both of the spouses are treated as owners of the trust under the grantor trust rules and the spouses file a joint income tax return (Reg. §1.671-4(b)(2)).

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Note: Recent final regulations reduce the reporting burden on certain trustees by expanding the exceptions to filing a Form 1041 to other trusts all of which are treated as owned by one or more grantors or other persons under the grantor trust rules (Reg. §1.671-4, §1.6012-3 and §301.6109-1). Thus, considerably more trustees are required to file a Form 1041.

Thus, a grantor who is also acting as trustee (or co-trustee) of his or her revocable trust, claims all deductions and credits available to the trust. All dividends, rents, interest, depreciation, capital gains or losses, or other tax items are reported on the grantor’s income tax return (Reg. §1.671-4(b)).

Note: Transferring assets to a revocable trust is not a taxable event. For example, the transfer of an installment obligation to a revocable trust is not a disposition under IRS regulations. However, the transfer of an installment obligation to an irrevocable trust of which the grantor is not treated as the owner is a taxable event.

No income tax return is filed for the trust. No tax identification number is obtained. The trustor’s social security number is used as the trust’s tax number (Reg. §301.6109-1(a)(2)). During the grantor’s life, the income from the trust is taxed to the grantor just as if the trust did not exist. This is true whether the income is paid to the grantor, retained in the trust, or turned over to someone else.

Note: The personal taxation required by the grantor trust rules can be an advantage. For example, if a residence is transferred to a revocable trust when the home is sold, the special tax rules for excluding gain on the sale of a residence continue to exist. If the home were transferred to any other type of trust, these benefits could be lost.

Grantor Retained Income Trust

A grantor retained income trust (GRIT) is structured to pay income to the grantor for a pre-determined time period, with the remainder interest later transferred to heirs. Such a trust is a grantor trust under §677 and is not primarily designed to save income tax but rather estate tax.

Under a GRIT, the grantor places assets into an irrevocable trust and retains the enjoyment of the trust income for a specified term. At the end of the term, trust principal passes to heirs. If the grantor lives out the term, none of the assets are included in the grantor’s estate be-cause the grantor has retained no interest in the trust asset at death (§2036). However, if the grantor dies before the term expires, the date of death value of the property will be included3 in the grantor’s estate (§2036(a)(1)).

The gift to the remainderman is valued using a table that is periodically updated by the IRS to reflect current interest rates. Since the gift is a future interest, it does not qualify for the annual gift tax exclusion. However, because the income right retained by the grantor reduces the value of the gift, a large amount of property can be transferred to heirs with only a rela-tively small reduction in the unified credit.

3 If there is estate inclusion, §2001(b) restores the applicable exclusion amount that was used (for gift purposes).

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Example

Dan sets up a GRIT for the benefit of his son, Ralph, by transferring property valued at $700,000 into the trust but retaining the right to all income for 10 years. The IRS table for that year values his income right at $425,000. Thus, the gift to Ralph is valued at $275,000 ($700,000 minus $425,000) and Dan still has $11,425,000 of his original $11,700,000 applicable exclusion amount for 2021.

Revocable Trusts Included in Estate - §646 & §2652(b)(1)

Both estates and revocable inter vivos trusts can function to settle the affairs of a decedent and distribute assets to heirs. In the case of revocable inter vivos trusts, the grantor transfers property into a trust that is revocable during his or her lifetime. Upon the grantor’s death, the power to revoke ceases and the trustee then performs the settlement functions typically performed by the executor of an estate. While both estates and revocable trusts perform essentially the same func-tion after the testator or grantor’s death, there are a number of ways in which an estate and a revocable trust operate differently. First, there can be only one estate per decedent while there can be more than one revocable trust. Second, estates are in existence only for a reasonable period of administration; revocable trusts can perform the same settlement functions as an estate but may continue in existence thereafter as testamentary trusts.

Numerous differences presently exist between the income tax treatment of estates and revoca-ble trusts, including:

(1) Estates are allowed a charitable deduction for amounts permanently set aside for chari-table purposes while post-death revocable trusts are allowed a charitable deduction only for amounts paid to charities;

(2) The active participation requirement in the passive loss rules under §469 is waived in the case of estates (but not revocable trusts) for two years after the owner’s death; and

(3) Estates (but not revocable trusts) can qualify for §194 amortization of reforestation ex-penditures.

Election for Income Tax Purposes

The tax law provides an irrevocable election to treat a qualified revocable trust as part of the decedent’s estate for Federal income tax purposes. This elective treatment is effective from the date of the decedent’s death until two years after his or her death (if no estate tax return is required) or, if later, six months after the final determination of estate tax liability (if an estate tax return is required). The election must be made by both the executor of the dece-dent’s estate (if any) and the trustee of the revocable trust no later than the time required for filing the income tax return of the estate for its first taxable year, taking into account any extensions. A conforming change is made to §2652(b) for generation-skipping transfer tax purposes.

Note: The election to treat a “qualified revocable trust” as part of the decedent’s estate for income tax purposes must be made both by the executor of the estate and the trustee of the revocable trust.

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For this purpose, a qualified revocable trust is any trust (or portion thereof) which was treated under §676 as owned by the decedent with respect to whom the election is being made, by reason of a power in the grantor (i.e., trusts that are treated as owned by the decedent solely by reason of a power in a nonadverse party would not qualify).

Note: The new election allows a fiduciary to obtain uniform tax treatment for estates and revocable inter vivos trusts, both of which can be used to settle the affairs of a decedent and distribute assets to heirs.

The separate share rule generally will apply when a qualified revocable trust is treated as part of the decedent’s estate.

Irrevocable Trust Taxation

Income taxation is more complex for an irrevocable trust. Generally, income is interest, divi-dends, and net rental income and does not include capital gains. When the trust requires income to be paid to a beneficiary, that beneficiary is taxed on the income.

Example

Years ago, Dan created an irrevocable trust for the benefit of his son, Ralph. This year the trust has $25,000 of interest and dividend income and a fiduciary income tax return must be filed. The trust reports the $25,000 as income but gets a deduction for pay-ments to Ralph. A form is attached to the trust’s return listing Ralph’s name, address, and social security number, and Ralph includes the $25,000 in income on his personal return. If Ralph is entitled to the income, he is taxed on it even if it was not actually paid.

When the trustee has discretion to pay or accumulate income, the income is taxed to the bene-ficiaries who receive it, if any. Income accumulated and kept in the trust is taxed to the trust4.

2021 Trust Income Tax Rates

First $2,650 10%

$2,650 - 9,550 24%

$9,550 - 13,050 35%

Over $13,050 37%

(For trust tax rates see: http://www.smbiz.com/sbrl001.html#pis21 )

Throwback Rules

If the trust accumulated income and later paid that income to a beneficiary, the trust was subject to the “throwback rule.” Under this rule contained in §666, any accumulated income

4 This type of trust is called a “complex trust” and has a $100 per year exemption, but quickly starts to pay tax at high

rates.

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that was later paid out was taxed to the beneficiary as if the beneficiary had received it in the year it was accumulated and taxed to the trust.

However, the Taxpayer Relief Act of 1997 repealed the "throwback rules" with respect to accumulation distributions made by most domestic trusts (as defined in §665(c)) The throw-back rules, nevertheless, still apply to foreign trusts, to domestic trusts that were at one time treated as foreign trusts, and to domestic trusts created before March 1, 1984, that would be treated as multiple trusts under §643(f).

Capital Gains

Some trusts permit the trustee to make payments of principal (as opposed to the income) for a beneficiary’s “health, support, maintenance, and education.” When the trust keeps the gain from the sale of a capital asset, the trust pays the income tax on the capital gain5. If the gain is later distributed, it is not subject to the throwback rule under §666. If current (not accumulated and taxed) gain is distributed, the beneficiary receiving it is taxed on the gain. However, the payment of principal without any taxable disposition does not give rise to any tax.

Example

Ralph has the right to invade the principal of a trust for his health and education and last year he needed $20,000 for tuition. To raise the money the trustee sold $20,000 worth of real estate incurring a $6,000 capital gain. Ralph was taxed on the $6,000 capital gain. The trust was not taxed on the gain. This year, Ralph needs $15,000. How-ever, the trust now has principal funds in excess of this amount and pays Ralph without the sale of any trust assets. Neither Ralph nor the trust is taxable on the $15,000.

Deduction of Estate Planning Expenses

The legal and accounting costs of establishing and operating the trust and trustee’s fees are usu-ally deductible by the grantor for federal income tax purposes. Section 212 provides that all the ordinary and necessary expenses paid for “the production or collection of income,” and for “the management, conservation, or maintenance of property held for the production of income” are deductible on a taxpayer’s return. However, these expenses are subject to the 2% of AGI limita-tion under §67.

Deductibility of Death Expenses

In the case of a revocable living trust, such expenses are deductible on the federal estate tax return or on the estate income tax return as elected by the fiduciary.

Gift Tax

Normally, there is no gift tax involved with a revocable trust. When a grantor transfers property to a revocable trust, there are no immediate gift tax consequences. Any such gift is incomplete since the

5 The trust gets a $100 or $300 exemption depending on the terms of the trust.

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grantor has the right to revoke the trust6. However, a gift does occur when trust property is distrib-uted to a beneficiary.

Example

Dan has a revocable trust. He transfers $20,000 from the trust to his son, Ralph. Be-cause the trust is revocable, Dan is the owner and the transfer is a gift.

When one sets up an irrevocable trust and puts assets in the trust, these assets are subject to gift taxes. However, the trust may qualify for the annual gift tax exclusion depending on its terms. Tes-tamentary trusts that are set up under a will and come into being at death are not subject to gift taxes.

Estate Tax

If a grantor can revoke a trust, the grantor owns the trust assets under both income and federal estate tax law. Thus, on the grantor’s death, the trust assets are subject to estate tax. In addition, if one is both beneficiary and trustee with the power to use trust principal for his or her benefit (other than for “health, support, maintenance, and education”) the trust assets will be included in his or her estates and subject to estate tax on death.

Note: A marital trust or a qualified terminable interest trust are not subject to estate tax when the first spouse dies, but are taxed on the death of the surviving spouse.

In an irrevocable trust where a beneficiary can direct who gets the assets at death, the trust assets are includable in the beneficiary’s estate and taxable. This right to leave the trust assets to anyone is called a “power of appointment.” There are two types of powers:

1. General power of appointment - This power permits one to leave trust assets to anyone with-out restriction and it is estate taxable (§2041(b)).

2. Limited power of appointment - Under this power one can only leave trust assets to a limited group of people and it is not estate taxable (§2041(b)).

Example

Dan creates a trust for his wife, Daphne, giving her the right to transfer trust assets to their children or grandchildren as she wishes on her death. On Daphne’s death, the assets would not be taxable in her estate.

Unlimited Marital Deduction

Under §2056, a deduction is permitted for all assets passing to a surviving spouse at death. For-merly, the maximum allowable deduction was fifty percent of the adjusted gross estate; how-ever, with the passage of the 1981 Revenue Act a deduction is allowed for all property passing to the spouse - i.e., a 100% deduction. Thus, if either husband or wife dies and leaves all assets to

6 Even if the grantor becomes incompetent and no longer able to revoke the trust, the gift does not become complete.

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the survivor, no federal estate tax is due, regardless of the amount. This marital deduction can be obtained in a number of different ways.

Outright to Spouse

Assets left outright to a spouse qualify under the marital deduction and pass tax-free. “Out-right” transfers can be made by:

(1) Joint tenancy,

(2) Will,

(3) Intestate succession,

(4) Beneficiary designation,

(5) Living trust, or

(6) Any other method provided there is no restriction on the surviving spouse.

Marital Deduction Trust

A marital deduction trust qualifies for the marital deduction (§2056(b)(5))). Under this trust, the first spouse to die leaves his or her assets in trust for the survivor’s benefit. The survivor is required to receive all the trust’s income and have a general power of appointment over the assets at death. Such a trust eliminates tax on the first death but causes the assets to be taxed on the second spouse’s death.

Qualified Terminable Interest Property (QTIP) Trust

This is also a trust for the spouse’s benefit. Here, the spouse can get all the trust income for life, but at death, the surviving spouse cannot direct who will get the trust assets ((§2056)(b)(7)). With the terminable interest trust, you can delay tax until the second spouse’s death and still control the final disposition of the assets.

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Types of Marital TrustsTypes of Marital Trusts

Estate Trust:

Remainder interest passes to surviving

spouse’s estate on surviving spouse’s

death

Power of Appointment Trust:

Surviving spouse receives income for life

with GPOA over trust assets

QTIP Trust:

Life income to surviving spouse,

Assets includable in surviving spouse’s

estate, and

Executor make proper election

Charitable QTIP Trust:

Surviving spouse is income beneficiary

of CRT

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“Qualified terminable interest property” is defined as property that passes from the dece-dent, in which the surviving spouse has a qualifying income interest for life, and for which the decedent’s executor makes an election7 to have the property qualify (§2056(b)(7)(B)(i)).

The surviving spouse has a “qualifying income interest for life” if he or she is entitled to all of the income from the property, payable at least annually, and no person has a power to ap-point any part of the property to anyone other than the surviving spouse, except that the surviving spouse (or some other person) may be granted a power of appointment if this power is exercisable only at or after the surviving spouse’s death (§2056(b)(7)(B)(ii)).

“A-B” Format

The funded revocable living trust permits the taxpayer to avoid probate on both deaths, avoid federal death tax on the first death and eliminate or reduce to a minimum federal death tax on the death of the second spouse.

To avoid or reduce death taxes on the second death something has to be created that does not die. This takes the form of a trust. In the example given the trust, along with the accompanying wills, would be created while both spouses were alive. The trust is thus called a living (or inter vivos) trust. Since only assets in the living trust at death avoid probate it is recommended that the trust is “funded” by having the spouses make lifetime transfers to the trust. However, during the joint lives of the spouses, the assets can be withdrawn from the trust at any time. This makes the trust revocable. On the death of the first spouse (normally the husband), the original living trust automatically divides itself into two trusts - the survivor’s trust known as “TRUST A” and the decedent’s trust known as “TRUST B”. Typically, the surviving spouse has control over TRUST A and can withdraw assets or even revoke the trust in its entirety8. However, in order to reduce or eliminate death taxes on the second death, TRUST B must be irrevocable and only limited powers over it can be given to the survivor.

Permitted Powers: Nevertheless, these powers are substantial and are as follows:

7 The election must be made on the estate tax return (for the decedent) filed by the executor and, once made, the

election is irrevocable (§2056(b)(7)(B)(v)). 8 Sometimes TRUST A is unfairly made irrevocable to the surviving spouse (i.e., the wife) supposedly to prevent her from

transferring the assets to a second husband or sexual equivalent. If the surviving spouse doesn’t consent to this he or

she is frequently denied benefits under TRUST B

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A-B Living Trust

Husband’s

Will

Husband’s

WillWife’s

Will

Wife’s

Will

Living

Trust-------------------

-------------------

-------------------

--------------------

Living

Trust-------------------

-------------------

-------------------

--------------------

RIGHT TO REVOKE

OR WITHDRAW

WATCH FOR

FORCED WIDOW’S

ELECTION

RIGHT TO REVOKE

OR WITHDRAW

WATCH FOR

FORCED WIDOW’S

ELECTION

INCOME TO SPOUSE

H.M.S.E. INVASION

$5,000 - 5% POWER

L.P.O.A.

INCOME TO SPOUSE

H.M.S.E. INVASION

$5,000 - 5% POWER

L.P.O.A.

R.I.P.

Normally

Husband

Dies First

CURRENT SUPPORT BUT

ASSETS HELD UNTIL

CHILD IS MATURE

CURRENT SUPPORT BUT

ASSETS HELD UNTIL

CHILD IS MATURE

R.I.P.

Death

of

Wife

CHILDREN’S TRUST

SURVIVOR’S TRUST DECEDENT’S TRUST

“ A” “ B”

POUR OVER

PROVISION

POUR OVER

PROVISION

LIFETIME

TRANSFERS

LIFETIME

TRANSFERS

PERSONAL ITEMS WILLED TO SURVIVING SPOUSE

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1. Right to All Income - the survivor can receive all the income generated by TRUST B;

2. Right to Invade Principal - the survivor can withdraw from the principal of the trust for health, maintenance, and support;

3. Five Percent or $5,000 Power - annually the survivor can withdraw the greater of 5% of the trust principal or $5,000;

4. Limited Power of Appointment - the survivor can retain the power to readjust the chil-dren’s or other heirs’ shares after the death of the first spouse;

5. Trusteeship - the survivor can have one or more (in fact all) the above powers and still be trustee over both TRUST A and TRUST B.

All these powers can be granted without any effect on the living trust’s ability to save death taxes.

Estate Size: Frequently, the “A-B” format is recommended for moderate size estates that are in excess of the applicable exclusion amount. This is because $11,700,000 (in 2021) can pass death tax-free from TRUST A to the CHILDREN’S TRUST and a like amount plus growth9 can pass to the CHILDREN’S TRUST from TRUST B.

Note: After TRUIRJCA, portability now makes it unnecessary to use Trust B to preserve the first spouse’s federal applicable exclusion amount. Since 2011, surviving spouses can add the unused applicable exclusion amount of the spouse who died most recently to their own applicable exclusion amount.

Children’s Trust: On the death of the second spouse, the assets of TRUST A and TRUST B are held in a CHILDREN’S TRUST which normally distributes income to the children and permits them to invade principal for health, maintenance, and support. When a child reaches a certain age the amount held for his or her benefit is distributed to them.

Wills: Although the living trust is the primary document under this format, the wills are also im-portant. In addition to naming the executor, the guardian for any minor children and authorizing a variety of necessary actions, the wills permit the passing of personal items (e.g. household fur-nishings, clothes, and small incidentals) that are not worth going through the trust and collect all valuable assets (under the “pour over” provision) that were not put into the trust and transfers them into trust on the first death. The “pour-over” provision is a “fail-safe” clause used to pick up forgotten assets. It doesn’t avoid probate. The ideal goal is to have all the major assets trans-ferred to the living trust prior to the first death and never have to invoke the “pour over” provi-sion.

“A-B-C” (QTIP) Format

For those estates above twice the applicable exclusion amount, the “A-B-C” living trust should be considered. Instead of dividing into two trusts upon the first death as in the “A-B” format, it di-vides into three (A, B, and C).

TRUST A is again the survivor’s trust and remains revocable by the surviving spouse. The former TRUST B (i.e. the decedent’s trust) is divided between a new TRUST B and TRUST C. The TRUST B is a “bypass” trust that is funded by and takes advantage of the applicable exclusion amount. The

9 Normally, an amount equal to the deceased spouse’s applicable exclusion amount is put into TRUST B. This sum plus

what it grows to during the life of the survivor can pass death tax free from TRUST B to the CHILDREN’S TRUST.

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survivor’s property goes into TRUST A as before and the balance goes into TRUST C - the QTIP trust.

Example: In an equal and joint estate of $28,000,000 in 2021, $14,000,000 would go into TRUST A. The decedent’s half would go $11,700,000 (the exclusion amount in 2021) into TRUST B (the bypass trust) and the balance ($2,300,000) would go into TRUST C - the QTIP trust.

The decedent’s portion is not subject to federal death tax because of the applicable exclusion amount (for TRUST B) and the unlimited marital deduction (for TRUST C). As a result of ERTA, assets that go into TRUST C (i.e., the QTIP trust) qualify for the unlimited marital deduction.

The “A-B-C” format does not necessarily increase the amount which can pass tax-free to the CHILDREN’S TRUST but does give the added flexibility of being able to pay part of the death taxes on the death of the first spouse and part on the death of the second spouse. In some instances, this can result in material tax savings. Paying the death tax entirely on the second death can be far greater than paying in installments on the first and second deaths. In any event, the “A-B-C” format gives the taxpayer the choice.

Valuation & Tax Basis

The transfer of property into a revocable living trust does not change the stepped-up basis treat-ment it receives on the grantor’s death. Property acquired from a decedent, including property from a revocable trust, receives a new basis equal to its fair market value at the date of death or its value at the alternate valuation date.

Note: Community property transferred to a revocable trust with provision that it retain its commu-nity character, gets a new stepped-up basis on both spouse’s shares.

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A-B-C Living Trust

R.I.P.

Normally

Husband

Dies First

CURRENT SUPPORT BUT

ASSETS HELD UNTIL

CHILD IS MATURE

CURRENT SUPPORT BUT

ASSETS HELD UNTIL

CHILD IS MATURE

R.I.P.

Death

of

Wife

CHILDREN’S TRUST

Husband’s

Will

Husband’s

WillWife’s

Will

Wife’s

Will

Living

Trust-------------------

-------------------

-------------------

--------------------

Living

Trust-------------------

-------------------

-------------------

--------------------

POUR OVER

PROVISION

POUR OVER

PROVISION

LIFETIME

TRANSFERS

LIFETIME

TRANSFERS

PERSONAL ITEMS WILLED TO SURVIVING SPOUSE

RIGHT TO REVOKE

OR WITHDRAW

WATCH FOR

FORCED WIDOW’S

ELECTION

RIGHT TO REVOKE

OR WITHDRAW

WATCH FOR

FORCED WIDOW’S

ELECTION

INCOME TO SPOUSE

H.M.S.E. INVASION

$5,000 - 5% POWER

INCOME TO SPOUSE

H.M.S.E. INVASION

$5,000 - 5% POWER

SURVIVOR’S TRUST QTIP TRUST

INCOME TO SPOUSE

H.M.S.E. INVASION

$5,000 - 5% POWER

L.P.O.A.

INCOME TO SPOUSE

H.M.S.E. INVASION

$5,000 - 5% POWER

L.P.O.A.

DECEDENT’S TRUST

“A” “B” “C”

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Alternate Valuation

When a grantor transfers property during life to a revocable living trust, it can have the entire six months for alternate valuation. However, if the same property was in the grantor’s estate at death and was then distributed to the trust during the first six months following the grantor’s death, the alternate valuation date of such assets is the date they were distributed by the exec-utor to the trust.

In probate, the executor can control the timing of distributions during the first six months and maximize the alternate valuation election. However, when a revocable living trust is required to distribute assets on the death of the grantor, there may not be any timing opportunity, because the alternate valuation date and the date of death would be the same.

When a trust becomes irrevocable on the grantor’s death and the assets are divided into two or three trusts, such as in the “A-B” or “A-B-C” marital deduction formats, is this division a distribu-tion for alternate valuation? The Service holds that distribution occurs on the physical division of the trust. Thus, the alternate valuation does not occur until the trustee makes a physical distri-bution of the assets. With proper planning, therefore, the alternate valuation election is not lost by the use of a funded revocable living trust.

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Review Questions

33. Trusts can be divided into two types based on when they are created. Which type comes into existence at the time of death and results in property having to go through probate?

a. a family trust.

b. a foreign trust.

c. a grantor trust.

d. a testamentary trust.

34. The author lists four disadvantages of a living trust. What is one of these disadvantages?

a. The grantor must transfer assets into the trust.

b. Inheritance taxes apply to the assets in the trust.

c. There are statutory restrictions on bequests of property.

d. It increases the possibility of a will contest.

35. Based on the grantor trust rules, five conditions must be met in order for the grantor to be treated as the trust owner and to have the trust income taxed to them. What is one of these conditions?

a. Neither the grantor nor spouse has the power to dispose of the corpus or trust income.

b. Administrative control of the trust cannot be exercisable mainly for the grantor’s or spouse’s benefit.

c. The corpus cannot revert to the grantor.

d. The trust may be revoked by the grantor’s spouse, and the corpus may be revested.

36. One type of trust requires that the surviving spouse receive all of the income in the trust and have a general power of appointment over the assets at death. What is this trust called?

a. living trust.

b. marital deduction trust.

c. revocable trust.

d. testamentary trust.

37. A qualified terminable interest trust may be used for a surviving spouse’s benefit. What is one characteristic of a qualified terminable interest?

a. It is a way to obtain a charitable deduction at death under §2055.

b. The surviving spouse cannot receive interest income.

c. Children can be the sole lifetime beneficiaries.

d. It must be composed of property that passes from the decedent.

38. Another type of trust that can be established is a living “A-B” revocable trust. What is a char-acteristic of this type of trust?

a. The surviving spouse controls Trust A from which assets may be withdrawn.

b. The surviving spouse cannot revoke Trust A in its entirety.

c. The surviving spouse cannot receive any of the income generated from trust B.

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d. For purposes of health, the surviving spouse cannot draw the principal of the trust.

39. A simple will can be used to transfer a taxpayer’s entire estate on death. However, what can result when taxpayers with large estates use a simple will?

a. minor death taxes on the survivor’s death.

b. increased probate avoidance.

c. severe death taxes on the first death.

d. stacking the surviving spouse’s estate.

40. An “A-B-C” trust separates into three separate trusts upon the death of the first spouse. Who should consider establishing an “A-B-C” living trust?

a. those who want to avoid the applicable exemption amount.

b. those whose estates are over double the applicable exclusion amount.

c. those with moderate size estates that are in excess of the unified credit equivalent.

d. those with small estates.

Fundamental Provisions - Revocable Living Trust

Drafting a trust involves serious legal considerations and should be done in conjunction with compe-tent legal and tax advisors. However, there are certain fundamental provisions that should be in any trust.

Identification Clause

This clause identifies the grantor, trustee, co-trustee, successor trustee, and beneficiaries. Also stated are where they live and where the trust is created.

Recital Clause

This provision identifies the property and states the purpose of the trust agreement and the use and disposition of the property.

Property Transfer Clause

This provision declares what property is currently transferred to the trust and is the key to avoiding probate. Because the property is transferred to a trustee, the grantor does not own it as a part of his or her probate estate.

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Income & Principal Clause

A trust agreement often refers to the “income” and directs that it be paid to some beneficiary. Gen-erally, “income” refers to what the trust earns in interest, dividends, and net rental income. It does not include capital gains on the sale of a trust asset.

The income can be paid to one or more people, can be accumulated, or can be paid out under some sort of standard of need. Moreover, income can be paid out, monthly, quarterly, or annually depend-ing upon the trust terms and the amount of income.

Example

Dan creates a trust for his wife, Daphne, and directs that the entire net income from the trust estate be paid to her. The income is taxed to the wife as beneficiary, not to the trust.

Payments of principal can be made to anyone, not just the recipient of the trust income.

Revocation & Amendment Clause

Since the grantor created a “revocable” living trust, the grantor should clearly have the right to com-pletely cancel the trust or change it in any way.

Trustee Clause

To create a trust you must name a trustee and should name a successor trustee. This person will hold title to all trust property after the death of the grantor.

Trustee’s Acceptance

Creating a trust agreement means exactly that; there must be an agreement between the parties. The selected trustee, co-trustee, or successor trustee must sign the document indicating that they truly agree to the terms and conditions set forth in it.

Choice of a Trustee

A trustee can be an individual, several individuals, a bank, a trust company, or a combination of indi-viduals and institutions. The trustee becomes the legal owner of the property transferred to the trust until such time as the trust agreement indicates dissolution by payments of principal to the named beneficiaries. In the meantime, the trustee runs the trust by making investment decisions, collecting the income, rents, and interest, making payments to the trust beneficiaries, keeping records, and filing the annual income tax returns for the trust.

The trustee is entitled to compensation for his or her services. A bank or trust company normally charges 1% of the value of the trust per year. If the trust is very large, the percentage declines. The trustee’s fee is an income tax deductible expense.

Factors for Corporate Trustees

1. They don’t die or become disabled - permanence.

4-24

2. They are financially accountable for their mistakes.

3. They are impartial as to the children. This may prevent the children from becoming bitter to-wards an individual trustee who happens to be a friend or relative, and who doesn’t make distri-butions whenever the children ask for something.

4. They have investment expertise, tax, and accounting abilities, and computer capabilities. Stud-ies show that they save many dollars in the average estate.

5. They refuse loans to “hard-up friends” of the trustee.

6. They keep current with the constant changes in the law.

Factors for Individual Trustees

1. A relative or friend may not charge a fee.

2. A relative or friend may have a more personal interest.

3. A relative or friend may have special investment expertise.

Some people prefer the use of an Individual and a Corporate Trustee, as co-trustees, to obtain the advantages of each.

Choice of Executor or Trustee

Who To Consider Factors

Individual

1. Surviving Spouse 2. Adult Children in order of: a. Age b. Maturity, or c. Financial Expertise 3. Relatives 4. Business Associates 5. Professional Advisors a. Attorney b. CPA 6. Any Combination of 1-5

1. Family Relationships (prior marriage) 2. Expense to Estate 3. Experience 4. Reliability 5. Integrity 6. Availability 7. Conflicts of Interest 8. Knowledge of Testator’s Affairs 9. Age 10. Emotional Stability 11. Tax Consequences

Corporate 1. Bank 2. Trust Company

1. Size of Trust or Estate 2. Reputation of the Company 3. Convenience to Surviving Heirs 4. Acceptance of Document: Powers, Obliga-tions & Limitations 5. Type of Assets: a. Cash b. Real Estate c. Stocks & Bonds d. Business Assets 6. Experience & Management Talent 7. Investment Philosophy & Performance 8. Fees & Recordkeeping 9. Personnel Qualifications

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Trust Termination Clause

A trust cannot last forever. Under the “Rule against Perpetuities," a trust can last no longer than for the lifetime of all of the designated people living when the trust creator dies, plus another 21 years. Thus, by their terms trusts must terminate at some time, and the assets pass to designated individ-uals.

Note: If a charity is involved, a trust can continue indefinitely.

Example

Dan sets a trust and dies. The trust can run for the lifetime of Dan’s children, grand-children, and great-grandchildren, who are alive when Dan dies. However, the trust must terminate no later than 21 years after the death of the last descendant who was alive when Dan died.

A trust can terminate at a certain date, when a beneficiary dies or when a beneficiary attains a certain age. Whatever the provisions, a fixed termination event or date must be set out, as well as the name or group of people who receive the trust assets.

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Review Questions

41. In a revocable living trust, the grantor should include certain basic provisions. Which provision names the property that is held within the trust, and identifies the intention of the trust agree-ment and how the property is to be used and disposed of?

a. the identification clause.

b. the income clause.

c. the property transfer clause.

d. the recital clause.

42. Choosing a trustee can be complicated. Why might someone choose an individual trustee over a corporate trustee?

a. financial accountability.

b. impartiality to children.

c. permanence.

d. personal interest.

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Learning Objectives

After reading Chapter 5, participants will be able to:

1. Identify tax and legal title formats naming differences among these entity formats by:

a. Specifying the advantages and disadvantages of holding property individually and through a sole proprietorship or a corporation stating how to avoid associated title pit-falls;

b. Selecting primary groups of C corporations specifying the estate-planning problems associated with each; and

c. Recalling advantages that partnerships can have over corporations.

2. Determine S corporation rules stating tax advantages and disadvantages and also spec-ify disadvantages and advantages of incorporating a farm.

3. Identify title holding benefits of trusts, co-tenancy, partnerships, and limited liability companies and the tax characteristics of each.

4. Specify types of retirement plans used to provide lifetime benefits to a business owner and to employees, identify how title can be held on behalf of minors and the tax treatment of custodianships, and recall the tax treatment of a probate estate.

5-1

CHAPTER 5

Entities & Title

Before launching ourselves off into an estate planning program, it’s important to know who owns what and exactly for whom we are planning. This requires that methods of holding title must be analyzed, considered, and selected.

Who or what holds title imposes its own unique tax and legal consequences on the estate plan. While each has its own separate characteristics, several may be used together in more sophisticated plan-ning.

Basic Entity Formats

There are nine basic tax and legal “persons.” These “persons” also represent the basic ways to hold title to assets. Here is the list of players:

(1) Individual & sole proprietorship;

(2) Corporate;

(3) Trust;

(4) Co-tenancy;

(5) Partnership;

(6) Limited liability company;

(7) Retirement plan;

(8) Custodian under UGMA or UTMA; and

(9) Estate.

Individual & Sole Proprietorship

The simplest and most direct way to hold property is absolute or fee simple ownership by an individ-ual either as separate, marital or community property. All incidents of taxation, arising from the property, are directly attributed to the owner.

Fee simple ownership means outright ownership by you alone. A fee simple owner is a sole and ab-solute owner. Fee simple property is included in the gross estate at fair market value on date of death.

5-2

In a business setting, the individual is a sole proprietorship. This is not a separate legal entity from the individual. No separate tax return is filed. The business income (or loss) is reported on the Sched-ule C to the Form 1040.

2021 Individual (MFJ) Income Tax Rates

0 -$19,900 10%

$19,900 - 81,050 12%

$81,050 - $172,750 22%

$172,750- 329,850 24%

$329,850- 418,850 32%

$418,850– 628,300 35%

Over $628,300 37%

Because of the TCJA, from 2018 through 2025, sole proprietors, S corporation shareholders, limited liability companies and partners in a partnership are entitled (subject to a number of restrictions) to a deduction equal to 20% of their allocable share of business income (§199A). The deduction does not reduce adjusted gross income nor is it an itemized deduction, but it is available to individuals who itemize and to those who claim the standard deduction.

Estate planning problems for the sole proprietor can be more severe than those posed by other busi-ness entities. In a sole proprietorship, there is no partner, shareholder, or separate entity to shoulder the burden if death or disability strikes. Often, there is no one ready to run the business and preserve its value on the sole proprietor’s death.

Note: In some instances, the sole proprietor should consider incorporation as a regular or S corpo-ration. This would expand the wealth-transfer possibilities, fringe benefits, and ability to save estate and gift taxes. Adding to the analysis is the 20% deduction for passthrough business income and the 21% corporate rate. Another alternative could be a family limited partnership in which the orig-inal sole proprietor could be the general partner with the remaining heirs as limited partners.

In most cases, sole proprietorships must rely on insurance to cover the risks of disability and prema-ture death. Personal service businesses are particularly sensitive to an owner’s disability. No service translates into no earnings. While accounts receivable may carry the business for a short time, unless the sole proprietor returns, the business is finished.

Death presents its own issues. Sale of the business is an obvious solution. If there are employees capable of running the business, perhaps a sale of the business to the employees is possible. A buy-sell agreement between the sole proprietor and the employees could be set up to take effect on retirement, death, or disability. Such an agreement would also be useful in establishing a value for the business at death.

Note: Under §2032A, an executor may elect to value real property used in a closely held business or as a farm on the basis of its value in the business, rather than its fair market value determined on its highest and best use.

However, a sale or liquidation can mean forced-sale prices, discount of accounts receivable, and the destruction of goodwill. An alternative might be to have the executor continue the business. How-ever, this is not a long-term solution since the executor will rarely be ready, able, and willing to run

5-3

the business. Another possibility is to transfer the business to family members. The success of this strategy will depend upon the individuals involved, their experience, and their credibility.

One family transfer possibility would be the use of a QTIP trust to house the business. Using such a trust would shield the business from federal estate tax by invoking the unlimited marital deduction while at the same time assuring operation of the business by younger family members. Such family members could operate the business as trustee or under a contract with an independent trustee.

Note: If the value of the business interest includable in the sole proprietor’s estate is equal to at least 35% of the adjusted gross estate, installment payment privileges for the payment of estate tax attributable to the business interest become available.

Marital Property

There are two types of states: common law states and community property states. The nine com-munity property law states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. All other states are classified as common law states.

Property owned by a husband or wife that is not community property includes property acquired by either, prior to marriage or by gift, will, inheritance or money damages for personal injury, and all of the rents, issues and profits thereof.

Timing & Domicile

This concept of community property came from France and Spain. A person’s domicile deter-mines the type of property at the time the property is acquired. In general, only property acquired during a marriage is community property. In community property states, any prop-erty acquired by spouses during marriage is construed to be one total community of property (i.e., they are 50-50 partners).

Corporate

Corporations provide centralized management, limited liability, ease of transferring interests and continuous uninterrupted existence. They work extremely well in protecting ordinary income gener-ated by a taxpayer in a business or trade. Corporations also permit retirement plans and fringe ben-efit programs that are often superior to those permitted to other entities.

Stock in the corporation is often the primary asset in the business owner’s estate. However, stock in a closely held corporation is illiquid and can present difficult valuation problems on death. Planning concerns in this area include:

(1) Arranging for any necessary successor management;

(2) An analysis of funds available to pay estate taxes attributable to the business;

(3) Potential recapitalization of stock ownership;

(4) The use of supporting entities and leasebacks;

(5) Installment payment of estate taxes,

(6) Stock redemptions, and

(7) The marketability of the business.

5-4

Categories of C Corporations

A C Corporation is any corporation that has not elected to be taxed under the rules of Subchapter S of the Code. There are at least three subcategories of C Corporations, all of which present spe-cial estate planning problems:

(i) The personal holding company,

(ii) The regular C corporation, and

(iii) The personal service corporation.

Personal Holding Company - §541

A personal holding company is any corporation that meets both of the following tests:

a. 60% of its adjusted ordinary gross income is personal holding company income, and

b. At any time during the last half of its tax year, more than 50% in value of its outstanding stock is owned by not more than 5 individuals (§542(a)).

Personal holding company income is determined under a complex set of mathematical rules, generally including dividends, interest, royalties, annuities, rents (subject to special rules), income from trusts and estates, and income from personal service contracts (§543).

Attribution Rules

Under broad attribution rules, stock owned by a corporation, partnership, estate or trust is considered owned proportionately by shareholders, partners, and beneficiaries; one partner is treated as owning stock owned by the other partner; and an individual is deemed to own stock owned by his or her spouse, lineal descendants, brothers and sisters (§544(a)).

Penalty Tax

If a personal holding company has undistributed personal holding company income, it is subject to a penalty tax of 20% (in 2021) in addition to regular corporate income tax (§541). Practically speaking, personal holding companies must make substantial dividend distribu-tions to avoid the penalty tax.

Regular C Corporation

A regular C corporation is generally not a desirable entity for holding investments. If an asset or investment is operated within a regular corporation, all income is attributed to the entity. If this income is then paid out or distributed to the shareholders as a dividend, the income from the investment will be taxed again.

This double taxation could be avoided by paying out the income as salary. However, such compensation can only be paid to employees providing services to the corporation and must be reasonable in amount.

Corporate Tax Rate

Regular corporations (often called “C” corporations) are separate legal and taxpaying en-tities. The income (or loss) of such a corporation is reported on Form 1120. A corporation’s

5-5

regular income tax liability generally was determined by applying the following tax rate schedule to its taxable income:

Taxable Income Tax Rate

Less than $50,000 15%

$50,001 to $75,000 25%

$75,001 to $100,000 34%

$100,001 to $335,000 39%

$335,001 to $10,000,000 34%

$10,000,001 to $15,000,000 35%

$15,000,001 to $18,333,333 38%

$18,333,334 to Infinity 35%

For 2018 and later, the corporate tax rate is reduced to a flat 21% rate.

Note: A personal service corporation is a corporation the principal activity of which is the per-formance of personal services in the fields of health, law, engineering, architecture, account-ing, actuarial science, performing arts, or consulting, and such services are substantially per-formed by the employee-owners. Personal service corporations are also subject to a flat 21% (not the former 35%) tax rate since 2018.

Comment: The maximum corporate rate is now lower than the maximum individual rate. This will obviously impact the decision whether to incorporate or use the S corporation election.

No Pass Through

Once the property is sold, the net proceeds belong to the corporation and can only be paid out as dividends or compensation. Again, this will result in double taxation1. If this were not bad enough, deductions such as depreciation, cost recovery, tax credits, interest, prop-erty taxes, and losses do not pass through to the shareholders and can only be carried forward or back by the corporation. This means that the shareholders will not be able to obtain any of the tax shelter that the assets throw off in the form of write-offs. Moreover, corporations can no longer use accelerated depreciation or cost recovery to determine their earnings and profits and thereby pay dividends that are tax-free.

Note: Regular corporations (often called “C” corporations) are separate legal and taxpaying entities. The income (or loss) of such a corporation is reported on Form 1120.

Getting Money Out of the C Corporation

Selection of the form of business organization should involve consideration as to how, af-ter the death of the owner, funds can be made available for death costs and support of family members. In the case of corporations, here are some ideas and observations:

1. It will be difficult to justify continuation of salary to surviving heirs if they are not working for the business. As a result, make the maximum use of qualified retirement plans to provide income for the survivors.

1 As a result of the repeal of the "General Utilities" doctrine, even distributions of corporate property are subject to

double taxation. The Tax Reform Act of 1986 essentially repealed §333, §336, §337 and §338.

5-6

Corporate Vortex

S corporations are

essentially treated as

conduits with their

shareholders liable

for federal tax. C

corporations are

subject to tax but are

entitled to more fringe

benefits

DOUBLE

TAXATION

0N

DISTRIBUTION

1. Stock - §351• As little as legal

Corporate SuckingMachine

2. Debt - §385

3. Rent - §162

4. Fringe Benefits

5. Wages - §162

WITHHOLDING

WITHHOLDING

WITHHOLDING

INTEREST

PORTFOLIO

RENT

PASSIVE

UNLESS

RELATED

MATERIAL

PARTICIPATION

NO PASSIVE

LOSS RULES

INCOME

STOCKDEBT

0 5 10

8

WITHHOLDING

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Note: Money taken out of a corporation as compensation or dividend is income taxable to the recipient. However, compensation is deductible to the corporation. Dividends are not deductible by the corporation. Since dividends are taxed twice, they are normally avoided in a small corporation.

2. Make use of business life insurance plans, such as group term, whole life, retired lives reserve, and split-dollar. These will provide cash on the death of the business owner.

Note: Corporate-owned life insurance may contribute to alternative minimum tax problems for the corporation. The inside build-up in all life insurance contracts adds to earnings when computing excess adjusted current earnings (ACE) under the alternative minimum tax (§7702(g) & §56(g)(4)(B)(ii)).

3. Consider nonqualified deferred compensation with a death benefit, §83 property, or nonqualified death benefits.

4. Capitalize new corporations with preferred stock. Such stock can be used for gifts, to structure control, and to provide income to heirs through dividends.

5. Corporate assets do not get a stepped-up basis at death under §1014, and the repeal of the General Utilities doctrine creates a tax on any distribution of corporate assets to shareholders. The tax is on the difference between the fair market value of the assets and their basis to the corporation. It applies to lifetime and post-mortem liquidations and stock redemptions.

If possible, do not transfer appreciating capital assets, such as land, buildings, and cer-tain machinery & equipment to newly formed corporations. If such assets are kept out of the entity, funds can be generated later through sale of such assets, possibly to the entity itself, or rental of such assets from the entity.

Note: Where such assets are not transferred to the corporation, mere passive leasing may not constitute the active conduct of a trade or business.

The IRS has ruled that such assets will not qualify under §6166 as interests in closely held businesses even though leased to a related and active entity (PLR 8140020, 8448006, and 8451014). However, the leasing activity itself may constitute a closely held business if active management is involved.

Note: For purposes of special use valuation under §2032A, aggregation of the leased prop-erty and related business entity may be permitted (Reg. §20.2032A-3(b)).

Passive Loss Restrictions

In deciding whether to transfer assets to a corporation or whether to retain them in indi-vidual or partnership name, consider the passive loss limitations under §469.

1. Section 469 provides that for noncorporate taxpayers net losses from passive activi-ties cannot be offset against income from nonpassive activities.

2. Rental activities are generally passive by definition (§469(c)(2)). Therefore, rental in-come from leasing assets to closely held corporations could arguably be used to offset passive losses that a shareholder could not otherwise deduct.

3. Related party leases or subleases with respect to property used in a trade or business which have the effect of reducing active business income and creating passive income

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may result in the rent being classified as portfolio income. Such income could not offset passive losses of the lessor. Recent regulations have confirmed this position.

4. In the event the rental produces a loss, such a loss would belong to the corporation as a separate legal and taxpaying entity and could not be distributed to the corporate shareholders.

5. Passive loss property may be transferred to a corporation to mitigate the effect of the passive loss limits since closely held corporations can offset passive losses against active income (§469(e)(2)(A)).

a. However, in the case of closely held corporations, as defined under personal hold-ing company rules, passive losses cannot offset portfolio income (§469(e)(2)(A)(ii)).

b. If the corporation is a personal service corporation, as defined with modifications under §269A(b), the passive loss rules are fully applicable (§469(e)(2)(A)).

c. Since an S corporation is a pass-through entity, its shareholders are subject to pas-sive loss limitations.

6. If passive loss property is transferred to a corporation, there will be a loss of basis adjustment on the death of a shareholder.

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Passive Loss Big Picture

PASSIVE PORTFOLIOMATERIAL

PARTICIPATION

EXCESS

LOSSES

ACTIVE

REAL

ESTATE

OTHER

PASSIVE

$25,000

ALLOWANCE

OFFSET

OR

FREED

FULLY

TAXABLE

DISPOSITION

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Partnership vs. Corporation

From the estate planning standpoint, a partnership may have advantages over a corpora-tion, because:

1. A partner’s share of the profits not withdrawn from the business increases the basis of the partner’s interest and therefore reduces the taxable gain on its sale or liquidation.

2. Through the flexible provisions of §736, liquidation of a partner’s interest can be planned to characterize a portion of such payments as guaranteed payments or a dis-tributive share of profits under §736(a), taxable to the survivor and deductible by the partnership, i.e., the remaining partners.

3. The interest of the decedent in the partnership could be retained either as a general or limited partnership interest, with income distributions pertaining to that interest only taxed once.

4. If the partnership interest is retained, the successor to the deceased partner can, if the partnership files an election under §754, obtain an adjustment to basis of partner-ship assets under §743.

a. The effect is to adjust the basis of the decedent’s interest in partnership assets.

b. If the partnership interest is community property, the adjustment can be made to the entire community interest on the death of either spouse (R.R. 79-124).

c. The repeal of General Utilities under TRA '86 gives the partnership a tremendous post-mortem advantage in obtaining a new basis for assets at death and in avoiding a double tax on liquidation.

d. Assets in the partnership can be leased to an operating corporation which itself has few appreciating assets.

Personal Service Corporation - §269A

A personal service corporation is any corporation the principal activity of which is the perfor-mance of personal services, and employee-owners substantially performed the services (§269A (b)(1)).

Employee-owners are defined in §269A(b)(2) as any employee who owns, on any day of the taxable year, more than 10% of the outstanding stock, subject to attribution under §318.

1. For purposes of the passive loss rules, and rules relating to deduction of payments to employee-owners, “any” is substituted for “l0%” (§469(j)(2) & §267(a)).

2. For at-risk purposes, “5%” is substituted for “l0%” (§465(c)(7)(B)(iii)). The personal ser-vice corporation is subject to the “at-risk” rules and cannot come under the qualified C corporation exception.

Since 2018, income of a “qualified personal service corporation,” defined in §448(d)(2), is taxed at a flat rate of 21% (not 35%).

S Corporation - §1361

Under certain conditions, it is possible to avoid some of the regular corporate tax problems dis-cussed above by using an “S” corporation. Such a corporation is taxed essentially like a

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partnership with the income and losses flowing through directly to the shareholders and not be-ing taxed on the corporate level. This can avoid double taxation.

S corporation rules provide for reallocation of S corporation income to shareholders and mem-bers of their families where an individual either renders services or furnishes capital to the cor-poration without being reasonably compensated (§1366(e)). Family members include spouses, ancestors, lineal descendants, or trusts for such persons (§704(e)(3)).

In order to qualify as an “S” corporation, there must be 100 or fewer shareholders, all of whom are U.S. citizens or permanent residents, estates or certain types of trusts (§1361(b)). An “S” cor-poration can only have one class of stock; however, differences in voting rights are permitted.

The S corporation can now be used as a vehicle for holding passive investments and may realize up to 100% of its income from passive sources so long as it has no corporate earnings and profits (§1362(d)(3)). However, there is a tax at the corporate level on certain capital gains and “excess passive income” for S corporations that were previously C corporations (§1374 & §1375).

The S corporation is normally employed as a lifetime planning technique, particularly after TRA 86, but it may be a useful estate planning technique as well. The S corporation can offer the following estate planning advantages:

(a) Avoiding penalty taxes on accumulated earnings and personal holding company status;

(b) Reducing unreasonable compensation problems;

(c) Splitting income among family members by way of gifts of stock; and

(d) Allowing shareholders to deduct business losses against outside income.

Minors as Shareholders

S corporation stock can be transferred to custodians for minors under the Uniform Transfers to Minors Act (R. R. 71-287). If no custodian or guardian for the minor is named, the courts and IRS may ignore the transfer and tax the corporate income to the grantors. Even if the transfer is to a custodian, it will not be recognized if the donors retain too much control (Du-arte, 44 T.C. 193 (1965); Beirne, 52 T.C. 510 (1969); Borkowski, 43 TCM 593 (1982)).

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Bequests & Estate Ownership

When S corporation stock is left to a beneficiary as an outright bequest under a will, the stock is initially owned by the decedent’s estate and held by the executor pending distribution. Section 1361 permits S corporation stock ownership by an estate without time limitation. However, to permit a smooth continuation of the business, the executor should be granted powers in the will to continue business operations. These powers should be similar to those granted to an executor who controls stock in a regular corporation.

The qualification rules of §1361 make it imperative that both succeeding and surviving own-ers are eligible to be S corporation shareholders. This is of particular concern in situations involving two or more unrelated shareholders. However, a properly drafted buy-sell agree-ment should eliminate this problem.

Note: Maintenance of the S corporation status requires additional vigilance and more coordinated buying than that required for regular corporations.

Trusts as Shareholders

Generally, a trust cannot be an S corporation shareholder. However, this rule is subject to several exceptions:

1. Qualified Subchapter S Trust: A “qualified subchapter S trust” (QSST) can be a share-holder in an S corporation if the income beneficiary so elects (§1361). The beneficiary will then be treated as the shareholder, and the trust will be ignored (§1361(d)).

This election must be filed by the later of:

(i) The 15th day of the third month beginning after the date on which the S corporation stock is initially transferred to the trust; or

(ii) The 15th day of the third month beginning after the first day of the first taxable year for which the S corporation is effective (Reg. §1.1361-1A(i)(3)).

Note: Such an election is not a substitute for the election to be an S corporation. However, it may be necessary to coordinate the two elections, particularly where a trust holds stock in a regular corporation that intends to make an S corporation election. In such a case, the election to be an S corporation should be made first. Although the trust would not be an eligible share-holder, when the S corporation election is made, it can file its QSST election to be retroactive to the date of the S corporation election.

Under §1361(d) a trust qualifies as an S corporation shareholder if:

(i) All of its income is taxed to only one beneficiary, who is a U.S. citizen or resident,

(ii) Any corpus distributed during his or her life can be distributed only to that benefi-ciary,

(iii) The interest of the beneficiary will terminate on his or her death or earlier termina-tion of the trust, and

(iv) The trust terminates during the lifetime of the beneficiary; all principal will be dis-tributed to that beneficiary (Prop. Reg. §1.1361-lA(i)).

A QTIP trust for a spouse will qualify. The QTIP is a close relative of the QSST. In a QTIP, the income must be paid only to the spouse and the spouse must receive all of the income

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at least annually. A QTIP trust permits no one to appoint its property to anyone other than the spouse.

Note: To qualify as a QTIP trust, the executor must make an irrevocable election on the federal estate tax return. The election is a requirement for QTIP status and must be made within nine months after the decedent’s death when the federal estate tax return is due. At this time, the surviving spouse should also be mindful of the filing deadline for the QSST election.

A trust that distributes all income to a beneficiary until he or she attains a certain age, then distributes corpus, will also qualify.

A trust in which the trustee can accumulate income will apparently qualify as long as the trustee distributes the income annually. This could include a §2503(c) trust, which distrib-utes corpus to the beneficiary at age 21 (Reg. §1.1361-1A(i) & §1.361-1A(j), Example (4)).

The following points should be emphasized regarding a qualified subchapter S trust:

(i) The stock of each S corporation requires a separate election (§1361(D)(2)(b)(i));

(ii) If the election is made by any beneficiary, it will be treated as made by each succes-sive beneficiary unless a later beneficiary refuses to consent to it (§1361(D)(2)(b)(ii));

(iii) Substantially separate and independent shares of different beneficiaries of a trust are treated as separate trusts (§1361(d)(3)); and

(iv) The election is revocable only with the consent of the IRS.

A beneficiary (or legal representative) makes the election by signing and filing a statement with the IRS Service Center where the S corporation files its income tax return. The state-ment must:

(i) Give the name, address, and taxpayer identification number of the current income beneficiary, the trust, and the S corporation,

(ii) Identify that it is an election being made under §1361(d)(2),

(iii) Specify the effective date of the election (not earlier than 15 days and two months before the date on which the election is filed), and

(iv) Provide all information necessary to show that the current income beneficiary is entitled to make the election.

The QSST is essentially a one beneficiary trust. While successive income beneficiaries are allowed, only the current income beneficiary may receive income or corpus during the beneficiary’s life (R.R. 89-45, R.R. 89-55). While only the current income beneficiary can receive distributions of corpus during that beneficiary’s lifetime, corpus distributions are not required. Moreover, income distributions are also not mandatory. Trust income can be accumulated or distributed, provided that income distributions are made to the income beneficiary.

Note: If the trust fails to qualify, then the trust is not an eligible shareholder and the S corpo-ration election may be lost subject to possible relief under the inadvertent termination rules.

2. Grantor Trust: A trust, all of the income of which is taxed (under §671 through §677) to the grantor or to a third party who has control over the trust (i.e., the “deemed owner”), can be a shareholder for 2 years after the death of the deemed owner (§1361(c)(2)(A)(i) & Reg. §1.1361-1A(h)(3)(i)). If the income of the trust is includable in the gross estate of the

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deemed owner, the trust can remain a shareholder for two years after the death of the deemed owner.

Note: A grantor trust is an eligible shareholder only if the grantor would be eligible, i.e., is a resident or citizen of the United States.

In private letter rulings, the IRS has permitted S corporation stock to be owned by a grantor retained income trust (LTR 9037011, LTR 8809043 & LTR 8613054). In the rulings, each trust was eligible to hold S stock since the trust income was taxable to the grantor enabling the trust to qualify under §1361(c)(2)(A)(i). However, such trusts are subject to the gift tax valuation rules in Chapter 14 of the Code. Under these rules, a transfer of S corporation stock to a GRIT in which transferor retains an income interest for a period of years results in a zero valuation for the retained interest. Thus, the entire value of the transferred stock is a gift.

3. Voting Trust: A voting trust can also be a shareholder (§1361(c)(2)()(vi)). A voting trust is a trust created to exercise the stock voting powers transferred to it. The beneficiaries of a voting trust are counted for purposes of complying with the 100-shareholder rule (§1361(c)(2)(B)(iv)).

Normally, a voting trust is established to permit a trustee to vote on behalf of beneficiaries who are entitled to the benefits of stock ownership other than the right to vote. The ben-eficiaries may be prohibited from voting because they are under a legal disability (i.e., they are minors) or they are family members who are inactive in the business.

The IRS has provided regulations dealing with how a voting trust should be drafted. Under Reg. §1.1361-1A(h)(3)(ii)), a voting trust must be a written agreement that:

(i) Delegates the right to vote to one or more trustees;

(ii) Requires all stock distributions to be to the beneficial owners of the stock;

(iii) Requires title and possession of the stock to the delivered to the beneficiaries on trust termination; and

(iv) Must terminate on or before a specific date or event.

4. Testamentary Trust: A testamentary trust can be a shareholder for a 60-day period starting on the day the stock is transferred (§1361(c)(2)(A)(iii)). The estate of the testator is treated as the deemed owner.

5. Section 678 Trust: Trusts in which a person other than the grantor is treated as the owner for income tax purposes under §678 are eligible shareholders. Section 678 provides that a person other than the grantor is to be treated as the owner if he or she has the sole power to vest the corpus or the income in themselves.

6. Electing Small Business Trusts: The Small Business Job Protection Act of 1996 added “electing small business trusts” to the list of trusts eligible to hold stock in an S corporation. “Electing small business trusts” are certain electing trusts in which all the beneficiaries are individuals or estates that are eligible to be S corporation shareholders. Under this rule, charitable organizations may hold contingent remainder interests. No interest in the trust may be acquired by purchase. Each current and contingent beneficiary of the trust is counted as a shareholder for purposes of the 100-shareholder limitation.

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S Corporation Assets

Many corporations are electing S status to mitigate the impact of double taxation on sales or distributions of corporate assets. This is particularly true with respect to liquidation of the corporation.

Gain on such sales or distributions would be taxable but would pass through to the share-holders. The shareholders then add the gain to the income tax basis of their stock thereby reducing gain on liquidating distributions (§1363, §1366 & §1367).

Built-In Gains Tax - §1374

If an S corporation has a net recognized built-in gain for any tax year beginning in the recognition period, a tax is imposed on the income of the S corporation for that tax year (§1374(d)(7)).

Comment: The tax generally applies only to a corporation that converted from a regular cor-poration to an S corporation after 1986. It does not generally apply to any corporation if an election to be an S corporation was in effect for each of its tax years. An S corporation and any predecessor corporation are treated as one corporation for this purpose.

The recognition period has been a ten-year period beginning with the first day of the first tax year for which the corporation is an S corporation (§1374(d)(7)(A)). However, this 10-year recognition period has varied, over time, from 7 to 5 years.

Thus, for 2009 and 2010, it was 7 years. For 2011 through 2014, the "recognition period" was a five-year period beginning with the first day of the first taxable year for which the corporation was an S corporation. In 2015, the five-year recognition period was scheduled to expire and revert to ten years. However, the PATH Act reinstated the five-year recogni-tion period and made it permanent.

Section 1366(f) provides that the built-in gain, less corporate tax paid, is again taxed to the shareholder. In effect, the shareholders will add the built-in gain, net of corporate tax, to their basis for the S stock. In any case, the corporate assets will not obtain a new income tax basis at the death of a shareholder. Compare that result with a partnership, where such an adjustment is made if an election under §754 is in effect.

Example

The assets of an S corporation have a net fair market value of $500,000. The built-in gain on these assets is $200,000. They have been held less than 5 years. The sole share-holder dies. Her stock in the corporation is valued at $500,000. If all of the assets are distributed to the estate of the deceased shareholder, a corporate tax of $70,000 (35% of $200,000) results. This will, in turn, produce a net taxable gain of $130,000 to the estate of the deceased shareholder. The basis of the stock will increase by that amount. If the basis of the stock is exactly equal to the net asset value of the corporation, the estate will have a loss on the distribution of $200,000, equal to the difference between the basis of the stock, $630,000, and the proceeds of the distribution, $430,000. Note - this assumes the transitional rule is inapplicable, and that the top corporate rate for the year in question is 35%.

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Example

Refer to the preceding example and assume the $200,000 prospective gain is not sub-ject to corporate tax under §1374. The gain on the distribution of the corporate assets to the estate will be passed through to the estate and thereby increase the basis of the S stock to $700,000. Since the proceeds of the distribution will be $500,000, a $200,000 capital loss results and will offset the pass-through of the gain. This result assumes: (1) the transactions are consummated in the same tax year, and (2) the gain on the distri-bution is capital gain, not ordinary income.

Incorporation of a Farm

From the estate planning standpoint, transfer of farmland to a corporation may be a disaster, for the following reasons:

1. In many farming operations, most of the profits are paid in the form of salaries to the active participants, i.e., the farmers. If the farmer dies, it is difficult to justify a continuing salary to a surviving spouse.

2. At the death of one of the shareholders, the stock owned by that person will receive a new income tax basis, but this will have no effect on the basis of the farmland itself. If a liquidation of the corporation is required or advisable, the shareholders face the possibility of a large gain on the proceeds of liquidation under §331, particularly since the repeal of the General Utilities doctrine under TRA 86.

3. Estates of farmers are famous for liquidity problems, which are made worse if land has to be sold out of a corporation to raise cash.

4. Also, sales of land or liquidation will cause problems if the estate is electing to defer tax under §6166 or special use valuation under §2032A.

5. The interest of the deceased shareholder may more appropriately be bought out at death. However, there is often a cash flow problem in farm operations, even though the value of the land is quite high. It may, therefore, be extremely difficult or impossible to fund the buy-out, even with insurance.

6. Since most farm corporations are family owned, it is difficult to redeem stock without div-idend problems, although this is less significant with the repeal of the long-term capital gain deduction.

However, the farm corporation can have some advantages:

1. It is easier to make gifts of stock in a corporation instead of interests in real property.

2. Section 303 stock redemptions may be available. Of course, if there were no corporation, there would be no redemption problems.

3. It may be easier to meet the requirements of §6166 and §2032A where the owner of the farm is not actively managing it.

4. The new TRA '86 limitations on installment sales of real property requiring recognition of gain based on seller’s outstanding indebtedness do not apply to sales of stock (§453C).

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To a great extent, the advantages of corporate and noncorporate organization of a farming busi-ness can be achieved through the use of a farm corporation to operate the farm business and a partnership to own the real property and lease it to the corporation.

Land Partnership Advantage

Upon the death of a partner in the partnership, the basis of that partner’s interest in the partnership and the partnership property can be adjusted if the partnership elects (§754). A surviving spouse can receive the profit share through the rents collected by the partnership, while the remaining farmers can be fully compensated for their services through the corpo-ration.

The interest of the deceased partner can be liquidated under the favorable provisions of §736. This can be done over a period of years, and at least part of the liquidating payments can be deductible to the remaining partners under §736(a). Gifts can be made through trans-fers of partnership interests with little more difficulty than gifts of stock in a farm corporation.

If land is simply leased to an operating corporation, the IRS will not treat the land as a business asset under §6166 (PLR 8140020, 8448006, and 8451014). There may also be problems under §2032A since qualified heirs must continue qualified use of the land in the farming activity (see R.R. 75-366, where crop sharing was held sufficient to constitute a closely held business where coupled with participation in management).

Leasebacks

When a corporation is formed, it is often a good strategy to keep real estate, machinery, equip-ment, and other operating assets outside of the corporation and to hold them in individual or partnership ownership controlled by family members. If such structuring was not done, it is pos-sible to do so later by using a sale-leaseback or gift-leaseback.

Under a sale-leaseback format, the corporation would sell all or a portion of its assets to a trust or family members who would, in turn, lease these assets back to the corporation. The IRS re-views sale-leasebacks closely to see if the transaction has the elements of an arms-length ar-rangement.

A gift-leaseback is where a person owning property used in a business transfers it to a trust or family member and then leases it back. The objective is to generate a deduction for the rent while splitting income with family members who are hopefully in a lower tax bracket.

Typically, a leaseback will be recognized if the following conditions are met:

(1) The leaseback is in writing and requires a reasonable rental;

(2) The transferor does not maintain control over the property;

(3) The leaseback has a bona fide business purpose; and

(4) The transferor does not maintain an equitable interest in any trust that may hold the leased property on behalf of the family members.

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Trusts

Trusts have many non-tax advantages over corporations or partnerships. They can be formed pri-vately without the necessity to apply to state authorities or file the names of all the partners with the County Clerk.

Title Holding

Taking title to property in the name of a trust may solve title problems2, make transfers easier, and avoid problems on the death of an investor. In addition, the liability of the beneficiaries may be limited if they do not have control over the trustee or the affairs of the trust.

Business Trusts

However, the use of a trust does not offer the tax advantages of conduit trust taxation in most business situations3. Trusts that have the characteristics of corporations will be taxed as corpo-rations, thereby denying participants beneficial tax treatment.

2021 Trust Income Tax Rates

First $2,650 10%

$2,650 - 9,550 24%

$9,550 - 13,050 35%

Over $13,050 37%

(For trust tax rates see: http://www.smbiz.com/sbrl001.html#pis21 )

Real estate and certain other ventures may be organized in a trust form, with the trustee as man-ager and the grantors as beneficiaries. However, there is a strong likelihood the trust will be characterized as a corporation for tax purposes (Morrissey v. Comm., 296 US 344 (1935); Reg. §301.7701-4(b); R.R. 78-321). Nevertheless, if the trustee is passive or management decisions require the approval of all beneficiaries, it may be characterized as a trust (Wyman Building Trust, 45 BTA 155, acq. 1941-2 CB 14; Elm Street Realty Trust v. Comm., 76 T.C. 803 (1981), acq.).

Co-Tenancy

There are various types of joint ownership of property. A tenancy in common is an undivided interest that can be transferred during life or death. In other words, to own property in tenancy in common is to own it with one or more other people. For example, you may own a duplex with another person. Each of you owns half of the duplex. You can sell your half during your lifetime. At death, the appli-cable portion of the undivided interest is included in gross estate (i.e., one-half of the duplex).

2 In some parts of the country, "Illinois Land Trusts" are use to hide the ownership of property. 3 We will find that the major use of a trust is in the gift and estate tax area.

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As for joint tenancy with rights of survivorship, you own all of the property with someone else. You can give your interest away, or you can sell it. However, you cannot leave your interest to anyone at death because the property automatically passes to the surviving tenant.

Taxation

The tax rules for property held jointly by spouses with survivorship rights are fairly simple. Each spouse is to be treated as one-half owner of joint tenancy assets, regardless of which spouse furnished the funds to acquire the property and regardless of how the joint tenancy was created. Thus, the first spouse to die includes one-half of the joint tenancy in the gross estate, and only one-half of any separate property will receive a step-up in basis. (Step-up in basis is the difference between the price the decedent originally paid for an asset and it's fair market value when an heir receives it.) If an asset’s value has increased, the resulting gain to the heir is not taxable to the heir, either when he or she receives the asset or when he or she eventually disposes of it. This is an extremely important concept in tax planning.

Example

A married couple owns a $190,000 house (that cost them $40,000 many years ago) in a separate-property state. Husband dies, and one-half of the value of the house is in-cluded in his gross estate, but it is not taxed because of the unlimited marital deduc-tion. Wife receives the home under the will with a basis of $115,000 ($40,000 + $75,000).

Example

Husband owns the house outright and dies first. Husband could leave the house to wife and obtain the marital deduction for the will transfer, paying no estate taxes. Here the wife would receive a full step-up in basis to $190,000.

If the wife in the first example sells the home, she would have a $75,000 potential taxable gain, but the wife in the second example would have none.

Percentage Interests

All joint tenants have an equal interest in the property. On the death of a joint tenant, the prop-erty must pass to the surviving joint tenants. This occurs by operation of law outside the probate estate and is therefore not affected by the will of a deceased joint tenant. A joint tenancy can be an advantage if the surviving joint tenants are intended to inherit the property in equal interests. A secret sale by one joint tenant normally ends the joint tenancy and creates a tenancy-in-com-mon4.

Two or more persons may hold title to real property as tenants-in-common that expresses their fractional or percentage interests in the undivided whole. Unlike joint tenancy, tenants-in-

4 Some states recognize a form of title known as "tenancy by the entirety" which can only be broken by all co-tenants.

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common may hold their interests in varying percentages; e.g., 60/40, 90/10, etc. A tenancy-in-common operates much the same as individual ownership in that each tenant-in-common treats the fractional ownership in the same manner as if that interest were the entire property.

Partition

A major disadvantage of co-tenancy is the right of partition, in which one tenant or creditor of one tenant can force a judicial sale of the entire property despite objection from the other co-tenant. Such a sale could arise from unpaid taxes or action by a judgment creditor against a co-tenant.

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Review Questions

43. Designing an estate plan can be problematic for individuals owning business entities. Who would likely have more difficulty designing such a plan?

a. a partner in a family limited partnership.

b. an owner of a regular corporation.

c. a sole proprietor.

d. an owner of an S corporation.

44. The author lists four potential advantages that partnerships may have over corporations from an estate-planning viewpoint. What is one of these advantages?

a. The basis of a partner’s interest decreases due to the partner’s share of profits that are not withdrawn.

b. A decedent partner’s successor may get a basis adjustment of partnership assets if the partnership interest is retained.

c. The partner may plan to characterize a portion of a liquidated interest as deductible by the survivor.

d. The decedent’s partnership interest could be retained as a co-tenant interest.

45. S corporations can be used to avoid some C corporation tax issues. What must the corpora-tion have so as to meet S corporation qualification requirements?

a. more than 100 shareholders.

b. shareholders who either reside in the United States or are estates or certain types of trusts.

c. similar voting rights for all shareholders.

d. two classes of stock.

46. From an estate planning perspective, there are at least six reasons why transferring farmland to a corporation could be disadvantageous. What is one of these reasons?

a. Making gifts of stock in a corporation is particularly difficult.

b. Where the farm owner is not active in management, §6166 and §2032A requirements will be hard to meet.

c. Funding a buy-out may be exceptionally tough.

d. Sales of stock are subject to the TRA ’86 limitations.

47. Trusts offer several tax and non-tax advantages over corporations. What is one of these ad-vantages?

a. They offer participants beneficial tax treatment if the trusts have corporate characteristics.

b. They offer private formation where state authorities need not be notified.

c. They offer a simple way to transfer interest and to have a continuous existence.

d. They are separate legal and tax entities.

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Partnership

A partnership is an association of two or more persons to carry on as co-owners of a business for their joint profit. Section 761 contains a more formal definition:

“... the term ‘partnership’ includes a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a corporation or a trust or estate.”

Some partnerships are general partnerships in which each partner involves himself or herself in the management of the company. Distinctions are sometimes made between general partnerships and joint ventures.

Limited partnerships have both general and limited partners. General partners manage the entity and limited partners are not permitted to participate in the day-to-day management of the company. However, limited partners generally have their liability limited to their capital investment.

Partnership Taxation

A partnership is not taxed as a separate entity but determines its income and files its return (Form 1065) essentially the same as an individual. While the partnership does file a return, this return is for informational purposes only (§6031). Each partner reports and is taxed on his or her share of the income and loss from the partnership (§702)5

Although a partnership is not considered a separate taxable entity for paying Federal income tax, it is treated as such for making various elections and selecting its taxable year, method of depre-ciation, and accounting method. In addition, a partnership is treated as a separate legal entity under civil law with the right to own property in its own name and to transact business.

Allocation of Income & Deduction

The general rule of partnership taxation is that a partner’s share of income, gain, loss, deduc-tion or credit is determined according to the partner’s interest in the partnership (§704(b)). Thus, when a partner has a 10% interest, he or she is entitled to 10% of the partnership’s income, losses, and deductions. This is known as “proportional allocation.”

Allocations can be disproportionate to a partner’s interest but they must meet the “substan-tial economic effect” test of §704(b). Such special or disproportionate allocations occur when a partner receives an allocation of a tax item that is different (normally greater) than his or her partnership interest.

Partnership Recapitalization

A partnership capital freeze involves techniques similar to a corporate recapitalization. The goal of estate freezing techniques is to shift the anticipated future appreciation of assets in the estate of the older generation taxpayer to his or her heirs so that the value of his or her estate assets for death tax purposes will remain frozen at their present value.

5 This information is given to the partner through the Form K-1.

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Two Class Format

A popular approach to estate freezing using partnership interests involves the restructuring of the partnership. Usually, two classes of partnership interests are created which are similar to preferred and common stock in a recapitalized corporation.

The older generation taxpayer will hold a “frozen” interest that should represent the current fair market value of his or her property initially transferred into the partnership. The frozen interest will have a fixed liquidation value and a preferred income position.

The “regular” partnership interests, held by successor generation taxpayers, have negligible value at the inception of the partnership, but regular partnership interests share in future appreciation of partnership property.

Valuation

Establishing the value of the parent’s frozen interest is a critical and complicated problem. If the older generation taxpayer obtains a “frozen” partnership interest with the liquida-tion value less than the fair market value of the property at the time of the contribution, he or she could be deemed to have made a gift to the holders of “regular” partnership interests at the time of the initial transfer.

The retention of management control rights, as well as the right to convert to a regular interest, should add to the value of older generation taxpayers’ frozen interests. Annual distributions to the partnership holding the frozen interest should reflect a reasonable re-turn on his or her investment in order to further substantiate the value of the initial frozen partnership interest and minimize the original value of the regular interest.

Guaranteed Payment

The frozen partner’s interest in profits should be similar to that of the frozen preferred stockholder with a fixed dividend rate that may or may not be cumulative. A partner with a frozen interest could receive a §707(c) guaranteed payment that is similar to a preferred stock dividend. Usually, a guaranteed payment is treated as ordinary income to the frozen partner and a deduction for the partnership. It is payable in all events, and therefore more dependable than the cumulative dividend right. Guaranteed payments may be based on a stated percentage of original donated capital. Profits in excess of a guaranteed payment may be allocated to the partners holding regular interest. How-ever, there is a risk that a partner who has no interest in partnership profits other than a guaranteed payment may not be a partner for tax purposes. Therefore, a frozen part-ner should be given some interest in profits and losses in addition to a guaranteed pay-ment right.

In the event a guaranteed payment is impractical, a shifting interest preference could be used. The frozen partner could share in profits up to the specified dollar level, and his or her interest in profits may be reduced or eliminated after the level has been reached. In the case of shifting interest preferences, no deduction will be available to the partnership. However, the share of profits allocated to regular interest will be re-duced.

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Control & Management

Control and management of a partnership may be retained by a frozen partner or may be transferred to a regular partner. If the frozen partnership is a limited partnership with the frozen interest a limited partnership interest, control could be shifted to the general part-ner holding the growth or regular interest. If the frozen partnership is a general partner-ship, the frozen partner may be designated the managing partner. The partnership could be structured with three classes of partnership interests; frozen interests, regular inter-ests, and managing interests. Such a structure facilitates transfer of interest without af-fecting control. Contributing partners may receive one or more types of interest in the formation of the partnership.

Structuring of a new partnership involves a balancing of objectives. The primary objective is to freeze the value of the older generation taxpayer’s interest in the partnership prop-erty without triggering gift tax. The value of the frozen partnership interests must be equal to the value of the contributive property to avoid a taxable gift by the contributing partner. The regular partnership interest will initially have a negligible value, but future apprecia-tion will be shifted to regular partnership interests. Management control rights should add to the value of the frozen interest along with the right to convert that interest to a regular interest. In addition, annual distributions to the partner holding the frozen interest should reflect a reasonable return on the investment to avoid a gift.

Estate Issues

Management control rights and the right to receive income from the property may create estate tax problems. If a taxable gift is made on the contribution of property to the part-nership, then retention of the right to receive income generated by contributed property will cause the value of the property to be included in the donor’s gross estate for death tax purposes under §2036. A high-income allocation to the parent holding a frozen part-nership interest could result in the application of §2036, and care should be taken that not all income is paid to the original donor of the property. If properly structured, a frozen partnership will have a substantive business purpose and if a partner does not receive total income interest generated by the property, he or she should avoid §2036 exposure.

Family Partnerships

The family partnership is an estate and income tax planning tool. With a family partnership, a parent can transfer business assets to heirs removing both the assets and their future apprecia-tion from the parent’s estate without giving up control. The partnership can be capitalized with business assets and investment properties that have a high potential for appreciation. Moreover, when a valid partnership exists under §704(e) or the Culbertson rule, only the decedent’s part-nership interest is includible in his or her estate under §2033 (B. Craig, DC S.D., 78-2 USTC § 13,252, 451 F. Supp 378; cf. see former §2036(c)).

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Estate Savings

The family partnership allows the sale or gifting of partnership interests to children and other family members. Older generation partners can manage the business while transferring asset value to the younger generation without unfavorable estate tax results (cf. former §2036(c)).

Note: If the business were a corporation, this retained control would cause inclusion of the value of the corporation in the estate of the individual with the retained control.

Income Tax Savings

The family partnership avoids the “double tax” payable if the business were a corporation. Moreover, the partnership allows income to be shifted from high-taxed to low-taxed family members. This results in a reduction in the total income tax paid by the family as a unit.

Family Partnership Requirements

To meet the statutory requirements of a family partnership, the starting point is, of course, the code section itself, §704(e):

Section 704(e)

(e) Family partnerships

(1) Recognition of interest created by purchase or gift

A person shall be recognized as a partner for purposes of this subtitle if he owns a capital interest in a partnership in which capital is a material income-producing fac-tor, whether or not such interest was derived by purchase or gift from any other per-son.

(2) Distributive share of donee includible in gross income

In the case of any partnership interest created by gift, the distributive share of the donee under the partnership agreement shall be includible in his gross income, ex-cept to the extent that such share is determined without allowance of reasonable compensation for services rendered to the partnership by the donor, and except to the extent that the portion of such share attributable to donated capital is propor-tionately greater than the share of the donor attributable to the donor’s capital. The distributive share of a partner in the earnings of the partnership shall not be dimin-ished because of absence due to military service.

(3) Purchase of interest by a member of the family

For purposes of this section, an interest purchased by one member of a family from another shall be considered to be created by gift from the seller, and the fair market value of the purchased interest shall be considered to be donated capital. The “fam-ily” of any individual shall include only his spouse, ancestors, and lineal descendants, and any trusts for the primary benefit of such persons.

Subsection (1) deals with the recognition of a partnership interest created by gift or purchase. A person is recognized as a partner if he or she owns a capital interest in a partnership in which capital is a material income-producing factor, whether or not he or she purchased the interest or it was given to him or her.

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Under subsection (2), if a partnership interest is created by gift, the donee includes his or her distributive share of partnership income in gross income, less an allowance for reasonable compensation for services rendered to the partnership by the donor.

Under subsection (3) an interest purchased by one member of a family from another is treated as a gift from the seller, and the fair market value of a purchased interest is to be considered donated capital. “Family” includes one’s spouse, ancestors, descendants, and any trusts for the primary benefit of such persons.

Recognizing a Partner

A donee or purchaser of a capital interest in a partnership is recognized as a partner only if his or her interest is acquired in a bona fide transaction, not a mere sham for tax avoid-ance purposes, and he or she is the real owner of such interest. To be recognized as a bona fide transaction, a transfer must vest dominion and control of the partnership interest in the transferee. This is determined from all the facts and circumstances (Reg. §1.704-1(e)(1)(iii)).

Control

When the transferor retains substantial control over the property, the transferor will be considered the owner of the partnership interest. Controls retained, directly or indi-rectly, by the donor or seller are major factors in determining ownership and include:

(1) Control of distribution of income or restrictions on distributions;

(2) Limiting the right to liquidate or sell;

(3) Control of assets essential to the business; and

(4) Retention of management powers inconsistent with normal relationships among partners.

Note: A minor child will generally not be recognized as a partner unless another person as a fiduciary exercises control and the fiduciary is subject to judicial supervision (Reg. §1.704-1(e)(2)).

The retention of management power is a problem for a “regular” family partnership; however, in a limited family partnership, if the transferor retains a general partnership interest, his or her management powers are consistent with normal relationships among limited and general partners. However, limited partners must still have the right either to sell or to redeem their interests.

Note: A restriction imposed by a buy-sell agreement that is applicable to all partners does not appear to be barred by the regulations, although nothing in the regulations specifically sanctions it.

Transferability

Reg. §1.7040(e)(2)(ix) provides that any restrictions on the right of the limited partner to transfer or liquidate his or her interest or the retention of controls by the general partner, that would substantially restrict the normal rights of the limited partner will be considered strong evidence of the lack of reality of ownership by the donee.

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Donee as a Partner

Where a donee is to be a partner, it should be announced publicly that he or she is a part-ner. His or her interest should also be recognized on all tax returns, insurance policies, leases, and other business contracts, and internal documents and records.

The regulations use as a factor the measure of control the donee partner has over business bank accounts. While such control would evidence the reality of his or her interest, it is unlikely that the lack of such control is significant.

Trusts as Partners

The Code expressly includes trusts as permissible partners. However, the trust may not be recognized for tax purposes unless the trustee functions as a fiduciary and the trust is ad-ministered solely in the beneficiary’s interest6.

Regulation §1.704-1(e)(2)(vii) provides, in part:

A trustee who is unrelated to and independent of the grantor, and who participates as a partner and receives distribution of the income distributable to the trust, will ordinarily be recognized as the legal owner of the partnership interest which he holds in trust unless the grantor has retained controls inconsistent with such ownership.

Thus, the trustee should be independent of the grantor. The use of a trust is especially advisable for minor children.

Note: A trust would permit the grantor to determine how the partnership income received by the trust is to be distributed.

Minor as a Partner

Minor children are not generally recognized as partners but may be when there is another person who controls the property for the minor, or when the minor has sufficient maturity and experience to be a partner (Reg. §1.704-1(e)(2)(vii)).

If control is to be exercised by another person, it must be as a fiduciary for the sole benefit of the child and there must be such judicial supervision of the fiduciary as is required by law. This includes the filing of required accountings and reports.

6 There is also a state law question involved, and a check should be made to ensure that the state in which the partnership

is to be set up is one of the great majority that permit a trust to be a partner in a business enterprise.

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Note: Use of the child’s property or income for support makes such income taxable to the parent (Reg. §1.704-1(e)(2)(viii)).

Purchased Interests

An interest purchased by one member of a family is treated as a gift from the seller (§704(e)(4)). Thus, if the “donee” is to be recognized as a partner, the reality of his or her ownership is measured by the control and transfer tests mentioned above.

However, a purchase of a partnership interest by a family member may be recognized as a purchase and not a gift, if either of two tests is satisfied:

(1) The purchase is a true arms-length transaction, considering all factors, including the terms of the purchase agreement, the terms of any loan or credit arrangement, the credit standing of the purchaser, and his or her legal capacity to contract; or

(2) The purchase was genuinely intended to promote the business by securing the par-ticipation of the purchaser or by adding his or her credit (Reg. §1.704-1(e)(4)(ii)).

Capital Interest in the Partnership

The requirement that the purchaser or donee possess a capital interest in the partnership means that he or she must have an interest in the capital assets of the partnership distrib-utable to him or her on withdrawal from the partnership or its liquidation (Reg. §1.704-1(e)(1)(v)).

Real

Property

FAMILY PARTNERSHIP

CHILD CHILD CHILD

INDIVIDUAL

TAXPAYER

PARENT

GIFT OR SALE

OF LIMITED

INTEREST

REAL PROPERTY

PARTNERSHIP

INTEREST

§721

FAMILY LIMITED PARTNERSHIP

§704(E)

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Note: The mere right to participate in the earnings and profits of the partnership is not a cap-ital interest.

Capital as a Material Income-Producing Item

The requirement that capital is a material income-producing factor is not one that lends itself to easy proof. The regulations recognize that capital is ordinarily a material income-producing factor if the operation of the business requires substantial inventories or substantial investment in “plant, machinery, or other equipment” (Reg. §1.704-1(e)(1)(iv)).

Note: Although the term “plant” is undefined, it may be limited to a place where some form of mechanical or manufacturing process takes place and does not include a place where per-sonal services are performed, such as a professional’s office.

Source of Capital

The capital of a family partnership must be contributed by the partners (Reg. §1.704-1(e)(1)(i)). As a general rule, the source of the contribution may be a gift or a loan. How-ever, in Carriage Square, Inc., 69 T.C. 119, CCH Dec. 34,710, the Tax Court held that bor-rowed capital could not be considered a material income-producing factor where the loans could not have been obtained without the guarantee of a nonpartner.

Family Partnerships Not Within §704(e)

When a family partnership does not meet the rules of §704(e), the partnership will not necessarily be denied recognition for tax purposes. In W.O. Culbertson, Sr., S. Ct., 49-1 USTC ¶ 9323, 337 US 733, the U.S. Supreme Court stated that the validity of a family part-nership is not necessarily determined by whether services or capital were contributed, but whether the parties, acting in good faith and acting with a business purpose, intended to join together in the conduct of an enterprise. However, the Supreme Court conceded that where a family member furnished neither capital nor services, it would be somewhat dif-ficult to prove that a family partnership was intended.

Real Estate Family Partnerships

A common use of a family partnership involves income-producing real estate. If real estate is transferred to a partnership and the partnership interest is made a gift to family mem-bers, significant tax benefits can be achieved. Where the donees (children or grandchil-dren) are in low tax brackets, there can be a tax savings of 20% to 50% for the family unit. The gift could also be attractive for estate tax purposes by removing appreciating assets from the donor’s estate.

Business Family Partnerships

The owner of a business operating as a partnership may transfer his or her entire interest in the business to family members, remain an employee of the partnership, and not be taxed on the partnership income (Montgomery, 230 F. 2d 472 (CA-5)).

However, in the creation of a family partnership, the question often arises whether there has been a mere assignment of income or a completed gift. The U.S. Supreme Court in

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Culbertson, (supra), ruled that the validity of a family partnership for tax purposes de-pended on “whether, considering all the facts, the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise.” Con-tributions of capital or “vital services,” once thought to have been the decisive factors, were merely factors to be considered in determining intent.

Structuring the Family Partnership

The following points should also be reviewed in setting up a family partnership:

a. The partnership agreement should be in writing. In most states, a written agreement and recording is required for a limited partnership.

b. Under §721, no gain or loss is recognized on a contribution to a partnership in ex-change for an interest in the partnership. However, if the property is mortgaged in ex-cess of basis or the partnership is an investment company under §351(e), gain or loss will be triggered.

c. The managing partner should control the distribution of income with due regard for the reasonable needs of the business (Reg. §1.704-(e)(2)(ii)). Annual pro rata distribu-tions of net profits raise no problems and are recommended (Reg. §1.704-1(e)(2)(v)). However, whenever distributions are made on any basis other than a pro-rata basis commensurate with the capital interest of the partners, the IRS is likely to challenge the distribution.

d. Business purpose must be shown. Otherwise, it may look that tax avoidance was the sole purpose and the partnership may be treated as a sham.

Note: A desire to keep the business in the family by making children partners can meet the requirement of business purpose (G. F. Meffley, Sr., 16 TCM 794, CCH Dec. 22,579(M)).

e. The partnership agreement must provide the general partners with reasonable com-pensation for their services. The family partnership rules restrict the amount of income that can be shifted to a donee by requiring a reasonable allowance for the services of the donor.

Note: The regulations address only the subject of adjustments for services rendered by the donor and are silent on allocation in cases where the donor does not contribute services and a non-donor partner contributes services. In such cases, unless it is shown that the partner performing services is the indirect donor, it appears that no allocation is required.

Limited Liability Company

Another entity that may be available for conducting a small business or holding title to assets is a limited liability company. A limited liability company (LLC) is an unincorporated business entity, es-tablished under state law, in which all owners have limited liability. Thus, the LLC is a blend of the corporation and partnership formats.

The IRS has treated an LLC as a partnership as long as it possesses no more than two of the following corporate characteristics:

(1) Centralized management;

(2) Continuity of life;

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(3) Limited liability for entity debt; and

(4) Free transferability of interests.

However, effective as of Jan. 1, 1997, the IRS adopted final “check-the-box” regulations (Notice 97-1; TD 8697). The rules allow entities that are not required to be classified as corporations (e.g., enti-ties that have complied with the formal state law requirements to be organized as “corporations”) to elect to be taxed as partnerships or corporations. This simplified regime, which applies to domestic as well as foreign business entities, replaces the fact-intensive classification regulations based on the historical differences between partnerships and corporations under local law (i.e., the “Kintner regs.” under §301.7701). The election may be made on Form 8832, Entity Classification Election.

The primary advantage of an LLC is that, without incorporation, owners are protected from personal liability for debts of the entity. Unlike a limited partnership, where at least one general partner is personally liable, with an LLC none of the personal assets of any of the owners is subject to creditor or tort claims. In addition, with an LLC, limited liability remains whether or not the owner actively participates in the affairs of the business.

The major disadvantage of LLCs is that they are new. There are many peculiarities that are not cur-rently addressed and many basic federal tax issues are unclear, for example:

(1) The application of the disproportionate special allocation rules,

(2) The effect of limited liability on recourse and non-recourse entity debt pass-through basis,

(3) The impact of the at-risk and asset activity rules, and

(4) The application of self-employment taxes.

For estate planning purposes, partnership strategies are available to those limited liability companies that are taxed as partnerships. When an LLC is a partnership for tax purposes, it can provide several benefits:

(1) Pass-through of tax attributes under partnership tax rules;

(2) Limited liability to all members;

(3) Control over the business by the members without the risk that management participation will cost members their limited liability; and

(4) Freedom from S corporation eligibility requirements.

No other entity provides all of these benefits. In a general partnership, the partners received pass-through taxation, but are jointly and severally liable for partnership liabilities. In a limited partner-ship, partners have pass-through taxation, but only limited partners have limited liability. S corpora-tions provide shareholders pass-through of tax attributes, limited liability, and control over the busi-ness without risk that management participation will jeopardize limited liability. However, such ben-efits are available only if restricted eligibility requirements are met.

Outside Basis & Debt Share Advantage

When an LLC is deemed to be a partnership, it is subject to partnership taxation provisions. Part-nership taxation provides that an increase in a partner’s share of the partnership’s liabilities is treated as a contribution of cash by the partner to the partnership resulting in a higher tax basis for the partner. This higher basis permits the partner to deduct greater pass-through losses and receive distributions tax-free.

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A partner’s share of a partnership liability depends on whether the liability is a recourse liability or a non-recourse liability (§752). A recourse liability is where the partner bears the economic risk of loss. A partner’s share of a recourse liability is that portion of the liability for which the partner bears the economic risk of loss.

A non-recourse liability is where no partner (or related party) bears the economic risk of loss. Generally, a partner’s share of nonrecourse liability is based on the partner’s share of partnership profits. In a limited partnership, the general partner normally bears the entire risk of loss for recourse liabilities, and the limited partners’ basis for those liabilities is therefore zero.

In an LLC, no member is personally liable for the LLC’s liabilities, except to the extent of their investment in the LLC. Thus, no member of an LLC bears the risk of loss or the LLC’s abilities whether recourse or non-recourse.

Since even recourse debt can be treated as non-recourse, LLC members share in the LLC’s liabili-ties based on their share of profits (i.e., the same rule used to determine a partner’s basis in partnership nonrecourse liabilities). As a result, LLC members can have larger tax bases than if they formed the business as a limited partnership. This analysis opens several related tax issues involving debt.

Substantial Economic Effect Rules

Section 704(b) requires that disproportionate special allocations to partners have substantial economic effect. The §704(b) rules track the outside basis principles of §752 and in the allo-cation of interest turn upon whether a loan is recourse or non-recourse. Since LLCs have the potential to make all loans non-recourse, guidance is needed to calculate non-recourse de-ductions that are intended to be specially allocated.

Discharge of Indebtedness Income

If a property transfer accompanies debt relief, a taxable disposition has occurred. For non-recourse debt, the entire debt is included in the amount realized regardless of the property’s fair market value. Thus, debt relief does not generate income eligible for the §108 exclusion. With the unsettled treatment of LLC debt, the question arises as to how that debt will be characterized for purposes of the debt relief rules.

Suggested Uses

Limited liability, flow-through tax treatment, and the ability to participate in management are the key attributes of an LLC. These attributes create a favorable environment when compared with other business formats in several situations.

Professional Firms

Professional firms can benefit from conducting business as an LLC, particularly, by limiting malpractice liability for other professionals with whom one practices. However, an LLC will not protect a professional from liability for his or her own acts.

An LLC can also shield the members from liabilities of the business (including loans for work-ing capital or furniture, fixtures and equipment, and lease obligations), although, as a practi-cal manner, the creditor will probably require personal guarantees.

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An LLC may also assist in avoiding Personal Service Corporation (PSC) problems. In addition to being subject to double taxation, taxable income of a PSC is taxed at a flat rate of 21% since 2018.

Joint Ventures

An LLC can provide preferential tax treatment where two or more corporations plan to form a joint venture. The LLC offers limited liability with only one level of taxation. This is a sub-stantial saving over using a corporate subsidiary format where distributions would only be eligible for the dividends received deduction of 70% or 80% depending on the ownership in-terest in the subsidiary. The use of an LLC would be the equivalent of a 100% dividends re-ceived deduction. Thus, the savings could be as much as 30% of the payments.

Substitute for Family Limited Partnership

A potential limitation of the family limited partnership is the personal liability of the general partner. While this liability can sometimes be resolved by using an S corporation as the gen-eral partner, such a solution can add substantial cost and complexity. An LLC could resolve this liability issue in a single entity, reducing costs and administration.

Retirement Plan

The right retirement program can offer substantial lifetime benefits to a business owner and his or her employees. In addition, it can be a major asset in one’s estate.

There are three basic types of retirement plans:

1. First is the IRA that is essentially for all persons having earned income. However, there are certain restrictions on establishing a deductible IRA if the taxpayer is also a participant in a com-pany retirement plan.

2. Next is the Keogh plan that is for self-employed persons. These plans were dramatically im-proved in 1983 and are now very similar to corporate plans.

3. Finally, there is the qualified corporate retirement plan. Normally, such plans are either labeled as defined benefit or defined contribution.

Although employer contributions to qualified plans are generally deductible immediately (subject to contribution and deductibility rules), these amounts are not subject to taxation until distributed to employees (§402(a)(1))7. This tax benefit to the employee allows retirement funds to compound us-ing money that would have been paid out as taxes8.

Retirement plans typically use a trust to hold funds until disbursement. Any income earned by the trust is not taxable to the retirement plan trust (§501(a)). The employees are taxed on such earnings when they receive retirement benefits.

7 When distributed to the employee, the employer doesn’t get another deduction. 8 The effect is an interest-free loan from the government.

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Employer Costs

While a retirement plan is probably one of the best fringe benefits, it can be a burdensome ex-pense to the employer since all employees must be covered in a non-discriminatory manner. Using one or more of the following features can reduce this cost:

1. Deferred Vesting - By using a deferred vesting schedule, an employer can require employ-ees to work a certain number of years before being entitled to entire contributions made on their behalf. This reduces costs for businesses with high employee turnover and encourages longer employee service.

2. Deferred Participation - When the employer does not use deferred vesting, he or she can choose to exclude any employee with less than two years of service from participation in the retirement plan.

3. Integration - Contributions to the plan can be reduced by the amount of employer contri-butions made to the OASDI portion of Social Security.

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Retirement Plans

INDIVIDUAL

RETIREMENT

ACCOUNTS

SELF

EMPLOYED

PLANS

CORPORATE

RETIREMENT

PLANS

MARRIED (2021) Amounts

NO PENSION PLAN ACTIVE PARTICIPANT

AGI UNDER $105,000

FULL CONTRIBUTION

FULL DEDUCTION

AGI UNDER $105,000

FULL CONTRIBUTION

FULL DEDUCTION

AGI $105,000 -$125,000

FULL CONTRIBUTION

FULL DEDUCTION

AGI $105,000 - $125,000

FULL CONTRIBUTION

REDUCED DEDUCTION

AGI OVER $125,000

FULL CONTRIBUTION

FULL DEDUCTION

AGI OVER $125000

FULL CONTRIBUTION

NO DEDUCTION

TY

PE

S O

F R

ET

IRE

ME

NT

PL

AN

KEOGHDEFINED CONTRIBUTION

CORPORATEDEFINED CONTRIBUTION

CORPORATEDEFINED BENEFIT

KEOGHDEFINED BENEFIT

MONEY PURCHASEPENSION

DEFINED BENEFITPENSION

ANNUITYPLAN

PROFIT SHARINGPLAN

FUND PERFORMANCE

YEARS

RETIREMENT PIPELINE

NOW RETIRE

DEFINES

CONTRIBUTION

DEFINES

BENEFIT

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This reduces contribution costs for an employee who earns less than the Social Security wage base.

4. Other Exclusions - An employer may choose to exclude part-time employees and those employees under age 21 from participation. Moreover, non-resident aliens and those cov-ered by collective bargaining agreements need not be covered. However, qualified retire-ment plans are required to cover the lesser of:

(a) 50 employees of the employer, or

(b) 40% or more of all employees of the employer.

Profit-Sharing Plan

The profit-sharing plan is a very flexible qualified plan. An employer can contribute the lesser of up to 25% of each employee’s compensation or $58,000 (in 2021). Since contributions are based on profits, they can be reduced or even skipped in any given year. Moreover, any amounts for-feited by terminating employees who are not fully vested may be reallocated to the accounts of active participants in that year on a pro-rata basis or used to reduce future employer contribu-tions.

Note: Investment of the plan assets can be directed by the employer in one account or directed individually by the participants in earmarked accounts. This rule also applies to other qualified plans.

Money Purchase Pension Plan

This type of plan permits a higher maximum contribution percentage than a profit-sharing plan. Employers can contribute the lesser of up to 10% of each employee’s compensation or $58,000 (in 2021). However, the employer is obligated to make the same percentage contribution each year, even if the business was not profitable.

Note: A money purchase plan can be matched with a profit-sharing, §401(k), SEP-IRA, or SAR-SEP plan to provide the maximum contribution level and still retain some flexibility.

Any amounts forfeited by terminating employees who are not fully vested may be reallocated to the accounts of active participants in that year on a pro-rata basis or used to reduce future em-ployer contributions.

Defined Benefit Pension Plan

This type of plan permits employers to contribute the highest proportion of compensation. A defined benefit pension plan provides for a future annual income of a certain amount during retirement. An actuary determines current contributions based on the specified retirement in-come and variables such as investment return, years until retirement and life expectancy. Some-times the contribution can actually exceed compensation paid to the employee. However, con-tributions are mandatory and must be made quarterly. The plan can provide for lifetime annual income at retirement of the lesser of up to $230,000 (in 2021) or 100% of compensation (§415(b)(1)(A)).

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Custodianship

Custodianship is generally used for holding title on behalf of minors and is based on two uniform acts. The first is the Uniform Gifts to Minors Act (UGMA). This permits adults (often parents) to hold title to bank accounts, insurance, and securities on behalf of minors (their children). The assets that can be held in this manner are restricted. The second is the Uniform Transfer to Minors Act (UTMA). This act permits any property to be held for the minor.

Note: However, in the case of a partnership interest a guardianship may be required.

Both acts simplify family income and gain shifting. They permit a gift to be made to a minor with an adult serving as custodian. Usually, a parent who made the gift is also named custodian.

Note: Using the parent as the custodian can be dangerous and result in the funds being included in the parents' estate on death if the parent can use the custodianship funds to satisfy a support obli-gation to the child. Caution may suggest that another relative (e.g., grandparent) be used instead.

The custodian is permitted to sell or redeem and reinvest the principal and to accumulate or distrib-ute the income, provided there is no commingling of the child’s income with the parents’ property. The income or gain of the custodianship is taxed to the child, subject to the “kiddie tax” unearned income rules for children under 19 or 24 if fulltime students.

Estate

Frequently, on death, a probate estate will be established. This entity is charged to collect and con-serve an individual’s assets, satisfy his or her liabilities, and distribute the assets to the heirs.

While probate is not always desirable, the resulting estate is a separate legal entity. Thus, taxpayers may find it profitable to prolong the estate’s existence. This could occur when the heirs are in a higher tax bracket than the estate.

Note: This would be rare since estates have the same tax rate as trusts discussed earlier.

Subchapter J of the Code governs the income taxation of estates (and trusts). Estate income is taxed to the estate or to its beneficiaries to the extent they receive income from the estate. This creates a modified conduit principle. Whoever receives the income is liable for the tax. The executor of the estate is responsible for filing Form 1041 and paying any income tax due.

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Review Questions

48. A popular way to hold title to assets is through a limited liability company (LLC). What is the principal advantage that LLCs offer?

a. They offer an exception to partnership taxation provisions.

b. They are a new format with new rules.

c. They provide that only one partner is liable for the entity’s debts.

d. They offer owners limited liability for the entity’s debts.

49. Three fundamental types of retirement plans exist. Which of these is uniquely designed for self-employed persons?

a. individual retirement account.

b. Keogh plan.

c. defined benefit retirement plan.

d. defined contribution retirement plan.

50. Employers can use one of four features to lower their expenses for retirement plans. Under which of the following features can the employer decrease plan contributions by the contribu-tions that the employer makes to the OASDI part of Social Security?

a. deferred participation.

b. deferred vesting.

c. participation exclusion.

d. integration.

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Learning Objectives

After reading Chapter 6, participants will be able to:

1. Specify persons in which rights are placed by life insurance and reasons to purchase life insurance.

2. Identify the tax treatment of life insurance proceeds by:

a. Determining the treatment of premiums for personally owned life insurance and re-lated benefits and specifying exceptions to this treatment including the transfer for value rule;

b. Select variables that influence whether life insurance is taxable for federal estate tax purposes; and

c. Recalling the gift tax associated with the transfer of life insurance policies.

3. Specify the pros and cons of various types of life insurance policies to guide clients in choosing a suitable policy.

4. Identify reasons for establishing an irrevocable life insurance trust to achieve estate tax planning advantage, specify considerations in establishing life insurance trusts, and deter-mine the differences between deferred and private annuities.

5. Determine what constitutes an entity purchase agreement and a cross-purchase agree-ment recognizing tax and legal advantages.

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CHAPTER 6

Life Insurance, Annuities & Buy-Sell Agreements

Life insurance is a contract1. It places rights in four different persons. For a premium payment, an insurer agrees to pay the insured, or his or her beneficiary, an amount on the insured’s death or some other specified event. The owner is the person who controls the policy and who can elect any options and who selects the beneficiary to receive the funds upon the insured’s death. Frequently, the same person is the owner as well as the insured.

Note: The beneficiary designation supersedes the will so that a person’s will does not control life insurance. For most insurance policies the beneficiaries are listed when the policy application is completed. A change of beneficiary form can later be used to alter the initial designation. A second-ary beneficiary is often used to receive the benefits if the primary beneficiary is dead. If no second-ary beneficiary is named, and the primary beneficiary does not survive, the insurance must be paid to the decedent’s estate and passes by the will.

Life insurance comprises the major portion of many people’s estates, yet it is frequently overlooked or ignored when it comes to estate planning. It is important that life insurance is tied to the overall estate plan.

Purpose

Life insurance is a way to pay death taxes and other costs with cheap dollars. The policy rarely costs in premiums as much as will be paid out in proceeds. Other uses include:

(1) Providing an income for family expenses and special needs such as college expenses or mort-gages,

(2) Cash required to fund buy-sell agreements and redemptions,

(3) Liquidity to prevent the forced sale of estate assets2,

(4) The payment of federal estate taxes at a “discount,” and

1 Section 7702 provides a definition of life insurance for all tax purposes. 2 Life insurance is not the only means of acquiring liquidity. Cash and cash equivalents such as government securities are

also liquid assets.

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Example

Dan purchases a $250,000 policy and dies in the first year of the contract (having paid $2,500 in premiums), $250,000 worth of taxes can be paid for only $2,500.

(5) The payment of estate settlement costs with no:

(a) Probate cost,

(b) Inheritance or other state death taxes,

(c) Income taxes,

(d) Transfer fees, and

(e) Federal estate taxes.

Life Expectancy at Selected Ages in U.S.: NVSR Table 3 (2016)

White Black Hispanic

Age in 2012

All M F M F M F

0 78.6 76.1 81.0 71.5 77.9 79.1 84.2

1 78.1 75.5 80.3 71.4 77.7 78.5 83.6

5 74.1 71.6 76.4 67.6 73.8 74.6 79.7

10 69.2 66.6 71.4 62.6 66.9 69.6 74.7

15 64.2 61.7 66.5 57.7 64.0 54.7 69.8

20 59.4 56.9 61.5 53.0 59.1 59.8 64.9

25 54.7 52.3 56.7 48.6 54.6 55.2 60.0

30 50.0 47.7 51.9 44.2 49.5 50.5 5511

35 45.3 43.2 47.1 39.7 44.8 45.8 50.3

40 40.7 38.6 42.4 35.4 40.2 41.2 45.4

45 36.1 34.1 37.8 31.1 35.7 36.5 40.6

50 31.6 29.8 33.2 26.9 31.3 32.0 35.9

55 27.3 25.6 28.8 22.9 27.1 27.7 31.4

60 23.3 21.7 24.6 19.4 23.2 23.6 26.9

65 19.4 18.0 20.5 16.2 19.5 19.7 22.7

70 15.7 14.4 16.5 13.2 15.9 16.0 18.5

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75 12.2 11.2 12.9 10.5 12.7 12.6 14.6

80 9.2 8.3 9.7 8.1 9.7 9.5 11.1

85 6.6 5.9 6.9 6.1 7.2 6.8 8.0

90 4.6 4.0 4.7 4.5 5.2 4.7 5.5

95 3.2 2.7 3.2 3.3 3.8 3.2 3.7

100 2.2 2.0 2.2 2.5 2.7 2.3 2.6

Tax Overview

Income Tax

Normally, life insurance proceeds are not income taxable. Such death benefit payments are, there-fore, excludable from the gross income of the beneficiary. Thus, if Dan dies and leaves his son, Ralph, $100,000, Ralph does not pay income tax on it.

Where the insurance company holds death proceeds, any interest on the proceeds until payment is income taxable to the beneficiary. However, the principal amount, when received, is exempt from income taxes.

Note: Insurance companies often allow a discount when premiums are paid early. The interest earned on these prepaid premiums is currently taxable.

Transfer for Value Rule

While insurance proceeds are normally not income, they are taxable income if the policy was purchased. This is known as the “transfer for value” rule. However, such proceeds are taxable income only to the extent they exceed:

(1) The consideration paid by the transferee, and

(2) The net premiums paid by the transferee after the transfer.

Example

Dan purchases a $25,000 policy on his own life. He pays four $500 annual premiums. Then he sells the policy to his son for $2,000. His son now owns a $25,000 policy on Dan’s life for which he paid $2,000. Assume that Dan’s son pays six additional $500 annual premiums ($3,000) and then Dan dies. At the time of Dan’s death, his son would have paid a total of $5,000 for the policy ($2,000 for the policy itself plus $3,000 in premiums). When he receives the $25,000 of proceeds, only his cost, $5,000, will be excludable from income. The remaining $20,000 will be entirely subject to income tax.

The “transfer for value” rule does not apply if the sale or transfer is to:

(1) The insured,

(2) The insured’s spouse, even if for value or incident to a divorce,

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(3) A partner of the insured or a partnership in which the insured is a partner,

(4) A corporation of which the insured is a stockholder or officer, or

(5) If the transferee’s basis is determined in whole or in part by the transferor’s basis, i.e., if the transfer does not result in a tax basis change.

Employee Death Benefit - §101(b) (Repealed)

Formerly, under §101(b) an employee’s estate or other beneficiary could have received up to $5,000 from the decedent’s employer income tax-free. However, the Small Business Jobs Protec-tion Act of 1996 repealed this provision.

Premiums

Premiums for personally owned life insurance are considered nondeductible personal expenses and are not deductible for income tax purposes unless:

(1) Premiums constitute alimony payments from a pre-2019 decree, or

(2) Premiums are paid on a policy irrevocably assigned to a charity.

Lifetime Benefits

When a policy owner receives a lump sum cash settlement in excess of the cost of the contract, the difference is taxable income. The “cost” is the total premiums paid (excluding premiums paid for accidental death benefits or waiver of premium).

Rather than take a lump sum payment, sometimes a policy owner will take lifetime benefits un-der a “settlement option.” Payments under settlement options (other than the interest option) are taxed under “annuity rules” (§72).

Section 72

Section 72 protects the annuitant so that he or she will not be taxed on the portion of the annuity that is a return of premium payments.

Under §72, each payment is divided into two parts:

(a) A non-taxable return of cost, and

(b) Taxable income.

An exclusion ratio is used to calculate the taxable and nontaxable portion of each payment. The exclusion ratio (i.e., the tax-free portion) is determined by dividing the investment in the contract (cost) by the expected return. The expected return is the annual payment multiplied by the recipient’s life expectancy (see table below). The exclusion ratio is multiplied by the annuity payments to yield the tax-free portion of payments received during the year. The balance of the payment is taxable as ordinary income.

Expected Return Multiples

Age Multiple Age Multiple Age Multiple

5 76.6 42 40.6 79 10.0

6 75.6 43 39.6 80 9.5

7 74.7 44 38.7 81 8.9

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8 73.7 45 37.7 82 8.4

9 72.7 46 36.8 83 7.9

10 71.7 47 35.9 84 7.4

11 70.7 48 34.9 85 6.9

12 69.7 49 34.0 86 6.5

13 68.8 50 33.1 87 6.1

14 67.8 51 32.2 88 5.7

15 66.8 52 31.3 89 5.3

16 65.8 53 30.4 90 5.0

17 64.8 54 29.5 91 4.7

18 63.9 55 28.6 92 4.4

19 62.9 56 27.7 93 4.1

20 61.9 57 26.8 94 3.9

21 60.9 58 25.9 95 3.7

22 59.9 59 25.0 96 3.4

23 59.0 60 24.2 97 3.2

24 58.0 61 23.3 98 3.0

25 57.0 62 22.5 99 2.8

26 56.0 63 21.6 100 2.7

27 55.1 64 20.8 101 2.5

28 54.1 65 20.0 102 2.3

29 53.1 66 19.2 103 2.1

30 52.2 67 18.4 104 1.9

31 51.2 68 17.6 105 1.8

32 50.2 69 16.8 106 1.6

33 49.3 70 16.0 107 1.4

34 48.3 71 15.3 108 1.3

35 47.3 72 14.6 109 1.1

36 46.4 73 13.9 110 1.0

37 45.4 74 13.2 111 0.9

38 44.4 75 12.5 112 0.8

39 43.5 76 11.9 113 0.7

40 42.5 77 11.2 114 0.6

41 41.5 78 10.6 115 0.5

Estate Taxes - §2042 & §2035(a)

Life insurance is taxable for federal estate tax purposes if:

(a) The proceeds are payable to or for the benefit of his or her estate, or

(b) At the time of death, the insured possessed any incidents of ownership in the policy; or

(c) The policy is transferred by the decedent within three years of his or her death (§2042 & §2035(a)).

Thus, if Dan dies owning $100,000 of life insurance, the life insurance is included in his estate. How-ever, if Dan’s spouse is the insurance beneficiary, the proceeds are exempt from estate tax because of the unlimited marital deduction.

Note: If the life insurance is community property, only one-half of the policy is taxable.

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To avoid estate tax, ownership of the insurance policy is often transferred to someone before death3. Such a transfer must occur at least three years prior to death, and the insured must not retain any rights of ownership in the policy. For example, if Dan transfers an insurance policy to his son, Ralph, the owner and insured are now different persons and the policy is not taxable at death.

Ownership

Policy ownership is important. The owner controls the policy, names the beneficiary, elects op-tions, borrows any cash proceeds, and so forth. To avoid estate taxes, the insured and the owner can be different people. For example, if Dan is the insured and names his son, Ralph, as the owner of the policy, the life insurance proceeds can be estate tax-free at Dan’s death.

Before the unlimited marital deduction, a common estate planning technique was to make the wife owner of any policies on the husband. If done properly, the policies were not taxable when the husband died since he was not the owner. Now, with the unlimited marital deduction, it does not matter if the other spouse is the owner or not when the survivor is the policy beneficiary.

Note: To transfer ownership of a policy to someone, contact the insurance company and complete an assignment transferring all rights, title, and interest in the policy to the new designated owner.

Gift Taxes

The transfer of a life insurance policy to someone is a gift. The value of the gift is the terminable reserve value of the policy. This value is the cash value plus a prorated portion of the current pre-mium. The $15,000 (in 2021) annual gift tax exclusion can be used as a gift of a life insurance policy when a present interest.

Community Property Gift Danger

When a policy on the husband is community property and the beneficiary is not the spouse, a gift will occur when the husband dies and the proceeds are paid to that third person. The gift is the wife’s one-half interest in the proceeds.

Even payment to a trust where the surviving spouse is the income beneficiary can be a gift if the surviving spouse does not have the power to determine who will receive the remainder interest on her death. The gift would be the actuarial value of the remainder interest at the time of the transfer to a trust, in the surviving spouse’s half of the insurance proceeds.

3 An unconditional sale or gift of all ownership rights in a life insurance policy is known as an “absolute” assignment.

When a policy is pledged as collateral for a loan, the assignment is known as a “collateral” assignment.

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Review Questions

51. Life insurance positions contractual rights among four separate parties. Which of these par-ties manages the policy and may elect any options?

a. the beneficiary.

b. the insured.

c. the insurer.

d. the owner.

52. Typically, life insurance is not controlled by a will. However, under what circumstance must a decedent’s estate be the recipient of life insurance and pass any proceeds by the will?

a. A will is not properly drafted.

b. No owner is listed on the policy designation.

c. A primary beneficiary has died and no other beneficiaries are named.

d. Only a primary beneficiary is named.

53. The “transfer for value” rule applies if a life insurance policy was purchased. To what extent are the insurance proceeds taxable when this rule applies?

a. to the extent of the excess that the transferee paid for both the net premiums after the purchase and the consideration paid.

b. to the extent that the policy was purchased by a corporation of which the insured is a stockholder or officer.

c. to the extent that policy was purchased by a partner of the insured, or a partnership, in which the insured is a partner.

d. to the extent that the policy was purchased by the insured’s spouse.

54. Section 72 separates each annuity payment into two portions. What are these two parts of such an annuity payment?

a. lump sum payment and settlement option.

b. nontaxable return of premium payments and taxable income.

c. deductible and nondeductible.

d. term and whole life.

55. Section 2042 provides three conditions that will cause life insurance to be taxable for federal estate tax purposes. What is one of these conditions?

a. When the insured purchased the policy, he or she owned incidents of ownership in the policy.

b. The decedent’s estate transfers the policy three years or more after his or her death.

c. The decedent’s estate does not benefit from the proceeds.

d. The decedent’s estate receives the proceeds.

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Types of Life Insurance

There are many types of life insurance. The fundamental choice is between pure insurance and some form of investment combined with insurance4.

Term Insurance

Term insurance is “pure” insurance. A fixed amount of protection is obtained for a fixed premium for a limited amount of time. It is designed to run for a specific time period, such as 10 or 15 years. At the end of the term specified in the insurance contract, the insurance protection ends. The cost is relatively low.

Many variations exist in term insurance. However, there are basically four types of term insurance:

Renewable term - This term insurance can be renewed each year regardless of the insured’s health but at an increasing premium.

Convertible term - This kind of term insurance can be exchanged for a whole life or endowment policy without evidence of insurability.

Decreasing term - Often called “mortgage” insurance, this type of term insurance has a death benefit that decreases over time, yet the premium remains level.

Level term - In this type of term insurance, the death benefit and premium remain the same for the entire policy term.

Whole Life (Permanent) Insurance

In whole life insurance the premium remains the same during the insurance contract and a “cash value” builds up which can be borrowed or taken as surrender proceeds.

Straight Life v. Limited Payment

There are two types of whole life insurance - straight life and limited payment life. The basic difference is that in a limited payment life policy, premiums are payable over a shorter time and the premiums are therefore higher.

Example

Dan purchases a $250,000 straight life policy and pays an annual premium of $600. If Dan had purchased a $250,000 20-payment life policy, the premium might be $1,350 - considerably higher under the limited payment plan.

4 Some would solve this choice by simply saying, “buy term and invest the difference.”

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Modified v. Preferred

These two types of whole life insurance can be either modified or preferred. A modified life policy initially has low premiums but correspondingly higher premiums during the later policy period5. Such policies are often marketed to young families who initially can’t afford large premiums.

In a preferred risk policy, the insured must be in excellent health and premiums are lower than standard policies. Such policies are marketed to nonsmokers or others in low-risk occupations.

Endowment Insurance

An endowment policy pays its benefit on the “endowment” date (i.e., the maturity of the contract) or the insured’s death, whichever is sooner. Endowment policies are a form of forced savings and the insurance element is minimal. They are more investments than insurance. As a result, they are often found in pension plans or personal savings programs. Individuals in high-income tax brackets often use such policies, since the cash value builds up tax-free.

Universal Life

This type of policy separates the cash value element and the term insurance element in a whole life policy. A portion of the premium is invested in a cash fund. The balance is used to purchase renewa-ble term insurance.

A universal life policy separately states and defines the investment, expense, and mortality elements. The customer chooses a death benefit that may increase with time, be linked with increasing cash value (option II), or remain level (option I). Thus, there is no “standard” universal life plan. Significant flexibility in premium payments is possible.

Charges

The insurance company deducts a “load” from the premium for expenses. Expense loads run between 5% and 10% of the gross premium and are charged year after year6. Mortality charges are then deducted and the remaining premium is applied to the cash value. Interest earned on the cash value is based on current investment earnings. Generally, there is a minimum guaran-teed interest.

Note: Many insurers recover expenses through “surrender charges.” Upon surrender, the benefit is reduced by a surrender charge.

Premium Payment

There is no requirement that premiums be paid beyond the initial premium. “Stop and go” fea-tures permit the discontinuance and later resumption of premiums at any time7. If the insured elects not to make a premium payment, the cash fund is used to make the payment. So long as

5 As a result, modified plans have lower initial cash values than straight life plans. 6 Additionally, because of greater first year acquisition costs, an extra first year expense may be levied. 7 It is not necessary to reinstate the policy to do this.

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there is sufficient cash value to pay the expense charges and mortality costs, the policy will con-tinue in effect. If the cash value is insufficient, the policy terminates8.

Variable life

A variable life resembles whole life with one major difference - both the death benefit and the sur-render value are not guaranteed but vary based on investment performance of policy assets. Variable life is a trade-off of the cash surrender value guarantee for the potential of investment growth. Be-cause of the investment aspects, a prospectus approved by the Securities and Exchange Commission must accompany the sale of a variable life insurance.

Investment Accounts

Net premiums, after expenses9, are invested in investment accounts selected by the policyholder. Types of accounts may include a money market account, a stock account, a bond account, or a balanced fund account. If the accounts earn more than a specified return, the death benefit, and cash surrender value increase. If the accounts earn less, they decrease. However, the death ben-efit never decreases below the original face amount.

Taxation

Earnings from investments in the selected accounts are income tax deferred. There is no tax on the cash value until surrender, and then only if the value exceeds the policyholder’s cost basis. If a policyholder wants access to the cash value without surrender, he or she can borrow up to a designated percentage of a cash value.

Survivor Life

This type of policy insures two or more people. It can be either a whole life or term policy. The death benefit is not paid until the last of the two or more insured individuals dies, at which time the death benefit is paid to the beneficiary.

These policies often provide for an increase in cash value upon the first death. Depending on the policy, premiums may continue until the survivor’s later death or the policy may be paid up at the first death.

The policy is a good tool to relieve the federal estate tax burden of couples who take maximum advantage of the marital deduction. Such insurance can match the situation where there is no federal estate tax on the first spouse’s death, but there is tax expected on the survivor’s death.

Single Premium Whole Life

Single premium whole life insurance is an investment advantaged life insurance policy that requires only one premium. Thus, the policy has immediate cash value.

8 Usually, there is a 61-day grace period. 9 Among the charges that are deducted from the premium before any investment is made in an account are administra-

tive and sales expenses, any state premium taxes, as well as the cost for the mortality element.

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Prior to the Technical and Miscellaneous Revenue Act of 1988 (TAMRA), such policies were popular and heavily promoted. TAMRA made income tax changes affecting withdrawals from cash value pol-icies, such as single premium whole life, failing a seven-payment level premium test. These failed policies are called "modified" endowment policies and policy loans and withdrawals are treated as first coming from taxable earnings.

Single premium life still offers some advantages. The money contributed to the policy builds up tax-free through policy cash values. The death benefit can go to the beneficiaries income tax-free and without probate.

Dividends

A dividend is a partial refund of the premiums paid to the insurance company and can be applied in a variety of ways. Dividends can be:

(a) Taken in cash;

(b) Used to reduce premiums;

(c) Converted into additional insurance;

(d) Left with the company to earn interest; or

(e) Used to pay off the policy earlier than expected.

Dividends paid on policies are not taxable income. However, if dividends are left on deposit with the insurance company and accumulate interest, any interest on the dividends is taxable to the policy owner. Dividends that are used to purchase additional insurance create no income tax liability. They are considered dividends paid in cash (a return of capital) used to buy single premium insurance.

Life Insurance Trust

The use of an irrevocable life insurance trust has several estate tax planning advantages. When life insurance policies are transferred to an irrevocable trust, the proceeds received under the policy can be kept out of both the insured’s and his or her spouse’s estate, provided, the trust is drafted cor-rectly. The policy must be transferred to the trust more than three years prior to death. The insured may not have any incidents of ownership in the policy nor the right to direct economic enjoyment of the trust. In addition, the insured should not be named as trustee since, as trustee, the insured may have retained an incident of ownership or the power to direct an economic benefit of the policy.

Example

Dan sets up an irrevocable trust with his wife and son as the beneficiaries. An inde-pendent trustee is named and Dan gives up all rights in connection with the trust. Dan then transfers his life insurance to the trust and sufficient cash (and perhaps other assets) to pay future premiums. On Dan’s death, the life insurance proceeds collected by the trustee are not subject to federal estate tax, since Dan was not the owner of the policies and the policies were transferred at least three years before death. On the wife’s death, the proceeds go to the son and are not taxable in the wife’s estate, since she did not set up the trust, could not revoke it and the trustee was independent.

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The trustee can be given discretionary power to accumulate income and/or “sprinkle” income among beneficiaries. Under such a power, the trustee can choose favorable tax years to distribute income and lower bracket beneficiaries. Trust income distributed to the beneficiaries is taxed to them as ordinary income. However, undistributed trust income is taxed to the trust.

Considerations

To work a life insurance trust must be approached very carefully. While the trust can save a large amount of potential federal estate tax, the following should be considered:

1. An independent trustee must be used.

2. The trust is irrevocable and cannot be changed or amended by the grantor; otherwise, it will be included as an asset of his or her estate.

Note: Although controversial, a special power of appointment in the hands of the insured’s spouse might permit that spouse to appoint the trust assets back out to the insured or to his or her children.

3. Legal fees are high.

4. Community property life insurance may have to be converted to one spouse’s separate prop-erty before transfer to the trust to avoid later inclusion of the policy in the surviving spouse’s estate.

5. When policies have cash value and are not transferred for value, there is a gift10 that may not qualify as a “present interest” under the annual exclusion.

Note: A possible way to avoid some or all of the gift tax liability is to take a full cash value loan on the policy prior to transfer.

6. If a policy is transferred for value, proceeds will only be income tax exempt to the extent of the consideration paid by the transferee and net premiums paid by the transferee after the trans-fer.

10 The value of an existing policy for gift tax purposes is the interpolated terminal reserve as of the date of transfer plus

the value of the unearned portion of the last premium. If a new policy is purchased and immediately transferred to the

trust, the gift tax value is the gross premium paid by the insured to the insurance company.

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Life Insurance Trust Format

Insurance

Policy----------------------------

----------------------------

----------------------------

----------------------------

----------------------------

----------------------------

----------------------------

Insurance

Policy----------------------------

----------------------------

----------------------------

----------------------------

----------------------------

----------------------------

----------------------------

Trustor Establishes Trust

By Gifting Policy to Trustee

TRUST

• Trustee Owns Policy

• Insurance Company Pays Proceeds To

Trustee on Death of Insured Trustor

• Trustee Can Buy Assets From Estate

• Trustee Can Loan Funds To Estate

Policy is

not in either

spouse’s

estate

Surviving

spouse and

children are

beneficiaries

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7. Additional transfers of income-producing assets to the trust may be necessary to “fund” the payment of later premiums11. A separate gift tax calculation is made for each such transfer.

8. Contributions to the trust are “future interests” and do not qualify for the annual exclusion of $15,000 (in 2021) per donee. Arguably, a policy and subsequent premium payments made by the insured to the trustee qualify as gifts of a present interest if the spouse (or other beneficiaries) has the:

(a) Right to have the trustee convert the policy to income-producing assets, and

(b) A noncumulative right to annually withdraw $5,000 or 5% of trust principal, whichever is greater.

An alternative might be to grant children who are beneficiaries a “Crummey” right to withdraw limited sums from the trust for a short time after the grantor makes the contribution.

Annuities

An annuity is where money is transferred to an insurance company and the company agrees to pay a fixed sum per year for life. At death, the annuity ends and the insurance company keeps whatever funds are left. Often an election can be made to have the annuity paid for joint lifetimes or in guar-anteed payments for a certain time period like 5 or 10 years12.

Deferred Annuity

Under a deferred annuity (sometimes called a single premium deferred life annuity or a tax-deferred annuity) money is given to an insurance company and it invests the funds and accumulates the in-terest. The interest accumulates tax-free and is not taxed until withdrawn.

Private Annuity

Under a private annuity, one transfers property to another in exchange for an unsecured promise to make fixed periodic payments of money for life. Normally, it is only used between close family mem-bers.

Note: Although estate planners talk frequently about this arrangement, the numbers rarely work out.

The transferred property and the value of the promised payments are excluded from the transferor’s estate13. If the transferee is an heir, he or she benefits from savings in estate taxes and administration costs in the transferor’s estate.

11 Funded irrevocable insurance trusts have income producing assets transferred into them, which will pay the premiums

on the insurance policy from the income earned. 12 If death occurs before the end of the time period, the payments will continue to be paid to the designated beneficiary. 13 However, estate tax savings may be illusory unless the annuitant consumes annuity payments.

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Example

Dan transfers real estate, worth $100,000, to his son, Ralph. Based on annuity tables, Ralph pays Dan $1,200 per month for life, the actuarial value of the $100,000. At Dan’s death, the annuity ends and nothing is taxed in Dan’s estate. No gift occurs since the property was transferred to Ralph for “consideration.”

The taxable gain recognized on the transfer of the property is spread over the transferor’s lifetime. Each payment is partially taxable to the annuitant (§72). Part is return of capital and is not taxable, part is long-term capital gains, and part is interest and is taxed as ordinary income. Although part of each annuity payment is regarded as interest, the transferee cannot deduct such part as interest.

The transferee’s basis in the transferred property is equal to the present value of the annuity14. If the property is depreciable, the transferee’s increased basis generates a favorable tax deduction. How-ever, if the transferor dies before his or her calculated life expectancy, the transferee’s basis must be adjusted downward to the payments actually made. If the transferee had sold the property prior to the transferor’s death, the excess of the sale price over the actual payments made must be re-ported as taxable gain.

Unsecured Promise

It is important that the promise to make periodic payments be unsecured and that the property is transferred for the present value of the expected series of payments. If the promise is secured, a taxable event occurs15. If the property is transferred for less than the value of the promised payments, the difference is a gift.

Note: If the transferee dies prematurely, the transferor will have to depend on the transferee’s estate for continued payment of the annuity. However, problems occurring because the transferee may predecease the transferor or become disabled might be minimized or eliminated with appro-priate insurance coverage.

Regulations Restrict Private Annuity Income

The IRS has issued regulations that eliminate the income tax advantages of selling appreciated property in exchange for a private annuity. Under these rules, the property seller's gain would be recognized in the year the transaction occurs rather than as payments are received ((Prop. Reg. § 1.72-6, Prop Reg § 1.1001-1)).

The regulations generally apply to transactions entered into after Oct. 18, 2006. However, certain transactions effected before Apr. 19, 2007 continue to be subject to prior law rules.

14 If the transferor outlives his or her life expectancy, the transferee may pay out more for the property without an

increase in basis. 15 Since the annuity payments cannot be secured, the only recourse on default may be to bring suit for breach of contract.

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Review Questions

56. There are fundamentally four types of term insurance. With which type can the policy owner exchange the policy for a whole life or endowment policy without having to show proof of insur-ability?

a. convertible term.

b. decreasing term.

c. level term.

d. renewable term.

57. Whole life insurance can be divided into two categories: straight life and limited payment life. What is a fundamental distinction that can be made between these two types?

a. In a limited payment life policy, initially premiums are low, and during the later policy period, the premiums are equally as high.

b. In a straight life policy, premiums are higher.

c. In a straight life policy, premiums are to be paid over a longer time.

d. In a limited payment life policy, the insured must be in excellent health.

58. An irrevocable life insurance trust can be a valuable estate tax-planning tool. For such a trust to be beneficial:

a. the grantor must transfer the policy to the trust less than three years before his or her death.

b. unrestricted power to accumulate income can be given to a trustee.

c. the insured must be designated the trustee.

d. a right to direct economic enjoyment of the trust must be given to the insured.

59. Eight factors are listed as considerations that should be made when establishing a life insur-ance trust. What is one issue that should be considered?

a. using a non-independent trustee.

b. the future interest nature of the contributions to the trust.

c. low formation costs.

d. amendments to the trust may only be made by the grantor.

60. A taxpayer may choose to transfer money to an insurance company in exchange for a lifetime fixed sum yearly payment. What is this financial planning tool?

a. a buy-sell agreement.

b. a life insurance trust.

c. an annuity.

d. a pension.

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Buy-Sell Agreements

A business owner must evaluate what will happen to the business upon his or her death and set up a realistic plan for its sale or continued operation. Whenever two or more persons own a small busi-ness, a buy-sell agreement is an absolute necessity.

Definition

A buy-sell agreement is an arrangement for the disposition of a business interest (normally stock) in the event of the owner’s:

(1) Death,

(2) Lifetime transfer,

(3) Disability,

(4) Divorce16, or

(5) Retirement.

A mere right of first refusal is not a buy-sell agreement. Many business agreements, particularly be-tween partners and shareholders of a closely held corporation, do not provide a mandatory buy-out but give the surviving partners or shareholders the right to buy the interest of a deceased owner before it can be sold under the same terms and conditions.

There are two basic types of buy-sell agreements:

Entity Purchase: This is an agreement between the business itself and the individual owners and is sometimes called a redemption agreement.

Cross Purchase: This is an agreement between the individual owners.

16 Divorce must be considered. Some buy-sell agreements require the spouse to relinquish all claims to the stock in the

event of a divorce.

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Buy/Sell Agreement

Requires buy out on:

1. Lifetime transfer

2. Death

3. Disability

4. Retirement, or

5. Divorce

Price:1. Appraisal

2. Formula

3. Book value

4. Agreed value

Terms:1. All cash, or

2. Installmentsale

Binds entity to purchase first in an entity

purchase plan

Insurance can be used to fund all or a

part of the purchase price

Shareholder or estate is contractually

bound to sell

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Contractual Format

A written agreement is drawn stating the purchase price, terms, and funding arrangements. The agreement obligates the retiring or disabled owner or owner’s estate to sell the business either:

(1) To the business itself (entity purchase), or

(2) To the surviving owners (cross-purchase).

Often both obligations are combined and give the individuals an option to purchase the stock but provide that if they fail to exercise the option, then the corporation must purchase the stock.

Where stock is to be jointly owned by a husband and wife, both spouses should become party to the buy-sell agreement. When one spouse dies, his or her interest in the shares can normally be transferred by will (or sometimes trust) to the surviving spouse outside of the buy-sell agree-ment. The agreement should only become binding on the death of the survivor.

Note: Cross-purchase plans tend to become unwieldy if there are a tremendous number of share-holders, where each shareholder must agree to purchase a specified percentage of every other shareholder’s stock. An entity purchase plan, on the other hand, only involves one purchaser, the corporation.

Funding

No matter how well conceived and established a buy-sell agreement is, adequate funding is the essential element in determining whether or not it is going to work. Although non-insurance types of funding will be required for redemptions other than on the death of a shareholder, death can occur at any time and, possibly, sooner than the corporation will be able to adequately fund the buy-sell agreement through non-insurance mediums.

Occasionally, a business will be cash heavy, and there will be sufficient funds to do this. More likely, there is insufficient cash to continue the operation for a long period of time, and with the death of an owner, the cash flow may decrease or stop altogether.

With a buy-sell agreement, there is generally a provision in the agreement that it is to be an all-cash payment or a major portion is to be in cash, with the balance paid over a period of time.

Life insurance may be a relatively cheap way to fund the future costs of the business at death, whether by a buyout or an inflow of capital to continue the business.

Life Insurance Funding

The use of life insurance to fund a buy-sell agreement has implications beyond the provision for the purchase price. The allocation of premium payments, the effect of insurance on the purchase price, and dispositions of the policies are also factors to be considered.

Obtaining adequate funds to execute the buy-sell agreement upon the death of the share-holder must be the primary consideration. In that respect, either term or cash value life in-surance may be purchased.

However, lifetime redemption is also a consideration. Toward this end, cash value insurance may be an effective funding vehicle. As an alternative, term insurance may be purchased and periodic investments made into some other investment vehicle.

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Term vs. Whole Life

Although term insurance is attractive because of its initial low premiums, the premiums will become substantial as the shareholder approaches retirement and, the issue of con-tinued insurability must be considered. Cash value insurance initially costs more than term insurance but the premiums remain level for the life of the insured (if dividends are paya-ble, then a corresponding reduction of premiums will result).

Policy Ownership & Premium Payment

In an entity purchase plan, the corporation should be the policy owner, beneficiary, and premium payor. However, under a cross-purchase plan, the remaining shareholders should be the owners and beneficiaries. They may or may not be the premium payors. If they are the premium payors, then the corporation will be totally uninvolved, unless they are compensated by an increase in salary that would be taxable to the shareholders and deductible to the corporation.

If the corporation pays the premiums, then a resolution should be adopted to show that the premium payments are intended as additional compensation if the corporation is to be afforded a tax deduction.

Entity & Cross-Purchase Agreements

Aside from the tax consequences, the economic results of the two plans are essentially identical. The stock of a deceased or withdrawing shareholder is purchased at a pre-arranged price and on pre-determined terms. Since virtually all states permit shareholders to enter into entity purchase or cross purchase plans, the choice between the two plans usually revolves around federal tax consequences.

Tax Consequences - Cross-Purchase Agreements

The most important tax advantage of a cross-purchase plan over an entity purchase plan is that the remaining shareholders will receive a stepped-up cost basis on the acquired stock. This stepped-up cost basis will minimize any recognition of gains on a subsequent lifetime resale of the assets or corporate liquidation17.

Note: Even though a higher price is established for estate tax purposes, in a cross-purchase agree-ment, the contract price will be the income tax basis of the stock. Therefore, the redeemed shares may have different basis attributed to them for estate tax and income tax purposes.

Non-Deductible Premiums

Life insurance or disability income premiums paid to fund the agreement are not deductible by the co-shareholders. However, the death proceeds or disability benefits will be received by the co-shareholders income tax-free.

17 The importance of the stepped-up cost basis has been dramatically increased by TRA ‘86 that effectively imposes or-

dinary income tax rates on capital gains (without altering the treatment of capital losses).

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No Dividend Danger

Since there is no transaction between the corporation and its shareholders in a cross-pur-chase agreement, there is no risk that a “redemption” will be treated as a dividend and no attribution problem. By definition, the entire transaction is between shareholders.

Tax Consequences - Entity Purchase Agreements

An entity purchase agreement has no tax consequences to the surviving shareholders or owners of the business. The basis of their stock or business interest will remain unchanged.

Non-Deductible Premiums

Premiums on life and disability insurance used to fund an entity purchase agreement are not deductible by the corporation (§264(a)(1)). However, insurance proceeds will be received in-come tax-free by the corporation. Premiums paid by the corporation are not taxable income to its shareholders.

When the corporation is owner and beneficiary of the insurance, its value will not be includ-ible in the decedent’s estate. However, the insurance proceeds are considered when valuing the decedent’s interest in the business unless the buy-sell agreement fixes the price for fed-eral estate tax purposes and the proceeds are excluded from the purchase price under the agreement.

Dividend Danger - §302

A problem for the entity purchase agreement is characterization of the redemption as a divi-dend distribution. Section 302 states that distributions of money or property in redemption of stock by a corporation will be treated as a dividend unless certain requirements are met.

Despite recent rate reductions for qualified dividends, the need to avoid dividend treatment can be essential. Even where the taxpayer has a low stock basis, the tax can be higher.

Example

Dan has a $1,000 cost basis in his stock which is worth $3,000. If the corporation re-deems all his stock for the $3,000, Dan has a $2,000 capital gain. Assuming Dan is in the 15% bracket, the tax will be $300. If the same redemption were considered a qual-ified dividend, the full $3,000 would be taxable also at 15%. A tax of about $450 is much higher. If the redemption were considered a nonqualified dividend, the full $3,000 could constitute ordinary income taxed as high as 39.6%.

However, where the shareholder’s basis is high, the difference in tax treatment can be mate-rial. Moreover, this distinction between sale and dividend treatment is critical for the de-ceased shareholder’s estate, since the estate receives a step-up in basis to the fair market value of the stock at the shareholder’s death.

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Example

Dan has a $2,400 cost basis in his corporate stock which is worth $3,000. If the corpo-ration redeems all his stock for the $3,000, Dan has a $600 capital gain. Assuming Dan is in the 15% bracket, the tax will be $90. If the same redemption is a qualified dividend, $3,000 would be taxable also at 15% but, the tax would be about $450 - a material difference.

Exception to Dividend Treatment

One exception (others exist, for example, see §303) to dividend treatment is a complete ter-mination of a shareholder’s interest in the corporation. Redemption of all of a shareholder’s stock is not a dividend (§302(b)(3)).

Example

Dan and Raul are not related and own stock in a small corporation. On Dan’s death, the corporation redeems all Dan’s stock from his estate. The redemption is not a divi-dend since Dan’s estate has completely terminated its interest in the corporation.

Constructive Ownership (Attribution) Rules

The use of the complete redemption exception to dividend treatment can be destroyed by the “constructive ownership” rules. The rules attribute stock ownership to individuals and entities based on relationship. There are several of these rules.

“Estate/Beneficiary” Rule

Stock owned by an estate beneficiary is treated as owned by the estate. Thus, redemption of all the stock held by an estate may be a partial redemption18 when there is no simultaneous redemption of stock held by estate beneficiaries.

Example

Dan and Ralph are father and son. Ralph is a beneficiary under Dan’s will. Dan owns 75 percent and Ralph owns 25 percent of a corporation. If the corporation redeems Dan’s stock from his estate when he dies, the redemption is a dividend because it is less than all the stock owned directly or indirectly by the estate, i.e., Ralph deems Dan’s estate to own the shares actually owned.

“Family/Trust/Corporation” Rule

An individual owns the stock held directly or indirectly by or for his or her spouse, chil-dren, grandchildren, and parents. Stock held by other parties and entities can also be attributed. These other parties include:

18 The estate is still a stockholder since it is deemed to own stock actually owned by the beneficiary.

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(i) A trust and its beneficiaries,

(ii) A partnership and its partners, and

(iii) A corporation and its shareholders.

There is also the possibility of an incomplete termination as a result of double attribu-tion. Thus, stock could be attributed first from a family member to an estate beneficiary and then through the estate beneficiary to the estate.

Example

Dan owns 2,000 shares and his son, Ralph, owns the remaining 1,000 shares in the family corporation. Dan’s widow is the sole heir under Dan’s will. If the cor-poration redeems Dan’s 2,000 shares on his death, it will be a dividend because Ralph’s 1,000 shares are attributed to his mother under the family attribution rules. Next, the shares she is deemed to own are now deemed owned by Dan’s estate under the estate/beneficiary attribution rules. Thus, Dan’s estate is still the owner of 3,000 shares.

Family Attribution Exception

It is possible to break the double attribution chain by “waiving” the family attribution rule19. However, this is only permitted under certain conditions.

Family attribution will not be applied if, immediately following the redemption, the redeemed stockholder:

(i) Has no interest in the corporation (except as creditor), and

(ii) Agrees not to acquire an interest for 10 years following the redemption, other than by bequest or inheritance.

Example

Using the facts in the previous example, the corporation would still redeem Dan’s stock from his estate. However, Dan’s widow would make an election to waive attribution between her son, Ralph, and herself. Since she doesn’t own any stock personally and has “waived” her right to receive any stock except by bequest or inheritance, there is no double attribution. The redemption would be a complete termination of the estate’s interest and not a dividend.

Entities may also waive family attribution20. However, the individual who is deemed to own stock must join in the waiver. After the redemption, the entity and the bene-ficiary must agree:

(i) Not to hold an interest in the corporation

(ii) Not to acquire such an interest for at least 10 years, and

19 This is not possible for the estate or entity attribution rules. 20 An entity may elect to break family attribution but not “entity” attribution.

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(iii) To notify the IRS if they do acquire such an interest.

Example

Ralph owns no stock personally but is the beneficiary of a trust owning 30% of a corporation. His mother owns 60% of the corporation’s stock. The mother’s stock is deemed owned by Ralph through “family” attribution. Next, the stock Ralph is deemed to own is then attributed to the trust through entity attribution. Thus, any redemption of stock from the trust by the corporation will not be a complete redemption. However, if the trust and Ralph waive attribution breaking the link connecting the mother’s stock to Ralph, the redemption would be complete.

No Gain on Sale

When decedent-shareholder’s interest is purchased (either through entity purchase or cross-pur-chase) his or her estate should not realize any taxable gain for income tax purposes, since the stock obtains a “stepped-up basis.” The usual result is that the amount paid for the stock equals the basis of the stock in the hands of the executor.

Estate Tax Valuation

The value of a business for federal estate tax purposes is its fair market value. In valuing a closely held corporation, the IRS looks at several factors if there is no buy-sell agreement or the business is not otherwise immediately sold:

(1) The nature and history of the corporation,

(2) The economic outlook for the business and industry,

(3) The book value of the stock and financial condition of the business,

(4) The earnings capacity of the company,

(5) The dividend paying capacity of the company,

(6) Any intangible value the corporation might have,

(7) Prior sales of corporate stock, and

(8) The market price of stocks of similar corporations.

If the business is sold within a year of death, the sales price is the fair market value. If the business is sold more than a year after death, the government will still look at that price closely to deter-mine if it should be used for the date of death value.

Using the Buy-Sell Agreement to Set Value

A large advantage to the buy-sell agreement, for estate tax purposes, is that the value of the shares is pre-determined. A properly drawn buy-sell agreement will be effective in establish-ing the value of the business for federal estate tax purposes providing:

(1) The deceased’s estate is obligated to sell;

(2) The agreement prohibits the shareholder from disposing of the stock during his or her lifetime without first offering the stock to the corporation or to the remaining sharehold-ers at the agreed-upon purchase price;

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(3) The purchase price was arrived at through an arms-length business deal (see §2703 for additional rules in this area); and

Note: Remember that the price set at the date of the agreement is the sole significant factor here, regardless of the actual value of the stock at the time of purchase.

(4) The purchaser(s) must either be required to buy, or the seller must be required to give the purchaser an option to buy (C.M. Land, Executor v. U.S., 60-2 USTC §11,970, 187 F. Supp. 521 (DC Ala. 1960)).

Enforcement of Contract Price

In the event that the IRS successfully attacks the contract price and imposes a higher price for federal estate tax purposes, the contract price must still be adhered to for redemption purposes. Therefore, it is imperative that the contract price is reasonably established.

Purchase Price & Terms

In the absence of an arm’s length buy-sell agreement, the law offers only loose guidelines for the valuation of closely held stock. The arm’s length requirement is undoubtedly met where unrelated shareholders set a price that in their opinion constitutes a reasonable value for their own stock.

Valuation

Although there are numerous ways of determining the value of closely held stock, the five most common valuation methods are as follows:

(1) A specific dollar amount with no adjustment provisions,

(2) A specific dollar amount with provisions for periodic future adjustments,

(3) A formula involving earnings, goodwill, and any other pertinent factors,

(4) Book value, or

(5) A professional appraisal at the time of sale.

Probably the most effective of these is a specified dollar amount with provisions for periodic adjustments. This avoids the accounting problems that are inherent in formula plans and also eliminates the hassles and costs of a professional appraisal.

Community Property

If all or part of the stock subject to a buy-sell agreement is community property, careful planning is required. Written consents should be obtained to protect against:

(1) The risk that the shareholder’s spouse may die first leaving his or her interest in the stock to third parties,

(2) Attachment by creditors of the shareholder’s spouse, and

(3) Attachment by the stockholder’s spouse if the spouse survives the stockholder and seeks to claim his or her community property interest in the stock free of the agreement.

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Professional Corporations

Buy-sell agreements are indispensable for professional corporations. Since in order to own stock in a professional firm usually requires that the shareholder be a licensed professional, the shares are not an asset that can be readily included in the deceased estate (unless his or her intended benefi-ciary is also licensed).

Marketability Problems

All closely held corporations face the problem of lack of marketability of their shares. The typical closely held corporation pays no dividends, and corporate profits usually are reinvested in the business to create growth and financial strength. Shareholders generally take money out of the corporation as salaries rather than as nondeductible dividends. This problem will be compounded where a minority interest is concerned since there will be a corresponding lack of control to the purchaser of such an interest.

Controlled Disposition

Another consideration for both the professional and non-professional corporation is the desire on the part of the remaining shareholders to prevent the stock from falling into unfriendly hands. A primary purpose of the buy-sell agreement then is to provide for the orderly disposition of the stock of a former shareholder.

S Corporations

After the Sub Chapter S revision Act of 1982, the choice of buy-sell agreement formats for S corpo-rations is now substantially similar with regard to the factors of consideration as for ordinary corpo-rations plus some additional factors.

When an S corporation pays a non-deductible life insurance premium, the shareholders will incur the cost in a manner directly proportionate to their individual percentages of ownership, with the largest shareholder paying the highest percentage of premium dollar. Should the policies be subject to con-tinuing loans to pay the premiums, the deductible interest will pass through to the shareholders in a like manner.

One factor which favors an entity purchase where there are more than two shareholders is that whenever there is a corporate distribution (assuming the absence of accumulated earnings and prof-its), it is regarded as a tax-free return of cost basis firstly, and any excess as a capital gain secondly. Therefore, the partial redemption of stock by an S corporation will not result in the distribution being reclassified as a nondeductible dividend. This will be particularly beneficial when a redemption can-not be regarded as a complete termination of interest due to the attribution rules of §318.

Another factor that should be considered by the shareholders is whether or not the purchase price for the redeemed shares is to be adjusted to reflect the income, deductions, or losses which are to be allocated to the deceased or withdrawing shareholder prior to the date of death (or withdrawal).

Sole Shareholder Planning

Generally, buy-sell agreements involve corporations with two or more shareholders and are for the purpose of ensuring the continuity of the corporation subsequent to the death or withdrawal of a

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shareholder. There are some interesting considerations for the sole shareholder corporation as well, although they are of a somewhat different note.

Complete Liquidations

A complete liquidation of the corporation upon the death or retirement of the sole shareholder may be the only possible solution, particularly in the “one-man show.” A lifetime sale of the stock, if possible, will usually provide a better purchase price since the owner’s bargaining position will be somewhat stronger if he or she is alive (although a strong argument, if presented by a corpse, will undoubtedly have a profound effect at the bargaining table).

Alternative Dispositions

An entity purchase is another possibility, although some states require that at least one share always be outstanding. The death of the sole shareholder will normally result in the dissolu-tion of the corporation by the estate representative and the distribution of corporate assets to the deceased’s family. In lieu of this, the stock may be sold to a key employee or a group of employees (or, in the case of a professional corporation, to another professional).

Use of Life Insurance

The question arises as to whether or not the sole shareholder corporation should bother to maintain life insurance on the life of the sole shareholder. Generally, corporate-owned life insurance premiums will not be taxed to the insured. While the death benefits of the corporate-owned policy will be subject to the claims of corporate creditors, they will not be included in the deceased’s gross estate for federal income tax purposes even though the de-ceased was the sole shareholder.

Estate Valuation

However, life insurance proceeds will be considered in valuing the decedent’s stock for inclu-sion in his or her gross estate for federal estate tax purposes unless the estate can prove an offsetting financial loss to the corporation. Since life insurance can be purchased for the pur-pose of protecting the corporation from the potential for the loss of earnings or goodwill, some careful planning in this area can achieve favorable tax results. For example, cross-ownership of the policy by an irrevocable trust would serve to remove the proceeds from the decedent’s estate.

One-Way Buy-Outs

When the sole shareholder employs qualified key employees, he or she may wish to consider a one-way buy-out agreement. This agreement works to obligate only the employees to purchase his or her stock upon his or her death, disability, or withdrawal. This agreement may be funded with life insurance owned by the employee on the shareholder’s life. The employees may pay the premiums for such life insurance from their separate funds or on a split-dollar plan with the cor-poration advancing the cash value portion of the premium.

Since under a split-dollar plan, the corporation will always recover at least its paid-in premiums, the net effect is essentially an interest-free loan to the employee(s). The employee(s) will be

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currently taxed on the value of the current term insurance protection reduced by their share of the premiums paid.

Review Questions

61. There are two basic types of buy-sell agreements. Which buy-sell agreement type is an agree-ment between the individual business owners for the disposition of a business interest?

a. cross-purchase.

b. entity-purchase.

c. redemption.

d. right of first refusal.

62. The types of buy-sell agreements are very similar. Where does the main difference between the two agreements lie?

a. in the economic results.

b. in the federal tax consequences.

c. in the state law.

d. in the stock of a deceased or withdrawing shareholder.

63. Cross-purchase buy-sell plans provide taxpayers an important tax advantage. What is the main benefit that such plans offer?

a. deductibility of life insurance or disability income premiums paid to fund the agreement by the co-shareholders.

b. a stepped-up cost basis on the acquired stock that the remaining shareholders will receive.

c. no tax consequences to the surviving shareholders or owners of the business.

d. a risk that a redemption will be treated as a dividend.

64. Constructive ownership rules can ruin the possibility of using the complete redemption ex-ception to dividend treatment. Under which constructive ownership rule can double attribution cause an incomplete termination?

a. estate/beneficiary rule.

b. complete termination exception.

c. family attribution waiver rule.

d. family/trust/corporation rule.

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Learning Objectives

After reading Chapter 7, participants will be able to:

1. Identify reasons why a business interest must be valued in an estate that is subject to federal estate tax, specify factors used to determine the net value of a business under the regulations, and recall the valuation factors in R.R. 59-60 specifying their impact.

2. Determine how tangible assets are normally valued identifying those assets whose val-uation is based on values other than book value, and specify the steps in R.R. 68-609’s valuation formula for intangible assets specifying the effect such amount can have on the total value of a business.

3. Identify special business valuation issues including redemptions under §303 by:

a. Determining what constituted the now repealed qualified family-owned business es-tate tax deduction;

b. Recalling the terms of the election that allows clients to exclude from their taxable estate 40% of the value of land subject to a qualified conservation easement;

c. Determining the value of a minority stock interest and fractional interests in order to obtain applicable valuation discounts, and

d. Citing the §303 exception to the dividend treatment of redemptions stating qualifica-tions.

4. Determine the tax consequences in leaving an estate to a surviving spouse, specify the elements of buy-sell agreements, stock redemptions, and stock recapitalizations in order to dispose of business interests before death, and identify deferred compensation agree-ments recognizing their estate planning impact.

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CHAPTER 7

Special Business Issues

Ownership of a business interest presents a number of estate planning issues and problems. Fre-quently, there is no ready market for closely held companies. This creates valuation and liquidity problems. Even estimating the death taxes on the business interest is difficult because of this uncer-tainty.

In addition, heirs are often unable to operate the business on the death of the principal. Thus, if the owner is a key person, the existence of the business itself after the owner’s death may be in jeopardy.

The business owner’s death can also create an “income gap” for his or her family. There may be a need to replace the owner’s business income to provide for his or her family’s support after the owner’s death.

Business Valuation

To value a closely held business, the company’s net worth, earning power and dividend-paying ca-pacity, and other relevant factors are considered. Thereafter, the value determined on these factors is usually discounted if it is a minority share interest. In addition, a buy-sell agreement may fix the value of the business for estate tax purposes.

A business interest must be valued in any estate that will be subject to federal estate tax. This is necessary to:

(1) Estimate the federal estate tax due

(2) Determine the possible use of the marital deduction and other estate planning tools, and

(3) Determine the means of paying the estate tax (e.g., life insurance).

However, valuation is an inexact science presenting a frequently litigated issue. Moreover, there are many different ways in which a business interest can be valued.

Federal estate tax makes a low value appealing. However, when the estate will not be subject to federal estate tax, a higher valuation may be desirable to give the business interest a high tax basis on the owner’s death1. In addition, an older co-owner joining in a buy-sell agreement may want as high a value as possible to maximize the sales price his or her family will receive.

1 The higher basis would result in less taxable gain to the heirs on a later sale.

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Under Regulation §20.2031-1(b), the fair market value of an asset is “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts2.”

Relevant Facts

Regulation §20.2031-3 and §20.2031-2(f) state that all relevant factors are used to determine the “net value” of a business including:

(1) Appraisal of assets,

(2) Demonstrated earning capacity,

(3) Dividend-paying capacity,

(4) Goodwill,

(5) Economic outlook,

(6) Quality of management,

(7) Degree of control represented by the business interest, and

(8) Values of similar publicly traded businesses.

Revenue Ruling 59-60

R.R. 59-60 (modified by R.R. 83-120) provides IRS guidelines for valuation of a closely held business for federal estate and gift tax purposes. However, the ruling fails to give an exact formula or safe harbor. In addition, while all the guidelines cannot be given equal weight, no details are given as to the importance to be accorded the various factors.

Note: While R.R. 59-60 deals with stock in a closely held corporation, it also applies to valuation of partnerships and proprietorships (R.R. 65-192; R.R. 68-609; Reg. §20.2031-3(c)).

The valuation factors in R.R. 59-60 are:

(1) Nature of the business and its history.

Here, the primary consideration is the riskiness of the business. The greatest weight is given to recent events with little importance given to past events that are unlikely to recur. This factor could be used in selecting a multiplier in a capitalization-of-earnings formula. Normally, a higher multiplier would be linked with a more stable business.

(2) Economic outlook.

The economic outlook for the entire economy, this particular industry, and the particular company in general and in its specific industry are to be considered. If the loss of key person-nel will have a significant effect on the value of the business, a subtraction from earnings to compensate for the loss of a key employee is suggested.

(3) Book value.

When a business has large amounts of real or tangible personal property, book value is an important beginning in valuing the business based on the worth of underlying assets. How-ever, in considering book value, remember that nonoperating assets may command a lower

2 See also Reg. §25.2512-1 for gifts.

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rate of return than operating assets and depreciation deductions affecting book value can be greater than actual economic depreciation.

(4) Earning capacity.

R.R. 59-60 holds that past income is useful in predicting future income but averages will be unrealistic if they disregard trends.

(5) Dividends

Actual dividends paid may not be related to the dividend paying capacity of the business. However, most closely held corporations try to avoid paying dividends. As a result, evaluating dividend-paying capacity is not likely to be significant in valuing such corporations.

(6) Goodwill.

Goodwill is defined as the excess of net earnings over a fair return on net tangible assets. Thus, when a business is earning more than a reasonable return on its assets, the additional return must be attributable to prestige, name, location, and other intangible value. In many service businesses, a large portion of the value is due to such intangible assets.

(7) Recent sales.

Often, a recent arm’s length stock sale is the best evidence of value. Moreover, R.R. 59-60 does recognize that the percentage of the business sold affects valuation. Thus, a premium for a controlling interest or a discount for a minority interest may be appropriate. However, sales between unrelated persons are rarely available.

(8) The price of similar traded stock.

When a publicly traded stock in a similar business can be found, the price-earnings ratio of that stock and other characteristics can be used to determine value. However, such compar-isons are rarely available.

Many appraisers use an average of several different valuation methods; however, the IRS does not favor this approach. In fact, R.R. 59-60 specifically disapproves of averaging.

Note: When valuing a business for gift tax purposes, special valuation rules under §2701 - 2704 apply. The special rules apply if an older generation owner gives certain interests to younger family members while retaining rights.

Tangible Assets

In valuing tangible assets, the starting point is book value. However, each asset should be reviewed to determine whether its book value is a proper indication of value.

Normally, cash, accounts receivable, and inventories are accepted at book value. Machinery, equip-ment, patents, and real estate3, unless recently purchased, will have values different from book value.

Special Real Estate Election - §2032A

In general, the value of real estate must be determined based upon its highest and best use. However, an executor may, when certain requirements are met, elect to value, for estate tax

3 Real estate is often worth substantially more than its book value.

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purposes, real estate used as a farm or other closely held business based on its actual use rather than its highest and best use (§2032A).

The basic requirements of §2032A are:

(1) The property must pass to or be purchased from the estate by a qualified heir4;

(2) The decedent or a member of the decedent’s family5 must have owned the property and have materially participated in the operation of the farm or business for five out of the eight years preceding the earlier of:

(a) The date of death,

(b) The date on which the decedent became disabled, or

(c) The date on which the decedent began receiving social security benefits (§2032A(b));

Note: If a corporation, partnership, or trust owns the real property, the decedent (or a mem-ber of the decedent’s family) must have materially participated in the entity.

(3) The real property must have been used as a farm or in a trade or business on the dece-dent’s death and for five out of eight years immediately before the decedent’s death; and

(4) The value of real and personal property used in the business must be at least 50% of the adjusted value6 of the decedent’s gross estate, and the qualifying real property must be at least 25% of the adjusted value of the decedent’s estate.

When the election is made, assets may be valued as follows:

Farms: A farm is valued by dividing the excess of the average annual gross cash rental for com-parable farm purpose land over the average annual state and local real estate taxes for such comparable land by the average annual effective interest rate for all Federal Home Loan Bank loans (§2032A(e)(7)).

Note: Since 1981, if cash rentals for comparable land in the same locality are not available, the use of net-share rentals is allowed. The net-share rental is equal to the value of the produce received by the lessor of comparable land on which the produce is grown during a calendar year minus the cash operating expenses (other than real estate taxes) of growing the produce paid by the lessor.

4 This term is defined as a member of the decedent’s family, including the decedent’s spouse, parents, children, stepchil-

dren, and spouses and lineal descendants of those individuals, or a trust for the exclusive benefit of such persons. 5 A special participation requirement applies for certain surviving spouses (§2032A(b)(5)(A)). 6 Adjusted value means the gross estate less indebtedness attributable to such property.

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Special Valuation - §2032A

Farmland and real property used in a

closely held business can be valued at

less than fair market value:

1. Farmland can be valued by dividing

the net average annual gross cash

rental for comparable land by the

average annual effective interest rate

for all new federal land bank loans

2. Business real property can be

valued by several methods which

primarily rely upon a capitalization of

earnings

In any event, the decrease in value for

estate tax purposes cannot exceed

$1,190,000 (in 2021)

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Business real estate: Such real estate is valued using capitalization of income, capitalization of fair rental value, assessed land values, and comparable sales (§2032A(e)(8)).

Limitations

The election cannot result in a reduction of more than $750,000 in fair market value. Tax law provides for annual indexing for inflation, starting with 1999 inflation, of the $750,000 ceiling on special use valuation. In 2021, the figure is $1,190,000.

If the real property is later sold to nonqualified heirs or the qualified use of the property ceases, then the tax savings are recaptured and the amount of additional tax which would have been payable if the election had not been made is then required to be paid.

Disposition occurs when the property is sold within 10 years of the decedent’s death and the qualified heir is still alive.

Qualified use ceases when:

(1) The property ceases to be used for its qualifying purpose, or

(2) During any eight-year period after the decedent’s death, there are periods aggregating three years or more during which there is no material participation in the operation of the farm or other business by the qualified heirs.

Note: The start of the eight-year period is extended for the lesser of (1) the time that no qual-ified heir is using the qualified real property, or (2) two years after the decedent’s death.

Related Party Cash Lease

The cash lease of specially-valued real property by a lineal descendant of the decedent to a member of the lineal descendant’s family, who continues to operate the farm or closely held business, does not cause the qualified use of such property to cease for purposes of imposing the additional estate tax under §2032A(c).

Intangible Assets & Goodwill

Whether goodwill existed on a certain date is a question of earnings in the years immediately pre-ceding that date. Goodwill is an expectation of earnings in excess of a fair return on capital invested.

Note: It has occasionally been held that even a constantly losing enterprise may have goodwill (Co-operative Publishing Co v. Commissioner, 115 F. 2d 1017 (1940, CA-9)).

R.R. 68-609

R.R. 68-609 gives a valuation formula for intangible assets and goodwill7. Once determined, this amount is added to the value of the tangible assets to arrive at the total value of the business.

Note: Goodwill is a controversial item in valuing a business. There should be a specific reason for failing to include some goodwill value.

The ruling’s formula requires several steps:

(1) Determine the average annual value of the net tangible assets of the business for at least five years immediately before the year of valuation;

7 The ruling cautions that the formula should not be used if there is better evidence to determine goodwill value.

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(2) Determine the percentage return that the average annual value of tangible assets should earn;

Note: The percentage may be determined by applying the prevailing rate in the industry, or, if this rate is not available, a rate of 8 to 10 percent.

(3) Deduct this percentage return on net tangible assets from the average earnings of the business over the same period to arrive at earnings from the intangible assets; and

Note: Earnings may be determined from profit-and-loss statements. However, adjustments should be made to take account of abnormal years and trends.

(4) Capitalize the earnings from the intangible assets at a rate of 15% to 20% to determine the value of the intangible assets.

Qualified Family-Owned Businesses - §2057 (Repealed)

A business estate tax deduction combined with the unified credit formerly permitted taxpayers to deduct up to $1.3 million in value (after discounts for lack of marketability, minority discounts, etc.) of business interests from the gross estate. However, the deduction was only for qualifying busi-nesses that comprised a substantial portion of the estate and met material participation and owner-ship requirements.

Note: The qualified family-owned business provision in the 1997 Act (§2033A) provided an exclu-sion from estate taxes for certain qualified family-owned business interests. Because the family-owned business provisions provided an exclusion from estate taxes, it was unclear how the provi-sions interacted with other Code sections.

For estate tax purposes, an executor could have elected to deduct the value of certain qualified “fam-ily-owned business interests” if such interests comprised more than 50% of a decedent’s estate, the business had its principal place of business in the United States and the interest was left to qualified heirs. The decedent had to be a U.S. citizen or resident at the time of death.

If a decedent held qualified family-owned business interests in more than one business, the executor had to aggregate all such interests. However, passive assets, excess cash, or marketable securities reduced the value of any family business interest.

Note: The deduction applies only for estate tax purposes. The deduction is not available for gift tax or generation-skipping transfer tax purposes.

Deduction Amount

The deduction could be taken only to the extent that the deduction for family-owned business interests, plus the amount effectively exempted by the applicable exclusion amount, did not ex-ceed $1.3 million.

The exclusion decreased as the effective exemption under the applicable exclusion amount in-creased, to maintain a consistent $1.3 million aggregate effective exclusion. Thus, the exclusion ranged from $675,000 in 1998, to $300,000 in 2003.

Year Applicable Exclusion Amount Business Deduction Total Excluded

1998 $625,000 $675,000 $1,300,000

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1999 $650,000 $650,000 $1,300,000

2000 $675,000 $625,000 $1,300,000

2001 $675,000 $625,000 $1,300,000

2002 $1,000,000 $300,000 $1,300,000

2003 $1,000,000 $300,000 $1,300,000

Definitions

Qualified family-owned business interests included a sole proprietorship interest as well as an interest in an entity carrying on a business if the decedent and his or her family members owned:

(a) At least 50% of an entity,

(b) At least 30% of an entity in which members of two families owned 70% or

(c) At least 30% of an entity in which members of three families owned 90%.

Note: Section 2057 applied to property owned through corporations, partnerships, and trusts.

An individual’s family included the individual’s:

(a) Spouse,

(b) Parents and grandparents, and

(c) Children, stepchildren, brothers, sisters, nieces, and nephews, and his or her spouses, and ancestors.

Qualified heirs included:

(a) Any individual who had been actively employed by the business for at least 10 years prior to decedent’s death, and

(b) Members of the decedent’s family.

Note: If a qualified heir was not a citizen of the United States, then different rules applied.

If all beneficiaries of a trust were qualified heirs (and in such other circumstances as the Secretary of the Treasury could provide), property passing to the trust could be treated as having passed to a qualified heir (§2057(i)(3)).

Requirements

The estate deduction for qualified family-owned businesses had several requirements:

(1) The decedent was a citizen or resident of the United States at the date of death;

(2) The business interests were includible in the gross estate;

(3) The interests must have passed to or been acquired by a qualified heir from the decedent;

(4) The adjusted value of the qualified family-owned business interests must have exceeded 50% of the adjusted gross estate;

Note: Under the 50% test, assets are valued at fair market value even though the estate may also be electing special use valuation for the land.

(5) The interest had to be in a trade or business that has its principal place of business in the United States;

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(6) The business interest was owned by the decedent or a member of the decedent's family during 5 of the 8 years before the decedent's death; and

(7) For 5 of the 8 years before the decedent's death, there was material participation by the decedent or a member of the decedent's family in the business to which the ownership in-terest relates.

Material Participation

Analogous to §2032A, §2057 imposed material participation requirements both before and for 10-years after the decedent’s death. The decedent or a family member had to have owned and materially participated in the business for at least five of the eight years before death. After death, each qualified heir (or a family member of that qualified heir) had to materially participate in the trade or business for at least five years in an eight-year period during the 10 years following death.

The existence of material participation was a factual determination, and the types of activities and financial risks that supported a finding of material participation varied with the mode of ownership. No single factor was determinative of the presence of material participation, but physical work and participation in management decisions were the principal factors to be con-sidered. Passively collecting rents, salaries, draws, dividends, or other income from the trade or business did not constitute material participation. Neither did merely advancing capital and re-viewing business plans and financial reports each business year.

Determining 50+% of AGE

In order to be eligible to exclude from the gross estate a portion of the value of a family-owned business, the sum of (1) The adjusted value of family-owned business interests includable in the decedent’s estate, and (2) The amount of gifts of family-owned business interests to family mem-bers of the decedent that is not included in the decedent’s gross estate, must exceed 50% of the decedent’s adjusted gross estate.

Interests Acquired From the Decedent

An interest in a business was considered to have been acquired from or to have passed from the decedent if one or more of the following applied:

(1) The interest was considered to have been acquired from or to have passed from the de-cedent under section 1014(b);

(2) The interest was acquired by any person from the estate; and

(3) The interest was acquired by any person from a trust to the extent the property was in-cludible in the gross estate.

Recapture

The benefits of this provision were recaptured on disposition or failure to meet the material par-ticipation requirements. If within 10 years of death, a qualified heir failed the material participa-tion requirement, or the property was sold (other than to a family member or through a conser-vation contribution), a recapture tax applied.

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Note: The sale of equipment or inventory in the ordinary course of business did not trigger the recapture tax.

The recapture tax was equal to the reduction in estate taxes attributable to the disqualified fam-ily-owned business interest. However, when the recapture event occurred more than six years after death, the recapture tax was reduced by 20%, with an additional 20% reduction for each year thereafter.

Trade or Business Requirement

A qualified family-owned business interest was defined as any interest in a trade or business that met certain requirements - e.g., the decedent and members of his or her family had to own cer-tain percentages of the trade or business, the decedent or members of his or her family had to have materially participated in the trade or business for five of the eight years preceding the decedent’s death, and the qualified heir or members of his or her family had to materially partic-ipate in the trade or business for at least five years of any eight-year period within 10 years fol-lowing the decedent’s death.

The RRA ‘98 clarified that an individual’s interest in property used in a trade or business could qualify for the qualified family-owned business provision as long as such property was used in a trade or business by the individual or a member of the individual’s family.

Thus, for example, if a brother and sister inherit farmland upon their father’s death, and the sister cash-leased her portion to her brother, who was engaged in the trade or business of farming, the “trade or business” requirement was satisfied with respect to both the brother and the sister. Similarly, if a father cash-leased farmland to his son and the son materially participated in the trade or business of farming the land for at least five of the eight years preceding his father’s death, the pre-death material participation and “trade or business” requirements were satisfied with respect to the father’s interest in the farm (§2057(e)(1)).

Example

Dan dies owning a farm that has been cash-leased to his daughter Danielle for the last eight years. Danielle has materially participated in the farming operation for the entire eight years. The pre-death material-participation requirement and the trade or busi-ness requirement were satisfied with respect to the decedent’s interest in the farm by reason of his daughter’s satisfaction of these requirements.

Sunset Provision

The Tax Relief Act of 2001 repealed the qualified family-owned business deduction beginning with the estates of decedents dying in 2004.

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Deduction: Excess of $1.3 million over unified credit

exemption equivalent ($675,000 minimum)

Conditions: 1) U.S. citizen or resident2) Executor must elect3) Value >50% of AGE

4) Material participation lookback (5 of 8years before death) and forward (5 ofany 8 within 10 years of death) for

decedent or family member – Section2032A

5) “Qualified Heir” (family member or 10

year employee) inherits

What is a

qualifiedfamily ownedbusiness?

1) Sole proprietorship

2) Any entity if:a) 50% owned by decedent’s family,b) 70% by two families, and

c) 90% by three families(Decedent’s family owns 30% in b & c)

3) Cannot be publicly traded4) Cannot have more than 35% of income

PHC income, and5) Exclude business assets that are:

a) Excess cash or market securities

b) Passive investments

Calculation of

50% excess:

1) Includable Interests

Adjusted Taxable Estate2) Include prior gifts of business interests

in numerator and denominator

3) Also include in denominator:a) All transfers to spouse within 10 years

of date of death, andb) All gifts within 3 years of death

Family-Owned Business Deduction

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Review Questions

65. Revenue Ruling 59-60 identifies eight basic factors that need to be examined in the valuation of stock of certain corporations where market quotations are limited. Which of these valuation factors is the main concern the degree of risk present in the business?

a. book value.

b. earning capacity.

c. economic outlook.

d. nature and history of the business.

66. Under R.R. 59-60, income earned by a corporation in the past is a valuable tool to project income that will be earned in the future. However, what must be considered in order for averages to be realistic?

a. dollar averaging.

b. dividends.

c. goodwill.

d. trends.

67. Book value is one way to value tangible assets. What is usually assumed to be at book value?

a. inventories.

b. machinery.

c. patents.

d. real estate.

68. Section 2032A provides an estate tax valuation election for certain real estate used as a farm to be valued according to its actual use. What is one of the four requirements that must be met in order to qualify for this election?

a. The real estate was owned by a decedent who materially participated in the farm’s opera-tion for 5 out of the 8 years prior to the date of death.

b. The estate purchased the real estate.

c. On the decedent’s death and for a year before, the real estate was used as a farm.

d. The value of real and personal property used in the operation of the farm is 25% or more of the adjusted value of the gross estate of the decedent.

69. Revenue Ruling 68-609 provides a formula to value intangible assets and goodwill. Under this formula, what is the first step in determining their value?

a. Determine the current value of earnings at a rate of 15% to 20%.

b. Subtract the percentage return on net tangible assets from the business’s average earnings over the same period.

c. Figure the average annual value of the business’s net tangible assets for no less than five years directly preceding the year of valuation.

d. Figure the percentage return that should be eared by the average annual value of tangible assets.

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Land Subject To Conservation Easement - §2032A(c)(8)

An executor may elect to exclude from the taxable estate 40% of the value of any land subject to a qualified conservation easement that meets the following requirements:

(1) The decedent or a member of the decedent's family must have owned the land for the 3-year period ending on the date of the decedent's death;

(2) No later than the date the election is made, a qualified conservation easement on the land has been made by the decedent, a member of the decedent's family, the executor of the dece-dent's estate, or the trustee of a trust that holds the land; and

(3) The land is located in the United States or one of its possessions.

The maximum exclusion for land subject to a qualified conservation easement is limited to $400,000 in 2001, and $500,000 in 2002 and thereafter.

The exclusion for land subject to a qualified conservation easement may be taken in addition to the maximum deduction for qualified family-owned business interests (i.e., there is no coordination be-tween the two provisions). Debt-financed property is eligible for this provision to the extent of the net equity in the property.

The election to exclude land subject to a conservation easement must be made on a timely filed estate tax return, including extensions (§2031(c)).

Family Member

Members of the decedent's family include the decedent's spouse; ancestors; lineal descendants of the decedent, of the decedent's spouse, and of the parents of the decedent; and the spouse of any lineal descendant. A legally adopted child of an individual is considered a child of the indi-vidual by blood.

Indirect Ownership of Land

The qualified conservation easement exclusion applies if the land is owned indirectly through a partnership, corporation, or trust if the decedent owned (directly or indirectly) at least 30% of the entity.

Qualified Conservation Easement

A qualified conservation easement is one that would qualify as a qualified conservation contri-bution under section 170(h). It must be a contribution:

(1) Of a qualified real property interest;

(2) To a qualified organization; and

(3) Exclusively for conservation purposes.

Qualified Real Property Interest

The term qualified real property interest means any of the following:

(a) The entire interest of the donor, other than a qualified mineral interest;

(b) A remainder interest; or

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(c) A restriction granted in perpetuity on the use that may be made of the real property. The restriction must include a prohibition on more than a de minimis use for commercial recreational activity.

Qualified Organization

Qualified organizations include:

(a) The United States, a possession of the United States, a state (or the District of Colum-bia), or a political subdivision of them, as long as the gift is for exclusively public purposes;

(b) A domestic entity that meets the general requirements for qualifying as a charity under section 170(c)(2) and that generally receives a substantial amount of its support from a governmental unit or from the general public; and

(c) Any entity that qualifies under section 170(h)(3)(B).

Conservation Purpose

The term conservation purpose means:

(a) The preservation of land areas for outdoor recreation by, or the education of, the pub-lic;

(b) The protection of a relatively natural habitat of fish, wildlife, or plants, or a similar eco-system; or

(c) The preservation of open space (including farmland and forest land) where such preser-vation is for the scenic enjoyment of the general public, or pursuant to a clearly delineated Federal, state, or local conservation policy and will yield a significant public benefit.

No Additional Income Tax Deduction

In the case of a qualified conservation contribution made after the date of the decedent’s death, an estate tax deduction is allowed under §2055(f). However, no income tax deduction is allowed to the estate or the qualified heirs with respect to such post-mortem conservation easements.

Note: Even without an income tax deduction, the §2055(f) estate tax deduction and the exclusion §2031(c) can give major tax savings to an estate.

Example

Dan dies with real property worth $500,000. Dan’s executor grants a conservation easement valued at $150,000 and takes a §2055(f) charitable estate tax deduction. In addition, the executor makes an election to exclude the qualified conservation ease-ment from the gross estate. The estate tax exclusion is $140,000 (40% of ($500,000 - 150,000)), leaving $210,000 subject to estate tax.

Valuation Discounts

Both §2031 (gross estate) and §2512(a) (valuation of gifts) use “value” without defining the term. However, Reg. §20.2031-l(b) defines fair market value as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to

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buy or to sell and both having reasonable knowledge of relevant facts8.” This definition is important in seeking discounts of fractional interests for marketability and minority interests in transfers to family members.

After the value of the entire business is determined, the next step is to value the fractional interest held. Sometimes it is only necessary to divide the total value by the percentage owned. However, if it is a minority interest, it may be possible to discount the value.

Minority Interests

A minority stock interest in a closely held business, owned by a person unrelated to the holders of the majority of the stock, will normally be valued at a substantial discount for estate and gift tax purposes (R.R. 59-60). This discount is based on the assumption that a business purchaser will pay less for a non-controlling interest.

R.R. 59-60 allows a discount for a minority interest in a closely held business. A minority owner has little control over the business. Thus, there is less demand for a minority interest and this justifies a lower value.

However, the IRS has historically taken the position that when the owner and other family mem-bers together control a majority interest, it would not allow a minority discount (R.R. 81-253). Minority discounts were only permitted if there was discord or other factors indicating that the family would not act as a unit.

Several courts disagreed with the IRS on this point holding that the relationship between the owners should be disregarded in determining value (Estate of Lee v. Commissioner, 69 T.C. 860 (1978), Propstra v U.S. (9th Cir 1982) 680 F. 2d 1248; Estate of Bright (5th Cir 1981) 658 F. 2d 999; Estate of Woodbury G. Andrews (1982) 79 T.C. 938, Ward, 87 T.C. 78 (1986); Estate of Berg, 976 F. 2d 1163 (CA-8, 1992)).

In 1993, the IRS amazingly reversed its position that minority discounts were not allowed on fam-ily transfers of stock if the family in aggregate controlled the business. In R.R. 93-12, the Service decided to accept the above court decisions holding that shares owned by family members are not attributed to another family member for purposes of determining the value of that person’s shares.

Consequently, the IRS will no longer assume that all voting power held by family members must be aggregated for purposes of determining whether the transferred interests should be valued as part of a controlling interest. Likewise, a minority discount will not be disallowed simply be-cause a transferred interest, when aggregated with the interests of other family members, would be part of a controlling interest. As a result of this ruling, R.R. 81-253 was revoked.

This new position makes it easier to dispose of an interest in a closely held business by gifting the interest on a “discounted” basis. The owner of a business could make sufficient minority interest gifts to family members over a period of time such that the owner would no longer hold a con-trolling interest at death. This strategy could accomplish several objectives:

(1) The lifetime gifts would be valued after applying the minority interest discount,

(2) Post-gift appreciation would be eliminated from the donor’s estate, and

8 Reg. §25.2512-1 provides a similar definition for gift tax purposes.

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(3) Upon the owner’s death, his or her remaining interest would also be valued as a minority interest.

Note: Any hope for minority valuation would still be subject to the estate freeze rules of §§2701-4. Section 2701 applies to the transfer of interests in corporations and partnerships. This section pro-vides that if a person transfers an interest in a corporation or partnership to a family member and retains an interest in the same business, the value of the interest will be the value of the entire business and the value of the retained interest will not be subtracted or considered. However, there are three general exceptions where §2701 does not apply:

(a) Where there is only one class of stock or interest (§2701(a)(2)(B) and (C));

(b) Where there is a proportionate transfer of all classes of interest (§2701(a)(2)(C)); or

(c) Where market quotations are readily available for the transferred stock or retained interest (§2701(a)(2)(A)).

Another discounted transfer strategy would be for the estate owner to bequest a majority inter-est in the business to the surviving spouse on death and a minority interest to his or her children. The bequest to the surviving spouse would be shielded from federal estate tax by the unlimited marital deduction. To the extent of the unified credit equivalent, the children’s minority interest would also escape death tax. Later, the surviving spouse can gradually gift small interests to the children until they own a majority interest. On the death of the surviving spouse, his or her inter-est should also qualify for a minority interest discount.

Special Valuation Plus Minority Discount

In Estate of Clara K. Hoover, 76 AFTR 2d § 95-5602 (10th Cir. 1995), an estate elected to value the decedent’s minority interest in certain ranch property under §2032A at its special use value rather than at fair market value. It argued that §2032A allowed it to apply a minority interest discount to arrive at the fair market value of the decedent’s interest in conjunction with reducing that value by the statutory maximum of $750,000 for federal estate tax report-ing purposes. The court agreed with the estate and held that the maximum reduction in value of qualified real property imposed by §2032A must be subtracted from the true fair market value of a minority interest in the property.

Fractional Interests

Recent cases have strengthened arguments for discounting fractional interests, particularly where real estate is involved. In Estate of Pillsbury, TCM 1992-426, despite criticism of the tax-payer’s expert, a 15% discount on a decedent’s fractional interest in the real estate was allowed.

In A.B. Cervin Est., Dec. 5O,219(M), the Tax Court held that an estate was entitled to discount the agreed fair market value of the decedent’s one-half interest in farmland and a homestead by 20%. Although it would be difficult to partition the farmland physically because of the farm’s varied soil compositions and layout and its limited access to the main road, it could be partitioned on the basis of value. Therefore, the discount was appropriate because a partition would involve substantial legal costs, appraisal fees, and delay. In addition, although the homestead could not be partitioned, a fractional interest owner could petition the court for a forced sale of the entire homestead. Therefore, a prospective buyer of the homestead would require a sizable discount because, under applicable state (Texas) law, the purchaser of a fractional interest discount in

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property incurs all of the costs associated with a forced sale of property. However, no discount was allowed for repair costs because the poor condition of the property was considered in de-termining the agreed fair market value of the homestead.

Even more interesting is Estate of Louis F. Bonner, 77 AFTR 2d Par. 96-868 (Fifth Circuit (June 4, 1996). In Bonner, the Fifth Circuit held that a fractional interest discount should be applied in valuing assets owned partly by the decedent and partly by a trust created under his wife’s will. This was upheld despite 100% of property being included in the gross estate (c.f. PLR 9608001).

Lack of Marketability

The absence of a ready or existing market for the sale or purchase of the securities being valued can create a substantial discount. The logic of such a discount is that to the extent a prospective purchaser will have difficulty reselling an ownership interest, the value of the interest is lower (Central Trust Company, 305 F. 2d 393 (Ct. Cls., 1962), Estate of Stoddard, TCM 1975-207).

The Service acknowledges that if owners of closely held stock should try to list a block of securi-ties on a stock exchange for sale to the public, they would have to make the offering through underwriters and incur costs for registration, distribution, and commissions. Using such costs to determine a lack of marketability has been upheld by the courts (Groff v. Munford, 150 F. 2d 825 (2d Cir. 1945; Bull v. Smith, 119 F. 2d 490, (2d Cir. 1941)).

However, in calculating the amount of such discount, no subtraction from the date of death value is allowed for hypothetical underwriting fees and other hypothetical selling expenses that would have been incurred if there had been a block offering of the stock on the date of death (Gillespie, 73 AFTR 2d. §94-844 (1994)).

In a gift valuation case, Carr, TCM 1985-19, a 25% discount on the value of shares transferred to children was allowed. The corporate assets were undeveloped real estate and the court held that it would be difficult for a buyer to estimate the profit of the corporation. The court reasoned that a minority shareholder might not realize any return on investment until the corporation was liq-uidated.

Swing Vote Premium

In PLR 9436005, a sole shareholder transferred approximately 30% of the outstanding shares in a corporation to each of his three children. At the same time, he transferred 5% to his wife. The IRS ruled that to value gifts of blocks of stock, representing 30% of a closely held corporation’s total outstanding shares, the swing-vote characteristic had to be considered along with its mi-nority nature and any marketability concerns. The IRS concluded that each 30% block had a swing-vote premium that offset the minority or marketability discounts.

Buy-Sell Agreements

A buy-sell agreement solves many estate planning problems in businesses where there are multiple owners. A buy-sell agreement is an agreement providing that on a business owner’s death, his or her interest will be purchased. When the remaining owners buy the business interest, the agreement is called a cross-purchase agreement. When the business buys the interest, it is an entity agreement.

Buy-sell agreements have a number of purposes, such as business continuation and liquidity. How-ever, the desire to minimize estate valuation is a primary reason for entering into a buy-sell

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agreement. A properly drafted buy-sell agreement can fix the value of a decedent’s interest for fed-eral estate tax purposes (Charles M. Land v. U.S., 187 F. Supp. 521 (1960)).

Note: For transfers after 10/9/90, buy-sell agreements may be ignored for purposes of determining value for gift tax purposes (§2701 - 2704). However, this rule disregarding buy-sell agreements does not apply if:

(1) It is a bona fide business arrangement (§2703(b)(1));

(2) It is not a device to transfer the property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth (§2703(b)(2)); and

(3) Its terms are comparable to similar arrangements entered into by persons in an arm’s length transaction (§2703(b)(3)).

The price in the agreement will set the estate tax value, even though the fair market value of the business interest is then actually higher than the agreed price, provided:

(1) The price is fixed or determinable according to the agreement;

(2) The obligation to sell is binding on the decedent during lifetime as well as on the estate after death; and

(3) The agreement is a bona fide business arrangement and not a device to pass the interest to related parties without adequate consideration (Reg. §20.2031-2(h)).

Note: There can be no certainty that the agreement will satisfy the third requirement when related parties purchase the interest, directly or indirectly.

When a business owner dies leaving the maximum marital deduction to the surviving spouse, there is no estate tax on his or her death. Here, there would be no benefit from a buy-sell agreement drafted solely to fix the estate tax value.

Redemptions Under §303

A major estate asset can be stock in a closely held corporation and while the corporation may have liquid assets, the estate may not. Unless there are co-owners and a buy-sell agreement, the estate may not be able to utilize the corporation’s liquidity to pay death taxes and expenses. However, most distributions from a corporation to a shareholder or his or her estate will be taxable as a dividend (§301(c) & §316).

Section 303 is an exception to this dividend treatment. This provision permits the redemption of a deceased shareholder’s stock in an amount not to exceed federal and state death taxes (including the generation-skipping transfer tax and funeral and administration expenses) without dividend treatment. However, even if the redemption qualifies under §303, there may be a taxable capital gain on the redemption to the extent the proceeds exceed the stock’s estate tax value.

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Note: The proceeds of the §303 redemption need not be used to pay the death taxes and funeral and administration expenses. The redemption may be solely a tool to withdraw corporate funds without dividend treatment.

Requirements

Distributions in redemption of stock included in a decedent’s gross estate for federal estate tax pur-poses are treated as payment for stock (rather than dividends) up to the sum of:

(a) All death taxes (federal and state), including interest on the taxes, and

(b) Funeral and administration expenses allowable as federal estate tax deductions (§303(a)) but only if:

(i) The value of the stock included in the estate exceeds 35% of the decedent’s adjusted gross estate9 (§303(b)(2)(A));

Note: Stock in two or more corporations is deemed stock of a single corporation if 20% or more in value of the outstanding stock of each corporation is included in the estate. A surviving spouse’s interest in stock held with the decedent as community property, joint tenants, ten-

ants by the entirety, or tenants in common is included in the decedent’s gross estate under this 20% test (§303(b)(2)(B)).

9 Stock gifted within three years of a decedent’s death is included in the gross estate for purposes of this 35% test.

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(ii) The redemption distribution takes place after the decedent’s death and not later than the time specified under §6501(a)10 (§303(b)(1)); and

(iii) The redeemed shareholder bears a burden of taxes or expenses11 (§303(b)(3)).

Note: When a decedent leaves an unlimited marital deduction bequest to his or her spouse, there is no federal estate tax and only that portion of the stock that does not exceed the amount of state death taxes and funeral and administration expenses may be redeemed un-der §303.

When there are plans to use §303, the business owner should not make gifts of stock that reduce ownership below the 35% requirement. It may also be advisable to gift nonstock assets to ensure that the value of the stock in the closely held corporation will be 35% of the estate.

Corporate Accumulation For §303 Redemption

When a §303 redemption is planned, the corporation may fund the redemption through corporate funds or life insurance on the stockholder. However, accumulating funds to redeem a shareholder’s stock at death under §303 has sometimes been held unreasonable for purpose of the accumulated earnings tax under §531 (Youngs Rubber Corp v Commissioner, 21 TCM 1593 (1962), aff’d, 331 F. 2d 12 (2d Cir. 1964)).

Under §537, an accumulation to redeem stock to pay death taxes, under §303, is reasonable if the accumulation is:

(1) Needed (or reasonably anticipated to be needed12) to redeem the stock, but is not greater than the amount required to pay death taxes and certain funeral and administrative expenses (§537(a)(2)), and

(2) Made in the taxable year of the corporation in which the shareholder died or in later years13 (§537(b)(1)).

Accumulation in Anticipation of Shareholder’s Death

Section 537 doesn’t apply to accumulations in taxable years of the corporation before the share-holder dies. The reasonableness of accumulation in years before death is determined solely by the facts and circumstances existing at the times the accumulations occur (Reg. §1.537-1(e)(3)).

In Wilcox Mfg. Co Inc., T.C. Memo 1979-92, an accumulation “far in advance” of the likelihood of death (such as for a 50-year-old shareholder not in poor health) was held to be an “opportunity for abuse,” especially where life insurance was a realistic alternative. However, redemption funds pro-vided by a life insurance policy have been held to be for the reasonable needs of a corporation’s business (Oman Construction Co Inc., T.C. Memo 1965-325).

10 Essentially within four years of the decedent’s death. However, the time can be extended up to 15 years from death if an

election is made to defer payment of estate tax under §6166 and §6166A. 11 In planning a §303 redemption, care should be taken that the stock to be redeemed is owned by a person or entity liable

for these items. For example, stock should not be redeemed from a marital deduction trust (or any other trust) that is not

liable for tax payments. 12 See Reg. §1.537-1(e)(1) for guidance on the amount needed or reasonably anticipated to be needed for redemption. 13 Note that accumulations before the year of death enjoy no special protection.

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If the redemption exceeds the amount chargeable to the capital account, the excess reduces the earnings and profits account of the corporation in determining dividend treatment for later distribu-tions (R.R. 79-376). This reduction also reduces the possibility of future unreasonable accumulation issues.

Under R.R. 65-289, redemption proceeds may be paid by a note or with other assets. However, if appreciated assets are distributed, the distribution will be a sale, and the corporation will realize taxable gain (§311(b)).

Death of a Spouse

A frequent assumption is that the spouse who is active in the business will die before the non-active spouse. This may not be the case and the possibility of a non-active spouse dying first should be considered, particularly, where the business is marital property.

Typically, a non-active spouse’s interest in a business is valued at death the same as if the active spouse died first. However, this similarity can be changed when:

(1) The active spouse’s services were a significant component of the business goodwill14, or

(2) There is a buy-sell agreement.

A properly drafted buy-sell agreement will set the value of the business interest for death tax pur-poses. However, often the buy-sell agreement is only triggered by the active spouse’s death and is not binding for death tax valuation purposes on the inactive spouse’s death since there is no obliga-tion to sell15.

Bypass Trust

When a spouse leaves his or her entire estate to the surviving spouse using the unlimited marital deduction, there will be no estate tax on death. However, use of the marital deduction may increase the surviving spouse’s estate. A bypass trust reduces this result. Thus, any buy-sell agreement should not prevent the inactive spouse from leaving his or her interest in the business to a bypass trust.

The buy-sell agreement should permit a disposition of the business interest, on the inactive spouse’s prior death, to a trust for the benefit of the surviving active spouse and/or other beneficiaries. The active spouse can be named as the trustee of the bypass trust if his or her powers are limited to an ascertainable standard. However, as trustee, the active spouse’s control of the business interest will be as a fiduciary and other beneficiaries may complain if the business interest is unproductive.

14 If the active spouse’s services contributed to the business goodwill, the value of the business should be reduced on the

active spouse’s death. 15 While the buy-sell price may not be determinative of valuation, it is at least one factor to be considered (R.R. 53-189).

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Lifetime Dispositions

An owner may wish to dispose of all or a part of his or her business interest before death. While such a disposition could be to third parties, estate planning primarily examines dispositions to family members.

Stock Redemptions Under §302

Normally, a corporation’s acquisition of its own stock from a shareholder for cash or property is a dividend to the shareholder. However, when a redemption is within any of the following categories under §302, the distribution to the shareholder is a payment for stock rather than a dividend:

(1) A redemption that is “substantially disproportionate” with respect to the redeeming share-holder;

(2) A redemption that is “not essentially equivalent to a dividend;” or

(3) A complete redemption of all of a shareholder’s stock in the corporation.

Substantially Disproportionate Redemption - 80/50 Rule

Under §302(b)(2), a redemption is “substantially disproportionate” if immediately after the re-demption:

(1) The ratio of the shareholder’s voting stock to the company’s total outstanding voting stock is less than 80% of that ratio immediately before the redemption: and

Note: This 80% test must be satisfied for the corporation’s voting and nonvoting common stock. Thus, a redemption solely of nonvoting stock does not qualify. However, when nonvoting (other than section 306 stock) and voting stock are redeemed at the same time, and the redemption of voting stock is substantially disproportionate, then the redemption of the nonvoting stock also qual-ifies (Reg. §1.302-3(a)).

(2) The shareholder owns less than 50% of the total voting stock of the company.

Redemptions Not Essentially Equivalent to a Dividend

Whether a redemption is not essentially equivalent to a dividend is determined based on the change in the redeemed shareholder’s corporate interest. A redemption is not essentially equiv-alent to a dividend if it results in a meaningful reduction in the redeemed shareholder’s propor-tionate interest.

A redemption that is prorata or from a sole shareholder does not result in any reduction in pro-portionate interest.

A redemption from a majority shareholder (i.e., a shareholder with over 50% of the voting power) usually results in a meaningful reduction if that shareholder’s voting power is reduced to 50% or less.

A redemption of voting stock from a substantial minority shareholder is meaningful if, after the redemption, the shareholder's ability to act without the redeemed shareholder to control the corporation is increased. Any redemption of voting stock from a low percentage minority share-holder usually is a meaningful reduction.

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Complete Redemptions

In a complete redemption, all the shareholder’s stock must be redeemed (§302(b)(3)). When a shareholder owns both common and preferred stock, a complete redemption of only one of the classes will not qualify.

A complete redemption can be done on the installment basis if the purchase agreement binds the parties to complete the redemption by a certain date for a maximum price.

Constructive Ownership - §318

Under the stock redemption rules, a shareholder owns not only his or her own direct holdings but also those of other related taxpayers (§302(c)). These constructive ownership rules provide that:

(1) An individual is treated as owning stock owned, directly or indirectly, by his or her spouse, children, grandchildren, and parents (§318(a)(1));

(2) Stock owned by an S corporation, partnership or estate is deemed owned proportionately by its shareholders, partners, or beneficiaries (§318(a)(2)(A), (5)(E));

(3) Stock owned by an S shareholder, partner, or estate beneficiary is attributed in full to the S corporation, partnership, or estate (§318(a)(3)(A), (5)(E));

(4) Stock owned by a trust (except an ESOT) is deemed owned by its beneficiaries in propor-tion to their actuarial interest in the trust (§318(a)(2)(B)(i));

(5) Stock owned by a trust beneficiary (other than the beneficiary of an ESOT) is attributed, in full to the trust (§318(a)(3)(B)(i));

(6) A 50% or more shareholder in a C corporation is treated as owning a proportionate share of stock in other corporations owned by the C corporation (§318(a)(2)(C));

(7) A C corporation is considered as owning all the stock (except its own) owned by a 50% or more shareholder (§318(a)(3)(C)); and

(8) The holder of an option to buy stock is treated as the owner of the stock covered by the option (§318(a)(4)).

Double Attribution

Stock constructively owned by a person is considered as actually owned by them in any fur-ther attribution (§318(a)(5)(A)) except that:

(a) Stock constructively owned by a person under family attribution rules will not be at-tributed again to make another family member the constructive owner of that stock (§318(a)(5)(B)); and

(b) Stock constructively owned by a partnership, estate, trust, or corporation cannot be further attributed from the entity to make another partner, heir, beneficiary, or stock-holder the constructive owner of that stock (§318(a)(5)(C)).

Stock Attribution in Complete Redemptions

Family attribution rules do not apply to persons whose actually owned stock is completely redeemed, if:

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(a) Immediately after the redemption, they have no personal financial interest in the cor-poration, other than as a creditor;

Note: They cannot serve as a director, officer, or employee.

(b) They do not acquire any such interest (except by inheritance) or position for a ten-year period running from the date of the redemption;

(c) They did not acquire any of the redeemed stock from close family members within 10 years before the redemption, and didn’t transfer any stock to them within that period except for a transfer not principally motivated by tax avoidance; and

(d) They attach a separate statement (in duplicate) to their return for the year of redemp-tion, in which they state that they have not acquired any new interest in the company (except by inheritance) and that they will notify the district director within 30 days after acquiring any new interest (§302(c)(2); Reg. §1.302-4)

Family attribution is also waived for a partnership, estate, trust, or corporation (“entity waiver rule”) if that entity and each related person meet the above requirements and agree to be liable for any tax resulting from any acquisition of interest within the 10-year period (§302(c)(2)(C)).

Stock Recapitalization

Closely held corporations normally have a single class of common stock. Even where there are several shareholders, the single stock structure can be satisfactory since a buy-sell agreement can cover most events during lifetime and at death.

However, some shareholders may not wish their stock sold at death but instead may desire family members to continue the business. In such a case, a recapitalization into a multistock structure might accomplish the following objectives:

(1) If some family members are active in the business and others are not, different classes of stock can be given to different family members;

(2) A recapitalization can be coordinated with a §303 redemption at death so that only a partic-ular class of stock is redeemed and voting control of the corporation is not affected; and

(3) A recapitalization can freeze the value of the stockholder’s interest and remove future growth from his or her estate.

Note: Section 2036(c) prevented estate freezes by causing transferred stock to be taxed in the do-nor’s estate. However, §2036(c) was repealed retroactively in 1990. In its place, Chapter 14 rules (§2701 - §2704) were enacted that focus on the gift tax aspects of the transfer (see later discussion of estate freezes).

A recapitalization is a reshuffling of the capital structure of a corporation. For example, a corporation might change an all common stock structure into one in which some stockholders have common stock and some have preferred stock.

The issuance and exchange of stock normally occurring in a recapitalization are not income taxable

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events16. The recapitalization will typically constitute either a tax-free dividend17 under §305(a) or a tax-free corporate reorganization under §368(a)(1)(E).

Section 306 Taint

Preferred stock, issued in exchange for common stock, will be tainted under §306. If a share-holder has §306 stock and it is redeemed, the redemption is a dividend to the extent of current earnings and profits (§306(a)(2)). If the §306 stock is sold, part of the sale price equal to the seller’s share of the earnings and profits at the time of the earlier stock dividend is ordinary in-come (§306(a)(1)). However, this taint does not apply when the shareholder’s entire stock inter-est (including any attributed under §318) is sold or redeemed at one time (§306(b)(1)). The §306 taint is also removed on the shareholder’s death.

Deferred Compensation Agreements

A deferred compensation agreement can be a valuable estate planning tool to replace lost salary income on the death of an active shareholder/employee. The basic thrust of such agreements is to postpone the receipt of currently earned income until a later taxable year. Instead of paying addi-tional compensation now, the corporation pays it to the shareholder/employee at some future time. These payments are called “deferred” compensation agreements because they represent compen-sation currently being earned but which will not be paid until a future date.

Note: If the income has already been earned (i.e., the employee has an undisputed right to it) de-ferral is generally impossible.

The deferred payout period may commence on any given date but could be the date of the em-ployee’s retirement or death, whichever occurs first. The agreement would designate a beneficiary to receive remaining payments should the employee die before receiving all payments.

Under §2039(a), the commuted value of the remaining payments to be made on or after death is includable in the employee’s gross estate (Reg. §20.2031-7(f).).

If the agreement provides that no deferred payments are payable to the employee during his or her lifetime, and only a death benefit is payable to a named beneficiary, it is unclear if the value of the death benefit is includable in the employee’s estate (Estate of Fermin D Fusz v Commissioner, 46 T.C. 214 (1966) and R.R. 78-15). The gift tax treatment is also unsettled. R.R. 81-31 provides that the employee who does not retain any rights or benefits in the agreement during life has made a com-pleted gift of the contractual benefits to the irrevocable beneficiary at the time the employee dies. However, the Tax Court took a conflicting position in Estate of DiMarco, 87 T.C. 653 (1986).

Nevertheless, one issue is clear. Payments under a deferred compensation agreement after the de-cedent’s death are subject to income tax in the hands of the recipient as income in respect of a decedent (§691).

16 However, they may be gift taxable, particularly, under Chapter 14 rules. 17 A transaction purporting to be a recapitalization can be a taxable dividend under §305(b) if it is a disproportionate

distribution. For example, if the preferred stock has an unreasonable redemption premium, dividend treatment can be

imposed (§305(b)(4) & §305(c)).

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Deferred compensation paid to the deceased employee’s beneficiary will be deductible by the cor-poration if such payments constitute reasonable compensation (§162(a)(1)).

Review Questions

70. When three requirements are met, 40% of the value of any land subject to a qualified con-servation easement may qualify for exclusion from the taxable estate. What is one of the require-ments necessary to meet this exclusion?

a. An executor of a decedent’s estate makes a qualified conservation easement on the land within 60 days of making the election.

b. The decedent owned (directly or indirectly) at least 20% of the entity that owns the land.

c. The land was owned by the decedent for the 2-year period ending on the date of his or her death.

d. The location of the land is within the United States or a possession of the United States.

71. Minority stock interest owners in a closely held business may be able to discount the value of their interest. In R.R. 93-12, what position does the IRS take on a minority interest owned by family members?

a. It is distinct from other family members’ interests, for valuation purposes.

b. It must be aggregated to ascertain whether transferred interests should be valued as part of a controlling interest.

c. It is valued as a majority interest simply because a transferred interest, when aggregated with the interests of other family members, is part of a controlling interest.

d. The only reason to allow a discount is if there is a conflict that suggests that the family members will act separately.

72. Certain stock redemption rules provide that shareholders can directly or constructively own stock. What is one of the eight constructive ownership rules of §318?

a. When a beneficiary of an ESOT owns stock, it is wholly attributed to the trust.

b. When an ESOT owns stock, its beneficiaries are considered to be owners in proportion to their actuarial interest in the trust.

c. When an S corporation, partnership, or estate owns stock, the shareholders, partners, or beneficiaries are considered to completely own it.

d. When an S shareholder, partner, or estate beneficiary owns stock, it is wholly attributed to the S corporation, partnership, or estate.

73. Some employees design, with their employer, a plan to receive current income in a later tax year. What is this device often referred to as?

a. a deferred compensation agreement.

b. a stock redemption.

c. a lifetime gift of stock in the business.

d. a swing-vote premium.

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Learning Objectives

After reading Chapter 8, participants will be able to:

1. Determine the benefits of an estate freeze and its ability to reduce the value of a busi-ness interest, identify transactions to which Chapter 14 rules apply and terminology used in the Chapter 14 valuation rule that applies to corporations and partnerships, and specify exceptions to §2701.

2. Identify the “zero value” rule under §2701 by:

a. Recalling the qualified payment exception and the consequence of being excepted;

b. Specifying variables that impact the application of §2701 stating how to avoid taxable events when valuing a distribution right;

c. Determining the transfer tax when a taxpayer fails to make a qualified payment on time identifying the appropriate election into or out of qualified payment treatment; and

d. Specifying a junior equity interest according to §2701 rules and determining the value of other rights held together with an extraordinary payment right.

3. Determine the application of §2701 provisions by:

a. Recalling the treatment of a capital contribution, a redemption, or a recapitalization under §2701;

b. Identifying when an individual is deemed the owner of an interest that is held indi-rectly through a corporation, partnership, trust, or other entity based on the §2701 at-tribution rules;

c. Specifying when transfer tax adjustments will be made to transfers or inclusions in the gross estate;

d. Identifying the split of an applicable retained interest allowing value to be given to a participating feature of a participating preferred interest; and

e. Specifying the stepped computation under the subtraction method to determine an amount of a gift resulting from a transfer to which §2701 applies.

4. Recall the terms used in §2702 concerning transfers of interests in trust, identify the application of the zero value rule to a transfer of interest in trust, and specify exceptions to §2702, determine the transfer of an interest in property when there are one or more term interests as a transfer of an interest in a trust, and specify the treatment of joint purchases.

5. Recognize the requirements and exceptions of §2703 to ensure property is valued ap-propriately, identify lapses as a transfer by gift or as includible in the decedent’s gross estate under §2704, recall the key terminology of §2704 under the evaluation rules, spec-ify the amount of the transfer stating which lapses or restrictions qualify as an applicable restriction.

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CHAPTER 8

Estate Freeze Rules

Historically, an estate freeze was a way of reducing the value of a business interest or other property for estate tax purposes. Normally, an older-generation family member transferred an appreciating business or property interest to a younger-generation transferee while retaining a non-appreciating interest. Sections 2701, 2702, 2703, and 2704, which make up Chapter 14 of the Code, now provide an elaborate set of rules which apply to estate freeze transactions1.

In essence, Chapter 14 ignores any retained interests and values them at zero when determining the amount of a gift. However, there are certain exceptions. Retained interests that are considered and given value are:

(1) Qualified payments in the case of corporations and partnerships, and

(2) Qualified interests where there is a transfer in trust, term interest, or joint purchase.

Valuing any retained interests at zero maximizes the gift and imposes the highest gift tax possible at the time of the transfer. This is accomplished by using a subtraction method in which the value of senior interests is subtracted from the value of the entire entity to determine the value of junior interests (Reg. §25.2701-3(a)).

Note: Repealed §2036(c) also dealt with estate freezes, but operated at the time of the transferor’s death by requiring that the transferred interest be included in the transferor’s estate.

1 Transfers before October 9, 1990 are not subject to special valuation rules.

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Estate Freeze RulesEstate Freeze Rules

If an interest in a corporation, or partnership

is transferred to a “family member” where the:

(1) transferor, or

(2) “applicable family member”

retains an “applicable retained interest,” then

the resulting gift is determined by taking the

value of the entire entity and subtracting the

value of any interests senior to those

transferred.

Note: Regardless of the subtraction method,

the minimum value assigned to the transfer of a

junior equity interest is 10% of all equity

interests plus the total debt of the entity to the

transferor or applicable family members.

§2701 Subtraction Method

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Application

When applicable, Chapter 14 rules replace the general valuation principles of Chapter P2. With rare exception, Chapter 14 valuation principles always result in a higher gift tax than the rules under Chapter P by imposing a gift tax valuation based on the property’s full value unreduced for interests retained.

Chapter 14 (§2701 through §2704) applies to:

(1) Transfers of interests in corporations and partnerships (§2701);

(2) Transfers of interests in trusts (§2702);

(3) Buy-sell agreements and options (§2703); and

(4) Lapsing rights (§2704).

Corporations & Partnerships - §2701

Chapter 14 valuation rules apply when a corporate or partnership interest is transferred to a member of the transferor’s family and the individual3 transferor or an applicable family member retains an applicable retained interest in the entity immediately after the transfer (§2701(a)(1)).

Definitions

Member of the Family

Member of the family means the:

(1) Transferor’s spouse (§2701(e)(1)(A)),

(2) A lineal descendant of the transferor or the transferor’s spouse (§2701(e)(1)(B)), and

(3) The spouse of any such descendant (§2701(e)(1)(C)).

Applicable Family Member

An applicable family member is:

(1) The transferor’s spouse (§2701(e)(2)(A)),

(2) An ancestor of the transferor or the transferor’s spouse (§2701(e)(2)(B)), and

2 However, the Chapter 14 requirements for buy-sell agreements and options are in addition to, not in place of, Chapter

P rules 3 Stock or partnership interests held indirectly by an individual through corporations, partnerships, trusts or other entities

are attributed to the individual (§2701(e)(3)(A)).

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Estate Freeze Rules

An “applicable family member” means:

(1) the transferor’s spouse,

(2) an ancestor of the transferor or

transferor’s spouse, or

(3) the spouse of an an ancestor

§2701 Applicable Family Member

§2701 Family Member

A “family member” means:

(1) the transferor’s spouse,

(2) a lineal descendant of the transferor

or transferor’s spouse, or

(3) the spouse of an ancestor

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(3) The spouse of any such ancestor (§2701(e)(2)(C)4.

This definition is the definition of applicable family member found at §2701(e)(2), which is used for general §2701 purposes. However, for purposes of determining control under §2701, an applicable family member also includes any lineal descendant of any parent of the transferor or the transferor’s spouse (§2701(b)(2)(C)). The result of this difference is to add brothers, sisters, nieces, and nephews to the definition used to determine control.

Applicable Retained Interest

An applicable retained interest is any interest in an entity with respect to which there is:

(1) A liquidation, put, call, or conversion right, (sometimes called “extraordinary payment rights”) or

Note: The term “liquidation, put, call, or conversion right” does not include any right which must be exercised at a specific time and at a specific amount5 (§2701(c)(2)(B)(i)). The term also does not include any right which (i) is a right to convert into a fixed number (or a fixed percentage) of shares of the same class of stock in a corporation as the transferred stock in such corporation (or stock which would be of the same class but for nonlapsing differences in voting power), (ii) is nonlapsing, (iii) is subject to proportionate adjustments for splits, combinations, reclassifications, and similar changes in the capital stock, and (iv) is subject to adjustments similar to the adjustments for accu-mulated but unpaid distributions (§2701(c)(2)(C)). A similar rule applies to partnerships6.

(2) A distribution right (except a right to a “qualified payment”), but only if before the trans-fer, the transferor and applicable family members7 control the entity.

4 A relationship by legal adoption is treated as a relationship by blood (§2701(e)(4) 5 For example, a liquidation right that is required to be exercised at a fixed date for a sum certain is unaffected by Chapter

14. 6 This exception is provided because the full appreciated value of the right will be subject to later transfer tax (S Rept, PL

101-508, 11/5/90, p. 63). 7 This definition is more inclusive than the definition of applicable family member found at §2701(e)(2), which is used for

general §2701 purposes. For purposes of determining control under §2701, applicable family member includes any lineal

descendant of any parent of the transferor or the transferor’s spouse.

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Estate Freeze RulesEstate Freeze Rules

An applicable retained interest consists of:

(1) a distribution right - which is valued at

zero unless it is a qualified payment right;

(2) a qualified payment right (i.e., a fixed

rate cumulative payment or payment

elected to be treated as such) - which is

valued at FMV; or

(3) an extraordinary payment right (i.e., a

discretionary liquidation, put, call,

conversion, or similar right) - which is

valued at zero.

Note: If an extraordinary payment right is

held with a qualified payment right, the

rights are valued as if exercised to give the

lowest value.

§2701 Applicable Retained Interest

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Estate Freeze RulesEstate Freeze Rules

A distribution right is a right to distribution

from:

(1) a corporation with respect to its

stock, or

(2) a partnership with respect to a

partnership interest,

if immediately after the transfer, the

transferor and “applicable family

members” control (50% or more) of the

entity, except:

(1) a right to distributions from an

interest which is junior to the

transferred interest,

(2) guaranteed payments from a

partnership, and

(3) any right to distributions of the same

class as the transferred interest.

§2701 Distribution Right

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Note: A distribution right is a right to distributions from a corporation based on stock (§2701(c)(1)(A)(i)) and a right to distributions from a partnership based on a partner’s interest (§2701(c)(1)(A)(ii)). The term “distribution right” does not include (i) a right to distributions with respect to any interest which is junior to the rights of the transferred interest8, (ii) any liquidation, put, call, or conversion right, or (iii) any right to receive any guaranteed payment described in §707(c) (i.e., payments to a partner for services or the use of capital) of a fixed amount.

Control

Control means:

(1) For a corporation, holding at least 50% (by vote9 or value) of the stock (§2701(b)(2)(A)),

(2) For a partnership, holding of at least 50% of the partnership capital or profits interests10 (§2701(b)(2)(B)(i)), and

(3) For a limited partnership, any interest as a general partner (§2701(b)(2)(B)(ii)).

Exceptions To §2701

Section 2701 does not apply to any right with respect to an applicable retained interest when:

(1) Market quotations are readily available (as of the date of the transfer) for such interest on an established securities market (§2701(a)(2)(A));

(2) The retained interest is of the same class as the transferred interest, or

(3) Such interest is proportionally11 the same as, the transferred interest without regard to nonlapsing differences12 in voting power or, for a partnership, nonlapsing differences in manage-ment or liability (§2701(a)(2)(B)).

Note: Thus, §2701 rules do not affect the gift value of common stock if the transferor only retains rights of that class of common. Similarly, §2701 does not affect the gift value of a partnership inter-est if all interests in the partnership share equally in all items of income, deduction, loss, and gain in the same proportion (S Rept, PL 101-508, 11/5/90, p. 62).

The last exception does not apply to any interest in a partnership if the transferor or an applicable family member has the right to alter the liability of the transferee of the transferred property.

8 As a result, §2701 does not affect the valuation of a transferred interest that is senior to the retained interest, even if

the retained interest is not a junior equity interest. 9 Entity interests that carry no right to vote other than on liquidation, merger, or a similar event are not voting. Neither

is a right to vote that is subject to a contingency. However, a voting right does include a right held in a fiduciary capacity.

(Reg. §25.2701-2(b)(5)(ii)(B)). 10 Guaranteed payments under §707(c) are disregarded in making this determination (Reg. §25.2701-2(b)(5)(iii)). 11 Thus, the zero value rule does not apply to a transfer if it results in a proportionate reduction of each class of equity

interest held by the transferor and all applicable family members in the aggregate (Reg. §25.2701-1(c)(4)). 12 Any difference which lapses by reason of any federal or state law is treated as a nonlapsing difference (§2701(a)(2)).

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Review Questions

74. Under the estate freeze rules, an applicable retained interest may consist of different rights that may affect its valuation. However, an applicable retained interest is valued at fair market value when it is comprised of:

a. a discretionary liquidation, put, call, conversion, or similar right.

b. a distribution right.

c. a qualified payment right.

d. an extraordinary payment right.

75. An applicable retained interest may be comprised of a distribution right. What is classified as a distribution right?

a. a right to distributions from a partnership based on a partner’s interest.

b. a right to distributions with respect to any interest which is junior to the rights of the trans-ferred interest.

c. any liquidation, put, call, or conversion right.

d. any right to receive any guaranteed payment to a partner for services or the use of capital of a fixed amount.

76. Control is critical and must be determined for §2701 purposes. Under this provision, control is defined as:

a. a corporation’s ownership of 50% or more of the entity interests that carry a right to vote only on liquidation, merger, or a similar vote.

b. a corporation owning 50% or more voting interests that are subject to a contingency.

c. any general partner interest in a limited partnership.

d. a partnership determining 50% or more of its guaranteed payments.

77. Three exceptions are provided to the application of §2701 for applicable retained interests. When does one of these exceptions to §2701 apply?

a. an applicable family member has the right to modify the liability of the transferee of the transferred property when such interest is in a partnership.

b. market quotations not readily available for such interest.

c. an applicable retained interest is proportionately the same as the transferred interest ex-clusive of nonlapsing disparities in voting power.

d. an applicable retained interest and transferred interest are of different classes.

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Zero Value Rule

Under §2701, the value of any applicable retained interest held by the transferor or an applicable family member after the transfer is deemed to be zero. Specifically, this means that:

(1) A retained liquidation, put, call or conversion right is valued at zero for gift tax purpose (§2701(a)(3)); and

(2) Retained distribution right in a controlled entity is valued at zero when:

(a) It is not a qualified payment; and

(b) The transferor and applicable family members hold (subject to attribution rules) control of the entity (§2701(b)(1)(A)).

Qualified Payment Exception to Zero Value Rule

A qualified payment is any dividend payable on a periodic basis under any cumulative preferred stock (or a comparable payment under any partnership interest) to the extent that such dividend (or comparable payment) is determined at a fixed rate13 (§2701(c)(3)(A)).

Note: When a qualified payment is not made within 4 years of its due date, the transferor’s taxable gifts or taxable estate will be increased when the applicable retained interest is later transferred (§2701(d)).

Valuation of Qualified Payments - Lowest Value Rule

If a distribution right is a qualified payment and there are liquidation, put, call, or conversion rights with respect to the interest, then the value of all such rights is determined as if each liquidation, put, call, or conversion right was exercised in the manner resulting in the lowest value (§2701(a)(3)(B)).

Example

Father retains cumulative preferred stock in a transaction to which Chapter 14 applies. The cumulative dividend is $100 per year and the stock may be redeemed at any time after two years for $1,000. The value of the cumulative preferred stock is the lesser of (1) the present value of two years of $100 dividends plus the present value of $1,000 in Year 2, or (2) the present value of $100 paid every year in perpetuity. If the present values are substantially identical, the stock receives such value (Conf Rept p.1134, Ex-ample (1)).

Example

P, an individual, holds all 1,000 shares of X Corporation’s $1,000 par value preferred stock bearing an annual cumulative dividend of $100 per share (a qualified payment, see definition below) and holds all 1,000 shares of X’s voting common stock. P has the

13 A payment is fixed to rate if the payment is determined at a rate that bears a fixed relationship to a specified market

interest rate (§2701(c)(3)(B)).

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right to put all the preferred stock to X at any time for $900,000, an extraordinary payment right. P transfers the common stock to P’s child and immediately thereafter holds the preferred stock. At the time of the transfer, the fair market value of X is $1,500,000, and the fair market value of P’s annual cumulative dividend right is $1,000,000. Because P has both an extraordinary payment right (the put right) and a qualified payment right (the right to receive cumulative dividends), the “lower of” rule would apply and the value of these rights would be determined as if the put right will be exercised in a manner that results in the lowest total value being determined for the rights (in this case, by assuming that the put will be exercised immediately). The value of P’s preferred stock would be $900,000 (the lower of $1,000,000 or $900,000). The amount of the gift would be $600,000 ($1,500,000 minus $900,000). Reg. §25.2701-2(a)(5).

On the other hand, if a distribution right is a qualified payment and there is no liquidation, put, call, or conversion right with respect to the interest, then the value of the distribution right is determined as if §2701 do not apply.

Cumulative but Unpaid Distributions - Compounding Rules

When a distribution right is valued as a qualified payment, later events (“taxable events”) can cause an increase in the transferor’s taxable estate or taxable gifts (§2701(d)(1)).

Note: This rule on cumulative but unpaid distributions treats an applicable family member in the same manner as the transferor with respect to any distribution right retained by that family mem-ber that was valued under the rule for qualified payments (§2701(d)(4)(A)). Moreover, if the appli-cable retained interest conferring the distribution right is transferred to an applicable family mem-ber other than the transferor’s spouse, the applicable family member is treated in the same manner as the transferor in applying the rule on cumulative distribution rights to distributions accumulating with respect to the interest after the transfer (§2701(d)(4)(B)).

Taxable Events

Events causing such an increase include:

(1) The death of the transferor if the applicable retained interest granting the distribu-tion right is includible in the transferor’s estate14 (§2701(d)(3)(A)(i));

Note: Event (1) increases the transferor’s taxable estate (§2701(d)(1)(A)).

(2) The transfer of such applicable retained interest (except to the transferor’s spouse15 (§2701(d)(3)(A)(ii)); and

Note: Any termination of an interest is treated as a transfer (§2701(d)(5)). In addition, if the transfer is from an applicable family member to the transferor, §2701 continues to apply to the transferor during any period the transferor holds such interest (§2701(d)(4)(C)).

14 Unless an estate taxes marital deduction is allowable for the interest (§2701(d)(3)(B)(i)). However, if an event is not

treated as a taxable event because of the exception for transfers to the transferor’s spouse where a marital deduction is

allowed, the transferee spouse is treated in the same manner as the transferor with respect to the interest. 15 A transfer to a spouse failing under the annual exclusion is treated the same as a transfer qualifying for the marital

deduction. Thus, no inclusion would occur upon the transfer of an applicable retained interest to a spouse. However,

subsequent transfers by the spouse would be subject to inclusion.

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(3) An election to treat payment of a distribution16 after the 4-year period beginning on its due date as a taxable gift (§2701(d)(2)(C)).

Note: Events (2) and (3) increase the transferor’s taxable gifts for the calendar year in which the event occurs (§2701(d)(1)(B)).

Amount of Increase

The increase to the transferor’s taxable estate or taxable gifts is the excess, if any, of:

(1) The value17 of the qualified payments payable during the period beginning on the date of the transfer and ending on the date of the triggering event determined as if:

(a) All such payments were paid on the date payment was due, and

(b) All such payments were reinvested by the transferor as of the date of payment at a yield equal to the discount rate used in determining the value of the applicable re-tained interest, over

(2) The value of the qualified payments paid during the period described in (1) based on the time payments were actually paid (§2701(d)(2)(A)).

In determining the amount of such increase, a grace period is provided: any payment of any distribution during the 4-year period beginning on its due date is treated as having been made on such due date.

Limitation

The increase in the transferor’s taxable estate or taxable gifts can’t exceed the applicable percentage of the excess, if any, of:

(1) The value (determined as of the date of the taxable event) of all equity interests in the entity which are junior to the retained interest, over

(2) The value of the interests described in (1) determined as of the date of the transfer (§2701(d)(2)(B)(i)).

Applicable Percentage

The applicable percentage is determined by dividing:

(1) The number of shares in the corporation held (as of the date of the taxable event) by the transferor that are applicable retained interests of the same class, by

(2) The total number of shares in the corporation as of that date that are of the same class as the class described in (1) (§2701(d)(2)(B)(ii)).

16 The election gives rise to an inclusion only with respect to the payment for which the election is made. The inclusion

with respect to other payments is unaffected. 17 Determined as if all payments were timely paid and reinvested as of the date of payment at a yield equal to the discount

rate used to value the retained interest. Payment of any distribution during the 4-year period beginning on its due date

is treated as having been made timely (§2701(d)(2)(C)).

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Transfer Tax Adjustment

When a taxpayer fails to make a qualified payment valued under the lowest value rule within four years of its due date, it results in an inclusion in the transfer tax base of the difference between the compounded value of the scheduled payments over the com-pounded value of the actual payments made.

This inclusion can happen when the holder transfers by sale or gift the applicable retained interest during life or at death. In addition, the taxpayer may, by election, treat the pay-ment of the qualified payment as giving rise to an inclusion with respect to prior periods.

To alleviate the possibility of double taxation, the Treasury Department has regulatory au-thority to make subsequent transfer tax adjustments to reflect the inclusion of unpaid amounts on a qualified payment. For example, this authority permits the Treasury Depart-ment to eliminate the double taxation that would occur if, with respect to a transfer, both the inclusion and the value of qualified payment arrearages were included in the transfer tax base.

Election into Qualified Payment Treatment

A transferor or applicable family member holding any distribution right which is not a quali-fied payment may elect to treat such right as a qualified payment, to be paid in specified amounts and at specified times. However, this rule applies only to the extent that the speci-fied amounts and times are legally consistent with the instrument creating the right (§2701(c)(3)(C)(ii)).

Example

Father and Daughter are partners in a partnership to which Father contributes an ex-isting business. Father is entitled to 80% of the net cash receipts of the partnership until he receives $1 million, after which time he and Daughter both receive 50% of the partnership’s cash flow. Father’s liquidation preference equals $1 million. The retained right to $1 million is valued at zero unless Father elects to treat it as a right to receive qualified payments in the amounts, and at the times, specified in the election. If Father elects such treatment, amounts not paid at the times specified in the election become subject to the compounding rules (Conf Rept No. 101-964 (PL 101-508) pp. 1134-1135, Example (4)).

This election decreases the gift tax paid at the time of the transfer. However, the transferor could increase future gift and estate tax because failure to pay future dividends may increase the transferor’s taxable gifts or taxable estate under the compounding rules.

This election, once made, is irrevocable (§2701(c)(3)(C)(iii)). The election is made by attaching a statement to the transferor’s federal gift tax return on which the transfer was reported (Reg. §25.2701-2(c)(5)).

Election Out of Qualified Payment Treatment

Payments under any interest held by a transferor that are qualified payments shall be treated as qualified payments unless the transferor elects not to treat such payments as qualified

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payments (§2701(c)(3)(C)(i)). While this will result in future unpaid amounts escaping gift or estate tax, the election can create an immediate increased gift tax since the retained interest will be valued at zero.

However, payments under any interest held by an applicable family member that are quali-fied payments shall be treated as qualified payments only if such member elects to treat such payments as qualified payments (§2701(c)(3)(C)(i)). Thus, if held by an applicable family mem-ber, such a distribution right is not treated as a qualified payment unless the holder so elects.

The election is made by attaching a statement to the transferor’s federal gift tax return on which the transfer is reported. This election, once made, is irrevocable (§2701(c)(3)(C)(iii)).

Minimum Valuation of a Junior Interest

When §2701 applies to the transfer of a junior equity interest in a corporation or partnership, in no event can the interest be valued at an amount less than a value determined as if the total value of all of the junior equity interests in the entity were equal to 10% of the sum of:

(1) The total value of all the equity interests in the equity, and

(2) The total amount of indebtedness18 of the entity to the transferor or an applicable family member (§2701(a)(4)(A)).

The minimum value established by this rule is intended to reflect the “option value” of the right of the residual interest to future appreciation (S Rept, PL 101-508, 11/5/90, p. 65).

Definitions

Junior Equity Interest

The term “junior equity interest” means common stock or, in the case of a partnership, any partnership interest under which the rights as to either income or capital are junior to the rights of all other classes of equity interests (§2701(a)(4)(B)(i)).

Equity Interest

The term “equity interest” means stock or any interest as a partner, as the case may be (§2701(a)(4)(B)(ii)).

Value of Other Rights

Any right other than:

(i) A distribution right,

(ii) An extraordinary payment right, or

(ii) A qualified payment right

held together with an extraordinary payment right is valued as if the rights valued at zero did not exist. Thus, if a retained interest carried no rights subject to the zero value rule, the value of the interest would be its fair market value (Reg. §25.2701-2(a)(4)).

18 Short-term indebtedness incurred with respect to the current conduct of trade or business (such as amounts payable

for current services) is not indebtedness of the entity (Reg. §25.2701-3(c)(2)).

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Example

P transfers non-voting common stock of X Corporation to P’s child while retaining $100 par value voting preferred stock bearing a cumulative annual dividend of $10. Imme-diately before the transfer, P, applicable family members of P, and members of P’s family hold 60% of the voting rights in X. Eighty percent of the vote is required to com-pel liquidation of any interest in X. P’s right to participate in liquidation is not an ex-traordinary payment right. P’s preferred stock is an applicable retained interest that carries no rights that are valued at zero under the zero value rule. Thus, in applying the three-step subtraction method, the value of P’s preferred stock would be its fair market value determined without regard to the special valuation rules (Reg. §25.2701-2(d), Example (4)).

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Review Questions

78. Certain retained distribution rights can escape the “zero value” rule when deemed qualified payments. However, later events can be taxable events increasing the transferor’s taxable gifts or estate. Under §2701(d), which of the following events is a nontaxable event?

a. The transferor elects to treat a distribution payment as a taxable gift after the 4-year period starting on the payment’s due date.

b. An applicable retained interest terminates.

c. At the transferor’s death, his or her estate includes the applicable retained interest that grants the distribution right.

d. The applicable retained interest is transferred to a spouse.

79. When determining the amount of increase in a transferor’s taxable estate or taxable gifts under §2701(d), the amount of corporate shares owned by the transferor that are applicable retained interests of the same class must be divided by the total amount of corporate shares as of that date that are of the same class. What is the result?

a. a qualified payment.

b. the amount of increase.

c. the applicable percentage.

d. the transfer tax adjustment.

80. If a taxpayer fails to make a qualified payment that has been valued according to the lowest value rule, within four years of its due date, double taxation can result. What can the Treasury Department do to lessen the possibility of double taxation?

a. apply the §2701(d) taxable events rule.

b. waive the applicable percentage limitation.

c. subsequently adjust the transfer tax.

d. use the zero value rule.

81. Amazingly, an election may be made to treat an unqualified distribution right as a qualified payment. However, this §2701(c) election:

a. is available only for precise amounts and times that are lawfully consistent.

b. increases the gift tax paid at the time of transfer.

c. is automatically made by consistent treatment on the return.

d. is revocable.

82. Under §2701, if a transferor holds any interest for which qualified payments must be made, he or she can make an election out of this treatment. What can occur if such an election is made?

a. Gift or estate tax can be avoided on future unpaid amounts.

b. Gift tax immediately decreases.

c. The transferor may later revoke the election.

d. The value of any retained interest becomes its fair market value.

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83. A minimum valuation rule applies when a transfer of a corporation’s common stock or a part-nership interest under which the income or capital rights are smaller than the rights of all other equity interest classes is subject to §2701. What term is used for such stock or partnership inter-est?

a. equity interest.

b. junior equity interest.

c. remainder interest.

d. term interest.

Capital Contributions, Redemptions, & Recapitalizations

Except as provided in regulations, a contribution to capital or a redemption, recapitalization, or other change in the capital structure of a corporation or partnership is a transfer of an interest in such entity under §2701 if the transferor or an applicable family member:

(1) Receives an applicable retained interest in such entity pursuant to such contribution to capital or such redemption, recapitalization, or other change, or

(2) Under regulations, otherwise holds, immediately after the transfer, an applicable retained interest in such entity (§2701(e)(5)).

This rule does not apply to any transaction (other than a contribution to capital) if the interests in the entity held by the transferor, applicable family members, and members of the transferor’s family before and after the transaction are substantially identical.

Example

Dan owns all the stock of XYZ Corporation and exchanges his shares for 50 shares of 8% cumulative preferred stock and 50 shares of common stock. Dan then transfers the common stock to Rocko, Dan’s child. Chapter 14 applies since Dan transferred an eq-uity interest (the common stock) to a member of his family, and immediately thereaf-ter held an applicable retained interest (the preferred stock). Dan’s gift would be de-termined by subtracting the value of Dan’s preferred stock from the entire value of XYZ Corporation.

Under Reg. §25.2701-1(b)(2), a transfer includes:

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(1) A contribution to the capital of a new19 or existing entity;

(2) A redemption, recapitalization, or other change in the capital structure of an entity (a “capital structure transaction”), if the transferor or an applicable family member receives an applicable retained interest in the capital structure transaction;

(3) A capital structure transaction, if either:

(a) The transferor or an applicable family member holding an applicable retained interest before the capital structure transaction receives property other than an applicable retained interest, or

(b) The fair market value of an applicable retained interest held by the transferor or an appli-cable family member before the capital structure transaction is increased; and

(4) A termination of an indirect holding in an entity.

Under Reg. §25.2701-1(b)(3)(i), a transfer does not include:

(1) A capital structure transaction (other than a contribution to capital or other increase in the value of the entity), if the transferor, each applicable family member, and each member of the transferor’s family holds substantially the same interest after the transaction as that individual held before the transaction. For this purpose, common stock with nonlapsing voting rights and nonvoting common stock would be interests that are substantially the same;

(2) A shift of rights occurring upon the execution of a qualified disclaimer under §2518; and

(3) A shift of rights occurring upon the exercise of a power of appointment other than a general power of appointment under §2514, except to the extent the exercise reduces the power-holder’s interest in the appointed property.

Attribution Rules

Under the attribution rules of §2701(e), an individual is deemed the owner of an interest to the ex-tent it is held indirectly by that individual through:

(1) A corporation,

(2) Partnership,

(3) Trust, or

(4) Other entity (§2701(e)(3)(A))20.

Note: If attribution results in any individual being treated as holding any interest, any transfer that results in the interest being treated as no longer held by that individual is treated as a transfer of the interest (§2701(e)(3)(A)).

Corporation

Equity interests held by or for a corporation are attributed to an individual shareholder in the ratio that the value of the shareholder’s stock bears to the value of all corporation stock (Reg. §25.2701-6(a)(2)).

19 The creation of a new entity presents the same opportunities for transferring wealth as a contribution to an existing

entity. 20 When an equity interest is deemed owned by an individual in more than one capacity, the interest is treated as held

in the manner that attributes the largest total ownership (Reg. §25.2701-6(a)(1)).

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Example

Dan owns 25% by value of each class of stock of XYZ Corporation. Persons unrelated to Dan own the remaining stock. XYZ Corporation owns 50% of the stock of ABC Cor-poration. XYZ Corporation’s interests in ABC Corporation are attributed proportion-ately to the shareholders of XYZ Corporation. Accordingly, Dan is considered to hold a 12.5% (25% X 50%) interest in ABC Corporation (Reg. §25.2701-6(b), Example (1)).

Example

Z Bank’s authorized capital consists of 100 shares of common stock and 100 shares of preferred stock. Dan holds 60 shares of each (common and preferred) and Dan’s child, Rocko, holds 40 shares of common stock. Z holds the balance of its own preferred stock, 30 shares as part of a common trust fund it maintains and 10 shares permanently set aside to satisfy a deferred obligation. For purposes of the special valuation rules, Dan owns 60 shares of common stock and 66 shares of preferred stock in Z, 60 shares of each class directly and 6 shares of preferred stock indirectly (60 percent of the 10 shares set aside to fund the deferred obligation). Reg. §25.2701-6(b), Example (2).

Partnership

Equity interests held by or for a partnership are attributed to an individual partner in the ratio that the larger of the partner’s profits interest or capital interest bears to the total partnership profits interests or capital interests (Reg. §25.2701-6(a)(3)).

Estate & Trust

Equity interests held by or for an estate21 or trust are attributed to an individual with a beneficial interest22 in the estate or trust to the extent the individual’s beneficial interest could be satisfied by the property held by the estate or trust, or the income or proceeds thereof23 (Reg. §25.2701-6(a)(4)(i)).

Example

An irrevocable trust holds a 10% general partnership interest in Partnership Q. One-half of the trust income is required to be distributed to O Charity. The other one-half of the income is to be distributed to Dan during Dan’s life and thereafter to Elane for such time as Elane survives Dan. Dan owns one-half of the trust’s interest in Q by rea-son of Dan’s present right to receive one-half of the trust’s income, and Elane owns

21 Property is held by a decedent’s estate if the property is subject to claims against the estate and expenses of admin-

istration (Reg. §25.2701-6(a)(4)(ii)(A)). 22 A person owns a beneficial interest in a trust or an estate so long as the person may receive distributions from the

trust or the estate other than payments for full and adequate consideration (Reg. §25.2701-6(a)(4)(ii)(B)). 23 Maximum use of the equity interest to satisfy the individual’s rights and maximum exercise of fiduciary discretion in

favor of the individual are assumed.

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one-half of the trust’s interest in Q by reason of Elane’s future right to receive one-half of the trust’s income. Nevertheless, no family member is treated as holding more than one-half of the trust’s interest in Q because at no time will either Dan or Elane actually hold, in the aggregate, any right with respect to income or corpus greater than one-half (Reg. §25.2701-6(b), Example (3)).

Example

An irrevocable trust holds a 10% general partnership interest in partnership M. One-half of the trust income is to be paid to Dan for life. The remaining income may, in the trustee’s discretion, be accumulated or paid to or for the benefit of a class that includes Dan’s child Rocko, in such amounts as the trustee determines. On the death of the survivor of Dan and Rocko, the trust corpus is required to be distributed to O Charity. The trust’s beneficiaries would hold the trust’s interest in M to the extent that present and future income or corpus may be distributed to them. Accordingly, Dan owns one-half of the trust’s interest in M because Dan is entitled to receive one-half of the trust income currently. Rocko owns the entire value of the interest because Rocko is a mem-ber of the class eligible to receive the entire trust income for such time as Rocko sur-vives Dan. The result would be the same if all the income were required to be paid to O Charity for the trust’s initial year (Reg. §25.2701-6(b), Examples (4) & (5)).

Any equity interest held by or for a trust deemed owned by an individual under the grantor trust rules is attributed to that individual (Reg. §25.2701-6(a)(4)(ii)(C)).

Siblings & Lineal Descendants

For purposes of determining whether an interest is a distribution right, an individual is treated as holding any interest held by his or her brothers, sisters, or lineal descendants (§2701(e)(3)(B)). In addition, the proposed regulations treated a transferor as holding any interest held by any lineal descendants of his or her parents or spouse (Reg. §25.2701-2(b)(5)(i)).

Note: The proposed regulations show how an interest would be attributed within a class of individ-uals if the above rules attribute an interest to more than one individual (Reg. §25.2701-6(a)(5)(i)).

Transfer Tax Adjustments

Under regulations prescribed by the Secretary, if there is any subsequent transfer, or inclusion in the gross estate, of any applicable retained interest which was valued under the zero value rule of §2701, appropriate adjustments are to be made for estate, gift, and generation-skipping transfer tax pur-poses to reflect the increase in the amount of any prior taxable gift made by the transferor or dece-dent by reason of such valuation (§2701(e)(6)).

Under Reg. §25.2701-5(a), if an applicable retained interest is valued under the zero value rule, the estate of the individual whose taxable gifts are determined under that rule would be entitled to a non-refundable credit against the estate tax.

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Splitting Retained Interests

Section 2701(e)(7) states that regulations may provide that any applicable retained interest be treated as two or more separate interests. Such treatment could allow value to be given to the par-ticipating feature of a participating preferred interest under the exception for retained interests that are of the same class as the transferred interest (Conf Rept No. 101-964 (PL 101-508) p. 1135).

Example

Mother owns all the stock in a corporation. One class is entitled to the first $10,000 in dividends each year plus half the dividends paid in excess of $10,000 that year; the second class is entitled to one-half of the dividends paid above $10,000. The preferred right under the first class is cumulative. Mother retains the first class and gives the second class to Child. Regs may treat an instrument of the first class as two instruments under the provision: one, an instrument bearing a preferred right to dividends of $10,000; the other, an instrument bearing the right to half the annual dividends in excess of $10,000, which would fall within the exception for retained interests of the same class as the transferred interest (Conf Rept No. 101-964 (PL 101-508) p. 1135, Example (3)).

Example

Father and Daughter enter into a partnership agreement under which Father is to re-ceive the first $1 million in net cash receipts and is thereafter to share equally in distri-butions with Daughter. Regs may treat Father’s retained interests as consisting of two interests: (1) a distribution right to $1 million and (2) a 50% partnership interest. Father could elect to treat the first interest as a right to receive qualified payments at specified amounts and times (see Q-3411); the second interest would fall within the exception for retained interests of the same class as the transferred interest (Conf Rept No. 101-964 (PL 101-508) p. 1135, Example (4)).

Regulation §25.2701-7 would exercise this authority by permitting taxpayers to request private letter rulings treating any applicable retained interest as two or more separate interests.

Subtraction Method

The amount of the gift resulting from any transfer to which section 2701 applies is determined by a subtraction method of valuation. Under the subtraction method established by the proposed regu-lations, the gift amount is determined by:

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(1) Subtracting the values24 of all senior25 equity interests from the value of the entity26 immedi-ately before the transfer, and

(2) Allocating the balance among the transferred interests and other same or subordinate class interests.

Three-Step Computation

The subtraction method requires the following steps to determine the value of the transferred interest:

Step 1. Determine the value of the entity, giving effect to appropriate adjustments to reflect the actual fragmented ownership (Reg. §25.2701-3(b)(1)).

Note: R.R. 59-60 and 83-120 would be applicable under this step.

Step 2. Reduce the value determined in Step 1 by the sum of:

(a) The fair market value of all senior equity interests other than applicable retained interests held by the transferor or applicable family members (Reg. §25.2701-3(b)(2)(i)), and

(b) The value of all applicable retained interests other than those included in (a) (Reg. §25.2701-3(b)(2)(ii)).

Step 3. Reduce the value determined in Step 2 by the fair market value of any equity interests of the same class as or a subordinate class to the transferred interests held by persons other than:

(a) The transferor,

(b) Members of the transferor’s family, and

(c) Applicable family members of the transferor (Reg. §25.2701-3(b)(3)(i)).

The remaining value after reduction is then allocated to the transferred interests and other in-terests of the same class or a subordinate class in a manner that fairly approximates their value as if rights valued at zero did not exist (Reg. §25.2701-3(b)(3)(ii)).

Example

Corporation X has outstanding 1,000 shares of $1,000 par value voting preferred stock, each share of which carries a cumulative annual dividend of 8% and a right to put the stock to X for its par value at any time. In addition, there are outstanding 1,000 shares of non-voting common stock. Sixty percent (determined by value) of the preferred stock and 75% (determined by value) of the common stock is held by A, and the balance of the preferred and common stock is held by B, a person unrelated to A. The fair market value of each share of preferred stock (without regard to the special valuation rules) is $1,000. A’s put right would be an extraordinary payment right valued at zero, and A’s cumulative dividend right, which would be a qualified payment right would be valued (taking account of A’s voting rights but disregarding

24 Determined using the special valuation rules of Chapter 14. 25 A senior equity interest has a right to distributions of income or capital that is preferred to the rights of the transferred

interest (Reg. §25.2701-3(a)). 26 The value of the entity would be the fair market value of the entire corporation or partnership, immediately before

the transfer, with appropriate adjustment for minority discount or control premium.

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A’s put right) at $800 per share. A transfers all of A’s common stock to A’s child. The method for determining the amount of A’s gift would be as follows:

Step 1: Assume the value of X, after taking account of applicable discounts that re-flect the actual fragmented ownership of the various interests, is determined to be $1.5 million.

Step 2: From the amount determined under Step 1, subtract $880,000, the sum of the following:

(a) $400,000 (the fair market value of the preferred stock held by persons other than the transferor, members of the transferor’s family and applicable family mem-bers); and

(b) $480,000 (the value of A’s preferred stock; i.e., 60 percent of the $800,000 value of the preferred stock computed under the “lower of” rule. The result of Step 2 is a balance of $620,000. This would be the aggregate value of the common stock.

Step 3: From the value determined under Step 2, subtract the fair market value of B’s common stock (assumed for this purpose to be $125,000). The difference ($495,000) would be the amount of A’s gift. Reg. §25.2701-3(d), Example (1).

Valuation Adjustment

When the transferor and applicable family members own a greater proportion of any senior eq-uity interest than the largest proportion of any class of subordinate interest (or aggregate thereof) held by the family27, an adjustment must be made under Step 2 of the three-step sub-traction method (Reg. §25.2701-3(b)(4)(i)).

For purposes of Step 2, the percentage (determined on the basis of the relative fair market val-ues) of any class of applicable retained interest held by the transferor and by applicable family members that exceeds the family interest percentage is not valued at the value determined un-der the special Chapter 14 valuation rules but rather is valued at the same value per share (or similar unit of interest) as interests of the same class held by individuals other than the transferor and applicable family members.

If the transferor and applicable family members hold all the applicable retained interests in any class, the percentage of the class that exceeds the family interest percentage is valued at its pro-rata share of the fair market value of the entire class (Reg. §25.2701-3(b)(4)(ii)).

27 That is, the transferor, members of the transferor’s family, and applicable family members of the transferor (Reg.

§25.2701-3(b)(3)(i)).

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Review Questions

84. Four transactions are identified under Reg. §25.2701-1(b)(2) as being transfers of interests in a corporation or a partnership under §2701. Which of the following is such a transfer under this regulation?

a. a capital structure transaction, if interests owned by a transferor, his or her family mem-bers, and applicable family members subsequent to the transaction are to a large extent equal to the interests owned prior to the transaction.

b. a change in an entity’s capital structure, if an applicable retained interest in the said trans-action is received by a transferor or applicable family member.

c. rights shift due to the carrying out of a qualified disclaimer under §2518.

d. rights shift due to the implementation of a power of appointment, other than a general power of appointment, under §2514.

85. Taxpayers must determine the amount of a gift that is produced from any transfer subject to §2701. What primary process is used to calculate this amount?

a. the subtraction method.

b. adding all senior equity interests’ values to the entity’s value directly preceding the trans-fer.

c. the attribution rules.

d. the zero value rule.

86. There are three computational steps in the subtraction method. What is the first step?

a. Ascertain the entity’s value, taking into consideration any adjustments to show the actual divided ownership.

b. Subtract the fair market value of all senior equity interests besides the transferor’s or ap-plicable family members’ applicable retained interests from the entity’s value.

c. Subtract the fair market value of any equity interests of the same class or a subordinate class to the transferred interests held from the entity’s value.

d. Subtract the value of all applicable retained interests from the entity’s value.

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Transfers of Interests in Trust - §2702

The valuation rules of §2702 apply to transfers of interests in trust to or for the benefit of a member of the transferor’s family if the transferor or any applicable family member retains any interest in the trust.

Definitions

The following definitions apply for purposes of §2702:

Applicable Family Member

The definition of “applicable family member” is the same as the definition of the term for pur-poses of the valuation rules for transfers of interests in corporations and partnerships.

Member of the Family

With respect to any individual, member of the family means:

(1) The individual’s spouse,

(2) Any ancestor or lineal descendant of the individual or the individual’s spouse,

(3) Any brother or sister of the individual, and

(4) Any spouse of the foregoing (Reg. §25.2702-2(a)(1)).

Note: This definition of “member of the family” is broader than the definition of the term for pur-poses of the valuation rules for transfers of interests in corporations and partnerships.

Transfer in Trust

A transfer in trust includes a transfer to a new or existing trust and an assignment of an interest in an existing trust. The transfer of an interest in property with respect to which there is one or more term interests is also treated as a transfer of an interest in a trust (§2702(c)(1)).

Transfer in trust does not include either the exercise of a power of appointment that is not a general power of appointment under §2514 or the execution of a qualified disclaimer under §2518 (Reg. §25.2702-2(a)(2)).

Term Interest

Term interest means:

(a) A life interest in property, or

(b) An interest in property for a term of years (§2702(c)(3)).

Retained

Retained means held by the same individual both before and after the transfer in trust. In the case of a creation of a term interest, any interest in the property held by the transferor

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immediately after the transfer is treated as held both before and after the transfer (Reg. §25.2702-2(a)(3))

Zero Value Rule

The value of any interest in a trust retained by the transferor or any applicable family member (except for certain term interests in tangible property) that is not a qualified interest is treated as being zero (§2702(a)(1)).

Under Reg. §25.2702-1(b), if the zero value rule applies, the amount of gift amount is determined by subtracting the value of any interest in the trust that the transferor or any applicable family member has retained from the value of the transferred property (i.e., the “subtraction method”).

Thus, a person who makes a completed transfer of nonresidential property in trust and retains:

(a) The right to the income of the trust for a term of years, and

(b) A reversionary right (or a testamentary general power of appointment with respect) to trust corpus

is treated as making a transfer equal to the value of the whole property (S Rept, PL 101-508, 11/5/90, p. 66).

Example

A transfers property to an irrevocable trust, retaining the right to receive the income of the trust for 10 years. On the expiration of the 10-year term, the trust is to terminate and the trust corpus is to be paid to A’s child. However, if A dies during the 10-year term, the entire trust corpus is to be paid to A’s estate at that time. Each retained interest is valued at zero because it is not a qualified interest. Thus, the amount of A’s gift is the fair market value of the property transferred to the trust (Reg. §25.2702-2(d), Example (1)).

The same result obtains if the transferor retains:

(1) The right to both income and appreciation for a term of years, plus

(2) A testamentary general power of appointment over trust corpus for that period (S Rept, PL 101-508, 11/5/90, p. 66).

In contrast, the creation of a trust the only interests in which are an annuity for a term of years and a noncontingent remainder interest is valued under pre-Chapter 14 tax law (S Rept, PL 101-508, 11/5/90, p. 66).

Qualified Interest

A qualified interest is a:

(a) Qualified annuity interest28 - i.e., any interest which consists of the right to receive fixed amounts payable not less frequently than annually (§2702(b)(1)),

28 Reg. §25.2702-2(a)(5)

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(b) Qualified unitrust interest29 - i.e., any interest which consists of the right to receive amounts which are payable not less frequently than annually and are a fixed percentage of the fair market value of the property in the trust (determined annually) (§2702(b)(2)), and

(c) Qualified remainder interest30- i.e., any noncontingent remainder interest if all of the other interests in the trust consist of interests described in (a) or (b). (§2702(b)(3)).

Section 2702(a)(2)(B) provides that the value of any retained interest which is a qualified interest is determined under §7520. Thus, a qualified interest generally is valued under pre-Chapter 14 tax law. (S Rept, PL 101-508, 11/5/90, p. 66)

Exceptions to §2702

Section 2702 does not apply to any transfer:

(1) To the extent such transfer is an incomplete gift (§2702(a)(3)(A)(i)),

Note: To qualify for this exception, the entire gift must be incomplete.

(2) If such transfer involves the transfer of an interest in trust all the property in which consists of a residence to be used as a personal residence by persons holding term interests in such trust (§2702(a)(3)(A)(i)), or

(3) To the extent that regulations provide that such transfer is not inconsistent with the purposes of §2702.

Note: For example, this authority could be used to except a charitable remainder trust that meets the requirements of §664 and that does not otherwise transfer property to a family member free of transfer tax.

Incompleted Gift

The term incomplete gift means any transfer that would not be treated as a gift whether or not consideration was received for such transfer. (§2702(a)(3)(B)).

Term Interests

Under §2702(c)(1), the transfer of an interest in property with respect to which there is one or more term interests is treated as a transfer of an interest in a trust. A term interest is a life interest in property or an interest in property for a term of years.

Successive v. Concurrent

Under Reg. §25.2702-4(a), a term interest is one of a series of successive (as contrasted with concurrent) interests. Thus, a life interest in property or an interest in property for a term of years would be a term interest.

However, a term interest would not include a fee interest in property merely because it is held as a tenant in common, a tenant by the entirety, or a joint tenant with right of survivorship.

29 Reg. §25.2702-2(a)(6) 30 Reg. §25.2702-2(a)(7)

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Example

G and G’s child each acquire a 50% undivided interest as tenants in common in an office building. The interests of G and G’s child would not be term interests to which the zero value rule applies (Reg. §25.2702-4(d), Example (3)).

Leasehold

Under Reg. §25.2702-4(b), a leasehold interest in property is not a term interest to the extent the lease is for full and adequate consideration. A lease is to be considered for full and adequate consideration if a good faith effort is made to determine the fair rental value of the property and the terms of the lease conform to the value so determined.

Joint Purchases

If:

(1) An individual acquires a term interest in property, and

(2) In the same transaction (or series of transactions), one or more members of the individual’s family acquire an interest in the same property,

the individual acquiring the term interest is treated as:

(1) Acquiring the entire property acquired by the individual and all members of the individual’s family, and

(2) Transferring to the other family members the interests acquired by the other family members in exchange for any consideration paid by the other family members.

Example

A purchases a 20-year term interest in an apartment building and A’s child purchases the remainder interest in the property. A and A’s child each provide the portion of the purchase price equal to the value of their respective interests in the property deter-mined under section 7520. Solely for purposes of section 2702, A is treated as acquiring the entire property and transferring the remainder interest to A’s child in exchange for the portion of the purchase price provided by A’s child. In determining the amount of A’s gift, A’s retained interest is valued at zero because it is not a qualified interest (Reg. §25.2702-4(d), Example (1)).

Example

K holds rental real estate valued at $100,000. K sells a remainder interest in the prop-erty to K’s child, retaining the right to receive the income from the property for 20 years. Assume the purchase price paid by K’s child for the remainder interest is equal to the value of the interest determined under section 7520. K’s retained interest is not a qualified interest and is therefore valued at zero. K has made a gift in the amount of $100,000 less the consideration received from K’s child (Reg. §25.2702-4(d), Example (2))

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The amount considered transferred by the individual acquiring the term interest shall not exceed the amount of consideration furnished by the individual for all interests acquired by the individual in the property (§2702(c)(2)).

Thus, for purposes of determining the amount of the gift, §2702 effectively treats the purchaser of a life estate under a joint purchase as making a transfer of the entire property less the consideration paid by the remainderman. (S Rept p. 67)

Example

B buys a life estate in property from R, B’s grandparent, for $10,000. The value of the life estate determined under Code Sec. 7520 is $25,000. R transfers the remainder in-terest in the property to B’s child by gift. B would be treated as acquiring the entire property and transferring the remainder interest to B’s child. However, the amount of B’s gift would be limited to $10,000, the amount of consideration furnished by B for B’s interest (Reg. §25.2702-4(d), Example (4)).

Term Interests in Tangible Property

If the nonexercise of rights under a term interest in tangible property would not have a substan-tial effect on the valuation of the remainder interest in the property, the term interest is not treated as having a zero value (§2702(c)(4)(A)).

The value of the term interest is the amount that the holder of the term interest establishes as the amount for which the interest could be sold to an unrelated third party (§2702(c)(4)(B)). If the taxpayer cannot establish the value of the term interest, the zero value rule or the rules for valuing qualified interests apply (Reg. §25.2702-2(c)(1)).

Example

A buys a 10-year income interest in a painting. The painting does not have an ascer-tainable useful life. B, A’s child, buys the remainder interest in the painting. A and B each pay a portion of the total purchase price ($2,000,000) determined by valuing their respective interests under Code Sec. 7520. A, as holder of the term interest, is treated as acquiring the painting and transferring the remainder interest to B. A’s income in-terest would not be a qualified interest. However, because of the nature of the prop-erty, A’s failure to exercise A’s rights with regard to the painting would not be expected to cause the value of the painting to be higher than it would otherwise be at the time it passes to B. For example, if A placed the painting in storage, foregoing A’s right to realize the rental value or otherwise to enjoy A’s rights in the painting, the value of the painting would not be increased at the time it passed to B. In addition, the painting would not be depreciable if it were used in a trade or business or held for the produc-tion of income. Accordingly, A’s interest would be valued under the rule in this para-graph. Assume that A furnishes $750,000 of the purchase price and that A establishes that a willing buyer of A’s interest would pay $100,000 for the interest. The amount of A’s gift would be $650,000 ($750,000 minus $100,000). Reg. 25.2702-2(d), Example (7).

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Transfers of Interest in Portion of Trust

In the case of a transfer of an income or remainder interest with respect to a specified portion of the property in a trust, only that portion is taken into account in applying the valuation rules of Chapter 14 to the transfer (§2702(d))

Buy-Sell Agreements & Options - §2703

Section 2703 provides that for estate, gift, and generation-skipping transfer tax purposes, the value of any property is determined without regard to:

(1) Any option, agreement, or other right to acquire or use the property at a price less than the fair market value of the property without regard to the option, agreement, or right (§2703(a)(1)), or

(2) Any restriction on the right to sell or use the property (§2703(a)(2)).

A right or restriction may be contained in a partnership agreement, articles of incorporation, corpo-rate bylaws, a shareholders’ agreement, or any other agreement. A right or restriction may be im-plicit in the capital structure of an entity.

However, a perpetual restriction on the use of real property that qualified for deduction under §170(h) is not treated as a right or restriction.

Exceptions to §2703

Section 2703 does not apply to any option, agreement, right, or restriction that meets each of the following three requirements:

(1) It is a bona fide business arrangement.

(2) It is not a device to transfer such property to members of the decedent’s family for less than full and adequate consideration in money or money’s worth.

(3) Its terms are comparable to similar arrangements entered into by persons in an arms’ length transaction (2703(b)).

Each of the three requirements must be independently satisfied. Thus, for example, the mere show-ing that a right or restriction is a bona fide business arrangement is not sufficient to establish the absence of a device to transfer property for less than full and adequate consideration.

Arm’s Length Bargain

Requirement (3) requires that the taxpayer show that the agreement was one that could have been obtained in an arm’s length bargain. A right or restriction is comparable to similar arrangements entered into by persons in an arm’s length transaction if the right or restriction is one that could have been obtained in a fair bargain among unrelated parties in the same business.

This determination generally will entail consideration of such factors as the expected term of the agreement, the current fair market value of the property, anticipated changes in value during the term of the arrangement, and the adequacy of any consideration given in exchange for the rights granted.

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A right or restriction is considered a fair bargain among unrelated parties in the same business if it conforms to the general practice of unrelated parties under negotiated agreements in the same busi-ness. While it is not necessary that the terms of a right or restriction parallel the terms of any partic-ular agreement, evidence of general business practice is not met by showing isolated comparables. If two or more valuation methods are commonly used in a business, a right or restriction does not fail to evidence general business practice merely because it uses one of the recognized methods. In the unusual case where comparables are difficult to find because the business is unique, compara-bles from similar businesses may be used.

Substantial Modifications

A right or restriction that is substantially modified is treated as a right or restriction created on the date of the modification. Any discretionary modification of a right or restriction, whether or not au-thorized by the terms of the agreement, that results in other than a de minimis change to the quality, value, or timing of the right or restriction is a substantial modification. If the terms of the right or restriction require periodic updating, the failure to update is presumed to substantially modify the right or restriction unless it can be shown that updating would not have resulted in a substantial modification. The addition of any family member as a party to a right or restriction is considered a substantial modification (unless the addition is mandatory under the terms of the right or re-striction).

Exceptions

The following are not considered a substantial modification:

(a) A modification required by the terms of a right or restriction;

(b) A discretionary modification of the agreement containing a right or restriction that does not change the right or restriction;

(c) A modification of a capitalization rate used with respect to a right or restriction if the rate is modified in a manner that bears a fixed relationship to a specified market interest rate; and

(d) A modification that results in an option price that more closely approximates fair market value.

Chapter 14 of the Code does not otherwise alter the requirements for giving weight to a buy-sell agreement. For example, it leaves intact rules requiring that an agreement has lifetime restrictions in order to be binding on death (Senate Finance Committee Report S. 3209 (October 18. 1990)).

Lapsing Rights & Restrictions - §2704

If:

(1) There is a lapse of any voting or liquidation right in a corporation or partnership, and

(2) The individual holding such right immediately before the lapse and members of such individ-ual’s family hold, both before and after the lapse, control of the entity,

such lapse shall be treated as a transfer by such individual by gift, or a transfer which is includible in the gross estate of the decedent, whichever is applicable (§2704).

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If the lapse of a voting right or a liquidation right occurs during the holder’s lifetime, the lapse is a transfer by gift. If the lapse occurs at the holder’s death, the lapse is a transfer includable in the holder’s gross estate.

Example

D owns all the preferred stock of corporation Y and D’s children own all the common stock. The preferred stock has 60 percent of the total voting power and the common stock has 40 percent. Under the corporate by-laws, the voting rights of the preferred stock terminate on D’s death. On D’s death, D’s gross estate includes an amount equal to the excess, if any, of the fair market value of the preferred stock immediately after D’s death (determined as though the voting rights had not lapsed and would not lapse) and the fair market value of the preferred stock determined after the lapse of the vot-ing rights (Reg. §25.2704-1(h), Example (1)).

Example

D owns all the preferred stock of corporation Y. The preferred stock and the common stock each carry 50 percent of the total voting power of Y. D’s children own 40 percent of the common stock and unrelated parties own the remaining 60 percent. Under the corporate by-laws, the voting rights of the preferred stock terminate on D’s death. Section 2704(a) does not apply to the lapse of D’s voting rights because members of D’s family do not control Y after the lapse (Reg. §25.2704-1(h), Example (2)).

Definitions

Member of the Family

The definition of “member of the family” is the same as the definition of the term for purposes of the valuation rules for transfers of interests in trusts, term interests, and joint purchases (§2702).

Lapse

A lapse of a voting or liquidation right occurs at the time a presently exercisable right is restricted or eliminated.

Voting Right

A voting right is a right to vote with respect to any matter of the entity. Thus, for example, the right of a shareholder to vote only with respect to the election of corporate directors is a voting right. In the case of a partnership, the right of a general partner to participate in partnership management is a voting right.

Liquidation Right

A liquidation right is a right to compel the entity to acquire all or a portion of the holder’s equity interest in the entity. A right is a liquidation right even though its exercise would not result in the

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complete liquidation of the entity. For purposes of this section, the right to compel liquidation by reason of aggregate voting power is a liquidation right only with respect to interests other than the interest conferring the power.

Control

The term “control” is the same as the definition of the term for purposes of §2701.

Amount of Transfer

The amount of the transfer is the excess (if any) of:

(1) The value of all interests in the entity held by the individual immediately before the lapse (determined as if the voting and liquidation rights were nonlapsing), over

(2) The value of such interests immediately after the lapse (§ 2704(a)(2)).

Example

Father and Child each own general and limited interests in a partnership. The general partnership interest carries with it the right to liquidate the partnership; the limited partnership interest has no such right. The liquidation right associated with the general partnership interest lapses after ten years. Under §2704, there is a gift at the time of the lapse equal to the excess of (1) the value of Father’s partnership interests deter-mined as if he held the right to liquidate over (2) the value of such interests determined as if he did not hold the right (Conf Rept p. 1138, Example (7)).

Restrictions on Liquidations Disregarded

Under §2704(b)(2), if a corporation or partnership interest is transferred to or for the benefit of a member of the transferor’s family, and the transferor and members of his or her family, immediately before the transfer, control of the entity31, any applicable restriction is disregarded in valuing the transferred interest.

An applicable restriction is a restriction limiting the ability of the corporation or partnership to liqui-date, if:

(1) The restriction lapses after the transfer of the interest, or

(2) The transferor or any member of his or her family32 has the right after the transfer to remove the restriction (§2704(b)(2)).

Example

Mother and Son are partners in a two-person partnership. The partnership agreement provides that the partnership cannot be terminated. Mother dies and leaves her part-nership interest to Daughter. As the sole partners, Daughter and Son acting together

31 §2704(b)(1)(B) 32 Under this rule, “member of the family” means spouse, any ancestor or lineal descendant of the individual or the

individual’s spouse, any brother or sister and any spouse of any individual described (§2704(c)(2)).

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could remove the restriction on partnership termination. The value of Mother’s part-nership interest in her estate is determined without regard to the restriction (Conf Rept No. 101-964 (PL 101-508) p. 1138, Example (8)).

An applicable restriction does not include:

(1) Any commercially reasonable restriction which arises as part of any financing by the corpora-tion or partnership with a person who is not related (as described in §267(b)) to the transferor or transferee, or a member of the family of either, or

Note: The financing has to be for trade or business operations (Reg. §25.2704-2(b)).

(2) Any restriction imposed, or required to be imposed, by any Federal or State law (§2704(b)(3)(A)).

Example

D and D’s children, A and B, are partners in limited partnership Y. Each has a 3.33% general partnership interest and a 30% limited partnership interest. Any general part-ner has the right to liquidate the partnership at any time. As part of a loan agreement with a lender who is related to D, each of the partners agreed that the partnership would not be liquidated without the lender’s consent while any portion of the loan remains outstanding. During the term of the loan agreement, D transfers one-half of both D’s partnership interests to each of A and B. Because the lender is a related party, the requirement that the lender consent to liquidation would be an applicable re-striction and the transfers of D’s interests would be valued as if such consent were not required (Reg. §25.2704-2(d), Example (4)).

Attribution Rules

The attribution rules of §2701 apply for purposes of determining the interests held by any individual.

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Review Questions

87. Section 2702 provides special valuation rules for certain transfers of interests in trust. Under Reg. §25.2702-2(a)(2), which transaction fails to qualify as such a transfer in trust?

a. a transfer to a trust that is newly established.

b. a transfer of an interest in a trust that has existed for many years.

c. an implementation of a power of appointment other than a general power of appointment under §2514.

d. a transfer of a property interest where there is at least one term interest in the property.

88. The zero value rule applies to the value of an unqualified interest in a trust that a transferor keeps. However, under §2701(a)(1), which transaction is treated as a transfer equal to the value of the entire property?

a. a transfer to a charitable remainder trust that meets the requirements of §664 and does not otherwise transfer property to a family member free of transfer tax.

b. a completed transfer of nonresidential property in trust where a transferor keeps the right to the income and assets in the trust for a certain period.

c. a transfer of property in trust that is an incomplete gift.

d. a transaction that involves a transfer of an interest in trust which includes a home that individuals who own term interests in such trust will use as a personal residence.

89. A substantial modification is treated as a right or restriction established on the modification date. What is considered a substantial modification?

a. a discretionary modification of a right or restriction that causes other than minor alteration of its quality.

b. a discretionary modification of the agreement that holds a right or restriction that does not change it.

c. an obligatory modification mandated by the terms of a right or restriction.

d. a modification that produces an option price that more closely resembles fair market value.

90. Section 2704 provides special rules for lapsing rights and restrictions. How is a lapse treated if it takes place at the death of the person holding a right?

a. as a substantial modification.

b. as a transfer by gift.

c. as a transfer that must be included in the holder’s gross estate.

d. as an arm’s length bargain.

91. Section 2704 defines several terms used in its coverage of lapsing rights and restrictions. Which term is used for a right to force an entity to partially or wholly acquire an equity interest in said entity that is held by an individual?

a. a lapse.

b. a liquidation right.

c. a voting right.

d. control.

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Learning Objectives

After reading Chapter 9, participants will be able to:

1. Recall estate management techniques for the elderly and disabled by:

a. Identifying joint tenancy and the benefits and drawbacks of using such a method for asset management;

b. Specifying levels of conservatorship that can influence management and protection of an estate and/or personal care and disadvantages of this tool; and

c. Determining what constitutes a durable power recognizing advantages of establishing a revocable living trust as a way to manage assets in an estate.

2. Cite the eldercare benefits of Medicare, Medicaid, and Supplemental Security Income, identify disadvantages of the Medicaid program stating how to divide income into asset groups, specify the dangers and benefits of gifting to family members, including how indi-viduals might use private insurance for catastrophic illness.

3. Identify tools that can allow patients to refuse treatment even when incompetent, de-termine Supplemental Security Income specifying how it relates to elderly and disability planning, and specify the requirements that must be met in order to receive disability ben-efits.

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CHAPTER 9

Elderly & Disabled Planning

As we move into the 21st century, we are facing a period of tremendous social change. In the next 40 years, the population of people over 65 will almost double. With increasing age comes more frailty and illness. Because of better health care and resulting longer life expectancies, there is an increasing chance that many will become incompetent or disabled prior to death.

Planning for the elderly and disabled can be divided into three areas:

(1) Managing the estate of the elderly, incompetent, or disabled person;

(2) Preventing the estate from being dissipated for the costs of catastrophic or other long-term illness; and

(3) Designating someone to make health care decisions.

Managing the Estate

There are several ways to manage the estate of an incompetent person:

(1) Joint tenancy

(2) Court-appointed conservator or guardian,

(3) Durable power of attorney, or

(4) Funded revocable living trust.

Joint Tenancy

Joint tenancy is a common method of managing an elderly or disabled person’s assets. Typically, a spouse or child is added to the elderly or disabled person’s bank account and, thereafter, bills are paid from that account.

No court procedure is necessary to establish joint tenancy. On the other hand, there is no court su-pervision either. A joint tenant could take all the funds in the joint bank account.

While joint tenants have broad powers, they have difficulty selling assets (since they are fractional owners) and cannot authorize medical care or hospitalization.

Normally, there is no special income or gift tax aspect for joint tenancy bank accounts where the funds are used for the elderly or disabled person. However, if a joint tenancy is created in other assets such as real estate, an immediate taxable gift (§6019) can result along with potential tax lia-bility for income from the property.

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On death, the transfer of joint tenancy assets to the surviving joint tenant will avoid probate. As a result, they pass outside of a person’s will. In addition, avoiding probate does not necessarily avoid federal estate tax. Under §2040, the entire value of joint tenancy property is includable in the dece-dent’s estate (less contribution by the other joint tenant) for federal estate tax purposes. An excep-tion to this rule applies to spouses (§2040(b)).

Conservatorship

A conservatorship is a court-supervised proceeding for the management of a disabled or incompe-tent person’s estate and/or personal care. Normally, the court appoints the conservator of the estate and person at the same time.

Many states permit, a person, while competent, to nominate one or more persons to act as conser-vator should the need arise (See Calif. Probate §1810). If no advance nomination has been made, family members or their nominees frequently have statutory preferences for appointment (See Calif. Probate §1812). However, if a person has no spouse or children willing to accept that responsibility, the court will appoint a conservator.

There can be a variety of “levels” or types of conservatorship:

(1) Limited conservatorship- Where a mentally disabled adult can still handle certain matters but requires management or protection in others, a limited conservatorship can be established (Calif. Probate §1801(d)).

(2) Full conservatorship - When a person is a life risk to themselves or others and in need of hospitalization in a psychiatric facility, a full conservatorship may be granted (Calif. Welf & Inst §5350 et seq.).

(3) Traditional conservatorship - If an elderly or disabled person needs court-supervised help and protection in managing his or her medical and financial affairs, a traditional conservatorship is used (Calif. Probate §1800 through §1910).

While a conservatorship is sometimes the only device available for an elderly or disabled person who refuses to cooperate, there are disadvantages to a conservatorship:

(1) The elderly or disabled person is publicly adjudicated as unable to manage his or her affairs;

(2) There are substantial costs for such items as periodic legal fees, court costs, court investiga-tion fees, and accounting fees;

(3) The person’s assets become a matter of public record;

(4) A conservator’s powers are often limited since court approval must be obtained for most sales and distributions; and

(5) When the person dies, his or her estate may have to be probated if other estate planning has not been done.

Durable Power

A power of attorney permits a designated party (“agent”) to act on behalf of another person (“prin-cipal”). A durable power of attorney is a power of attorney that continues after incapacity. However, if the person who granted the durable power of attorney is still competent, he or she can revoke the power. Most states permit a durable power.

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Typically, a durable power of attorney contains the words “This power of attorney shall not be af-fected by subsequent disability or incapacity of the principal,” or “This power of attorney shall be-come effective upon the disability or incapacity of the principal,” or similar words showing the same intent (Uniform Durable Power of Attorney Act §1). The power should state how disability is proved, such as by the opinion of two licensed physicians; otherwise, third parties may be unwilling to deal with the agent (Calif. CC §2475 for a statutory form).

A durable power of attorney can be a general power granting all powers exercisable by the principal or limited to specific acts, such as selling a certain property, operating a business, or transferring assets to a revocable living trust.

Note: A power of attorney cannot delegate the power to make and execute a will. It can grant the right to make gifts to third persons. However, if the agent can make gifts to themselves, it will be a general power and may have adverse tax consequences.

While a durable power of attorney is a simple and inexpensive tool, there are several disadvantages:

(1) The agent is not court-supervised,

(2) Third parties may be reluctant to recognize the power, and

Note: Some title companies question the validity of the Uniform Durable Power of Attorney Act. Banks may only recognize a power if their form is used.

(3) When the principal dies, his or her estate may have to be probated.

Revocable Living Trust

Another management method is a revocable living trust. A person could create a revocable living trust while competent; then transfer the estate to it providing for a successor trustee to act in the event of later incapacity. A variation on this method could be the creation of an unfunded revocable living trust (while competent) together with a durable power of attorney giving the agent power to transfer assets into the trust.

A revocable living trust has many advantages:

(1) No court approval is needed

(2) It is widely accepted by third parties;

(3) There is no public disclosure of assets;

(4) Duties and responsibilities of the trustee can be specified;

(5) Continuous and consistent management can be provided; and

(6) At death, probate can be avoided.

Catastrophic illness

Catastrophic illness requiring long-term care is a concern for all. Medicare and most private insurance do not cover the cost of such care. In addition, the problem can be acute when family members depend on the sick person for support.

Medical expenses are paid through one of four sources:

(1) Cash

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(2) Medicare

(3) Medicaid, and

(4) Private insurance.

Medicare

Medicare is an entitlement program for the elderly. It is the primary insurance plan covering people on Social Security. Assistance with hospital and medical bills is given to persons who have paid into the system. Medicare is available to the elderly regardless of their financial status.

Before 1984, Medicare paid all medical bills submitted by the hospital. This system resulted in enor-mous expense and was changed in 1984. A new reimbursement system called Diagnosis Related Groupings (DRGs) was established.

Medicare now pays the hospital a flat rate. When the hospital can “stabilize” the patient for less, it keeps the difference. If not, the hospital pays the additional costs. Obviously, there is an incentive for the hospital to move a patient out once stabilized.

Note: Stabilized does not mean that the patient has gotten better. It means the illness won’t get worse.

Medicaid

Title XIX of the Social Security Act is a program that provides medical assistance for certain individuals with disabilities and families with low incomes and resources. The program, known as Medicaid, be-came law in 1965 as a jointly funded cooperative venture between the Federal and State govern-ments to assist States in the provision of adequate medical care to eligible needy persons.

Note: Medicaid is the largest program providing medical and health-related services to America’s poorest people and the largest single funding source for nursing homes and institutions for people with disabilities in the U.S.

Medicaid is a joint federal-state program. Unlike Medicare, it is an entitlement program based on income and asset guidelines. The federal contribution is approximately 50%. The states pay the re-maining costs and they are given wide discretion about whom to cover and what benefits to provide. There is a single state agency in charge of the program in each state, but many states have the pro-gram administered by county and city governments.

Within broad national guidelines which the Federal government provides, each of the States:

(1) Establishes its own eligibility standards;

(2) Determines the type, amount, duration, and scope of services;

(3) Sets the rate of payment for services; and

(4) Administers its own program.

Thus, the Medicaid program varies considerably from State to State, as well as within each State over time.

Medicaid is a means-tested assistance program, i.e., one must qualify to receive assistance. In gen-eral, there are two ways to receive Medicaid:

(1) Be a member of a mandatory eligibility group, or

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Note: States are required to provide Medicaid coverage for most individuals who receive federally assisted income maintenance payments, as well as for related groups not receiving cash payments. Some examples of the mandatory Medicaid eligibility groups are:

(a) Recipients of Aid to Families with Dependent Children (AFDC),

(b) Supplemental Security Income (SSI) recipients, and

(c) Infants born to Medicaid-eligible pregnant women.

(2) “Spend down” your assets.

Note: Medicaid requires persons to “spend down” their assets before they get government assis-tance. The requirements of each state differ.

When savings are gone, Medicaid picks up medical costs. For married couples, this means the well spouse will be impoverished. The Spousal Impoverishment Act of 1989 seeks to correct this problem by setting aside a portion of the couple’s assets and income for the well spouse. However, it is still too early to judge its impact.

Assets and income determine eligibility for Medicaid. Income is all money or funds received from whatever source including:

(1) Social security and private pensions,

(2) Interest, investment, and rental income,

(3) Funds transferred from family members, and

(4) Trust distributions and income.

When a person has monthly income exceeding the nursing home bill, the person pays the nursing home directly.

When a person’s monthly income is less than the nursing home bill:

(1) In about half of the states, Medicaid has them give it to the home and Medicaid makes up the difference;

(2) In the remainder of the states, if the applicant’s monthly income exceeds a “cap” ($2,382 in 2021) he or she cannot qualify for Medicaid or SSI (See http://medicaid.gov ).

However, most states allow a person to keep:

(1) A personal needs allowance

(2) A home maintenance allowance if planning to go home, and

(3) A monthly premium to pay for medical insurance.

Income rules do not apply to the well spouse’s separate income. In addition, Federal law requires states to let the well spouse keep a specified amount from total joint income (the minimum is $2,155 per month, the maximum is $3,259 in 2021). (See http://medicaid.gov ) The well spouse has the opportunity to increase the state-set amount if he or she can show that his or her housing expenses are unusually high.

Example

Dan and Althea’s only income is $2,400 a month in social security. Of that, $ 2,200 is Dan’s, $200 is Althea’s. If Dan goes into a nursing home he will be allowed to make the following deductions from his $2,200:

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(1) A personal needs account (approximately $50 a month in most states)

(2) The premium for his insurance policy that pays the deductibles on his Medicare policy

(3) $1,857.50 monthly to supplement Althea’s $200 a month since the minimum spousal allowance is $2,155 Althea’s separate income is unaffected. If working, Althea can keep her entire salary. She does not have to make a contribution to Dan’s nursing home expense.

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Assets are divided into three groups:

(1) Countable,

(2) Non-countable, and

(3) Inaccessible.

Countable Assets

Countable assets are non-exempt assets and must be spent to zero before Medicaid is available. These assets include:

(i) Cash over $2,000 (for most states),

(ii) Stocks and bonds,

(iii) Individual retirement accounts (IRAs) and Keoghs,

(iv) Certificates of deposit,

(v) Single premium deferred annuities,

(vi) Treasury notes and bills,

(vii) Savings bonds,

(viii) Investment property,

(ix) Whole life insurance above a certain amount,

(x) Vacation homes,

(xi) Second vehicles, and

(xii) Any other asset not specifically listed as exempt.

Non-Countable Assets

Non-countable assets are exempt and are not counted in determining eligibility for Medicaid. Non-countable assets include:

(i) A primary residence (this might include a multi-family home),

(ii) A limited amount of cash (usually $2,000 in most states),

(iii) A car,

(iv) Personal jewelry and household effects,

(v) A prepaid funeral or burial account (not to exceed $2,500 in most states),

(vi) Business property, and

(vii) Term life insurance policies without cash surrender value.

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Personal Residence

While a person’s home is listed as a non-countable asset, every state has the power to put a lien on the home to recover the cost of Medicaid. Generally, the lien can only be placed on the home after death.

For married couples, the lien can only be placed on the home if there is no surviving spouse. Thus, the surviving spouse cannot only live in the house after the Medicaid recipient spouse’s death but also transfer it without being subject to such a lien.

Single people do not fare so well. If a person is:

(a) Single,

(b) In a nursing home, and

(c) Cannot show he or she will be coming home within six months,

his or her home can be reclassified as a countable asset. Once reclassified, the home can be sold to pay Medicaid bills or the person’s qualification under Medicaid terminated.

Gifting the Residence - General Rule

Special rules apply when a gift of the personal residence is made. The general rule is that a transfer of a primary residence to anyone, other than a protected class of persons, within 36 months of applying for Medicaid results in disqualification.

Note: Transfers to certain types of trusts can trigger a 60 months “look back” period. For ex-ample, if an applicant has his or her house in a revocable trust and then transfers it back to his or her spouse, the 60 month “look back” period may be triggered.

The number of months that an applicant is disqualified from receiving Medicaid is deter-mined by dividing the value of the assets transferred by the average monthly nursing home bill as established by the local state welfare department.

Example

Dan has a home worth $81,000 that he transfers to his brother for $1. Medicaid has established the average monthly nursing home bill at $4,500. The resulting ineligibility period would be 18 months ($81,000 divided by $4,500). Thus, Dan must wait 18 months to qualify for Medicaid.

There is an additional trap. If as a result of the application of this formula:

(1) An applicant receives an ineligibility period that is longer than 36 months, and

(2) Applies for Medicaid within the 36-month “look back” period,

then the disqualification will not be 36 months but will be the longer period created by the transfer.

Example

Dan has a home worth $180,000 which he transfers to his brother for $1. Medicaid has established the average monthly nursing home bill at $4,500. Dan applies for Medicaid

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35 months later. The ineligibility period is 40 months ($180,000 divided by $4,500) not 36. Thus, Dan must wait 4 additional months to qualify for Medicaid. Had Dan applied after the 36 month “look back” period, he could have qualified.

Exceptions

There are several exceptions to the general rule. Without triggering an ineligibility pe-riod, a single or married person can transfer his or her home to:

(1) Anyone at any time for fair market value,

(2) Anyone, provided the transfer takes place at least 36 months before application for Medicaid,

Note: In certain instances, there is a 60-month “look back” period. However, a person is free to give his or her home to anyone and later qualify for Medicaid, provided the ineligi-bility period runs prior to application for Medicaid.

(3) A child who has lived in the home for at least two years before the parent’s insti-tutionalization and cared for the parent when at home,

(4) A child who is blind, disabled, or under 21,

(5) A brother or sister who owns a portion of the home and has lived there for at least one year before institutionalization, and

(6) Anyone provided the purpose of the transfer was not to qualify for Medicaid.

For married couples, either spouse may gift the home to the other spouse (even while on Medicaid) without disqualification. The spouse who receives the home can then transfer it to another person.

Inaccessible Assets

Inaccessible assets are countable assets that are unavailable to Medicaid. Assets can be made inaccessible by:

(i) A gift of the asset, or

(ii) A transfer to a Medicaid trust.

Gifts

If the onset of catastrophic illness is foreseeable, gifts to family members may be advisable. However, when a transfer of a countable asset is made for less than fair market value within 36 months of applying for Medicaid, such asset remains countable.

Note: Prior to October 1, 1989, disqualification periods ran from two to five years based on the state. Federal statute now sets the disqualification period at 36 months for all states.

Example

On January 1, 2021, Dan gifts $75,000 to his son, Rocko. Dan goes into a nursing home on January 1, 2022. Because Dan gave his money to Rocko within 36 months, he will not qualify for Medicaid until either 24 months have passed (36 months minus 12 months) or until Dan spends $75,000 on nursing home bills.

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Spousal Transfers

Although Medicaid permits unlimited transfers of countable assets between spouses, there is little advantage to doing so since Medicaid lumps together all the couple’s assets when determining eligibility.

Since 1989, if the well spouse transfers assets for less than fair market value, Medicaid considers the transfer as being made by the ill spouse. This is true even if the well spouse has held the assets in his or her name alone for more than 36 months.

Spousal Allowance

The Spousal Impoverishment Act was passed to protect the well spouse by allowing them to keep certain assets and income. Under this legislation, the at-home spouse is allowed to keep a certain amount of countable assets called the Community Spousal Resource Al-lowance (CSRA) determined by Medicaid using the following formula:

1. Medicaid fixes the day a spouse goes into a nursing home or medical institution.

2. Medicaid requires that the couple list all their countable assets regardless of whose name they are in, who earned them, or how long they’ve been in either’s name, includ-ing any assets that were transferred within the past 36 months (60 months if transferred into certain trusts).

3. Medicaid determines the combined assets on the day the spouse goes into the nursing home or medical institution. Regardless of what the combined assets are on the day the ill spouse applies for Medicaid, the well spouse’s share is determined on the admission day to a hospital for at least 30 days or to a nursing home.

4. The well spouse is then allowed to keep one-half of the total combined assets, but not less than $26,076 or more than $130,380 (in 2021). (See http://medicaid.gov ) The minimum and maximum amounts are a range. The actual dollar amounts vary by state. The well spouse is allowed to keep all of their income including that earned from work-ing and from assets they are allowed to keep.

Note: The well spouse may be entitled to additional funds if they can show that housing and utility expenses exceed 30% of the monthly amount the state allows them to keep.

Example

On July 9, Dan is going into a nursing home. He and his wife Althea have combined assets of $24,000 as of that date. Althea is allowed to keep one-half of $24,000. How-ever, since half of $24,000 is $12,000, she is allowed to keep $26,076, the minimum (in their state). If Dan and Althea had $300,000, Althea would not be allowed to keep half ($150,000) but only $130,380, the maximum (in their state).

The Spousal Impoverishment Act permits the well spouse to keep some of the ill spouse’s income. In 2021, the minimum amount set by federal law is $2,155 per month and the maximum is $3,259 per month. (See http://medicaid.gov ) If this amount, together with their own income, is not sufficient for the well spouse to financially survive, there are two alternatives:

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(1) Appeal directly to the state welfare office for additional funds; or

(2) File for divorce or separate maintenance and request more funds from the ill spouse’s income.

Medicaid Trusts

An irrevocable trust that properly limits the trustee’s discretion may protect countable assets. However, since 1986, if an irrevocable trust is set up, names the grantor as a beneficiary, and gives power to the trustee to give all, some or none of the income and assets to the grantor, Medicaid assumes the trustee will make all the income and principal available. Therefore, Medicaid counts the trust assets.

To overcome the 1986 change, some planners drafted a trust to give the trustee no discretion over principle but allow distribution of income from the principal. The income could be dis-tributed to either or both spouses. Such trusts were often called “income only trusts.” How-ever, while the principal might have been protected since the income was available, that money would end up being counted by Medicaid.

Several devices were used to reduce or eliminate the inclusion of the income distribution:

(i) If the illness is foreseeable, the well spouse could be made the sole income beneficiary, provided 30 months (old “look back” period) have passed before Medicaid application;

(ii) If both spouses are healthy, there could be a provision to split the income thereby risking inclusion of only half; or

(iii) A provision could be used to stop income payments to an ill spouse giving income only to the well spouse.

However, Congress did not like any trust that could protect assets or income. The Omnibus Budget Reconciliation Act of 1993 (“OBRA ‘93”) generally tightened eligibility rules governing the use of trusts by Medicaid applicants and recipients to discourage the transfer or shelter-ing of income and resources. Section 1917(c) of the Social Security Act (the “Act”) prescribes a penalty for individuals who transfer assets for less than fair market value. Section 1917(d) requires that states count, for purposes of an individual’s Medicaid eligibility, trusts estab-lished by an individual (or certain other designated persons) if assets of the individual were used to form all or part of the trust corpus. An individual’s “assets,” as defined in Section 1917(e)(1)(A), include all income and resources of the individual and of the individual’s spouse, including any income or resources which the individual or spouse is entitled to but does not receive because of action by the individual or by certain other designated persons or entities.

On August 10, 1993, Congress adopted the following language in OBRA ‘93:

“... if there are any circumstances under which payment from the (irrevocable) trusts could be made to or for the benefit of the individual (or his or her spouse), the portion of the corpus from which or the income on the corpus from which payment to the individual (or for her spouse) could be made shall be considered a resource available to the individual.”

As a result of this language, the consensus among planners is that the only thing that will protect assets is an irrevocable trust in which the grantors are not beneficiaries and do not participate at all in receiving income or principal.

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Limited Trust Exceptions

Certain trusts are not counted as being available to the individual. They include the follow-ing:

1. Trusts established by a parent, grandparent, guardian, or court for the benefit of an individual who is disabled and under the age of 65, using the individual's own funds.

2. Trusts established by a disabled individual, parent, grandparent, guardian, or court for the disabled individual, using the individual's own funds, where the trust is made up of pooled funds and managed by a non-profit organization for the sole benefit of each individual included in the trust.

3. Trusts composed only of pension, Social Security, and other income of the individual, in states which make individuals eligible for institutional care under a special income level, but do not cover institutional care for the medically needy.

However, in all of the above instances, the trust must provide that the state receives any funds, up to the amount of Medicaid benefits paid on behalf of the individual, remaining in the trust when the individual dies (§1917(d) of the Social Security Act; U.S. Code 42 U.S.C. §1396p(d)).

Note: A trust will not be counted as available to the individual where the State determines that counting the trust would work an undue hardship.

Criminalization of Medicaid Asset Transfers

Effective January 1, 1997, the Health Insurance Portability and Accountability Act of 1996 crimi-nalized certain transfers of assets for the purpose of qualifying for Medicaid. The law added the following provision to the list of acts that constitute a federal crime:

(6) knowingly and willfully disposes of assets (including by any transfer in trust) in order for an individual to become eligible for medical assistance under a State plan under title XIX, if disposing of the assets results in the imposition of a period of ineligibility for such assistance under section 1917(c). (42 U.S.C. §1320a-7b(a))

This provision proved unpopular and was repealed by the Balanced Budget Act of 1997, effective in August 1997, but was replaced with a new criminal provision targeting the advisor. The new provision, that passed as §4734 of the Balanced Budget Act of 1997, provides that criminal charges may be brought against anyone who, for a fee knowingly and willfully counsels or assists an individual to dispose of assets (including by any transfer in trust) in order for the individual to become eligible for medical assistance under a State plan under title XIX, if disposing of the assets results in the imposition of a period of ineligibility for such assistance under §1917(c) of the Social Security Act.

Thus, amazingly, under this provision, it is no longer criminal to make a transfer in order to be-come eligible for benefits, but it remains a crime to advise persons, for a fee, that they may legally make such transfers. However, on March 11, 1998, Attorney General Reno wrote Congress that she would not defend the constitutionality of the Medicaid criminalization law.

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Private Insurance

Because of its expense, long-term care and catastrophic illness insurance are not the answer for all people, particularly those of modest means. Even when these policies can be purchased, there are restrictions, exceptions, and language that disqualify the policyholder from collecting in many in-stances. Finding a good policy with adequate cover is difficult.

Note: Medicare and most forms of basic health and Medigap insurance do not pay for custodial care in a nursing home.

If a person finds the right policy, a strategy might be to have limited coverage for at least the 36-month disqualification period. This would buy time and permit transfers that might position the per-son for Medicaid eligibility.

Health Care Decisions

Modern medicine can keep the body alive when the mind is essentially dead. As a result, people often wish to die a natural death and not be kept alive by artificial means.

Obviously, a conscious and competent patient has the right to refuse treatment. In addition, there are several tools for having this right exercised by other persons when the patient is incompetent:

(1) A guardian of the person, with court approval, can instruct physicians,

(2) A living will or natural death act directive to physicians, and

(3) A durable power of attorney for health care.

A living will is a directive to a person’s physician stating that he or she does not wish to be kept alive by artificial means. However, normally, such documents are not legally binding on the doctor.

A durable power of attorney is a special form of power of attorney which authorizes a party to make medical decisions for a person if he or she is incapacitated and cannot make such decisions.

Note: In California, the durable power of attorney of health care is not used. The California Medical Association has prepared a preprinted form for the Advanced Health Care Directive. It can be ob-tained for a nominal charge from the Association.

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Review Questions

92. Three levels of conservatorship are described in the material. Which type of conservatorship is likely to be established for a mentally disabled adult who can partially manage his or her affairs?

a. a full conservatorship.

b. a limited conservatorship.

c. a partial conservatorship.

d. a traditional conservatorship.

93. The author lists five disadvantages to using a conservatorship as an asset management method. What is one of these disadvantages?

a. A conservator could confiscate all bank account funds.

b. The person’s property is publicly recorded.

c. The court does not supervise conservatorships.

d. The conservatorship may not be recognized by third parties.

94. When using a durable power of attorney, the document should be drafted to include how disability is proved. Why should a durable power of attorney state this?

a. Selling assets may be difficult because the agent is only a partial owner.

b. Public adjudication that the principal is incompetent is required.

c. The agent may have difficulty dealing with third parties.

d. The principal’s estate may have to be probated at death.

95. Many elderly rely on a government program as their main health insurance plan. What is this entitlement program that covers people receiving Social Security income?

a. Disability.

b. Welfare.

c. Medicare.

d. Supplemental Security Income.

96. Medicaid is one source through which medical expenses can be paid. What is Medicaid?

a. a federal program that provides a monthly income to individuals in financial need.

b. a combined federal and state program that bases assistance on specified income and asset guidelines.

c. a program that pays all hospital-submitted medical expenses.

d. a reimbursement system that classifies hospital cases into groups.

97. In determining Medicaid eligibility, assets are separated into three groups. Which assets would be classified as a countable asset?

a. a gift of the asset.

b. personal jewelry and household belongings.

c. term life insurance policies without surrender value.

d. whole life insurance over a specified amount.

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98. If certain requirements are met, a personal residence can be reclassified as a countable asset so that the home can be sold to pay Medicaid bills or the person’s qualification under Medicaid can be terminated. What is one requirement that must be met for such action can be taken?

a. The person is married.

b. The person lives in the personal residence.

c. A lien must be put on the home first.

d. The person is unable to show he or she will return home within six months.

99. Medicaid disqualification can result when a person transfers a primary residence to anyone other than a protected class of persons within a certain time period before his or her Medicaid application. However, under an exception to this rule, a single or married person can transfer his or her personal residence, without activating a period of ineligibility, to:

a. a child who has lived in the home for at least one year prior to institutionalization.

b. a child who is unemployed.

c. a sibling who is a partial owner of the residence and has lived there for over one year prior to institutionalization.

d. anyone at any time if consideration is paid.

Supplemental Security Income

Supplemental Security Income (SSI) benefits are available to aged, blind, and disabled people with little or no income and few assets. SSI is a federal program providing minimum monthly income1 to people in financial need who are:

(1) Age 65 or older,

(2) Any age if blind or disabled, and

(3) A resident and citizen of the United States or an alien lawfully admitted for permanent resi-dence in the United States.

1 SSI may also ensure eligibility to receive, in addition to cash benefits, social services managed through state or local

agencies.

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Although administered by the Social Security Administration, SSI is not the same as Social Security. SSI benefits are paid from general revenues of the U.S. Treasury and not from Social Security funds.

Maximum federal monthly cash payments under SSI vary from $30 to $1,191 (for 2021), see www.ssa.gov/OACT/COLA/SSIamts.html) depending on the applicant’s status. In addition to cash benefits, SSI also provides social services available from state and local government agencies.

Income

Two types of income are considered in calculating SSI benefits. Earned income is money earned from a job. This may be from self-employment or from working for someone else. Unearned income is money received from other sources such as a gift of cash or someone helping to pay for food, cloth-ing, or shelter. Each of these two types of income affects SSI income differently.

Note: The amount of income you can have each month and still get SSI depends partly on where you live. You can call the Social Security Administration at 1 (800) 772-1213 to find out the income limits in your state.

Unearned Income

Up to $20 per month of unearned income may be received from any source without affecting the SSI payment. Unearned income above the $20 will result in a dollar-for-dollar reduction in SSI. One dollar ($1) will be deducted from the SSI check for every dollar received above $20.

Earned Income

Up to $85 per month of earned income may be received without affecting the SSI payment. If a person also receives unearned income, up to $20 of that money is counted towards the $85. This means that if there is unearned income of $20, then only $65 of earned income is allowed with-out affecting the SSI amount. Earned income above $85 (or $65) results in a reduction of $1 in SSI benefits for every $2 earned.

Exempt Income

Income that is not counted includes:

(a) Earned or unearned income of $20 a month,

(b) Earned income of $65 a month plus half of earned income over $65 a month, or, if there is no unearned income, earned income of $85 a month plus half of the balance,

(c) Grants, scholarships, and fellowships for tuition and fees,

(d) Refunds of real property taxes and public assistance based on need paid from a state or local political subdivision,

(e) Foster care payments for a child who is not receiving SSI payments,

(f) Earnings of an unmarried blind or disabled child who is a student under 22 (up to $1,930 a month, but not more than $7,770 a year in 2021, see http://www.ssa.gov/OACT/COLA/studentEIE.html), and

(g) Food stamp and housing assistance.

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Assets

To be eligible for SSI, an applicant must have assets of less than $2,000. A married couple must have combined assets of less than $3,000.

When assets exceed these limits, an individual may still be eligible for SSI, if he or she sells excess assets within 6 months for real estate and 3 months for personal property.

Countable Assets

SSI counts the following assets:

(a) Real estate,

(b) Personal property and household goods including jewelry, books, and appliances,

(c) Bank accounts, and

(d) Stocks and bonds.

Non-Countable Assets

SSI does not count the following assets:

(a) A primary residence regardless of value,

(b) Personal property or household goods with a total equity value of $2,000,

(c) A car with a value of less than $4,5002,

(d) Life insurance policies with a face value of $1,500 or less,

(e) Assets needed by a blind or disabled person for an approved self-support program,

(f) Burial funds up to $1,500 for a person and his or her spouse ($3,000 for both), and

(g) Income-producing property (regardless of value), when used in a business essential to self-support.

Disability Benefits

In 1956, Social Security was expanded to include disability. The program covers workers who are disabled before age 65. A worker is considered disabled if he or she has a physical or mental condition that:

(1) Prevents them from doing any kind of work, and

(2) The condition is expected to:

(a) Last, or has lasted, for at least 12 months, or

(b) Result in death.

To obtain disability benefits the worker needs a certain number of Social Security quarters of cover-age. The number of quarters depends on age. If the worker is:

(1) Under 24, six quarters out of the 3-year period prior to disability are needed,

2 The value of one car is not counted when used by the household for transportation to a job, a place of regular treatment

for a specific medical problem, or for use by a handicapped person.

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Note When a child has a disability that began before age 22 and that prevents the child from doing any substantial gainful work, payments may start at any age.

(2) Between 24 and 31, quarters equal to at least half the calendar quarters during the period beginning with the quarter after the quarter the worker reached age 21 and ending with the quarter the disability began.

(3) Age 31 or older, quarters based on the following table:

Born before

Born after 1930, become Years of

1929, become disabled before quarters

disabled at age age 62 needed

42 or less 5

44 5.5

46 6

48 6.5

50 7

52 1981 7.5

53 1982 7.75

54 1983 8

55 1984 8.25

56 1985 8.5

58 1987 9

60 1989 9.5

62 or older 1991 or later 10

Blind

When an individual is blind, he or she does not have to meet the recent work requirement, but does need one quarter for each year after 1950 up to the year he or she became blind. A minimum of six quarters is required. Blindness is vision in the better eye of no better than 20/200 with corrective lenses or a limited visual field of 20 degrees or less.

Note: If an individual has received disability benefits for 24 months, he or she automatically be-comes eligible for Medicare.

Kidney Disease

People who are disabled by kidney disease are eligible for Medicare Part A and Medicare B benefits regardless of their age. When maintenance dialysis or kidney transplant surgery is needed because of kidney failure, individuals are eligible for these Medicare benefits when they:

(1) Have worked long enough to be insured by Social Security,

(2) Are already receiving monthly Social Security benefits, or

(3) Are the spouse, or dependent child of someone insured or already receiving Social Security benefits.

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AIDS

AIDS victims who are not able to work because of the virus, and who meet Social Security coverage requirements qualify for disability benefits. Individuals infected with HIV that causes AIDS may also qualify if their condition prevents them from working.

Review Questions

100. Certain individuals may qualify for Supplemental Security Income (SSI) benefits. What is the source of this assistance?

a. Diagnosis Related Groupings (DRGs).

b. general revenues of the U.S. Treasury.

c. Social Security funds.

d. state and federal funds.

101. Disability benefits are provided to workers who become disabled before they are age 65. Who must have at least six quarters but is exempt from the recent work requirement?

a. a blind individual.

b. an individual who has kidney disease.

c. an individual who has HIV.

d. an individual who has AIDS.

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Learning Objectives

After reading Chapter 10, participants will be able to:

1. Determine post-mortem estate planning action in the face of funeral and administrative expenses using elections and disclaimers.

2. Cite the due dates of post-mortem federal forms, specify the filing requirements of a decedent’s estate tax return, and identify exceptions to the general rule of estate tax pay-ment.

3. Determine the processes and procedures necessary in the preparation and filing of Form 706.

4. Identify the filing requirements for estate income tax and decedent’s final income tax returns by:

a. Determining the estate income tax under available tax accounting methods and tax years; and

b. Specify the use of Form 1310 for a decedent or a joint return for a decedent and his or her surviving spouse.

5. Determine total income to be included on the decedent’s final income tax return using available exemptions or deductions.

6. Identify how to avoid penalties when filing a gift tax return, recognize gift splitting to reduce gift taxes, and recall special gift applications and traps stating ways to avoid their tax consequences.

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CHAPTER 10

Post-Mortem Planning & Tax Return Require-ments

After Death Planning

Obviously, most estate planning should be done before death. However, many estates have little or no planning, the planning was faulty, or additional administration is necessary.

In some cases, planning opportunities only arise after the decedent’s death. Here, the executor and beneficiaries must act to take full advantage of these opportunities.

Alternate Valuation Election

Instead of valuing assets as of the date of death, the executor may elect to value the estate as of an alternate valuation date. Under §2032, the executor is given an election to value the estate assets either at the date of the decedent’s death or at the “alternate valuation date.” When the alternate date is elected, all assets included in the gross estate are valued as of six months after the decedent’s death, except that any assets sold, distributed, exchanged, or otherwise disposed of during the six months following death are valued as of the date of their disposition (Reg. §20.2032-1(a)).

The executor’s election to value assets at the alternate valuation date must be made on the estate tax return. Once made, the election is irrevocable and affects all assets (Reg. §20.202-1(b).

Special Use Valuation

For estate tax purposes, an executor may elect to value certain real property used in farming or other closely held business operations at its current use value rather than its highest and best use value. Under §2032A, the decrease in the value of the gross estate because of this election is limited to $1,190,000 in 2021.

Election to Defer Payment

An executor may elect to have the estate pay the federal estate tax attributable to the value of a closely held business in two to ten equal annual installments beginning five years after the due date of the federal estate tax return. Interest only is payable for the first four years. In addition, a very low interest rate is payable on the amount of estate tax due but unpaid.

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Note: The executor remains personally liable for payment of the deferred tax unless a written ap-plication for discharge is made and the required form is furnished or a special lien is elected.

An interest in a closely held business may consist of an interest in a sole proprietorship, partnership, or corporation.

Final Medical Expenses

At the election of the executor, unpaid medical bills after death may be deducted from either the estate tax or the income tax return - but not from both. Medical expenses paid from the estate within one year after death may be deducted on the decedent’s income tax return. However, the right to deduct such expenses for federal estate tax purposes must be waived and they must exceed 7.5% of the decedent’s AGI.

Administration Expenses

Administration expenses may be claimed as tax deductions from the gross estate. However, the ex-ecutor may elect to take such items as deductions for income tax purposes instead. If used for income tax purposes, an appropriate waiver of the right to claim them as estate tax deductions must the filed timely. Such a waiver is irrevocable.

QTIP Election

Section 2056(b)(7) allows the marital deduction in the case of “qualified terminable interest prop-erty.” However, an affirmative election by the decedent’s executor is a requirement for allowance of this deduction. This election must be made on the estate tax return filed by the executor and once made is irrevocable. A fractional or percentile election is permitted.

Disclaimers

Any heir may disclaim his or her rights within nine months of the decedent’s death. The law provides that a proper disclaimer is the same as the heir dying before the decedent. Such a disclaimer may save income, estate, gift, and generation-skipping taxes on large estates.

A disclaimer is an unqualified refusal to accept a transfer of property. Although other persons may acquire an interest in property as a result of the disclaimer, an effective disclaimer is not a taxable transfer (Reg. §25.2511-1(c)). To be effective, a disclaimer must be an irrevocable and unqualified refusal to accept an interest in property that satisfies four conditions under §2518(b):

(1) The disclaimer must be in writing;

(2) The disclaimer must be received by the donor (or the donor’s estate) within nine months of the date of the transfer creating the interest (or within nine months of the day on which the donee attains age 21);

(3) The donee must not have accepted the interest or any of its benefits; and

(4) As a result of the refusal to accept the property, the interest must pass to a person other than the disclaimant without any direction on the part of the disclaimant.

Note: A disclaimer may be made of an undivided portion of an asset. Subject to certain limitations, a partial disclaimer is valid for federal tax purposes (Reg. §2518-3(a)).

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Disclaimers can be an important estate planning tool. They can be used to:

(1) Bypass a generation that does not need the inheritance;

(2) Permit a surviving spouse to increase the assets transferred to the bypass trust, and

(3) Pay estate taxes upon the death of the first spouse and avoid stacking assets in the second spouse’s estate at higher death tax rates.

Federal Returns

Form 1040 - Decedent’s Income Tax

This form is due three and a half months after the close of the decedent’s taxable year, without regard to his or her death, i.e., April 15th of the year following his or her death.

Form 1041 - Estate’s Income Tax

The estate’s fiduciary income tax return is Form 1041. It is due three and a half months after the end of the estate’s taxable year and is required for any taxable year in which the estate’s gross income is $600 or more.

Form 706 - Decedent’s Estate Tax

The federal estate tax return is Form 706. It is due nine months after the decedent’s death, although a six-month extension is available. In late 2018, the IRS released a revised Form 706 which can be obtained at http://www.irs.gov/pub/irs-pdf/f706.pdf.

Carryover Basis Election & Information Return For 2010

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“TRUIRJCA”) permitted the executor of the estate of a decedent who died after December 31, 2009, and before January 1, 2011 (i.e., a decedent who died in 2010), to elect to apply the Code as if the reinstatement of the estate tax had not occurred. Under such an election, the estate tax did not apply to the estate and the carryover basis rules applied to assets transferred. Thus, an executor of an estate of a dece-dent who died in 2010 could have elected to apply the §1022 carryover basis rules instead of applying the TRUIRJCA estate tax rules. Once made, the election was revocable only with IRS consent.

Even if the election was made, the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") required executors to file an information return (Form 8939) if the property acquired from the decedent exceeded $1.3 million or if the decedent acquired certain property by gift within three years of death. The information return was used to report the carryover basis of the decedent’s property and the allocation of the basis increase allowed under the §1022 basis rules.

While no Form 706 was required, the information return was originally scheduled to be due with the decedent’s final Form 1040 income tax return. This would have meant that for decedents dying in 2010, the due date would have been April 18, 2011. However, IR-2011-91 extended the Form 8939 filing date to January 17, 2012. Failure to file this information return could have resulted in a penalty of $10,000.

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Note: IR-2011-91 also provided that most 2010 estates that timely filed a Form 4768 extension had until March 19, 2012, to file Form 706 or Form 706-NA. For estates of those dying late in 2010 (after Dec. 16, 2010, and before Jan. 1, 2011), the due date was 15 months after the date of death. No penalties were due but, interest was charged on any estate tax paid after the original due date.

In addition, EGTRRA required executors to provide to each beneficiary a written statement that listed the information reported on the Form 8939 information return with respect to the property that beneficiary acquired from the decedent. The executor had to furnish the beneficiaries with this state-ment no later than 30 days after the filing of the estate information return. Failure to provide each beneficiary with this statement could have resulted in a penalty of $50 for each failure.

Note: Publication 4895, Basis of Inherited Property Held by Decedents Who Died in 2010, explains some of the impact on heirs when an executor makes this election (See http://www.irs.gov/pub/irs-pdf/p4895.pdf ).

Decedent’s Estate Tax - Form 706

The executor of a decedent’s estate uses Form 706 to figure the estate tax. This tax is levied on the entire taxable estate, not just the share received by a particular beneficiary. Form 706 is also used to compute the generation-skipping transfer tax.

In August 2013, the IRS released a revised Form 706 for use by estates of decedents dying after De-cember 31, 2012. Changes reflected in the revision included law and indexing changes.

Filing Requirements

Form 706 must be filed by the executor for the estate of every U.S. citizen or resident where the value of the gross estate on the date of death exceeds $11,700,000 in 2021 (§6018(a)(1)).

For purposes of determining this $11,700,000 (in 2021) value, the gross estate must be increased by:

(i) The adjusted taxable gifts (under §2001(b)) made by the decedent after December 31, 1976, and

(ii) The specific exemption (under §2521 before its repeal) of gifts made after September 8, 1976, and before January 1, 1977.

The obligation to file is on the executor of the estate (§6018(a)(1)). Executor means the personal representative or administrator of the estate. If none of these are appointed or qualified in the U.S., then every person in actual or constructive possession of any property of the decedent (i.e., the beneficiaries) must file a return (§6018(b)). However, if one is executor because no other person was appointed or qualified in the U.S., his or her liability is limited to the value of the property in his or her possession.

If the executor is unable to make a complete return for any property interest in the gross estate, the executor must include on the return the names of everyone holding a legal or beneficial interest in that property and furnish a description of the property. If notified by the district director, anyone holding a legal or beneficial interest in this property must file a return for that part of the gross estate.

The estate tax return is due nine months after death (§6075(a)). For missing persons, the due date is nine months after the date set by local statute for declaring a missing person dead (R.R. 80-347). A

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six-month1 extension of time to file is available by filing Form 4768 (§6018(a)). However, an extension of time for filing a return does not extend the due date for paying the tax.

Form 706 is filed with the Internal Revenue Service Center for the state in which the decedent was domiciled at the time of his or her death (§6091(b)(3)).

If the decedent was neither a resident nor a citizen of the U.S., the executor must file Form 706NR, if the value of the gross estate located in the U.S. is more than $60,000.

If the estate tax return is not filed timely, the IRS will impose a penalty of .5% of the estate tax liability per month, up to a maximum of 25%, until the return is filed, unless the estate representative can show that the failure to file is due to reasonable cause and not to willful neglect (§6651(a)(1)). If the failure to file is shown to be fraudulent, the penalties range from 25% to a maximum of 75% (§6151(f)).

Paying the Estate Tax

Payment of the estate tax is due at the same time as the return is filed (i.e., nine months after death) unless:

(i) An extension of time to pay was granted under §6161,

(ii) The estate has properly elected under §6166 to pay in installments, or

(iii) An election under §6163 has been made to postpone the part of the tax attributable to a reversionary or remainder interest.

The executor must pay the entire estate tax, even if some of the property of the gross estate is not in the executor’s possession. All checks should be made to the “Internal Revenue Service” and con-tain the decedent’s name and social security number.

Failure to pay the tax with the return can cause the imposition of a penalty of .5% of the estate tax liability for each month or part of a month that the tax remains unpaid, up to a maximum of 25% (§6651). This penalty is in addition to the late-filing penalty.

In cases where the failure to pay is after notice and demand by the IRS, the penalty is increased to 1% per month (§6651(d)).

Where both the failure to file penalty and failure to pay penalty apply, the failure to file penalty is reduced by the amount of the failure to pay penalty (§6651(c)(1)).

Section 6161

An extension of time to pay can be obtained by filing a Form 4768 and showing reasonable cause (§6161(a)(2)), such as when:

(i) The estate includes a claim subject to a lawsuit,

(ii) Liquid assets are not within the executor’s control, and

(iii) When the majority of estate assets are rights to receive payments in the future.

While the extension to pay can be for up to ten years, the extension allowed is generally for 12 months. File two copies of Form 4768 if requesting only an extension of time to pay the tax. If also requesting an extension of time to file the return, file four copies of Form 4768.

1 Additional time may be permitted if the executor is abroad

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Note: An extension of time to pay does not relieve the estate from liability for paying interest on the balance due during the period of the extension.

If a request for an extension of time is denied, a written appeal may be made to the regional commissioner. This appeal must be made within 10 days after the denial is mailed.

Section 6166

If the gross estate includes an interest in a closely held business, the executor may be able to elect to pay part of the estate tax in installments.

Section 6166 is available where the interest in the closely held business exceeds 35% of the adjusted gross estate (gross estate less estate expenses and losses).

Section 6163

If the gross estate includes the value of a reversionary or remainder interest, the executor may elect to postpone the payment of the tax attributable to that interest until 6 months after the preceding interests in the property have ended. The executor elects this extension in Part 3 on page 2 of Form 706.

Note: Prepayment of the tax attributable to such property is allowed without the payment of ac-crued interest or acceleration of the remaining estate tax (R.R. 83-103).

If at the end of the 6 months, the executor shows reasonable cause, the Service may grant addi-tional time of up to 3 years for payment of the tax attributable to these interests.

Overview of Form 706

The Federal Estate Tax Return - Form 706 is made up of five parts and more than two dozen schedules and sub-schedules. Completing Form 706 requires the preparer to work backward by filling out the schedules first and then the front pages of the form. The schedules are used to report assets, deduc-tions, tax credits, and additional taxes if any.

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Overview of Form 706

• Form 706 has six parts:

– Part 1 - Decedent & Executor

– Part 2 - Tax Computation

– Part 3 - Elections by the Executor

– Part 4 - General Information

– Part 5 - Recapitulation

– Part 6 - Portability of Deceased Spousal Unused Exclusion (DSUE)

• Schedules A - I = Gross estate

• Schedules J - O = Deductions

• Schedule P - Foreign Death Tax Credit

• Schedule Q - Tax on Prior Transfers Credit

• Schedule R - Generation-Skipping Transfer Tax

• Schedule T - Qualified Family-Owned Business Interest

• Schedule U - Qualified Conservation Easement Exclusion

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Definitions

There are a number of concepts that are unique to the estate tax return. While many of these concepts were discussed earlier, here is a brief review for Form 706 purposes:

Gross Estate: the value of all property retained by the decedent at death and certain property transferred during the decedent’s life (§2031).

Valuation Date: the date of death or the alternate valuation date six months after the date of death unless there is an intervening disposition (§§2031 and 2032). The purpose of this requirement is to prevent the estate from increasing the income tax basis of estate assets when there is no federal estate tax payable.

Note: The alternate valuation date can be elected only if it reduces the size of the gross estate and the estate tax liability (§2032(c)).

Taxable Estate: the gross estate less allowable deductions (§2051).

Note: Deductions include expenses of the estate (including debts of the decedent, mortgages, and liens), losses of the estate, gifts to charity, and certain transfers to or for the benefit of a surviving spouse (§§2053, 2054, 2055, 2056A, and 2056).

Tentative Tax: estate tax figured on taxable estate plus adjusted taxable gifts (§2001(b)(1)).

Gross Estate Tax: tentative tax less the gift tax payable on gifts after December 31, 1976.

Net Estate Tax: gross estate tax less allowable credits.

Balance Due: net estate tax, plus other taxes (e.g., generation-skipping transfer tax), less any tax payments (e.g., flower bonds).

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Review Questions

102. When an interest is held in a closely held business, an executor may make an election to defer payment of federal estate due to the value of the interest. What does this election allow?

a. fifteen annual installments payments.

b. a deferment of fifteen years.

c. a low-interest rate on unpaid estate tax owed.

d. payments of only interest in the first nine years of payment.

103. Heirs may disclaim their rights to a transfer of property from a decedent. What is one of the four conditions that such a disclaimer must meet in order to qualify under §2518(b)?

a. The disclaimant may not direct who will receive the property.

b. The disclaimant must orally refuse acceptance.

c. The donor must receive the disclaimer within 3 months of the transfer date.

d. The donee must have accepted some of the benefits of the interest.

104. There is an exception to the rule that estate taxes must be paid when the return is filed. Under §6166, a taxpayer may elect to pay a portion of this tax in installments if a closely held business interest surpasses _____ of the adjusted gross estate.

a. .5%

b. 1%

c. 25%

d. 35%

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Preparing Form 706

What follows is a discussion of the basic sections and schedules of Form 706 in the order in which they are typically filled out.

Form 706, Part 1, Page 1 - Decedent & Executor

This section solicits basic information regarding:

(1) Decedent’s name, address, social security number, domicile at the time of death, the year that domicile was established, dates of birth and death,

(2) Executor’s name, address, and social security number,

(3) Court where the estate is being probated or administered (including case number),

(4) Whether the decedent died testate,

(5) Whether an extension of time to file and/or pay tax was obtained, and

(6) Whether the return includes a generation-skipping transfer tax.

Form 706, Part 3, Page 2 - Elections by the Executor

The executor may elect to make the following elections:

(1) The alternate valuation (see earlier discussion),

Note: If the alternate valuation is elected, then throughout the return both the date of death value and the alternate value for each item must be shown.

(2) The special use valuation under §2032A,

(3) Installment payment of estate tax under §6166, and

(4) Postponement of taxes attributable to reversionary or remainder interests under §6163.

Note: Some elections are made elsewhere on the return. Elections affecting the marital deduction are made on Schedule M. The election by a beneficiary to report lump-sum distributions is on Schedule I.

Form 706, Part 4, Pages 2 & 3 - General Information

This section requests a variety of information. Special items to note when completing Part 4 are:

(1) A Form 2848 must be filed for someone other than the executor to enter into a closing agreement for the estate, and

Note: Form 8821 has replaced Form 2848-D.

(2) This is where the attorney, accountant, or enrolled agent who prepared the return signs.

Schedule A, Page 5 - Real Estate

Schedule A is used to report the value of all real estate, including foreign real estate, which is part of the gross estate (§2031). The full value of the real estate is reported and there is no reduction for homestead, dower, or curtsey. If the estate is liable for a mortgage on the property, describe the mortgage but deduct the mortgage on Schedule K.

Some real estate is reported elsewhere on the return:

(1) Jointly owned property is reported on Schedule E,

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(2) Property owned by a sole proprietorship is reported on Schedule F,

(3) Property includible under §§2035 through 2038 is reported on Schedule G, and

(4) Property subject to a power of appointment is reported on Schedule H.

Describe the property in detail and indicate what the valuation is based on. If a special valuation election is made, Schedule A-1 must also be completed.

Schedule A-1, Pages 6 thru 9 - Section 2032A Valuation

The requirements under §2032A for special valuation have been discussed earlier. Some special items to note are:

(1) The property must pass to a qualified heir, who must sign the agreement for special use valuation,

(2) The property must have been devoted to a qualified use on the date of death,

Note: Qualified use means farm or business use for an aggregate of five out of eight years prior to the date of death.

(3) The adjusted value of the real and personal property used in farming or a closely held business must constitute at least 50% of the adjusted value of the gross estate,

(4) The executor must elect the special use valuation and the heir must agree to it, and

Note: A protective election may be used when it is not clear whether all requirements are satisfied (Reg. §20.2032A-8(b)).

(5) Recapture will occur if the property ceases to be used in a qualified use or is disposed of outside the family within 10 years.

Note: Form 706-A is used to report the recapture of these tax benefits.

Schedule B, Page 10 - Stocks and Bonds

Schedule B is used to report the value of all stocks and bonds included in the gross estate. In doing so, some special items include:

(1) Group and denote any stocks or bonds subject to foreign death taxes,

(2) Be sure to include even tax-exempt securities,

(3) Treat interest and dividends separately from the securities to which they relate,

(4) If the stocks are publicly traded, valuation is based on selling price, and

Note: Flower bonds are included at their face or par value. The author is not aware of any flower bonds being available after 1998.

(5) If the securities are not publicly traded, special rules apply including potential minority discounts and the effect of buy-sell agreements.

Schedule C, Page 11 - Mortgages, Notes, and Cash

Schedule C is used to report cash and all items owed to the decedent at the time of death. Mort-gages and notes are valued based on their unpaid principal plus accrued interest unless special circumstances (e.g., below-market interest rate or insolvency of the debtor) permit a lower val-uation (Reg. §20.2031-4).

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Schedule D, Page 12 - Insurance on Decedent’s Life

All insurance on decedent’s life whether or not includible in the gross estate is listed on Schedule D. This includes insurance receivable:

(1) By or for the benefit of the estate, and

(2) By beneficiaries other than the estate from a policy in which the decedent possessed in-cidents of ownership.

Note: Incidents of ownership include (i) the right of the insured or his or her estate to economic benefits, (ii) the power to change beneficiaries, (iii) the power to assign the policy, (iv) the power to borrow on the policy, or (v) a reversionary interest of more than 5% of the policy’s value.

Include the name of each insurance company, the number of the policy, and attach Form 712. Lump-sum payments are on line 24 of Form 712. Installment payments are on line 25.

Schedule E, Page 13 - Jointly Owned Property

In Part 1, report qualified jointly owned interests owned with his or her spouse as tenants by the entirety or as joint tenants. In Part 2, report interests owned with other tenants. The full value of all property must be included unless there is proof that the other tenant furnished some or all the consideration.

There are some joint interests that are not reported on Schedule E, for example:

(1) Tenancy in common (Schedule A),

(2) Community property (Schedules A through I), and

(3) Partnership interests unless the interest itself is held jointly (Schedule F).

Schedule F, Page 14 - Other Miscellaneous Property

This is the catchall schedule and includes:

(1) Unincorporated business and partnership interests,

(2) Insurance on the life of another

(3) QTIP property in the estate of the surviving spouse under §2044,

(4) Household goods and personal effects,

(5) Claims (e.g., refunds of federal and state income tax),

(6) Rights, royalties, leaseholds, judgments, autos, and shares in a trust,

(7) Reversionary or remainder interests, and

(8) Farm products and growing crops, livestock, and farm equipment.

Schedule G, Page 15 - Transfers During Decedent’s Life

There are five types of transfers reported on the Schedule G:

(1) Gift tax paid on transfers within 3 years of death by the decedent or his or her spouse,

(2) Transfers within three years of death under §2035(a),

(3) Transfers with a retained life estate under §2036,

(4) Transfers taking effect at death under §2037, and

(5) Revocable transfers under §2038

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Schedule H, Page 15 - Powers of Appointment

Reported on this schedule is the value of property for which the decedent had a general power of appointment at death (§2041). Limited powers are not included.

Schedule I, Page 16 - Annuities

Under §2039, annuities payable to someone on the death of the decedent are included in the gross estate and reported on this schedule if four requirements are met:

(1) The contract or agreement is not a policy of life insurance on the decedent,

(2) The contract or agreement was entered into after March 3, 1931,

(3) The annuity is receivable because of having survived the decedent, and

(4) The annuity had been payable to the decedent.

Schedule J, Page 17 - Funeral and Administration Expenses

This schedule lists estate tax deductions for:

(1) Funeral expenses under §2053(a)(1),

Note: Deductible expenses include tombstone, monument, mausoleum, burial lot, and cost of transportation to the cemetery (§2055(a)(1)). In community property states the amount deductible depends on whether the community or the decedent’s estate was responsible for the cost.

(2) Administration expenses2 incurred to administer estate property subject to claims,

(3) Executors’, accountants’ and attorneys’ fees, and

Note: If the executor is the primary beneficiary, he or she should consider waiving his or her fees depending on a comparison of his or her individual tax bracket versus the estate’s bracket.

(4) Miscellaneous expenses such as appraisals, probate fees, cost of collecting assets, and selling expenses.

Executors’, attorneys’, and accountants’ fees, administration, and other miscellaneous expenses can be claimed as a deduction on the estate’s income tax return, Form 1041 if a waiver is filed on Form 706. Typically, there is no double deduction.

However, it is possible to get a double deduction for such items as interest, taxes, business ex-penses, and other §691(b) deductions in respect of a decedent, provided the items were accrued and unpaid at death (§642(g)). For example, interest paid on federal estate taxes is a proper ex-pense of administration and the double deduction rule applies.

While estates using the maximum marital deduction may benefit by claiming expenses on Form 1041, it is impossible to generalize when the waiver is advisable.

Note: When the entire estate is left to the surviving spouse, there will be no tax savings by deduct-ing administration expenses on the estate tax return.

2 Any portion of administrative expenses which are attributable to the surviving spouse’s community property, may be

deducted on the spouse’s individual income tax return, but not by the estate.

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Schedule K, Page 18 - Debts of Decedent, and Mortgages and Liens

This Schedule reports all valid debts owed by the decedent at death (§2053(a)(3)). This can in-clude:

(1) Past due alimony,

(2) Medical expenses of last illness incurred for the care of the decedent and paid by the estate within one year of death,

Note: An election can be made to claim these expenses on the decedent’s final income tax return, Form 1040, instead of Form 706. However, no double deduction is allowed. Compare income and estate tax rates before deciding since there is a “Catch-22.” Using the medical expenses on the decedent’s final income tax return reduces the decedent’s final income tax liability, which in turn reduces the estate tax return’s deduction of that income tax liability. If the expense is used on the estate tax return, there is more income tax on the final return but a larger tax liability deduction on the estate tax return. Got it!

(3) Outstanding utility bills and credit card charges on date of death,

(4) Income taxes unpaid but attributable to income earned while alive,

(5) Property taxes accrued prior to death, and

(6) Mortgages and liens.

Schedule L, Page 19 - Net Losses During Administration and Expenses Incurred in Administering Property Not Subject to Claims

Items here include:

(1) Casualty and theft losses (not claimed on the estate’s income tax return), and

(2) Expenses incurred in administering property not subject to claims.

Schedule M, Page 20 - Bequests to Surviving Spouse

This Schedule computes the deduction for property passing to the surviving spouse that is not terminable interest property. Part 1 is for interests not subject to the QTIP election. Part 2 is for property interest subject to the QTIP election. Part 3 is a reconciliation that totals parts 1 and 2.

Schedule O, Page 21 - Charitable Gifts and Bequests

This schedule permits a full deduction for the value of amounts passing to charity (§2055). The property must pass to the federal, state, or local government for exclusively public purposes or to a charitable institution or fraternal society approved by the IRS. Charitable remainder trusts qualify for the charitable deduction.

Schedule P, Page 22 - Credit for Foreign Death Taxes

This Schedule allows a credit for estate, inheritance, legacy, and succession taxes paid to a foreign country (§2014). Complete a separate Schedule P for each country to which foreign taxes paid.

Schedule Q, Page 22 - Credit for Tax on Prior Transfers

A credit is permitted on this schedule for estate taxes on property where the property was taxed in another estate within the last 10 years. If the prior decedent predeceased the current decedent

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by more than two years, the credit is reduced by 20% for each full two years the original dece-dent’s death preceded the current decedent’s death.

Schedules R & R-1, Pages 23 thru 27 - Generation-Skipping Transfer Tax

The GST is due on direct skips occurring at death (§2601 et seq.). If the tax is payable by the estate, file Schedule R. If the tax is payable by a trust includible in the estate, file Schedule R-1.

Old Schedule T Gone - Qualified Family-Owned Business Interest

This Schedule was based on §2057 and allowed a deduction (formerly an exclusion) for the value of certain family-owned business interests from the gross estate. The election to use the deduc-tion (assuming the interest qualifies) was made by filing Schedule T, attaching all required state-ments, and deducting the value of the interest in Part 5, Recapitulation. This provision expired in 2004 and Schedule T is no longer part of Form 706.

Note: You can only deduct the value of property that was also reported on Schedules A, B, C, F, G, or H.

Schedule U, Page 28 - Qualified Conservation Easement Exclusion

This Schedule is based on §2031(c) and permits an election to exclude a portion of the value of land that is subject to a qualified conservation easement. The election is made by filing Schedule U with all the required information and excluding the applicable value of the land that is subject to the easement in Part 5, Recapitulation.

Note: To elect the exclusion, you must include on Schedules A, B, E, F, G, or H, as appropriate, the decedent’s interest in the land that is subject to the exclusion.

Form 706, Part 5, Page 3 - Recapitulation

The recapitulation is completed by totaling the gross estate items (Schedules A-I) and the allow-able deductions (Schedules J through T).

Form 706, Part 6, Page 4 - Portability of Deceased Spousal Unused Exclusion (DSUE)

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 author-ized estates of decedents dying after December 31, 2010, to elect to transfer any unused exclu-sion to the surviving spouse. The amount received by the surviving spouse is called the deceased spousal unused exclusion, or DSUE, amount. If the executor of the decedent’s estate elects trans-fer, or portability, of the DSUE amount, the surviving spouse can apply the DSUE amount received from the estate of his or her last deceased spouse against any tax liability arising from subsequent lifetime gifts and transfers at death.

Form 706, Part 2, Page 1 - Tax Computation

Total deductions are subtracted from the total gross estate. Adjusted taxable gifts are added. The gross estate tax is computed and credits are applied. For 2012, the estate tax applicable exclusion amount was $5.12 million. For 2021, the estate tax applicable exclusion amount was inflation ad-justed to $11.7 million. Amounts exceeding the applicable exclusion amount are taxed at 40% (up

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from 35% in 2012). As a result, the applicable exclusion amounts and their credit equivalents are as follows:

Year of death Exclusion Amount Credit Equivalent

2012 5,120,000 1,772,800

2013 5,250,000 2,045,800

2014 5,340,000 2,081,800

2015 5,430,000 2,117,800

2016 5,450,000 2,125,800

2017 5,490,000 2,141,800

2018 11,180,000 4,360,200

2019 11,400,000 4,505,800

2020 11,580,000 4,577,800

2021 11,700,000 4,625,800

Schedule PC, Pages 29 - 31 - Protective Claim for Refund

A protective claim for refund preserves the estate’s right to a refund of tax paid on any amount included in the gross estate which would be deductible under §2053 but has not been paid or otherwise will not meet the requirements of §2053 until after the limitations period for filing the claim has passed (see §6511(a)).

Note: Only use Schedule PC for §2053 protective claims for refund being filed with Form 706. If the initial notice of the protective claim for refund is being submitted after Form 706 has been filed, use Form 843, Claim for Refund and Request for Abatement, to file the claim.

Schedule PC may be used to file a §2053 protective claim for refund by estates of decedents who died after December 31, 2011. It also will be used to inform the IRS when the contingency leading to the protective claim for refund is resolved and the refund due the estate is finalized. The estate must indicate whether the Schedule PC being filed is the initial notice of protective claim for refund, notice of partial claim for refund, or notice of the final resolution of the claim for refund.

Discharge from Personal Liability

Under §2204, an executor may make written application to the IRS for early determination of the amount of estate tax and discharge from personal liability. The IRS must respond within 9 months of the application notifying the executor of the estate tax. On payment of the noticed amount the ex-ecutor is discharged from personal liability.

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Review Questions

105. On the federal estate tax return, taxpayers must familiarize themselves with several im-portant concepts. What term is defined as the gross estate minus deductions such as the estate’s expenses, losses, and charitable gifts?

a. gross estate tax.

b. net estate tax.

c. taxable estate.

d. tentative tax.

106. On Form 706, part 3, page 2 - Elections by the Executor, up to four elections may be made. What is one of these elections that may be made?

a. one that affects the marital deduction.

b. one that is made by a beneficiary to report lump-sum distributions.

c. one to exclude a portion of the value of land that is subject to a qualified conservation easement.

d. one to use the special use valuation under §2032A.

107. On Form 706, taxpayers must report how much cash the decedent had at the time of death and also what was owed to the decedent. What schedule should be used to report these amounts?

a. Schedule B.

b. Schedule C.

c. Schedule D.

d. Schedule E.

108. On Form 706, taxpayers must report all QTIP property in the surviving spouse’s estate under §2044. What schedule is used to report this information in addition to reversionary or remainder interests?

a. Schedule F.

b. Schedule G.

c. Schedule H.

d. Schedule I.

109. Under §642(g), a double deduction may be available for certain expenses so long as the decedent accrued, but had not paid, these expenses. What type of expenses may qualify for this double deduction?

a. business expenses.

b. executors’, attorneys’, and accountants’ fees.

c. funeral expenses.

d. medical expenses of last illness incurred for the care of the decedent and paid by the estate within one year of death.

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110. On Form 706, property qualifies for a credit for estate taxes if it has been included and taxed in another estate within the last ten years. On what schedule is this credit taken?

a. Schedule O.

b. Schedule P.

c. Schedule Q.

d. Schedule T.

111. Expenses can be reported in a variety of ways. Under §642(g), estate administration ex-penses are reported on:

a. Form 706 only.

b. Form 706 or Form 1041.

c. Form 706 or Form 1041 or split.

d. Forms 706 and 1041.

112. An estate income tax return must be filed for certain estates. What is a filing requirement of this Form 1041, Estate Income Tax Return?

a. Income, age, and filing status of a decedent determine the sections needed to be com-pleted.

b. It is to be filed no later than the 15th day of the 4th month subsequent to the end of the tax year for the estate.

c. The beneficiaries must file the form.

d. It must be filed on time - no extension of time will be granted.

Estate Income Tax Return - Form 1041

An estate is a separate taxable entity that comes into existence on the death of a decedent. The estate continues to exist until the final distribution to heirs and other beneficiaries. Income from estate assets must be reported on a fiduciary tax return. The tax is generally figured in the same manner and on the same basis as for individuals, with certain differences in the computation of de-ductions and credits.

Filing Requirements

Fiduciaries are required to file an income tax return on Form 1041 for the following estates of do-mestic decedents:

(1) Estates that have a gross income of $600 or more for the taxable year, or

(2) Estates where any beneficiary is a nonresident alien.

The fiduciary responsible for filing Form 1041 may be the executor, administrator, or personal rep-resentative of the estate. When an estate has an ancillary representative, that representative is also required to file a fiduciary return for the activities in his or her jurisdiction.

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Note: The fiduciary must file a written notice of fiduciary relationship, Form 56, with the IRS. This notice should be filed as soon as possible after the fiduciary is appointed. However, if the fiduciary is required to file a tax return, the notice can be filed with the first return. The Service will then deal directly with the fiduciary and will send him or her notices of any prior tax deficiencies and assess-ments. After filing this notice, the fiduciary is personally responsible for taxes owed by the estate or trust only if he or she violates the rule regarding payment of other debts ahead of the taxes. When fiduciary capacity is ended, a notice of that fact should also be mailed.

Form 1041 must be filed by the 15th day of the 4th month following the close of the estate’s tax year. The IRS will grant a reasonable extension of time for filing the estate’s income tax return if the fiduciary shows reasonable cause and files Form 2758. The extension is generally limited to 60 days. In hardship cases, an estate may be able to obtain an extension of time for payment by filing Form 1127.

Note: An estate is required to make estimated income tax payments for any tax year ending two or more years after the date of the decedent’s death.

A fiduciary for a nonresident alien estate with U.S. source income, including any income that is ef-fectively connected with the conduct of a trade or business in the United States, must file Form 1040NR, U.S. Nonresident Alien Income Tax Return, as the income tax return of the estate.

Schedule K-1

A personal representative must also file a separate Schedule K-1 (Form 1041) for each benefi-ciary. These schedules are filed with Form 1041. Each beneficiary’s taxpayer identification num-ber must be shown. A $50 penalty is charged for each failure to provide the identifying number of each beneficiary unless reasonable cause is established for not providing it.

Note: When the executor assumes duties as the personal representative, he or she should request each beneficiary to give their taxpayer identification number. However, it is not required of a non-resident alien beneficiary who is not engaged in a trade or business within the United States or of an executor or administrator of the estate unless that person is also a beneficiary.

A personal representative must also furnish a Schedule K-1 to the beneficiary on or before the date on which Form 1041 is filed. Failure to provide this payee statement can result in a penalty of $50 for each failure. This penalty also applies if the executor omits information or includes incorrect information on the payee statement.

Tax Computation

The estate’s taxable income generally is figured the same way as an individual’s income. Gross in-come of an estate consists of all items of income received or accrued during the tax year. It includes dividends, interest, rents, royalties, gain from the sale of property, and income from business, part-nerships, trusts, and any other sources.

Since the income tax rates on estates and trusts are the worst in the Code, the executor should con-sider distributing estate income to the surviving spouse in the year of the decedent’s death. When the surviving spouse files a joint income tax return with the decedent, this income may be taxed at a lower rate than if taxed in the estate.

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Exemption Deduction

Personal and dependent exemptions formerly available to individuals are not available to an es-tate or trust. However, an estate may claim a personal exemption of $600 in figuring its taxable income (§642(b). No exemption for dependents is allowed to an estate. Even though the first return of an estate may be for a period of less than 12 months, the exemption is $600. If, how-ever, the estate was given permission to change its accounting period, the exemption is $50 for each month of the short year.

Contributions

An estate qualifies for a deduction for amounts of gross income paid or permanently set aside for qualified charitable organizations. The adjusted gross income limitations for individuals do not apply. However, to be deductible by an estate, the contribution must be specifically provided for in the decedent’s will. If there is no will, or if the will makes no provision for the payment to a charitable organization, then a deduction will not be allowed even though all of the beneficiar-ies may agree to the gift.

Statute of Limitations

Generally, the IRS can assess additional tax at any time within three years of the time the return was filed. However, the taxpayer can agree with the Service to extend the statute on Form 872. When the taxpayer omits income exceeding 25% of the gross income stated in the return, the statute of limitations is increased to six years. False or fraudulent returns and failure to file a return can result in suspension of the statute.

Accounting Methods

An estate or trust may use any of the tax accounting methods available to individuals. The method of accounting used by the decedent does not carry over to the estate or trust. However, once the method has been adopted, any change is subject to IRS approval.

Taxable Year

The executor can elect to report the estate’s income on a fiscal or calendar year3. If a fiscal year is desired, the election must be made within three and one-half months after the close of the fiscal year selected (§441). Absent such a timely election, the estate must use the calendar year.

Note: Careful selection of the tax year can spread income and reduce overall tax liability. For exam-ple, since beneficiaries are taxable on distributions for the year in which the estate’s tax year ends, a fiscal year may push taxable income for the beneficiaries into a later year.

Double, Split & Solo Deductions

Some expenses may be deducted on Form 1041 only if not deducted from the gross estate on Form 706. These deductions may be split between the two returns in any manner desired.

3 All trusts must use the calendar year.

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Certain debts paid after death are deductible for both federal estate tax (Form 706) and fiduciary income tax (Form 1041) purposes. These are often referred to as “double deductions” and are enu-merated in §691(b).

Finally, medical expenses may be claimed on Form 706 the Form 1040, while funeral expenses may only be claimed on Form 706.

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Deduction Alternatives

Description 706*

& 1041

706 or

1041 or

split

706 or

1040 706 only

Trade or business ex-penses (§162)

YES NO NO NO

Interest (§163) YES NO NO NO

Taxes (§164) YES NO NO NO

Expenses for the pro-duction or collection

of income (§212) YES NO NO NO

Expenses for the management and maintenance of

income-producing property (§212)

YES NO NO NO

Expenses in connec-tion with the deter-mination, collection, or refund of any tax

(§212)

YES NO NO NO

Alimony (§215) YES NO NO NO

Estate Administration Expenses (§642(g)

NO YES NO NO

Medical Expenses of Decedent Paid Within

One Year (§213(d)) NO NO YES NO

Funeral Expenses (§2053(a))

NO NO NO yes

Casualty or Theft Losses (§165)

No Yes No no

* Items are deductible on both returns only if they are expenses in respect of a decedent, except for alimony.

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Decedent’s Final Income Tax Return - Form 1040

Unless the decedent died on December 31st while mailing his or her federal income tax return early, a final income tax return (Form 1040) is due for the year of death if the decedent received any income in excess of the filing limit. The personal representative must file the final income tax return of the decedent for the year of death and any returns not filed for preceding years.

Note: A personal representative of an estate is an executor, administrator, or anyone who is in charge of the decedent’s property. Generally, an executor (or executrix) is named in a decedent’s will to administer the estate and distribute properties as the decedent has directed. An administra-tor (or administratrix) is usually appointed by the court if no will exists, if no executor was named in the will, or if the named executor cannot or will not serve.

Preceding Year Return

If an individual dies after the close of the tax year, but before the return for that year was filed, the return for the year just closed is not the final return. The return for that year is a regular return and the personal representative must file it.

Example

Dan died on March 21, 2022, before filing his 2021 tax return. His personal representa-tive must file his 2021 return by April 15, 2022. His final tax return is due April 15, 2023.

Filing Requirements

The income, age, and filing status of a decedent generally determine the filing requirements. In gen-eral, filing status depends on whether the decedent was considered single or married at the time of death. Gross income usually means money, goods, and property an individual received on which he or she must pay tax. It includes gross receipts from self-employment minus any cost of goods sold. It does not include nontaxable income.

Refund

A return should be filed to obtain a refund if tax was withheld from salaries, wages, pensions, or annuities, or if estimated tax was paid, even if the decedent is not required to file.

Form 1310

Any person who is filing a return for a decedent and claiming a refund must file a Form 1310, Statement of Person Claiming Refund Due a Deceased Taxpayer, with the return. However, if the person claiming the refund is a surviving spouse filing an original joint return with the decedent, or a court-appointed or certified personal representative filing an original return for the dece-dent, Form 1310 is not needed.

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Joint Return with Surviving Spouse

Generally, the personal representative and the surviving spouse can file a joint return for the decedent and the surviving spouse. However, the surviving spouse alone can file the joint return if no personal representative has been appointed before the due date for filing the final joint return for the year of death.

Note: If no fiduciary is appointed by the time of filing, then just the spouse signs. The surviving spouse writes “Filing as Surviving Spouse” in the signature area, and writes “Deceased” and the date of death next to the decedent’s name in the name and address area.

This also applies to the return for the preceding year if the decedent died after the close of the preceding tax year and before the due date for filing that return. The income of the decedent that was includible on his or her return for the year up to the date of death and the income of the surviving spouse for the entire year must be included in the final joint return.

Note: A final joint return with the deceased spouse cannot be filed if the surviving spouse remarried before the end of the year of the decedent’s death. The filing status of the deceased spouse is “married filing separate return.”

If the court subsequently appoints a personal representative, that person may revoke an election to file a joint return that was previously made by the surviving spouse alone. This is done by filing a separate return for the decedent within one year from the due date of the return (including any extensions). The joint return made by the surviving spouse will then be regarded as the sep-arate return of that spouse by excluding the decedent’s items and refiguring the tax liability.

There may be a substantial tax break in filing a joint return4 since the income and deductions are split equally between two taxpayers, especially if one spouse earns more than the other. More-over, one spouse’s deductions (e.g., a capital loss or NOL) may be of benefit when applied against the other’s income.

Request for Prompt Assessment

The IRS ordinarily has 3 years from the date an income tax return is filed, or its due date, whichever is later, to charge any additional tax due. However, the fiduciary may request a prompt assessment of tax after the return has been filed. Form 4810 is used for making this request. This request can be made for any income tax return of the decedent and for the income tax return of the decedent’s estate.

Included Income

The decedent’s return must include all income and deductions to the date of death, based on the accounting method (cash or accrual) used by the decedent when alive. All items of income actually or constructively received prior to death must be included. The following instances illustrate this inclusion:

(1) A check mailed before death is payment;

(2) Expenses charged to a bank credit card are treated as paid at the time of the charge;

4 If a joint return is filed, the estate will be jointly and severally liable for any tax.

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(3) Uncashed checks received before death are constructively received;

(4) Interest is constructively received if it is subject to withdrawal;

(5) Interest from coupons on bonds that matured before death but were uncashed is construc-tively received; and

(6) Dividends are constructively received when made subject to shareholder demand.

Partnership Income

The death of a partner generally does not close the partnership’s tax year before it normally ends. It continues for both the remaining partners and the deceased partner. Even if the partnership has only two partners, the death of one does not terminate the partnership or close its tax year, provided the deceased partner’s estate or successor continues to share in the partnership’s prof-its or losses.

If the surviving partner terminates the partnership by discontinuing its business operations, the partnership tax year closes as of the date of termination. If the deceased partner’s estate or suc-cessor sells, exchanges, or liquidates its entire interest in the partnership, the partnership’s tax year with respect to the estate or successor will close as of the date of the sale or exchange or the date the liquidation is completed.

The decedent’s final return must include the decedent’s distributive share of partnership income for the partnership’s tax year ending within or with the decedent’s last tax year (i.e., the year ending on the date of death).

The final return does not include the distributive share of partnership income for a partnership’s tax year ending after the decedent’s death. In this case, partnership income earned up to and including the date of death is income in respect of the decedent. Income earned after the date of death to the end of the partnership’s tax year is income to the estate or successor in interest.

Example

Dan is a partner in the XYZ partnership that has a calendar year. If Dan dies on any day other than December 31, none of his share of partnership income or loss is included on his final return. If Dan’s estate is the successor in interest to his partnership interest, the estate will include all of the income earned by the partnership for the entire year. Partnership income earned up to and including the date of death is income in respect of a decedent.

Example

Dan was a partner in XYZ partnership and reported his income on a tax year ending December 31. The partnership uses a tax year ending June 30. Dan died August 31, 2021, and his estate established its tax year ending August 31. The distributive share of taxable income from the partnership based on the decedent’s partnership interest is reported as follows:

(1) The final return for the decedent for period January 1 through August 31, 2021, includes income from the XYZ partnership year ending June 30, 2021, and

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(2) The income tax return of the estate for the period September 1, 2021, through August 31, 2022, includes income from the XYZ partnership year ending June 30, 2022.

The portion of income from the partnership for the period July 1, 2021, through August 31, 2021, is income in respect of a decedent.

If the partnership agreement provides for a sale or exchange of the decedent’s interest at the date of death, the taxable year of the partnership closes upon the date of death with respect to the deceased partner.

S Corporation Income

If the decedent was a shareholder in an S corporation, the final return must include the dece-dent’s share of S corporation income for the corporation’s tax year that ends within or with the decedent’s last tax year (year ending on the date of death). The final return must also include the decedent’s pro-rata share of the S corporation’s income for the period between the end of the corporation’s last tax year and the date of death.

Note: If a shareholder dies during an S corporation’s tax year, his or her pro-rata share of the cor-poration’s income is included in the decedent’s final return. Income is allocated proportionally to the decedent according to the number of days in the corporation’s tax year prior to death, without regard to income or loss actually incurred by the corporation throughout the tax year. However, if all shareholders agree, the corporation may elect to allocate income or loss as if the year consisted of two short years — one ending at the date of death and the other ending on the last day of the corporate year.

The income for the part of the S corporation’s tax year after the shareholder’s death is income to the estate or other person who has acquired the stock in the S corporation.

Self-Employment Income

Self-employment income actually or constructively received or accrued is included in the final return.

For self-employment tax purposes only, the decedent’s self-employment income will include the decedent’s distributive share of a partnership’s income or loss through the end of the month in which death occurred. For this purpose only, the partnership’s income or loss is considered earned ratably over the partnership’s tax year.

Community Income

If the decedent was married and was domiciled in a community property state, half of the income received and half of the expenses paid during the decedent’s tax year by either the decedent or spouse may be considered to be the income or expense of the other.

Interest & Dividend Income

Payers of interest and dividends report amounts on Form 1099 using the identification number of the person to whom the account is payable. After a decedent’s death, Form 1099 must reflect the identification number of the estate or beneficiary to whom the amounts are payable. The personal representative handling the estate must furnish this identification number to the payer.

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A Form 1099 should be received for the decedent reporting interest and dividends that were includible on his or her return before death. A separate Form 1099 should be received showing the interest and dividends includible on the returns of the estate or other recipient after the date of death and payable to the estate or other recipient. Corrected Form 1099 can be requested if these forms do not properly reflect the right recipient or amounts.

Exemptions & Deductions

Generally, the rules for exemptions and deductions allowed to an individual also apply to the dece-dent’s final income tax return. The final return should show deductible items the decedent paid be-fore death (or accrued, if the decedent reported deductions on an accrual method).

Prior to 2018, the personal exemption could be claimed in full on a final income tax return. If the decedent was another person’s dependent (i.e., a parent’s), the personal exemption could not be claimed on the decedent’s final return. However, from 2018 through 2025, personal exemptions are now suspended.

If deductions are not itemized on the final return, the full amount of the appropriate standard de-duction is allowed regardless of the date of death.

Medical Expenses

Medical expenses paid before death by the decedent are deductible on the final income tax re-turn if deductions are itemized. This includes expenses for the decedent as well as for the dece-dent’s spouse and dependents.

Election for Decedent’s Expenses

Medical expenses that are not deductible on the final income tax return are liabilities of the estate and are shown on the federal estate tax return (Form 706). However, if medical ex-penses for the decedent are paid out of the estate during the 1-year period beginning with the day after death, an election can be made to treat all or part of the expenses as paid by the decedent at the time they were incurred.

When the election is made, all or part of the expenses can be claimed on the decedent’s income tax return rather than on the federal estate tax return (Form 706). Expenses incurred in the year of death can be deducted on the final income tax return. An amended return (Form 1040X) should be filed for medical expenses incurred in an earlier year unless the stat-utory period for filing a claim for that year has expired.

Making the Election

The election is made by filing with the decedent’s income tax return, or amended return, a statement in duplicate that the amount has not been claimed as an estate tax deduction, and that the estate waives the right to claim the amount as a deduction. This election applies only to expenses incurred for the decedent, not to expenses incurred to provide medical care for dependents.

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AGI Limit

The amount deductible on the income tax return is the amount in excess of 7.5% (in 2021) of adjusted gross income. The amounts not deductible because of this percentage cannot be claimed on the federal estate tax return.

Example

Dan used the cash method of accounting and filed his return on a calendar year ba-sis. He died on June 1, 2022, after incurring $800 in medical expenses. Of that amount, $500 was incurred in 2021 and $300 was incurred in 2022. Dan filed his 2021 income tax return before April 15, 2022. The personal representative of the estate paid the entire $800 liability in August 2021.

The personal representative may then file an amended return (Form 1040X) for 2021 claiming the $500 medical expense as a deduction. The $300 of expenses incurred in 2022 can be deducted on the final income tax return, although it was paid after Dan’s death. The personal representative must file a statement in duplicate with each return stating that these amounts have not been claimed on the federal estate tax return (Form 706), and waiving the right to claim such a deduction on Form 706 in the future.

Medical Expenses Not Paid By Estate

Medical expenses for the care of the decedent paid by a survivor who can claim the decedent as a dependent are deductible on the survivor’s income tax return for the tax year in which paid, whether or not they are paid before or after the decedent’s death. If the decedent was a child of divorced or separated parents, the medical expenses are usually deductible by both the custodial and noncustodial parent to the extent paid by each parent during the year.

Insurance Reimbursements

Insurance reimbursements of previously deducted medical expenses due a decedent at the time of death and later received by the decedent’s estate are includible in the income tax return of the estate (Form 1041) for the year the reimbursements are received. The reim-bursements are also includible in the decedent’s gross estate.

Deduction for Losses

A decedent’s net operating loss from prior-year business operations and any capital losses (in-cluding a capital loss carryover) can only be deducted on the decedent’s final income tax return. Any unused net operating loss or capital loss cannot be deducted on the estate’s income tax return. However, a net operating loss carryback resulting from a net business loss on the dece-dent’s final income tax return can be carried back to prior years.

At-Risk Loss Limits

Special at-risk rules apply to most activities that are engaged in as a trade or business or for the production of income. These rules limit the amount of deductible loss to the amount for which the decedent was considered at risk in the activity.

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Passive Activity Rules

In general, if a passive activity interest is transferred because of the death of a taxpayer, the accumulated unused passive activity losses are allowed as a deduction against the decedent’s income in the year of death. However, losses are allowed only to the extent they are greater than the excess of the transferee’s (recipient of the interest transferred) basis in the property over the decedent’s adjusted basis in the property immediately before death. The portion of the losses that is equal to the excess is not allowed as a deduction for any tax year.

Example

Dan had suspended passive losses of $150,000 from his passive activities at the time of his death. The passive activities received a step up in basis of $100,000 (the fair market value at the date of death). $50,000 of suspended losses may be claimed on Dan’s final return.

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Review Questions

113. The decedent's gross income must be reported on a final income tax return, Form 1040. What is excluded from this amount?

a. stock dividends.

b. self-employment income.

c. municipal bond income.

d. property received for services.

114. A taxpayer who files a decedent’s final income tax return and claims a refund is required to file another form. What form must be sent with the tax return?

a. a separate Schedule K-1.

b. Form 1040X.

c. Form 1099.

d. Form 1310.

115. When applicable, partnership income must be included on the decedent’s return. If a sur-viving partner terminates the partnership’s business operations, when does the partnership tax year close?

a. as of the date of death.

b. as of the date of termination.

c. as of the date of the liquidation.

d. as of the date of the sale or exchange.

116. The decedent’s self-employment income includes the decedent’s distributive portion of a partnership’s income or loss for the entire month in which the decedent died:

a. for community income purposes.

b. for partnership tax purposes only.

c. for S corporation tax purposes only.

d. for self-employment tax purposes only.

117. Taxpayers may make an election to treat all or a portion of a decedent’s medical expenses as paid by the decedent when incurred. Which expenses fail to qualify for this election?

a. expenses incurred for the decedent.

b. expenses incurred to provide medical care for dependents.

c. expenses that are not deductible on the final income tax return.

d. the amount in excess of 10% of adjusted gross income.

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Gift Tax Return - Form 709

The Federal gift tax applies to any transfer by gift of real or personal property, whether tangible or intangible, made directly or indirectly, in trust, or by any other means to a donee. In other words, all transactions in which property or property interests are transferred to another without adequate consideration constitute gifts subject to gift tax.

Note: The gift tax is not imposed on the receipt of gift property, but rather upon the donor’s act of making a completed gift.

A gift is complete if a donor has parted with dominion and control over the transferred property or property interest, leaving the donor without the power to change its disposition, whether for the benefit of the donor or for the benefit of others.

Penalties

Penalties similar to those applicable to the estate tax return (see earlier discussion) may be incurred for failure to file the return or to pay the tax when due. For example, a penalty of one-half percent per month of the unpaid balance, up to 25%, will be charged on the failure to pay, unless reasonable cause can be shown.

Filing

The donor is required to file a return, Form 709, reporting both gifts of present and future interests. Form 709 is filed on an annual basis with the due date the 15th day of the 4th month following the close of the calendar year of the gift.

Note: For a calendar year in which the donor dies, the gift tax return is required to be filed no later than the due date for filing the donor’s estate tax return, Form 706, including extensions (§6075(b)).

Form 709 is filed with the Internal Revenue Service Center serving the state in which donor’s legal residence or principal place of business is located. If the donor has no legal residence or principal place of business in the United States, the return is filed with the Internal Revenue Service Center, Philadelphia, PA 19255.

However, no gift tax return is due for:

(1) A transfer that is not more than the annual exclusion (i.e., a present interest of $15,000 (in 2021) or less),

(2) A qualified transfer for educational or medical expenses, or

(3) A spousal transfer that qualifies for the unlimited marital deduction.

The donor must submit certain documents with the return. Copies of instruments executed for trans-fers of property, statements by insurance companies (Form 712), and copies of appraisals of real property must be submitted. If shares of stock in closely held corporations are listed on the return, the documents used to value the shares, such as balance sheets, profit and loss statements for each of the 5 years preceding the valuation date, and statements of dividends paid during that period must be attached.

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Extension of Time to File

An extension of time to file a gift tax return (up to 6 months) may be requested from the District Director or Service Center for the donor’s area. The reason for the delay must be fully explained. An extension of time to file does not extend the time to pay the tax. No form is provided for this request.

Note: An extension of time to file an income tax return for any tax year that is a calendar year automatically extends the time for filing the annual gift tax return for that calendar year until the due date of the income tax return.

Extension of Time to Pay

The tax shown on the gift tax return must be paid by the person required to file the return at the time and place fixed for filing. However, at the request of the donor, a reasonable extension of time, up to 6 months, may be granted by the Service Center for the payment of the tax shown on the return. The extension may exceed 6 months if the donor is abroad.

Note: For a deficiency, an extension of time for up to 18 months may be granted. In an exceptional situation, another 12 months may be granted.

Interest must be paid on any amount of tax that is not paid by the last date prescribed for the payment of the tax. The last date for payment is the due date determined without regard to any extensions of time to pay.

Split Gifts

A gift made by a person to someone other than a spouse may be considered as made one-half by each spouse. This is known as gift splitting and both spouses must consent to its use. Generally, if a gift is split a lower gift tax rate bracket applies to the total taxable gift. In addition, the annual exclu-sion and the applicable exclusion amount ($11,700,000 in 2021) allowable to each spouse applies to the gift.

Form 709 must be filed if a donor and spouse chose to gift-split. In general, if a donor and spouse agree, all gifts either spouse makes to a third party during the calendar year will be considered as made one-half by each spouse.

Note: Form 709-A, United States Short Form Gift Tax Return, previously used by married couples to report nontaxable gifts they consent to split is obsolete.

When the donor and his or her spouse elect gift splitting, then both spouses must file his or her own individual gift tax return. A married couple may not file a joint gift tax return. However, only one spouse must file a return if all the requirements of either of the following exceptions are met:

1. During the calendar year:

a. only one spouse made any gifts,

b. the total value of these gifts to each third-party donee does not exceed $30,000 (in 2021), and

c. all of the gifts were of present interests; or

2. During the calendar year:

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a. only one spouse (the donor spouse) made gifts of more than $15,000 but not more than $30,000 (in 2021) to any third-party donee,

b. the only gifts made by the other spouse (the consenting spouse) were gifts of not more than $15,000 (in 2021) to third-party donees other than those to whom the donor spouse made gifts, and

c. all of the gifts by both spouses were of present interests.

If either of the above exceptions is met, only the donor spouse must file a return and the consenting spouse signifies consent on that return.

Form 709 must be filed by April 15 of the calendar year following the year the donor made the non-taxable split gifts unless an extension of time to file has been granted.

Note: Generally, in community property states the election is not available to spouses who make gifts of community property because both spouses are already considered to own the gift property equally.

Special Applications & Traps

Bargain Sales

The gift tax applies not only to the gratuitous transfer of any kind of property, but also to sales or exchanges, not made in the ordinary course of business, where money or money’s worth is exchanged but, the value of the money received is less than the value of what is sold or ex-changed. In such a case, the tax is imposed only on the value of the excess. However, if a bona fide transfer, sale, or exchange is made at arm’s length in the ordinary course of business, the transaction will be considered a transfer for adequate consideration and not subject to gift tax.

Below Market Loans

Below-market loans have gift tax consequences. The right to use money is the property right being transferred and, if no interest or a low rate of interest is charged, the transfer is for less than adequate consideration. If a below-market loan is a gift loan, it may be subject to the gift tax.

A below-market loan is:

(1) A demand loan on which the interest is payable at a rate less than the applicable federal rate, or

(2) A term loan in which the amount loaned (amount received by the borrower) exceeds the present value of all payments due under the loan.

A gift loan is any below-market loan where the forgone interest is in the nature of a gift. A loan between unrelated persons can qualify as a gift loan.

Foregone interest is the excess of:

(1) The amount of interest that would have been payable for the period if interest accrued at the applicable federal rate and were payable annually on the last day of the calendar year, over

Note: For demand loans, the applicable federal rate is the federal short-term rate in effect for the period for which the amount of foregone interest is being determined, compounded semiannually. The applicable federal rate for a semiannual period (January 1 through June 30 or July 1 through

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December 31) is the short-term rate that is in effect for the first month of that semiannual period (i.e., January or July). In the case of a below-market demand loan of a fixed principal amount that remains outstanding for an entire calendar year, the “blended annual rate” may be used to com-pute foregone interest. For term loans, the applicable federal rate is the federal short-term, mid-term, or long-term rate, based on the term of the loan, in effect on the day the loan was made, compounded semiannually. These federal rates are published monthly.

(2) Any interest payable on the loan properly allocable to that period.

If the gift loan is a below-market demand loan, the foregone interest is treated as transferred (as a gift) by the lender to the borrower. Any foregone interest attributable to periods during any calendar year is treated as transferred on the last day of that calendar year.

If the gift loan is a below-market term loan, the lender is treated as having transferred (as a gift) on the date the loan was made an amount equal to the excess of the amount loaned, over the present value of all payments that are required to be made under the terms of the loan. Present value is determined on the date of the loan by using a discount rate equal to the applicable fed-eral rate.

Exception

These provisions do not apply to gift loans directly between individuals for any day on which the total outstanding amount of loans between these individuals is not more than $15,000 (in 2021). This exception does not apply to any gift loan directly attributable to the purchase or carrying of income-producing assets.

Net Gifts

If a gift is made on the express or implied condition that the donee pays the gift tax, the payment of this tax is deducted from the value of the gift made as partial consideration for the gift. It should be noted that such an agreement does not release the donor from the principal liability of paying the gift tax if, in fact, the tax is not paid. The payment of gift taxes by a donee causes an interrelated or circular computation known as a net gift computation (R.R. 75-72).

Note: If the donee pays the gift tax, the donor realizes taxable income to the extent the gift taxes paid by the donee exceed the donor’s adjusted basis in the property.

Promises to Make a Gift

A promise to make a gift becomes taxable in the year the obligation becomes binding and not when the discharging payments are made. As a result, if one promises to transfer property in the future, the gift becomes taxable as of the first date on which it is possible to determine that the transfer must be made and that it will be of a determinable amount.

Example

Dan creates a trust under the terms of which he can revoke the transfer and revest title in his name, the transfer is an incomplete gift. The same would be true if Dan reserved the power to alter the instrument, enabling him to name new beneficiaries or change the interests of the beneficiaries. The gift would, in either case, become complete at such time as Dan renounces the power, or the right to exercise it ceases, because of some event or contingency or the fulfillment of some condition other than his death.

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The gift would be considered complete if the powers could be exercised only with the consent of a person having a substantial adverse interest.

Checks

If the donor delivers his or her own check to another as a gift, the gift is not complete, for gift tax purposes, until the check is paid, certified, or transferred for value to a third person.

Stock Certificates

If the donor delivers a properly endorsed stock certificate to the donee or to the donee’s agent, the gift is completed, for gift tax purposes, on the date of delivery. However, if the donor delivers the certificate to his or her bank or broker as donor’s agent, or to the issuing corporation or its transfer agent, for transfer to the donee’s name, the gift is only completed on the date the stock is transferred on the corporation’s books.

Promissory Notes

If the donor transfers his or her own promissory note to another as a gift, the gift is completed on the date of the transfer if the promissory note is legally enforceable. The transfer of a legally unenforceable promissory note is an incomplete gift until the note is paid or transferred for value.

Powers of Appointment

A power of appointment is a power to determine who will own or enjoy the property subject to the power. The exercise or complete release of a general power of appointment is treated as a gift unless the exercise or release was for adequate consideration.

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Review Questions

118. A taxpayer may give a gift to a person other than a spouse and have it be treated as made one-half by each spouse. What is this called?

a. bargain sales.

b. gift loaning.

c. gift splitting.

d. powers of appointment.

119. Taxpayers may be required to pay gift tax on gift loans. Under what type of gift loan is fore-gone interest treated as a transferred gift by the lender to the borrower?

a. below-market demand loan.

b. below-market term loan.

c. foregone loan.

d. net gift.

120. A donor can gift stock certificates. For gift tax purposes, if such a gift is delivered to the donee, when is the gift deemed completed?

a. on the delivery date.

b. under the same rules that apply to promissory notes.

c. under the check delivery rules.

d. on the date the stock is transferred on the corporation’s books.

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Answers & Explanations

1. When considering income, gift, and, ultimately, death taxes, taxpayers should attempt to re-duce the overall tax load for the whole family unit. What is this process called?

a. Incorrect. Estate planning tries to encourage wealth building for everyone. Building an estate involves financial and investment planning and goes beyond reducing the overall tax load for the family unit.

b. Incorrect. Once you have made and preserved an estate, you must determine how to distribute it to your heirs. Estate distribution is multifaceted and involves more than family tax reduction.

c. Incorrect. Estate planning is more than just planning for family tax reduction. It includes build-ing an estate during a lifetime, then seeing that those assets are protected in an estate that can be passed to the next generation. It allows you the opportunity to control your success both during life and on death.

d. Correct. Preservation is the process of looking at income, gift, and, ultimately, death taxes to minimize the overall tax burden for the total family unit. [Chp. 1]

2. An accountant, an attorney, a financial planner, and an insurance agent are the professionals most often on an estate planning team. Of these professionals, whose responsibilities include being familiar with the client’s financial affairs and being well-informed on income and estate tax laws?

a. Correct. The accountant should know the financial affairs of the taxpayer, recognize the client’s need for potential estate planning, and be knowledgeable with respect to income and estate tax laws. The accountant should also be able to advise on valuation problems and family income needs.

b. Incorrect. The attorney should decide whether suggestions, recommendations, and phases in the plan have legal substance and merit. A competent attorney must draft the legal documents that are the framework of an effective estate plan. Only a lawyer may legally practice law.

c. Incorrect. The financial planner should be able to advise on investment return, asset manage-ment, and cash flow analysis. The financial planner should also know enough about insurance, estate taxes, and law to suggest possible solutions for the client to discuss with his or her ac-countant and attorney.

d. Incorrect. Insurance agents are great motivators in getting persons involved in the estate plan-ning process and can provide excellent advice and ideas. The agent should have specialized knowledge of the many forms of life insurance and know what various policies can and cannot do. [Chp. 1]

3. Individuals create wills to instruct how they would like their possessions to be disposed of upon their death. What must a will go through in order for an executor to carry out the decedent’s instructions?

a. Incorrect. While there are many devices for the transfer of assets outside of the probate sys-tem, a will is not one of them. Typically, these probate avoidance arrangements produce no state or federal death tax savings. Their primary rationale is avoidance of probate and transfer conven-ience.

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b. Incorrect. If there’s no will, property in the probate estate is distributed according to the state law of intestacy. When an individual dies intestate, the probate court chooses a person respon-sible for administering the estate and distributing the probate assets.

c. Correct. Upon the decedent’s death, the will must go through the probate process in order to have the instructions carried out.

d. Incorrect. Probate avoidance techniques are transfers that operate independently of one’s will. These transfer devices determine who gets property at the estate owner’s death regardless of the owner’s will or trust. [Chp. 1]

4. Life insurance proceeds are included in a decedent’s estate where the decedent retained inci-dents of ownership over the policy. What planning device can taxpayers use to avoid this in-clusion?

a. Incorrect. Under a payable on death account, or “Totten” trust, a bank account owner names a beneficiary (or payee) who automatically receives the account balance on the death of the owner. Such accounts are not used to hold life insurance policies.

b. Incorrect. A private annuity is where one person transfers property (not a life insurance policy) to another (who is not in the business of selling annuities) for that person’s unsecured promise to make fixed periodic payments to the other for life. Recent regulations have compromised pri-vate annuities.

c. Incorrect. A self-canceling installment note is a device that arose to prevent the inclusion of an installment note in a seller’s estate. This type of installment sale uses a promissory note that by its terms expires on the death of the payee.

d. Correct. Frequently, an irrevocable insurance trust is used to avoid inclusion of the insurance proceeds in the decedent’s estate. In such a case, the incidents of ownership over the life insur-ance policy are typically transferred to the trust. [Chp. 1]

5. Crummey trusts are based on a court case in which a taxpayer wanted to make present interest gifts through a trust. What is a characteristic of such a Crummey trust?

a. Incorrect. In a Crummey trust, gifts are made to an irrevocable trust.

b. Correct. Under a Crummey trust, if the beneficiaries do not make a withdrawal, the funds re-main in the trust and are administered pursuant to its terms. The result is hopefully the use of the annual exclusion with subsequent control of the funds by the trustee.

c. Incorrect. Generally, making gifts to a trust presents problems when one also wants to take advantage of the annual exclusion. The annual exclusion requires that any excluded gifts must be present interests, not future - as in a trust. The Crummey trust is meant to overcome this prob-lem.

d. Incorrect. Under a Crummey trust, the beneficiaries are given only a short period of time each year to withdraw the gift from the trust. [Chp. 1]

6. For their heirs, grantors may transfer some assets to an irrevocable trust and, for themselves, they may keep an income or beneficial right in the transferred property. What is such an estate-planning device often called?

a. Incorrect. A buy-sell agreement is a contract between business owners for the disposition of their interests upon the happening of certain events. Whenever two or more people are in busi-ness together it is an absolute necessity that they have a buy-sell agreement.

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b. Incorrect. A family limited partnership can be a great income, estate, and gift tax savings de-vice. However, while senior family members can control property transferred to such a partner-ship, they may not retain an income or beneficial right in the property.

c. Correct. A grantor retained income trust is an estate planning tool in which a grantor transfers certain property to an irrevocable trust for the benefit of his or her heirs while retaining for them-selves an income or beneficial right in the property.

d. Incorrect. Minor trusts under §2503 are similar in purpose to Crummey trusts. If properly struc-tured these trusts qualify in whole or in part for the annual gift tax exclusion by law. [Chp. 1]

7. Upon a decedent’s death, numerous tax forms must be filed. Which form is due for the period of January 1 to the date of the decedent’s death?

a. Incorrect. Form 706 is filed for taxes imposed by the federal government on the transfer of assets on death - i.e., estate taxes. This form is due nine months after the decedent's death.

b. Incorrect. Form 709 is filed if the decedent made taxable gifts during his or her lifetime but failed to pay gift taxes. The executor must pay these taxes plus interest and penalty.

c. Correct. A decedent’s final income tax return, Form 1040, must be filed for the period of Janu-ary 1 to the date of death.

d. Incorrect. Form 1041 must be filed and income taxes paid if your estate has any income after your death. [Chp. 2]

8. Federal estate tax is one of eight potential death taxes. What is a distinguishing characteristic of the federal estate tax?

a. Incorrect. Federal estate tax is privilege tax. Apparently, the government feels it is granting you the privilege to receive property.

b. Correct. Federal estate tax is a tax that is imposed on property transfers.

c. Incorrect. Amazingly, the federal estate tax is technically considered an excise tax.

d. Incorrect. - Conceptually, the federal estate tax is not imposed on property itself but on the right to transfer it. [Chp. 2]

9. Estate and inheritance taxes are the two basic types of state death taxes. What is a character-istic of the estate tax used by many states?

a. Incorrect. Most inheritance tax systems apply separate exemptions and rates to the share re-ceived by each heir. Typically, the rates and exemptions vary depending upon the relationship of the heir.

b. Incorrect. Inheritance tax is a tax upon property received by heirs.

c. Correct. Estate tax is basically a tax upon the value of all property owned at death which is transferred to heirs.

d. Incorrect. Even where there is no direct tie, state inheritance taxes are often similar to federal estate tax concerning the property and transfers subject to tax. Thus, federal estate tax planning should achieve suitable state inheritance tax results as well. [Chp. 2]

10. Section 2033 provides that when an interest terminates at death, said interest is excluded from taxation. Under R.R. 75-127, what has also been excluded from taxation?

a. Incorrect. If the insured is dead when the insurance policy owner dies, then any proceeds re-maining at death are taxable.

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b. Incorrect. Income accruing from rental property after death is not included but is income tax-able to the estate or heirs.

c. Incorrect. Income accruing from stocks or bonds after death is not included but is income tax-able to the estate or heirs.

d. Correct. For many years the Service insisted that wrongful death actions were taxable under §2033. However, in R.R. 75-127, the Service reversed itself and agreed that the value of wrongful death claims (or the proceeds) is not taxable. [Chp. 2]

11. If a remainder person dies prior to obtaining a decedent’s property interest, it can be included in the remainder person’s estate. In such a case, what is this interest called?

a. Incorrect. A contingent remainder is an interest that does not come into enjoyment or posses-sion unless a future condition occurs, or can end on the occurrence (or nonoccurrence) of a future event.

b. Incorrect. A curtsey is a statutory provision in a common-law state that directs a certain portion of the estate to the husband.

c. Incorrect. A dower is a statutory provision in a common-law state that directs a certain portion of the estate to the wife.

d. Correct. A vested remainder is included in the estate of a remainder person who dies before obtaining such property interest. However, a remainder interest can be limited to the remainder person’s life. [Chp. 2]

12. Section 2036(a) imposes four requirements for taxation of transfers with a retained life inter-est. What is one of those requirements?

a. Incorrect. Section 2036 does not apply to a power held solely by a person other than the de-cedent, such as an independent trustee. However, if the decedent reserved the power to remove a trustee and appoint himself or herself as trustee, the decedent is considered as having the powers of the trustee.

b. Correct. One of the four requirements specified in §2036(a) for taxation of transfers with a retained life interest is that the decedent must have retained interests in or powers over the property.

c. Incorrect. The entire value of property subject to a retained interest or power is taxable under §2036. The tax is not limited to the value of the specific interest or power. However, where the retained right relates only to a portion of the property, only that portion is taxed.

d. Incorrect. One of the four requirements specified in §2036(a) for taxation of transfers with a retained life interest is that there must have been a lifetime transfer of property. [Chp. 2]

13. According to the author, taxpayers may make charitable contributions in three basic ways. In which method are property interests received by both charitable and noncharitable beneficiar-ies?

a. Incorrect. An immediate contribution is made in cash, by check, or by transferring property to a charitable organization.

b. Incorrect. Life insurance can be used to fund charitable contributions by assigning ownership of an existing policy to a charity, making a charity beneficiary of an existing policy, or making a charity an irrevocable beneficiary of a new policy.

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c. Incorrect. The three primary ways to make a charitable contribution are immediate, split-in-terest, and insurance-related. A pledge is typically a promise to make a future gift.

d. Correct. In a split-interest contribution, interests in the same property are given to both char-itable and noncharitable beneficiaries. Examples of split interests include charitable remainder trusts and partial interests. [Chp. 2]

14. A taxpayer can make a deductible contribution in trust to a charity. What is a planning consid-eration in establishing a charitable remainder trust?

a. Incorrect. A contribution of a remainder interest in tangible personal property is deductible only when all intervening interests are held by parties unrelated to the donor.

b. Incorrect. A contribution of a remainder interest in tangible personal property is deductible only when all intervening interests have expired.

c. Incorrect. Any individual beneficiaries must be alive when the trust is created.

d. Correct. The contribution must be of real property or intangibles. [Chp. 2]

15. Under §§170 and 2055(e), split gifts can be in three formats. In which format does the charity maintain the trust?

a. Incorrect. A charitable lead trust is not one of the three basic formats that can be used to split gifts. However, this type of trust is not maintained by the charity but is maintained by a trustee other than the charity.

b. Incorrect. A charitable remainder annuity trust is a type of annuity trust that can be used for interest splitting purposes. However, the charity that receives interest from this trust does not maintain said trust.

c. Incorrect. A charitable remainder trust is a way to split gifts. However, a trustee other than the charity maintains a charitable remainder trust.

d. Correct. A pooled income fund is a trust maintained by the charity into which each donor trans-fers property. [Chp. 2]

16. In a charitable remainder trust, a taxpayer makes a contribution of property to a trust for the immediate benefit of the taxpayer and the future benefit of a charity. What is fundamentally the opposite of a charitable remainder trust?

a. Correct. A charitable lead trust is essentially the reverse of a charitable remainder trust. The donor gives an income interest to the charity, with the remainder reverting to the donor or named beneficiaries.

b. Incorrect. Under a charitable remainder annuity trust, the trustee annually distributes to the noncharitable beneficiary at least five percent of the original value of the trust assets. On termi-nation of the payments, the remainder interest is transferred to the charity or retained by the trust for the benefit of the charity.

c. Incorrect. A charitable remainder unitrust is a trust where the trustee must distribute annually the lesser of a fixed percentage (at least 5%) of the trust estate (determined annually), or all trust income. A charitable remainder unitrust provides the noncharitable beneficiary a variable payout based on the annual valuation of the trust assets.

d. Incorrect. In a pooled income fund, each donor transfers property into a trust from which each named beneficiary receives an income interest. Donors contribute property to the trust reserving

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a life estate in a share of the total property. The public charity must be the irrevocable remainder. [Chp. 2]

17. Upon the decedent’s death, a marital deduction is allowed for assets that pass completely to the surviving spouse. When is said deduction denied for assets?

a. Incorrect. A marital deduction trust qualifies for the marital deduction. Under this trust, the first spouse to die leaves his or her assets in trust for the survivor’s benefit.

b. Incorrect. A marital deduction is permitted for property passing to a qualified domestic trust of which the noncitizen surviving spouse is a beneficiary. A qualified domestic trust is a trust that has as its trustee at least one U.S. citizen or U.S. corporation.

c. Incorrect. Assets left outright to a spouse qualify under the marital deduction and pass tax-free.

d. Correct. A marital deduction is denied for property passing to a surviving spouse who is not a citizen of the United States. [Chp. 2]

18. The property basis for an asset can vary based on how it was acquired. In what type of trans-action is the basis the lesser of the original owner's basis or the fair market value on the trans-action date?

a. Incorrect. In a gift later sold at a gain, the basis is the donor’s basis.

b. Correct. In a gift later sold at a loss, the basis is the lesser of the donor’s basis or the fair market value on the date of the gift.

c. Incorrect. In a purchase, the basis is the cost of property plus improvements.

d. Incorrect. In a tax-deferred exchange, the basis is the original basis of property given up, plus “boot” given, plus any net increase in debt. [Chp. 2]

19. The start of a holding period for an asset can depend on how it was acquired. In which of the events below does the holding period for an asset commence on the date of someone's death?

a. Incorrect. For a reversion, the holding period starts on the date the property is received.

b. Incorrect. For a gift with a gain, the holding period starts on the date the donor’s holding period started.

c. Correct. In an inheritance, the holding period starts on the date of the decedent’s death.

d. Incorrect. In a seller repossession, the holding period includes the period before and after the seller repossession. [Chp. 2]

20. Under the 2010 special estate election, property received from a decedent was subject to the modified carryover basis rules. According to this legislation, what qualified as an asset obtained from the decedent?

a. Incorrect. The modified carryover basis rules applied to property acquired from the decedent, which is property acquired by bequest, devise, or inheritance - not by gift.

b. Incorrect. The modified carryover basis rules applied to property acquired by the decedent’s estate from the decedent. Property acquired by the decedent estate from the surviving spouse would not qualify.

c. Correct. The modified carryover basis rules applied to property acquired from the decedent, which is property passing from the decedent by reason of the decedent’s death to the extent

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such property passed without consideration (e.g., property held as joint tenants with right of survivorship or as tenants by the entireties).

d. Incorrect. The modified carryover basis rules applied to the surviving spouse’s one-half share of certain community property held by the decedent and the surviving spouse as community property. [Chp. 2]

21. Six types of property were ineligible for a modified basis increase under the 2010 special elec-tion. However, what property qualified for a basis increase?

a. Incorrect. Property not eligible for a basis increase included property that constitutes a right to receive income in respect of a decedent. This was one of the six types of property that are ineligible for a basis increase.

b. Correct. In general, the basis of property could be increased above the decedent’s adjusted basis in that property only if the property was owned, or was treated as owned, by the decedent at the time of the decedent’s death. The decedent was treated as the owner of property (which will be eligible for a basis increase) if the property was transferred by the decedent during his or her lifetime to a revocable trust that pays all of its income during the decedent’s life to the dece-dent or at the direction of the decedent.

c. Incorrect. Property not eligible for a basis increase included stock of a foreign investment com-pany. This was one of the six types of property that are ineligible for a basis increase.

d. Incorrect. Property not eligible for a basis increase included stock or securities of a foreign personal holding company. This was one of the six types of property that are ineligible for a basis increase. [Chp. 2]

22. The generation-skipping transfer tax (§2601) applies to three basic types of transfers. Which of these transfer types is considered an outright transfer to a second generation family mem-ber?

a. Incorrect. Under, §2601, the generation-skipping transfer tax applies to taxable terminations, taxable distributions, and direct skips.

b. Correct. A direct skip is a transfer subject to gift or estate tax but is made to a second genera-tion family member - i.e., a skip person. However, a transfer to a grandchild is exempt if the parent of the grandchild is dead.

c. Incorrect. A taxable distribution means any distribution from a trust to a skip person and is not made outright.

d. Incorrect. A taxable termination is defined as any termination (by death, lapse of time, release of a power, or otherwise) of an interest in property held in trust, unless: immediately after such termination, a non-skip person has an interest in such property, or at no time after such termina-tion may a distribution be made from such trust to a skip person. It is not made outright. [Chp. 2]

23. Most gifts are subject to gift tax. However, under §2501, what type of transfer is not subject to gift tax?

a. Correct. Under §2501, the gift tax can be imposed on the transfer of property by gift by any individual. This language implies that gift tax cannot apply to entities.

b. Incorrect. Under §2501, the gift tax can be imposed on the transfer of property by gift whether the transfer is in trust or otherwise.

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c. Incorrect. Under §2501, the gift tax can be imposed on the transfer of property by gift whether the gift is direct or indirect.

d. Incorrect. Under §2501, the gift tax can be imposed on the transfer of property by gift whether the property is real or personal, tangible or intangible. [Chp. 2]

24. A gift’s value must be determined for federal gift tax purposes. For which of the following items are IRS tables used to determine present value on the date that the gift is completed?

a. Incorrect. The value of a life insurance policy, issued by a company regularly engaged in the selling of such contracts, is the amount that the issuing company would charge for a comparable contract on the date of the decedent’s death.

b. Incorrect. Generally, the best indication of the value of real property is the price paid for the property in an arms-length transaction on or before the valuation date.

c. Correct. The value of remainders or reversions is generally the present value on the date of the gift determined by IRS tables. The tables and factors used depend on the date of the transfer.

d. Incorrect. The value of stocks and bonds is their fair market value per unit (share or bond) on the date of the gift. If there is a market for stocks and bonds on a stock exchange, in an over-the-counter market, or otherwise, the fair market value per unit is the mean (midpoint) between the highest and lowest quoted selling prices on the date of the gift. [Chp. 2]

25. The portion of a property interest that is transferred to a charity, when the transfer is for com-bined charitable and noncharitable purposes, may qualify for a charitable deduction. Under what circumstance is this deduction allowed for said portion of the interest?

a. Correct. If the donor transfers a qualified real property interest to a qualified organization ex-clusively for conservation purposes, the value of that interest is deductible.

b. Incorrect. An undivided portion of the donor’s entire interest in property must consist of a fraction or a percentage of each interest or right the donor owns in the property, and it must extend over the entire term of his or her interest in that property or in other property into which the donated property is converted.

c. Incorrect. If the donor transfers the remainder interest, not in trust, in a farm to a qualified charity, the value of that interest is deductible.

d. Incorrect. If the donor transfers for a charitable purpose the remainder interest, not in trust, in his or her personal residence, the value of the interest is a deductible charitable contribution. [Chp. 2]

26. Six disadvantages of giving gifts are provided in the course material. What is one of these dis-advantages?

a. Incorrect. An advantage of giving gifts is that gifts from one spouse to the other are completely free of gift tax.

b. Incorrect. An advantage of giving gifts is that $15,000 (in 2021) may be transferred free of any transfer tax to any donee, each and every year; the amount may be $30,000 if spouses join in the gifts.

c. Correct. A disadvantage of giving gifts is that gifts can make the donee wealthier than the do-nor, thus making the ultimate tax burdens even higher, and shifting the obligation to pay those taxes from the donor to the donee.

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d. Incorrect. An advantage of giving gifts is that, in a community property state, a gift of low basis separate property to the community (a gift of one-half to the non-owning spouse) may ensure that upon the death of either spouse, the entire property will qualify for a step up in basis. [Chp. 2]

27. A bequest can be used to dispose of assets at death. What type of bequest is actually a dispo-sition of cash?

a. Incorrect. Some people add specific conditions to their will. This frequently cannot be done. Once you will something outright, you cannot add conditions to it.

b. Correct. A general bequest is actually a cash bequest. If there is not sufficient cash in the estate on death, the executor must sell assets to raise the necessary funds.

c. Incorrect. Even if the testator believes he has distributed everything, there still should be a clause that covers the “residue” of the estate. This means everything that is not specifically item-ized will go to someone who really deserves it.

d. Incorrect. A specific bequest (called a specific devise when real property) is the distribution of a specific asset. [Chp. 3]

28. Two individuals, typically spouses, may sign one will in which they dispose of both of their assets. What is such a will called?

a. Incorrect. A living will is a written document that allows an individual to designate a repre-sentative to make medical decisions for him or her if incapacitated due to accident or illness.

b. Correct. A joint will is when two people (usually husband and wife) sign one will disposing of both of their assets. This can be dangerous since there is some question whether such a will can be changed after the death of one of the parties.

c. Incorrect. A statutory will is exactly that - a simple preprinted form established by statute. Normally, you cannot change most provisions.

d. Incorrect. Two or three people must witness a will. The witnesses have to see the will signed by the testator. The testator then declares the document to be his or her will and asks the wit-nesses to attest to it by also signing the will. The witnesses should not receive any assets under the will. [Chp. 3]

29. When certain assets are put into a joint tenancy, the transaction can be treated as a gift. Which of the following assets become gifts when put into joint tenancy?

a. Incorrect. Bank accounts do not become gifts when put into joint tenancy.

b. Incorrect. Credit union accounts do not become gifts when put into joint tenancy.

c. Correct. Money market funds become gifts when put into joint tenancy. If the transfer of an asset into joint tenancy is a gift, then the other joint tenant(s) own a proportionate share of the assets and will be taxed on its income.

d. Incorrect. Vehicles do not become gifts when put into joint tenancy. [Chp. 3]

30. Rather than making changes directly on an original will, a separate document can be created. What is the name of such a document?

a. Correct. A codicil is a document that changes a will. It is the same as if the will had been retyped with the changes.

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b. Incorrect. A community property agreement is a document stating that regardless of how a husband and wife have taken title to property, some or all of their assets are to be treated as community property (R.R. 87-98).

c. Incorrect. A will is a legal document executed by a competent person according to the pre-scribed statutes of his or her state and contains instructions to be followed at death.

d. Incorrect. The original will should not be written on after it is signed. Going through the will crossing out language or making other changes is dangerous. This is referred to as “obliteration” and can completely cancel the will. The will should not be marked in any way after it is signed. [Chp. 3]

31. Individuals can choose from a variety of types of wills. What is a holographic will?

a. Correct. A holographic will is a handwritten will. The majority of states allow such wills if en-tirely in the decedent’s handwriting, dated and signed by the decedent. Normally, witnesses are not required.

b. Incorrect. An oral will is called a nuncupative will and is seldom valid.

c. Incorrect. A simple “I love you will” leaves all assets in small estates to a surviving spouse.

d. Incorrect. A deathbed will is a will that is established and executed when a testator faces im-minent death. [Chp. 3]

32. Three disadvantages of having an estate go through probate proceedings. What is one of these disadvantages?

a. Incorrect. An advantage claimed for probate proceedings is that the costs are deductible for tax purposes.

b. Correct. A disadvantage asserted against probated proceedings is that court proceedings are inherently inflexible.

c. Incorrect. An advantage claimed for probate proceedings is that the court protects the heirs and beneficiaries.

d. Incorrect. An advantage claimed for probate proceedings is that the transfer of title is a public record that prevents problems with title companies. [Chp. 3]

33. Trusts can be divided into two types based on when they are created. Which type comes into existence at the time of death and results in property having to go through probate?

a. Incorrect. Using a family trust, an individual typically sets up an irrevocable trust and appoints a committee to run it. The individual may then attempt to assign all his or her income (including future income) to the trust. The trust income is then either accumulated or distributed among spouses, children, or other relatives. The trust also pays for and deducts any expenses of the grantor. Such a trust would be created during an individual's lifetime.

b. Incorrect. Under §679, a U.S. citizen or permanent resident, who sets up a foreign trust which can make any payments to a beneficiary in the United States, is the owner for income and estate tax purposes and is taxed on all of the income and capital gains. Such a trust would be created during an individual's lifetime.

c. Incorrect. A grantor trust is a trust that a grantor can revoke or terminate. Trusts that fall in this category are not required to pay income tax or file an income tax return. The reasoning of the grantor trust rule is that if one can revoke a trust, he or she is the owner of the trust assets for income tax purposes. Grantor trusts are created during lifetime.

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d. Correct. Since the testamentary trust does not come into existence until the time of death, property cannot be put into such a trust while the testator is alive. Property must go through probate to fund this type of trust. After death, there is little difference between a living trust and a testamentary trust. [Chp. 4]

34. The author lists four disadvantages of a living trust. What is one of these disadvantages?

a. Correct. A disadvantage of a living trust is that assets must be transferred into the trust. Indi-viduals often forget to fully fund the living trust and thereby miss the opportunity to take full advantage of it.

b. Incorrect. An advantage of a living trust is that it avoids inheritance taxes. A living trust may also reduce or avoid probate costs.

c. Incorrect. An advantage of a living trust is that it avoids statutory restrictions on bequests of property.

d. Incorrect. A living trust does not increase the possibility of a will contest. In fact, an advantage of a living trust is that it often avoids will contests. [Chp. 4]

35. Based on the grantor trust rules, five conditions must be met in order for the grantor to be treated as the trust owner and to have the trust income taxed to them. What is one of these conditions?

a. Incorrect. Under the grantor trust rules, the grantor will be treated as the owner of the trust and be taxable on the trust income if the grantor, his or her spouse, or a nonadverse party has powers of disposition over the corpus or income.

b. Incorrect. Under the grantor trust rules, the grantor will be treated as the owner of the trust and be taxed on the trust income if the administrative control of the trust is, or may be, exercis-able primarily for the benefit of the grantor or his or her spouse.

c. Incorrect. Under the grantor trust rules, the grantor will be treated as the owner of the trust and be taxable on the trust income if the corpus will revert to the grantor or to the grantor’s spouse at any time and the reversionary interest is worth at least 5% of the value of the corpus as of the inception of the trust.

d. Correct. Under the grantor trust rules, the grantor will be treated as the owner of the trust and be taxable on the trust income if the grantor, his or her spouse, or a nonadverse party has the power to revoke the trust and revest all or a portion of the corpus in the grantor. [Chp. 4]

36. One type of trust requires that the surviving spouse receive all of the income in the trust and have a general power of appointment over the assets at death. What is this trust called?

a. Incorrect. A living trust (sometimes called an “inter vivos” trust) is created during a person’s lifetime. A living trust can be set up by husband and wife, or by a single person. Assets transferred into a living trust avoid probate but must be transferred before death.

b. Correct. Under a marital deduction trust, the survivor is required to receive all the trust’s in-come and have a general power of appointment over the assets at death.

c. Incorrect. A revocable trust can be changed or terminated as the need arises.

d. Incorrect. A testamentary trust is created at death under the provisions of your will. Assets cannot be put into this trust before death, since the trust does not exist until death. To fund such a trust, assets must go through probate. [Chp. 4]

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37. A qualified terminable interest trust may be used for a surviving spouse’s benefit. What is one characteristic of a qualified terminable interest?

a. Incorrect. A qualified terminable interest is a way to obtain the marital deduction under §2056.

b. Incorrect. To be a qualified terminable interest the surviving spouse must have a qualifying income interest for life.

c. Incorrect. A “qualifying income interest for life” exists if: the surviving spouse is entitled to all the income from the property (payable annually or at more frequent intervals) or the right to use property during the spouse’s life, and no person has the power to appoint any part of the prop-erty to any person other than the surviving spouse.

d. Correct. One characteristic of a qualified terminable interest is that it is property that passes from the decedent. [Chp. 4]

38. Another type of trust that can be established is a living “A-B” revocable trust. What is a char-acteristic of this type of trust?

a. Correct. Typically, under a living “A-B” revocable trust, the surviving spouse has control over TRUST A and can withdraw assets from the trust.

b. Incorrect. Typically, under a living “A-B” revocable trust, the surviving spouse can even revoke Trust A in its entirety.

c. Incorrect. Under a living “A-B” revocable trust, the survivor can receive all the income gener-ated by TRUST B.

d. Incorrect. Under a living “A-B” revocable trust, the survivor for purposes of health, mainte-nance, and support can withdraw the principal of the trust. [Chp. 4]

39. A simple will can be used to transfer a taxpayer’s entire estate on death. However, what can result when taxpayers with large estates use a simple will?

a. Incorrect. In larger estates, a simple will can result in severe death taxes on the survivor’s death when the remaining assets are conveyed to the children or other heirs.

b. Incorrect. A simple will may not avoid probate regardless of the size of the estate.

c. Incorrect. Because of the unlimited marital deduction, there should be no death taxes on the death of the first spouse regardless of the size of the estate. However, for larger estates using a simple will, the price of avoiding death taxes on the first death can be greater death taxes on the second death under this simple will format.

d. Correct. In larger estates, a simple will can result in “stacking” the surviving spouse’s estate. Stacking occurs when assets are transferred to the surviving spouse, and then when the surviving spouse dies, all remaining assets are passed to the children or other heirs with detrimental tax consequences. [Chp. 4]

40. An “A-B-C” trust separates into three separate trusts upon the death of the first spouse. Who should consider establishing an “A-B-C” living trust?

a. Incorrect. In the A-B-C living trust, TRUST B is a “bypass” trust that is funded by and takes advantage of the applicable exemption amount ($11,700,000 in 2021).

b. Correct. For those estates above twice the applicable exclusion amount ($11,700,000 in 2021), the “A-B-C” living trust should be considered. Federal death tax does not apply to the decedent’s portion because of the applicable exclusion amount for TRUST B and the unlimited marital de-duction for TRUST C. Because of ERTA, TRUST C assets qualify for the unlimited marital deduction.

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c. Incorrect. Frequently, the “A-B” format is recommended for moderate size estates that are in excess of the applicable exemption amount ($11,700,000 in 2021). This is because the applicable exemption amount can pass death tax-free from TRUST A to the CHILDRENS’ TRUST and a like amount plus growth can pass to the CHILDRENS’ TRUST.

d. Incorrect. Those with small estates might consider using only a simple will. [Chp. 4]

41. In a revocable living trust, the grantor should include certain basic provisions. Which provision names the property that is held within the trust, and identifies the intention of the trust agree-ment and how the property is to be used and disposed?

a. Incorrect. The identification clause identifies the grantor, trustee, co-trustee, successor trus-tee, and beneficiaries. Also stated are where they live and where the trust is created.

b. Incorrect. A trust agreement often refers to the income and directs that it be paid to some beneficiary. Generally, income refers to what the trust earns in interest, dividends, and net rental income. It does not include capital gains on the sale of a trust asset.

c. Incorrect. The property transfer clause declares what property is currently transferred to the trust and is the key to avoiding probate.

d. Correct. The recital clause identifies the property and states the purpose of the trust agree-ment and the use and disposition of the property. [Chp. 4]

42. Choosing a trustee can be complicated. Why might someone choose an individual trustee over a corporate trustee?

a. Incorrect. Someone might choose a corporate trustee over an individual trustee because it is financially accountable for mistakes.

b. Incorrect. Someone might choose a corporate trustee over an individual trustee because it is impartial as to the children. This may prevent the children from becoming bitter towards an in-dividual trustee who happens to be a friend or relative, and who doesn’t make distributions whenever the children ask for something.

c. Incorrect. Someone might choose a corporate trustee over an individual trustee because of permanence - it doesn’t die or become disabled.

d. Correct. Someone might choose an individual trustee over a corporate trustee because a rela-tive or friend may have a more personal interest. [Chp. 4]

43. Designing an estate plan can be problematic for individuals owning business entities. Who would likely have more difficulty designing such a plan?

a. Incorrect. Family limited partnerships are great estate planning devices. They offer many plan-ning opportunities. Business owners should consider establishing a family limited partnership for assets used by the business. The original owner could be the general partner with the remaining heirs as limited partners. However, the business itself should not be operated through the family limited partnership since capital is required to be a material income-producing item.

b. Incorrect. In many instances, business owners should consider incorporating as a regular cor-poration just for the tax benefits. This would expand the wealth-transfer possibilities, fringe ben-efits, and ability to save estate and gift taxes. With a corporation, it is possible to gift or bequest fractional interests in the entity by transferring stock. In addition, discounts can be taken for lack of marketability, blockage, and minority interests.

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c. Correct. Estate planning problems for the sole proprietor can be more severe than those posed by other business entities. In a sole proprietorship, there is no partner, shareholder, or separate entity to shoulder the burden if death or disability strikes. Often, there is no one ready to run the business and preserve its value on the sole proprietor’s death. It is impossible to gift or bequest fractional interests in the business.

d. Incorrect. In many instances, business owners should consider incorporating as an S corpora-tion just for the tax benefits. This would expand the wealth-transfer possibilities, fringe benefits, and ability to save estate and gift taxes. Like regular corporations, S corporations can be the sub-ject of fractional interests in gifts and bequests. [Chp. 5]

44. The author lists four potential advantages that partnerships may have over corporations from an estate-planning viewpoint. What is one of these advantages?

a. Incorrect. From the estate planning standpoint, a partnership has an advantage over a corpo-ration in that a partner’s share of the profits not withdrawn from the business increases the basis of the partner’s interest and therefore reduces the taxable gain on its sale or liquidation.

b. Correct. From the estate planning standpoint, a partnership has an advantage over a corpora-tion in that, if the partnership interest is retained, the successor to the deceased partner can, if the partnership files an election under §754, obtain an adjustment to basis of partnership assets under §743.

c. Incorrect. From the estate planning standpoint, a partnership has an advantage over a corpo-ration in that, through the flexible provisions of §736, liquidation of a partner’s interest can be planned to characterize a portion of such payments as guaranteed payments or a distributive share of profits under §736(a), taxable to the survivor and deductible by the partnership, i.e., the remaining partners.

d. Incorrect. From the estate planning standpoint, a partnership has an advantage over a corpo-ration in that the interest of the decedent in the partnership could be retained either as a general or limited partnership interest, with income distributions pertaining to that interest only taxed once. [Chp. 5]

45. S corporations can be used to avoid some C corporation tax issues. What must the corporation have so as to meet S corporation qualification requirements?

a. Incorrect. In order to qualify as an “S” corporation, there must be 100 or fewer shareholders. Remember, S corporations limit the number of shareholders that are permissible.

b. Correct. In order to qualify as an “S” corporation, all shareholders must be individuals residing in the United States, estates, or certain types of trusts. These are the eligible shareholders for an S corporation. Any other shareholders jeopardize S corporation status.

c. Incorrect. Differences in voting rights are permitted in an S corporation. While the regulations speak of a single classification of stock requirement, differences in voting rights are permitted.

d. Incorrect. An “S” corporation can only have one class of stock. However, differences between voting and nonvoting shares are ignored. This is a major planning exception for S corporations. [Chp. 5]

46. From an estate planning perspective, there are at least six reasons why transferring farmland to a corporation could be disadvantageous. What is one of these reasons?

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a. Incorrect. An advantage of a farm corporation is that it is easier to make gifts of stock in a corporation instead of interests in real property.

b. Incorrect. An advantage of a farm corporation is that it may be easier to meet the requirements of §6166 and §2032A where the owner of the farm is not actively managing it.

c. Correct. From an estate-planning standpoint, a transfer of farmland to a corporation would be a disaster because, even though the interest of the deceased shareholder may more appropri-ately be bought out at death, there is often a cash flow problem in farm operations, although the value of the land is quite high. It may therefore be extremely difficult or impossible to fund the buy-out, even with insurance.

d. Incorrect. An advantage of a farm corporation is that the TRA '86 limitations on installment sales of real property requiring recognition of gain based on seller’s outstanding indebtedness do not apply to sales of stock. [Chp. 5]

47. Trusts offer several tax and non-tax advantages over corporations. What is one of these ad-vantages?

a. Incorrect. Trusts that have the characteristics of corporations will be taxed as corporations, thereby often denying participants anticipated tax treatment.

b. Correct. Trusts have many non-tax advantages over corporations or partnerships. They can be formed privately without the necessity to apply to state authorities or file the names of all the participants with the County Clerk.

c. Incorrect. Corporations provide centralized management, limited liability, ease in transferring interests, and continuous uninterrupted existence. Some trusts may have these characteristics, but most do not. In fact, under the rule against perpetuities, most trusts must terminate within a life in being plus 21 years.

d. Incorrect. Regular corporations are separate legal and tax entities. Under the grantor trust rules, many trusts are not separate tax entities. [Chp. 5]

48. A popular way to hold title to assets is through a limited liability company (LLC). What is the principal advantage that LLCs offer?

a. Incorrect. When an LLC is deemed to be a partnership, it is subject to partnership taxation provisions.

b. Incorrect. The major disadvantage to an LLC is that it is new. Many legal and tax concepts await further refinement and clarification.

c. Incorrect. Unlike a limited partnership, where at least one general partner is personally liable, with an LLC none of the personal assets of any of the owners is subject to creditors.

d. Correct. The primary advantage of an LLC is that, without incorporation, owners are protected from personal liability for debts of the entity. In addition, with an LLC, limited liability remains whether or not the owner actively participates in the affairs of the business. [Chp. 5]

49. Three fundamental types of retirement plans exist. Which of these is uniquely designed for self-employed persons?

a. Incorrect. The individual retirement account (IRA) is essentially for all persons having earned income. However, it is not the predominant plan of choice for self-employed persons and is typ-ically used by employees and other wage earners.

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b. Correct. The Keogh plan is specifically designed for self-employed persons. These plans were dramatically improved in 1983 and are now very similar to corporate plans.

c. Incorrect. Typically, a defined benefit plan is a type of qualified corporate retirement plan. However, a defined benefit formula may be used for self-employeds’ plans.

d. Incorrect. Typically, a defined contribution plan is a type of qualified corporate retirement plan. However, a defined contribution formula can be used for self-employeds’ plans. [Chp. 5]

50. Employers can use one of four features to lower their expenses for retirement plans. Under which of the following features can the employer decrease plan contributions by the contribu-tions that the employer makes to the OASDI part of Social Security?

a. Incorrect. Under ERISA, retirement plans are subject to strict coverage and participation re-quirements. Once an employee meets these conditions his or her participation cannot be de-ferred.

b. Incorrect. By using a deferred vesting schedule, an employer can require employees to work a certain number of years before being entitled to entire contributions made on their behalf. This reduces costs for businesses with high employee turnover and encourages longer employee ser-vice.

c. Incorrect. An employer may choose to exclude part-time employees and those employees un-der age 21 from participation. Moreover, non-resident aliens and those covered by collective bargaining agreements need not be covered.

d. Correct. Contributions to the plan can be reduced by the amount of employer contributions made to the OASDI portion of Social Security. This reduces contribution costs for an employee who earns less than the Social Security wage base. [Chp. 5]

51. Life insurance positions contractual rights among four separate parties. Which of these parties manages the policy and may elect any options?

a. Incorrect. A beneficiary is the party paid policy proceeds on the insured’s death or some other specified event.

b. Incorrect. The insured is the party whose lifetime or other life event is used to determine the maturity of the policy. The insured does not necessarily manage the policy or make any elections.

c. Incorrect. For a premium payment, an insurer agrees to pay an amount on the insured’s death or some other specified event. Although the insurer can control what is offered, once the policy is issued it is a contract between the parties.

d. Correct. The owner is the person who controls the policy and who can elect any options and who selects the beneficiary to receive the funds upon the insured’s death. Frequently, the same person is the owner as well as the insured. [Chp. 6]

52. Typically, life insurance is not controlled by a will. However, under what circumstance must a decedent’s estate be the recipient of life insurance and pass any proceeds by the will?

a. Incorrect. A will, whether it is properly drafted or not, does not typically control life insurance.

b. Incorrect. If no owner is listed on the policy designation, this would not necessarily make the proceeds subject to the will. However, the owner must select the beneficiaries that will receive funds upon the insured’s death.

c. Correct. The insurance must be paid to the decedent’s estate and passes by the will if the primary beneficiary has died and no other beneficiary is named.

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d. Incorrect. If the primary beneficiary is living, any proceeds will go directly to him or her without going through the estate. [Chp. 6]

53. The “transfer for value” rule applies if a life insurance policy was purchased. To what extent are the insurance proceeds taxable when this rule applies?

a. Correct. While insurance proceeds are normally not income, they are taxable income if the policy was purchased. This is known as the “transfer for value” rule. However, such proceeds are taxable income only to the extent they exceed: the consideration paid by the transferee and the net premiums paid by the transferee after the transfer.

b. Incorrect. The “transfer for value” rule does not apply if the sale or transfer is to a corporation of which the insured is a stockholder or officer.

c. Incorrect. The “transfer for value” rule does not apply if the sale or transfer is to a partner of the insured or a partnership, in which the insured is a partner.

d. Incorrect. The “transfer for value” rule does not apply if the sale or transfer is to the insured’s spouse, even if for value or incident to a divorce. [Chp. 6]

54. Section 72 separates each annuity payment into two portions. What are these two parts of such an annuity payment?

a. Incorrect. Rather than take a lump sum payment, sometimes a policy owner will take lifetime benefits under a “settlement option.” These choices are alternative methods of payment not a conceptual division.

b. Correct. Under §72, each payment is divided into two parts: a nontaxable return of cost and taxable income.

c. Incorrect. Premiums for personally owned life insurance are considered nondeductible per-sonal expenses and are not deductible for income tax purposes unless: premiums constitute ali-mony payments from a pre-2019 decree, or premiums are paid on a policy irrevocably assigned to a charity.

d. Incorrect. Term and whole life are types of life insurance that are available. [Chp. 6]

55. Section 2042 provides three conditions that will cause life insurance to be taxable for federal estate tax purposes. What is one of these conditions?

a. Incorrect. Under §2042, life insurance is taxable for federal estate tax purposes if, at the time of death, the insured possessed any incidents of ownership in the policy.

b. Incorrect. Under §2035, life insurance is taxable for federal estate tax purposes if the policy is transferred by the decedent within three years of his or her death.

c. Incorrect. Under §2042, life insurance is taxable for federal estate tax purposes if the proceeds are for the benefit of his or her estate.

d. Correct. Under §2042, life insurance is taxable for federal estate tax purposes if the proceeds are payable to the decedent’s estate. [Chp. 6]

56. There are fundamentally four types of term insurance. With which type can the policy owner exchange the policy for a whole life or endowment policy without having to show proof of insurability?

a. Correct. Convertible term can be exchanged for a whole life or endowment policy without evidence of insurability.

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b. Incorrect. Decreasing term, also called mortgage term, has a death benefit that decreases over time, yet the premium remains level.

c. Incorrect. In level term insurance, the death benefit and premium remain the same for the entire policy term.

d. Incorrect. Renewable term can be renewed each year regardless of the insured’s health but at an increasing premium. [Chp. 6]

57. Whole life insurance can be divided into two categories: straight life and limited payment life. What is a fundamental distinction that can be made between these two types?

a. Incorrect. A modified life policy initially has low premiums but correspondingly higher premi-ums during the later policy period. Such policies are often marketed to young families who ini-tially can’t afford large premiums.

b. Incorrect. A basic difference between straight life and limited payment life is that in a limited payment life policy, the premiums are higher.

c. Correct. A basic difference between straight life and limited payment life is that in a limited payment life policy, premiums are payable over a shorter time.

d. Incorrect. In a preferred risk policy, the insured must be in excellent health and premiums are lower than standard policies. Such policies are marketed to nonsmokers or others in low risk occupations. [Chp. 6]

58. An irrevocable life insurance trust can be a valuable estate tax-planning tool. For such a trust to be beneficial:

a. Incorrect. For an irrevocable life insurance trust to be beneficial, the policy must be transferred to the trust more than three years prior to death.

b. Correct. For an irrevocable life insurance trust to be beneficial, the trustee can be given dis-cretionary power to accumulate income and/or “sprinkle” income among beneficiaries. Under such a power, the trustee can choose favorable tax years to distribute income and lower bracket beneficiaries. Trust income distributed to the beneficiaries is taxed to them as ordinary income. However, undistributed trust income is taxed to the trust.

c. Incorrect. For an irrevocable life insurance trust to be beneficial, the insured should not be named as trustee since, as trustee, the insured may have retained an incident of ownership or the power to direct an economic benefit of the policy.

d. Incorrect. For an irrevocable life insurance trust to be beneficial, the insured may not have any incidents of ownership in the policy nor the right to direct economic enjoyment of the trust. [Chp. 6]

59. Eight factors are listed as considerations that should be made when establishing a life insur-ance trust. What is one issue that should be considered?

a. Incorrect. An independent trustee must be used in a life insurance trust.

b. Correct. Contributions to a life insurance trust are “future interests” and do not qualify for the annual exclusion of $14,000 per donee.

c. Incorrect. Legal fees for setting up a life insurance trust are high.

d. Incorrect. The life insurance trust is irrevocable and cannot be changed or amended by the grantor. Otherwise, it will be included as an asset of his or her estate. [Chp. 6]

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60. A taxpayer may choose to transfer money to an insurance company in exchange for a lifetime fixed sum yearly payment. What is this financial planning tool?

a. Incorrect. A buy-sell agreement is an arrangement for the disposition of a business interest (normally stock) in the event of the owner’s death, lifetime transfer, disability, divorce, or retire-ment.

b. Incorrect. A life insurance trust is used to hold life insurance policies and protect their proceeds from federal estate tax. Such trusts are not meant to provide annuity payments.

c. Correct. An annuity is where money is transferred to an insurance company and the company agrees to pay a fixed sum per year for life. At death, the annuity ends and the insurance company keeps whatever funds are left.

d. Incorrect. A pension is a retirement plan set up by a business and qualified under ERISA. [Chp. 6]

61. There are two basic types of buy-sell agreements. Which buy-sell agreement type is an agree-ment between the individual business owners for the disposition of a business interest?

a. Correct. A cross-purchase buy-sell agreement is an agreement between the individual owners.

b. Incorrect. An entity purchase buy-sell agreement is an agreement between the business itself and the individual owners and is sometimes called a redemption agreement.

c. Incorrect. A redemption agreement is also known as an entity purchase agreement.

d. Incorrect. A mere right of first refusal is not a buy-sell agreement. Many business agreements, particularly between partners and shareholders of a closely held corporation, do not provide a mandatory buy-out but give the surviving partners or shareholders the right to buy the interest of a deceased owner before it can be sold under the same terms and conditions. [Chp. 6]

62. The types of buy-sell agreements are very similar. Where does the main difference between the two agreements lie?

a. Incorrect. Aside from the tax consequences, the economic results of the two plans are essen-tially identical.

b. Correct. The choice between the two plans usually revolves around federal tax consequences.

c. Incorrect. Virtually all states permit shareholders to enter into either type of agreement.

d. Incorrect. The stock of a deceased or withdrawing shareholder is purchased at a pre-arranged price and on pre-determined terms. The choice between an entity purchase agreement and a cross-purchase agreement does not revolve around the type of stock owned. [Chp. 6]

63. Cross-purchase buy-sell plans provide taxpayers an important tax advantage. What is the main benefit that such plans offer?

a. Incorrect. With a cross-purchase plan, life insurance or disability income premiums paid to fund the agreement are not deductible by the co-shareholders. However, the death proceeds or disability benefits will be received by the co-shareholders income tax-free.

b. Correct. The most important tax advantage of a cross-purchase plan over an entity purchase plan is that the remaining shareholders will receive a stepped-up cost basis on the acquired stock. This stepped-up cost basis will minimize any recognition of gains on a subsequent lifetime resale of the assets or corporate liquidation.

c. Incorrect. An entity purchase agreement has no tax consequences to the surviving sharehold-ers or owners of the business. The basis of their stock or business interest will remain unchanged.

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d. Incorrect. Since there is no transaction between the corporation and its shareholders in a cross-purchase agreement, there is no risk that a “redemption” will be treated as a dividend and no attribution problem. By definition, the entire transaction is between shareholders. [Chp. 6]

64. Constructive ownership rules can ruin the possibility of using the complete redemption excep-tion to dividend treatment. Under which constructive ownership rule can double attribution cause an incomplete termination?

a. Incorrect. The estate/beneficiary rule is a single attribution rule. Under the estate/beneficiary rule, stock owned by an estate beneficiary is treated as owned by the estate. Thus, redemption of all the stock held by an estate may be a partial redemption when there is no simultaneous redemption of stock held by estate beneficiaries.

b. Incorrect. The complete termination exception is not a rule of constructive ownership but an exception to dividend treatment on stock redemption. Redemption of all of a shareholder’s stock is not a dividend. However, a complete termination can be destroyed by the “constructive own-ership” rules.

c. Incorrect. The family attribution waiver rule is a technique to break double attribution. Under this rule, it is possible to break the double attribution chain by “waiving” the family attribution rule. Entities may also waive family attribution.

d. Correct. Under a family/trust/corporation rule, an individual owns the stock held directly or indirectly by or for his or her spouse, children, grandchildren, and parents. Stock held by other parties and entities can also be attributed. There is also the possibility of an incomplete termina-tion as a result of double attribution. Thus, stock could be attributed first from a family member to an estate beneficiary and then through the estate beneficiary to the estate. [Chp. 6]

65. Revenue Ruling 59-60 identifies eight basic factors that need to be examined in the valuation of stock of certain corporations where market quotations are limited. Which of these valuation factors is the main concern the degree of risk present in the business?

a. Incorrect. When a business has large amounts of real or tangible personal property, book value is an important beginning in valuing the business based on the worth of underlying assets.

b. Incorrect. R.R. 59-60 holds earning capacity is an important valuation factor, but its main con-cern is past earnings, not risk.

c. Incorrect. The economic outlook for the entire economy, a particular industry, and a particular company in general and in its specific industry are to be considered as a valuation factor.

d. Correct. When looking at the nature of the business and its history, the primary consideration is the riskiness of the business. The greatest weight is given to recent events with little im-portance given to past events that are unlikely to recur. This factor could be used in selecting a multiplier in a capitalization-of-earnings formula. Normally, a higher multiplier would be linked with a more stable business. [Chp. 7]

66. Under R.R. 59-60, income earned by a corporation in the past is a valuable tool to project in-come that will be earned in the future. However, what must be considered in order for aver-ages to be realistic?

a. Incorrect. Dollar averaging is an investment concept used to spread the purchase of stocks and securities over the duration of a volatile period.

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b. Incorrect. Actual dividends paid may not be related to the dividend paying capacity of the business. However, most closely held corporations try to avoid paying dividends. As a result, eval-uating dividend paying capacity is not likely to be significant in valuing such corporations.

c. Incorrect. When a business is earning more than a reasonable return on its assets, the addi-tional return must be attributable to prestige, name, location, and other intangible value. In many service businesses, a large portion of the value is due to such intangible assets.

d. Correct. R.R. 59-60 holds that past income is useful in predicting future income but averages will be unrealistic if they disregard trends. [Chp. 7]

67. Book value is one way to value tangible assets. What is usually assumed to be at book value?

a. Correct. Typically, cash, accounts receivable, and inventories are accepted at book value.

b. Incorrect. Machinery, unless recently purchased, will have values different from book value.

c. Incorrect. Patents will have values different from book value.

d. Incorrect. Real estate is often worth substantially more than its book value. [Chp. 7]

68. Section 2032A provides an estate tax valuation election for certain real estate used as a farm to be valued according to its actual use. What is one of the four requirements that must be met in order to qualify for this election?

a. Correct. One of the basic requirements of §2032A is that the decedent or a member of the decedent’s family must have owned the property and have materially participated in the opera-tion of the farm or business for five out of the eight years preceding the earlier of the date of death, the date on which the decedent became disabled, or the date on which the decedent began receiving social security benefits.

b. Incorrect. A §2032A requirement is that the property must pass to or be purchased from the estate by a qualified heir.

c. Incorrect. Under §2032A, the real property must have been used as a farm or in a trade or business on the decedent’s death and for five out of eight years immediately before the dece-dent’s death.

d. Incorrect. Section 2032A requires that the value of real and personal property used in the business must be at least 50% of the adjusted value of the decedent’s gross estate, and the qual-ifying real property must be at least 25% of the adjusted value of the decedent’s estate. [Chp. 7]

69. Revenue Ruling 68-609 provides a formula to value intangible assets and goodwill. Under this formula, what is the first step in determining their value?

a. Incorrect. The fourth step of R.R. 68-609’s valuation formula for intangible assets and goodwill is to capitalize the earnings from the intangible assets at a rate of 15% to 20% to determine the value of the intangible assets.

b. Incorrect. The third step of R.R. 68-609’s valuation formula for intangible assets and goodwill is to deduct the percentage return on net tangible assets from the average earnings of the busi-ness over the same period to arrive at earnings from the intangible assets.

c. Correct. The first step of R.R. 68-609’s valuation formula for intangible assets and goodwill is to determine the average annual value of the net tangible assets of the business for at least five years immediately before the year of valuation.

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d. Incorrect. The second step of Revenue Ruling 68-609’s valuation formula for intangible assets and goodwill is to determine the percentage return that the average annual value of tangible assets should earn. [Chp. 7]

70. When three requirements are met, 40% of the value of any land subject to a qualified conser-vation easement may qualify for exclusion from the taxable estate. What is one of the require-ments necessary to meet this exclusion?

a. Incorrect. An executor may elect to exclude from the taxable estate 40% of the value of any land subject to a qualified conservation easement when, no later than the date the election is made, a qualified conservation easement on the land has been made by the decedent, a member of the decedent's family, the executor of the decedent's estate, or the trustee of a trust that holds the land.

b. Incorrect. The qualified conservation easement exclusion applies if the land is owned indirectly through a partnership, corporation, or trust if the decedent owned (directly or indirectly) at least 30% of the entity.

c. Incorrect. An executor may elect to exclude from the taxable estate 40% of the value of any land subject to a qualified conservation easement when the decedent or a member of the dece-dent's family owned the land for the 3-year period ending on the date of the decedent's death.

d. Correct. An executor may elect to exclude from the taxable estate 40% of the value of any land subject to a qualified conservation easement when the land is located in the United States or one of its possessions. [Chp. 7]

71. Minority stock interest owners in a closely held business may be able to discount the value of their interest. In R.R. 93-12, what position does the IRS take on a minority interest owned by family members?

a. Correct. In R.R. 93-12, the Service decided to accept court decisions holding that shares owned by family members are not attributed to another family member for purposes of determining the value of that person’s shares.

b. Incorrect. The IRS will no longer assume that all voting power held by family members must be aggregated for purposes of determining whether the transferred interests should be valued as part of a controlling interest.

c. Incorrect. A minority discount will not be disallowed simply because a transferred interest when aggregated with the interests of other family members, would be part of a controlling in-terest.

d. Incorrect. The IRS has historically taken the position that, when the owner and other family members together control a majority interest, it would not allow a minority discount. Minority discounts were only permitted if there was discord or other factors indicating that the family would not act as a unit. [Chp. 7]

72. Certain stock redemption rules provide that shareholders can directly or constructively own stock. What is one of the eight constructive ownership rules of §318?

a. Incorrect. The constructive ownership rules (§318) provide that stock owned by a trust bene-ficiary (other than the beneficiary of an ESOT) is attributed in full to the trust.

b. Incorrect. The constructive ownership rules (§318) provide that stock owned by a trust, except an ESOT, is deemed owned by its beneficiaries in proportion to their actuarial interest in the trust.

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c. Incorrect. The constructive ownership rules (§318) provide that stock owned by an S corpora-tion, partnership, or estate is deemed owned proportionately by its shareholders, partners, or beneficiaries.

d. Correct. The constructive ownership rules (§318) provide that stock owned by an S share-holder, partner, or estate beneficiary is attributed in full to the S corporation, partnership, or estate. [Chp. 7]

73. Some employees design, with their employer, a plan to receive current income in a later tax year. What is this device often referred to as?

a. Correct. A deferred compensation agreement can be a valuable estate planning tool to replace lost income on the death of an active shareholder/employee. The basic thrust of such agree-ments is to postpone the receipt of currently earned income until a later taxable year.

b. Incorrect. In a stock redemption, some or all of a shareholder’s stock is redeemed.

c. Incorrect. While an excellent estate planning technique may be to make lifetime gifts of stock in the business to adult children who may be working in it, this is not a plan to receive current income in a later tax year.

d. Incorrect. A swing-vote premium is used to offset minority or marketability discounts. [Chp. 7]

74. Under the estate freeze rules, an applicable retained interest may consist of different rights that may affect its valuation. However, an applicable retained interest is valued at fair market value when it is comprised of:

a. Incorrect. An applicable retained interest that consists of a discretionary liquidation, put, call, conversion, or similar right is valued at zero.

b. Incorrect. An applicable retained interest that consists of a distribution right is valued at zero unless it is a qualified payment right.

c. Correct. An applicable retained interest that consists of a qualified payment right (i.e., a fixed rate cumulative payment or payment elected to be treated as such) is valued at fair market value.

d. Incorrect. An applicable retained interest that consists of an extraordinary payment right is valued at zero. If an extraordinary payment right is held with a qualified payment right, the rights are valued as if exercised to give the lowest value. [Chp. 8]

75. An applicable retained interest may be comprised of a distribution right. What is classified as a distribution right?

a. Correct. A distribution right is a right to distributions from a corporation based on stock (§2701(c)(1)(A)(i)) and a right to distributions from a partnership based on a partner’s interest (§2701(c)(1)(A)(ii)).

b. Incorrect. The term “distribution right” does not include a right to distributions with respect to any interest which is junior to the rights of the transferred interest.

c. Incorrect. The term “distribution right” does not include any liquidation, put, call, or conversion right.

d. Incorrect. The term “distribution right” does not include any right to receive any guaranteed payment described in §707(c) (i.e., payments to a partner for services or the use of capital) of a fixed amount. [Chp. 8]

76. Control is critical and must be determined for §2701 purposes. Under this provision, control is defined as:

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a. Incorrect. Under §2701, control means, for a corporation, holding at least 50% (by vote or value) of the stock. Entity interests that carry no right to vote other than on liquidation, merger, or a similar event are not voting.

b. Incorrect. A right to vote that is subject to a contingency is not a voting interest.

c. Incorrect. Under §2701, control means, for a limited partnership, any interest as a general partner.

d. Correct. Under §2701, control means, for a partnership, holding at least 50% of the partnership capital or profits interests. Guaranteed payments under §707(c) are disregarded in making this determination. [Chp. 8]

77. Three exceptions are provided to the application of §2701 for applicable retained interests. When does one of these exceptions to §2701 apply?

a. Incorrect. An exception to §2701 does not apply to any interest in a partnership if the trans-feror or an applicable family member has the right to alter the liability of the transferee of the transferred property.

b. Incorrect. Section 2701 does not apply to any right with respect to an applicable retained in-terest when market quotations are readily available (as of the date of the transfer) for such in-terest on an established securities market.

c. Correct. Section 2701 does not apply to any right with respect to an applicable retained interest when such interest is proportionally the same as, the transferred interest without regard to nonlapsing differences in voting power or, for a partnership, nonlapsing differences in manage-ment or liability.

d. Incorrect. Section 2701 does not apply to any right with respect to an applicable retained in-terest when the retained interest is of the same class as the transferred interest. [Chp. 8]

78. Certain retained distribution rights can escape the “zero value” rule when deemed qualified payments. However, later events can be taxable events increasing the transferor’s taxable gifts or estate. Under §2701(d), which of the following events is a nontaxable event?

a. Incorrect. An event that can cause such an increase is an election to treat payment of a distri-bution after the 4-year period beginning on its due date as a taxable gift.

b. Incorrect. An event that can cause such an increase is any termination of an applicable retained interest because under §2701(d)(5) any termination of an interest is treated as a transfer.

c. Incorrect. An event that can cause such an increase is the death of the transferor if the appli-cable retained interest granting the distribution right is includible in the transferor’s estate.

d. Correct. A transfer to a spouse failing under the annual exclusion is treated the same as a transfer qualifying for the marital deduction. Thus, no inclusion would occur upon the transfer of an applicable retained interest to a spouse. However, subsequent transfers by the spouse would be subject to inclusion. [Chp. 8]

79. When determining the amount of increase in a transferor’s taxable estate or taxable gifts under §2701(d), the amount of corporate shares owned by the transferor that are applicable retained interests of the same class must be divided by the total amount of corporate shares as of that date that are of the same class. What is the result?

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a. Incorrect. A qualified payment is any dividend payable on a periodic basis under any cumula-tive preferred stock (or a comparable payment under any partnership interest) to the extent that such dividend (or comparable payment) is determined at a fixed rate.

b. Incorrect. The increase to the transferor’s taxable estate or taxable gifts is the excess, if any, of:

(1) the value of the qualified payments payable during the period beginning on the date of the transfer and ending on the date of the triggering event determined as if:

(a) all such payments were paid on the date payment was due, and

(b) all such payments were reinvested by the transferor as of the date of payment at a yield equal to the discount rate used in determining the value of the applicable retained interest, over

(2) the value of the qualified payments paid during the period described in (1) based on the time payments were actually paid.

c. Correct. The applicable percentage is determined by dividing the number of shares in the cor-poration held (as of the date of the taxable event) by the transferor that are applicable retained interests of the same class, by the total number of shares in the corporation as of that date that are of the same class.

d. Incorrect. Transfer tax adjustments reflect the inclusion of unpaid amounts on a qualified pay-ment. [Chp. 8]

80. If a taxpayer fails to make a qualified payment that has been valued according to the lowest value rule, within four years of its due date, double taxation can result. What can the Treasury Department do to lessen the possibility of double taxation?

a. Incorrect. When a distribution right is valued as a qualified payment, later events (“taxable events”) can cause an increase in the transferor’s taxable estate or taxable gifts.

b. Incorrect. The increase in the transferor’s taxable estate or taxable gifts can’t exceed the ex-cess, if any, of the value of all equity interests in the entity which are junior to the retained inter-est, over the value of the interests determined as of the date of the transfer. Waiver of this limi-tation would be a detriment not a benefit.

c. Correct. To alleviate the possibility of double taxation, the Treasury Department has regulatory authority to make subsequent transfer tax adjustments.

d. Incorrect. Application of the zero value rule would eliminate the tax benefit of a distribution right being deemed a qualified payment. [Chp. 8]

81. Amazingly, an election may be made to treat an unqualified distribution right as a qualified payment. However, this §2701(c) election:

a. Correct. Under §2701, this qualified payment treatment election applies only to the extent that the specified amounts and times are legally consistent with the instrument creating the right.

b. Incorrect. This election decreases the gift tax paid at the time of the transfer. However, the transferor could increase future gift and estate tax because failure to pay future dividends may increase the transferor’s taxable gifts or taxable estate under the compounding rules.

c. Incorrect. The election is made by attaching a statement to the transferor’s federal gift tax return on which the transfer was reported.

d. Incorrect. This election, once made, is irrevocable. [Chp. 8]

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82. Under §2701, if a transferor holds any interest for which qualified payments must be made, he or she can make an election out of this treatment. What can occur if such an election is made?

a. Correct. Payments under any interest held by a transferor that are qualified payments shall be treated as qualified payments unless the transferor elects not to treat such payments as qualified payments. This will result in future unpaid amounts escaping gift or estate tax.

b. Incorrect. If a transferor elects out of qualified payment treatment, the election can create an immediate increased gift tax.

c. Incorrect. If a transferor elects out of qualified payment treatment, it is irrevocable.

d. Incorrect. If a transferor elects out of qualified payment treatment, the retained interest will be valued at zero. [Chp. 8]

83. A minimum valuation rule applies when a transfer of a corporation’s common stock or a part-nership interest under which the income or capital rights are smaller than the rights of all other equity interest classes is subject to §2701. What term is used for such stock or partnership interest?

a. Incorrect. “Equity interest” is a general term that means stock or any interest as a partner, as the case may be.

b. Correct. The term “junior equity interest” means common stock or, in the case of a partnership, any partnership interest under which the rights as to either income or capital are junior to the rights of all other classes of equity interests.

c. Incorrect. A remainder interest is a future interest in an asset.

d. Incorrect. Term interest means a life interest in property or an interest in property for a term of years. [Chp. 8]

84. Four transactions are identified under Reg. §25.2701-1(b)(2) as being transfers of interests in a corporation or a partnership under §2701. Which of the following is such a transfer under this regulation?

a. Incorrect. Under Reg. §25.2701-1(b)(3)(i), a transfer does not include a capital structure trans-action (other than a contribution to capital or other increase in the value of the entity), if the transferor, each applicable family member, and each member of the transferor’s family hold sub-stantially the same interest after the transaction as that individual held before the transaction.

b. Correct. Under Reg. §25.2701-1(b)(2), a transfer includes a redemption, recapitalization, or other change in the capital structure of an entity (a “capital structure transaction”), if the trans-feror or an applicable family member receives an applicable retained interest in the capital struc-ture transaction.

c. Incorrect. Under Reg. §25.2701-1(b)(3)(i), a transfer does not include a shift of rights occurring upon the execution of a qualified disclaimer under §2518.

d. Incorrect. Under Reg. §25.2701-1(b)(3)(i), a transfer does not include a shift of rights occurring upon the exercise of a power of appointment other than a general power of appointment under §2514, except to the extent the exercise reduces the power-holder’s interest in the appointed property. [Chp. 8]

85. Taxpayers must determine the amount of a gift that is produced from any transfer subject to §2701. What primary process is used to calculate this amount?

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a. Correct. The amount of the gift resulting from any transfer to which §2701 applies is deter-mined by a subtraction method of valuation.

b. Incorrect. One of the steps used to determine the gift amount is to subtract the values of all senior equity interests from the value of the entity immediately before the transfer.

c. Incorrect. Under the attribution rules of §2701(e), an individual is deemed the owner of an interest to the extent it is held indirectly by that individual through a corporation, partnership, trust, or other entity.

d. Incorrect. Under §2701, the value of any applicable retained interest held by the transferor or an applicable family member after the transfer is deemed to be zero. [Chp. 8]

86. There are three computational steps in the subtraction method. What is the first step?

a. Correct. The first step in determining the value of the transferred interest using the subtraction method is to determine the value of the entity, giving effect to appropriate adjustments to reflect the actual fragmented ownership.

b. Incorrect. The first part of the second step in determining the value of the transferred interest using the subtraction method is to reduce the value of the entity by the fair market value of all senior equity interests other than applicable retained interests held by the transferor or applica-ble family members.

c. Incorrect. The third step in determining the value of the transferred interest using the subtrac-tion method is to reduce the value of the entity by the fair market value of any equity interests of the same class as or a subordinate class to the transferred interests held.

d. Incorrect. The second part of the second step in determining the value of the transferred in-terest using the subtraction method is to reduce the value of the entity by the value of all appli-cable retained interests other than those included in the first part of the second step. [Chp. 8]

87. Section 2702 provides special valuation rules for certain transfers of interests in trust. Under Reg. §25.2702-2(a)(2), which transaction fails to qualify as such a transfer in trust?

a. Incorrect. A transfer in trust includes a transfer to a new trust.

b. Incorrect. A transfer in trust includes an assignment of an interest in an existing trust.

c. Correct. Transfer in trust does not include either the exercise of a power of appointment that is not a general power of appointment under §2514 or the execution of a qualified disclaimer under §2518.

d. Incorrect. The transfer of an interest in property with respect to which there is one or more term interests is treated as a transfer of an interest in a trust. [Chp. 8]

88. The zero value rule applies to the value of an unqualified interest in a trust that a transferor keeps. However, under §2701(a)(1), which transaction is treated as a transfer equal to the value of the entire property?

a. Incorrect. Section 2702 does not apply to any transfer to the extent that regulations provide that such transfer is not inconsistent with the purposes of §2702. For example, this authority could be used to except a charitable remainder trust that meets the requirements of §664 and that does not otherwise transfer property to a family member free of transfer tax.

b. Correct. A person who makes a completed transfer of nonresidential property in trust and retains the right to the income of the trust for a term of years, and a reversionary right (or a

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testamentary general power of appointment with respect) to trust corpus is treated as making a transfer equal to the value of the whole property.

c. Incorrect. Section 2702 does not apply to any transfer to the extent such transfer is an incom-plete gift.

d. Incorrect. Section 2702 does not apply to any transfer if such transfer involves the transfer of an interest in trust which consists of a residence to be used as a personal residence by persons holding term interests in such trust. [Chp. 8]

89. A substantial modification is treated as a right or restriction established on the modification date. What is considered a substantial modification?

a. Correct. Any discretionary modification of a right or restriction, whether or not authorized by the terms of the agreement, that results in other than a de minimis change to the quality, value, or timing of the right or restriction is a substantial modification.

b. Incorrect. A discretionary modification of the agreement containing a right or restriction that does not change the right or restriction is not considered a substantial modification.

c. Incorrect. A modification required by the terms of a right or restriction is not considered a substantial modification.

d. Incorrect. A modification that results in an option price that more closely approximates fair market value is not considered a substantial modification. [Chp. 8]

90. Section 2704 provides special rules for lapsing rights and restrictions. How is a lapse treated if it takes place at the death of the person holding a right?

a. Incorrect. A right or restriction that is substantially modified is treated as a right or restriction created on the date of the modification.

b. Incorrect. If the lapse of a voting right or a liquidation right occurs during the holder’s lifetime, the lapse is a transfer by gift.

c. Correct. If the lapse occurs at the holder’s death, the lapse is a transfer includable in the holder’s gross estate.

d. Incorrect. Section 2703 does not apply to any option, agreement, right, or restriction that meets the requirement, among others, that its terms are comparable to similar arrangements entered into by persons in an arm’s length transaction. [Chp. 8]

91. Section 2704 defines several terms used in its coverage of lapsing rights and restrictions. Which term is used for a right to force an entity to partially or wholly acquire an equity interest in said entity that is held by an individual?

a. Incorrect. A lapse of a voting or liquidation right occurs at the time a presently exercisable right is restricted or eliminated.

b. Correct. A liquidation right is a right to compel the entity to acquire all or a portion of the holder’s equity interest in the entity. A right is a liquidation right even though its exercise would not result in the complete liquidation of the entity.

c. Incorrect. A voting right is a right to vote with respect to any matter of the entity.

d. Incorrect. Control means: for a corporation, holding at least 50% (by vote or value) of the stock; for a partnership, holding of at least 50% of the partnership capital or profits interests; and for a limited partnership, any interest as a general partner. [Chp. 8]

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92. Three levels of conservatorship are described in the material. Which type of conservatorship is likely to be established for a mentally disabled adult who can partially manage his or her af-fairs?

a. Incorrect. When a person is a life risk to themselves or others and in need of hospitalization in a psychiatric facility, a full conservatorship may be granted.

b. Correct. Where a mentally disabled adult can still handle certain matters but requires manage-ment or protection in others, a limited conservatorship can be established.

c. Incorrect. There can be a variety of “levels” or types of conservatorship. They include limited conservatorship, full conservatorship, and traditional conservatorship. Partial conservatorship is not an official category.

d. Incorrect. If an elderly or physically disabled person needs court supervised help and protec-tion in managing his or her medical and financial affairs, a traditional conservatorship is used. [Chp. 9]

93. The author lists five disadvantages for using a conservatorship as an asset management method. What is one of these disadvantages?

a. Incorrect. A disadvantage of joint tenancy is that a joint tenant could take all of the funds in the joint bank account. Conservators are subject to court supervision and accounting.

b. Correct. A disadvantage of a conservatorship is that the person’s assets become a matter of public record.

c. Incorrect. A disadvantage of joint tenancy is that there is no court supervision. However, no court procedure is necessary to establish joint tenancy. A conservatorship is supervised by a court.

d. Incorrect. A disadvantage of a durable power of attorney is that third parties may be reluctant to recognize the power. [Chp. 9]

94. When using a durable power of attorney, the document should be drafted to include how dis-ability is proven. Why should a durable power of attorney state this?

a. Incorrect. Being a part owner of property has little, if anything, to do with one’s durable power of attorney and its disability standard. It is important to accurately define disability regardless of the ownership percentage.

b. Incorrect. A disadvantage to having a conservatorship is that the elderly or disabled person is publicly adjudicated as unable to manage his or her affairs.

c. Correct. The durable power of attorney should state how disability is proved, such as by the opinion of two licensed physicians; otherwise, third parties may be unwilling to deal with the agent.

d. Incorrect. A disadvantage to having either a conservatorship or a durable power of attorney is that when the person dies, his or her estate may have to be probated if other estate planning has not been done. [Chp. 9]

95. Many elderly rely on a government program as their main health insurance plan. What is this entitlement program that covers people receiving Social Security income?

a. Incorrect. Disability is a Social Security program that covers workers who are disabled before age 65.

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b. Incorrect. Welfare is a federal program that aids unemployed individuals or those who earn very low income or who require assistance.

c. Correct. Medicare is an entitlement program for the elderly that is the primary health insurance plan covering people on Social Security.

d. Incorrect. Supplemental Security Income (SSI) benefits are available to aged, blind, and disa-bled people with little or no income and few assets. [Chp. 9]

96. Medicaid is one source through which medical expenses can be paid. What is Medicaid?

a. Incorrect. Supplemental Security Income (SSI) is a federal program providing minimum monthly income to people in financial need.

b. Correct. Medicaid is a joint federal-state program. Unlike Medicare, it is a program based on income and asset guidelines.

c. Incorrect. Prior to 1984, Medicare paid all hospital-submitted medical expenses on a fee-for-service basis. In 1984, the system was changed to reduce costs.

d. Incorrect. The Diagnosis Related Groupings (DRGs) were established to classify hospital cases into groups to simplify Medicare payments. Medicare now pays fixed rates to hospitals. [Chp. 9]

97. In determining Medicaid eligibility, assets are separated into three groups. Which assets would be classified as a countable asset?

a. Incorrect. A gift of the asset or a transfer to a Medicaid trust would be classified as an inacces-sible asset.

b. Incorrect. Personal jewelry and household effects would be classified as non-countable assets.

c. Incorrect. Term life insurance policies without surrender value would be classified as non-countable assets.

d. Correct. Whole life insurance above a certain amount would be classified as a countable asset, as would cash over $2,000 (for most states); stocks and bonds; individual retirement accounts; certificates of deposit; single premium deferred annuities; Treasury notes and bills; savings bonds; investment property; vacation homes; second vehicles; and any other asset not specifi-cally listed as exempt. [Chp. 9]

98. If certain requirements are met, a personal residence can be reclassified as a countable asset so that the home can be sold to pay Medicaid bills or the person’s qualification under Medicaid can be terminated. What is one requirement that must be met for such action can be taken?

a. Incorrect. One requirement is that the person must be single. For married couples, the lien can only be placed on the home if there is no surviving spouse. Thus, the surviving spouse cannot only live in the house after the Medicaid recipient spouse’s death but also transfer it without being subject to such a lien.

b. Incorrect. A requirement for this reclassification of assets is that the person must live in a nursing home. If he or she lives in the personal residence, the residence remains uncountable.

c. Incorrect. Reclassifying the personal residence as a countable asset permits the state to put a lien on the home to recover the costs. Thus, a lien will be put on the home subsequent to the reclassification.

d. Correct. One requirement for the reclassification is that the person must be unable to show he or she will be coming home within six months. [Chp. 9]

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99. Medicaid disqualification can result when a person transfers a primary residence to anyone other than a protected class of persons within a certain time period before his or her Medicaid application. However, under an exception to this rule, a single or married person can transfer his or her personal residence, without activating a period of ineligibility, to:

a. Incorrect. Without triggering an ineligibility period, a single or married person can transfer his or her home to a child who has lived in the home for at least two years before the parent’s insti-tutionalization and cared for the parent when at home.

b. Incorrect. Without triggering an ineligibility period, a single or married person can transfer his or her home to a child who is blind, disabled, or under 21.

c. Correct. Without triggering an ineligibility period, a single or married person can transfer his or her home to a sibling who owns a portion of the home and has lived there for at least one year before institutionalization.

d. Incorrect. Without triggering an ineligibility period, a single or married person can transfer his or her home to anyone at any time for fair market value. [Chp. 9]

100. Certain individuals may qualify for Supplemental Security Income (SSI) benefits. What is the source of this assistance?

a. Incorrect. Diagnosis Related Groupings (DRGs) reimburses hospitals; it does not pay individuals directly.

b. Correct. SSI benefits are paid from general revenues of the U.S. Treasury.

c. Incorrect. SSI benefits are not paid from Social Security funds.

d. Incorrect. Medicaid is paid from state and federal funds. [Chp. 9]

101. Disability benefits are provided to workers who become disabled before they are age 65. Who must have at least six quarters but is exempt from the recent work requirement?

a. Correct. Blind individuals are exempt from having to meet the recent work requirement. How-ever, they must have one quarter for each year after 1950 up to the year they became blind and must have a minimum of six quarters.

b. Incorrect. Individuals with kidney disease are eligible for Medicare Part A and Medicare Part B regardless of their age. Three requirements must be met if maintenance dialysis or kidney trans-plant surgery is needed due to kidney failure.

c. Incorrect. Individuals who have HIV may qualify for Social Security coverage if their condition makes them incapable of working.

d. Incorrect. Individuals with AIDS who are unable to work because of the illness must meet Social Security coverage requirements to qualify for disability benefits. [Chp. 9]

102. When an interest is held in a closely held business, an executor may make an election to defer payment of federal estate due to the value of the interest. What does this election allow?

a. Incorrect. This election allows the estate to make between two and ten equal annual install-ments.

b. Incorrect. If the election is made, payments may begin five years after the due date of the federal estate tax return.

c. Correct. With this election, the estate receives a very low interest rate on unpaid estate tax owed.

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d. Incorrect. Payments of only interest are allowed for the first four years of payment when this election is made. [Chp. 10]

103. Heirs may disclaim their rights to a transfer of property from a decedent. What is one of the four conditions that such a disclaimer must meet in order to qualify under §2518(b)?

a. Correct. To be effective, a disclaimer must be an irrevocable and unqualified refusal to accept an interest in property that satisfies the following condition under §2518(b): as a result of the refusal to accept the property, the interest must pass to a person other than the disclaimant without any direction on the part of the disclaimant.

b. Incorrect. A disclaimer must be in writing.

c. Incorrect. The disclaimer must be received by the donor (or the donor’s estate) within nine months of the date of the transfer creating the interest (or within nine months of the day on which the donee attains age 21).

d. Incorrect. To be effective, the donee must not have accepted the interest or any of its benefits. [Chp. 10]

104. There is an exception to the rule that estate taxes must be paid when the return is filed. Under §6166, a taxpayer may elect to pay a portion of this tax in installments if a closely held business interest surpasses _____ of the adjusted gross estate.

a. Incorrect. Failure to pay the estate tax with the return can cause the imposition of a penalty of .5% of the estate tax liability for each month or part of a month that the tax remains unpaid.

b. Incorrect. In cases where the failure to pay the estate tax is after notice and demand by the IRS, the penalty is increased to 1% per month.

c. Incorrect. Failure to pay the tax with the return can cause the imposition of a penalty up to a maximum of 25%.

d. Correct. Section 6166 is available where the interest in the closely held business exceeds 35% of the adjusted gross estate. [Chp. 10]

105. On the federal estate tax return, taxpayers must familiarize themselves with several important concepts. What term is defined as the gross estate minus deductions such as the estate’s ex-penses, losses, and charitable gifts?

a. Incorrect. The gross estate tax is the tentative tax less the gift tax payable on gifts after De-cember 31, 1976.

b. Incorrect. The net estate tax is the gross estate tax less allowable credits.

c. Correct. The taxable estate is the gross estate less allowable deductions.

d. Incorrect. The tentative tax is the estate tax figured on taxable estate plus adjusted taxable gifts. [Chp. 10]

106. On Form 706, part 3, page 2 - Elections by the Executor, up to four elections may be made. What is one of these elections that may be made?

a. Incorrect. Elections affecting the marital deduction are made on Schedule M.

b. Incorrect. The election by a beneficiary to report lump-sum distributions is on Schedule I.

c. Incorrect. Schedule U is based on §2031(c) and permits an election to exclude a portion of the value of land that is subject to a qualified conservation easement.

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d. Correct. On Form 706, part 3, page 2—Elections by the Executor, the executor may elect to make an election to use the special use valuation under §2032A. [Chp. 10]

107. On Form 706, taxpayers must report how much cash the decedent had at the time of death and also what was owed to the decedent. What schedule should be used to report these amounts?

a. Incorrect. Schedule B is used to report the value of all stocks and bonds included in the gross estate.

b. Correct. Schedule C is used to report cash and all items owed to the decedent at the time of death.

c. Incorrect. All insurance on decedent’s life whether or not includible in the gross estate is listed on Schedule D.

d. Incorrect. In Part 1 of Schedule E, report qualified jointly owned interests owned with his or her spouse as tenants by the entirety or as joint tenants. In Part 2, report interests owned with other tenants. [Chp. 10]

108. On Form 706, taxpayers must report all QTIP property in the surviving spouse’s estate under §2044. What schedule is used to report this information in addition to reversionary or remain-der interests?

a. Correct. Schedule F is the catchall schedule and includes all QTIP property in the estate of the surviving spouse under §2044 and reversionary or remainder interests.

b. Incorrect. There are five types of transfers reported on Schedule G but it does not include QTIP property.

c. Incorrect. Reported on Schedule H is the value of property for which the decedent had a gen-eral power of appointment at death (§2041).

d. Incorrect. Under §2039, annuities payable to someone on the death of the decedent are in-cluded in the gross estate and reported on Schedule I if four requirements are met. [Chp. 10]

109. Under §642(g), a double deduction may be available for certain expenses so long as the dece-dent accrued, but had not paid, these expenses. What type of expenses may qualify for this double deduction?

a. Correct. It is possible to get a double deduction for such items as interest, taxes, business ex-penses, and other §691(b) deductions in respect of a decedent, provided the items were accrued and unpaid at death.

b. Incorrect. Executors’, attorneys’, and accountants’ fees can be claimed as a deduction on the estate’s income tax return, Form 1041 if a waiver is filed on Form 706. Typically, there is no dou-ble deduction.

c. Incorrect. Funeral expenses may only be claimed on one of these tax forms, and thus, they do not qualify for a double deduction.

d. Incorrect. An election can be made to claim medical expenses of last illness incurred for the care of the decedent and paid by the estate within one year of death. However, no double de-duction is allowed. [Chp. 10]

110. On Form 706, property qualifies for a credit for estate taxes if it has been included and taxed in another estate within the last ten years. On what schedule is this credit taken?

a. Incorrect. Schedule O permits a full deduction for the value of amounts passing to charity.

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b. Incorrect. Schedule P allows a credit for estate, inheritance, legacy, and succession taxes paid to a foreign country.

c. Correct. A credit is permitted on Schedule Q for estate taxes on property where the property was taxed in another estate within the last 10 years. If the prior decedent predeceased the cur-rent decedent by more than two years, the credit is reduced by 20% for each full two years the original decedent’s death preceded the current decedent’s death.

d. Incorrect. Schedule T, an expired provision, was based on §2057 and allowed a deduction (for-merly an exclusion) for the value of certain family-owned business interests from the gross es-tate. [Chp. 10]

111. Expenses can be reported in a variety of ways. Under §642(g), estate administration expenses are reported on:

a. Incorrect. Funeral expenses are reported on Form 706 only.

b. Incorrect. Medical expenses of decedent paid within one year are reported on either Form 706 or Form 1041.

c. Correct. Under §642(g), estate administration expenses are reported on Form 706 or Form 1041 or split.

d. Incorrect. Trade or business expenses, interest, taxes, expenses for the production or collec-tion of income, expenses for the management and maintenance of income producing property, expenses in connection with the determination, collection, or refund of any tax, and alimony are reported on Forms 706 and 1041. Items are deductible on both returns only if they are expenses in respect of a decedent, except for alimony. [Chp. 10]

112. An estate income tax return must be filed for certain estates. What is a filing requirement of this Form 1041, Estate Income Tax Return:

a. Incorrect. The income, age, and filing status of a decedent generally determine the filing re-quirements of the decedent’s final income tax return, Form 1040.

b. Correct. Form 1041 must be filed by the 15th day of the 4th month following the close of the estate’s tax year.

c. Incorrect. Typically, the executor, administrator, or personal representative of the estate acts as the fiduciary. Said fiduciary is responsible for filing this form. When applicable, an ancillary representative must file a fiduciary return.

d. Incorrect. The IRS will grant a reasonable extension of time for filing the estate’s income tax return, Form 1041 if the fiduciary shows reasonable cause and files the Form 2758. The extension is generally limited to 60 days. [Chp. 10]

113. The decedent's gross income must be reported on a final income tax return, Form 1040. What is excluded from this amount?

a. Incorrect. For purposes of filing Form 1040, gross income usually includes stock dividends an individual received on which he or she must pay tax.

b. Incorrect. For purposes of filing Form 1040, gross income includes gross receipts from self-employment minus any cost of goods sold.

c. Correct. For purposes of filing Form 1040, gross income does not include nontaxable income.

d. Incorrect. For purposes of filing Form 1040, gross income usually includes property an individ-ual received on which he or she must pay tax. [Chp. 10]

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114. A taxpayer who files a decedent’s final income tax return and claims a refund is required to file another form. What form must be sent with the tax return?

a. Incorrect. A personal representative must file a separate Schedule K-1 (Form 1041) for each beneficiary.

b. Incorrect. An amended return (Form 1040X) should be filed for medical expenses incurred in an earlier year unless the statutory period for filing a claim for that year has expired.

c. Incorrect. Payers of interest and dividends report amounts on Form 1099 using the identifica-tion number of the person to whom the account is payable. After a decedent’s death, Form 1099 must reflect the identification number of the estate or beneficiary to whom the amounts are payable.

d. Correct. Any person who is filing a final income tax return for a decedent and claiming a refund must file Form 1310, Statement of Person Claiming Refund Due a Deceased Taxpayer, with the return. [Chp. 10]

115. When applicable, partnership income must be included on the decedent’s return. If a surviving partner terminates the partnership’s business operations, when does the partnership tax year close?

a. Incorrect. Even if the partnership has only two partners, the death of one does not terminate the partnership or close its tax year, provided the deceased partner’s estate or successor contin-ues to share in the partnership’s profits or losses.

b. Correct. If the surviving partner terminates the partnership by discontinuing its business oper-ations, the partnership tax year closes as of the date of termination.

c. Incorrect. If the deceased partner’s estate or successor liquidates its entire interest in the part-nership, the partnership’s tax year with respect to the estate or successor will close as of the date the liquidation is completed.

d. Incorrect. If the deceased partner’s estate or successor sells or exchanges, its entire interest in the partnership, the partnership’s tax year with respect to the estate or successor will close as of the date of the sale or exchange. [Chp. 10]

116. The decedent’s self-employment income includes the decedent’s distributive portion of a part-nership’s income or loss for the entire month in which the decedent died:

a. Incorrect. If the decedent was married and was domiciled in a community property state, half of the income received and half of the expenses paid during the decedent’s tax year by either the decedent or spouse may be considered to be the income or expense of the other.

b. Incorrect. The decedent’s final return must include the decedent’s distributive share of part-nership income for the partnership’s tax year ending within or with the decedent’s last tax year (i.e., the year ending on the date of death).

c. Incorrect. The income for the part of the S corporation’s tax year after the shareholder’s death is income to the estate or other person who has acquired the stock in the S corporation.

d. Correct. For self-employment tax purposes only, the decedent’s self-employment income will include the decedent’s distributive share of a partnership’s income or loss through the end of the month in which death occurred. For this purpose only, the partnership’s income or loss is consid-ered earned ratably over the partnership’s tax year. [Chp. 10]

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117. Taxpayers may make an election to treat all or a portion of a decedent’s medical expenses as paid by the decedent when incurred. Which expenses fail to qualify for this election?

a. Incorrect. The election for decedent’s medical expenses applies to expenses incurred for the decedent.

b. Correct. The election for decedent’s medical expenses does not apply to expenses incurred to provide medical care for dependents.

c. Incorrect. Medical expenses that are not deductible on the final income tax return are liabilities of the estate and are shown on the federal estate tax return (Form 706).

d. Incorrect. The amount deductible on the income tax return for medical expenses is the amount in excess of 10% of adjusted gross income. The amounts not deductible because of this percent-age cannot be claimed on the federal estate tax return. [Chp. 10]

118. A taxpayer may give a gift to a person other than a spouse and have it be treated as made one-half by each spouse. What is this called?

a. Incorrect. A bargain sale is a sale or exchange, not made in the ordinary course of business, where money or money’s worth is exchanged, but the value of the money received is less than the value of what is sold or exchanged.

b. Incorrect. A gift loan is any below-market loan where the foregone interest is in the nature of a gift. A loan between unrelated persons can qualify as a gift loan.

c. Correct. A gift made by a person to someone other than a spouse may be considered as made one-half by each spouse. This is known as gift splitting and both spouses must consent to its use.

d. Incorrect. A power of appointment is a power to determine who will own or enjoy the property subject to the power. [Chp. 10]

119. Taxpayers may be required to pay gift tax on gift loans. Under what type of gift loan is foregone interest treated as a transferred gift by the lender to the borrower?

a. Correct. If the gift loan is a below-market demand loan, the foregone interest is treated as transferred (as a gift) by the lender to the borrower. Any foregone interest attributable to periods during any calendar year is treated as transferred on the last day of that calendar year.

b. Incorrect. If the gift loan is a below-market term loan, the lender is treated as having trans-ferred (as a gift) on the date the loan was made an amount equal to the excess of the amount loaned, over the present value of all payments that are required to be made under the terms of the loan.

c. Incorrect. Foregone interest is the excess of the amount of interest that would have been pay-able for the period if interest accrued at the applicable federal rate and was payable annually on the last day of the calendar year, over any interest payable on the loan properly allocable to that period. There's no such thing as a foregone loan under tax law.

d. Incorrect. If a net gift is made on the express or implied condition that the donee pays the gift tax, the payment of this tax is deducted from the value of the gift made as partial consideration for the gift. [Chp. 10]

120. A donor can gift stock certificates. For gift tax purposes, if such a gift is delivered to the donee, when is the gift deemed completed?

a. Correct. If the donor delivers a properly endorsed stock certificate to the donee or to the do-nee’s agent, the gift is completed, for gift tax purposes, on the date of delivery.

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b. Incorrect. If the donor transfers his or her own promissory note to another as a gift, the gift is completed on the date of the transfer if the promissory note is legally enforceable. The transfer of a legally unenforceable promissory note is an incomplete gift until the note is paid or trans-ferred for value.

c. Incorrect. If the donor delivers his or her own check to another as a gift, the gift is not complete, for gift tax purposes, until the check is paid, certified, or transferred for value to a third person.

d. Incorrect. If the donor delivers a certificate to his or her bank or broker as donor’s agent, or to the issuing corporation or its transfer agent, for transfer to the donee’s name, the gift is only completed on the date the stock is transferred on the corporation’s books. [Chp. 10]

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Appendix A Warning

The drafting of a trust requires complex estate planning and tax considerations and must be done by a qualified professional. This text is provided for illustration purposes only.

Sample Revocable Living “A-B” Trust Agreement

(Community Property State - California)

DECLARATION OF TRUST

THIS DECLARATION OF TRUST executed by HUSBAND and WIFE, herein designated as the “Trustee,”

WITNESSETH:

That HUSBAND and WIFE, husband and wife, herein designated as the “Trustors,” have conveyed, transferred, assigned, and/or delivered to the Trustee by Exhibit A and other appropriate instru-ments, duly executed and absolute in form, all that certain property described in Exhibit A attached hereto and made a part hereof, which property, together with any other property which may here-after be transferred to the Trustee to be held under this trust, is designated in this Declaration of Trust as the “trust estate;”

That the Trustors have caused or may cause the Trustee to be named as beneficiary of the insurance policies listed on Exhibit B attached hereto; that the proceeds of said policies when received by the Trustee after the insured’s death shall be subject to the terms and conditions of this Agreement, and the Trustee accepts such designation IN TRUST for the purposes and on the conditions hereinafter set forth.

That no consideration was or will be given by the Trustee for the transfer to the Trustee of any of the trust estate; that the Trustee accepts such title to the trust estate as is conveyed to the Trustee hereunder, without liability or responsibility for the condition or validity of such title, and the same has been or will be transferred to the Trustee IN TRUST, WITH POWER OF SALE, for the purpose of holding, managing, controlling and disposing of the same and all income or other proceeds derived

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therefrom in the manner and for the uses and purposes and upon the terms, trust and conditions herein provided;

That the property transferred to the trust is the community property of both Trustors unless it is clearly designated to the contrary; that the community property transferred to this trust shall retain its character as community property; that the income from the community property in the trust shall be reported for income tax purposes as community property income; that any part of the community property withdrawn by the Trustors during their joint lifetimes shall retain its character as commu-nity property.

That any quasi-community property or separate property of either Trustor and the proceeds thereof shall retain its character as quasi-community property or separate property during the joint lifetimes of the Trustors; and on revocation of this trust or withdrawal of the assets, said assets shall revert to the Trustor transferring them and shall constitute his or her separate or quasi-community property as if this trust had not been created.

ARTICLE I

RIGHTS RESERVED BY TRUSTORS DURING THEIR JOINT LIFETIMES

The Trustors specifically reserve the following rights and privileges:

A. RIGHT TO ADD PROPERTY TO TRUST

The Trustors, jointly, or either of them, or any other person, may from time to time, with the consent of Trustee, add other insurance policies and/or further property, real, personal or mixed, to the trust estate or any part thereof, by making such insurance payable or by transferring such property to the Trustee hereunder by deed of assignment, bequest or devise, and if so added, the proceed of such additional insurance policies and such property shall be subject to the pro-visions hereof, the same as if originally included hereunder.

B. RIGHT TO AMEND OR REVOKE TRUST

At any time or times, by written notice to the Trustee and upon payment of all sums due the Trustee, the Trustors, jointly, may change any beneficiary; alter or amend any provision hereof; or withdraw all or any part of the trust estate.

Either Trustor may revoke this trust during the joint lifetimes of the Trustors. Upon revocation, all property that originated in community property shall be redistributed to the parties as com-munity property; any property that was originally separate property shall be redistributed to the party contributing said separate property; and any property that was originally quasi-community property shall be redistributed to the party in whose name the property was prior to the transfer to this trust. Any property so redistributed shall, after such redistribution, retain the same char-acter as prior to the transfer to this trust.

Except as specifically provided in this Declaration of Trust, the trusts created herein shall be ir-revocable and may not be altered, amended, or modified in any way.

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C. RIGHT TO DIRECT TRUSTEE RE INVESTMENTS, ETC

The Trustors jointly may direct the Trustee in writing to invest the trust estate in specific securi-ties, properties, or investments, at any time held hereunder, for such lengths of time as such directions may provide. The Trustors, jointly, may also direct the Trustee in writing with respect to the sale, encumbrance, lease, management, control, or disposition of any property of the trust estate. The Trustee shall not be liable for any loss sustained or incurred by reason of the Trustee’s compliance with any written directions of the Trustors. Except as so directed by the Trustors in writing, the Trustee shall have sole discretion with regard to the above-mentioned transactions.

ARTICLE II

DISTRIBUTION OF INCOME AND PRINCIPAL

The Trustee shall apply and distribute the net income and principal of the trust estate in the following manner:

A. DURING THE JOINT LIFETIMES OF BOTH TRUSTORS.

1. After paying or reserving sufficient money to pay any expenses of management of the trust estate and administering this trust, all or any part of which may, in the sole discretion of the Trustee, be charged to the principal of the trust estate, all income which is available for distribu-tion shall be distributed to or for the benefit of the Trustors during their joint lifetimes in monthly or other convenient installments; provided, however, at the request of both of the Trustors, the Trustee shall add undistributed income to the principal. Any net income from property that was originally community property shall be community property, any net income from property that was originally separate property shall retain its character as separate property, and any net in-come from property that was originally quasi-community property shall retain its character as quasi-community property.

2. The Trustors, jointly, may take out any or all of the principal of the trust estate during their joint lifetimes, at any time and for any purpose. Any principal that originated in community prop-erty, once withdrawn, shall be community property; any principal that originated in separate property, once withdrawn, shall be separate property of the party who contributed said separate property; and any principal that originated in quasi-community property, once withdrawn, shall be quasi-community property.

3. The Trustee may, in its sole discretion, pay such amounts of the principal as it deems necessary for the care, support, and maintenance of the Trustors.

B. UPON THE DEATH OF EITHER TRUSTOR SURVIVED BY THE OTHER.

1. Upon the death of either Trustor survived by the other, the Trustee shall divide the trust estate into two (2) separate shares, which are hereinafter called “Trust A” and “Trust B,” each of which shares shall constitute and be held, administered and distributed by the Trustee as a separate trust.

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(a) Trust A shall consist of the surviving Trustor’s share of the community property in the trust, if any, plus any property in the trust which is construed to be the separate property of the surviving Trustor; plus that fractional share of the trust estate (excluding any property or interests in property not eligible to satisfy the marital deduction for federal estate tax pur-poses, and excluding any insurance policies on the life of the surviving Trustor) which when added to the total value for federal estate tax purposes of all other interests in property that pass or have passed from the deceased Trustor to the surviving Trustor under provisions of the deceased Trustor’s Will, through life insurance or otherwise, and which are includable in the gross estate of the deceased Trustor for federal tax purposes and which qualify for the marital deduction, equals the minimum amount which if subtracted from the value of the deceased Trustor’s gross estate as finally determined for federal estate tax purposes would result in no federal estate tax payable after taking into account all other available deductions taken from the deceased Trustor’s gross estate, and all available credits taken against the federal estate tax, it being the intent of the Trustors that property (other than the surviving Trustor’s community or separate property) shall be transferred to Trust A only to the extent that such transfer would effect a reduction in the federal estate tax otherwise payable by the deceased Trustor’s estate.

In establishing this fraction, values as finally determined for federal estate tax purposes shall control. Nothing in this Section B, paragraph 1(a) shall be construed as limiting the discretion of the Trustee or the executor of the deceased Trustor in making an election for federal estate tax purposes between the valuation of the deceased Trustor’s estate on the date of his or her death and valuation on an alternate date.

(b) All of the remaining trust estate shall be set aside as a separate trust, without need for physical segregation, and shall constitute the trust estate of Trust B.

(c) Subject to the restrictions contained in subparagraph (d) below, all estate and inheritance taxes payable by reason of the death of the Trustor dying first may be deducted from Trust A, and in addition, the Trustee may pay the deceased Trustor’s last illness and funeral ex-penses, attorneys’ fees, and other probate expenses and other obligations incurred for the deceased Trustor’s support out of Trust A as the Trustee deems advisable.

(d) The Trustee shall not use any amount received by the Trustee from any employees’ trust meeting the requirements of 401 of the Internal Revenue Code to pay the obligations of the estate of the employee, including without limitation funeral and last illness expenses, debts, estate, inheritance or income taxes or costs.

2. Distribution of Trust A During Lifetime of Surviving Trustor:

(a) The Trustee shall pay to or apply for the benefit of the surviving Trustor, during his or her lifetime, quarter-annually or at more frequent intervals, all of the net income from Trust A. The obligation for said payments shall commence upon the death of the Trustor first to die.

(b) The surviving Trustor shall have the right to withdraw such amounts of the principal of Trust A as he or she may desire, at any time and for any purpose, up to the whole thereof.

(c) If the surviving Trustor shall be unable for any reason to exercise the rights reserved to him or her under subparagraph (b) above, and if the Trustee deems that said Trustor is in need of additional funds for his or her proper support and maintenance, the Trustee may, in its sole discretion, pay to apply for the benefit of the surviving Trustor such amounts of the

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principal of Trust A, up to the whole thereof, as the Trustee may deem necessary or advisable for that purpose.

(d) The surviving Trustor shall have the power to amend, revoke, or terminate Trust A, but Trust B may not be amended, revoked, or terminated. On the death of the surviving Trustor, neither trust may be amended or revoked and shall terminate only in accordance with the terms hereof. On the revocation or termination of Trust A, all its assets shall be delivered to the surviving Trustor.

3. Distribution of Trust A on Death of Surviving Trustor:

(a) On the death of the surviving Trustor, the Trustee may, in the Trustee’s discretion and subject to the restrictions on use of funds from an employees’ trust as contained herein, pay-out of the principal of Trust A the surviving Trustor’s last illness and funeral expenses, attor-neys’ fees, executor’s fees, and other costs incurred in administering the surviving Trustor’s probate estate; other obligations incurred for support of the surviving Trustor; and any estate or inheritance taxes, including interest and penalties, arising by reason of the death of the surviving Trustor. In no event, however, shall the Trustee use any amount received by the Trustee from any employees’ trust meeting the requirements of 401 of the Internal Revenue Code to pay the obligations of the estate of the employee, including without limitation fu-neral and last illness expenses, debts, estate, inheritance or income taxes or costs.

(b) The Trustee shall distribute the balance then remaining, if any, of Trust A (including both principal and any accrued or undistributed income) to such one or more persons and entities, including the surviving Trustor’s own estate and on such terms and conditions, either outright or in trust, as the surviving Trustor shall appoint by Will or Codicil specifically referring to and exercising this power of appointment (whether said surviving Trustor’s Will or Codicil is exe-cuted before or after the death of the Trustor first to die, provided that he or she is the sur-viving Trustor).

(c) Any balance remaining in Trust A shall be added to Trust B, to be held, administered, and distributed as a part of said Trust B as hereinafter provided.

4. Distribution of Trust B During Lifetime of Surviving Trustor:

(a) The Trustee shall pay to or apply for the benefit of the surviving Trustor, during his or her lifetime, quarter-annually or at more frequent intervals, all of the net income from Trust B. The obligation for said payments shall commence upon the death of the Trustor first to die.

(b) The surviving Trustor shall have the right to continue to occupy all real property in the trust estate that the Trustors were using for residential purposes (whether on a full- or part-time basis, including resort property); provided, however, that the surviving Trustor may di-rect the Trustee to sell any such property and replace it with or rent or lease another resi-dence, selected by the surviving Trustor, of comparable or lower value. The Trustee shall pay a proportionate part of the mortgage or trust deed payments, property taxes, assessments, insurance, maintenance, and ordinary repairs on all such property, or any rent or lease pay-ments equal to the Trustee’s proportionate interest in the property. If the surviving Trustor is not serving as Trustee, such payments may be made out of the principal or income of the trust estate as the Trustee in the Trustee’s discretion shall determine. If the surviving Trustor is serving as Trustee, such payments shall be made out of the income of the trust estate.

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(c) The Trustee shall in addition pay to the surviving Trustor, on his or her written request, such amounts of principal of Trust B as are reasonably required for the support of the surviv-ing Trustor in his or her accustomed manner of living. The surviving Trustor need not exhaust his or her other income or resources in order to be entitled to receive such payments.

(d) If the surviving Trustor is not serving as Trustee hereunder, and if said surviving Trustor should at any time be in need of funds for his or her proper support and maintenance, in the sole discretion of the successor Trustee, said successor Trustee shall pay to or apply for the benefit of the surviving Trustor such sums out of the principal of Trust B as the successor Trustee in its sole discretion deems advisable for the benefit of the surviving Trustor.

(e) The Trustee shall in addition pay to the surviving Trustor, during his or her lifetime, from the principal of Trust B, such amounts as he or she may request in writing, not exceeding in any calendar year the greater of the following amounts: Five Thousand Dollars ($5,000.00) or five percent (5%) of the value of the principal of Trust B, determined as of the end of the calendar year. This right of withdrawal is noncumulative, so that if the surviving Trustor does not withdraw, during any calendar year, the full amount to which he or she is entitled under this provision, his or her right to withdraw the amount not withdrawn shall lapse at the end of that calendar year.

(f) On the surviving Trustor’s death, the Trustee shall distribute the balance then remaining, if any, of Trust B (including both principal and any accrued or undistributed income) to such of the then living lawful issue of the Trustors and on such terms and conditions, either out-right or in trust, as the surviving Trustor shall appoint by Will or Codicil specifically referring to and exercising this limited power of appointment (whether said surviving Trustor’s Will or Codicil is executed before or after the death of the Trustor first to die, provided that he or she is the surviving Trustor). Any balance remaining in Trust B shall be held, administered, and distributed as set forth in paragraph 5 below.

5. Distribution of Trust B after Death of Surviving Trustor:

On the death of the surviving Trustor, Trust B shall be divided into equal shares. One share shall be set aside for each child of the Trustors who is then living. One share shall be set aside for the then living lawful issue of each child of the Trustors who is not then living if said child leaves lawful issue then living. No share shall be set aside for a child of the Trustors who is not then living if said child fails to leave lawful issue then living. Each share so divided shall be distributed, or retained in trust, as hereinafter provided:

(a) Each share set aside for the benefit of a living child of the Trustors shall be distributed to such child, free of trust.

(b) Each share set aside for the benefit of the living lawful issue of a deceased child of the Trustors shall be retained and administered by the Trustee in a separate trust as follows:

(1) As long as any lawful child of said deceased child of the Trustors who was living at the death of the Trustor last to die is under age twenty-one (21), the Trustee shall pay to or apply for the benefit of the then living lawful issue of said deceased child of the Trustors including those who are age twenty-one (21) or older, as much of the net income and principal as the Trustee in the Trustee’s discretion deems advisable for their proper case, support, maintenance, and education, after taking into consideration, to the extent the Trustee deems advisable, any other income or resources of said issue known to the

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Trustee. Any net income not distributed shall be accumulated and added to principal. In exercising the discretions conferred by this subparagraph, the Trustee may pay more to or apply more for some beneficiaries than others and may make payments to or applications of benefits for one or more beneficiaries to the exclusion of others if the Trustee deems this necessary or appropriate in the light of the circumstances, the size of the trust estate, and the probable future needs of the beneficiaries. Any payment or application of benefits pursuant to this subparagraph shall be charged against the trust as a whole rather than against the ultimate distributive share of a beneficiary to whom or for whose benefit the payment is made.

(2) When no lawful child of said deceased child of the Trustors who was living at the death of the Trustor last to die is under age twenty-one (21), the Trustee shall distribute the remaining balance of said share to the lawful issue of said deceased child of the Trustors, by right of representation. If any lawful issue of a deceased child of the Trustors is not then living, his or her portion shall be distributed to his or her then living lawful issue, by right of representation, or if there are none to the then living lawful issue of said deceased child of the Trustors, by right of representation, or if there are none to the then living lawful issue of the Trustors, by right of representation; provided, however, if any part of that balance would otherwise be distributed to a person for whose benefit a trust is being ad-ministered under this Declaration of Trust, the part shall instead be added to that trust and shall thereafter be administered according to its terms, except that an addition to a partially distributed trust shall augment proportionally the distributed and undistributed portions of the trust.

C. SIMULTANEOUS DEATH OF BOTH TRUSTORS

If both of the Trustors should die simultaneously, then the remaining balance of the trust estate shall be held and distributed in the manner provided for in Section B, paragraph 5 above.

D. TERMINATION OF TRUST

Unless sooner terminated in accordance with other provisions of this instrument, each trust cre-ated herein shall terminate twenty-one (21) years after the death of the last survivor of the Trus-tors and those of their issue who are living at the time of death of the Trustor first to die. All principal and undistributed income of any trust so terminated shall be distributed to the then income beneficiaries of that trust in the proportions in which they are, at the time of termination, entitled to receive income; provided, however, that if the rights to income are not then fixed by the terms of the trust, distribution under this clause shall be made, by right of representation, to such issue of the Trustors or other persons as are entitled or authorized, in the Trustee’s discre-tion, to receive payments from that trust.

E. CONTEST OF TRUST

The Trustors have, except as otherwise provided herein or in their Wills, intentionally and with full knowledge, declined to provide for any of their heirs, and such persons, if any, shall take no part of the estate or this trust. If any beneficiary hereunder or any devisee, legatee or beneficiary under either Trustor’s Will shall directly or indirectly contest this trust or either Trustor’s Will or any of their parts or provisions, any share given to that person shall be revoked and augment

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proportionately the shares of such of the devisees, legatees, and beneficiaries as shall not have joined or participated in said contest.

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ARTICLE III

POWERS OF TRUSTEE

To carry out the purposes of the trusts hereinabove created, and subject to any limitations set forth herein, the Trustee is vested with the following powers with respect to the trust estate and any part of it, in addition to those powers now or hereafter conferred by law:

A. GENERAL POWERS

1. To continue to hold any property, including shares of stock of any Trustee under this trust, and to operate at the risk of the trust estate any business received or acquired under the trust by the Trustee as long as the Trustee deems advisable; provided, however, that unproductive or under-productive property shall not be held as an asset of Trust A for more than a reasonable time during the lifetime of the surviving Trustor without the consent of the surviving Trustor.

2. To manage, control, grant options on, sell (for cash or on deferred payments), convey, ex-change, partition, divide, subdivide, improve and repair trust property.

3. To lease trust property for terms within or beyond the term of the trust and for any purpose, including exploration for and removal of gas, oil, and other minerals; and to enter into community oil leases, pooling, and unitization agreements.

4. To borrow money, and to encumber or hypothecate trust property by mortgage, deed of trust, pledge, or otherwise; and to invest in margin accounts with stockbrokers.

5. To carry, at the expense of the trust, insurance of such kinds and in such amounts as the Trus-tee shall deem advisable to protect the trust estate and the Trustee against any hazard.

6. To commence or defend such litigation with respect to the trust or any property of the trust estate as the Trustee may deem advisable, at the expense of the trust.

7. To compromise or otherwise adjust any claims or litigation against or in favor of the trust.

8. To invest or reinvest the trust estate in every kind of property, real, personal or mixed, and every kind of investment, specifically including, but not by way of limitation, corporate obliga-tions of every kind, stocks, preferred or common, shares of investment trusts, investment com-panies, and mutual funds, and mortgage participations, and any common trust fund administered by the Trustee under this trust; provided, however, that the aggregate property held in Trust A shall bear a reasonable return.

9. With respect to securities held in trust, to have all the rights, powers, and privileges of an owner, including, but not by way of limitation, power to vote, give proxies and pay assessments; to purchase or sell options on any securities; to participate in public offerings; to participate in voting trusts, pooling agreements, foreclosures, reorganizations, consolidations, mergers, liqui-dations, sales and leases, and incident to such participation, to deposit securities with and trans-fer title to any protective or other committee on such terms as the Trustee deems advisable; and to exercise or sell stock subscription or conversion rights.

10. In any case in which the Trustee is required, pursuant to the provisions of the trust, to divide any trust property into parts or shares for the purpose of distribution or otherwise, the Trustee

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is authorized, in the Trustee’s absolute discretion, to make the division and distribution in kind, including undivided interests in any property, or partly in kind and partly in money, and for this purpose to make such sales of the trust property as the Trustee may deem necessary on such terms and conditions as the Trustee shall see fit.

11. Subject to the provisions of subparagraph 12 of this Paragraph A, matters relating to the rights of beneficiaries among themselves as to principal and income shall be governed by the provisions of the Principal and Income Act from time to time existing. In the event the Principal and Income Act shall contain no provision concerning a particular item, the Trustee shall have the power to determine what is principal or income of the trust estate and apportion and allocate, in the Trus-tee’s reasonable discretion, receipts, and expenses as between these accounts.

12. All of the foregoing powers shall be subject to the Trustee’s duties to treat equitably both the income beneficiaries and remaindermen under this trust. In this consideration, the Trustee shall observe the following:

(a) A reasonable reserve for depreciation of all depreciable real property, capital improve-ments and extraordinary repairs thereto (such as a new roof and new plumbing system) shall be charged to income from time to time.

(b) A reasonable reserve for depletion of all natural resources including, but not limited to, oil, gas, mineral, and timber property shall be charged to income from time to time.

(c) A reasonable reserve for amortization of all intangible property having a limited economic life including, but not limited to, patents and copyrights, shall be charged to income from time to time.

(d) All distributions by mutual funds and similar entities of gains from the sale or other dispo-sition shall be credited to principal.

(e) All premiums paid and all discounts received in connection with the purchase of any bond or other obligation shall be amortized by making an appropriate charge or credit to income as the case may be.

B. NO PHYSICAL DIVISION REQUIRED

There need be no physical segregation or division of the various trusts except as segregation or division may be required by the termination of any of the trusts, but the Trustee shall keep sep-arate accounts for the different undivided interests.

C. PAYMENTS TO MINORS OR INCOMPETENTS

The Trustee in the Trustee’s discretion may make payments to a minor or other beneficiary under disability by making payments to the guardian of his or her person, or the Trustee may apply payments directly for the beneficiary’s benefit. The Trustee in the Trustee’s discretion may make payments directly to a minor if in the Trustee’s judgment he or she is of sufficient age and ma-turity to spend the money properly.

D. ADDITION OF ASSETS TO TRUST

The Trustee shall have the power to receive from any source additional properties acceptable to the Trustee.

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E. RETENTION OF ASSETS

The Trustee is expressly authorized to hold and retain any securities, properties, or investments, and to continue to hold, manage and operate any property, business, or enterprise received by the Trustee hereunder, as long as, in the Trustee’s sole and absolute discretion, the Trustee elects to do so; provided, however, that unproductive or underproductive property shall not be held as an asset of Trust A for more than a reasonable time during the lifetime of the surviving Trustor without the consent of the surviving Trustor. Profits and losses therefrom, if any, are to inure or be chargeable, respectively, to the trust estate and not to the Trustee.

F. TRANSACTIONS WITH ESTATE OF TRUSTOR

Upon the death of either Trustor, the Trustee, in the Trustee’s discretion, may purchase assets from the estate of the deceased Trustor at a fair value. The Trustee shall incur no liability as a result of such purchase or purchases, whether or not such assets constitute investments which may legally be made by trustees; or, at the Trustee’s discretion, the Trustee may lend money to the estate of the deceased Trustor upon such terms as the Trustee and the personal representa-tive of the deceased Trustor may agree.

G. LOANS TO TRUST ESTATE

The Trustee may lend or advance its own funds for any trust purpose to this trust, said loans or advances to bear interest at the then current rate from date of advancement until repaid, and, together with interest, to constitute a first lien upon the entire trust estate, but the Trustee shall in no event be required to make any loan or advancement to this trust.

H. ENUMERATION OF POWERS NOT LIMITATION

The enumeration of certain powers of the Trustee shall not limit the Trustee’s general powers, the Trustee, subject always to the discharge of the Trustee’s fiduciary obligations, being hereby given all the rights, powers, and privileges which an absolute owner of the same property would have; provided, however, during the joint lifetimes of the Trustors the Trustee shall have no greater powers than those possessed by either Trustor, under California Civil Code 5125 and 5127.

I. PURCHASE OF TREASURY BONDS

The Trustee may, in the Trustee’s discretion, purchase at less than par obligations of the United States of America that are redeemable at par in payment of any federal estate tax liability of the Trustors in such amounts as the Trustee deems advisable. The Trustee shall exercise the Trustee’s discretion and purchase such obligations if the Trustee has reason to believe that one of the Trustors is in substantial danger of death, and may borrow funds and give security for that pur-pose. The Trustee shall resolve any doubt concerning the desirability of making the purchase and its amount in favor of making the purchase and in purchasing a larger, even though somewhat excessive, amount. The Trustee shall not be liable to the Trustors, any heir of the Trustors, or any beneficiary of this trust for losses resulting from purchases made in good faith. The Trustee is directed to redeem any such obligations that are part of trust corpus to the fullest extent possible in payment of federal estate tax liability of the Trustors.

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J. POWERS CONSISTENT WITH MARITAL DEDUCTION

Anything herein to the contrary notwithstanding, the Trustee shall exercise power and discretion only in a manner consistent with the allowance of the full federal estate tax marital deduction to which either Trustor’s estate shall otherwise be entitled.

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ARTICLE IV

GENERAL PROVISIONS

A. Except as otherwise specifically provided in this instrument, or in the Will of the deceased Trustor in question, federal estate taxes imposed upon or by reason of the inclusion of any portion of the trust estate in the gross taxable estate of a Trustor under the provisions of any federal tax law may be paid by the Trustee and charged to, prorated among, or recovered from the trust estate or the persons entitled to the benefits under these trusts as and to the extent provided by applicable tax law or any proration statute. Except where otherwise specifically provided, inheritance taxes shall be paid and charged to the trust estate or deducted and collected as provided by law. In particular, any taxes paid out of the trust by reason of the death of the predeceased spouse shall be paid out of Trust B, and any taxes paid by reason of the death of the surviving spouse shall be paid out of Trust A.

B. If any provision of this instrument is unenforceable, the remaining provisions shall nevertheless be carried into effect.

C. These trusts have been accepted by the Trustee in the State of California, and unless otherwise provided in this instrument, their validity, construction, and all rights under them shall be governed by the laws of that State.

D. As used in this instrument, the term “issue” shall refer to lineal descendants of all degrees, and the terms “child,” “children,” and “issue” shall include adopted persons.

E. As used in this instrument, the masculine, feminine or neuter gender, and the singular or plural number shall each be allowed to include the others whenever the context so indicates.

F. The rights, powers, and obligations of the Trustee and the owner of any life insurance policy pay-able to any trust created hereunder shall be as follows:

1. The Trustee shall not be required to pay premiums, assessments, or other charges upon any of the policies or otherwise to keep them or any of them binding contracts of insurance.

2. The owner of each policy made payable to any trust created hereunder has reserved all rights, options, and privileges conferred upon the owner by the terms of the policies, including, but not limited to, the right to change the beneficiary designation thereof, to hypothecate the policy and to borrow funds from the insurer. Sickness, disability, or other benefits and all dividends accruing on the policies during the insured’s life may be paid by the insurer to the owner.

3. Upon receipt of proof of death of the insured, and upon receiving possession of the policies, the Trustee shall use reasonable efforts to collect all sums payable under their terms, which sums upon receipt shall become principal of the trust estate, except interest paid by the insurer, which shall become income. Subject to any contrary provision in the beneficiary designation of any pol-icy, all sums payable under any policy shall be allocated between Trust A and Trust B in the man-ner provided in Section B, paragraph 1 of Article II and by taking into consideration the ownership of the policy immediately preceding the death of the insured.

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4. The Trustee may compromise, arbitrate, or otherwise adjust claims upon any of the policies. The receipt of the Trustee to any insurer shall be a full discharge, and such insurer is not required to see to the application of the proceeds.

5. The Trustee shall not be responsible for any acts or omissions of the Trustors in connection with or relating to any policy, and shall not be required to prosecute any action to collect any insurance or to defend any action relating to any policy unless indemnified in a manner and amount satisfactory to the Trustee.

6. Notwithstanding anything herein to the contrary, the Trustee, during the joint lifetimes of the Trustors, shall have no greater powers than those possessed by either Trustor under California Civil Code 5125 and 5127.

G. Any Trustee may render an accounting from time to time regarding the transactions of a trust created in this instrument by delivering a written accounting to each beneficiary entitled to current income distribution of the trust, or to current distributions out of income or principal of the trust in the Trustee’s discretion. In the event a current beneficiary is a minor, the accounting shall be deliv-ered to the minor’s parents or guardian of his or her person. Unless one or more of the beneficiaries (or a minor’s parent or guardian of a minor’s person) shall deliver a written objection to the Trustee within ninety (90) days of receipt of the Trustee’s account, the account shall be deemed settled and shall be final and conclusive in respect to transactions disclosed in the accounts as to all beneficiaries of the trust, including unborn and unascertained beneficiaries, in respect to transactions disclosed in the account, except for the Trustee’s intentional wrongdoing or fraud.

H. Upon the death of either Trustor with the other acting as a Trustee or Co-Trustee, all insurance policies on the life of the surviving Trustor which are the community property of the parties and in which the deceased Trustor has willed his or her community property interest to this trust, shall be surrendered to the insurance company in exchange for two predated policies. One policy shall be distributed to Trust A, representing the interest of the surviving Trustor as set forth in Article II, par-agraph B. The remaining policy shall be issued to the Insurance-Holding Trustee named in Article VII of this trust, and shall become an asset of Trust B. Any insurance policy on the life of the surviving Trustor which is the separate property of the deceased Trustor shall become an asset of Trust B.

The rights, powers, and obligations of the Insurance-Holding Trustee over the life insurance policies deposited to Trust B shall be exercised solely and exclusively by said Insurance-Holding Trustee. The surviving Trustor as Trustee shall have no rights, powers, or obligations with respect to such policies.

The rights, powers, and obligations of the Insurance-Holding Trustee shall be as follows with respect to the life insurance policies deposited to Trust B:

1. The Insurance-Holding Trustee shall not be required to pay premiums, assessments, or other charges upon any of the policies or otherwise to keep them or any of them binding contracts of insurance.

2. The Insurance-Holding Trustee as owner of each policy shall have all rights, options, and privi-leges conferred upon the owner by the terms of the policies, including, but not limited to, the right to change the beneficiary designation thereof, to hypothecate the policy and to borrow funds from the insurer. Sickness, disability, or other benefits and all dividends accruing on the policies during the insured’s life shall inure to the benefit of Trust B.

3. Upon receipt of proof of death of the insured and upon receiving possession of the policies, the Insurance-Holding Trustee shall use reasonable efforts to collect all sums payable under their

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terms, which sums, upon receipt, shall become principal of the estate of Trust B, except interest paid by the insurer, which shall become income to Trust B. Subject to any contrary provisions of the beneficiary designation of any policy, all sums payable under any policy shall be added to Trust B.

4. The Insurance-Holding Trustee may compromise, arbitrate, or otherwise adjust claims upon any of the policies. The receipt of the Insurance-Holding Trustee to any insurer shall be a full discharge, and such insurer is not required to see to the application of the proceeds.

5. The Insurance-Holding Trustee shall not be responsible for any acts or omissions of the Trustors in connection with or relating to any policy, and shall not be required to prosecute any action to collect any insurance or defend any action relating to any policy unless indemnified in a manner and amount satisfactory to the Trustee.

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ARTICLE V

DEATH OF ALL BENEFICIARIES

If at any time before full distribution of the trust estate as herein provided, the Trustors and all of their issue are deceased and no other disposition of the trust property is directed herein, the trust estate or the portion of it then remaining shall be distributed as though the death of each Trustor had then occurred, one-half to the heirs at law of HUSBAND and one-half to the heirs at law of WIFE according to the laws of the State of California in effect at the date of execution of this trust relating to the succession of separate property not acquired from a predeceased spouse.

ARTICLE VI

SPENDTHRIFT PROVISIONS

The interest of any beneficiary in the principal or income of this trust shall not be subject to claims of his or her creditors, or others, or liable to attachment, execution or other process of law, and no beneficiary shall have any right to encumber, hypothecate or alienate his or her interest in the trust in any manner; provided, however, that this shall not be construed to restrict the general power of appointment granted the surviving Trustor over Trust A as set forth hereinabove. The Trustee may, however, deposit to any bank designated by the beneficiary, to his or her credit, income, or principal payable to such beneficiary.

ARTICLE VII

SUCCESSOR TO ORIGINAL TRUSTEE

In the event of the death, inability to serve, or resignation of either Trustor as Trustee, then the other shall be the sole successor Trustee. In the event of the death, inability to serve, or resignation of both Trustors as Trustee, then SUCCESSOR#1 shall be the sole successor Trustee. In the event of the death, inability to serve, or resignation of SUCCESSOR#1 as Trustee, then SUCCESSOR#2 shall be the succes-sor Trustee. In the event of the death, inability to serve, or resignation of SUCCESSOR#2 as Trustee, then SUCCESSOR#3 shall be the successor Trustee.

In the event of the death of one of the Trustors, with the other acting as Trustee, then SUCCESSOR#1 shall become a Trustee for the sole purpose of exercising all rights, powers, and obligations over any life insurance policies on the life of the surviving Trustor which have become a part of Trust B pursu-ant to Article IV, Section H. SUCCESSOR#1 shall be known as the “Insurance-Holding Trustee” and shall have no rights, powers or obligations with respect to any other trust property. The surviving

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Trustor as Trustee shall continue to have all rights, powers, and duties set forth in Article III of this trust with respect to all of the assets other than life insurance policies.

In the event of the death, inability to serve, or resignation of HUSBAND as Trustee, then WIFE shall become the Trustee and shall have all rights, powers, and duties set forth in Article III of this trust with respect to all of the assets other than life insurance policies. SUCCESSOR#1 shall be the “Insur-ance-Holding Trustee” and shall have all rights, powers, and obligations over any life insurance poli-cies on the life of WIFE which have become part of Trust B pursuant to Article IV, Section H.

If SUCCESSOR#1 shall for any reason be unable to serve as Insurance- Holding Trustee, then SUCCESSOR#2 shall become the Insurance-Holding Trustee, and shall have all the rights, powers, and duties as such, hereinbefore set forth. If SUCCESSOR#2 shall for any reason be unable to serve as Insurance-Holding Trustee, then SUCCESSOR#3 shall become the Insurance-Holding Trustee, and shall have all the rights, powers, and duties as such, hereinbefore set forth.

No successor Trustee acting hereunder shall be held responsible for the willful or negligent defaults of any prior Trustee; nor shall it be the duty of any successor Trustee to audit or obtain auditing of the trust estate or to demand an accounting by any prior Trustee or to investigate the administration of the trust estate of any prior Trustee; nor shall it be the duty of any successor Trustee to initiate or conduct any proceedings to redress a breach of trust committed by a prior Trustee, unless so re-quested in writing by a person having a present or future beneficial interest under a trust hereunder; but any successor Trustee shall be liable only for its own willful misconduct or breach of good faith.

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ARTICLE VIII

RESIGNATION OF TRUSTEE

The Trustee, or any successor, may resign at any time upon giving written notice, thirty (30) days before such resignation shall take effect, to the successor Trustee named in Article VII, if any, and to the Trustors, or, after the death of both Trustors, to all adult beneficiaries and to guardians, conser-vators, or other fiduciaries of the estate of any minor or incompetent beneficiaries who may then be receiving or entitled to receive income hereunder. The successor Trustee next designated in Article VII shall succeed the resigning Trustee. In the event a successor Trustee shall not be so designated, the resigning Trustee shall have the right to appoint a successor Trustee, or the resigning Trustee or any such beneficiary of this trust may secure the appointment of a successor Trustee by a court of competent jurisdiction, at the expense of the trust estate. However, no beneficiary of this trust shall be appointed successor Trustee unless named in Article VII.

The resigning Trustee shall transfer and deliver to its successor the entire trust estate and it shall thereupon be discharged as trustee of this trust and shall have no further powers, discretions, rights, obligations, or duties with reference to the trust estate and all such powers, discretions, rights, obli-gations and duties of the resigning Trustee shall inure to and be binding upon such successor Trustee.

ARTICLE IX

TRUSTEE’S COMPENSATION

If an individual is serving as Trustee, he or she shall be allowed reasonable compensation for his or her services.

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ARTICLE X

NAME OF TRUSTS

These trusts may be referred to collectively as the “HUSBAND and WIFE 20__ TRUST” and each sep-arate trust created herein may be referred to as the “HUSBAND and WIFE 20__ TRUST A” and the “HUSBAND and WIFE 20__ TRUST B.”

THIS DECLARATION OF TRUST has been executed by the Trustors and the Trustee this ___ day of MONTH, 20__, at Newport Beach, California.

__________________________ HUSBAND, Trustee

__________________________ WIFE, Trustee

__________________________ HUSBAND, Trustor

__________________________ WIFE, Trustor

STATE OF CALIFORNIA )

) ss.

COUNTY OF ORANGE )

On MONTH ___, 20__, before me, the undersigned, a Notary Public in and for said County and State, personally appeared HUSBAND and WIFE, personally known to me or proved to me on the basis of satisfactory evidence to be the Trustees of the “HUSBAND and WIFE 2011 TRUST,” and acknowledged to me that they executed the within instrument as such Trustees.

WITNESS my hand and official seal.

Notary Public for the

State of California

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STATE OF CALIFORNIA )

) ss.

COUNTY OF ORANGE )

On MONTH ___, 20__, before me, the undersigned, a Notary Public in and for said County and State, personally appeared HUSBAND and WIFE, personally known to me or proved to me on the basis of satisfactory evidence to be the Trustors of the “HUSBAND and WIFE 20__ TRUST,” and acknowledged to me that they executed the within instrument as such Trustors.

WITNESS my hand and official seal.

Notary Public for the

State of California

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EXHIBIT A

One Dollar ($1.00) cash.

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EXHIBIT B

INSURANCE POLICIES:

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Appendix B Warning

This sample agreement does not contain all of the provisions which may be appropri-ate or desirable in governing a family limited partnership and is solely for illustration purposes.

Family Limited Partnership Agreement

THIS AGREEMENT is made and entered into this __________ day of _____________________, 20 _____, by and among Father, the “General Partner,” and Son and Daughter, the Limited Partners, all residing in the City of Anytown, USA.

l. Partnership Name & Business. The parties hereby form a limited partnership under the name of “Family Company” (hereinafter referred to as the “Partnership”), for the purpose of acquiring and managing real property, and for such further lawful purposes deemed prudent by the General Part-ner in order to achieve successful operations for the Partnership. The principal office and place of business of the Partnership shall be at 2222 Peach Ave., Anytown, USA.

2. Term of Partnership. The partnership shall begin on the ____ day of ________________, 20__ and continue until terminated as herein provided.

3. Capital Contributions. The initial capital of the partnership shall be contributed by the parties as follows:

Father $50,000

Son $25,000

Daughter $25,000

The above capital shall be contributed by each partner in the form of undivided interests in the as-sets, subject to the liabilities, to be set forth in an Exhibit A to be attached to this Agreement. No interest shall be paid on the initial capital contributions or on any subsequent capital contributions.

4. Profit & Loss. The net profits and losses of the Partnership shall be divided and borne by each of the partners in the proportion to which the partners contributed capital. The partners shall have the right to withdraw their shares of the partnership net profits, at such times as deemed prudent by the General Partner but all such withdrawals shall be made in the ratios in which the partners are entitled to share in net profits. Such distribution of net profits shall be subsequent to the salary provided for in paragraph 5 below.

5. Salaries. Father agrees to spend full time working in the partnership business. Father shall receive a salary of $15,000 a year, payable in equal monthly installments. Such salary shall be treated as an

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expense of the partnership in determining its net profits and net losses. The salary of Father may be increased or decreased from time to time by the General Partner, but in all events, such salary shall be reasonable in relation to services performed. Limited Partners shall not be required to render any services to the partnership. No partner shall receive draws for services rendered on behalf of the Partnership in their capacity as partners.

6. Management. No Limited Partner shall participate in the management of the Partnership busi-ness. The partnership business shall be managed by the General Partner. However, no partner shall, without the unanimous consent of all partners:

(a) guarantee any note, or act as an accommodation party or otherwise become a surety for any person;

(b) borrow or lend money, on behalf of the partnership, or make, deliver or accept any commer-cial paper, execute any mortgage, security agreement, pledge or lease, or purchase or sell any property for or of the partnership other than the type of property bought or sold in the regular course of the partnership business;

(c) assign, mortgage, create a security interest in, or sell his or her interest in the partnership, or enter into any agreement as a result of which any person shall become interested with him or her in the partnership, or do any act detrimental to the best interests of the partnership or which would make it impossible to carry on the ordinary business of the partnership.

The General Partner shall not be liable for any action taken or omitted, which may result in loss or damage to the Partnership if such action was taken or omitted in reliance upon the opinion of legal or other professional counsel for the Partnership.

7. Banking. All partnership income shall be deposited in its name in such checking account or ac-counts as shall be designated by the General Partner, and all partnership expenses shall be paid therefrom.

8. Books & Records. The partnership books and records shall be maintained at the principal office of the partnership, and each partner shall at all times have access thereto. The fiscal year of the Part-nership shall be the calendar year.

9. Liquidation. Upon any liquidation of the partnership business, the partners shall continue to share in net profits and net losses in the proportions set forth in paragraph 4. The proceeds of liquidation shall first be paid in discharge of all partnership liabilities, then in payment of all unpaid salaries due partners, thereafter in the equalization and payment of undrawn partnership profits, and finally in proportionate distributions against the respective balances in the capital accounts of the partners.

10. Termination. The Partnership may be terminated by the General Partner, after 90 days prior written notice by the General Partner to each of the Limited Partners. In such event, the General Partner shall wind up and liquidate the Partnership. Upon completion of the liquidation, the Partner-ship shall be deemed completely dissolved and terminated.

11. Power of Attorney. Each Limited Partner appoints the General Partner lawful attorney for the undersigned, to make, execute, sign, acknowledge, and file a Certificate of Limited Partnership or amendments thereto, and, upon termination of the Partnership, a Certificate of Dissolution, as re-quired under the laws of this state, and also to make, execute, sign, acknowledge, and file such other instruments as may be required under the laws of this state.

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12. Title. The General Partner is authorized to take title to any Partnership real property and to exe-cute any and all documents related thereto on behalf of the Partnership, whether or not a Certificate of Limited Partnership has been filed prior to the date of such acceptance of title or execution of such documents, and all of the parties hereto hereby ratify and confirm any such action by the Gen-eral Partner.

13. Binding Effect. This Agreement shall be binding upon all the parties and their estates, heirs, or legatees.

14. Governing Law. This agreement and all transactions contemplated hereby shall be governed by, construed, and enforced in accordance with the laws of the State of _________________.

15. Arbitration. Any controversy or claim arising out of or relating to this Agreement, or the breach thereof, shall be settled by arbitration in accordance with the rules of the American Arbitration As-sociation, and judgment upon the award rendered may be entered in any court having jurisdiction thereof.

N WITNESS WHEREOF the parties hereby execute this Agreement.

FATHER

SON

DAUGHTER

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EXHIBIT “A”

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Appendix C Warning

This sample agreement does not contain all of the provisions which may be appropri-ate or desirable in governing a buy & sell agreement and is solely for illustration pur-poses.

Buy & Sell Agreement

THIS AGREEMENT is made this ________ day of 20___, by and between _______________and __________________, (hereinafter called the “partners”).

THE PARTIES HEREBY AGREE THAT:

1. Identity of Partnership. The above-named partners are the sole owners as general partners of that certain business known as which maintains its principal office for the transaction of business at _____________________, California.

2. Purpose. The purpose of this Agreement is to provide for the continuance of the partnership busi-ness on the death or retirement of a partner and the purchase of his or her interest in the partnership by the remaining partner.

3. Purchase by Partnership on Death. On the death of either partner, the surviving partner shall pur-chase from the estate of the deceased partner, and the executors or administrators of the estate of such deceased partner shall sell to the surviving partner, the entire interest of the deceased partner in the partnership at the price and on the terms and conditions specified in provisions (a) through (g) herein.

(a) Closing. The closing of such purchase and sale shall take place at the office of the partnership at a date designated by the surviving partner, which shall not be more than sixty (60) days fol-lowing the date of qualification of the personal representative of the deceased partner.

(b) Purchase Price. The purchase price of the partnership interest to be sold under this Agreement shall be the agreed upon or formula value reached by the parties. On each and every year, the parties hereto shall meet and either agree upon (i) a value for each partnership interest for the coming year or (ii) a formula for ascertaining the value of each partnership interest for the coming year. The parties hereto agree that such value or formula shall be determined with reference to the partnership’s records according to generally accepted principles of accounting with the assis-tance of the accountant of the partnership who customarily prepares its financial statements.

(c) Terms. At the time of closing as described in paragraph (a), the surviving partner shall pay percent (___%) of the purchase price in cash. The surviving partner shall give to the personal

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representative of the deceased partner an unsecured promissory note signed by the remaining and purchasing partner for the balance of the purchase price. The note shall provide for _______ equal annual installments, the first such installment payable one (1) year after the closing, plus interest of _______ percent (___%) per annum until paid in full. The note shall provide that if a payment is missed the entire balance shall become due and payable at the option of the holder thereof. The note shall contain a provision for payment of reasonable attorney fees in the event of default.

(d) Insurance. If the partnership shall receive any proceeds of any insurance policy on the life of the deceased partner, such proceeds may, at the discretion of the surviving partner, at the time of closing, be paid by the partnership to the deceased partner’s personal representative to the extent of the purchase price of the decedent’s interest. Such payment shall be deemed made on account of said purchase price.

(e) Balance of Purchase Price. The balance of the purchase price remaining after credit for any such insurance proceeds shall be represented by an unsecured promissory note of the partner-ship delivered to the personal representative, payable in ______ equal annual installments, plus interest at percent (___%) per annum, the first such installment payable one year after the clos-ing. Said note shall contain a provision that if one payment is missed, the entire principal of the note shall become due and payable at the option of the holder. Said note shall also contain a provision for payment of reasonable attorney’s fees in the event of default.

(f) Hold Harmless. The surviving partner agrees to hold the estate of a deceased partner harmless from any and all debts of the partnership, including bank loans.

(g) Execution of Instruments. At the time of closing, as described above, the personal representa-tive of the estate of the deceased partner shall execute and deliver to the surviving partner such instruments as are necessary to transfer full and complete title to the deceased partner’s interest in the partnership to the surviving partner and as may be required by the surviving partner to conveniently carry on the business of the partnership.

4. Partnership Profits After Death. All profits earned by the partnership business after the date of the deceased partner’s death shall belong to the surviving partner, and the estate of the deceased part-ner shall have no right or claim thereto nor any right to an interest in lieu thereof.

5. Assumption of Partnership Obligations. On any purchase and sale of the interest of a deceased partner in the partnership being made, the surviving partner shall assume all the partnership obliga-tions and shall protect and indemnify the estate of the deceased partner, the executors, or adminis-trators of such estate, and the property of such estate from liability on such obligation.

6. Publication of Notice. On any purchase and sale of the interest of a deceased partner in the part-nership being made, the surviving partner shall, at their own cost and expense, cause to be published such notices as may be required by law to protect the estate of the deceased partner and the exec-utors or administrators of such estate from liability for any future obligations of the partnership busi-ness.

7. Life Insurance Policies. The partnership shall have the right on the unanimous vote of the partners, to purchase life insurance on the lives of either or both of the partners. Any such insurance shall be listed on a schedule hereto attached and marked Schedule A. The proceeds of such policies may be used, at the discretion of the surviving partner toward the payment of a deceased partner’s interest in the partnership to such deceased partner’s personal representative as noted in paragraph 3(d).

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(a) Ownership. The partnership shall be the beneficiary and sole owner of each insurance policy procured by it pursuant to this Agreement and shall hold full legal title to each such insurance policy. It is agreed, however, that no rights, options, or privileges provided for in any such policy shall be exercised without the written consent of all the partners.

(b) Payment of Premiums. The partnership shall pay as they become due all premiums on the insurance policies procured by it pursuant to this Agreement and shall give proof of the payment of each such premium to each partner within ________ days after its due date. If any premium on any such policy is not paid by the partnership within _________ days after its due date, any partner shall have the right to pay such premiums and be reimbursed there for by the partner-ship. The insurance company issuing any such policy is authorized and directed to furnish any partner with any information he or she may request in writing pertaining to the status of any such insurance policy.

(c) Premiums as Partnership Expense. The total amount of premiums payable each year by the partnership on all insurance policies procured by it pursuant to this Agreement shall be borne equally by the partners and, although not deductible for federal or state income tax purposes, shall be considered, as between the partners, as an ordinary and necessary expense of the part-nership business deductible before determination of the net profits of the partnership.

(d) Insurance Policies as Partnership Assets. The cash surrender value of each insurance policy procured by the Partnership pursuant to this Agreement shall be considered, for the purpose of determining the value of any partner’s interest in the Partnership, an asset of the partnership.

(e) Purchase of Policies on Termination. In the event this Agreement is terminated before the death of either partner, each partner shall be entitled to an assignment to him or her from the partnership of the policy or policies insuring his or her life on the payment by him or her to the partnership within __________ (___) days after such termination of an amount equal to the in-terpolated terminal reserve of such policies as of the date of transfer, less any existing indebted-ness charged against such policies, and plus the proportionate part of the gross premiums last paid on such policies before the date of transfer which cover a period extending beyond that date.

(f) Purchase of Policies on Withdrawal. Any partner who is permitted to withdraw from the part-nership shall have the right to purchase the policy or policies owned by the partnership insuring his or her life by paying to the partnership within __________ days after his or her withdrawal an amount equal to the interpolated terminal reserve value of the policies as of the date of his or her withdrawal, less any existing indebtedness charged against such policies and plus the pro-portionate part of the gross premiums last paid on such policies before the date of his or her withdrawal which cover a period extended beyond that date.

(g) Performance by Insurance Company. No insurance company whose policies shall be issued because of this Agreement shall have any liability except as set forth in its policies. No such com-pany shall be hound to inquire into or take notice of any of the provisions of this Agreement relating to such policies of insurance or to the application of the proceeds of such policies. Pay-ment or other performance by such insurance company in accordance with the terms of its poli-cies shall completely discharge such company from all claims, suits, and demands on all persons whatsoever.

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8. Retirement. Either partner shall have the right to retire from the partnership at the end of any fiscal year. Written notice of intention to retire shall be served upon the remaining partner at the office of the partnership at least _________ days before the end of the calendar year. The retirement of either partner shall have no effect upon the continuance of the partnership business.

9. Right of First Refusal. The remaining partner shall have the right of first refusal to purchase the retiring partner’s interest under the terms and conditions set forth below. The remaining partner shall notify the retiring partner prior to the end of the calendar year as to whether or not he or she shall purchase the retiring partner’s interest.

10. Remaining Partner’s Election to Purchase. If the remaining partner elects to purchase said retiring partner’s interest he or she shall give the retiring partner written notice prior to the end of the year. The purchase shall be under the following conditions:

(a) Closing. The closing of the purchase and sale shall take place at the office of the partnership within ________ days after notice to retiring partner of the election to purchase.

(b) Purchase Price. The purchase price of the partnership interest to be sold under this Agreement shall be the agreed upon or formula value reached by the parties. On of each and every year, the parties hereto shall meet and either agree upon (i) the value for each partnership interest for the coming year or (ii) a formula for ascertaining the value of each partnership interest for the coming year. The parties agree that such value or formula shall be determined with reference to the partnership’s records according to generally accepted principles of accounting with the assis-tance of the accountant of the partnership who customarily prepares its financial statements.

(c) Terms of Purchase. The purchasing partner shall pay _______ percent (___%) of the purchase price in cash. The remaining purchase price shall be paid to the retiring partner by an unsecured promissory note signed by the remaining partner acquiring the interest of the retiring partner. The note shall provide for ___________ equal annual installments, the first such installment pay-able one (1) year after the closing, plus interest of ________ percent (___%) per annum until paid in full. The note shall further provide that if a payment is missed the entire balance shall become due and payable at the option of the holder thereof. The note shall contain a provision for pay-ment of reasonable attorney’s fees in the event of default.

11. Purchase by a Third Party. If the remaining partner does not elect to purchase the retiring part-ner’s interest by the end of the year, the retiring partner shall be free to solicit the offers of third parties to purchase the retiring partner’s interest. Before the retiring partner shall accept any such offer, the retiring partner shall obtain the written consent of the remaining, partner to the retiring partner’s acceptance of such offer.

12. Prohibition of Sale During Lifetime. No partner shall, during his or her lifetime, assign, encumber, or dispose of his or her interest in the partnership, or any portion thereof, by sale or otherwise, without the written consent of the other partner.

13. Amendment. This Agreement may be altered, amended, or terminated by a writing signed by a majority of the partners.

14. Termination. This Agreement shall terminate on the occurrence of any of the following events:

(a) Cessation of the partnership business.

(b) Bankruptcy, receivership, or dissolution of the partnership.

(c) Bankruptcy of any partner.

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15. Binding on Heirs. This Agreement shall be binding on the parties hereto, their heirs, executors, administrators, successors, and assigns.

16. Attorney’s Fees. Should any litigation be commenced between the parties hereto or their per-sonal representatives, concerning any provision of this Agreement or the rights and duties of any person in relation thereto, the party or parties prevailing in such litigation shall be entitled, in addi-tion to such other relief as may be granted, to a reasonable sum as and for their or his or her attor-ney’s fees in such litigation which shall be determined by the court in such litigation or in a separate action brought for that purpose.

17. Governing Law. The laws of the State of California shall govern this Agreement.

Executed on_____________, 20____, at___________________________________

County, California.

CONSENT OF SPOUSES

We, the undersigned, certify that:

1. We are the spouses of the persons who signed the foregoing Partnership Agreement and who constitute the partners of the partnership firm therein described.

2. We have read and approve of the provisions of such Partnership Agreement relating to the pur-chase and sale of the interest of a deceased, withdrawing, or terminated partner.

3. We agree to be bound by and accept the provisions of such Agreement in lieu of all other interests we, or any of us, may have in such partnership, be such interest community property or otherwise.

Executed ___________, 20__ , at

County, California.

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Appendix D Warning

These sample agreements do not contain all of the provisions which may be appropri-ate or desirable and are solely for illustration purposes.

Care Documents

CALIFORNIA NATURAL DEATH ACT

GUIDELINES AND DIRECTIVE

These guidelines have been drafted by an ad hoc committee convened at the request of Assembly-man Barry Keene, and composed of the Los Angeles County Bar Association’s Committee on Bioeth-ics, California Hospital Association Legal Counsel, California Medical Association Legal Counsel, and representatives of the office of Assemblyman Keene.

GUIDELINES FOR SIGNERS

The DIRECTIVE allows you to instruct your doctor not to use artificial methods to extend the natural process of dying.

Before signing the DIRECTIVE, you may ask advice from anyone you wish, but you do not have to see a lawyer or have the DIRECTIVE certified by a Notary Public.

If you sign a DIRECTIVE, talk it over with your doctor and ask that it be made part of your medical record.

The DIRECTIVE must be WITNESSED by two adults who (1) are not related to you by blood or mar-riage; (2) are not mentioned in your will; and, (3) would have no claim on your estate.

The DIRECTIVE may NOT be witnessed by your doctor or by anyone working for your doctor. If you are in a HOSPITAL at the time you sign the DIRECTIVE, none of its employees may be a witness. If you are in a SKILLED NURSING FACILITY, one of your two witnesses MUST be a “patient advocate” or “ombudsman” designated by the State Department on aging.

You may sign a DIRECTIVE TO PHYSICIANS if you are at least 18 years old and of sound mind, acting of your own free will in the presence of two qualified witnesses.

No one may force you to sign the DIRECTIVE. No one may deny you insurance or health care services because you have chosen not to sign it. If you do sign the DIRECTIVE, it will not affect your insurance or any other rights you may have to accept or reject medical treatment.

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Your doctor is bound by the DIRECTIVE only if (1) he or she is satisfied that your DIRECTIVE is valid; (2) another doctor has certified your condition as terminal; and, (3) at least 14 days have gone by since you were informed of your condition.

If you sign a DIRECTIVE while in good health, your doctor may respect your wishes but is not bound by the DIRECTIVE.

The DIRECTIVE is valid for a period of five years, at which time you may sign a new one.

The DIRECTIVE is not valid during pregnancy.

You may revoke the DIRECTIVE at any time, even in the final stages of a terminal illness, by (1) de-stroying it; (2) signing and dating a written statement; or, (3) by informing your doctor. No matter how you revoke the DIRECTIVE, be sure your doctor is told of your decision.

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DIRECTIVE TO PHYSICIANS

Directive made this _______ day of ______________________________, 20____.

I, _____________________________, being of sound mind, willfully, and voluntarily make known my desire that my life shall not be artificially prolonged under the circumstances set forth below, do hereby declare:

1. If at any time I should have an incurable injury, disease, or illness certified to be a terminal condi-tion by two physicians, and where the application of life-sustaining procedures would serve only to artificially prolong the moment of my death and where my physician determines that my death is imminent whether or not life-sustaining procedures are utilized, I direct that such procedures be withheld or withdrawn and that I be permitted to die naturally.

2. In the absence of my ability to give directions regarding the use of such life-sustaining procedures, it is my intention that this Directive shall be honored by my family and physician(s) as the final ex-pression of my legal right to refuse medical or surgical treatment and accept the consequences from such refusal.

3. If I have been diagnosed as pregnant and that diagnosis is known to my physician, this DIRECTIVE shall have no force or effect during the course of my pregnancy.

4. I have been diagnosed and notified at least 14 days ago as having a terminal condition by ________________________, M.D., whose address is _____________________________________________________________________ and whose tel-ephone number is ________________________________

I understand that if I have not filled in the physician's name and address, it shall be presumed that I did not have a terminal condition when I made out this Directive.

5. This Directive shall have no force or effect five years from the date filled in above.

6. I understand the full import of this DIRECTIVE and I am emotionally and mentally competent to make this Directive.

Signed: _____________________________ City, County, and State of Residence:

___________________________________________________________________

___________________________________________________________________

The declarant has been personally known to me and I believe him or her to be of sound mind.

Witness: _____________________________

Witness: _____________________________

This DIRECTIVE complies in form with the “Natural Death Act”, California Health and Safety Code, Section 7188, Assembly Bill 3060 (Keene).

SUMMARY AND GUIDELINES FOR PHYSICIANS

INTRODUCTION

A person who is at least 18 years of age and of sound mind may sign a DIRECTIVE TO PHYSICIANS as contained in the 1976 California “Natural Death Act.” This Act permits a person who meets certain qualifications to give legal effect to his or her wishes to avoid artificial prolongation of the dying

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process. It also imposes certain obligations — and provides certain protections — for a physician dealing with a person presenting a DIRECTIVE.

SIGNATURE AND WITNESSES

To be effective, the DIRECTIVE must be signed by the patient and witnessed by two persons who are not related to the patient by blood or marriage, are not mentioned in his or her will, and are not potential claimants to his or her estate, and are not involved with the patient’s medical care. Thus. the DIRECTIVE cannot be witnessed by you or any of your employees. Likewise, it should not be wit-nessed by any other physician or his or her employees, or the employees of any health facility. In addition, if the patient is in a skilled nursing facility at the time of signing, a “patient advocate” or “ombudsman” (designated by the state Department of aging) MUST be a witness.

The DIRECTIVE is effective for five years after which a person may sign a new one. A person signing a DIRECTIVE should, if possible, present the document to his or her physician so that it can be made part of his or her current medical record.

EFFECT OF A DIRECTIVE

Upon receipt of a DIRECTIVE from any patient (qualified or unqualified), the attending physician must determine that the DIRECTIVE meets legal requirements. Under the Act, a “qualified patient” is a person diagnosed and certified in writing to be afflicted with a terminal condition by two physicians, one of whom shall be the attending physician, who has personally examined the patient.

Whether or not a DIRECTIVE is binding depends upon the condition of the patient at the time the DIRECTIVE was signed.

In order for a DIRECTIVE to be binding the patient must be qualified and have signed or reexecuted the DIRECTIVE at least 14 days after being notified of his or her terminal condition. If you do not wish to carry out the DIRECTIVE of such a patient, you are required to transfer care of the patient to a physician who is willing to comply with the DIRECTIVE. If you do not transfer such a patient, you may be found guilty of unprofessional conduct. If you do carry out the DIRECTIVE, you are protected from civil and criminal liability.

The DIRECTIVE is not binding if the patient executed the DIRECTIVE while in good health (in anticipa-tion of a terminal illness or injury). However, should the patient be subsequently diagnosed and certified as terminal, you may carry out the DIRECTIVE if, in your judgment, all of the circumstances known to you justify doing so. If you carry out the DIRECTIVE you are protected from civil and criminal liability.

Regardless of the binding or nonbinding nature of the DIRECTIVE, it is not to be given effect until you have determined that death is imminent, whether or not “life-sustaining procedures” are uti-lized. Such procedures include mechanical or other “artificial means” which sustain vital functions only to postpone the moment of death. These do not include medications or procedures deemed necessary to alleviate pain.

The DIRECTIVE is invalid and has no effect if the patient is pregnant at the time it is to be carried out.

REVOCATION

A patient may revoke the DIRECTIVE at any time by (l) destroying it; (2) signing a written statement; or (3) communicating to the attending physician his or her wish to revoke the DIRECTIVE. Should you

D-5

receive such revocation from or on behalf of a patient who has previously signed a DIRECTIVE, enter that information promptly and prominently in the patient’s current medical record.

OTHER RIGHTS

No person may be forced to sign a DIRECTIVE. A person who has not signed a DIRECTIVE may not be denied health care or health insurance. The DIRECTIVE has no effect on any insurance policy and does not limit a person’s right to accept or reject health care of any kind.

PRECAUTIONS

A person who knowingly conceals or destroys a valid DIRECTIVE is guilty of a misdemeanor. A person who forges or falsifies a DIRECTIVE, or who withholds knowledge of a revocation of a DIRECTIVE may be guilty of unlawful homicide.

SUMMARY

Withholding “life-sustaining procedures” in compliance with a DIRECTIVE is not euthanasia or “mercy killing”. The DIRECTIVE is not a “living will”. The DIRECTIVE is merely a method, recognized under California law, by which a physician may respect a patient’s instruction to permit an imminent death to proceed naturally.

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Recording Requested By:

_____________________________

When Recorded Return To:

_____________________________

_____________________________

_____________________________

—————————————————-Recorder’s Use Only———————

PROPERTY AGREEMENT

_________________________ and _______________________,husband and wife, of _________________________,_______________________ County, California, hereby confirm that each and every item of property, or interest therein, of whatever kind or character, held by them as joint tenants, is and constitutes community property; and further declare that any property they acquire in the future as joint tenants which originated in community property shall be community property of the parties.

Dated: _______________________, 20___

_____________________________________

_____________________________________

State of California }

} ss.

County of _____________}

On _______________________, 20___, before me, the undersigned, a Notary Public in and for said County and State, personally appeared _______________________ and _______________________, personally known to me or proved to me on the basis of satisfactory evidence to be the persons whose names are subscribed to the within instrument, and acknowledged that they executed the same.

WITNESS my hand and official seal.

______________________________________

Notary Public in and for said County and State

D-7

APPOINTMENT OF CONSERVATOR OF THE PERSON AND ESTATE PURSUANT TO SECTION 1810 OF THE PROBATE CODE

I, ____________________________, residing in the State of California, County of _________________, declare that I am aware of the provisions of Section 1810 of the Probate Code of the State of California and, recognizing the possible frailties of life which may later come about by reason of accident, illness or advancing years, I hereby make the following nomination:

In the event that I should ever become unable, by reason of illness, injury, advanced age, or other cause, to properly care for my property, or if for any cause I am likely to be deceived or be imposed upon by artful or designing persons, I hereby nominate ___________________________, Conserva-tor of my person and estate. My Conservatory shall act without bond.

Dated: _______________________, 20____

____________________________________

Signature

State of California }

} ss.

County of _________}

On _________________________, 20____, before me, the undersigned, a Notary Public in and for said State, personally appeared_________________________ personally known to me or proved to me on the basis of satisfactory evidence to be the person___ whose name _______ subscribed to the within instrument and acknowledged that _______ executed the same.

WITNESS my hand and official seal.

___________________________________

Notary Public in and for said County and State

D-8

RECORDING REQUESTED BY

_______________________________

AND WHEN RECORDED MAIL TO

_______________________________

_______________________________

_______________________________

——————————————————Recorder’s Use Only——————

DURABLE POWER OF ATTORNEY FOR HEALTH CARE DECISIONS

(California Civil Code Sections 2410-2443)

WARNING TO PERSON EXECUTING THIS DOCUMENT*

THIS IS AN IMPORTANT LEGAL DOCUMENT. IT CREATES A DURABLE POWER OF ATTORNEY FOR HEALTH CARE. BEFORE EXECUTING THIS DOCUMENT, YOU SHOULD KNOW THESE IMPORTANT FACTS:

1. THIS DOCUMENT GIVES THE PERSON YOU DESIGNATE AS YOUR ATTORNEY-IN-FACT THE POWER TO MAKE HEALTH CARE DECISIONS FOR YOU. THIS POWER IS SUBJECT TO ANY LIMITATIONS OR STATEMENT OF YOUR DESIRES THAT YOU INCLUDE IN THIS DOCUMENT. THE POWER TO MAKE HEALTH CARE DECISIONS FOR YOU MAY INCLUDE CONSENT, REFUSAL OF CONSENT, OR WITHDRAWAL OF CONSENT TO ANY CARE, TREATMENT, SERVICE, OR PROCEDURE TO MAINTAIN, DIAGNOSE, OR TREAT A PHYSICAL OR MENTAL CONDITION. YOU MAY STATE IN THIS DOCUMENT ANY TYPES OF TREATMENT OR PLACEMENTS THAT YOU DO NOT DESIRE.

2. THE PERSON YOU DESIGNATE IN THIS DOCUMENT HAS A DUTY TO ACT CONSISTENT WITH YOUR DESIRES AS STATED IN THIS DOCUMENT OR OTHERWISE MADE KNOWN OR, IF YOUR DESIRES ARE UNKNOWN, TO ACT IN YOUR BEST INTERESTS.

3. EXCEPT AS YOU OTHERWISE SPECIFY IN THIS DOCUMENT, THE POWER OF THE PERSON YOU DESIGNATE TO MAKE HEALTH CARE DECISIONS FOR YOU MAY INCLUDE THE POWER TO CONSENT TO YOUR DOCTOR NOT GIVING TREATMENT OR STOPPING TREATMENT WHICH WOULD KEEP YOU ALIVE.

4. UNLESS YOU SPECIFY A SHORTER PERIOD IN THIS DOCUMENT, THIS POWER WILL EXIST FOR SEVEN YEARS FROM THE DATE YOU EXECUTE THIS DOCUMENT AND, IF YOU ARE UNABLE TO MAKE HEALTH CARE DECISIONS FOR YOURSELF AT THE TIME WHEN THIS SEVEN-YEAR PERIOD ENDS, THIS POWER WILL CONTINUE TO EXIST UNTIL THE TIME WHEN YOU BECOME ABLE TO MAKE HEALTH CARE DECISIONS FOR YOURSELF.

5. NOTWITHSTANDING THIS DOCUMENT, YOU HAVE THE RIGHT TO MAKE MEDICAL AND OTHER HEALTH CARE DECISIONS FOR YOURSELF SO LONG AS YOU CAN GIVE INFORMED CONSENT WITH RESPECT TO THE PARTICULAR DECISION. IN ADDITION, NO TREATMENT MAY BE GIVEN TO YOU OVER

D-9

YOUR OBJECTION, AND HEALTH CARE NECESSARY TO KEEP YOU ALIVE MAY NOT BE STOPPED IF YOU OBJECT.

6. YOU HAVE THE RIGHT TO REVOKE THE APPOINTMENT OF THE PERSON DESIGNATED IN THIS DOCUMENT TO MAKE HEALTH CARE DECISIONS FOR YOU BY NOTIFYING THAT PERSON OF THE REVOCATION ORALLY OR IN WRITING.

7. YOU HAVE THE RIGHT TO REVOKE THE AUTHORITY GRANTED TO THE PERSON DESIGNATED IN THIS DOCUMENT TO MAKE HEALTH CARE DECISIONS FOR YOU BY NOTIFYING THE TREATING PHYSICIAN, HOSPITAL, OR OTHER HEALTH CARE PROVIDER ORALLY OR IN WRITING.

8. THE PERSON DESIGNATED IN THIS DOCUMENT TO MAKE HEALTH CARE DECISIONS FOR YOU HAS THE RIGHT TO EXAMINE YOUR MEDICAL RECORDS AND TO CONSENT TO THEIR DISCLOSURE UNLESS YOU LIMIT THIS RIGHT IN THIS DOCUMENT.

9. THIS DOCUMENT REVOKES ANY PRIOR DURABLE POWER OF ATTORNEY FOR HEALTH CARE.

10. IF THERE IS ANYTHING IN THIS DOCUMENT THAT YOU DO NOT UNDERSTAND, YOU SHOULD ASK A LAWYER TO EXPLAIN IT TO YOU.

1. DESIGNATION OF HEALTH CARE AGENT.

I, __________________________________, do hereby designate and appoint: Name: ______________________________________________________________

Address: ____________________________________________________________

Telephone Number: __________________________________________________

as my attorney-in-fact to make health care decisions for me as authorized in this document.

(Insert the name and address of the person you wish to designate as your attorney-in-fact to make health care decisions for you. None of the following may be designated as your attorney-in-fact: (1) your treating health care provider, (2) an employee of your treating health care provider, (3) an op-erator of a community care facility, or (4) an employee of an operator of a community care facility.)

2. CREATION OF DURABLE POWER OF ATTORNEY FOR HEALTH CARE.

By this document, I intend to create a durable power of attorney by appointing the person designated above to make health care decisions for me as allowed by Sections 2410 to 2443, inclusive, of the California Civil Code. This power of attorney shall not be affected by my subsequent incapacity.

3. GENERAL STATEMENT OF AUTHORITY GRANTED.

In the event that I am incapable of giving informed consent with respect to health care decisions, I hereby grant to the attorney-in-fact named above full power and authority to make health care de-cisions for me before, or after my death, including consent, refusal of consent, or withdrawal of con-sent to any care, treatment, service, or procedure to maintain, diagnose, or treat a physical or mental condition, subject only to the limitations and special provisions, if any, set forth in Paragraph 4 or 6.

4. SPECIAL PROVISIONS AND LIMITATIONS.

(By law, your attorney-in-fact is not permitted to consent to any of the following: commitment to or placement in a mental health treatment facility, convulsive treatment, psychosurgery, sterilization, or abortion. If there are any other types of treatment or placement that you do not want your at-torney-in-fact to have authority to give consent for or other restriction you wish to place on his or her attorney-in-fact’s authority, you should list them in the space below. If you do not write in any limitations, your attorney-in-fact will have the broad powers to make health care decisions on your behalf which are set forth in Paragraph 3, except to the extent that there are limits provided by law.)

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In exercising the authority under this durable power of attorney for health care, the authority of my attorney-in-fact is subject to the following special provisions and limitations:

____________________________________________________________________

____________________________________________________________________

____________________________________________________________________

____________________________________________________________________

5. DURATION.

I understand that this power of attorney will exist for seven years from the date I execute this docu-ment unless I establish a shorter time. If I am unable to make health care decisions for myself when this power of attorney expires, the authority I have granted my attorney-in-fact will continue to exist until the time when I become able to make health care decisions for myself.

I wish to have this power of attorney end before seven years on the following date: ________________________________________.

6. STATEMENT OF DESIRES.

(With respect to decisions to withhold or withdraw life-sustaining treatment, your attorney-in-fact must make health care decisions that are consistent with your known desires. You can, but are not required to, indicate your desires below. If your desires are unknown, your attorney-in-fact has the duty to act in your best interests; and, under some circumstances, a judicial proceeding may be nec-essary so that a court can determine the health care decision that is in your best interests. If you wish to indicate your desires, you may INITIAL the statement or statements that reflect your desires and/or write your own statements in the space below.)

[If the statement reflects your desires, initial the box next to the statement.]

1. I desire that my life be prolonged to

the greatest extent possible, without

regard to my condition, the chances I [_____________]

have for recovery or long-term survival,

or the cost of the procedures.

2. If I am in a coma which my doctors have

reasonably concluded is irreversible, I [_____________]

desire that life-sustaining or prolong-

ing treatments or procedures not be used.

3. If I have an incurable or terminal con-

dition or illness and no reasonable hope

of long-term recovery or survival, I [_____________]

desire that life-sustaining or prolong-

ing treatments not be used.

4. I do not desire treatment to be provided

and/or continued if the burdens of the

treatment outweigh the expected benefits.

My attorney-in-fact is to consider the [_____________]

D-11

relief of suffering, the preservation or

restoration of functioning, and the quality

as well as the extent of the possible

extension of my life.

(If you wish to change your answer, you may do so by drawing an “X” through the answer you do not want, and circling the answer you prefer.)

Other or Additional Statements of Desires:

________________________________________________________________

________________________________________________________________

________________________________________________________________

________________________________________________________________

7. DESIGNATION OF ALTERNATE ATTORNEY-IN-FACT.

(You are not required to designate any alternative attorney-in-fact but you may do so. Any alterna-tive attorney-in-fact you designate will be able to make the same health care decisions as the attor-ney-in-fact designated in Paragraph 1 above in the event that he or she is unable or unwilling to act as your attorney-in-fact. Also, if the attorney-in-fact designated in Paragraph 1 is your spouse, his or her designation as your attorney-in-fact is automatically revoked by law if your marriage is dissolved.)

If the person designated in Paragraph 1 as my attorney-in-fact is unable to make health care decisions for me, then I designate the following persons to serve as my attorney-in-fact to make health care decisions for me as authorized in this document, such persons to serve in the order listed below:

A. First Alternative Attorney-in-fact

Name: _______________________________________________

Address: _____________________________________________

____________________________________________

Telephone Number: ___________________________________

B. Second Alternative Attorney-in-fact

Name: _______________________________________________

Address: ____________________________________________

____________________________________________

Telephone Number: ___________________________________

8. PRIOR DESIGNATIONS REVOKED. I revoke any prior durable power of attorney for health care.

(YOU MUST DATE AND SIGN THIS POWER OF ATTORNEY)

I sign my name to this Statutory Short Form Durable Power of Attorney for Health Care on_____________________, 20____, at_______________________ _________________California.

___________________________________

Signature

(THIS POWER OF ATTORNEY WILL NOT BE VALID FOR MAKING HEALTH CARE DECISIONS UNLESS IT IS EITHER (1) SIGNED BY AT LEAST TWO QUALIFIED WITNESSES WHO ARE PERSONALLY KNOWN TO YOU

D-12

AND WHO ARE PRESENT WHEN YOU SIGN OR ACKNOWLEDGE YOUR SIGNATURE OR (2) ACKNOWLEDGED BEFORE A NOTARY PUBLIC IN CALIFORNIA.)

ACKNOWLEDGMENT OF NOTARY PUBLIC]

(You may use acknowledgment before a notary public instead of the statement of witnesses.)]

State of California }

} ss.

County of ________________}

On this __________ day of ____________________, in the year_______, before me, the under-signed, personally appeared ______________________________,

personally known to me or proved to me on the basis of satisfactory evidence to be the person whose name is subscribed to this instrument, and acknowledged that he or she executed it.

I declare under penalty of perjury that the person whose name is subscribed to this instrument ap-pears to be of sound mind and under no duress, fraud, or undue influence.

____________________________________

Notary Public

STATEMENT OF WITNESSES

(You should carefully read and follow this witnessing procedure. This document will not be valid un-less you comply with the witnessing procedure. If you elect to use witnesses instead of having this document notarized, you must use two qualified adult witnesses. None of the following may be used as a witness: (1) a person you designate as the attorney-in-fact, (2) a health care provider, (3) an employee of a health care provider, (4) the operator of a community care facility, (5) an employer of an operator of a community care facility. At least one of the witnesses must make the additional declaration set out following the place where the witnesses sign.)

I declare under penalty of perjury under the laws of California that the principal is personally known to me, that the principal signed or acknowledged this durable power of attorney in my presence, that the principal appears to be of sound mind and under no duress, fraud, or undue influence, that I am not the person appointed as attorney-in-fact by this document, and that I am not a health care pro-vider, an employee of a health care provider, the operator of a community care facility, nor an em-ployee of an operator of a community care facility.

Signature: ____________________ Residence Address: _____________________

Print Name: ___________________ _______________________________

Date: _________________________ _______________________________

Signature: ____________________ Residence Address: _____________________

Print Name: ___________________ ________________________________

Date: _________________________ ________________________________

(AT LEAST ONE OF THE ABOVE WITNESSES MUST ALSO SIGN THE

D-13

FOLLOWING DECLARATION.) I declare under penalty of perjury under the laws of California that I am not related to the principal by blood, marriage, or adoption, and to the best of my knowledge I am not entitled to any part of the estate of the principal upon the death of the principal under a will now existing or by operation of law.

Signature: ____________________________________

Signature: ____________________________________

REQUIREMENTS

(Special additional requirements must be satisfied for this document to be valid if (1) you are a pa-tient in a skilled nursing facility or (2) you are a conservatee under the Lanterman-Petris-Short Act and you are appointing the conservator as your agent to make health care decisions for you.)

1. If you are a patient in a skilled nursing facility (as defined in Health and Safety Code Section 1250l(c)) at least one witness must be a patient advocate or ombudsman. The patient advocate or ombudsman must sign the witness statement and must also sign the following declaration.

I declare under penalty of perjury under the laws of California that I am a patient advocate or om-budsman as designated by the State Department of Aging and am serving as a witness as required by subdivision (a) (2)A of Civil Code 2432.

Signature: _____________________ Address:______________________________

Print Name: ____________________ _____________________________

Date: __________________________ _____________________________

2. If you are a conservatee under the Lanterman-Petris-Short Act (of Division 5 of the Welfare and Institutions Code) and you wish to designate your conservator as your agent to make health care decisions, you must be represented by legal counsel. Your lawyer must sign the following statement:

I have advised my client_____________________ concerning his or her rights in connection with this matter and the consequences of signing or not signing this durable power of attorney and my client, after being so advised, has executed this durable power of attorney.

Signature: _________________________ Address:__________________________

Print Name: _______________________ __________________________

Date: __________________________ __________________________

COPIES: You should retain an executed copy of this document and give one to your attorney-in-fact. The power of attorney should be available so a copy may be given to your health care providers.

D-14

RECORDING REQUESTED BY

__________________________________

AND WHEN RECORDED MAIL TO

__________________________________

__________________________________

__________________________________

———————————————————Recorder’s Use Only—————

DURABLE POWER OF ATTORNEY

(PROPERTY)]

I, _________________________, of __________________________, City of _______________________, State of California, do hereby appoint _________________________, of ________________________, City of _____________________, State of California, my true and lawful attorney in fact, for me and in my name, place, and stead, and for my use and benefit, to:

a. To ask, demand, sue for, recover, collect and receive each and every sum of money, debt, account, legacy bequest, interest, dividend, annuity, and demand (which now is or hereafter shall become due, owing, or payable) belonging to or claimed by me, and to use and take any lawful means for the recovery thereof by legal process or otherwise, and to execute and deliver a satisfaction or release there for, together with the right and power to compromise or compound any claim or demand;

b. To exercise any or all of the following powers as to real property, any interest therein and/or building thereon: To contract for, purchase, receive and take possession thereof and of evidence of title thereto; to lease the same for any term or purpose, including leases for business, residence, and oil and/or mineral development; to sell, exchange, grant or convey the same with or without war-ranty; and to mortgage, transfer in trust, or otherwise encumber or hypothecate the same to secure payment of a negotiable or non-negotiable note or performance of any obligation or agreement;

c. To exercise any or all of the following powers as to all kinds of personal property and goods, wares and merchandise, choses in action and other property in possession or in action; To contract for, buy-sell, exchange, transfer, and in any legal manner deal in and with the same; and to mortgage, transfer in trust, or otherwise encumber or hypothecate the same to secure payment of a negotiable or non-negotiable note or performance of any obligation or agreement;

d. To borrow money and to execute and deliver negotiable or non-negotiable notes therefor with or without security, and to loan money and receive negotiable or non-negotiable notes therefor with such security as he or she shall deem proper;

e. To create, amend, supplement and terminate any trust and to instruct and advise the trustee of any trust wherein I am or may be trustor or beneficiary; to represent and vote stock, exercise stock rights, accept and deal with any dividend, distribution, or bonus, join in any corporate financing, reorganization, merger, liquidation, consolidation or other action and the extension, compromise, conversion, adjustment, enforcement or foreclosure, singularly or in conjunction with others of any corporate stock, bond, note, debenture or other security; to compound, compromise, adjust, settle

D-15

and satisfy any obligation, secured or unsecured, owing by or to me and to give or accept any prop-erty and/or money whether or not equal to or less in value than the amount owing in payment, settlement or satisfaction thereof;

f. To transact business of any kind or class and as my act and deed to sign, execute, acknowledge and deliver any deed, lease, assignment of lease, covenant, indenture, indemnity, agreement, mortgage, deed of trust, assignment of mortgage, or of the beneficial interest under deed of trust, extension or renewal of any obligation, subordination or waiver of priority, hypothecation, bottomry, charter-party, bill of lading, bill of sale, bill, bond, note, whether negotiable or non-negotiable, receipt, evi-dence of debt, full or partial release or satisfaction of mortgage, judgment and other debt, request for partial or full reconveyance of deed of trust and such other instruments in writing or any kind or class as may be necessary or proper in the premises.

I further give and grant unto my said attorney in fact full power and authority to do and perform every act necessary and proper to be done in the exercise of any of the foregoing powers as fully as I might or could do if personally present, with full power of substitution and revocation, hereby rat-ifying and confirming all that my said attorney shall lawfully do or cause to be done by virtue hereof.

[(Choose the appropriate provision by marking the correct line.)]

This Durable Power of Attorney shall not be affected by subsequent incapacity of the principal and shall remain effective for a period of one (1) year after the disability or incapacity occurs.

This Durable Power of Attorney shall become effective upon the incapacity of the principal and shall remain effective for a period of one (1) year after the disability or incapacity occurs.

WARNING TO THE PERSON EXECUTING THIS DOCUMENT:]

This is an important legal document. It creates a durable power of attorney. Before executing this document, you should know these important facts:

1. This document may provide the person you designate as your attorney in fact with broad powers to dispose, sell, convey, and encumber your real and personal property.

2. These powers will exist for an indefinite period of time unless you limit their duration in this doc-ument. These powers will continue to exist notwithstanding your subsequent disability or incapacity.

3. You have the right to revoke or terminate this durable power of attorney at any time.

Executed this ______ day of _____________________, 20__, at __________________, California.

State of California }

} ss.

County of ______________ }

On _____________________________, 20__, before me, the undersigned, a Notary Public in and for said State, personally appeared ____________________________, personally known to me or proved to me on the basis of satisfactory evidence to be the person whose name is subscribed to the within instrument, and acknowledged that _____ executed the same.

WITNESS my hand and official seal:

_______________________________

Notary Public

D-16

D-17

Glossary

Annual exclusion: The exclusion of the first $15,000 of gifts made per donee during each calendar year from gift taxation.

Annuity: An annual payment of money by a company or individual to a person called an annuitant.

Applicable exclusion amount: The amount of a decedent's estate exempt from federal estate tax.

Bequest: A gift of personal property by will.

Bypass trust: A trust fund that passes assets to children or other heirs while giving lifetime economic benefits to a surviving spouse.

Charitable remainder trust: A split interest charitable trust in which limited income is periodically paid to non charitable beneficiaries and a remainder interest is later transferred to a charity.

Conservatorship: A legal process in which an adult is appointed by a Court to make financial and medical decisions for another who is deemed incapacitated or disabled.

Crummey trust: A trust which gives the beneficiary the right to demand a withdrawal funds.

Estate tax: A tax on the value of a decedent's taxable estate after deductions and credits.

Gift tax: A graduated federal tax paid by donors on gifts exceeding $15,000 per year per donee.

Inheritance tax: A tax imposed on the “privilege” of inheriting something that is paid by the recipient.

Irrevocable trust: A living or testamentary trust that is supposedly drafted so that no changes may be made to it.

Marital deduction: A provision that allows for unlimited transfers from one spouse to another with-out having to pay any gift or estate taxes.

Power of appointment: A right given to one person by another to transfer property on death.

Qualified terminal interest property (QTIP): Property that qualifies for the unlimited marital deduc-tion even though it may be transferred through a trust.

Remainder interest: A future interest in an asset.

Revocable trust: A trust that may be changed or terminated by its creator.

D-a

Index of Keywords & Phrases

A

abortion, D-9

accelerated depreciation, 5-5

accidents, 1-10

accounting fees, 9-2

accounting methods, 10-20

accounts receivable, 5-2, 7-3

accrual method, 10-27

accrued interest, 2-45, 10-6, 10-11

accumulated earnings and profits, 6-26

accumulated earnings tax, 7-20

active income, 5-8

active participation, 4-9

adjusted basis, 2-46, 2-47, 10-29, 10-34

adjusted current earnings, 5-7

adjusted gross income, 5-2, 10-20, 10-28

administration expenses, 2-24, 7-18, 7-19, 7-20, 10-13

administrator, 1-6, 1-10, 3-9, 3-13, 10-4, 10-18, 10-19, 10-23

Agents, 1-6

aggregation, 5-7

AGI, 2-24, 4-11, 10-2, 10-28

aliens, 2-4, 2-43, 2-55

alimony, 6-4, 10-14, 10-22

alternative minimum tax, 5-7

amortization, 4-9, A-10

amount realized, 5-32

annual exclusion, 1-20, 2-13, 2-57, 2-58, 2-59, 2-62, 2-65, 2-66,

2-68, 6-12, 6-14, 8-11, 10-31, 10-32

annuity, 1-17, 1-20, 1-22, 2-11, 2-16, 2-17, 2-30, 2-35, 2-50, 2-

56, 2-59, 2-64, 6-4, 6-14, 6-15, 8-26, 10-13, D-14

annuity contract, 2-11, 2-59

applicable exclusion amount, 1-13, 1-15, 1-16, 1-21, 2-2, 2-3, 2-

4, 2-5, 2-33, 2-43, 2-48, 2-50, 2-54, 2-55, 2-57, 2-58, 4-8, 4-9,

4-17, 4-18, 7-7, 10-15, 10-16, 10-32

applicable family member, 8-3, 8-5, 8-8, 8-10, 8-11, 8-13, 8-14,

8-15, 8-17, 8-18, 8-22, 8-23, 8-25, 8-26

applicable federal rate, 10-33, 10-34

applicable percentage, 8-12

applicable retained interest, 8-3, 8-5, 8-8, 8-10, 8-11, 8-12, 8-

13, 8-15, 8-17, 8-18, 8-20, 8-21, 8-22, 8-23

appraisal fees, 7-16

appraisals, 10-13, 10-31

appreciated property, 1-17, 2-65, 2-68, 6-15

ascertainable standard, 2-18, 7-21

ascertainable useful life, 8-29

assessments, 10-19, A-5, A-9, A-13, A-14

assignment of income, 5-29

at-risk rules, 10-28

attribution, 5-4, 5-10, 6-21, 6-23, 6-24, 6-26, 7-23, 7-24, 8-10, 8-

18, 8-34

attribution rules, 5-4, 6-23, 6-26, 7-23, 8-10, 8-18, 8-34

audit, A-17

averaging, 7-3

B

balance sheet, 10-31

beneficial interest, 2-11, 2-21, 2-55, 8-19, 10-4, A-17, D-15

beneficial ownership, 2-11

beneficiary designation, 6-1, A-13, A-14, A-15

bequests, 2-36, 2-70, 3-2, 4-6

book value, 6-24, 7-2, 7-3

boot, 2-45

brokerage account, 3-4

burden of proof, 2-42

business expenses, 10-13, 10-22

business interest, 1-16, 1-22, 1-23, 2-43, 2-44, 5-3, 6-17, 6-21,

7-1, 7-2, 7-7, 7-8, 7-9, 7-10, 7-13, 7-17, 7-18, 7-21, 7-22, 8-1,

10-15

business purpose, 5-17, 5-24, 5-29, 5-30

business trust, 5-14

buy-sell agreement, 1-22, 5-2, 5-12, 5-26, 6-1, 6-17, 6-19, 6-21,

6-24, 6-25, 6-26, 7-1, 7-17, 7-18, 7-21, 7-24, 8-3, 8-31, 10-11

bypass trust, 4-18, 7-21, 10-3

C

C corporation, 5-4, 5-10, 5-11, 7-23

calendar year, 2-7, 2-19, 2-38, 2-40, 2-62, 2-63, 2-66, 7-4, 8-12,

10-20, 10-25, 10-28, 10-31, 10-32, 10-33, 10-34, A-6, B-2, C-

4

California, 1-24, 2-1, 2-8, 2-38, 3-2, 3-3, 3-4, 3-7, 3-8, 3-14, 3-15,

5-3, 9-12, A-1, A-11, A-13, A-14, A-16, A-19, A-20, C-1, C-5,

D-1, D-3, D-5, D-6, D-7, D-8, D-9, D-11, D-12, D-13, D-14, D-

15

D-b

California law, D-5

cancellation of indebtedness, 2-68

capital account, 7-21, B-2

capital asset, 4-11, 5-7, 5-28

capital contribution, B-1

capital gains, 2-32, 2-65, 4-3, 4-4, 4-8, 4-10, 4-23, 5-11, 6-15, 6-

20

capital improvements, A-10

capital interest, 2-44, 5-25, 5-26, 5-28, 5-29, 5-30, 8-19

capital losses, 2-47, 6-20, 10-28

capitalization, 2-42, 7-2, 7-6, 8-31

carryover basis, 1-16, 2-7, 2-46, 2-47, 10-3

cash equivalent, 6-1

cash method, 10-28

cash surrender value, 6-10, 9-6, C-3

casualty, 2-24

centralized management, 5-3

charitable contributions, 2-24, 2-35

charitable lead trust, 2-35

charitable remainder annuity trust, 1-22, 2-30, 2-64

charitable remainder trust, 1-20, 2-27, 2-32, 2-33, 2-35, 2-64, 8-

27

check-the-box, 5-31

children, 1-10, 1-11, 1-24, 2-14, 2-35, 2-49, 2-63, 2-64, 3-1, 3-3,

3-6, 3-8, 3-9, 3-10, 3-12, 4-2, 4-4, 4-12, 4-17, 4-24, 4-25, 5-

25, 5-27, 5-29, 5-30, 5-37, 6-12, 6-14, 6-22, 7-4, 7-16, 7-17,

7-23, 8-32, 8-34, 9-2, A-13

citizenship, 2-38

claims against the estate, 1-10, 2-23, 2-24, 8-19

claims for refund, 10-16

closing agreement, 10-10

clothes, 4-17

college expenses, 6-1

commissions, 7-17

common law, 5-3

common stock, 5-23, 7-22, 7-24, 7-25, 8-8, 8-10, 8-14, 8-15, 8-

17, 8-18, 8-19, 8-22, 8-23, 8-32

community property, 1-23, 1-24, 2-13, 2-17, 2-18, 2-21, 2-46, 2-

47, 2-57, 2-65, 3-4, 3-5, 3-7, 3-8, 3-9, 3-10, 3-15, 5-1, 5-3, 5-

10, 6-5, 6-6, 6-25, 7-19, 10-13, 10-26, 10-33, A-2, A-3, A-4, A-

14, C-5, D-6

compensation, 4-23, 5-4, 5-5, 5-7, 5-36, 6-20, 7-25, 7-26

complete termination, 6-22, 6-23, 6-26

completed transfer, 8-26

complex trust, 4-10

conservation easement, 7-13, 7-14, 10-15

conservatorship, 1-1, 9-2

consolidation, D-14

constructive ownership, 6-22, 7-23

contract price, 6-20, 6-25

controlled entity, 8-10

copyrights, 2-65, A-10

corporate liquidation, 6-20

corpus, 2-39, 4-3, 4-7, 5-12, 5-13, 5-14, 8-20, 8-26, 9-10, A-11

cost basis, 2-46, 6-10, 6-20, 6-21, 6-22, 6-26

cost of goods, 10-23

cost of goods sold, 10-23

credit cards, 1-10

cross purchase, 6-20

Crummey trust, 1-20, 1-21

custodianship, 2-59, 5-37

custody, 3-3

D

damages, 5-3

death benefits, 1-10, 1-23, 5-7, 6-4, 6-27

death of a partner, 5-17, 10-25

declaratory judgment, 2-44

deed of trust, A-9, D-15

deferred annuity, 6-14

deferred compensation, 5-7, 7-25

deferred tax, 10-2

demand loans, 10-33

direct skip, 2-49, 2-50, 2-52, 10-15

disability income, 6-20

disability insurance, 6-21

disaster, 5-16

disclaimer, 8-18, 8-25, 10-2

disclosure, 9-3

disease, 9-17, D-3

disproportionate allocation, 5-22

dividends, 2-11, 4-8, 4-10, 4-23, 5-4, 5-5, 5-7, 5-33, 6-11, 6-20,

6-21, 6-26, 7-3, 7-9, 7-19, 8-10, 8-11, 8-13, 8-21, 10-11, 10-

19, 10-26, 10-27, 10-31, A-14

domestic trust, 2-38, 2-39, 4-11

domicile, 1-9, 5-3, 10-10

double taxation, 5-4, 5-5, 5-11, 5-15, 5-33, 8-13

drugs, 2-18

E

earned income, 5-33, 5-36, 7-25, 9-15

D-c

earnings and profits, 5-5, 5-11, 5-29, 7-21, 7-25

economic effect, 5-22, 5-32

enrolled agent, 10-10

entity purchase, 6-19, 6-20, 6-21, 6-24, 6-26, 6-27

estate tax, 1-5, 1-6, 1-9, 1-11, 1-12, 1-13, 1-15, 1-16, 1-18, 1-20,

1-21, 1-22, 1-23, 2-1, 2-2, 2-3, 2-4, 2-5, 2-7, 2-8, 2-9, 2-11, 2-

13, 2-15, 2-16, 2-17, 2-19, 2-23, 2-24, 2-27, 2-33, 2-36, 2-38,

2-39, 2-42, 2-43, 2-44, 2-45, 2-46, 2-48, 2-49, 2-50, 2-54, 2-

55, 2-58, 2-65, 2-68, 2-70, 3-5, 4-1, 4-4, 4-6, 4-8, 4-9, 4-11, 4-

12, 4-13, 4-15, 5-3, 5-13, 5-18, 5-19, 5-24, 5-25, 5-29, 6-1, 6-

2, 6-5, 6-6, 6-10, 6-11, 6-12, 6-14, 6-20, 6-21, 6-24, 6-25, 6-

27, 7-1, 7-3, 7-6, 7-7, 7-10, 7-13, 7-14, 7-16, 7-18, 7-19, 7-20,

7-21, 8-1, 8-11, 8-13, 8-14, 8-20, 9-2, 10-1, 10-2, 10-3, 10-4,

10-5, 10-6, 10-8, 10-10, 10-13, 10-14, 10-15, 10-16, 10-21,

10-27, 10-28, 10-31, A-4, A-11, A-12, A-13

estimated tax, 10-23

exchange, 1-17, 2-45, 2-56, 5-30, 6-14, 6-15, 7-17, 7-24, 7-25, 8-

28, 8-30, 10-25, 10-26, 10-33, A-9, A-14, D-14

exclusion ratio, 6-4

exclusions, 2-43, 2-56

exemptions, 2-4, 2-7, 10-20, 10-27

extensions, 1-15, 2-3, 2-63, 4-9, 7-13, 10-24, 10-31, 10-32

F

face value, 2-69, 9-16

failure to file, 10-5, 10-20, 10-31

failure to pay, 8-13, 10-5, 10-31

fair market value, 1-16, 1-20, 2-1, 2-7, 2-25, 2-28, 2-30, 2-35, 2-

39, 2-42, 2-45, 2-46, 2-48, 2-55, 2-56, 2-64, 2-65, 2-69, 4-18,

5-1, 5-2, 5-7, 5-15, 5-19, 5-23, 5-25, 5-26, 5-32, 6-21, 6-24, 7-

2, 7-6, 7-8, 7-14, 7-16, 7-18, 8-11, 8-14, 8-15, 8-18, 8-22, 8-

23, 8-26, 8-27, 8-30, 8-31, 8-32, 9-8, 9-9, 9-10, 10-29

fair rental value, 7-6, 8-28

family attribution, 6-23, 7-23

family members, 1-9, 1-12, 1-17, 1-21, 1-22, 1-23, 2-68, 3-1, 3-

10, 5-3, 5-5, 5-11, 5-14, 5-17, 5-25, 5-29, 6-14, 7-3, 7-8, 7-9,

7-15, 7-22, 7-24, 8-22, 8-23, 8-28, 9-2, 9-3, 9-5, 9-8

fellowships, 9-15

filing requirements, 10-23

filing status, 10-23, 10-24

final tax return, 10-23

fiscal year, 10-20, B-2, C-4

foreclosure, D-14

foregone interest, 2-62, 10-33, 10-34

foreign taxes, 10-14

Form 1040, 1-9, 2-1, 5-2, 10-3, 10-14, 10-19, 10-21, 10-23, 10-

27, 10-28

Form 1065, 5-22

Form 1099, 10-26, 10-27

Form 1120, 5-4, 5-5

Form 706, 1-9, 2-1, 2-42, 2-43, 3-14, 10-3, 10-4, 10-5, 10-6, 10-

8, 10-10, 10-11, 10-13, 10-14, 10-15, 10-16, 10-20, 10-21,

10-27, 10-28, 10-31

Form 709, 1-9, 2-1, 2-40, 2-52, 2-66, 10-31, 10-32, 10-33

fraud, A-14, D-12

fringe benefits, 5-2, 5-34

funeral expenses, 10-21, A-4, A-5

future interests, 2-11, 2-57, 6-14, 10-31

G

generation skipping transfer tax, 1-15, 2-2, 2-3

generation-skipping, 1-15, 2-2, 2-3, 2-33, 2-46, 2-48, 2-49, 2-50,

2-52, 4-9, 7-7, 7-18, 8-20, 8-30, 10-2, 10-4, 10-8, 10-10

gift loans, 10-34

gift splitting, 10-32

gift tax, 1-2, 1-9, 1-13, 1-15, 1-21, 2-1, 2-2, 2-3, 2-4, 2-7, 2-13, 2-

24, 2-33, 2-36, 2-39, 2-40, 2-42, 2-49, 2-50, 2-52, 2-54, 2-55,

2-56, 2-57, 2-58, 2-59, 2-62, 2-63, 2-65, 2-66, 2-68, 2-70, 3-6,

4-8, 4-11, 4-12, 5-2, 5-14, 5-24, 6-6, 6-12, 6-14, 7-2, 7-3, 7-7,

7-15, 7-18, 7-24, 7-25, 8-1, 8-3, 8-10, 8-13, 8-14, 9-1, 10-8,

10-31, 10-32, 10-33, 10-34, 10-35

goodwill, 5-2, 6-25, 6-27, 7-6, 7-21

grandparents, 7-8

grantor trust, 4-6, 4-7, 4-8, 5-14, 8-20

grants, 3-13, 7-14

GRIT, 4-8, 4-9, 5-14

gross estate, 1-16, 2-8, 2-9, 2-11, 2-12, 2-13, 2-14, 2-15, 2-16, 2-

17, 2-18, 2-19, 2-23, 2-24, 2-27, 2-36, 2-42, 2-43, 2-44, 2-58,

2-66, 2-70, 4-12, 5-1, 5-3, 5-13, 5-18, 5-19, 5-24, 6-27, 7-4, 7-

7, 7-8, 7-9, 7-14, 7-17, 7-19, 7-25, 8-20, 8-31, 8-32, 10-1, 10-

2, 10-4, 10-5, 10-6, 10-8, 10-10, 10-11, 10-12, 10-13, 10-15,

10-16, 10-20, 10-28, A-4

gross income, 1-16, 2-70, 5-2, 5-4, 5-25, 5-26, 6-3, 10-3, 10-18,

10-20

gross profit percentage, 2-70

guaranteed payment, 5-10, 5-23, 6-14, 8-8

guarantees, 5-32

H

HAS, D-8, D-9

D-d

health insurance, D-5

highest and best use, 1-20, 5-2, 7-3, 10-1

holding company, 5-4

holding period, 2-45

I

improvements, 2-45, 2-56

income in respect of a decedent, 2-48, 2-69, 2-70, 7-25, 10-25,

10-26

incomplete transfer, 2-66

information return, 10-3, 10-4

inheritance tax, 1-9, 1-11, 2-7, 2-8, 3-5, 4-6, A-4, A-5, A-13

insolvency, 10-11

installment notes, 1-17, 2-11

installment payment of estate tax, 2-44

installment sales, 2-68, 5-16

insurance premiums, 6-27

insurance trust, 1-12, 1-17, 4-4, 6-14

intangible asset, 7-3, 7-6, 7-7

inter vivos trust, 4-9, 4-10

intestate succession, 1-6, 1-11, 2-11, 3-9

investment company, 2-48, 5-30

IRA, 1-12, 5-33, 5-36

irrevocable trust, 1-20, 1-21, 4-3, 4-4, 4-8, 4-10, 4-12, 6-11, 6-

27, 8-19, 8-20, 8-26, 9-10

J

jewelry, 2-65, 3-8, 9-6, 9-16

joint tenancy, 1-11, 1-23, 2-17, 2-18, 3-4, 3-5, 3-6, 3-7, 3-8, 3-

15, 3-17, 5-19, 9-1, 9-2

joint ventures, 5-22

K

key employees, 6-27

kiddie tax, 5-37

L

lack of marketability, 6-26, 7-7, 7-17

leaseback, 5-17

leases, 5-7, 5-17, 5-27, A-9, D-14

legal fees, 4-5, 9-2

life annuity, 6-14

life estate, 2-11, 2-15, 2-32, 2-56, 2-63, 3-9, 8-29

life expectancy, 1-17, 5-36, 6-4, 6-15

life insurance, 1-6, 1-12, 1-17, 2-1, 2-16, 2-19, 2-27, 2-30, 2-56,

2-58, 2-59, 2-66, 3-17, 4-5, 5-7, 6-1, 6-3, 6-4, 6-5, 6-6, 6-8, 6-

10, 6-11, 6-12, 6-19, 6-26, 6-27, 7-1, 7-20, 9-6, 10-13, A-4, A-

13, A-14, A-16, A-17, C-2

limited liability companies, 5-2, 5-31

limited power of appointment, A-6

liquidating distributions, 5-15

livestock, 10-12

living trust, 1-7, 1-12, 1-13, 3-17, 4-2, 4-3, 4-4, 4-5, 4-6, 4-11, 4-

15, 4-17, 4-18, 4-20, 4-23, 9-1, 9-3

living will, 9-12, D-5

loss limitation, 5-7, 5-8

M

made available, 5-5

margin accounts, A-9

marital deduction, 1-13, 1-16, 1-23, 2-23, 2-35, 2-36, 2-38, 2-39,

2-58, 2-62, 2-63, 3-9, 4-13, 4-18, 4-20, 5-3, 5-19, 6-5, 6-6, 6-

10, 7-1, 7-16, 7-18, 7-20, 7-21, 8-11, 10-2, 10-10, 10-13, 10-

31, A-4, A-12

marital deduction trust, 1-13, 1-16, 4-13, 7-20

marital property, 7-21

marital status, 1-10, 2-35

marketable securities, 7-7

material participation, 7-6, 7-7, 7-9, 7-10

Medicaid, 4-5, 9-4, 9-5, 9-6, 9-7, 9-8, 9-9, 9-10, 9-11, 9-12

medical expenses, 1-13, 2-62, 10-14, 10-21, 10-27, 10-28, 10-31

medical insurance, 9-5

Medicare, 9-3, 9-4, 9-6, 9-12, 9-17

medications, D-4

military, 5-25

mortality tables, 2-15

mortgages, 2-24, 6-1, 10-8

mutual funds, A-9, A-10

N

net income, 2-28, 2-30, 4-23, A-3, A-4, A-5, A-6

net loss, 5-7, B-2

net operating loss, 2-47, 10-28

net proceeds, 5-5

net worth, 1-25, 7-1

non-citizen spouse, 2-38, 2-39

noncorporate taxpayers, 5-7

noncustodial parent, 10-28

non-resident aliens, 5-36

D-e

nontaxable income, 10-23

nonvoting stock, 7-22

notes, 1-17, 1-25, 2-11, 3-17, 9-6, 10-11, D-14

nursing homes, 4-5, 9-4

O

operating expenses, 7-4

options, 6-1, 6-4, 6-6, 8-3, A-9, A-13, A-14, C-3

ordinary and necessary expenses, 4-11

original basis, 3-8

outside basis, 5-32

P

par value, 2-45, 8-10, 8-15, 8-22, 10-11

partnership agreement, 5-25, 5-30, 8-21, 8-30, 8-33, 10-26

partnership expenses, B-2

passive activity, 10-29

passive activity losses, 10-29

passive income, 5-7, 5-11

patents, 2-63, 2-65, 7-3, A-10

periodic payment, 1-17, 6-14, 6-15

personal exemptions, 10-27

personal holding company, 2-48, 5-4, 5-8, 5-11

personal interest, 4-24

personal property, 7-4, 9-16, 10-11, 10-31, D-14, D-15

personal service corporation, 5-4, 5-5, 5-8, 5-10

points, 2-27, 5-13, 5-30

pooled income fund, 2-32, 2-64

portfolio income, 5-7, 5-8

power of appointment, 2-15, 2-18, 2-48, 2-63, 4-12, 4-13, 4-15,

6-12, 8-18, 8-25, 8-26, 10-11, 10-13, 10-35, A-5, A-16

power of attorney, 9-1, 9-2, 9-3, 9-12, D-9, D-10, D-11, D-12, D-

13, D-15

preferred stock, 5-7, 5-23, 7-23, 7-24, 7-25, 8-10, 8-15, 8-17, 8-

19, 8-22, 8-23, 8-32

present interests, 1-20, 2-56, 2-57, 10-32, 10-33

principal place of business, 1-16, 7-7, 7-8, 10-31

probate estate, 1-6, 1-10, 1-11, 2-24, 3-13, 4-22, 5-19, 5-37, A-5

property taxes, 5-5, 9-15, A-5

proportionate distributions, B-2

Q

QDT, 2-38, 2-39

QTIP, 4-13, 4-17, 4-18, 5-3, 5-12, 5-13, 10-2, 10-12, 10-14

qualified charitable organization, 2-64, 10-20

qualified payment, 8-5, 8-10, 8-11, 8-12, 8-13, 8-14, 8-21, 8-22

qualified person, 1-21, 5-10

qualified personal residence trust, 1-21

qualified tuition, 1-13, 2-70

quarters of coverage, 9-16

R

real estate taxes, 2-42, 7-4

reasonable cause, 2-43, 2-70, 10-5, 10-6, 10-19, 10-31

reasonable compensation, 5-25, 5-26, 5-30, 7-26, A-18

reasonable needs, 5-30, 7-20

recapture, 2-46, 7-9, 7-10, 10-11

refundable credit, 8-20

refunds, 10-12

regular corporations, 5-12

reimbursements, 10-28

related parties, 7-18

related person, 2-69, 7-24

remainder interest, 1-21, 1-22, 2-12, 2-27, 2-28, 2-30, 2-32, 2-

33, 2-35, 2-50, 2-64, 4-8, 5-14, 6-6, 7-13, 8-26, 8-27, 8-28, 8-

29, 8-30, 10-5, 10-6, 10-10, 10-12

rental income, 4-10, 4-23, 5-7, 9-5

reorganizations, A-9

repair costs, 7-17

repossession, 2-45

resident aliens, 5-36

retained life estate, 2-11, 2-66, 10-12

retirement plans, 3-17, 5-3, 5-5, 5-33, 5-36

return of capital, 6-11, 6-15

reversionary interest, 2-15, 2-16, 4-7, 10-12

revocable trust, 1-13, 2-13, 2-47, 4-8, 4-9, 4-10, 4-11, 4-12, 4-

18, 9-7

royalties, 5-4, 10-12, 10-19

S

S corporations, 5-11, 5-31, 6-26

safe harbor, 7-2

savings bonds, 3-17

scholarships, 9-15

self-employed persons, 5-33

self-employment tax, 5-31, 10-26

selling expenses, 7-17, 10-13

selling price, 2-56, 10-11

SEP, 5-36

separate maintenance, 9-10

D-f

separate share rule, 4-10

small business trust, 5-14

Social Security, 5-34, 5-36, 9-4, 9-10, 9-11, 9-15, 9-16, 9-17, 9-

18

Social Security benefits, 9-17

Social Security wage base, 5-36

sole proprietorship, 2-44, 5-1, 5-2, 7-8, 10-2, 10-11

special allocations, 5-32

special use valuation, 5-7, 5-16, 7-6, 7-8, 10-10, 10-11

specific bequest, 1-11, 3-2

SSI, 9-5, 9-14, 9-15, 9-16

SSI payments, 9-15

standard deduction, 5-2, 10-27

state death tax credit, 2-2, 2-7, 2-8

statute of limitations, 2-24, 10-20

stepped-up basis, 2-45, 3-7, 3-8, 4-18, 5-7, 6-24

stock redemptions, 5-7, 5-16

substantial effect, 8-29

surtax, 2-2

suspended losses, 10-29

T

tangible personal property, 2-28, 7-2

tax attributes, 5-31

tax avoidance purpose, 5-26

tax credits, 5-5, 10-6

tax haven, 4-4

tax home, 2-39

tax planning, 1-12, 2-7, 3-14, 5-19, 5-24

tax returns, 1-7, 1-9, 4-6, 4-23, 5-27

tax year, 2-39, 5-4, 5-15, 5-16, 6-12, 10-19, 10-20, 10-23, 10-24,

10-25, 10-26, 10-28, 10-29, 10-32

taxable event, 2-38, 4-8, 6-15, 7-25, 8-11, 8-12

taxable income, 1-12, 5-5, 5-33, 6-3, 6-4, 6-11, 6-21, 10-19, 10-

20, 10-25, 10-34

taxable year, 2-70, 4-9, 5-10, 5-12, 5-15, 5-22, 7-20, 7-25, 10-3,

10-18, 10-26

tax-exempt income, 2-33

tax-exempt organizations, 2-70

TCJA, 5-2

tenants by the entirety, 3-7, 7-19, 10-12

tenants in common, 3-4, 3-6, 3-7, 7-19, 8-28

term loans, 10-34

testamentary trust, 1-7, 1-13, 3-5, 4-3, 4-4, 4-6, 4-9, 5-14

theft losses, 2-23, 2-24, 10-14

throwback rules, 4-11

tools, 1-13, 4-1, 7-1, 9-12

trust income, 2-14, 2-28, 4-2, 4-3, 4-4, 4-7, 4-8, 4-13, 4-23, 5-14,

6-12, 8-19, 8-20

U

unified credit equivalent, 7-16

Uniform Gifts to Minors Act, 1-12, 2-59, 5-37

Uniform Transfers to Minors Act, 1-12, 5-11

unreasonable compensation, 5-11

V

valuation, 1-5, 1-22, 2-28, 2-30, 2-42, 2-55, 2-56, 2-65, 2-68, 3-

11, 4-18, 4-20, 5-3, 5-14, 6-25, 7-1, 7-2, 7-3, 7-6, 7-14, 7-16,

7-17, 7-21, 8-1, 8-3, 8-8, 8-15, 8-19, 8-20, 8-21, 8-22, 8-23, 8-

25, 8-29, 8-30, 8-31, 8-32, 10-1, 10-8, 10-10, 10-11, 10-31, A-

4

vesting, 5-34

Vesting, 5-34

virus, 9-18

W

whole life insurance, 6-8, 6-9, 6-10

Z

zero value rule, 8-8, 8-14, 8-15, 8-20, 8-26, 8-28, 8-29