JULY 13-14, 2017

SEMINAR & WEBINAR

FARM AND RANCH INCOME TAX/ESTATE

& BUSINESS PLANNING

SHERIDAN COLLEGE SHERIDAN, WYOMING

Continuing EducationUpcoming events include:• Farm Income Tax/Estate and Business Planning CLE -

6/15- 6/16/2017: Public Accountants Society of Colorado (Loveland, Colorado)

• Rules and Developments in Agriculture Taxation - 6/26/2017: Lorman Education Services live webinar

• MU Extension Summer Tax School - 7/6/2017: University of Missouri Extension (Columbia, Missouri)

• Farm and Ranch Income Tax/Estate and Business Planning Seminar/Webinar - 7/13-7/14/2017: Washburn University School of Law CLE, Sheridan College (Sheridan, Wyoming)

Textbook/CasebookPrinciples of Agricultural Law, by Roger A. McEowen, is an 850-page cutting-edge textbook on agricultural law and taxation. Now in its 40th release, the book blends the features of a casebook and a law treatise, with cases chosen that illustrate the concepts discussed in the text to provide a real-life relevance to the reader.

McEowen’s latest book, Agricultural Law in a Nutshell, is forthcoming in the summer of 2017, published by West Publishing Company.

The Washburn Agricultural Law and Tax Report (WALTR) is authored by Roger A. McEowen, the Kansas Farm Bureau Professor of Agricultural Law and Taxation at Washburn University School of Law. WALTR focuses on legal and tax issues that agricultural producers, agricultural businesses, and rural landowners face.

Some issues are encountered on a daily basis; others may arise on a more cyclical basis. Many issues illustrate how the legal and tax systems in the United States uniquely treat agriculture and the singular relationship between the farm family and the farm fi rm. In addition, there are basic legal principles that have wide application throughout the entire economy, and those principles are evident in the annotations, articles, and media resources.

@washburnwaltr @washburnwaltr

washburnlaw.edu/waltr

Ag Law & Tax Bloghttp://lawprofessors.typepad.com/agriculturallaw/(signup for email alert)

AnnotationsTh e Washburn Agricultural Law and Tax Report covers annotations of court cases, IRS developments, and other technical rulings involving agricultural law and taxation. Th e annotations are broken down by topic area and are the most signifi cant recent developments from the courts, regulatory agencies, and the IRS so you can stay on the cutting edge of all things legal and tax in agriculture. Each annotation is a concise summary of the particular development with just enough technical information for practitioners to use for additional research purposes.

Articleshttp://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/articles/index.html

Roger on the AirProfessor McEowen regularly appears on radio and television programs heard nationally and on the internet. He is regularly featured on:

• RFD TV (and Sirius Satellite Radio)• WIBW Radio’s “Kansas Ag Issues Podcast” (Ag-Issues)• WHO-TV’s “Agribusiness Report” (AgBus-Report)

You Tube

PMoratr

For students and those involved in agriculture either as producers of commodities, consumers, or in the agricultural industry, WALTR helps you gain an ability to identify agricultural legal problems and become acquainted with the basic legal framework surrounding agricultural issues and the tax concepts peculiar to agriculture. It will become evident that agricultural law and taxation is a very dynamic fi eld that has wide application to everyday situations.

WALTR is also designed to be a research tool for practitioners with agricultural-related clients. Many technical issues are addressed and practitioners can also fi nd seminars to attend where the concepts discussed are more fully explored. In addition, media resources address agricultural law and taxation in action as it applies to current events impacting the sector.

Roger A. McEowen Paul Neiffer Kansas Farm Bureau Professor of Principal Agricultural Law and Taxation CliftonLarsonAllen LLP Washburn University School of Law Yakima, Washington

roger.mceowen@washburn.edu paul.neiffer@claconnect.com @WashburnWaltr @Farmcpa www.washburnlaw.edu/waltr

TABLE OF CONTENTS ESTATE AND BUSINESS PLANNING CASES, RULINGS AND LEGISLATIVE UPDATE………………………………………………………………. 1

THE USE OF CHARITABLE TRUSTS IN THE ESTATE AND BUSINESS PLANNING PROCESS…………………………………………………………………. 31

THE IMPACT OF ATRA ON ESTATE PLANNING……………………………………... 45

2014 FARM BILL AND FSA PLANNING………………………………………………… 67

TAX ISSUES ASSOCIATED WITH THE SALE OF A DECEDENT’S RESIDENCE…... 74

THE STRUCTURE QUESTION AND SELF-EMPLOYMENT TAX…………………….. 75

FARM CORPORATIONS – TAX-FREE INCORPORATION……………………………. 82

OWNERSHIP TRANSITION STRATEGIES……………………………………………… 91

LONG-TERM CARE PLANNING …………………………………………………….. 103

TAXABLE INCOME OF TRUSTS AND ESTATES……………………………………. 105

SALE OF A DECEDENT’S PERSONAL RESIDENCE…………………………………. 110

TERMINATION OF ESTATES AND TRUSTS…………………………………………. 111

VALUATION DISCOUNTING VIA FAMILY LIMITED PARTNERSHIPS…………… 115

THE LIFE ESTATE/REMAINDER TRANSFER STRATEGY………………………….. 119

ESTATE AND GIFT TAX PLANNING WITH FORMULA AND PRICE ADJUSTMENT CLAUSES…………………………………………………………….. 122

SPECIAL USE VALUATION AND INSTALLMENT PAYMENT OF

FEDERAL ESTATE TAX……………………………………………………………. 127 FARM SUCCESSION PLANNING VEHICLES………………………………………… 139 FINAL REGULATIONS ON THE NET INVESTMENT INCOME TAX………………. 150 USE OF GRATS AND IDGTS FOR WEALTH TRANSFER AND BUSINESS SUCCESSION………………………………………………………………………….. 160 PORTABILITY PLANNING………………………………………………………………. 167 POTPOURRI……………………………………………………………………………….. 170 C CORP PENALTY TAXES…………………………………………………………… 170 DISINHERITING A SPOUSE………………………………………………………….. 173 SMALL PARTNERSHIP EXCEPTION……………………………………………….. 175 DISCOUNTING IRAs FOR INCOME TAX LIABILITY?............................................. 178

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Estate and Business Planning Cases, Rulings and Legislative

Update

1. Family Settlement Agreement Valid To Transfer Title. Upon their mother’s death, the

parties entered into a family settlement agreement (agreement) on November 19, 2012 in

order to avoid probate. The agreement granted both tracts of property owned by the estate to

the defendant with all mineral, oil and gas interests reserved in the plaintiff. On March 23,

2015, the plaintiff filed a petition which sought to quiet title in the properties in accordance

with the decree of descent, which had declared that each of the siblings were entitled to an

undivided one-half interest in the properties. The court determined that the agreement

clearly identified the parties, there was ample consideration with each party promising to

convey certain rights to the other, the property at issue was accurately defined, the

agreement contained sufficient granting language, and the agreement was properly signed

by the parties. For these reasons, the court held that the agreement was a valid contract that

was sufficient to transfer title to the real estate to the defendant. The plaintiff claimed that

the agreement was an executory contract, because the parties did not exchange deeds after

the agreement was finalized, making the agreement unenforceable. However, the court

determined that execution of the deeds was not an essential element of the parties'

agreement, but rather were merely a formalization of the agreement. The plaintiff also

claimed that the agreement was invalid because it was not approved by the district court,

however the appellate court held that such approval is only necessary to obtain a decree of

final settlement and an assignment of property. In this case, however, the parties obviously

agreed beforehand that a decree of final settlement was not necessary as the agreement itself

expressly and specifically provided that it did "not require the approval of ay court in order

to be effective and binding on the parties." The plaintiff also claimed that the statute of

limitations had expired because neither party attempted to enforce the agreement in a timely

manner. The court determined that even if the statute of limitations had run it would not bar

enforcement of the agreement because there was no breach of the agreement. Thus, the

court held that the parties' entered into a valid family settlement agreement that was

sufficient to transfer the title of the real estate to the defendant. Wise v. Bailey, No. 115,583,

2017 Kan. App. Unpub. LEXIS 466 (Kan. Ct. App. Jun. 16, 2017).

2. Estate Executor Not Personally Liable For Corporate Debts. A dairy farmer placed

ownership interests for the land and business operations of his farm in several corporate

entities. He purchased feed on credit through one of these entities, in which he was the

owner of 100 percent of the stock. When the farmer died, his son (the defendant) was the

sole beneficiary of his estate and exercised control over the farm and its operations as the

executor of the estate and as an employee of the entity. The son continued to order feed

from the plaintiff, a dairy cattle feed supply company, through the entity. The plaintiff sued

to claim the outstanding debts owed by the entity for feed already delivered. The trial court

pierced the corporate veil to find that the son was individually liable for the debts incurred

by the entity. However, on appeal the state Supreme Court found that the piercing of the

corporate veil was improper because the defendant did not possess or exercise ownership

interests as a shareholder of the entity. The Court acknowledged that as an executor of his

father’s estate the defendant acted as an employee and exercised sole control over the entity.

However, the Court determined that this did not transform the defendant’s status into a

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shareholder or equity holder. Therefore, the Court held that the corporate veil should not be

pierced with the result that the defendant was not individually responsible for the entity’s

debts. Mark Hershey Farms, Inc. v. Robinson, 2017 Pa. Super. LEXIS 376, No. 1070 MDA

2016, 2017 Pa. Super. LEXIS 376 (Pa. Sup. Ct. May 25, 2017).

3. IRS Guidance on Making Late Portability Election. A decedent’s estate can make a

portability election to allow the decedent’s unused exclusion amount (deceased spousal

unused exclusion amount, or DSUE amount) for estate and gift tax purposes to be available

for the surviving spouse’s subsequent transfers during life or at death. Before 2015, the IRS

had provided a simplified method for an estate to obtain an extension of time to make the

portability election which applied if the estate did not have to file an estate tax return. After

2014, an estate must submit a ruling request to be able to file a late portability election.

Numerous rulings since that time have been issued that have granted estates an extension of

time to elect portability where the estate was not required to file a return. In the recent

guidance, IRS again provides a simplified method for an estate to receive an extension of

time to make a portability election if the estate does not have a filing requirement under I.R.C.

§6018(a). The guidance applies until the later of January 2, 2018 or two years from the date

of the decedent’s death. To qualify for the relief, the executor must file a complete and

properly prepared Form 706, and state at the top “Filed Pursuant to Rev. Proc. 2017-34 to

Elect Portability Under I.R.C. §2010(c)(5)(A). The IRS notes that an estate that has an I.R.C.

§6018(a) filing requirement is not eligible for the relief. However, for those estates that

qualify under the new guidance, the IRS waives the user fee for a submission for relief. Once

the two-year period is exceeded, relief may be sought by requesting a letter ruling. Rev. Proc.

2017-34.

4. Estate Tax Collection Case Timely. The decedent died in late 1997 leaving her entire estate

to her nephew and his wife. The nephew’s wife was the executor of the estate. The nephew,

a CPA and tax attorney, filed Form 706 in July of 1998 reporting a gross estate of $2.9 million

and a tax liability of $700,000 which was paid with the return. Upon audit, the IRS asserted

that the taxable estate value was $4.7 million and an additional $1.2 million of federal estate

tax was owed. The estate filed a Tax Court petition, and the court, in 2004, ultimately

determined that the estate owed and additional $215,264 in estate tax. The amount remained

unpaid and stood at $530,000 by March of 2015. The IRS placed liens on the some of the

estate property in 2013 and 2014 and issued the estate a Notice of Intent to Levy in late 2013.

The Notice included a statement that the estate could request a Collection Due Process (CDP)

hearing. The estate made the request which the IRS claimed it never received, but then

conceded due to the estate retaining a certified mail receipt. The IRS then sustained the levy

amount and sued in district court to foreclose the liens and get a money judgment for the

unpaid taxes, penalties and fees. The estate counterclaimed for damages under I.R.C. §7433.

The estate claimed that an “improper” lien had barred the estate from refinancing the home

at a lower interest rate. The estate executor claimed that the lien should only have been filed

against the estate rather than against the executor personally. The estate also claimed that the

IRS claim was untimely filed due to the 10-year statue of I.R.C. §6502(a)(1). The trial court

granted the IRS summary judgment motion in part and rejected the statute of limitations

claim. The appellate court affirmed on the statute of limitations issue noting that the nephew

had represented to the IRS that the hearing request had been sent and received and that IRS

relied on that representation. The appellate court also denied the estate damages. United

States v. Holmes, No. 16-20790, 2017 U.S. App. LEXIS 10013 (5th Cir. Jun. 6, 2017).

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5. Transfers to Partnership Shortly Before Death Trigger Application of Retained Interest

Rule. The decedent’s son, pursuant to a power of attorney, transferred the decedent’s assets

to a newly formed partnership within a week of the decedent’s death in exchange for a 99

percent interest in the partnership. The transferred was followed the same day by an

attempted gift of the partnership interest to a charitable lead annuity trust (CLAT). The court,

agreeing with the IRS, held that the attempted dissolution of the partnership made the initial

transfer subject to the retained interest rules of I.R.C. §2036(a)(2) and that the transfer was

not bona fide. Accordingly, the value of the assets transferred were included in the decedent’s

gross estate under either I.R.C.§2036(a) or I.R.C. §2035 as limited by I.R.C. §2043. Thus,

the amount included in the decedent’s estate was the excess value as of the date of the

decedent’s death over the value of the partnership interest issued in return on the transfer date.

But, due to the attempted gift to the CLAT being invalidated due to the son not having the

authority to make the transfer under the power of attorney, the date of death value of the

partnership interest was included in the decedent’s estate under either I.R.C. §2033 or I.R.C.

§2038. Because of full inclusion in the estate, no gift tax liability was triggered. Powell v.

Comr., 148 T.C. No. 18 (2017).

6. Market Value of Revocable Trust’s Interest in LLC Determined. The decedent, before

death, created an LLC and transferred funds to it derived from the sale of stock in the

decedent's closely-held business which was undergoing a buy-out from Pepsi, Corp. The

LLC was worth $317.9 million (primarily cash) in net asset value. The decedent's children

redeemed their interests in the LLC before the decedent's death resulting in the decedent's

estate holding a 70.42 percent voting interest and a 70.9 percent equity in the LLC. The

decedent's estate had liquid assets of over $19 million, and the anticipated estate and GSTT

tax was $26 million. The estate borrowed $10.75 million from the LLC in return for an

installment note with the initial payment deferred until 2024 (18 years) with interest set at 9.5

percent (at a time when the long-term AFR was 4.61 percent). The estate claimed a discount

for the decedent's LLC interest of 31.7 percent which court rejected and allowed a 7.5 percent

discount that the IRS conceded. The estate's expert based his analysis on companies that

derived profits primarily from active business operations, unlike the decedent's LLC. The

Tax Court noted that while an estate tax deduction for estate administration expenses is

allowed, the court’s prior decision in Estate of Gilman v. Comr., T.C. Memo. 2004-286 was

inapplicable. Gilman allowed an estate tax deduction for interest if a loan is necessary to

raise money to pay estate tax without liquidating estate assets at forced-sale prices. In the

present case, the court noted that the LLC was cash-rich and that the estate had the power to

require the LLC to make pro-rata distribution to members. That, therefore, eliminated the

need to sell assets. The Tax Court also noted that the loan would deplete the company's cash

similar to a distribution. The Tax Court disallowed the $71.4 interest deduction. The Tax

Court also noted that the case was also unlike Estate of Duncan v. Comr., T.C. Memo. 2011-

255 and Estate of Kahanic, T.C. Memo. 2012-81 in which the deduction was allowed in cases

where estates were much less liquid. On further review, the appellate court affirmed. The

appellate court concluded that value reductions based on discounts were properly disallowed

and that certain redemption were actually likely to occur due to existing offers. The appellate

court also upheld the Tax Court’s disallowance of a $70 million deduction for interest to cover

a loan to pay estate tax because the estate’s assets were liquid and loan repayment could be

made from future distributions, if any. Estate of Koons v. Comr., No. 16-10646, 2017 U.S.

App. LEXIS 7415, aff’g., T.C. Memo. 2013-94.

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7. Like-Kind Exchange Leads to Adeemed Bequest. A married couple created a trust and

named themselves and one of their sons as co-trustees. Upon the last of the parents to die,

the two sons were to be the co-trustees. The father died in 2011 and the wife died in 2013.

The trust became irrevocable upon the wife’s death and the sons became co-trustees. At the

time of the wife’s death, the trust contained various tracts of real estate – an 80-acre

Minnesota tract, a 40-acre Iowa tract and another 80-acre Iowa tract. The trust provided that

one son was to receive the 40-acre Iowa tract, and the other son would receive the 80-acre

Iowa tract and have the first right to buy or rent the other 40-acre Iowa tract. The balance of

the trust assets were to be split equally between the sons. In 2008, the trust exchanged the

80-acre Iowa tract for the 80-acre Minnesota property. Thus, when the trust became

irrevocable upon the surviving spouse’s death, the trust held the 80-acre Minnesota tract and

the 40-acre Iowa tract (and other non-real estate assets). The son with the purchase option

gave notice to buy the Iowa tract, and the other son then filed a declaratory judgment action.

The one son claimed that the option was only to rent the property from him while he continued

to own it and that the Minnesota tract should be split between the two brothers, because the

specific bequest of the 80-acre Iowa tract to his brother had been adeemed by the like-kind

exchange. The other son claimed that the 80-acre Minnesota tract should be devised to him

directly. The trial court held that the gift of the 80-acre Iowa tract had been adeemed and it

was subject to the trust provision requiring it to be owned equally by the two sons. The trial

court also held that the one brother merely had an option to rent the Iowa tract from his brother

for the specified price in the trust for as long as the other brother owned it. On further review,

the Iowa Supreme Court affirmed on the ademption issue, not recognizing any exception from

ademption under Iowa law for property received in a like-kind exchange. The court refused

to adopt UPC §2-606(a)(5) which states, “a specific devisee has a right to specifically devised

property in the testator’s estate at the testator’s death and to any real property or tangible

personal property owned by the testator at death which the testator acquired as a replacement

for specifically devised real property or tangible personal property.” The court opined that it

was up to the legislature to specifically adopt the UPC provision, as it has done with other

selected UPC provisions. Thus, the court affirmed the trial court’s decision that the because

of the 80-acre Iowa tract had been adeemed and the brothers owned the replacement property

equally. While the court stated that its rule of interpretation for trusts was that “the testator’s

intent is paramount,” the result the court reached most likely violated that precept by resulting

in a co-owned tract of farmland which it appears that the trust provisions were trying to avoid.

The court vacated the trial court’s ruling on the option provision and remanded the issue for

consideration of extrinsic evidence as to its meaning. In re Steinberg Family Living Trust,

No. 16-0380, 2017 Iowa Sup. LEXIS 44 (Iowa Sup. Ct. Apr. 28, 2017).

8. IRS Guidance on Discharging Estate Tax Liens. Upon death, the assets in the decedent’s

gross estate become subject to a federal estate tax lien under I.R.C. §6324(a). The line arises

before any estate tax is assessed and is an unrecorded (“silent”) lien that exists for 10 years

from the date of the decedent’s death. The lien is in addition to the regular federal estate tax

lien of I.R.C. §6321, which arises upon the assessment of tax. The lien can be discharged by

making a request via Form 4422. The lien is discharged if IRS determines that the lien has

been fully satisfied or provided for. Form 792 is used to discharge the lien from particular

property under I.R.C. §6325(c). Historically, the lien would be released within a few days,

but beginning in June of 2016 all applications for discharge of the liens began processing

through Specialty Collections Offers, Liens and Advisory (Advisory) in the Estate Tax Lien

Group. Upon the IRS accepting a filed Form 4422, the net proceeds of estate asset sales are

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either to be deposited with the IRS or held in escrow until IRS issues a closing letter or

determines that the federal estate tax return will not be audited. The amount deposited with

IRS or held in escrow is the amount of proceeds remaining after the amount necessary to pay

estate tax. IRS has issued guidance to the Special Advisory Group concerning how to handle

lien discharge requests. Under applicable regulations, if the “appropriate” official determines

that the tax liability for the estate has been fully satisfied or adequately provided for, a

certificate that discharges the property from the lien may be issued. The interim guidance

provides instruction on who inside IRS is to be consulted and provide assistance in handling

lien discharge requests, and what Code sections apply. The interim guidance also notes that

Letter 1352 is to be issued when an estate does not have a filing requirement. Also, the

interim guidance notes the procedures utilized to substantiate facts for nontaxable estates.

The interim guidance also notes the circumstances when an escrow/payment will or will not

be required. Treasury Memo SBSE-05-0417-0011 (Apr. 5, 2017).

9. IRAs Can’t Be Used to Pay Spousal Allowance of Surviving Spouse. The decedent died,

leaving a surviving spouse and two daughters. The decedent’s will provided for the

distribution of his personal property and established a trust for the benefit of his daughters.

In addition, 90 percent of the residue of the estate was to be distributed to the daughters. The

surviving spouse filed for an elective share of the estate and requested a spousal support

allowance of $4,000 per month. The daughters resisted the surviving spouse’s application

for spousal support, claiming that the decedent’s retirement accounts (two IRAs and a SEP

IRA) were not subject to the spousal allowance as not part of the decedent’s probate estate.

The probate court determined that the decedent’s probate estate would not have had enough

assets to pay a spousal allowance without the retirement accounts included. The surviving

spouse claimed that the retirement accounts should have been included in the probate estate

for purposes of spousal support based on Iowa Code §633D8.1 that provides that “a transfer

at death of a security registered in beneficiary form is not effective against the estate of the

deceased sole owner…to the extent…needed to pay…statutory allowances to the surviving

spouse.” The surviving spouse argued that because the funds in the accounts were likely

mutual funds or index funds, that the accounts should be “securities” within the statutory

meaning. The daughters disagreed on the basis that the Uniform Iowa Securities Act excludes

any interest in a pension or welfare plan subject to ERISA. The probate court ruled for the

daughters on the basis that the retirement accounts were not available for spousal support

because they were not probate assets and became the personal property of the daughters at

the time of their father’s death. The probate court also noted that the Iowa legislature would

have to take action to make beneficiary accounts available to satisfy a spousal allowance. On

appeal, the Iowa Supreme Court affirmed. The court noted that the accounts were traditional

IRAs governed by I.R.C. §408 that pass outside of the probate estate under Iowa law and

were not covered by Iowa Code §633D as a transfer-on-death security. The retirement

accounts were not “security” accounts merely because they contained securities. Rather, it is

a custodial account that does not actually transfer on death to anyone other than a spouse. In

re Estate of Gantner III, No. 16-1028, 2017 Iowa Sup. LEXIS 40 (Iowa Sup. Ct. Apr. 21,

2017).

10. IRS Abused Its Discretion in Denying Hardship Waiver On IRA Rollover. The petitioner

retired from the New York Police Department and subsequently suffered from depression.

He started receiving IRA distributions, but left the checks on his dresser at his home for more

than a month before depositing them into his bank account. The petitioner did not use the

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deposited funds and collected interest on the funds at 0.25 percent. He also failed to see his

tax preparer until late in the next tax season. At that time, the preparer discovered the Forms

1099R and advised the petitioner to transfer those funds to an IRA account. The petitioner

made the transfer well after the expiration of the 60-day period. The tax preparer did not

suggest that the petitioner obtain an IRS private letter ruling to get a waiver from the 60-day

rule so as to avoid having a penalty imposed. The petitioner received a CP2000 Notice from

the IRS asserting a deficiency of approximately $40,000, and replied with a letter detailing

his depression and his good faith transfer to an IRA account before the IRS discovered the

problem. The IRS claimed that because the petitioner didn’t file a private letter ruling request

in accordance with Rev. Proc. 2003-16, that it couldn’t grant relief. The court disagreed with

the IRS. The court noted that the statute, I.R.C. §402(c)(3)(B), allows the Treasury Secretary

the discretion to waive the 60-day requirement when the failure to do so would be against

equity or good conscience, including events beyond the reasonable control of the individual.

In addition, the court noted that Rev. Proc. 2016-47 (issued after the letter in question) noted

that the IRS can determine qualification for a waiver under the statutory provision. The court

noted that the IRS employee handling the petitioner’s exam could have granted the waiver

based on the statute and that Rev. Proc. 2003-16 did not indicate that obtaining a private letter

ruling was the only way in which relief could be granted. The court also noted that the

Internal Revenue Manual provides that examining agents can consider all issues that a

taxpayer might have. The court also dismissed the IRS argument that the court lacked

jurisdiction on the basis that the statute did not indicate that the IRS decision was not

reviewable. The court concluded that the IRS had acted in an arbitrary manner that was an

abuse of its discretion. Trimmer v. Comr., 148 T.C. No. 14 (2017).

11. Deeds Transferring Farmland Not Shown To Be Subject of Undue Influence. Shortly

before his 87th birthday, a bachelor with no remaining family members executed two joint

tenancy warranty deeds to about 1,000 acres of farmland to the defendant, the bachelor’s

tenant farmer. After the transferor died, the administrator of his estate sued, claiming that the

deeds were the product of undue influence and should be set aside. The defendant

counterclaimed for the improvements made on the land after the transfer in the event the

deeds were set aside. The trial court conducted a lengthy trial and concluded that the estate

administrator had to show by clear and convincing evidence that the transferee had a

confidential relationship with the transferor and that suspicious circumstances existed. The

trial court determined that a confidential relationship existed before the execution of the

deeds, but that the evidence was mixed as to whether the administrator had met his burden of

proof by clear and convincing evidence. Thus, the trial court found in favor of the transferees

on the undue influence claim and determined that their counterclaim was moot. The trial

court also awarded mileage fees, witness fees and postage to the transferee of the deeds, but

no deposition costs. On appeal, the appellate court affirmed. The appellate court noted that

the standard for determining undue influence in an action to set aside a deed involves an

examination of all of the evidence. Based on the evidence, the appellate court noted that the

transferee had long been a part of the transferor’s estate planning and that the transferee had

long contemplated giving or selling some of his land to the transferee. The transferee was

represented by legal counsel who had no concerns that the transferee was being unduly

influenced. The transferee also had no surviving family members and the transferees had

farmed his ground for some time. The transferee also depended heavily on one the transferee

for his care. Thus, the estate administrator failed to prove by clear and convincing evidence

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that the deeds at issue resulted from undue influence. Mark v. Neumeister, 296 Neb. 376

(2017).

12. Trust Language At Issue Over Meaning of Term “Operate” In Context of Farming

Activity. A father leased his farmland to his daughter beginning in 1988. Beginning in 1990,

she had her husband farm the land. The father also suggested that his daughter buy adjacent

farmland. The daughter and her husband divorced, and the father provided deposition

testimony in the divorce action that his intent was that the land stay in the family and that he

would continue to lease the land to his daughter and assist her. The father also testified that

he wanted his daughter to turn over the farming operation to his grandson (her son), and that

he would only renew the lease with the daughter if the grandson became the primary operator

of the farming operation. The father’s will established a testamentary trust that gave all of

the father’s farming interests to the daughter as trustee. The grandson was appointed the

successor trustee, and the trust was to last “as long as there are family members willing and

able to farm or manage the farming activity.” Income from the farm was to be distributed to

the daughter as trustee, except that if the grandson “operates the farm at any time herein, then

he shall be entitled to two-thirds of such income and [the daughter] shall be entitled to one-

third.” The trust was to pay all expenses of the farming operation. The grandson took over

the farming operation, but the daughter claimed that she was the “operator” of the farm and,

as such, declined to pay the grandson any share of the farming profits while her father’s estate

was being settled. She also wanted her son to sign an “at-will employment contract” to be

able to continue farming. He refused, and his mother brought an unlawful detainer action to

forcibly evict her son from the farmhouse. She then leased the farmhouse and farmland to

third parties. Her son sued, and the trial court held that the term “operate” in the trust was

ambiguous and therefore extrinsic evidence (deposition testimony of the decedent father in

the dissolution action) could be used to divine its meaning. The trial court determined that

the lease to third parties violated the decedent’s intent as did failing to pay the decedent’s

grandson. The trial court removed the daughter as trustee and appointed the grandson to serve

as trustee, calculated damages for the grandson at $340,000 and assessed attorney fees to the

daughter (mother) to pay personally. On appeal, the appellate court affirmed. The court

agreed that the term “operator” was ambiguous and susceptible to differing interpretations

such as “manage” or “to farm.” As such, the trial court acted properly in considering extrinsic

evidence such as the testator’s deposition testimony that he wanted his grandson to farm the

land. The appellate court also held that the daughter was properly removed as trustee,

damages were calculated properly, and attorney fees appropriately assessed against the

daughter. In re Estate of Kile, No. 33613-1-III, 2017 Wash. App. LEXIS 556 (Wash. Ct. App.

Mar. 7, 2017).

13. Discretionary Trust Beneficiary Cannot Challenge Adoption. The defendant is the

plaintiff’s son and was named the beneficiary of three irrevocable trusts established by his

great-great grandparents. The trustees had the sole discretion to determine if and when

eligible trust beneficiaries could receive trust distributions. In 2004, the plaintiff adopted a

son which had the legal effect of making the adopted son an eligible trust beneficiary. The

trustees disbursed thousands of dollars to the adopted son. The defendant claimed that he

didn’t know about the adoption and challenged it upon learning of it. In 2014, the defendant

filed a motion to set aside the final judgment of adoption, alleging fraud had been committed

on the court because he had a right to notice of the adoption and the right to intervene in the

proceeding. The defendant claimed that the adoption should be vacated because he didn’t

8

receive notice despite his legal interest in preventing the trust benefits from flowing to the

adopted son. The trial court agreed and vacated the order of adoption. On appeal, the

appellate court reversed and remanded. The appellate court noted that adoption was a matter

of state (FL) statutory law, and that the applicable statute specified when a third-party was

entitled to notice of an adoption. Under FL law, the court noted that the defendant had to

show that he had a direct, financial and immediate interest in an adoption to be entitled to

notice, or to have legal standing to vacate the adoption order. The appellate court held that

the defendant lacked standing because he was not entitled to notice as a contingent trust

beneficiary. The trusts were discretionary trusts that gave the trustees sole discretion over

distributions, both in amount and to whom. Thus, the defendant did not have a direct,

financial and immediate interest in the trusts and had no right to receive notice about the

adoption that added the adopted son as an eligible beneficiary. The court also noted that

another case was inapposite because the adoption did not divest the defendant of his entire

interest in the trusts. Edwards v. Maxwell, NO. 1D16-2168, 2017 Fla. App. LEXIS 4409 (Fla.

Ct. App. Mar. 31, 2017).

14. Battle of Experts – Value of Paintings Determined. The decedent died in 2005 owning

two valuable paintings. The paintings were auctioned off after the decedent’s death, but the

executor cleaned and reframed them before the auction. One of the paintings sold three years

after the decedent’s death for $2.43 million. On the earlier-filed estate tax return that painting

had been valued at $500,000 and the other painting at $100,000 based on an expert’s opinion.

The IRS claimed that the paintings should have been valued at $2.1 million and $500,000

respectively. The court rejected the estate expert’s opinion as unreliable and unpersuasive.

The executor was valuing the paintings and simultaneously soliciting the executor for

exclusive rights to auction the paintings and, thus, had a conflict of evidence. The court also

determined that the expert had placed too much emphasis on how dirty the paintings were

and how risky it would be to clean them. In addition, no comparable sales were provided to

support the expert’s valuations. Also, the court noted that the post-death sale of the one

painting was highly conclusive of its value. The government’s expert provided comparable

sales and discounted for the painting’s condition including dirtiness, etc. Estate of Kollsman

v. Comr., T.C. Memo. 2017-40.

15. Daughters Unduly Influenced Dad’s Estate Plan and Tortiously Interfered With

Brother’s Inheritance. The parents had two daughters and a son. The son farmed with his

father and the daughters married and moved away from the farm. Under a 1965 will, the

father left his property to the three children in equal shares. In 1997, the parents executed a

revocable trust under which one daughter disclaimed any interest in the trust (she already had

over $1 million in net worth) and the other two children would each receive one-half of the

trust’s income for 25 years, then they each would receive one-half of the trust assets. In 1999,

the trust was amended such that the two children would split the trust income for ten years

and the son would get all of the farm machinery and tools. The daughter that had originally

disclaimed her interest was to receive one-third of the personal property. In 2001, the trust

was amended to make sure that if the son predeceased his parents that his share would pass

to his children in trust until the youngest child was 21. The parents moved off of the farm in

2001 into a nearby condo. The son moved into the farmhouse at his parents’ request and was

told to keep the rent from a smaller home on the farm. The son paid his parents bills and

arranged services for them and served as their agent under a medical power of attorney. The

trust was again amended in 2002, revoking all prior amendments and again giving the two

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children each one-half shares, and the son having the right to buy his sister’s share of the

farm. Due to a dispute over the parents’ medical conditions, in 2008, the parents executed

medical powers of attorney making all three children co-agents with decisionmaking

controlled by any two of them. The sisters then moved the parents to assisted living near

them and approximately 100 miles from the farm. In 2009, the sister that stood to took

nothing from the estate plan began paying the parents’ bills and handling their care. The trust

was again amended to convert the son’s outright interest in one-half of the farm upon their

death to a life estate. Upon the son’s death, the trust would terminate with the principal and

income being distributed to the two girls. Even though the son was farming the land and

helping his father make farming decisions, his sisters did not inform him of the amendment.

The parents ultimately returned to the condo. The father began suffering from dementia in

2011. Later that year, the son was informed that his interest had been changed to a life estate.

In the summer of 2011, the parents, at the urging of the daughters, terminated the trust and

created mutual wills that effectively disinherited the son. The mother died in early 2012, and

the son learned he had been disinherited. The father died a year later and the sisters made

sure their brother was not informed of his death until after the private funeral. In May of

2013, the son sued to invalidate the 2011 will on the grounds that his father lacked

testamentary capacity or was unduly influenced. The son also sought damages for tortious

interference with a bequest. The sisters moved for summary judgment and the trial court

rejected it on the will contest as well as the tortious interference claim. The jury set aside the

father’s will and found in favor of the son on the tortious interference claim. The son was

awarded $1,183,430.50 for loss of inheritance and consequential damages of $295,857.62.

The jury also levied punitive damages against the sisters of approximately $178,000. The

trial court denied the sisters’ motion for a judgment notwithstanding the verdict or for a new

trial. On appeal, the court affirmed. While the father had testamentary capacity, the evidence

showed that he was unduly influenced and had tortuously interfered with their brother’s

inheritance. In re Estate of Boman, No. 16-0110, 2017 Iowa App. LEXIS 120 (Iowa Ct. App.

Feb. 8, 2017).

16. Payment Designation In Check to IRS Controls. The wife died in 2007 and her surviving

husband died in 2012. Their son was the executor of both estates. In 2012, the wife’s estate

filed a Form 709 for the 2007 tax year showing a total tax liability of $1.3 million. There was

no “split-gift” election. Form 709 was also filed for the husband’s 2007 tax year on the same

day in 2012. The Form 709 for the husband’s estate showed the same tax liability and also

no split-gift election. Payments attributable to both Form 709s were remitted on the same

day. In early 2013, IRS assessed the total gift tax of $1.3 million that was shown on the wife’s

Form 709, credited her estate with the payment of that amount and assessed additions to tax

of about $1 million of penalties and interest. The IRS sent Notice CP 161 to her estate of that

total amount. Later in 2013, the IRS sent a similar notice of assessment to the son as executor

of his father’s estate for approximately the same amount. In 2014, the IRS sent a letter to the

executor of the wife’s estate stating that her 2007 tax liability remained unpaid. The estate

sent the IRS a copy of the check that had been sent to the IRS with a letter from the husband’s

estate with his Social Security number on it and where the enclosed check said the check

“represented final payment pursuant to…the CP220 dated June 17, 2013.” In 2015, at a

telephonic hearing, the attorney for the estates argued that the 2013 check was intended to

pay the wife’s 2007 liability. A Notice of determination sustaining the levy notice was issued

to the wife’s estate a few days later. The wife’s estate acknowledged that the check was to

be applied against her husband’s estate, but that the intent was to apply it to her estate. The

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court rejected the argument on the basis that the IRS must honor a taxpayer’s designation of

a voluntary tax payment, and the check clearly instructed the IRS to apply the payment against

the husband’s gift tax liability. Estate of Beckenfeld, T.C. Memo. 2017-25.

17. Undue Influence Not Present In Family Trust Dispute. This case arose in a family setting.

Mom inherited about 400 acres in 1965 consisting of timber and 3,500 feet of shoreline. In

1976, Mom and Dad formed a corporation and put the land in the corporation including cabins

and leasable sites for additional cabins. The corporation’s income is derived from leasing

property and logging operations. The couple have five children, four of which were involved

in the case. By 1998, the parents had gifted a 10 percent interest in the corporation to four of

the children. In 1998, Mom created a trust to hold the couple’s remaining 60 percent

corporate interest. In 2010, the bylaws were amended such that three of the children were no

longer on the board. In addition, those three opposed giving another sibling, the defendant,

(who remained on the board) a long-term lease of a cabin site on the tract for a reduced price

as an unequal distribution to the shareholders. The three children then hired legal counsel to

voice their concern about their parents’ competency and threatened legal action if a lease were

entered into with the one child. The parents’ trust was amended several times and the three

children sued claiming undue influence . The one child that would be the long-term tenant

filed a motion for partial summary judgment which the trial court granted and dismissed the

complaint. On further review, the appellate court affirmed. The appellate court found that

there was insufficient evidence to trigger the presumption of undue influence. There was no

relationship between the defendant’s position as a board member and the modifications to the

trust. Green v. Green, No. 42916, 2017 Ida. LEXIS 10 (Idaho Sup. Ct. Jan. 23, 2017).

18. Executor Personally Liable for Unpaid Estate Taxes. The decedent died in 2002, survived

by his wife who was the executor of his estate. His four minor children also survived. At the

time of death, the decedent had over $340,000 of unpaid federal income tax liabilities which

exceeded the value of his estate. The estate was insolvent. The estate contained primarily

stock of two corporations, each of which owned a fishing vessel as its only asset. One

corporation was entirely owned by the estate and the other corporation was owned 50 percent

by the estate and 50 percent by the surviving wife. The wife transferred all of the shares of

both corporations that the estate owned to herself without consideration. At the time of the

transfer, the wife knew of the unpaid tax debt. In 2003, the IRS submitted a claim for unpaid

taxes, interest and penalties totaling over $342,000. The claim went unpaid and IRS served

the wife with a formal notice of potential liability for unpaid tax by an estate under 31 U.S.C.

§3713(b) and filed suit. For liability to attach under the statute, the government must establish

that the estate fiduciary distributed estate assets, that the estate was insolvent at the time of

the distribution (or the distribution rendered the estate insolvent), and that the distribution

occurred after the fiduciary had either actual or constructive knowledge of the liability for

unpaid tax. The trial court determined that the wife was liable up to the value of the assets

that she had transferred -$125,938 (the selling of price of both fishing vessels less the value

of a lien against one vessel). On appeal, the appellate court affirmed. The appellate court

determined that the wife filed a faulty summary judgment motion which meant the facts as

submitted by IRS were deemed admitted. The appellate court also held that the government

had successfully established the requirements for liability to attach under 31 U.S.C. §3713(b).

The appellate court also determined that the wife did not qualify for any “equitable exception”

to the statute because she didn’t use the stock transfer to herself to pay the estate’s

administrative expenses, but to maintain the income stream that the vessels provided. The

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U.S. Supreme Court denied to hear the case. United States v. McNicol, 829 F.3d 77 (1st Cir.

2016), cert. den., No. 16-627, 2017 U.S. LEXIS 403 (U.S. Sup. Ct. Jan. 9, 2017).

19. IRS Again Says That Transcripts Serve as Estate Closing Letters. Following-up on a

Notice that it issued in mid-2015, the IRS has again issued guidance in which it reiterates that

an estate and its authorized representative can request an accounting transcript from IRS in

lieu of a closing letter in confirmation that the estate is closed. The IRS noted that a closing

letter can still be obtained on specific request. A transcript is to be requested by filing Form

4506-T via mail or fax. The IRS points out that requests be made no earlier than four months

after the filing of the estate tax return. When a closing letter is desired, the authorized

representative on an estate can call the IRS at (866) 699-4083 no earlier than four months

after the filing of the estate tax return. IRS Notice 2017-12, 2017-4 IRB.

20. No Late Portability Election Waiver If Form 706 Had To Be Filed. The IRS view is that

a late portability election cannot be made under I.R.C. §2010 if Form 706 was required to be

filed but was not actually filed. This is the case, according to the IRS even if the estate is non-

taxable due to, for example, the marital or charitable deduction. In such situations, the

statutorily prescribed time for filing Form 706 is nine months after death, and the IRS position

is that in such situations they lack the authority to grant relief. If Form 706 is not required to

be filed, relief for a late portability election can be granted upon issuance of a private letter

ruling (and payment of the associated fee. C.C. Email Advice 201650017 (Oct. 14, 2016).

21. No Charitable Deduction For Payments To Charity From Trust. The decedent created a

testamentary trust under his 1955 will. Upon the decedent’s death in 1957, the trust became

operative. ITEM IV provided that the residue of the estate was to make payments out of net

income if available, and if not, then out of principal to each of the decedent’s brothers and

sisters then living for life as the trustee deemed necessary, but not to exceed $100/month to

each of them. There were other similar provisions for nieces and nephews, who were entitled

to up to $50/month and another person who was entitled to $75/month. ITEM V of the will

specified that the trust was to end on the death of the last person receiving benefits under the

trust unless the trustees decided to continue the trust under specified terms. In that event, it

could continue for up to 10 years and all unused income and the remainder of principal could

be distributed if the distributions would be exempt from federal estate and state (OH)

inheritance taxes. In 2009, the year in issue, only a niece and the person entitled to $75/month

were still living. The will also created a marital trust that, if the decedent’s wife survived

him, one-half of the decedent’s estate would fund the marital trust and the surviving wife

would be entitled to the income from the trust for life. The decedent’s will also directed the

trustees to pay the remainder of the trust assets to the surviving wife as she might direct in

her will, and if she made no direction, the balance of the assets would be part of the trust

created under ITEM IV of his will. She did not survive, and the marital trust did not come

into existence. The trustees were given the power to create a foundation, but did not do so.

In early 1960, the trust was valued at slightly over $2 million. Over the years, the trustees

made charitable contributions along with making the required distributions. They did so in

2009 and the IRS disallowed the charitable deduction of $26,700 based on I.R.C. §642(c)(1)

which requires that a charitable donation made by a trust to be made “pursuant to the terms

of the governing instrument.” The court construed the terms of the trust to mean that

charitable contributions could not be made until all of the annuitants had died and the trustee

decided to continue the trust. The court believed this to be the correct result because the will

12

also created a marital trust to receive one-half of the decedent’s property if she survived, and

also because the annuity payments were to be paid out of net income, if available, and then

out of principal, which indicated a concern that the trust income would not be enough to pay

the annual annuities. Even though the trust had large amounts of taxable income and the

monthly payment became only nominal over time, the drafting of the trust did not allow for

charitable contributions until all annuitants were dead. Harvey C. Hubbell Trust v. Comr.,

T.C. Sum. Op. 2016-67.

22. IRS Lien Beats Out Estate Executor’s Claim for Unpaid Fees. An estate executor granted

the IRS a special estate tax lien in accordance with I.R.C. §6324A in connection with an

I.R.C. §6166 election to pay the estate tax in installments over 15 years. At the time the lien

was granted, the executor’s fees had not been fully paid. During the 15-year period, the value

of the estate property subject to the IRS lien dropped below the amount due the IRS for unpaid

estate tax. The executor claimed that he had a priority claim against the estate assets for the

amount of his unpaid fee. The IRS claimed that it had a priority claim on the estate assets for

the amount of the unpaid estate tax. The trial court granted the executor’s motion for

summary judgment on the basis that the operative statute was silent as to the payment of

administrative expenses. Thus, the trial court gave the executor’s claim priority on a “first in

time, first in right” theory. On appeal, the appellate court reversed. The appellate court

reasoned that the executor’s claim for unpaid fees was not a lien and, as such, the trial court’s

priority theory had no application. The appellate court then noted that I.R.C. §6324, the IRS

general estate tax lien provision, does provide for administrative expenses to have priority

over a government lien. However, the government’s lien in this case was a special lien under

I.R.C. §6324A which did not contain provide any special rule for administrative expenses.

The executor claimed that he should prevail on the basis that if his claim did not have priority

that it would be hard to find executors to serve. The court disagreed on the basis that the

executor could have planned for payment before granting the IRS the special lien (not putting

the lien on all of the estate property, not making the I.R.C. §6166 election, or making other

arrangements, for example). The appellate court also noted that if the IRS special lien were

subject to administrative expenses then partially unsecured deferred payment obligations

under I.R.C. §6166 could result. Also, the court noted that the executor’s claim for unpaid

fees would not have priority over a any bond to secured the estate tax deferred under I.R.C.

§6166 and, thus, should not be given priority over the IRS claim. United States v. Spoor, 838

F.3d 1197 (11th Cir. 2016).

23. Court Deals With Burden of Proof in Gift Tax Case. This case involved the merger of

two corporations, one owned by the parents and one owned by a son. The parents' S

corporation developed and manufactured a machine that the son had invented. The son did

not patent the invention, and the parents' corporation claimed the research and development

credits associated with the machine. The sons' corporation sold the machine (liquid

dispenser) to various users, but the intellectual property rights associated with the machine

were never formally received. The two corporations were merged for estate planning

purposes, with the parents' receiving less stock value than their asset ownership value. The

lawyers involved in structuring the transaction "postulated" a technology transfer for

significant value from the son to the parents that had occurred in 1987. The transfer was

postulated because there were no documents concerning the alleged transaction executed in

1987. Instead, the lawyers executed the transfer documents in 1995. The IRS asserted that

no technology transfer had occurred and that the merger resulted in a gift from the parents to

13

the son of $29.6 million for which no gift tax return had been filed and no taxes paid. The

Tax Court agreed with the IRS and the resulting gift tax (at 1995 rates) was $14.8 million. No

penalties were imposed on the taxpayers. On appeal, the parents claimed that the Tax Court

erred by not shifting the burden of proof to the IRS because the original notices of deficiency

were arbitrary and excessive and/or because the IRS relied on a new theory of liability. The

parents also alleged that the Tax Court incorrectly concluded that the parents’ company

owned all of the technology and that the Tax Court erred by misstating their burden of proof

and then failing to consider alleged flaws in the IRS expert’s valuation of the two companies.

The appellate court reversed and remanded on the issue of the nature of the parents’ burden

of proof and the Tax Court’s failure to allow them to rebut the IRS expert’s report. However,

the appellate court determined that the parents bore the burden to prove that the deficiency

notices were in error and that the burden of proving a gift tax deficiency didn’t shift to the

IRS even though the IRS later conceded somewhat on the valuation issue because the initial

conclusion of IRS on value was not arbitrary. The appellate court also determined that the

parents could not shift the burden of proof on the grounds that the IRS raised a new matter

because the IRS theory that their corporation was undervalued was consistently postulated

throughout and the original notices that implied that undervaluation of the parents’

corporation allowed for a disguised gift transfer from the parents to their adult children. The

Tax Court’s finding that the parents’ corporation owned the technology was also upheld. The

appellate court did allow the parents to challenge the IRS expert’s valuation and how the Tax

Court handled the objections to the valuation. Thus, the court remanded on that

issue. Cavallaro v. Comr., No. 15-1368, 2016 U.S. App. LEXIS 20713 (1st Cir. Nov. 18,

2016), aff’g. in part, and rev’g. in part, and remanding, T.C. Memo. 2014-189.

24. Evidence Insufficient to Establish Undue Influence. The decedent died about eight months

after her husband. The husband had five adult children from a prior marriage, and the couple

executed mirror wills in 1991, approximately 13 years before their deaths. The wills provided

that upon the death of the first spouse the property of the surviving spouse (which included a

farm) was to go pass to a specified son of the husband. Shortly after her husband’s death, the

surviving wife revoked her 1991 will and executed a new will about five weeks before her

death. The new will benefitted a different son of the pre-deceased husband to the exclusion

of the son that benefitted from the earlier will. The disinherited son petitioned to admit an

unsigned copy of the decedent’s 1991 will into probate and his brother objected and sought

to petition the subsequently executed will. The disinherited son claimed that the decedent

had been unduly influenced by his brother. The trial court determined that the son benefitting

from the new will had set forth a prima facie case showing that the 1991 will should be denied

admission to probate. On appeal, the court affirmed. The appellate court noted that the facts

did not indicate that the decedent was susceptible to undue influence. While the decedent

suffered from congestive heart failure, she was not in poor mental health and her physician

testified that her diabetes was improving and that she was living an active life and doing her

own finances. The court also determined that the evidence showed that the decedent had a

strong personality and could handle her own affairs. The court also determined that the

challenging son did not establish that his brother had a confidential or fiduciary relationship

with the decedent and that suspicious circumstances were not present. As a result, the

subsequent will was properly admitted to probate. In re Estate of Born, No. 2015AP2519,

2016 Wisc. App. LEXIS 660 (Wis. Ct. App. Oct. 6, 2016).

14

25. No Extension of Statute for Assessment of Tax Due to Omission of Prior Year Gifts. On

For 709, the taxpayer properly reported the amount of gifts made in the current year, but had

omitted the amount of prior-year gifts. The omission resulted in the tax for the current year

to be less than what it should have been (because the tax is computed based on lifetime

transfers). The gifts for the earlier years were properly reported in those years. The IRS

didn’t notice the omission of the prior year gifts until after the three-year statute of limitations

for assessment of tax under I.R.C. §6501(a) had expired. While the statute contains an

exception to the three-year rule, the omission of gifts made in prior years does not trigger the

exception. The IRS Chief Counsel’s office noted that the exception only applies if the gift

has not been reported on the gift tax return and does not apply where the gift was adequately

disclosed. Thus, the only relevant gifts are those made in the current year. On the return, the

current year gifts were reported and disclosed and the exception to the three-year statute

applied. The only thing that keeps the statute open is the assessment of tax on the gift for the

year in question. If that gift is subject to tax and is properly disclosed, then the exception to

the three-year statute is inapplicable. C.C.A. 201643020 (Jun. 4, 2015).

26. Without Sufficient Contact, State Can’t Tax Trust. The trust at issue, a revocable living

trust, was created in 1992 with a situs of New York. The primary beneficiaries were the

settlor’s descendants. None of the descendants lived in North Carolina at the time of the

trust’s creation. The trust was divided into three separate trusts in 2002, one for each of the

settlor’s children. The beneficiary of one of the sub-trusts was a North Carolina resident at

that time. The trustee was replaced in 2005 with a successor trustee who resided in

Connecticut. North Carolina tax returns were filed for tax years 2005-2008 for the

accumulated trust income, that was distributed to the beneficiaries, including the non-North

Carolina beneficiaries. In 2009, the trust filed a claim for a refund of North Carolina taxes in

an amount slightly exceeding $1.3 million. The trust claimed that N.C. Gen. Stat. §105-160.2,

which assesses tax on the amount of taxable income of the estate or trust that is for the benefit

of a North Carolina resident, was unconstitutional on due process and Commerce Clause

grounds. The defendant denied the claim, and the hearing officer later dismissed the case for

lack of jurisdiction. The trial court dismissed the request for injunctive relief with respect to

the refund claim, but denied the defendant’s motion to dismiss the constitutional claims. The

trial court then granted summary judgment for the trust on the constitutional claim and

ordered the defendant to refund the taxes paid on its accumulated income. On appeal, the

appellate court affirmed. The court determined that the trust failed to have sufficient

minimum contacts (as required by the Due Process Clause) with North Carolina to subject

the trust to North Carolina income tax. The court cited both International Shoe Co. v.

Washington, 326 U.S. 310 (1945) and Quill Corp. v. North Dakota, 504 U.S. 298 (1992) to

support its position on this point. The trust did not have any physical presence in the state

during the tax years at issue, contained no North Carolina property or investments, had no

trust records that were created or kept in North Carolina, and the place of trust administration

was not in North Carolina. Basing the imposition of state tax on a beneficiary’s domicile, by

itself, did not establish sufficient minimum contacts with the state to satisfy the Due Process

Clause and allow North Carolina to tax a non-North Carolina trust. The appellate court held

that Brooke v. Norfolk, 277 U.S. 27 (1928) was controlling. In that case, a Maryland resident

created a testamentary trust with a Maryland situs for a Virginia beneficiary. Virginia

assessed tax on the trust corpus, but the Court held the assessment to be unconstitutional. As

such, the North Carolina statute violated the Due Process Clause of the U.S. Constitution.

15

Kaestner v. North Carolina Department of Revenue, No. COA15-896, 2016 N.C. App. LEXIS

715 (N.C. Ct. App. Jul. 5, 2016).

27. IRS Lien Attaches to Trust Share. The decedent’s will divided her personal property and

the residue of her estate into three shares, with one of the shares to be in trust to the extent

the share exceeded $50,000. Under the terms of the trust (created under Arizona law) the

trustee “shall” pay the beneficiary (her son) “so much or all of the net income and principal

of the trust as in the sole discretion of the Trustee may be required for support in the

beneficiary's accustomed manner of living, for medical, dental, hospital, and nursing

expenses, or for reasonable expenses of education, including study at college and graduate

levels.” Thus, the trustee was obligated to distribute income and principal in accordance with

an ascertainable standard, but only in the trustee’s sole discretion. The beneficiary failed to

meet his tax obligations for 2007 through 2011 and the IRS made assessments of over

$700,000. The beneficiary made substantial payments before his mother’s death in 2013, but

an unpaid balance remained. As part of the probate final accounting, over $175,000 was to

be paid to the trust for the beneficiary. The IRS then served the trustee with a notice of federal

tax lien and notice of levy asserting a balance due on the unpaid taxes of almost $500,000.

The question before the court was whether the lien attached to the funds contained in the trust.

The court first noted that the caselaw is mixed on whether such a trust clause creates a

property interest to which a lien could attach. Ultimately, the court determined that the lien

attached given the mandatory language (“shall pay”) in the trust clause with only the amount

paid up to the trustee’s discretion. However, the court denied the IRS summary judgment on

the issue of whether the lien attached to the trust corpus immediately. Duckett v. Enomoto,

CV-14-01771-PHX-NVW, 2016 U.S. Dist. LEXI 51502 (D. Ariz. Apr. 18, 2016).

28. Children of Deceased Parent Inherit Parent’s Share Because Grandma’s Conservators

Engaged in Self-Dealing. The decedent had eight children, one of whom predeceased the

decedent leaving children – grandchildren of the decedent. The decedent executed a

revocable trust about 18 years before she died that provided that each of her eight children

would receive an equal share of her estate upon her death, subject to a life estate in her

husband and options to buy the family farm provided to three of the children. About 8 years

before her death, and after her husband died, the decedent amended her trust to remove the

language about her husband’s life estate (no longer relevant) and added language providing

that if one her children predeceased her that a predeceased child’s surviving children would

inherit their deceased parent’s equal share of the decedent’s estate. The provision providing

the option to buy the family farm for three of the children was retained. The decedent, about

six years before death, made four more amendments to the trust in order to disinherit two of

her daughters that were causing family problems. She also added language that was favorable

to two of her other children. For the disinherited children, the trust provided that the shares

of those children would pass to their children equally. With one of the subsequent

amendments during this timeframe, the decedent un-disinherited one of the daughters that she

previously disinherited, again giving her an equal share of the estate. The other daughter

remained disinherited. About four years before her death, the decedent again amended the

trust, now reverting essentially to the original terms of the trust – all eight of her children

inheriting equally. The trust specified that the share of any pre-deceased child would pass

equally to that predeceased child’s children. If a predeceased child left no surviving children,

then that child’s share would pass equally to the decedent’s other surviving children. Again,

16

the bulk of the farm property was to pass to two of the children, one of whom predeceased

the decedent, leaving children. The decedent then executed a pour-over will. The decedent

was hospitalized about six months before her death and spent the remaining months of her

life in and out of the hospital and nursing homes. During this time, the previously disinherited

children had their mother’s lawyer prepare documents to get them appointed as co-guardians

and conservators of their mother’s estate. No power of attorney was prepared. The court

approved the two as co-guardians/conservators. They then executed an amendment to their

mother’s trust via a different attorney while their mother was hospitalized. The mother did

not see the amendment before it was signed. The pair named themselves as trustee and

successor trustee in place of a brother, and disinherited the two siblings that were getting the

bulk of the farm property – one of whom had already died. As a result, the two would now

each receive a sixth of their mother’s estate. They also changed the name of the beneficiary

of life insurance from the deceased sister to the trust the day before their mother died. The

amendments were never approved by any court. Their mother died a month later. Ultimately,

the children of the deceased child (grandchildren of the decedent) sued on four counts, only

one of which was key to the case – self-dealing. The trial court determined that the pair had

engaged in self-dealing by negating bequests to two of their siblings. The court also held that

the one-year statute of limitations applicable to actions involving the validity of a trust did

not apply because the claim was against the pair in their capacities as guardians and

conservators. Thus, the five-year statute of limitations for unwritten contracts, injury to

property and fraud (Iowa Code §614.1(4)). The appellate court affirmed. As a result, the

deceased child’s grandchildren received one-seventh of their mother’s estate. Kerber v.

Eischeid, et al., No. 15-1249, 2016 Iowa App. LEXIS 421 (Apr. 27, 2016).

29. Strict Privity Rule Confirmed in Estate Planning Malpractice Case. The plaintiffs are

children of the decedent husband. The defendants prepared the husband’s estate plan and set

up a will and testamentary trusts as part of the plan. His will provided that each of the four

children (his children and step-children) would each receive $10,000 and the surviving wife

would receive his condominium, with the residue of the estate being divided equally between

a marital and credit shelter trust established in the will. The surviving wife was the

beneficiary of the trusts and had the right to income and principal from the assets of each

trust. On the surviving wife’s death, the remaining trust assets were to be divided equally

among the four children. The husband died in 2003, survived by his wife and the four

children. Assets held in joint tenancy with the wife went to her as the surviving joint tenant,

and each child received $10,000. The testamentary trusts were also funded. The credit shelter

trust received $929,000 and the marital trust received $64,000. The same firm also prepared

the defendants to prepare her estate plan. Her will was executed in 2004 and later executed

two codicils. She died in 2009 survived by one of her children and the plaintiffs. Under the

wife’s will, the condo passed to her daughter and the residue was split between her daughter

and the plaintiffs. The plaintiffs claimed that the distribution of the probate and non-probate

assets resulted in the plaintiffs receiving 30 percent of the wife’s assets and her daughter

receiving 70 percent ($3.2 million for the daughter and $962,000 for each of the plaintiffs).

The plaintiffs sued for breach of contract, negligence, fraudulent concealment and negligent

misrepresentation. They claimed that the defendants did not advise their father of the impact

of jointly held property at death and had failed to sever joint tenancies to further the estate

plan. The claimed that the defendants’ negligence allowed the wife to defeat the husband’s

estate plan and that they were the intended beneficiaries of the husband’s will. The defendants

moved for dismissal for failure to state a claim on which relief could be granted because they

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didn’t owe any duty to the non-client beneficiaries. The court agreed and dismissed the claims

for lack of privity. The court held that lawyers do not owe any duty to non-clients absent

allegations of fraud, or malicious or tortious acts including negligent misrepresentation. The

court rejected the approach of Lucas v. Hamm, 364 P.2d 685 (1961) and Schreiner v. Scoville,

410 N.W.2d 679 (Iowa 1987). The court pointed out that common law and statutory remedies

were available to disappointed beneficiaries for claims involving fraud, malicious conduct or

negligent misrepresentation). The court also rejected the fraudulent concealment claims.

Baker v. Wood, Ris & Hames, P.C., 364 P.3d 872 (Colo. Sup. Ct. 2016).

30. No Gift – Split-Dollar Life Insurance Governed By Economic Benefit Rule. The

decedent’s revocable trust entered into two split-dollar life insurance arrangements with three

separate trusts. The revocable trust later contributed $29.9 million to the separate trusts to

fund the purchase of life insurance policies on each of the decedent’s three sons. The split-

dollar arrangements specified that the revocable trust would receive the cash surrender value

of the respective policy or the aggregate premium payments on that policy, which was greater,

upon either the termination of the split-dollar life insurance arrangement or the decedent’s

death. The IRS asserted the contribution to the revocable trust was a gift and asserted a gift

tax deficiency against the decedent’s estate of almost $14 million plus an underpayment

penalty of almost $3 million. The estate moved for partial summary judgment on the issue

of whether the split-dollar life insurance arrangements were covered by the economic benefit

regime of Treas. Reg. Sec. §1.61-22. The Tax Court agreed, noting the only economic benefit

that the trusts received was current life insurance protection. Estate of Morrissette, 146 T.C.

No. 11 (2016).

31. Binding, Non-Judicial Settlement Can Make a Trust a QSST. The taxpayers sought IRS

guidance on whether a non-judicial settlement that is binding under state law with respect to

the language of a trust would make the trust qualified to hold the stock of an S corporation.

The trust had a provision that the taxpayer believed violated the “one beneficiary”

requirement of I.R.C. §1361(d)(3) because it required the trustee to consider the needs of the

beneficiary’s descendants when invading corpus which could be construed to be indirect

distributions to such persons. State law allowed all interested parties to enter into a binding,

non-judicial agreement concerning the interpretation and construction of trust terms. Under

the agreement, it was specified that any distribution would be for the beneficiary only and not

for any other person during the beneficiary’s lifetime. The IRS determined that, in light of

the agreement, the trust qualified for Qualified Subchapter S Trust status. Priv. Ltr. Ruls.

201614002-003 (Dec. 18, 2015).

32. IRS Doesn’t Necessarily Have an Unlimited Statute of Limitations For Assessing Gift

Tax. The IRS normally has an unlimited statute of limitations to assess gift tax on a gift for

which Form 709 was not filed and the gift reported on that form. However, IRS has

determined that I.R.C. §6501(c)(9) only holds open the tax year the gift was omitted from

and not any other years which may have had an underpayment of gift tax due to the omitted

gift. In such a situation, the IRS is subject to the three-year statute of limitations (absent

fraud, etc.). C.C.A. 201614036 (Mar. 10, 2016).

33. Will Language Creates “Right to Reside” Rather Than Life Estate, But Surviving

Spouse Still Responsible for Repairs and Maintenance. The decedent was survived by his

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wife and children. His will gave his wife the “right to reside” in his residence rent-free as

long as she wanted to or until she cohabited with another male non-family member or

remarried. Her right to reside was conditioned on her paying real estate taxes and insurance

premiums attributable to the residence. A prenuptial agreement said essentially the same

thing. Thirteen years after the decedent’s death, the surviving spouse sought a declaratory

judgment that the children should pay for past and future repairs and maintenance on the

$60,000 home. The repairs sought by the surviving spouse were substantial. The trial court

held that the surviving spouse was a life tenant that did not obligate her to make and pay for

repairs, but that the children bore that responsibility and cost. On appeal, the court reversed

the finding that the surviving spouse was a life tenant. Instead, the court held that she merely

had a right to reside. However, the court determined that old caselaw and logic indicated that

she was responsible for repair and maintenance costs attributable to her occupancy. The

children were responsible for capital improvements and major repairs that do not arise as a

result of the surviving spouse’s occupancy. In re Estate of Culig, No. 1884 WDA 2014, 2016

Pa. Super. LEXIS 165 (Mar. 18, 2016).

34. Post-Death Events Impact Charitable Deduction. Before death, the decedent owned

majority shares of voting and non-voting stock in a family C corporation that managed real

estate. The decedent created trust that would receive all of the decedent’s property at the time

of death. The decedent also created a charitable foundation that was designed to receive the

decedent’s C corporate stock at death. The decedent’ estate filed a Form 706 that reported

the fair market value of the stock at $14.1 million (a 5 percent discount was claimed on the

non-voting stock) and claimed a charitable deduction for the payment to the foundation based

on a date-of-death appraisal. Seven months after the decedent died and before the stock was

transferred to the charitable foundation, the C corporation elected S corporate status. In

addition, the C corporation redeemed all of the decedent’s stock from the trust. The

corporation and the trust then amended and modified the redemption agreement with the

corporation redeeming all of the voting shares and approximately 72 percent of the non-voting

shares. In exchange, the trust received a short-term promissory note for $2,250,000 and a

long-term promissory note for $2,968,462. Simultaneously, three of the decedent’s sons

bought additional shares in the corporation. The charitable foundation later reported receipt

of three non-cash contributions consisting of the short-term and long-term promissory notes

plus nonvoting shares. The estate did not make an election to value the estate assets at six

months after death under I.R.C. §2032, thus the estate claimed that the charitable deduction

should equate to the date-of-death value of the decedent’s corporate stock interest. The IRS

claimed that the post-death events had changed the nature of the contributed stock and

reduced its value. The court, agreeing with the IRS, first noted that a charitable deduction

does not necessarily always equal the date of death value of the contributed property because

certain post-death events can impact the deduction. While the estate claimed that it had

legitimate business reasons for the post-death events such as avoiding the built-in gains tax

and freezing stock values via the promissory notes, and making the foundation a preferred

creditor of the trust by means of the redemption, the court disagreed. The court noted that

the evidence the post-death drop in the value of the stock was due to poor business decisions

rather than the economy, and that the post-death appraisal for redemption purposes

downgraded the stock value as a minority interest even though it was valued as a majority

interest on the date of death appraisal. The court determined that the executor (one of the

decedent’s children) had personally enriched himself at the expense of the foundation by

redeeming the decedent’s majority interest as a minority interest. The court upheld the IRS

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imposition of the 20 percent accuracy penalty because the estate knew that a large portion of

the stock value would not pass to the foundation as the decedent intended and that the

decedent’s children acquired a majority interest in the corporation at a discounted value.

Estate of Dieringer v. Comr., 146 T.C. No. 8 (2016).

35. Estate Executor Is Not Personally Liable for Estate Tax. The decedent died in 1990. The

IRS filed a claim against the estate for unpaid income tax in the amount of $4 million in 1996

stemming from the decedent's unpaid income taxes throughout the 1980s. The estate

ultimately settled the claim for $1 million. The IRS issued a closing letter concerning the

estate in 1994 asserting that the estate owed estate tax of over $1.8 million. The executor had

distributed property to named beneficiaries and sought contribution from them for payment

of estate tax. In 1999, the estate paid over $440,000 to the IRS. In 2013, the IRS filed a claim

against the executor for personal liability of the unpaid estate tax in the amount of $422,694.

The court held that the executor was not personally liable under I.R.C. §6901(a) because the

estate could have regained solvency by contributions from the heirs, thus the estate was not

insolvent as required as a condition of I.R.C. §6901. Singer v. Comr., T.C. Memo. 2016-48.

36. Estate Must Pay Interest on 2003 Gift Tax Liability Despite 2010 Settlement of Estate

Tax Liability. Before death, and at the age of 93, the decedent formed a family LLC and

contributed cash, marketable securities and a 25 percent share in a holding company and a 10

percent share in another company. In exchange, the decedent received a 100 percent

ownership interest in the LLC. Approximately a year and a half later, at the age of 95, the

decedent sold 99 percent of his LLC interest to his daughter and two grandchildren for $2.8

million in exchange for an annuity. The annuity was to pay him just under $1 million annually

for the balance of his life. The value of the decedent's retained 1 percent interest was valued

at $28,100. The decedent's minority interests in the two companies that he contributed to the

LLC were discounted substantially - 50 percent and 35 percent. The decedent died at age 96

in 2004 after having received one annuity payment. An estate tax return was filed reporting

the decedent's one percent LLC interest at $28,100. The annuity was not included in the gross

estate based on the executor's interpretation of Treas. Reg. §1.7520-3(b)(3). The IRS

disagreed, claiming that the annuity should be included in the gross estate at a value of $4.4

million. In addition, the IRS challenged the level of the discounts claimed on the decedent's

minority interests in the two companies. Consequently, the IRS asserted a deficiency of $2

million. The parties settled that matter with the IRS conceding that the decedent's life

expectancy exceeded a year at the time the LLC was created, and the estate conceding that

excessive discounts had been claimed. The parties also agreed that to the extent the value of

the decedent's transferred LLC interest exceeded the annuity received in return a gift resulted

to the decedent's daughter and grandchildren. In mid-2010, the estate motioned the court for

entry of a decision to enforce the settlement, agreeing on a 25 percent discount for each of

the decedent's minority interests. The estate sought an entry of a decision specifying an estate

tax deficiency of $177,418 and a gift tax deficiency of $234,976. Statutory interest was

applied. There was nothing specified in the settlement that interest on the gift tax deficiency

would not apply. The fact that the estate was time-barred from claiming a deduction for that

interest against the estate tax was immaterial. Estate of La Sala v. Comr., T.C. Memo. 2016-

42.

37. Gift of Corporate Stock Complete and Sister Has No Grounds To Remove Brother As

Executor of Father's Estate. A father died testate in 2012 and the will appointed his son as

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executor. The decedent named his son and his daughter as beneficiaries - the decedent's wife

had died in early 2011. The estate was valued at just shy of $1.2 million and included

farmland, livestock, farm implements, bank accounts, an unincorporated feed store, and stock

in the family farming corporation. The son was the president of the corporation and the father,

as director, ran the day-to-day operations. The son drove the grain truck and was paid 25

percent of the payment for each load delivered. The daughter was not involved in the farming

corporation. When the will was admitted to probate, the daughter filed a petitioner to remove

her brother as executor and also objected to the estate inventory. She claimed that the

inventory should include all of the corporate stock rather than just 50 percent on the basis that

her father's gift of half of the corporate stock to her brother was not a completed gift. A court-

appointed temporary executor issued a report finding that the stock gift was complete, and

the daughter objected claiming the report was invalid. The trial court refused to remove the

brother as executor and determined that the gift was complete and only 50 percent of the

corporate stock belonged in the estate. The daughter appealed and the appellate court

affirmed. The court determined that the father had the present intent to make a gift and

divested himself of dominion and control over the stock. The father told his lawyer and the

son about the gift and had new stock certificates created and did not have the ability to rescind

the transfer. The father acted on his donative intent by directing the transfer of 50 percent of

the corporate stock to his son and the transfer were recorded on the corporate books. In

addition, there was insufficient evidence to rebut the presumption of acceptance of the gift by

the son. The fact that the father signed the stock certificates as corporate president (a position

the son held) did not invalidate the intended gift. The court also upheld the trial court's refusal

to remove the son as executor. The son did not mismanage or fail to self-deal or fail to perform

any duty imposed by law. Simply paying himself a salary equal to what he was paid for

hauling grain pre-death while he continued to haul grain post-death was not improper and

generated no personal benefit to the son. It was also not improper for the son to have the estate

pay the mortgage, taxes and other bills related to estate assets. While the son did not get court

permission to continue the unincorporated feed store, there was no disadvantage to the estate

in him doing so. The court also found no reason to believe that there was any risk to the estate

in having the son continue as executor. In re Estate of Poths, No. 15-0343 (Iowa Ct. App.

Mar. 23, 2016).

38. Court Upholds Surviving Spouse’s Consent To Take Under Deceased Spouse’s Will. A

couple married in 1983 until the husband died in 2009. Each spouse had children from prior

marriages. During their marriage, the wife maintained her own checking account and her

own separate investment account, and the husband maintained a separate money market

account that he used for his farming operations. The husband executed a will in 1992 that

left the couple’s residence to his wife, all household goods, furniture, jewelry and personal

effects and any automobile he owned at the time of his death. All other property of the

decedent passed to his children. The same day he executed his will, the decedent also

executed a revocable living trust where, upon his death, his wife would be paid the net income

on a quarterly basis for life. Her children would receive $100,000 each of trust corpus. The

balance of the trust property would pass to the decedent’s children. Also in 1992, the wife

signed a consent to the decedent’s will which meant that she agreed to waive her right to take

an elective share against the will rather than what the will provided for her. In 1995, the state

(KS) legislature altered the computation of the elective share, moving to an augmented estate

approach which would give the surviving spouse rights to more property. The surviving

spouse claimed that the legislative change invalidated her 1992 consent to the will. The trial

21

court upheld the consent on the basis that it was validly executed at the time and that the

surviving spouse was of sound mind and memory at the time and executed it under her own

free will. On appeal, the court affirmed. The court determined that the 1995 change to the

elective share computation had no impact on the procedure to validly execute a consent to a

will. The court also noted that invalidating the consent would produce an absurd result

because of the provisions made for the spouse under the will. In re Estate of Cross, No.

113,266, 2016 Kan. App. LEXIS 6 (Kan. Ct. App. Feb. 5, 2016).

39. Appointed Guardian Removed For “Good Cause.” A mother had eighth children and

executed a Health Care Durable Power of Attorney (POA) in 2004 that named one of her

daughters as her agent and nominee for guardian and conservator in the event that the mother

ever needed care. The mother became in need of care in 2014 and two other sisters also

sought to be appointed as guardian. One of the sisters withdrew and the court took much

testimony over several months on the issue of whether the sister named in the POA should be

her mother’s guardian and conservator. The testimony revealed an acrimonious relationship

among the siblings with the non-appointed children not being able to get updates on their

mother’s health and the appointed child becoming estranged from her siblings. Testimony

also revealed that the appointed child could not be trusted to handle her mother’s finances.

The trial court appointed the other sister as guardian and a brother as conservator. On appeal,

the court affirmed. The court found that the trial court had “good cause” to remove the

appointed child from serving as guardian and conservator as being in the best interests of the

mother under Kan. Stat. Ann. §59-3088(c). In re Burrell, No. 113,335, (Kan. Ct. App. Feb.

12, 2016).

40. Will Created “Floating” Royalty in Heirs. The decedent executed a will in 1947 at a time

when she owned three tracts of land. Her will divided the property among her three children

in fee-simple, with one daughter receiving 600 acres of a 1065-acre tract, another daughter

the remaining 465 acres in that tract, and a separate 200 acres to a son along with the 150-

acre homestead. The will also devised to each child a non-participating royalty interest of an

“undivided one-third (1/3) of an undivided one-eighth (1/8) of all oil, gas or other minerals

in or under or that may be produced from any of said lands, the same being a nonparticipating

royalty interest…”. The will also stated that each child “shall receive one-third of one-eighth

royalty” unless there has been an inter vivos sale or conveyance of royalty on land willed to

that child, in which case the children “shall each receive one-third of the remainder of the

unsold royalty.” The heirs of the children battled over the meaning of the will provisions and

the amount of the royalty bequeathed to each child because some of the property became

subject to mineral leases providing for royalties exceeding 1/8. The issue before the court

was whether the 1/3 of 1/8 will language provided for a fixed 1/24 royalty which would allow

the fee owner all of the benefit of any negotiated royalty that exceeded 1/8, or whether the

decedent intended the children to share equally in all future royalties at 1/3 of whatever the

royalty might be (a floating royalty). The trial determined that the decedent intended for

equal sharing and held that each child was entitled to 1/3 of any and all royalty interest on the

devised lands. On appeal, the appellate court reversed. The court held that the will devised

all mineral interests in the 1065-acre tract, including royalty interests, to the surface-estate

devisee subject to two 1/24 fractional royalty interests held by the non-fee-owning siblings,

and a floating one-third of any future royalty on the 200 and 150-acre tracts. Thus, due to the

decedent’s inter vivos royalty gifts to the children, the will created equal sharing of royalties

on the son’s tracts, but greater royalty interests to the fee-simple owners of the daughters’

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tracts (a fixed 1/24 plus any royalty exceeding two 1/24 royalty interests bequeathed to the

non-surface owning siblings). On further review, the Supreme Court reversed. The Court

determined that the 1/8 language in the will was synonymous with “landowner royalty” such

that any new lease providing for a greater share to the royalty owner entitled the royalty owner

to a floating 1/3 of the greater royalty rather than a fixed 1/24. The Court determined that the

appellate court opinion was contrary to other appellate court opinions and did not account for

the Supreme Court’s recent opinion involving grants that included the use or reference to a

1/8 royalty that was once common. In addition, the Court determined that the testator’s intent

was to benefit the children equally by giving each of them an equal royalty interest. Hysaw

v. Dawkins, No. 14-0984, 2016 Tex. LEXIS 100 (Tex. Sup. Ct. Jan. 29, 2016).

41. Transfers To LLC Were Bona Fide and Did Not Result in Inclusion in Decedent’s

Estate. Before death, the decedent transferred marketable securities, a commercial

building, a promissory note and a certificate of deposit to a family limited liability

company. In return, the decedent received a proportional ownership interest in the LLC.

While the decedent realized reduced transfer taxes as a result of the transfers, the court

determined that a significant reason for the transfers was to consolidate various

investments into a family vehicle that could be managed by one person. Accordingly, the

court held that the transfers were bona fide sales for adequate consideration and, as a result,

were excluded from the decedent’s gross estate. In addition, the court found it persuasive

that, at the time of the transfers, the decedent was not financially dependent on LLC

distributions, personal funds were not commingled with LLC funds, and the decedent was

not in failing health at the time of the transfers. Thus, the transfers were not merely an

attempt to change the form in which the assets were held before death. The court also held

that the estate was entitled to a deduction for interest on loans made by other LLC members

to pay the decedent’s estate tax under I.R.C. Sec. 2053(a)(2). The court determined that

the loans were bona fide and were necessarily incurred in the administration of the

decedent’s estate and were essential to the administration of the estate and its settlement.

In addition, the court also held that gifts of the LLC interests to a family trust qualified as

present interest gifts that were excludible from the decedent’s estate under I.R.C. Sec.

2503(b). While the rights of the trust beneficiaries were limited by virtue of not being able

transfer their interests without the unanimous consent of other LLC members, the

beneficiaries did receive an unrestricted income right associated with the interest, and that

income right was not just illusory because the LLC generated income via lease of the

commercial building and publicly traded marketable securities that paid dividends

Estate of Purdue v. Comr., T.C. Memo. 2015-249.

42. S Corporation Shareholder Can’t Claim Losses Due to Insufficient Basis. The

petitioner was the sole shareholder of multiple S corporations that operated nursing homes.

His business strategy was to acquire distressed nursing homes and make them profitable

again. During tax years 2007-2010, several of the S corporations sustained losses that the

petitioner deducted on his personal returns. The S corporations funded the losses by

borrowing funds from various LLCs that the petitioner and his spouse had interests in as

well as other operating companies that the petitioner owned (and banks and other

commercial lenders). The petitioner signed as a co-borrower or guarantor in his individual

capacity on the loans. The lenders advanced the funds directly to the S corporations and

the S corporations made payments on the loans directly to the lenders, with the petitioner

never expending any personal funds in satisfaction of the S corporation’s debt. The IRS

23

determined that the petitioner’s status as co-guarantor of the debt of the S corporations did

not amount to basis and, thus, did not allow him to deduct the losses for 2007-2008. The

petitioner claimed that state (AR) law characterized a co-borrower as being “directly

liable” with the same liability as a borrower to whom the loan was made individually.

Thus, the petitioner claimed that the corporations were in debt to him and his funds were

at risk. The court disagreed, finding that his potential liability without any economic

outlay was not enough to establish bases. The court noted that the petitioner had not

pledged any personal assets and had no evidence showing that the lenders looked to him

as the primary obligor and no funds were advanced to him individually. Hargis v. Comr.,

T.C. Memo. 2016-232.

43. No “Oppression” of Minority Shareholder in Farm Corporation. The defendant was

incorporated as an S corporation in 1976 by a married couple. The couple had four children

– two sons and two daughters. The sons began farming with their parents in the mid-1970s,

with one of them becoming corporate president when the father resigned in 1989 and the other

son becoming vice-president. Upon incorporation, the parents were the majority shareholders

and the sons held the minority interests. The mother died in 2010 and her corporate stock

shares passed equally to all four children. In 2012, the father gifted his stock equally to the

sons and, after the gift, the sons each owned 42.875 percent of the corporate stock and the

daughters each owned 7.125 percent. The father died in early 2014 at a time when the

corporate assets included 1,100 acres of irrigated farmland and dry cropland. The

corporation, since 1991, leased its land to two other corporations, one owned by one son and

his wife, and the other corporation owned by the other son and his wife. The land leases are

50/50 crop share leases with the sons performing all of the farming duties under the leases.

In 1993, the corporation converted to a C corporation with corporate employees being paid

in-kind commodity wages. For tax planning purposes, corporate net income was kept near

$50,000 annually to take advantage of the 15 percent tax rate by timing the purchase of crop

inputs, replacing assets and paying in-kind wages. The father and sons did not receive any

cash wages, but did receive an amount of commodity wages tied to crop prices and yields –

all with an eye to keeping the corporate net income low. Hence, the amount of commodity

wages varied widely from year-to-year. The corporation’s CPA testified that he believed the

high commodity wages in the later years was appropriate because of the amount of accrued

unpaid wages since 1976. The CPA also testified that the corporation was not legally

obligated to pay any wages, but that it was merely optional for the corporation to do so. The

corporation’s articles of incorporation required a shareholder to offer their shares to the

corporation for purchase at book value before selling, giving or transferring them to anyone

else. Shortly after her father died, the plaintiff, one of the daughters, offered to sell her shares

to the corporation for $240,650 – the fair market value of the shares based on a December

2010 valuation done for purposes of the mother’s estate. The corporation, in return, offered

to buy the shares for $47,503.90, the book value as of December 2011 less $6,000 due to a

corporate loss sustained by the plaintiff’s failure to return a form to the local Farm Service

Agency office. The plaintiff sued in early 2013 seeking an accounting, damages for breach

of fiduciary duty and conflicting interests, judicial dissolution of the corporation based on

oppressive conduct, misapplication and waste of corporate assets and illegal conduct. The

trial court denied all of the plaintiff’s claims, finding specifically that the payment of

commodity wages and purchase of expensive farm equipment were not unreasonable or

inappropriate.

24

On appeal, the appellate court affirmed. The appellate court, noting that state (NE) law does

provide a remedy to minority shareholders for oppressive conduct, the court stated that the

remedy of dissolution and liquidation is so drastic that it can only be invoked with “extreme

caution.” The court noted that the plaintiff was essentially challenging the corporation’s tax

strategy, and asserting that the corporation should be maximizing its income and paying

dividends and the failure to do so constitutes oppressive conduct (the corporation had over

$13 million in assets and no debt). The appellate court disagreed, noting that a corporation

is not required to pay dividends under state law, and the corporation had a long history in

never paying dividends. Furthermore, the appellate court determined that the high level of

commodity wages in the later years was not oppressive because it made up for years the

shareholders worked without compensation. The court also noted that the plaintiff did not

have a reasonable expectation of sharing in corporate profits because the plaintiff never

committed capital to the corporation and acquired her stock interest entirely by gift or devise.

Furthermore, the court noted that since incorporation in 1976, no minority shareholder had

ever been paid profits. The court also held that the payment of commodity wages was not

illegal deferred compensation. In addition, the corporation’s offer to pay book value for the

plaintiff’s shares was consistent with the corporate articles of incorporation. The plaintiff did

not challenge the method by which book value was calculated, and the stock transfer

restriction was upheld as enforceable contract. Jones v. McDonald Farms, Inc., 24 Neb. App.

649 (2017).

44. Business Reorganization Transaction Taxable. Two business partners owned distressed

debt loan portfolio companies collectively and created a spinoff nonprofit S corporation to

manage an employee stock ownership plan (ESOP). In an I.R.C. §351 transaction, the

partners transferred their ownership in the companies to the S corporation in exchange for a

combined 95 percent of the S corporation’s common stock with the ESOP owning the

remaining five percent. As part of the transaction, the partners entered into a five-year

employment agreement specifying that the common stock could be taken back by the S

corporation if either of the men were terminated for cause. Based on the agreement, the

partners considered the stock as being subject to a substantial risk of forfeiture such that its

value would not be included in income under I.R.C. §83(a) which applies when property is

transferred to a taxpayer in connection with the performance of services. The amount

included is the excess of the FMV of the property over the amount (if any) paid for the

property. Consequently, the partners treated the S corporation as the owner of the stock and

the all of the income allocated to the S corporation. As a non-profit, the S corporation was

tax-exempt. The IRS claimed that the “for cause” provision in the employment agreement

made the stock ownership plan substantially vested which meant that the partners were the

owners of the stock and subject to tax on the S corporation income. In 2013, the Tax Court

held that the stock was subject to a substantial risk of forfeiture. However, the court left open

an alternative IRS argument that the partners’ stock was not subject to a substantial risk of

forfeiture because the partners were the sole directors which made the forfeiture provisions

in the employment agreement not likely to be enforced. The court rejected the IRS argument,

but held that after the five-year employment agreement expired, the stock was no longer

subject to substantial restrictions and they had taxable income from of almost $46 million.

While the court determined that the planning and formation of the ESOP was valid, the court

25

did uphold an accuracy-related penalty for 2004. Austin, et al. v. Comr., T.C. Memo. 2017-

69.

45. No S Corporation Basis Increase for Guarantee of Bank Loans. The petitioner owned a

50 percent interest in an S corporation and personally guaranteed bank loans on behalf of the

S corporation. Ultimately, the S corporation defaulted and the bank sued to recover the

outstanding balance on the loan and received a judgment which it sought to recover from the

petitioner and spouse. The petitioner claimed an S corporation stock basis increase based on

the judgments and resulting losses. The IRS disagreed and the court found for the IRS. The

court held that the petitioner was not entitled to an increase in stock basis for the unpaid

judgments against the petitioner due to her personal guarantees of the defaulted loans. Basis

increase was not possible without an economic outlay. Most of the possible penalties did not

apply due to reliance on tax counsel. Philllips v. Comr., T.C. Memo. 2017-61.

46. Members of Member-Managed LLC Have Self-Employment Income on Amounts

Exceeding Guaranteed Payment. A group of lawyers structured their law practice as

member-managed Professional LLC (PLLC). On the advice of a CPA, they tied each of their

guaranteed payments to what reasonable compensation would be for a comparable attorney

in the locale with similar experience. They paid self-employment tax on those amounts.

However, the Schedule K-1 showed allocable income exceeding the member’s guaranteed

payment. Self-employment tax was not paid on the excess amounts. The IRS disagreed with

that characterization, asserting self-employment tax on all amounts allocated. The Tax Court

agreed with the IRS. Based on the Uniform Limited Partnership Act of 1916, the Revised

Limited Partnership Act of 1976 and Mississippi law (the state in which the PLLC operated),

the court determined that a limited partner is defined by limited liability and the inability to

control the business. The members couldn’t satisfy the second test. Because of the member-

managed structure, each member had management power of the PLLC business. In addition,

because there was no written operating agreement, the court had no other evidence of a

limitation on a member’s management authority. In addition, the evidence showed that the

members actually did participate in management by determining their respective distributive

shares, borrowing money, making employment-related decisions, supervising non-partner

attorneys of the firm and signing checks. The court also noted that to be a limited partnership,

there must be at least one general partner and a limited partner, but the facts revealed that all

members conducted themselves as general partners with identical rights and responsibilities.

In addition, before becoming a PLLC, the law firm was a general partnership. After the

change to the PLLC status, their management structure didn’t change. Member-managed

LLCs are subject to self-employment tax because all members have management authority.

The IRS had also claimed that the attorney trust funds were taxable to the PLLC. The court,

however, disagreed because the lawyers were not entitled to the funds. The court didn’t

impose penalties on the PLLC because of reliance on an experienced professional for their

filing position. Castigliola, et al. v. Comr, T.C. Memo. 2017-62.

47. Losses Limited By Basis in S Corporation. The petitioner was the sole shareholder of an

S corporation. The corporation borrowed $100,000 from a bank before the corporation

26

dissolved. The corporation reported a loss on its Form 1120S and no basis for the petitioner’s

stock, and the shareholder also reported it on his personal return. The bank renewed the loan,

but listed the now-defunct S corporation as the borrower. The bank also had the petitioner

guarantee the loan. The petitioner continued to operate the corporation’s computer business

under the old corporate name. The IRS disallowed the loss on the petitioner’s personal return

on the grounds that the petitioner didn’t have any tax basis in his S-corporate stock. The

petitioner claimed that he did have basis attributable to the personal guarantee of the $100,000

loan on the grounds that the petitioner assumed the balance due on the note as the guarantor

and sole obligor which should be treated as a contribution to capital. The court upheld the

IRS disallowance of the loss. The mere guarantee of the corporate debt is not enough to

generate basis under I.R.C. §1366(d). There must be an economic outlay that, the court said,

leaves the shareholder “poorer in a material sense.” This can result, the court noted if the

lender looks primarily to the taxpayer to repay the loan, but there was no evidence that the

lender looked primarily to the taxpayer to repay the loan. The court believed that the lender

was looked to the defunct corporation and the record did not indicate that the petitioner was

the party paying the loan. Tinsley v. Comr., T.C. Sum. Op. 2017-9.

48. Treasury Issues Statement on Proposed I.R.C. §2704 Regulations. In the fall of 2016, the

Treasury Department issued proposed regulations involving valuation issues under I.R.C.

§2704. Those regulations established serious limitations to valuation discounts, such as

minority interest discounts and lack of marketability discounts. In early December of 2016,

a public hearing was held concerning the proposed regulations. The proposed regulations

were not finalized before President Trump took office, which raises a question as to whether

they will ever be finalized. The Treasury Department has now unofficially stated,

unbelievably, that the regulations are not intended to do away with minority interest discounts

despite what the regulations actually say. The Treasury Department also has stated

(unofficially) that the regulations do not require valuations to always be made in conformity

with a deemed put right, and that the three-year rule that requires transfers within three years

of death will not be retroactive to transfers made before the effective date of when the

regulations are finalized (if at all). The Treasury Department has also unofficially stated the

if the regulations are finalized, they will not have an effective date before the date of issuance

of the final regulations, and for some parts, will not be effective before 30 days after the final

regulations are issues. Unofficial statements of Treasury Department Official at Jan. 2017,

Miami, Florida, Heckerling Estate Planning Institute.

49. Accumulated Earnings Tax Applies Even Though Corporation Illiquid. A C corporation

was formed by an individual who contributed his interests in eight partnerships to it. One

partnership was the manager for all of the other partnership and the individual was one of six

board members that managed the management partnership. The individual could not, acting

alone, cause the partnerships to distribute cash to the corporation. The partnership agreement

required all funds to be retained in the partnership except for those amounts needed to be

distributed to any particular partner so that the partner could meet the partner’s federal and

state tax liability. The only income that the corporation reported was flow-through income

from the partnerships. The C corporation also reported flow-through expenses and a small

amount of corporate expenses. The corporation accumulated earnings exceeding $250,000

and the IRS asserted that the accumulated earnings tax should apply. The individual claimed

it should not, particularly because the corporation did not even have enough funds to pay a

dividend and had no way to force the partnerships to distribute funds to the corporation which

27

would provide the funds to pay a dividend. The individual claimed that the corporation was

formed to avoid potential taxation by various tax jurisdictions where the partnerships were

located. Thus, the corporation was merely a holding company that didn’t conduct any

business of its own besides holding the partnership interests. The IRS noted that under I.R.C.

§535(b), the fact that any corporation is merely a holding or investment company is prima

facie evidence of the purpose to avoid the income tax with respect to the shareholders. The

IRS also noted that the accumulated earnings tax does not depend on the amount of cash

available for distribution. The tax is based on accumulated taxable income and is not based

on the liquid assets of the corporation. The IRS also noted that I.R.C. §565 contained consent

dividend procedures that the corporation could use to allow the payment of a deemed dividend

even though the corporation was illiquid. Thus, the IRS concluded that the accumulated

earnings tax applied. C.C.A. 201653017 (Sept. 8, 2016).

50. No Discounts on FLP Interests and No Exclusion From Estate. The decedent was in his

upper 90s at the time of his death. He had never married and had no children, but he did have

four sisters. The decedent had been the CFA of Abbott Lab and had acquired stock options

from the company, starting exercising them in 1962 and had accumulated a great deal of

Abbott stock. He formed a trust in 1999 and put 800,000 shares of Abbott stock into the trust.

He amended the trust in 2001 and again in 2002. Ultimately, the decedent created another

trust, and irrevocable trust, and it eventually ended up owning a limited partnership. Within

three years of his death, the decedent made substantial gifts to family members from his living

trust. Significant gifts were also made to the partnership. The IRS claimed that the value of

the assets that the decedent transferred via the trust were includable in the value of his gross

estate under I.R.C. §2036(a). The estate claimed that the transfers to the partnership were

designed to keep the Abbott stock in a block and keep his investment portfolio intact, and

wanted to transition a family member into managing his assets. The IRS claimed that the sole

purpose of the transfers to the partnership were to generate transfer tax savings. The

partnership agreement contained a list of the purposes the decedent wanted to accomplish by

forming the partnership. None of the decedent’s stated reasons for the transfers were in the

list. The court determined that the facts did not support the decedent’s claims and the transfers

were properly included in his estate. The decedent also continued to use assets that he

transferred to the partnership and did not retain sufficient assets outside of the partnership to

pay his anticipated financial obligations. On the valuation issue, the court disallowed

valuation discounts because the partnership held assets in a restricted management account

where distributions of principal were prohibited. Estate of Beyer v. Comr., T.C. Memo. 2016-

183.

51. Self-Employment Tax Not Limited to Guaranteed Payments Received By LLC

Member-Partner. The taxpayer was a partner in a partnership. The partnership operated

restaurants as a franchisee and the taxpayer was paid a guaranteed payment for his services

on which he paid self-employment tax. The taxpayer also received flow-through income from

the partnership on which he did not pay self-employment tax. The taxpayer was the

partnership’s operating manager, president and CEO. The IRS sought advice from the IRS

National Office as to whether the taxpayer’s flow-through income was subject to self-

employment tax. The taxpayer claimed that the pass-through income was a return on his

invested capital and that he had the status of a limited partner under I.R.C. §1402(a)(13) with

respect to his distributive share. The National Office of IRS disagreed, noting that the

taxpayer actively participated in the partnership’s operations and performed extensive

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executive and operational management services for the partnership in his capacity as a

partner. The National Office of IRS also concluded that there is no “reasonable

compensation” limitation on self-employment income for partners in a partnership. The

advice from the National Office did not discuss that the taxpayer's desired outcome could

have been achieved had the entity been structured as a manager-managed LLC. That

structure, in accordance with Prop. Treas. Reg. Sec. 1.1402(a)-2(h)(2), allows treatment as a

limited partner with no self-employment tax on non-guaranteed payments that represent

returns on capital invested if there are two classes of membership and the managing partner’s

share of partnership income is bifurcated between managing class and investor class interests.

C.C.A. 201640014 (Jun. 15, 2016).

52. North Dakota Corporate Farming Law Not Modified. Historically, a North Dakota

corporation could own farmland if it had 15 or fewer persons as shareholders. However, in

2015, S.B. 2351 was signed into law that would allow the ownership or leasing of land used

for a dairy farm or swine production facility by a domestic corporation or an LLC on up to

640 acres where the dairy operation became operational within three years of the date of the

land acquisition and the dairy farm is permitted as an animal feeding operation or as a

concentrated animal feeding operation by the state department of health and consists of at

least 50 cows or at least 500 swine. (N.D. Cent. Code §10-06.1-12.1). The law was to go

into effect on August 1, 2015, but the effectiveness of the law change was delayed until after

a vote on a referendum concerning the new law set for June 14, 2016. At the referendum

vote, ND voters rejected the bill by a 75.7 percent to a 24.3 percent vote. On a related note, a

lawsuit has been filed challenging the existing corporate farming law as unconstitutionally

discriminatory.

53. LLC Operating Agreement Controls Exit of Minority Owner. Three siblings inherited

their parents’ property equally. They created an LLC with the inherited property to hold

various investments that they would engage in. The defendant, the brother of the two plaintiff

sisters, held back $80,000 of his inheritance and invested the balance in the LLC, while the

sisters fully invested their inheritances in the LLC. As a result, the sisters each had a 36.46

percent ownership interest in the LLC and the defendant had a 27.08 percent ownership

interest. The brother became dissatisfied with the performance of LLC investments and

expressed his desire to get out of the LLC, but didn’t formally seek to be terminate his

association with the LLC in accordance with the LLC operating agreement. The brother did

offer to sell his interest in the LLC to the LLC in exchange for 99 acres of land and would

provide the LLC cash or a note for the difference in value between his interest and the value

of the land. The sisters viewed his communications (emails) as an intent to withdraw that

triggered the operation agreement which tied the purchase price of the brother’s interest to

the value of his capital account, which at the time was zero. Alternatively, the sisters offered

to pay him $150,000 for his LLC interest in lieu of the buyout terms of the operating

agreement. The brother rejected the $150,000 offer as too low, and the sisters sued claiming

that he had withdrawn from the LLC and should be compelled to transfer his LLC interest to

them. The brother claimed that his communications did not amount to notice of intent to

withdraw per the LLC operating agreement, and that the sisters therefore, had no right to his

LLC interest. He also claimed unconscionability and sought dissolution of the LLC. The

trial court ruled for the sisters on all claims. On review, the court determined that the brother

had not given notice of intent to withdraw but was merely negotiating over the selling price

of his interest and that the operating agreement did allow for a sale of an LLC interest different

29

than the capital account value. Thus, the sisters were not entitled to specific performance of

the operating agreement that would permit them to obtain his interest for no consideration

and, as a result, the court did not need to rule on the brother’s claim that the operating

agreement was unconscionable. The court also denied the brother’s claim that the LLC

should be dissolved because of the sisters’ “oppressive” conduct. While the court noted that

the brother had made several attempts to sell his interest in the LLC, he did not make any

specific offer for the sisters to consider until he final offered to sell his interest for the 99

acres. Morse v. Rosendahl., No. 15-0912, 2016 Iowa App. LXIS 625 (Iowa Ct. App. Jun. 15,

2016).

54. Valuation of Timber Farming Partnership At Issue. The decedent's estate held a 41.128

percent limited partner interest in a partnership that was involved in forestry operations. The

Tax Court weighted at 75 percent the partnership value of $52 million as determined by a

cash flow method (going concern) and assigned a 25 percent weight via the asset value

method. There was no evidence that any sale or liquidation was anticipated. The result was

that the estate's interest was valued at 27.45 million rather than the $13 million amount that

the estate valued the interest at or the $33.5 million value that the IRS came up with. The

Tax Court, as to the cash flow value, allowed a lack of marketability discount and added

factored in a reduced premium for the partnership’s unique risk. The Tax Court did not

impose any accuracy-related penalty. On appeal, the appellate court reversed as to the 25

percent valuation weight and remanded the case to the Tax Court for a recalculation of the

value of the decedent's interest based on the partnership being valued as a going concern. The

appellate court stated that the Tax Court had engaged in "imaginary scenarios" and on remand

the Tax Court was also to more fully explain its decision to reduce the premium. The Tax

Court’s remand decision concluded that the going-concern value was the same value as the

present value of the cash flows that the partnership would receive. As such, the court gave

no weight to the partnership assets. But, because of transfer limitations in the partnership

agreement and the general partners wanting to continue the business, it was not likely that an

entity would be able to diversity its by buying the partnership interest. Thus, a buyer would

likely demand a premium for the unique risk of the partnership. So, the court valued the

decedent’s interest as a going concern with the application of a premium for the partnership.

Estate of Giustina v. Comr., T.C. Memo. 2016-114, on remand from, 586 F. Appx. 417 (9th

Cir. 2014), rev'g. in part, T.C. Memo. 2011-141.

55. LLC Operating Agreement Language Voided. In this bankruptcy case, the debtor was an

LLC that filed for Chapter 11 relief. A secured creditor moved to dismiss the Chapter 11 case

on the grounds that the filing was unauthorized because, before the filing, the debtor defaulted

on a loan from the creditor and issued the creditor a common equity unit in the debtor and

also amended its operating agreement to require the unanimous consent of all equity unit

holders as a precondition to any voluntary bankruptcy filing. The court, however, denied the

creditor’s motion to dismiss on the basis that the unanimous consent provision in the amended

LLC agreement amounted to an unenforceable contractual waiver of the debtor of the right

to file for bankruptcy. The court noted the public policy of assuring debtors the right to seek

bankruptcy relief under the Constitution, and that the policy applied equally to corporations

and other business entities such as LLCs. The court also noted that the amended LLC

operating agreement had the effect of putting into the hands of a single minority equity holder

(in reality a creditor) the ability to eliminate the right of the debtor to file bankruptcy and that

even if doing so were permissible under state law, the provision violated public policy. In re

30

Intervention Energy Holdings, LLC, et al., No. 16-11247 (KJC), 2016 Bankr. LEXIS 2241

(Bankr. D. Del. Jun. 3, 2016).

56. Corporate Bonus Payment Deemed to Be Reasonable Compensation. The plaintiff was

a residential concrete construction business that had been formed in 1974 with most of the

daily operation of the business transitioned to two of the founder’s sons. The founder’s wife

owned 51 percent of the plaintiff’s stock and the two sons owned the balance. In the early

2000s, the plaintiff’s revenue increased substantially – going from $24 million in 2003 to $38

million in 2004. For those years (the years under audit) the sons earned (combined) $4 million

in 2003 and $7.3 million in 2004 (salary plus bonus as a percentage of sales). The company

also had a practice of paying dividends. For 2003 and 2004, net income went from $388,000

to $348,600. The IRS asserted that the compensation was excessive for 2003 and 2004, but

the Tax Court disagreed. The court noted that the sons worked over 60 hours a week and

were in charge of the two divisions, and that the IRS conceded that it was difficult to find

similar companies with similar profits. The court also noted that the compensation had been

paid consistent with the bonus plan. The court also allowed a $500,000 payment to an

affiliated company despite the fact that there was no written contract and it was recorded as

an administrative expense on the tax return. The court also rejected the IRS argument that

an independent investor would require a greater return on equity. H.W. Johnson, Inc. v.

Comr., T.C. Memo. 2016-95.

57. No Breach of Fiduciary Duty and No Right of Dissociation in Family Partnership. A

mother and her two sons formed a family limited partnership (FLP) in 2002. The two sons

each owned a 45.8 percent interest (paying nothing for their interests) in the FLP and the

mother owned 8.4 percent. The mother was the general partner and was responsible for

managing the partnership, and her sons were the limited partners with no significant duties.

The FLP contained over 2,000 acres and the sons jointly farmed the land until 2006, when

the each started separate cattle and farming operations. In early 2007, the FLP loaned one of

the sons $350,000 and leased the FLP land to him. The other brother sued his mother and

brother claiming that his mother breached fiduciary duties along with other claims including

slander, negligence, fraud, deceit, an accounting and valuation of the limited partnership and

judicial dissolution of the partnership. The trial court jury determined that the mother did not

breach any fiduciary duties by making the loan and leasing the property to the other brother.

The FLP then renewed the lease and entered into a contract for deed to sell 830 acres of the

leased property to the tenant-son for the appraised price of $1,100,000. The plaintiff son filed

a new suit pleading multiple causes of action including a renewed claim that his mother

breached her fiduciary duty to the FLP and froze him out of the partnership and caused him

to incur tax liabilities without receiving any partnership distributions to pay the tax. The

plaintiff son also sought dissociation from the partnership for value. The jury ruled against

the son on the breach of fiduciary duties claim and dismissed the other claims. The court also

denied the dissociation for value claim. On appeal, the appellate court affirmed. The court

noted that the son failed to show that he had any duties that he was incapable of performing

(a statutory requirement for dissociation), being admittedly a passive investor in the FLP.

The court also held that the son was not entitled to dissociation based on equity because

dissociation based on equity was not allowed by statute. Gibson v. Gibson Family Limited

Partnership, et al., No. 27476, 2016 S.D. LEXIS 48 (S.D. Sup. Ct. Mar. 23, 2016).

31

58. Boilerplate FLP Language Contributed To Implied Retained Interest That Defeated

Estate Tax Savings. The decedent’s predeceased husband established trusts and a family

limited partnership (FLP). The FLP agreement stated that, “To the extent that the General

Partner determines that the Partnership has sufficient funds in excess of its current operating

needs to make distributions to the Partners, periodic distributions of Distributable Cash shall

be made to the partners on a regular basis according to their respective Partnership Interests.”

The decedent, who was living in a nursing home at the time the FLP was formed, contributed

approximately $6 million of marketable securities to the FLP and held a 99.9 percent limited

partner interest. Before death, the decedent received one check from the FLP (a pro-rata

distribution of $35,000). At trial, the General Partner testified that he believed that the FLP

language was merely boilerplate and that distributions weren’t made because “no one needed

a distribution.” The court viewed the FLP language and the General Partner’s testimony as

indicating that the decedent retained an implied right to the possession or enjoyment of the

right to income from the property she had transferred to the FLP. The decedent also retained

a large amount of valuable assets personally, thus defeating the General Partners’ arguments

that distributions were not made to prevent theft and caregiver abuse. The court also noted

that the FLP was not necessary for the stated purposes to protect the surviving spouse from

others and for centralized management because trusts would have accomplished the same

result. The decedent was also not involved in the decision whether to form an FLP or some

other structure, indicating that she didn’t really express any desire to insure family assets

remained in the family. The court also noted that there was no meaningful bargaining

involved in establishing the FLP, with the family simply acquiescing to what the attorney

suggested. The FLP also ignored the FLP agreement – no books and records were maintained,

and no formal meetings were maintained. As such, the court determined that there was no

non-tax purpose for the formation of the FLP, there was no bona fide sale of assets to the FLP

and the decedent had retained an implied right to income from the FLP assets for life under

I.R.C. §2036(c) causing inclusion of the FLP assets in the decedent’s estate. Estate of

Holliday v. Comr., T.C. Memo. 2016-51.

TAX STRATEGY FOR A RETIRING FARMER – THE USE OF A

CHARITABLE REMAINDER TRUST TO AVOID

ORDINARY INCOME SALES

Background

Grain farmers approaching retirement face a difficult tax reality of significant grain to sell but no offsetting

expenses. If the level of the carryover grain is in the $500,000 to $1 million territory, spreading the sales over

several years doesn’t avoid high tax rates. Additionally, even when successfully spread over many years, the

15.3 percent self-employed social security tax will add to the tax cost.

One tax strategy for the retiring famer involved the creation of a Charitable Remainder Trust (CRT). A CRT

can be structured either as a Charitable Remainder Unitrust (CRUT) or a Charitable Remainder Annuity

Trust (CRUT). A properly structured CRT results in the retiring farmer transferring the grain to the CRT,

the CRT selling the grain tax-free, and the farmer receiving an annuity annually for a specified term without

any self-employment tax and the income from the annuity likely taxed at lower tax rates as it is received

over the life of the annuity. In addition, a charity benefits at the end of the annuity term.

32

Other Features of a CRT

The CRT must be irrevocable, valid under state law, and organized as either a CRAT or CRUT.1 Both the

donor and the beneficiary must be a person which may include corporations, partnerships and individuals

(individual must be living to create the trust.2 A CRAT provides for a payment each year to a person or

other specified beneficiary (or a person and a beneficiary) of either a fixed amount, or a percentage of the

initial value of the trust. A CRUT provides for an annual payment to a donor or other specified beneficiary

(or donor and beneficiary, or for a term certain) computed as a percentage of an annual revaluation of the

market value of the trust assets.

Note: The IRS has provided sample copies of pre-approved annuity trust instruments in Rev. Procs. 2003-53

through 2003-60, and sample copies of pre-approved unitrust instruments in Rev. Procs. 2005-52 through 2005-

59. Use of the pre-approved IRS sample documents eliminates any tax uncertainty, and saves legal fees in

creating the trust (an attorney familiar with state law should still be used to finalize the drafting of the CRT

document).

Unitrust vs. Annuity Trust

Both the annuity trust and unitrust require minimum percentage distributions of 5% (fixed on the initial

value of the annuity trust or on the annual market value of the unitrust).3 Both forms may have a fixed term

not to exceed 20 years, or payments to continue for the life of the beneficiary (ies).4 The unitrust agreement

may provide that distributions will not be made in excess of the trust’s accounting income.5 That limitation

may further provide for make-up distributions in later years.6 A unitrust may accept additional contributions

in later years; an annuity trust may not.

A step-by-step process is involved in establishing a CRAT or a CRUT to derive the beneficial tax results:

• Step one: The donor creates an irrevocable charitable remainder trust; the terms of the trust require

an annual income stream back to the donor, but with the remainder value passing to a charitable

organization at the death of the donor/beneficiary or after a specified term of years.

1 I.R.C. §664. 2 I.R.C. §§664(d)(1)(A) and 664(d)(2)(A). 3 I.R.C. §§664(d)(1)(A) and (2)(A). 4 I.R.C. §§664(d)(1)(A) and (2)(A). 5 I.R.C. §664(d)(3)(A). 6 I.R.C. §664(d)(3)(B). 7 “Capital gain asset” includes I.R.C. §1231 assets, except to the extent of I.R.C. §1245 and I.R.C. §1250 ordinary

income recapture. 8 I.R.C. §170(b)(1)(C).

33

• Step two: The donor transfers assets to the trust. If the asset is an appreciated long-term capital

gain asset,7 a charitable income tax deduction for the market value of the asset is available, but

reduced by the value of the retained income interest. A contribution of non-capital gain assets will

yield a charitable deduction equal to the lesser of fair market value or basis. No charitable

deduction applies if a zero basis ordinary income asset is transferred to the trust.

• Step three: After receipt of the asset, the charitable trust typically sells the asset, but reports no

taxable gain due to its charitable status.

• Step four: The charitable trust invests the sale proceeds to provide a source of income to allow

payment of the specified income interest to the donor.

• Step five: At the death of the donor/income beneficiary, the property within the trust passes to the

charity; the property is not part of the taxable estate of the donor and thus escapes any estate taxes.

Tax and Planning Strategies with Charitable Remainder Trusts

To achieve a charitable deduction, the asset contributed to the charitable remainder trust must be eligible for

long-term capital gain status. Stock in a corporation or appreciated real estate would be typical examples.

Ordinary income assets, such as inventory or depreciable equipment, would not produce a charitable deduction

for the donor, other than to the extent of any basis in the asset.

Note. Charitable remainder trust donations are deductible for both regular tax and alternative tax purposes.

The charitable income tax deduction of the donor is subject to a 30 percent AGI annual limitation.8 If a large

charitable contribution exceeds this annual 30 percent-of-income limit, the excess is eligible for a five-year

carryover to future tax returns of the donor. This 30%-of-income limitation has the advantage of spreading

the charitable contribution into several tax years, and often allows the contribution to be used against the

highest bracket income over several tax returns.

Note. 50% charitable contributions are considered before the allowance of the 30 percent contributions, and

current year contributions are considered before using charitable contribution carryovers into the current year.

Because of the percentage limitations and the ordering rule, it is important to plan the utilization of the

charitable contribution, to assure that it will be fully utilized within the six eligible tax return years (the year

of donation plus five forward years). In some cases, it is necessary to fund a CRUT over a number of years to

assure utilization of the contribution carryovers.

The amount of the charitable income tax deduction is contingent upon three primary factors:

• The amount or percentage of the retained income interest (the higher the annual income back to the

donor, the smaller the value of the charitable deduction for the remainder portion).

• The term of years or life expectancy of the retained income interest (the shorter the income interest or

the shorter the life expectancies of the beneficiaries, the greater the charitable income tax deduction).

34

Note. The IRS tables for term and remainder interests and life expectancies are issued in three publications, IRS

Publ. 1457 “Actuarial Values-Alpha Volume”, IRS Publ. 1458 “Actuarial Values-Beta Volume”, and IRS Publ.

1459 “Actuarial Values-Gamma Volume”.

• The IRS-published 120 percent annual mid-term AFR interest rate which must be selected from either

the current month or two month period prior to the charitable transfer (the greater the interest rate, the

larger the charitable deduction). This rate is identified in Table 5 of the monthly publication of the

AFR by the IRS.

Observation. If the donor desires to replace the value of the asset which has been given to charity, the income

stream and tax savings from the charitable trust may be used by the donor to purchase a life insurance contract

to benefit the heirs of the donor. If this life insurance is acquired within an irrevocable life insurance trust,

the death benefit proceeds are unreduced by estate taxes.

Funding a Charitable Trust with Ordinary Income Farm Assets

In late 1993, the IRS issued a private letter ruling which approved a cash method farm proprietor's

transfer of crops and raised beef cattle to a charitable remainder unitrust.9

Key income tax aspects of the ruling:

• The farm proprietor did not recognize any taxable income, or any self-employed social security

income, upon the transfers of the farm inventory items to the unitrust.

• The expenses that the farmer incurred in raising the cattle and crops prior to transfer to the unitrust

would remain as allowable deductions within his tax return.

• The unitrust would not recognize any income on its subsequent sale of the farm inventory items, even

if the sale occurred within a short period of time following the donation by the farmer, provided that

the sale was not a prearranged transaction, and was independently enacted by the trustee of the

unitrust.

The annual distributions from the unitrust to the farmer-donor would be ordinary income, but would not

be self-employment income.10

Observation: Because the transfers of assets in this ruling all represented ordinary income property (as

opposed to capital gain property), there would be no charitable deduction to the farmer-donor at the time of

transfer of the assets to the CRUT.11 Rather, the objective of this strategy is to convert grain, livestock and

machinery into cash at retirement without incurring the usual high income and social security tax costs (often

nearly 50 percent) and subsequently receive an income stream from this cash.

Example 1 Sale vs. gift of grain

Assume that Jim is a 65 year old cash method farm proprietor with a substantial amount of unsold crop inventory

on hand at the point of retirement. The following calculations illustrate the tax return and cash flow results to Jim

9 Priv. Ltr. Rul. 9413020 (Dec. 22, 1993). 10 The facts in the ruling also noted that the farmer intended to contribute farm machinery to the CRUT at a later point in

time. 11 [Sec. 170(e)(1)].

35

if he sells the grain in a taxable transaction and invests the proceeds to provide retirement income, or alternatively

contributes the grain to a charitable remainder unitrust, retaining a lifetime annual income for him and his spouse:

Strategy No. 1: Sell grain and invest proceeds

Annual

Tax Cash

Return Flow

Sale of grain $ 200,000

Less federal, state and SS tax

costs (50%) (100,000)

Excess cash to invest $ 100,000

x Annual yield x 4%

Annual income $ 4,000

Asset to heirs $ 100,000

Strategy No. 2: Contribute grain to CRT, with 4% retained income

Annual

Tax Cash

Return Flow

Sale of grain by CRT $ 200,000

Less tax costs -0-

Excess cash to invest $ 200,000

x Annual yield x 4%

Annual income $ 8,000

Asset to heirs $ -0-

36

Observations:

• In the case of contributing the grain to the CRT, there is no charitable deduction to the farmer, because

the asset is ordinary income/zero basis.

• For years beginning after 2012, the Net Investment Income Tax (NIIT) of 3.8 percent applies against

the net investment income distributed from the CRT. IRS final regulations provide that the trust’s

distributions are presumed to carry out the trust’s NII first.

• The danger with the CRT strategy would involve untimely early deaths by both beneficiaries, such

that the extra annual income generated by the CRT would be interrupted. Strategies to eliminate this

risk include:

o Purchase of a life insurance policy to replace the asset lost to the heirs.

o Addition of a second life (such as a spouse) as a successor income beneficiary, to assure

that the income stream remains within the family for a longer period of time. However, the

charitable remainder value must be at least 10 percent.

• Use a fixed term CRAT which continues to make its payments to the estate or heirs of the grantor.

Example 2 Use of a 10-year CRT

Red, a 50-year old farmer, learns that health problems require him to exit from his cash method farm proprietorship

business. When Red meets with his tax planner, he learns that selling his zero basis commodity inventory, with

an approximate value of $400,000, will trigger about $200,000 in federal and state income tax and self-employed

social security tax (about 50% of the value of the crop). At the suggestion of his tax planner, Red forms a CRT,

transferring the unsold grain to this trust at a time when its market value is $400,000. The trust has a term of 10

years. If structured as a CRUT, the trust can pay an annual 20.6 percent amount to Red and his spouse (20.6% of

the beginning fair market value of the trust, redetermined annually). If structured as a CRAT, the trust can pay a

fixed amount of $39,650 per year to Red for the 10 year period. In both cases, the percentage of the gift benefiting

the charity is projected to be slightly in excess of 10 percent, ensuring that the trust qualifies under I.R.C. §664 as

a CRT. Since the trust is a fixed term, distributions will continue to Red’s beneficiary(ies) (presumably, his wife).

In either case, Red has replaced a present value tax cost of 50 percent for a present value charitable gift of

about 10%. However, Red must still pay ordinary income tax on the payments received from the charitable

trust. The efficiency of this arrangement lies in the possibility of lower federal and state income tax rates if

this ordinary income is spread over 10 years, and in the fact that the SE tax is eliminated.

Caution. The payout optimization varies depending upon the I.R.C. §7520 rate published monthly by the

IRS; the preceding illustrations are based upon a 1.8 percent I.R.C. §7520 AFR.

The Anti-Abuse Barriers to Using CRTs

37

The value of the charitable remainder in any transfer to a qualified charitable remainder annuity trust or a

charitable remainder unitrust must be at least 10% of the net fair market value of the property as of the date

of the contribution to the trust.12

The statute measures the necessary charitable remainder amount by reference to net present value at inception

of the trust. Ultimately, when the trust reaches its conclusion at either the end of the term certain or the

lifetime(s) of the donor/spouse, there may be significantly more or significantly less than the 10 percent target,

but that is immaterial to the eligibility of the entity as a qualified charitable remainder trust.

In view of today’s relatively low AFR interest rates, charitable remainder trusts that are structured for the

lifetime of the donor may not qualify under the 10 percent test, unless a lower payback percentage is selected.

This is particularly true for CRATs with a fixed annual payback as compared to CRUTs with a declining

annual payback, as illustrated by the following charts:

Present Value of Charitable Remainder: CRUT

Single Life Unitrust (Assume 1.8% AFR, quarterly income)

Donor Age Unitrust %: 6% 8% 10%

70 46.52% 37.37% 30.53%

60 31.12% 23.52% 17.79%

50 20.91% 13.79% 9.59%*

Present Value of Charitable Remainder: CRAT

Single Life Annuity Trust (Assume 1.8% AFR, quarterly income)

Donor Age Fixed %: 6% 8% 10%

70 27.03% 2.71% 0%

60 0% 0% 0%

50 0% 0% 0%

Present Value of Charitable Remainder: CRUT

Two Life Unitrust (Assume 1.8% AFR, quarterly income)

Donor Age Unitrust %: 6% 8% 10%

70 and 70 34.59% 24.86% 18.08%

65 and 65 27.38% 18.31% 12.45%

12 I.R.C. §664(d)(1)(D) and (d)(2)(D).

38

60 and 60 21.37% 13.24% 8.39%

Comment. With very low interest rates, unless the donor/beneficiary is at least age 66 with a fixed

% of 6% or less, the present value going to the charity will fail the test for a CRAT. The CRUT is only

likely to fail with lower-age donor/beneficiaries or a larger percentage.

The maximum annual payout percentage may not exceed 50 percent of the initial net fair market value of all

property placed in the trust in the case of a CRAT and 50 percent of the net fair market value of the assets as

annually revalued in the case of a CRUT.13

Five Percent Probability-of-Exhaustion Rule

In 1977, the IRS indicated that no charitable deduction would be allowable at creation of a CRAT if there is a

greater than 5 percent actuarial probability that the income beneficiary will survive the exhaustion of the

corpus of the charitable trust.14 The foundation for this position is the provision in estate and gift tax

regulations holding that no deduction is allowable where a charitable transfer is subject to a condition “unless

the possibility that the charitable transfer will not become effective is so remote as to be negligible.”15

Note. Although the 5 percent probability-of-exhaustion rule is defined in terms of the estate and gift tax

charitable deduction, the I.R.C. §170 income tax charitable deduction regulations contain similar language.16

This 5 perceent probability rule is not applicable to a CRUT that provides a payback limited to annual income,

because under this formula the trust corpus is never invaded.17 However, the IRS approaches the application

of the 5 percent rule to other unitrust paybacks on a case-by-case basis.18

Note. With the enactment of the 10 percent charitable remainder minimum in 1997, as discussed above, this

rather vague IRS 5 percent probability position is now considered by most practitioners to be eliminated in

favor of the statutory 10 percent threshold.

As a practical matter, most practitioners rely on their charitable planning software to test a CRAT’s eligibility

under the 5 percent probability-of-exhaustion test. With today’s low interest rates, many CRATs based on the

donor’s life expectancy will fail the 5 percent probability test, even though they pass the 10 percent charitable

remainder threshold. However, fixed term CRATs, particularly those designed to provide only a short-term

income tax deferral, face less likelihood of encountering the 5 percent probability problem.

Charitable Remainder Annuity Trust (CRAT)

($100,000 corpus, 1.8% AFR, quarterly income payback)

Charitable

Remainder %

5% Probability Test

Passed?

13 I.R.C. §§664(d)(1)(A) and (d)(2)(A). 14 Rev. Rul. 77-374, 1977-2 CB 329. 15 Treas. Reg. §§20.2055-2(b)(1), Reg. 25.2522(c)-3(b)(1). 16 Treas. Reg. §1.170A-1(e). 17 Priv. Ltr. Rul. 7915038 (Jan. 12, 1979). 18 GCM 37770 (Nov. 30, 1978).

39

Term Fixed Payout

5 yr. $18,858 10.01% Yes

10 yr. $9,848 10.01% Yes

15 yr. $6,854 10.01% Yes

20 yr. $5,362 10.01% Yes

Lifetime

(age 65, 1 life)

$5,000

26.55%

No

Fixed-Term CRT Design Issues

Selecting the AFR. In calculating the charitable remainder (in order to test the required 10% charitable

remainder minimum or the 5% probability-of-exhaustion rule), the current Applicable Federal Rate (AFR) is

a factor in the calculation. Table 5 of the monthly AFR release is the Section 7520 rate used for CRTs. It is

used in computing the remainder interest. The taxpayer has the flexibility of selecting the AFR for the month

in which the valuation date falls or either of the two preceding months.19

Comment. Selecting the largest AFR available will maximize the charitable remainder amount.

Accordingly, if the CRT is being designed to target approximately a 10% charitable remainder, selecting the

largest AFR available will maximize the quarterly or annual income payout to the donor.

Example 3. Selecting AFR for a fixed term CRAT

Bea is considering the use of a 10-year CRAT, to be funded with an appreciated asset worth $750,000. The

trust will pay income annually, and will be designed to meet the minimum 10% charitable remainder threshold.

Bea’s tax advisor tests the AFR for the current and prior two months and determines that the April rate should

be selected:

Annual Payout to Produce

Month AFR 10% Charitable Minimum

March 1.8% $ 74,355

April 2.0% 75,143

May 1.8% 74,355

In the example, if the AFR increased to 2.2%, the annual payout would increase to $75,930.

19 Treas. Reg. §1.7520-2(a).

40

Fixed term CRAT vs. CRUT. In the case of a CRAT or CRUT with a fixed term of years, the payments may

be continued to the donor’s estate or heirs, in the event the donor(s) decease before expiration of the income

payout term.20

• A CRAT tends to minimize the income tax consequences of the CRT payout to the donor, as the

payments are level.

• Conversely, under a short-term CRUT, the income payout in the first few years can be substantial,

causing a higher income tax bracket consequence to the donor.

Client income tax variables must be considered on a client-by-client basis. When a short-term CRAT or

CRUT is being considered in order to provide income tax deferral on a large gain or other high income event,

the tax advisor should carefully analyze other income factors affecting the client’s 1040. For most higher

income clients, the attainment of age 70½ brings the inception of large minimum required distributions of

IRAs and qualified retirement plan accounts.21 In this case, a short-term CRT might be designed to end before

the beginning of the MRD payouts.

Example 4. CRT ending at MRD inception

Willis, age 61, a proprietor operating in LLC form, is selling his business assets and retiring. Willis is

considering the use of a short-term CRT to accommodate the disposition of $500,000 of fully depreciated

machinery and equipment to be sold at an auction. Recognizing that in about nine years Willis will attain age

70½ and be required to begin large minimum distributions from his retirement plan, his tax advisor designs a

CRAT for a nine-year term. Effectively, the $500,000 of equipment auction proceeds will be spread over the

next nine years’ tax returns, filling the gap between Willis’ prior high income from operating the business and

future high income that will commence with retirement plan distributions.

Net investment income tax (NIIT).22 For tax years beginning after 2012, accumulated NII of a CRT is

subject to the 3.8%. NII of a CRT is categorized and distributed based on the existing Section 664 income

tier system23 Under this “worst first” system, ordinary income is considered to be the first tier distributed,

capital gains the second tier, and exempt income the third tier. Because NII accumulated in post-2012 years

is at a higher rate that pre-2013 investment income (due to the 3.8% tax), it is considered to be the first

income distribution from within each of the first two tiers.

Comment. The gain on the post-2012 sale of assets contributed by the farmer presumably are NII gains, as they

are not material participation income in the hands of the CRT. Under the distribution scheme presented above,

the NII is considered distributed first. In the past, the breakdown of the CRT distribution between the interest

income portion and the ordinary income portion was moot. But since 2013, any interest other investment income

that is part of the CRT distribution will be subject to the 3.8% NII tax.

Taxability of social security benefits. While most high income clients will automatically have 85% of

their social security benefits brought into taxable income, other middle and lower income clients may be in

the midst of an expensive phase-in range under I.R.C. §86.

The following chart is an approximation of the formula used to phase-in the taxation of social security

benefits. Income for this purpose includes federal adjusted gross income increased by tax-exempt interest

income and 50% of social security benefits:

20 Rev. Rul. 74-39, 1974-1 CB 156. 21 I.R.C. §401(a)(9). 22 I.R.C. §1411. 23 Treas. Reg. §1.1411-3(d)(2)(i).

41

Taxable portion Income

of S.S. benefits Joint Single

0% Under $32,000 Under $25,000

50% Over $32,000 Over $25,000

85% Over $44,000 Over $34,000

Example 5. Taxable social security – joint filers

George and Mary, both over age 65, receive interest, rent and other retirement income of $26,000. Their social

security benefits are $12,000. At this level, they are just beneath the phase-in of taxable social security benefits,

and would incur $300 of federal income tax for 2015. If they add an additional $10,000 of income each year,

such as from CRT payouts, they must also add $5,000 of social security benefits to their tax return. This increases

their tax to about $1,800. This increase represents a 15% rate on the $10,000 of added income, even though most

that income is taxed in the 10% tax bracket:

Before After

Interest, rent income $ 26,000 $ 26,000

Add income — 10,000

Taxable Social Security — 5,000

Total Income $ 26,000 $ 41,000

Taxable Income $ 2,900 $ 17,900

Tax $ 290 $ 1,790

$ 1,500

Example 6. Taxable social security – single filer

If the same numbers occur in a retired single taxpayer’s return, with only one personal exemption and the

standard deduction is less, the effective tax rate is 25%, even though the taxpayer is in the 15% bracket.

Before After

42

Interest, rent income $ 26,000 $ 26,000

Add income — 10,000

Taxable Social Security 3,500 10,200

Total Income $ 29,500 $ 46,200

Taxable Income $ 16,100 $ 32,800

Tax $ 1,954 $ 4,459

$ 2,505

CRT Illustrations

CRAT vs. CRUT – fixed term.

Example 7.

Assume that David intends to fund a 10-year CRT with a $750,000 asset, in an attempt to spread the tax gain

from the disposition of that asset over 10 future tax returns. If the objective is to design a CRAT or a CRUT

that leaves the requisite 10% minimum to the charitable remainder entities, the following would be the

design parameters assuming a 1.4% AFR:

10 Yr. CRT (annual payout, end of yr.)

CRAT a. CRUT

Value of gift $750,000 $750,000

AFR Selected 1.4% 1.4%

Term 10 yrs. 10 yrs.

Payout amount $72,800 20.855%

Charitable Remainder 10.00% 10.00%

43

The payout amount ($72,800 in the case of the CRAT or 20.855% in the case of the CRUT) is determined

through trial and error, with an objective of achieving a charitable remainder percentage that meets or

slightly exceeds 10 percent.

Comment. If tax deferral is the objective of using the CRT, the CRAT will generally perform better

than the CRUT, due to the level payout stream under the CRAT. A short-term CRUT results in very

large payouts in the early years and declining payouts in later years.

Outright Sale vs. CRT Illustrations. The following four scenarios illustrate the after-tax cash flow to a

client if an appreciated asset is sold outright vs. disposed of in a deferred transaction through a 10-year CRAT

or CRUT assuming the same assumptions as in the previous example. Each outright sale alternative involves

a different category of asset, in terms of the type or rate of federal tax incurred on the asset, as follows:

Illustration Fed. Tax Rate

Capital Gain Property: Stock or Land 15%/20% LTCG

Ord. Depreciation Recapture: Machinery & Equip. 39.6% Ordinary

Ord.: Raised Grain/Livestock 39.6% Ordinary

+ SE tax

Built-in Gains Tax – S Corporation (Three years left) 35% BIG tax

+39.6% Ordinary

The following is a summary of the accumulation fund that the client would have available after 10 years:

Client After-Tax Accumulation Fund

App. Outright

Sale

10 yr. CRAT 10 yr. CRUT

2. 15%/20% LTCG Sale $670,533 $634,747 $634,780

3. Ordinary Depr. Recapture 460,238 504,151 504,190

4. Ordinary and SE Tax 413,869 504,151 504,190

5. BIG Tax – S corporation 254,050 433,070 379,000

Observations:

• The contribution of capital gain property generally produces a charitable deduction to the donor, in

this case approximately equal to the 10 percent remainder value targeted for charity at the end of the

10-year term of the trust. However, ordinary income property with zero basis produces no charitable

deduction.

44

• At the lower capital gain rates, incurring the tax on an outright sale leads to a greater after-tax

accumulation than deferring under the CRAT or CRUT alternatives. Part of the reason for this

outcome is that the capital gain rate is flat, regardless of whether the capital gain is incurred in a single

year or spread over 10 years through the CRT technique.

• If the sale of the property increases AGI over the threshold of the imposition of the 3.8 percent net

investment income tax under I.R.C. §1411, the use of a CRAT or CRUT may reduce or eliminate this

effect if the years of distribution are under the modified AGI threshold levels for the 3.8 percent tax.

• A large gain may be subject to the 20 percent capital gains rate.

• Using a short-term CRAT or CRUT to defer a capital gain can be a solution to eliminating the AMT

cost that often occurs in a return with a very large capital gain. The large capital gain increases

AGI, which in turns causes the phase-out of the AMT exemption. As a result, individuals become

subject to AMT on their ordinary income (taxed at the 26%/28% AMT rate rather than the graduated

10%/15%/25% regular rates).

• An element in the favorable outcome for the ordinary income models is the lower tax rate when the

CRT spreads the income over 10 tax returns vs. a single tax return for the outright sale. In the

illustrations above, it is assumed that a single year sale with $750,000 of ordinary income occurs at a

top 39.6% federal rate, whereas deferral over the 10-year term drops the marginal federal rate to 28%.

• When SE tax is involved, as in the case of the illustration with the raised grain and livestock, the CRT

alternative eliminates the SE tax, as the payout from the CRAT or CRUT is an annuity that is not

subject to self-employment social security tax.

• A CRT can be utilized when an S corporation with a built-in gains tax period that is close to

expiration. If the assets are sold outright, all of the gain is subject to the tax, whereas by placing the

assets in a CRAT or CRUT, the tax is imposed only the remaining built-in gains period and

eliminated thereafter. The CRUT results in lower accumulation of after-tax funds due to the larger

payouts in the early years.

• A CRT can be utilized by a C corporation to spread income from the sale of fully depreciated

equipment/grain sales/livestock sales over several years to maximize the benefit of the lower

155/25% brackets (assuming the continued existence of the corporation).

Cautions Regarding Transfer of Appreciated Assets to a CRT

If unmarketable assets are transferred to a CRT, the trust will fail to qualify for charitable status unless

valuation of the property is completed by an independent trustee or determined by a qualified appraisal.24 Also,

there is the possibility of unrelated business taxable income (UBTI) in a CRT, particularly if the CRT attempts

to hold an ownership interest in an actively conducted business. A CRT that has UBTI becomes nonexempt

and subject to taxation as a complex trust.25

24 Treas. Reg. §1.664-1(a)(7)(i). 25 Treas. Reg. §1.664-1(c).

45

Note. Transfers to a CRT of interests in a general partnership, limited partnership or limited liability units

may expose the CRT to UBTI. Also, the transfer of debt-financed assets or the existence of debt within the

business entity can trigger unrelated business taxable income.

The two-tiered “self-dealing” excise tax of I.R.C. §4941 can apply to a CRT that sells property to a

disqualified person or otherwise transacts, leases or deals with the donor or a related party.26

Compliance Issues

Filing requirements for CRTs. Split-interest trusts described in I.R.C. §4947(a)(2) are required to file an

annual Form 5227 (Split-Interest Trust Information Return), reporting the annual income and balance sheet

information of the trust. Form 1041 Schedule K-1 is attached to the Form 5227, to report each beneficiary's

share of trust income/distributions. A copy of the charitable trust document must be attached to the Form 5227

for the first year the return is required to be filed, accompanied by a written declaration signed by the trustee

indicating that the trust instrument is a true and complete copy.

Note. Form 1041-A, Trust Accumulation of Charitable Amount is no longer necessary for years beginning

after 2006.

Form 5227 is due on April 15 for CRTs. All CRTs must be on the calendar year. All Forms 5227 are

required to be filed with the Internal Revenue Service in Ogden, UT 84201-0027.

THE IMPACT OF ATRA ON ESTATE PLANNING; PLANNING IN

LIGHT OF UNCERTAINTY; AND PORTABILITY PLANNING AND

GIFT REPORTING

OVERVIEW

2013 marked the beginning of major changes in the estate planning landscape and its impact on estates and

beneficiaries. While there had been significant changes to the transfer tax system before 2013, particularly

with respect to the changes wrought by the Economic Growth and Tax Relief Recovery Act of 2001

(EGTRRA), the EGTRRA changes expired after 10 years. Further extensions of EGTRRA were only of a

temporary nature until the enactment of the American Taxpayer Relief Act (ATRA) of 2013 which

constituted a major income tax increase, and increased the tax rates on capital gains, dividends and transfer

taxes. ATRA’s changes were of a permanent nature. Also, the additional 3.8 percent tax on passive sources

of income under I.R.C. §1411, included in the Patient Protection and Affordable Care Act which was enacted

in 2010 and effective for tax years beginning after 2012, has important implications for the structuring of

business entities and succession planning, particularly for taxpayers with passive sources of income.

Under ATRA, the transfer tax system, beginning in 2013, is characterized by four key components:

• Permanency;

• Indexing;

26 I.R.C. §4947(a).

46

• Unification of the estate and gift tax systems; and

• Portability of the unused portion of the applicable exclusion at the death of the first spouse

PRE-2013 PLANNING

Before the changes to the transfer tax system beginning in 2013, much of estate planning for moderate to

high-wealth clients involved the aggressive use of lifetime asset transfers. Often, these asset transfers were

accomplished through trusts that typically involved the use of life insurance. However, such strategy came

at a cost. Lifetime transfers preclude the recipient(s) of those transfers from receiving a “stepped-up” basis

under I.R.C. §1014. But, that was often only a minor concern for the transferor because the strategy was to

avoid estate tax for the transferor. The strategy made sense particularly when the estate tax exemption was

significantly lower than the current (2017) level of $5.49 million and estate tax rates were significantly higher

than income tax rates. For example, before 2002, the top estate and gift tax rate was 55 percent and didn’t

drop to 45 percent until 2007. Now, the top income tax rate is 39.6 percent with the potential for an additional

3.8 percent on passive sources of income (for a combined 43.4 percent) and the top estate tax rate is 45

percent.

The standard pre-2013 estate plan for many higher-wealth clients had a common pattern as follows:

• A lifetime taxable gift (or gifts) utilizing the estate tax exemption equivalent, thereby removing all future

appreciation attributable to that property from the decedent’s future estate tax base. In many instances, the

gifted property was used to fund an intentionally defective grantor trust (IDGT).

Note: An IDGT is drafted to invoke the grantor trust rules with a deliberate flaw ensuring that

the individual continues to pay income taxes – i.e., the grantor is treated as the owner of the trust

for income tax purposes, but not the owner of the assets for estate tax purposes. Thus, the grantor’s

estate by the amount of the assets transferred to the trust. An IDGT is part of an estate “freeze”

technique. In a typical sale to an IDGT, the grantor sells appreciating assets at their fair market

value to the trust in exchange for a note at a very low interest rate. The installment note will be

treated as full and adequate consideration if the minimum interest rate charged on the installment

note is at least the applicable federal rate (AFR) and all of the formalities of a loan are followed.

The goal is to remove future asset appreciation, above the mandated interest rate, from the

grantor’s estate.

• The utilization of trusts (such as a “dynasty trust”) and other estate planning techniques to avoid having assets

included in the gross estate for as long as possible by virtue of leveraging the generation-skipping transfer

tax (GSTT) and establishing the GSTT trust in a jurisdiction that has abolished the rule against perpetuities.

If the trust was established in a state without an income tax, the trust income would also escape income

taxation.

Observation: The typical pre-2013 estate plan deemphasized the income tax consequences of the

plan. The emphasis focused on the avoidance of federal estate tax. Also, post-2010, the temporary

nature of the transfer tax system and the lateness of legislation dealing with expiring transfer tax

provisions persuaded many clients to make significant gifts late in the year based on the fear that the

estate tax exemption would drop significantly. In addition, the decedent’s and the beneficiaries’ states

of residence at the time of the decedent’s death was typically of little concern because there was a large

gap in the tax rates applicable to gifts and estates and those applicable to income at the state level.

47

Estate Tax Data27

According to IRS data, the number of federal estate tax returns (Form 706) filed declined nearly 76 percent

from 49,050 in 2006 to 11,917 in 2015. That reduction was the result of the gradual increase in the filing

threshold from $2 million in 2006 to $5.43 million in 2015. In 2015, the total net estate tax reported on all

estate tax returns filed for the year was $17.1 billion. California had the highest number of estate tax returns

filed in 2015, followed by Florida, New York, Texas, and Illinois. The top five states for filed federal estate

tax returns as a percentage of the state’s adult population (ages 18 and older) were (in descending order) were

South Dakota, District of Columbia, Florida, Connecticut and North Dakota. Stock and real estate made up

more than half of all estate tax decedents’ asset holdings in 2015. Taxable estates with total assets of $20

million or more held a greater share of their portfolio in stocks (over 38 percent) and lesser shares in real estate

(13 percent) and retirement assets (2.4 percent) than did decedents in other total asset categories.

Note: The IRS statistics reveal that the estate tax is of particular concern to

farm and ranch estates and other small businesses. It also reveals that the

primary asset likely to be included in a generation-skipping (“dynasty”) trust,

is stock rather than agricultural land.

THE CHANGED LANDSCAPE – 2013 AND FORWARD

In General

As noted above, the changes in estate planning beginning in 2013 are characterized by the following:

• Continuing trend of states repealing taxes imposed at death;

Note: As of the beginning of 2016, 18 states (and the District of Columbia) have some

variation of an estate tax or inheritance tax that is imposed at death. Those states are

as follows: CT, DE, HI, IL, IA, KY, ME, MD, MA, MN, NE, NJ, NY, OR, PA, RI,

VT and WA.

• Increase in the applicable exclusion and indexing of the amount (note – with moderate inflation, the exclusion is anticipated to be approximately $6.5 million by 2023 and $9 million by 2033).

• Reunification of the estate and gift tax;

• Permanency of portability of the deceased spouse’s unused exclusion;

• Permanency of transfer taxes.

Other changes that influence estate planning that began in 2013 include:

• An increase in the top federal ordinary income tax bracket to 39.6 percent;

• An increase in the highest federal long-term capital gain tax bracket to 20 percent;

27 IRS Statistics of Income Tax Stats – Estate Tax Statistics, accessible at https://www.irs.gov/uac/soi-tax-stats-estate-tax-statistics.

48

• An increase in the highest federal “qualified dividend income” tax rate to 20 percent;

• The 3.8 percent net investment income tax (NIIT) of I.R.C. §1411;

• For agricultural estates, land values more than doubled from 2000 to 2010, and continued to increase post-

2010. From 2009-2013, the overall increase in agricultural land values was 37 percent.28 In the cornbelt, from

2006-2013, the average farm real estate value increased by 229.6 percent.29 During that same timeframe, the

applicable exclusion increased 262.5 percent. For the year ending June 1, 2016, cornbelt farm real estate

values declined approximately one percent.30 That decline is in response to lower farm earnings due to

declines in crop and livestock revenue. It is anticipated that cornbelt farm real estate values will trend slightly

downward in 2017. This all means that even with the increase in the applicable exemption to $5.49 million

(for 2017) and subsequent adjustments for inflation, many agricultural estates still face potential estate tax

issues;

State-Level Impacts and Income Tax Ramifications

At the state level, the landscape has dramatically changed. At the time of enactment of EGTRRA in 2001,

practically every state imposed taxes at death that were tied to the federal state death tax credit. Since that

time, however, the federal state death tax credit has replaced with a federal estate tax deduction under I.R.C.

§2058 and, presently, only 19 states (and the District of Columbia) impose some type of tax at death (whether

a state estate tax or a state inheritance tax). In those jurisdictions, the size of the estate exempt from tax (in

states with an estate tax) and the states with an inheritance tax have various statutory procedures that set forth

the amount and type of bequests that are exempt from tax.

The following table sets forth the various state death tax systems as of April 1, 2017:

States Imposing An Estate Tax States Imposing An Inheritance Tax

Exemption Amount Maximum Tax Rate Exemption Amount Maximum Tax Rate

CT $2,000,000 12% IA Varies 15%

DE $5,490,000 16% KY Varies 16%

DC $1,000,000 16% MD $150 10%

HI $5,490,000 16% NE Varies 18%

IL $4,000,000 16% NJ $0 16%

ME $5,490,000 12% PA Varies 15%

MD $3,000,000 15%

MA $1,000,000 16%

MN $1,800,000 16%

NJ $2,000,000 16%

NY $5,250,000 16%

OR $1,000,000 16%

RI $1,515,156 16%

VT $2,750,000 16%

WA $2,129,000 19%

Maryland and New York gradually increase the exemption until it equates with the federal estate tax

28 National Agricultural Statistics Service Land Values 2012 Summary, Cornell University, current through August 2, 2013. 29 Id. 30 USDA Economic Research Service, Farmland Value, accessible at https://www.ers.usda.gov/topics/farm-economy/land-use-land-

value-tenure/farmland-value/.

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exemption effective January 1, 2019. But, in New York, the exemption is phased out for estates exceeding

105 percent in value of the applicable exemption amount. The Minnesota exemption gradually increases in

$200,000 increments annually until 2018 when it is set at $2,000,000.

Note: Connecticut is the only state that imposes a gift tax.

Also, numerous states have no state income tax (AK, FL, NV, SD, TX, WA and WY), TN and NH only tax

dividend and interest income and other states such as CA, HI, MN, NJ, NY and OR have a relatively high

state income tax burden compared to other states having an income tax.

This all means that the post-2012 estate planning landscape is, generally speaking, characterized by lower

transfer tax costs, higher income tax rates, and greater disparity among the states between transfer taxes and

income taxes.

Note: Post-2012, income tax issues play a greater role in estate planning. Because of

that, planners will need to consider whether it is possible for a client to minimize the

overall tax burden for a particular client (or family) by moving to a state with a reduced

(or eliminated) income tax and no transfer taxes. In general, clients domiciled in

relatively higher income tax states will generally place an emphasis on ensuring a basis

“step-up” at death. For those clients with family businesses, the ability of the client

to be domiciled in a “tax favorable” state at death means that pre-death

transition/succession planning will be important.

Focusing Estate Planning Post-2012

The key issues for the “estate planning team” beginning in 2013 and going forward would appear to be the

following:

• The client’s life expectancy;

• The client’s lifestyle;

• The potential need for long-term health care and whether a plan is in place to deal with that possibility;

• The size of the potential gross estate;

• The type of assets the decedent owns and their potential for appreciation in value;

• For farm estates, preserving the eligibility for the estate executor to make a special use valuation election;

• For relatively illiquid estates (commonplace among agricultural estates and other estates for small

business owners), preserving qualification for various liquidity planning techniques such as installment

payment of federal estate tax and properly making the election on the estate tax return;

Note: I.R.C. §6166(d) specifies that the election is to be made on a timely-filed (including

extensions) return in accordance with the regulations. The regulations are detailed, and require that

the appropriate box on Form 706 be checked and a notice of election be attached to the return. The

notice of election must also contain certain information. In Estate of Woodbury v. Comr., T.C.

Memo. 2014-66, however, the estate filed for an extension of time to file and included in that filing

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a letter that expressed the estate's intent to make an installment payment election and estimated that

approximately $10,000,000 in tax would be paid in installments. A subsequent request for an

additional extension was made along with another letter containing some of the required information

for an I.R.C. §6166 election. The IRS denied the second extension and informed the estate to file by

the previously extended due date. The estate ultimately filed its estate tax return late and attached a

proper notice of election to pay the tax in installments. The IRS rejected the election for lack of

timely filing, but estate claimed that it substantially complied. The court determined that the estate's

letters did not contain all of the information required by the regulations to make the election,

particularly valuation information to allow IRS to determine if the percentage qualification tests had

been satisfied. Thus, the estate did not substantially comply with the regulations and the election

was disallowed.

• Whether a basis increase at death will be beneficial/essential;

• Where the decedent resides at death;

• Where the beneficiaries reside at the time of the decedent’s death;

• If the decedent has a business, whether succession planning is needed;

• Entity structuring and whether multiple entities are necessary;

• For agricultural clients, the impact of farm program eligibility rules on the business structure;

• Asset protection strategies, including the use of a Spousal Lifetime Access Trust

• General economic conditions and predictions concerning the future. For agricultural clients, land

values, and commodity prices and marketing strategies are important factors to monitor.

The uncertainty concerning the future of the federal estate tax (and whether basis step-up will be retained)

also means that existing estate planning documents should be reviewed to make sure they comport with the

present level of the exemption and the availability of portability (discussed below). Existing estate plans

should also be reviewed if/when the federal estate tax system is eliminated or modified and if/when the basis

step-up rule is either modified or eliminated. For instance, formula clauses in existing documents should be

examined. The classic bequest to a credit shelter trust of the maximum amount possible without incurring

estate tax may result in the entire estate passing to the credit shelter trust if the estate tax is repealed. This

may not comport with the original intent of the estate plan. Also, formula general power of appointment might

also be impacted if the federal estate tax is repealed. For example, if the general power of appointment ties

its existence to not causing the estate to incur any estate tax to be paid by the holder of the power, federal

estate tax repeal would trigger the operation of the power.

Impact of Coupling

Because of the “coupled” nature of the estate and gift tax systems and portability of the unused exclusion at

the death of the first of the spouses to die, it will likely be desirable to use as little of the applicable exclusion

during life to cover taxable gifts. For many clients, the applicable exclusion will shelter the entire value of

their gross estate and inclusion of assets in the estate at death will allow for a basis increase in the hands of

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the heirs. Thus, for most clients, there will be little to no transfer tax cost. Again, that fact will cause most

clients to place an emphasis on preserving income tax basis “step-up” at death. If there are to be asset transfers

pre-death, such transfers will most likely occur in the context of business succession/transition planning. But,

for many clients, gifting assets during life will take on diminished importance.

Portability

The amount of the estate tax applicable exclusion that is not used in the estate of the first spouse to die is

available to be used in the estate of the surviving spouse, by election. This process is referred to as

“portability.” What is available to be “ported” to the estate of the surviving spouse is the “deceased

spouse’s unused exclusion amount (DSUEA). Before portability,

Portability of the deceased spouse’s unused exclusion amount (DSUEA) has become a key aspect of post-

2012 estate planning. The Treasury Department issued proposed and temporary regulations addressing

the DSUEA under I.R.C. §2010(c)(2)(B) and I.R.C.§2010(c)(4) on June 15, 2012. The proposed

regulations applied until June 15, 2015, and were then replaced with final regulations.

Note: The inherited DSUE amount is available for use by the surviving spouse as

of the date of the deceased spouse's death and is applied to gifts and the estate of the

surviving spouse before his or her own exemption is used. Accordingly, the

surviving spouse may use the DSUE amount to shelter lifetime gifts from gift tax,

or to reduce the estate tax liability of the surviving spouse's estate at death.

The portability election must be made on a timely filed estate tax return (Form 706) for the first spouse to

die.31 That’s the rule for nontaxable estates also, and the return is due by the same deadline (including

extensions) that applies for taxable estates. The election is also revocable until the deadline for filing the

return expires.

While an affirmative election is required by statute, Part 6 of Form 706 (which is entirely dedicated to the

portability election, the DSUE calculation and roll forward of the DSUE amount) provides that "a decedent

with a surviving spouse elects portability of the DSUE amount, if any, by completing and timely-filing the

Form 706. No further action is required to elect portability…." This election, therefore, is made by default if

there is a DSUE amount and an estate tax return is filed (so long as the box in Section A of Part 6 is not

checked affirmatively electing out of portability.

Note: In Rev. Proc. 2014-18, 2014-7 I.R.B. 513, the IRS provided a simplified method for

particular estates to get an extended time to make the portability election in the first spouse's

estate. The relief for making a late portability election applies if the decedent died in 2011,

2012 or 2013 and was a U.S. citizen or resident at the time of death. Also, the decedent'

estate must not have been required to file a federal estate tax return and did not file such a

return within the nine-month deadline (or within an extended timeframe if an extension was

involved). If those requirements are satisfied, the Form 706 can be filed to make the

portability election by the end of 2014 and the Rev. Proc. should be noted at the top of the

form.

The regulations allow the surviving spouse to use the DSUEA before the deceased spouse’s return is filed

(and before the amount of the DSUEA is established). However, the DSUEA amount is subject to audit until

the statute of limitations runs on the surviving spouse’s estate tax return.32 However, the regulations do not

address whether a presumption of survivorship can be established. If a married couple were able to establish

31 I.R.C. §2010(c)(5)(A). 32 Temp. Treas. Reg. §§20.2010-3T(c)(1); 25.2505-2T(d)(1).

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such a presumption that would be recognized under state law, the spouse deemed as the survivor could use

the DSUEA of the other spouse. That would allow a spouse with more wealth to use the DSUEA from the

less wealthy spouse when simultaneous deaths occur. Or, property could be transferred via a QTIP trust to

the spouse with less wealth for the benefit of the wealthier spouse’s children. Either way, the DSUEA of the

less wealthy spouse should be sheltered.

Requirements of Form 706. I.R.C. §2010(c)(5) requires that the DSUEA election be made by filing a

“complete and properly-prepared” Form 706. Temporary Regulation §20.2010- 2T(a)(7)(ii)(A) permits the

“appointed” executor who is not otherwise required to file an estate tax return, to use the executor's "best

estimate" of the value of certain property, and then report on Form 706 the gross amount in aggregate rounded

up to the nearest $250,000.

Note: Treas. Reg. §20.2010-2T(a)(7)(ii) sets forth “simplified reporting” for

particular assets on Form 706 which allows for “best faith estimates.” The simplified

reporting rules applies to estates that do not otherwise have a filing requirement under

I.R.C. §6018(a). This means that for any estate where the gross estate exceeds the basic

exclusion amount ($5,340,000 in 2014) simplified reporting is not applicable.

The availability of simplified reporting is available only for marital and charitable deduction property

(under §§2056, 2056A and 2055) but not to such property if:

• The value of the property involved “relates to, affects, or is needed to determine the value passing from

the decedent to another recipient; the value of the property is needed to determine the estate's eligibility

for alternate valuation, special use valuation estate tax deferral, “or other provision of the Code”;

• “[L]ess than the entire value of an interest in property includible in the decedent’s gross estate is marital

deduction property or charitable deduction property.”

• A partial qualifying terminable interest property (QTIP) election or a partial disclaimer is made with respect to the property that results in less than all of the subject property qualifying for the marital or charitable

deduction.

Assets reported under the simplified method are to be listed on the applicable Form 706 schedule without

any value listed in the column for "Value at date of death." The sum of the asset values included in the

return under the simplified method are rounded up to the next $250,000 increment and reported on lines 10

and 23 of the Part 5 - Recapitulation (as "assets subject the special rule of Treas. Reg. §20.2010-

2T(a)(7)(ii))."

In addition to listing the assets on the appropriate schedules the Temporary Regulations require that the

following be included for each asset must:

1. Property description;

2. Evidence of ownership of the property (i.e., a copy of a deed or account statement);

3. Evidence of the beneficiary of the property (i.e., copy of beneficiary statement); and

4. Information necessary to establish that the property qualifies for the marital or charitable deduction

(i.e., copy of the trust or will).

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Note: These documentation requirements are not contained in the Form 706 instructions,

but the regulations require the reporting of these items. Example 1 under Treas. Reg.

§20.2010-2T(a)(7)(ii) provides that a return is properly filed if it includes such documentation

and proof of ownership. The question is whether that means, at least by implication, a return

is not properly filed if it does not contain such documentation.

While the statute for assessing additional tax with respect to the estate tax return is the later of three years

from the date of filing or two years from the date the tax was paid), the IRS has the power to examine the

DSUE amount at any time through the period of the limitations as it applies to the estate of the deceased

spouse. Temp. Treas. Reg. §§20.2010-2T(d) and 3T(d) allows the IRS to examine the estate and gift tax

returns of each of the decedent's predeceased spouses. Any materials that are relevant to the calculation of

the DSUE amount, including the estate tax (and gift tax) returns of each deceased spouse can be examined.

Thus, surviving spouse will need to retain appraisals, work papers and documentation substantiating the

"good- faith" estimate, along with all intervening estate and gift tax returns to be able to substantiate the

DSUEA amount.

Note: The election to utilize portability allows the IRS an extended timeframe to question

valuations. The use of a bypass/credit shelter trust that accomplishes the same result for many

clients, does not. This is an important consideration for estate planners.

Role for traditional bypass/credit shelter trusts. Portability, at least in theory, can allow the surviving

spouse’s estate to benefit from basis “step-up” with little (and possibly zero) transfer tax cost. While

traditional bypass/credit shelter trust estate plans still have merit, for many clients (married couples whose

total net worth is less than or equal to twice the applicable exclusion), relying on portability means that it is

not possible to “overstuff” the marital portion of the surviving spouse’s estate. This could become a bigger

issue in future years as the applicable exclusion amount grows with inflation, this strategy will allow for

even greater funding of the marital portion of the estate with minimal (or no) gifts. But, a key point is that

for existing plans utilizing the traditional bypass/credit shelter approach, it is probably not worth redoing

the estate plan simply because of portability unless there are extenuating circumstances or the client has

other goals and objectives that need to be dealt with in a revised estate plan.

For wealthy clients with large estates that are above the applicable exclusion (or are expected to be at the time

of death), one planning option might be to use the DSUEA in the surviving spouse’s estate to fund a

contribution to an IDGT. The DSUEA is applied against a surviving spouse’s taxable gift first before

reducing the surviving spouse’s applicable exclusion amount. Thus, an IDGT would provide the same estate

tax benefits as the by-pass trust would have, but the assets would be taxed to the surviving spouse as a grantor

trust. Therefore, the trust assets would appreciate outside of the surviving spouse’s estate.

Note: Portability planning is slightly less appealing to couples in community property

states because, as discussed below, all community property gets a “step-up” in basis

on the first spouse’s death.

Portability “arbitrage.” A surviving spouse can utilize multiple DSUEAs by virtue of outliving multiple

spouses where the DSUEA election is made in each of those spouse’s estates. The surviving spouse must

gift the DSUEA of the last deceased spouse before the next spouse dies.

TRANSFER TAX COST AS COMPARED TO SAVING INCOME TAX BY

VIRTUE OF BASIS “STEP-UP”

In General

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As noted above, for many clients a beginning estate planning step is the attempt to determine the potential

transfer tax costs as compared to the income tax savings that would arise from a “step-up” in basis. This is not

a precise science because the applicable exclusion will continue to be adjusted for inflation or deflation. The

rate of inflation/deflation and the client’s remaining lifespan are uncontrollable variables. Also, as indicated

above, the tax structure of the state where the decedent and beneficiaries are domiciled matters.

Under present law, the vast majority of estates do not face federal estate tax at death. Obtaining a basis

increase for assets included in the gross estate is typically viewed as more important. It is possible that future

legislation could repeal the federal estate tax while simultaneously leaving basis step-up under I.R.C. §1014

in place. The federal estate tax and basis step-up are not necessarily “married” together. The federal income

tax was enacted in 1913 and the federal estate tax was enacted into law in 1916. As originally enacted, neither

the income tax nor the estate tax made any provision for the basis of assets received from a decedent’s estate.

It wasn’t until the Revenue Act of 1921 that there was a rule concerning basis of assets passing at death. Later,

the Congress added various “string” provisions to the federal estate tax and the basis rules began to track the

estate tax.

Observation. This means that it is possible that future legislation could eliminate the federal estate tax and

retain basis step-up at death. In that case, ensuring a basis increase at death for the decedent’s assets will be

of primary importance to heirs. But, while I.R.C. §1014(b)(9) covers all property included in a decedent’s

gross estate under Chapter 11, and probate assets are covered by I.R.C. §1014(b)(1), the Congress will have

to clarify the type of non-probate assets to which basis step-up applies.33

Benefitting From Basis “Step-Up”

The only way to capture the income tax benefits of the stepped-up basis adjustment is for the recipients of

those assets to dispose of them in a taxable transaction. This raises several questions that the estate planner

must consider:

• Whether the asset is of a type (such as a farm, ranch or other closely-held family business) that the

heirs may never sell it, or may sell it in the very distant future;

• Whether the asset is depreciable or subject to depletion; and

• Whether the asset involved is an interest in a pass-through entity such as a partnership or an S corporation.

Exceptions To The Basis “Step-Up” Rule

There are also exceptions to the general rule of date- of-death basis:

• If the estate executor elects alternate valuation under I.R.C. §2032, then basis is established as of

the alternate valuation date;

• If the estate executor elects special use valuation under I.R.C. §2032A, the value of the elected

property as reported on the federal estate tax return establishes the basis in the hands of the heirs.

This is true even though the executor and the IRS strike a deal to value the elected land at less than

what would otherwise be allowed by statute (for deaths in 2017, the maximum statutory value

33 This includes assets included in a revocable trust, assets subject to a general power of appointment by the decedent to appoint the

assets to the decedent’s creditors or estate, and assets that would have been included in the estate by virtue of I.R.C. §2034-2042.

Also, whether assets included in a Qualified Terminable Interest (QTIP) trust would be entitled to a basis step-up at the time of the

surviving spouse’s death would need to be clarified by an amendment to I.R.C. §1014(b).

55

reduction for elected land is $1,120,000).

Observation. In Van Alen v. Comr.,34 the petitioners were two children of a 1994

decedent and were beneficiaries of a residuary testamentary trust that received most of

decedent’s estate, including a 13/16 interest in a cattle ranch. The ranch value was

reported on estate tax return at substantially below FMV in accordance with I.R.C.

§2032A. The petitioners signed a consent agreement (one via guardian ad litem) agreeing

to personal liability for any additional taxes imposed as result of the sale of the elected

property or cessation of qualified use. The IRS disputed the reported value but the matter

settled. Years later, the trust sold an easement on the ranch restricting development. The

gain on the sale of the easement was reported with reference to the I.R.C. §2032A value

and K-1s were issued showing that the proceeds had been distributed to the beneficiaries.

The beneficiaries did not report the gain as reflected on the K-1s and then asserted that

the ranch had been undervalued on the estate tax return and that the gain reportable should

be reduced by using a FMV tax basis. The court determined that the I.R.C. §2032A value

pegs the basis of the elected property via I.R.C. §1014(a)(3). The court upheld the

consent agreement and an accuracy-related penalty was imposed because tax advice was

sought only after the petitioners failed to report any gain.

• For land subject to a qualified conservation easement that is excluded from the gross estate under I.R.C.

§2031(c), a carryover basis applies to such property.

• Property that constitutes income in respect of a decedent (includes unrecognized interest on U.S. savings

bonds, accounts receivable for cash basis taxpayers, qualified retirement plan assets, and IRAs, among other

things); and

• Appreciated property (determined on date of the gift) that was gifted to the decedent within one year of death,

where the decedent transferred the property back to the original donor of such property (or the spouse of the

donor). The donor receiving the property back will take as a basis the basis that the decedent had in the

property immediately before the date of death.

Community Property Considerations

On the basis step-up issue, estates of clients in community property states have an advantage over estates of

clients in separate property states. The ownership portion of the couple’s community property that is

attributable to the surviving spouse by virtue of I.R.C. §1014(b)(6) gets a new basis when the first spouse

dies if at least one-half of the community property is included in the decedent’s estate for federal estate tax

purposes. This became the rule for deaths after 1947. Restated differently, there is a basis adjustment of

both the decedent’s and surviving spouse’s one-half of community property at death if at least one-half of

the community property was include in the decedent’s gross estate under chapter 11. If future legislation

repeals the federal estate tax (chapter 11), a question will arise as to whether the so-called “double basis

step-up” for community property will survive.

Note: The community property states are AZ, CA, ID, LA, NV, NM, TX, WA and WI.

Two common law property states, AK and TN, allow couples to convert or elect to treat

their property as community property. In these states, resident and nonresident couples

can classify property as community property by transferring the property to a qualifying

trust. For nonresidents, a qualifying trust requires at least one trustee who is a resident of

the state or a company authorized to act as a fiduciary, and specific trust language

34 T.C. Memo. 2013-235.

56

declaring the trust asset as community property.

Presently, sixteen states (AK, AR, CO, CT, FL, HI, KY, MI, MN, MT, NY, NC, OR, UT, VA and WY) have

enacted the Uniform Disposition of Community Property Rights at Death Act (“UDCPRDA”). Under the

UDCPRDA, when the first spouse dies, half of the community property is considered the property of a

surviving spouse and the other half is considered to belong to the deceased spouse. But, a couple can change

their interests in the property (Act, §8), and can adopt an estate plan that control the inheritance of their

property. O n e d r a w b a c k f o r p l a n n e r i s t h a t t h e r e a r e n ’ t a n y cases or IRS

rulings on the impact of the UDCPRDA on basis step-up under I.R.C. §1014(b)(6).

Observation. Because the unlimited marital deduction under I.R.C. §2056 essentially gives couples in

community property states the ability to have no transfer taxes on the first spouse’s death, this “step-up” in

basis provides an immediate income tax savings for the surviving spouse’s benefit. This changes the planning

dynamic as compared to similarly situated clients in non-community property states.

Suggested Approach. The following is a suggested estate planning approach for married couples in

community property states where emphasis is placed on achieving a stepped-up basis:

• Minimal gifting of assets during the lifetimes of both spouses, so that the maximum value of assets is included

in the estates where they will be eligible for a basis increase under

I.R.C. §1014(b)(6).

• After the death of the first spouse, if the value of the survivor’s gross estate exceeds the available applicable

exclusion, utilize strategies to reduce the potential estate tax in the survivor’s estate consistent with the

surviving spouse’s goals. Such strategies may involve income tax planning, planning to avoid or at least

account for the NIIT, gifting, and the use of entities to create minority interest and lack of marketability

discounts, and discounts for built-in capital gain (applicable to S corporations).

Estate Planning Techniques Designed To Achieve Income Tax Basis

“Step-Up”

The disparate treatment of community and common law property under I.R.C. §1014 has incentivized estate

planners to come up with techniques designed to achieve a basis “step up” for the surviving spouse’s

common law property at the death of the first spouse. These techniques can be summarized as follows:

• General power of appointment given to each spouse over the other spouse’s property which causes, on the death of the first spouse, the deceased’s spouse’s property to be included in the decedent’s estate by virtue

of I.R.C. §2033 (if owned outright) and I.R.C.§2038 if owned in a revocable trust. The surviving spouse’s property would also be included in the decedent’s estate by virtue of I.R.C. §2041. The power held by the

first spouse to die terminates upon the first spouse’s death and would be deemed to have passed at that time to the surviving spouse.

• Joint exempt step-up trust (JEST).35 In essence, both spouses contribute their property to the JEST that

holds the assets as a common fund for the benefit of both spouses. Either spouse may terminate the trust

while both are living, in which case the trustee distributes half of the assets back to each spouse. If there

is no termination, the joint trust becomes irrevocable upon the first spouse’s death. Upon the first

spouse’s death, all assets are included in that spouse’s estate. Upon the first spouse’s death, assets equal

35 For a detailed explanation of the JEST concept, see Gassman, Denicolo and Hohnadell, 40 Estate Planning, Nos. 10-11 (Oct and

Nov. 2013).

57

in value to the first spouse’s unused exclusion will be used to fund a bypass trust for the benefit of the

surviving spouse and descendants. These assets will receive a stepped-up basis and will not be included

in the surviving spouse’s estate. Any asset in excess of the funding of the bypass trust will go into an

electing qualified terminable interest property (QTIP) trust under I.R.C. §2056(b)(7). If the first spouse’s

share of the trust is less than the available exclusion, then the surviving spouse’s share will be used to

fund a bypass credit shelter trust. These assets will avoid estate taxation at the surviving spouse’s death.

Note: I.R.C. §1014(e) may operate to prevent the planning benefits of these techniques.

Under I.R.C. §1014(e), property with a fair market value that exceeds its basis at the time of

the transfer is ineligible for a basis step- up if the transferee dies within one year of the

transfer and, as a result of the transferee’s death, the transferred property is “acquired from”

the transferee by the original transferor or “passes from” the transferee to the original

transferor under I.R.C. §1014(e). The primary question is whether I.R.C.§1014(e) applies to

the general power of appointment held by a deceased spouse over the surviving spouse’s

interest in trust property. The IRS has ruled negatively on the technique. In Priv. Ltr. Rul.

9308002 (Nov. 16, 1992), IRS disallowed a basis increase to the surviving spouse’s one-half

interest in a trust because the policy of I.R.C. §1014(e) requires relinquishment of dominion

and control over the property transferred to the decedent at least one year before death.

Because the surviving spouse (the donor) could revoke the joint revocable living trust at any

time, the surviving spouse had dominion and control over the trust assets during the year

before and up to the time of the decedent spouse’s death. The IRS again ruled similarly in

Priv. Ltr. Rul. 20010102136 The 1993 letter ruling has been criticized.37 However, there is

support for the position of the IRS.38

Clearly, the drafting required to achieve the desired result is very complex. The administration of trusts

always requires care. That level of care is elevated with respect to estate planning techniques designed to

achieve a basis increase for common law property equivalent to that of community property.

A recent tax court case illustrates the need for care in trust administration. Estate of Olsen v. Comr.39 points

out the perils of not properly administrating trusts. In the case, a married couple had revocable living trusts

with identical terms that would be split on death into a marital trust and then two marital sub-trusts. The

wife’s trust contained approximately $2.1 million worth of assets at the time the spouse died in 1998 at a

time when the federal estate tax exemption was $600,000. The trust specified that the assets of the trust were

be divided into a pecuniary marital trust and a residuary credit shelter trust. This was not done by the husband

as the executor. In addition, the marital trust was to be divided into GSTT exempt and non-exempt trusts.

The husband (the decedent in this case) had a limited power of appointment over principal from the credit

shelter trust to appoint principal to his children, grandchildren or charity. After his wife’s death, the surviving

spouse made over $1 million in withdrawals from the revocable living trust principal for chartable

distributions and claimed charitable deductions on personal return. He also withdrew other funds for

distribution to his children and grandchildren.

At the valuation date for the trust after the surviving spouse’s death in 2008 (when the exemption was $2

million), the revocable living trust contained over $1 million in assets. The estate took the position that all

withdrawals had been from the marital trust (which were subject to an ascertainable standard) such that the

decedent's gross estate value was zero. The IRS claimed that withdrawn amounts were attributable to the

36 Oct. 2, 2000. 37 See, e.g., Zaritsky, Running With the Bulls: Estate Planning Solutions to the “Problem”of Highly Appreciated Stock, 31-14

University of Miami Law Center on Estate Planning §1404; Williams, Stepped-Up Basis in Joint Revocable Trusts, Trusts & Estates

(June 1994). 38 See, e.g., Keydel, Question and Answer Session II of the Twenty-Eighth Annual Institute on Estate Planning, 28-20, University of

Miami Law Center on Estate Planning §2007. 39 T.C. Memo. 2014-58.

58

credit shelter trust and here included in decedent's gross estate or, in the alternative, were pro rata

withdrawals. The IRS asserted an estate tax deficiency of $482,050.80. The Tax Court determined that

charitable gifts were from the credit shelter trust via the decedent's limited power of appointment and the

other distributions were from the marital trust as discretionary distributions, and rejected the estate's argument

that Treas. Reg. §20.2044-1(d)(3) applied. The court also determined that the decedent's limited power of

appointment to appoint to charity from the credit shelter trust was exercisable during life. The court also

noted that distributions from principal could only come from the marital trust. The value of the decedent's

gross estate was determined by subtracting all personal withdrawals from value of remaining trust assets.

The end result was an increase in tax liability by approximately $250,000.

At the present time, there is uncertainty over the future of the federal estate tax and basis step-up. If the estate

tax is repealed along with basis step-up (in other words, no estate tax and carryover basis), the planning process

will consist of additional planning considerations. For example, consider the following:

• Lifetime transfers of appreciated assets would not lose a basis adjustment at the transferor’s death;

• A carryover basis system could have a serious negative impact on taxpayers that have depreciated

assets, refinanced their assets, or engaged in a tax-deferred exchange. If the assets were currently

liquidated, the income tax liability could be large, and death would not provide an opportunity to

escape that tax liability by achieving a basis step-up.

TRANSFEREE LIABILITY

Upon a decedent’s death, any liabilities for deficiencies on the decedent’s tax returns do not die. The

decedent’s estate, in essence, is liable for the decedent’s tax deficiency in existence at the time of death.

Individuals receiving assets from a decedent take the assets subject to the claims of the decedent’s creditors

– including the government as a creditor. Asset transferees are liable for taxes due from the decedent to the

extent of the assets that they receive. A trust can be liable as a transferee of a transferee under I.R.C. §6901

to the extent provided in state law.40

The courts have address transferee liability issues in several recent cases:

• United States v. Mangiardi.41 In this case, the court held that the IRS could collect estate tax via an estate tax

lien more than 12 years after taxes were assessed. The decedent died in

2000 owning assets via revocable trust of approximately $4.57 million and an IRA worth

$3.85 million. The estate tax was determined to be approximately $2.47 million. Four years of

extensions were granted due to a market value decline of publicly traded securities. $200,000 of

estate tax was paid and insufficient assets were in the trust to pay the balance. The IRS sought

payment of tax from the transferee of an IRA under I.R.C.§6324. The court held that the IRS was

not bound by the four-year assessment period of I.R.C. §§6501 and 6901(c) and could proceed under

the I.R.C. §6324 (10-year provision). 10-year provision was extended by the four-year extension

period that had previously been granted to the estate, and IRA transferee liability was derivative of

estate's liability. The court held that it was immaterial that the transferee may have not known of the

unpaid estate tax. The amounts withdrawn from the IRA to pay the estate tax liability was also

subject to income tax in transferee's hands. The court also held that while an income tax deduction

for estate taxes attributable to the IRA was available under I.R.C.

§6901(c), the deduction could be limited due to the failure to match the tax year of the deduction

40 See, e.g., Frank Sawyer Trust of May 1992 v. Comr., T.C. Memo. 2014-59. 41 No. 13-80256-CIV-MARRA, 2013 U.S. Dist. LEXIS10212 (S.D. Fla. Jul. 22, 2013).

59

and income.

• In United States v. Tyler,42 a married couple owned real estate as tenants by the entirety (a special form

a marital ownership recognized in a minority of states). The husband owed the IRS $436,849 in income

tax. He transferred his interest in the real estate to his wife for $1 and the IRS then placed a lien on the

real estate. The husband died with no distributable assets and no other assets with which to pay tax lien.

The surviving spouse died within a year after the husband’s death and the property passed to a son, the

defendant in the case. The son was named as a co-executor of mother’s estate. The IRS claimed that

the tax lien applied to the real estate before legal title passed to mother and that the executors had to

satisfy the lien out of the assets of mother’s estate. The executors conveyed the real estate to the son for

a dollar after receiving letters from the IRS asserting the lien. The son later sold the real estate and

invested the proceeds in the stock market, subsequently losing his investment. The IRS brought a

collection action for 50 percent of the sale proceeds from the executors under federal claims statute (31

U.S.C. §3713 via I.R.C. §6901(a)(1)(B)). The trial court ruled for the IRS and the appellate court

affirmed. Under the federal claims statute, the executor has personal liability for the debts and

obligations of the decedent, and the fiduciary that disposes of assets of an estate before paying a

governmental claim is liable to the extent of payment for unpaid governmental claims if the fiduciary

distributes assets of the estate, the distribution renders the estate insolvent, and the distribution took place

after the fiduciary had actual or constructive knowledge of the liability for unpaid taxes).

• United States v. Whisenhunt, et al.43 This is another case that points out that an executor has personal liability

for unpaid federal estate tax when the estate assets are distributed before the estate tax is paid in full. I.R.C.

Sec. 7402 controlled and the executor was personally liable for $526,506.50 in delinquent federal estate tax

and penalties - the amount of distribution at the time of the decedent's death.

IRS GUIDANCE ON DISCHARGING ESTATE TAX LIENS

In Treasury Memo SBSE-05-0417-0011 (Apr. 5, 2017), the IRS provided interim guidance to its Estate Tax

Lien Advisory Group concerning applications or requests for discharge of the federal estate tax lien that are

made after June 2016.

Upon death, the assets in the decedent’s gross estate become subject to a federal estate tax lien under I.R.C.

§6324(a). The lien arises before any estate tax is assessed and is an unrecorded (“silent”) lien that exists for

10 years from the date of the decedent’s death. The lien is in addition to the regular federal estate tax lien of

I.R.C. §6321, which arises upon the assessment of tax. The lien can be discharged by making a request via

Form 4422. The lien is discharged if IRS determines that the lien has been fully satisfied or provided for. Form

792 is used to discharge the lien from particular property under I.R.C. §6325(c).

Historically, the lien would be released within a few days, but beginning in June of 2016 all applications for

discharge of the liens began processing through Specialty Collections Offers, Liens and Advisory (Advisory)

in the Estate Tax Lien Group. Upon the IRS accepting a filed Form 4422, the net proceeds of estate asset sales

are either to be deposited with the IRS or held in escrow until IRS issues a closing letter or determines that the

federal estate tax return will not be audited. The amount deposited with IRS or held in escrow is the amount

of proceeds remaining after the amount necessary to pay estate tax.

IRS has issued guidance to the Special Advisory Group concerning how to handle lien discharge requests.

Under applicable regulations, if the “appropriate” official determines that the tax liability for the estate has

been fully satisfied or adequately provided for, a certificate that discharges the property from the lien may be

issued. The interim guidance provides instruction on who inside IRS is to be consulted and provide assistance

42 No. 12-2034, 2013 U.S. App. LEXIS 11722 (3rd Cir. Jun. 11, 2013). 43 No. 3:12-CV-0614-B, 2014 U.S. Dist. LEXIS 38969 (N.D. Tex. Mar. 25, 2014).

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in handling lien discharge requests, and what Code sections apply. The interim guidance also notes that Letter

1352 is to be issued when an estate does not have a filing requirement. Also, the interim guidance notes the

procedures utilized to substantiate facts for nontaxable estates. The interim guidance also notes the

circumstances when an escrow/payment will or will not be required.

BASIS OF ASSETS IN ESTATES

Date of Death Valuation and Alternate Valuation. The general rule is the basis of an inherited asset from

a decedent is the FMV of the asset on the decedent’s date of death. There are a number of exceptions to this

general rule, including income in respect of the decedent (IRD) and certain gifts of appreciated property

acquired by the decedent by gift within one year of death 44

Note. For an extensive discussion regarding basis for inherited assets, see the 2013 University

of Illinois Federal Tax Workbook, Volume B, Chapter 3: Advanced Individual Issues which

includes sections on inherited assets, inheriting retirement assets, inheriting a partnership

interest, and inheriting S corporation stock.

The executor of an estate may choose to use the FMV on the date of death or on the alternate valuation date

when filing Form 706.45 The alternate valuation date is the date that is exactly six months after the date of

death. The alternate valuation election may only be made if it lowers the overall value of the estate, lowers the

estate tax, and is used for all assets in the estate. If the executor makes an alternate valuation date election, the

beneficiary’s basis is equal to the FMV of the property as of the alternate valuation date.

The executor can make an alternate valuation election only if the value of the property in the gross estate and

the estate’s federal estate tax liability are both reduced by making the election. Thus, the decedent’s gross

estate must be a taxable estate.46 The purpose of alternate valuation is to lessen the federal estate tax burden

if values decline in the six-month period immediately following death. In that event, the estate can be valued

up to six months after death.

Observation. If an estate would not be subject to federal estate tax, an alternate valuation election could allow

the estate’s heirs to obtain a higher income tax basis on property included in the gross estate if values had risen

after death. That is not permissible.

For most businesses, alternate valuation is straightforward. There is one value as of the date of death and a

different value six months after death. However, in some estates, events can occur during the six-month period

immediately following the decedent’s death. This of particular concern with respect to an agricultural estate.

For example, a decedent may have planted a crop shortly before death, which was harvested and sold within

six months after death. Or perhaps the decedent had cows that were bred before the date of death and calved

after death and were sold after the six-month period following death. To determine whether these types of

property are subject to alternate valuation requires a determination of “included” and “excluded” property.

“Included property” is all property that is in existence at death. Under an alternate valuation election “included

property” is valued six months after death or as of the date of sale, whichever comes first. Thus, crops that are

growing as of the date of death and are harvested and sold after death are valued as of the earlier of six months

after death or the date of sale. Conversely property coming into existence after death such as crops planted

after death, are ignored for purposes of alternate valuation. This property is termed “excluded property.” For

property that exists as of the date of death, and is disposed of gradually during the six-month period after death

(such as silage that is fed during the six months’ period following death), every day’s feeding is a disposition.

Thus, a calculation must be made not only as to the value, but as to how much disappeared. The same is true

of shelled corn, hay, or similar items. The inventory must show the disappearance over that time period, and

44 IRC §1014. 45 IRC §2032. 46 Treas. Reg. § 20.2032-1(b)(1) (1958); Tax Reform Act of 1984, Sec. 1923(a), 98th Cong., 2d Sess. (1984).

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some value must be attached to it.

Basis Consistency Rules

The Surface Transportation and Veterans Health Care Improvement Act of 2015 (Act) added I.R.C. §6035 to

the Code. I.R.C. §6035 specifies that a decedent's estate that is required to file a federal estate tax return

(Form 706) after July 31, 2015, must provide basis information to the IRS and estate beneficiaries by the

earlier of 30 days after the date Form 706 was required to be filed (including extensions, if granted) or 30 days

after the actual date of filing of Form 706. The purpose of the provision is to ensure that beneficiaries of estate

assets use the same basis numbers when later selling the assets as were used in the decedent’s estate.

The initial filing deadline was moved forward to March 31, 2016 (from February 29, 2016).47 However, IRS

failed to timely issue proposed regulations (and a temporary regulation), waiting until early March (in the

middle of tax filing season) to do so, mere days before the filing deadline.48 As a result, practitioners had very

little time to study the proposed regulations and deal with their inconsistencies and breadth. Consequently, in

late March, the IRS again delayed the filing deadline, this time to June 30, 2016.49

The new rules do two things – (1) specify that the basis of property subject to the new rules cannot exceed the

final value as determined for estate tax purposes in a decedent’s estate; and (2) impose a reporting requirement

with regard to the value of property included in a decedent’s gross estate.

The Filing Requirement. Under the Act, I.R.C. §6035(a)(1) requires the executor of an estate that is required

to file Form 706 by I.R.C. §6018(b) to furnish to the IRS and the person acquiring any interest in property that

is included in the decedent’s gross estate for federal estate tax purposes, a statement detailing the value of each

interest in the property inherited as reported on Form 706 along with any other information that the IRS might

require by regulation.50

Note: An estate executor must: (1) furnish a statement (IRS Form 8971 and the accompanying Schedule A)

to the IRS identifying the reported value of each asset that was included in the gross estate; and (2) give that

information (Schedule A of Form 8971) to each person who acquired the interests and identify those

individuals in the report to the IRS.

The Act allowed IRS to move the filing deadline forward and the IRS did move the date forward to February

29, 2016, for statements that would be due before that date under the 30-day rule contained in the Act.51 IRS

stated at the time that executors and other persons were not to file or furnish basis information statements

until the IRS issued forms or additional guidance. Relatedly, the Act modifies I.R.C. §1014(f) to require

beneficiaries to limit basis claimed on inherited property to either the value of the property as finally

determined for federal estate tax purposes, or the value reported to the IRS and beneficiary under I.R.C. §6035.

In early 2016, the IRS again delayed the estate basis reporting due date to March 31, 2016 to allow time for

proposed regulations to be issued that provide guidance on numerous questions concerning the new

47 By statute, the filing deadline was August 31, 2015 for executors who either filed Form 706 on August 1, 2015 or should have

filed Form 706 with a due date of August 1, 2015. However, there was no way to comply with the law without forms on which to

report the required information. Thus, the IRS issued Notice 2015-57 stating that any reports due before February 29, 2016, should

not be filed before that date. 48 REG-127923-15, Mar. 4, 2016. The temporary regulation (Temp. Reg. §1.6035-2T), merely specifies the due date of the relief

that was provided in I.R.S. Notice 2016-19, 2016-9, I.R.B. 362. 49 I.R.S. Notice 2016-27, 2016-15 I.R.B. 1. 50 I.R.C. §6035(a)(2). Any statement filed under I.R.C. §6035 is subject to the failure to file penalties contained in I.R.C. §§6721

and 6722. 51 I.R.S. Notice 2015-57, 2015-36, I.R.B. 294.

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provision.52 The IRS again pushed the deadline forward to June 30, 2016.53 The information reporting is to

be accomplished via Form 8971.

Form 8971. The information required to be furnished to the IRS and beneficiaries is reported on Form 8971.

Form 8971 that is filed with the IRS is to include a copy of each statement that is required to be furnished to

the beneficiaries – Schedule A. Schedule A is the beneficiary statement form that gets filed with the

beneficiaries.54 Form 8971 and the attached Schedule A are not to be filed with Form 706.

Note: The purpose of the Form is to make sure that when a beneficiary later sells the inherited assets, that

the gain on sale (if any) is properly reported by using the same value for the heir’s basis in the asset on sale as

was reported on Form 8971.

Form 8971 is to be completed within 30 days of the due date of the Form 706 or within 30 days of when Form

706 is actually filed,55 which could be difficult to comply with.56 In an attempt to deal with this situation, the

Form 8971 instructions direct the executor to report all of the potential assets that a beneficiary might possibly

inherit on Schedule A.57 In addition, when the administration process is far enough down the road so that the

executor knows the actual asset allocation to the beneficiaries, the executor is to file an “updated” Form 8971.58

Observation: It would make sense to statutorily change the due date of Form 8971 to either the time when

the actual assets to be distributed to a particular beneficiary can be determined or when the distribution to a

beneficiary is actually made.

While the instructions to Form 8971 state that the Form need not be filed if the only reason for filing the Form

is to elect the GSTT or make a GSTT allocation, the instructions are silent on the portability issue. The statute,

I.R.C. §1014(f)(2), says that the new “basis consistency” rules only apply to property included in an estate

that increases the estate’s federal estate tax liability (reduced by any credits allowed against the tax). That

would mean that property passing outright to a surviving spouse that qualifies for the marital deduction and

property passing to a charity aren’t subject to the basis consistency rules because they don’t trigger estate tax.

By the same logic, estates that file Form 706 for the sole purpose of electing portability of the unused estate

tax exclusion at the death of the first spouse should not trigger a Form 8971 filing requirement.

Proposed Regulations.59 The statute60 specifies that the application of the basis consistency rule is limited in

its application to property that would increase the liability for estate tax (reduced by allowable credits against

52 I.R.S. Notice 2016-19, 2016-9 I.R.B. 362 and Treas. Reg. §1.6035-2T(a). 53 I.R.S. Notice 2016-27, 2016-15, I.R.B. 1. 54 I.R.C. §6035(a)(3)(A). The Schedule A for a beneficiary lists the assets the beneficiary receives and the value of those assets for

federal estate tax purposes. 55 I.R.C. §6035(a)(3)(A). The Form 8971 instructions state that basis information statements are due within 30 days of the filing

date when Form 706 is not filed in a timely manner. In addition, if an adjustment is made to Form 706, a supplemental basis

information statement is to be filed within 30 days after the adjusted Form 706 is filed.

56 In many situations, estates (and trusts that are related to estates) have not proceeded through the administration process sufficiently

within 30 days of the 706 filing to be able to pin-down the heirs that are to receive particular assets. Determining value is one thing,

but interpreting will and trust language to determine who gets what is a completely different task. 57 This is consistent with Prop. Treas. Reg. §1.6035-1(c)(3). As the preamble to the proposed regulations note, this will result in

duplicate reporting of assets on multiple Forms Schedule A. Also, assets do not have to be reported if they are not “property for

which reporting is required.” 58 That will present some interesting client consultations, especially in large estates. For those estates, any particular beneficiary

could receive a rather lengthy Schedule A and might assume that they will be inheriting all of the assets listed on the Schedule. That

assumption will be “corrected” when they receive the “updated” Form 8971. 59 Prop. Treas. Reg. §1.1014-10. 60 I.R.C. §1014(f)(2).

63

the tax). if it were included in the decedent’s estate.61 This rule, however, applies only for purposes of the

basis consistency rule. It does not apply to the information reporting requirements. Thus, for example,

property that qualifies for the estate tax marital or charitable deduction does not impact an estate’s tax liability

and is not subject to the basis consistency rule but is subject to the information reporting requirement.

Likewise, Prop. Treas. Reg. §1.1014-10(b)(2) states that property for which an appraisal is not required under

Treas. Reg. §20.2031-6(b) is not subject to the basis consistency requirement,62 and the basis consistency rule

also doesn’t apply to a “no tax” estate even where a Form 706 filing is required.63

Note: On the appraisal issue, Example 1 in Prop. Reg. §1.6035-1(b)(2)

indicates the exception applies to any individual asset that is valued at less

than $3,000. However, Treas. Reg. §20.2031-6(b) applies if the total value

of articles having marked artistic or intrinsic value exceeds $3,000. The

instructions to Form 706 state that an appraisal is required for “works of art,”

etc., if any item is valued at more than $3,000.

The proposed regulations allow for post-death changes in basis,64 and also apply the basis consistency rules to

property that had been omitted from Form 706.65 If the omission is discovered and the omitted property is

reported on a supplemental Form 706 before the period of limitation on assessment of tax expires, nothing

changes. The normal rules on final value are applicable.66 If the omission is discovered after the statute of

limitations has expired on assessing estate tax against the estate, the proposed regulations assert that the

beneficiary of the property will receive a zero basis.67

Note: There is no statutory authority in I.R.C. §1014(f) for the position taken

in the proposed regulations of adjusting basis to zero for omitted assets

discovered after the statute of limitations on assessment has run. Also, for

assets discovered after Form 706 is filed, but before the statute of limitations

on assessment of estate tax has run, practitioners may not find it worthwhile to

file a supplemental Form 706 (to avoid a zero basis). That’s because no duty

exists to report after-discovered property with respect to an estate for which

Form 706 was filed in good faith.68

The proposed regulations are the sole guidance on the basis consistency rules and must be relied upon for both

the preparation of Form 8971 and the preparation of income tax returns of heirs receiving property subject to

the basis consistency rules until final regulations are published.

Reporting requirement regulations.69 The proposed regulations do provide an exception from the reporting

requirements for estates that file Form 706 for the sole purpose of making a portability election under I.R.C.

61 The corresponding regulation is Prop. Treas. Reg. §1.1014-10(b)(1). This means that the basis consistency rule applies to property

that is included in a decedent’s estate under either I.R.C. §2031 or I.R.C. §2106 which triggers a federal estate tax that exceeds

allowable credits (except for the credit for prepayment of estate tax). 62 This regulation requires an appraisal for “household and personal effects articles having marked artistic or intrinsic value of a total

value in excess of $3,000. Thus, the appraisal requirement generally applies to jewelry, furs, silverware, paintings, etchings,

engravings, antiques, books, statuary vases, oriental rugs, coin or stamp collections. 63 Treas. Reg. §1.1014-10(b)(3). Thus, if the estate owes no federal estate tax, the basis consistency rules apply to none of the assets

in the estate. 64 Prop. Treas. Reg. §1.1014-10(a)(2). The estate tax value of the property sets the upper limit on the initial basis of the property

after the decedent’s death. 65 Prop. Treas. Reg. §1.1014-10(c)(3). 66 Prop. Treas. Reg. §1.1014-10(c)(3)(i)(A). 67 Prop. Treas. Reg. §1.1014-10(c)(3)(i)(B). 68 As noted by Steve R. Akers in “Basis Consistency Temporary and Proposed Regulations, March 8, 2016, located at

www.bessemer.com/advisor, this rule could put an estate executor in conflict. The estate will not want to report the newly

discovered asset, but the beneficiary will want the asset reported to get a date-of-death basis. 69 Prop. Treas. Regs. §§1.6035-1 and 2.

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§2010(c)(5), or simply to make a GSTT exemption allocation or election, or to make a protective filing.70

The proposed regulations on the reporting issue generally follow the initial guidance:

• The values to be reported are the “final values” as reported on Form 706 (or as the IRS later determines

then, or as agreed to or determined by a court);71

• For “final values” that later change, the estate must supply a new “final value”;

• Basis reporting for a non-resident, non-citizen decedent applies only to property in the estate that is

subject to federal estate tax;

• If property is subject to non-recourse debt, the basis of the property is its gross value (rather than the

net value that is reported on Form 706);72

• For a decedent’s community property, only the decedent’s one-half of community property is subject

to the basis consistency reporting requirement;73

• Generally, all property reported on Form 706 must be reported on Form 8971. However, exceptions

exist for income in respect of a decedent (IRD) property,74 cash (other than collectible coins and bills)

or property for which an appraisal is not required (personal effects of the decedent, for example),75 or

property that the estate disposed of that triggered capital gain or loss.

• If the executor hasn’t determined the property that will be transferred to each beneficiary as of the

reporting deadline, the executor is to give the beneficiary a list of every asset the beneficiary might

receive;76

• The executor must include a statement concerning any beneficiaries that cannot be located, and

explain efforts undertaken to locate them. A supplemental filing will be required if the property is

ultimately distributed to someone else, just as it is required to be filed within 30 days of the locating

of the previously unascertained beneficiary;77 and

• A supplemental Form 8971 must be filed with the IRS and each beneficiary is to receive a

supplemental Schedule A if previously reported information turns out to be incorrect or incomplete,

unless the erroneous information is merely an inconsequential error or omission.78

Note: Generally, a 30-day rule applies to supplemental returns – 30 days after the final value is determined;

30 days after the executor discovers incomplete or incorrect information; 30 days after a supplemental Form

706 is filed.79

70 Prop. Treas. Reg. §1.6035-1(a)(2). 71 Prop. Treas. Reg. §1.6035-(a)(1) with “final value defined in Prop. Treas. Reg. §1.1014-10(c). This “final value” establishes the

initial basis with the normal post-death basis adjustments remaining available. Once a final value is determined, if it turns out to be

less than the reported value, the recipient of the property so valued cannot rely on the value that was listed in the original statement

and could have a deficiency and underpayment attributable to the difference. Prop. Treas. Reg. §1.1014-10(c)(2). 72 Prop. Treas. Reg. §§1.1014-10(a)(2) and 1.1014-10(e), Example 4. 73 But, both halves of the community property will receive a basis adjustment in accordance with I.R.C. §1014(b)(6). 74 It may not always be the case that IRA funds are not subject to the basis reporting rules. For example, an account could consist of

non-deductible contributions and part of the amounts in the account mat not be IRD. 75 However, works of art or an item or collection of items with an artistic or collectible value exceeding $3,000 as of the date of

death must be reported. 76 Prop. Treas. Reg. §1.6035-1(c)(3). After the bequest is funded, a supplemental Schedule A need not be filed with the IRS or the

beneficiary. 77 Prop. Treas. Reg. §1.6035-1(c)(4). 78 As stated in the Form 8971 instructions, a Form 8971 error that relates to a taxpayer identification number, a beneficiary’s

surname or value of the asset that a beneficiary is receiving is not inconsequential. Likewise, errors on Schedule A to Form 8971

that relate to the value of an asset that a beneficiary receives from an estate or relate to a “significant item in a beneficiary’s address”

are not inconsequential. 79 Prop. Treas. Reg. §1.6035-1(a)(4)(ii). But, the rule is 30 days from the date property is distributed to a beneficiary from a probate

estate or revocable trust if final value is determined before the distribution, or the executor discovers an incorrect or incomplete

65

Contingent beneficiaries. For a contingent beneficiary, the executor’s reporting requirement is triggered

when the contingent beneficiary actually receives the property from the estate.80 Thus, for a life tenant that

is the beneficiary of a life estate, the executor must send Schedule A of Form 8971 to the life tenant and the

remainder holders as the beneficiary of the remainder interest. Also, any change in a beneficiary due to a

contingency must be reported.81

Note: This rule appears to subject an estate executor to a continuing duty to

provide supplemental reports into the future.

Entity beneficiaries. For beneficiaries that are entities, the executor files the basis information (Schedule A

of Form 8971) with “the appropriate” entity representative of a trust or an estate (i.e., the trustee or executor)

or directly with a business entity that is a beneficiary.82

Transfers by beneficiaries. If a beneficiary that receives property (that is subject to a basis reporting

requirement) from an estate later transfers the property to a related party83 and the transferee’s basis is

determined at least partially by the transferor’s basis, the beneficiary that transfers the property must file a

supplemental Schedule A with the IRS and give the transferee a copy that reports the change in ownership and

the final estate tax value of the property.84 The supplemental Form 8971 for such transfers is due within 30

days after the date of the transfer.85 Thus, when a beneficiary subsequently gifts the inherited property, for

example, the basis reporting rule applies and Form 8971 must be filed within 30 days of the transfer.

Note: The position taken in the proposed regulations is contrary to I.R.C. §6035

which imposes the basis reporting requirement solely on the party responsible for

filing Form 706.86

Other scenarios can involve subsequent transfers:

• If the original recipient transfers the property before the estate is required to file a Form 8971, the

original recipient still must file Form 8971 but only need report the change in ownership;87

• Where the basis of the property has changed after being distributed to the beneficiary, the transferor

is to report the original basis as received from the decedent’s estate, and has the option of providing

information on the basis change of the asset while in the transferor’s hands.

• Where a subsequent transfer occurs before a “final value” is set, the transferor is to provide the

executor with a copy of the supplemental statement that is filed with the IRS, and the executor is to

provide any required basis notification statement to the transferee.

information return before the distribution, or a supplemental Form 706 is filed before the distribution. Prop. Treas. Reg. §1.6035-

1(f). 80 Prop. Treas. Reg. §1.6035-1(c)(1). 81 For example, if a remainderman dies before a life tenant, the executor must file a supplemental report with the IRS and the new

remainderman. Id. 82 Prop. Treas. Reg. §1.6035-1(c)(2). Supplemental reporting could be triggered if the entity transfers the asset and the carryover

basis rule applies. 83 A “related party” for this purpose is any member of the transferee’s family as defined in I.R.C. §2704(c)(2), any controlled entity

and any trust of which the transferor is the deemed owner for income tax purposes. That would include a grantor trust as a “related

party,” but not a non-grantor trust. For grantor trusts, it appears that when the trust makes a distribution to a beneficiary, the trustee

need not file a basis information statement with the IRS and beneficiary. 84 Prop. Treas. Reg. §1.6035-1(f). Thus, the rule could apply ad nauseum and would also apply is situations that involve, for

example, a like-kind exchange of the property or an involuntary conversion of the property. 85 There is no specification in the proposed regulations that gifts covered by the present interest annual exclusion are excluded from

the reporting requirement, and there is also no de minimis amount specified that would be exempt from the reporting requirement. 86 See I.R.C. §6035(a)(1). 87 Prop. Treas. Reg. §1.6035-1(f).

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• If an individual beneficiary transfers the property to a grantor trust (a non-taxable event), the transferor

will have to file a basis information statement with the IRS and the trustee of the trust (probably the

transferor). But, a similar requirement does not apply if the transfer is made to a non-grantor trust.

Accuracy-related penalty. An accuracy-related penalty is imposed on taxpayers who report a basis higher

than that reported by the estate on Form 8971 with respect to transactions reported on the taxpayer’s income

tax return.88

Effective Date. The Proposed Regulations are effective only upon publication as final regulations, but can be

relied upon before final regulations are issued. Temp. Treas. Reg. §1.6035-2T specifies that March 31, 2016

is the due date for any basis information statement required to be filed before March 31, 2016. However, as

noted earlier, that deadline has been moved to June 30, 2016.89

Observation. The new basis information reporting rules are designed to deal with the problem of property

being reported for federal estate tax purposes at one value (which establishes the basis of the assets included

in the decedent’s estate), and then having gain reported for tax purposes based on an entirely different income

tax basis. The problem is real. The solution as proposed in the regulations has shortfalls. Hopefully, final

regulations will clean up the problems that the proposed regulations create. In any event, the administration

of many decedents’ estates has become more complicated.

PRACTICAL (POST-2012) ESTATE PLANNING

Moderate Wealth Clients ($5.49 million - $10.98 million (Married Couple); Less Than $5.49 Million

(Single Person). For these individuals, the possibility and fear of estate tax is largely irrelevant. But, there

is a continual need for the guidance of estate planners. The estate planning focus for these individuals should

be on basic estate planning matters. Those basic matters include income tax basis planning, and a focus on

common errors with a plan to avoid them. In addition, for some clients, divorce planning/protection is

necessary. Also, a determination will need to be made as to whether asset control is necessary as well as

creditor protection. Likewise, a consideration may need to be made of the income tax benefits of family

entities to shift income (subject to family partnership rules of I.R.C. §704(e)) and qualifying deductions to the

entity. The entity may have been created for estate and gift tax discount purposes, but now could provide

income tax benefits. In any event, family entities (such as FLPs and LLCs) will continue to be valuable estate

planning tools for many clients in this wealth range.

Most of the moderate wealth clients will likely fare better by not making gifts and retaining the ability to

achieve a basis step-up at death for the heirs. Also, consideration should be made to determine whether

insurance is still necessary to fund any potential estate tax liability It also may be possible to recast insurance

to fund state death taxes and serve investment and retirement needs, minimize current income taxes, etc.

Other estate planning points for moderate wealth clients:

• Trust-owned life insurance. Clients should be cautioned to not cancel policies before it is evaluated.

• Pension-owned life insurance – if the client’s estate is safely below the exemption, the adverse tax

consequences may be avoided.

88 Prop. Treas. Reg. §1.6662-8. 89 Notice 2016-7, 2016-15 I.R.B. 1

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• Evaluate irrevocable trusts.

• For durable powers of attorney, examine the caps on gifted amounts (annual exclusion is now $14,000)

and make sure to not have inflation adjusting references to the annual exclusion.

• For qualified personal residence trusts (QPRTs) that were created when the estate tax exemption was

$2 million, the conventional advice was to deed the house from the QPRT to the children or a

remainder trust (which might have been a grantor trust), with a written lease agreement in favor of the

parent/donor who would continue to live in the house. Now, it may be desired to have the home

included in the estate for basis step-up purposes.

• While FLPs and LLCs may have been created to deal with the I.R.C. §2036 issue, it may not be wise

to simply dismantle them because estate tax is no longer a problem for the client. Indeed, the client

may actually want to trigger the application of I.R.C. §2036 and cause inclusion of the FLP interest

in the parent’s estate. This can be accomplished by revising the partnership or operating agreement

and having the parent document control over the FLP. Then, an I.R.C. §754 election can be made

which can allow the heirs to get a basis step-up.

High Net Worth Clients (or Could Become High Net Worth). A major issue for these individuals is their

state of domicile and whether the state has a decoupled estate tax or not. If the client is middle-aged with a

growing business, or a widow/widower with a $7 million estate and a portable exemption amount from the

pre-deceased spouse, the planning considerations turn on numerous factors. The relatively higher income

taxes (and fewer deductions) on wealthier clients could push such clients to establish domicile/residency in a

state with either no state income taxes or relatively low-income taxes (as well as property taxes). For these

clients, creditor protection is often a major concern. If a small business is involved, business succession and

retirement planning is also important. Common “bypass” trust schemes may no longer appreciate the

complexity of the current transfer tax system which includes the permanency of portability.

Observation. Estate plans that rely simply on portability, the estate of the first spouse to de forfeits the

generation skipping transfer tax exemption. Thus, if grandchildren are part of estate plan and the assets exceed

the applicable exclusion, sole reliance on portability is not estate and GSTT tax optimal.

2014 Farm Bill

A. Farm Bill Provisions.

1. The Agricultural Act of 2014 repealed the following provisions for farmers:

a. Direct payments which had a payment limitation of $40,000 [Sec. 1101]

b. Counter-cyclical payments which had a payment limitation of $65,000 [Sec.

1102]

c. Average crop revenue election (ACRE) program which also had a payment limitation of $65,000 [Sec. 1103].

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2. The new payment limitation for programs used to replace the above listed programs is now $125,000 [Sec. 1603(b)]. Peanut growers are allowed an additional $125,000 payment limit [Sec. 1603 (c)]. Farmers with a spouse enrolled at the local FSA office would get an additional $125,000 payment limitation.

3. These payment limitations are both at the entity level and then at the individual level (up to four levels of ownership). Partnerships and joint-ventures have no limits; rather, the payment limit is calculated at the individual level. Any “limited entity” (corporation, LLC, LP, LLP, LLLP) has one payment limitation. The chart below summarizes how the payment limitations would apply for a partnership or joint-venture versus any type of limited entity.

An example of how the payment limitations are applied where various entities are involved in farming and how the ownership of those entities affect payment limitations follows:

Farm Entity Structure

General Partnership V. LL()

25.00% 25.00% 25.00% 25.00%

General Partnership Totals Owner 1 Owner 2 Owner 3 Owner 4

Total FSA Payment for entity 500,000$

General Partnership 500,000$ 125,000$ 125,000$ 125,000$ 125,000$

Joint venture 500,000$ 125,000$ 125,000$ 125,000$ 125,000$

C corporation 125,000$ 31,250$ 31,250$ 31,250$ 31,250$

S corporation 125,000$ 31,250$ 31,250$ 31,250$ 31,250$

Limited partnership 125,000$ 31,250$ 31,250$ 31,250$ 31,250$

Limited liability company 125,000$ 31,250$ 31,250$ 31,250$ 31,250$

Limited liability partnership 125,000$ 31,250$ 31,250$ 31,250$ 31,250$

Limited limited liability partnership 125,000$ 31,250$ 31,250$ 31,250$ 31,250$

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4. Base Acre Reallocation options – Farmers had a one-time option to update their base acres to reflect the average acres planted to covered crops for the period 2008-2012. They could either retain their current base acres (which in many cases had not been updated for several decades) or reallocate.

5. Payment Yield Update – Farmers also had a one-time option to update their payment yield (only for purpose of calculation Price Loss Coverage payments) to reflect 90% of their average yield for crop years 2009-2012.

6. Price Loss Coverage (PLC) makes a payment based upon the mid-year average price (MYA) versus a reference price. If the MYA price is less than the reference price, then a payment is made. If above the reference price, no payment is made. There is no limitation on the amount of payment other than the overall payment limitations referenced above. Major crop reference prices are as follows:

a. Corn - $3.70 b. Soybeans - $8.40 c. Wheat - $5.50 d. Barley - $4.95 e. Sorghum - $3.90

7. Agricultural Risk Coverage (ARC) would make a payment if the actual farm revenue

for the crop year was less than 86% of the calculated benchmark revenue. Benchmark revenue is equal to the five-year Olympic average (throw out high and low and take average of remaining three) price times Olympic average yield. The maximum payment is equal to 10% of benchmark revenue.

8. Payments are allowed based on 85% of base acres for PLC and ARC at the county

ABC LLC DEF S Corp XYX GP

Ownership %

John 33.33% 50.00% 25.00%

Paul 33.33% 0.00% 50.00%

Jones 33.33% 50.00% 25.00%

Gross payment earned 225,000.00$ 300,000.00$ 150,000.00$

Payment allowed to be allocated 125,000.00$ 125,000.00$ 150,000.00$

Allocation of payment

John 141,667$ 41,667$ 62,500$ 37,500$

Paul 116,666$ 41,666$ -$ 75,000$

Jones 141,667$ 41,667$ 62,500$ 37,500$

Totals 400,000$ 125,000$ 125,000$ 150,000$

John and Jones would have to give up $16,667 each allocated between ABC LLC and DEF S Corp

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level (ARC-CO). Payments for ARC at the individual farm level (ARC-IC) are only allowed on 65% of base acres. The actual planting for each year of the farm bill (2014-2018) is irrelevant for purposes of calculating any payments. It is simply based on the amount of elected base acres.

9. Payments are based upon a marketing year (summer harvested crops such as wheat is June 1 to May 31 and fall harvested crops such as corn and soybeans is September 1 to August 31). Once the MYA price is determined for these crops, payments will be issued by the FSA after October 1 of each year. Due to this delay, there are likely to be very little program payments received by farmers in 2014 since that crop payment will not be received until after October 1, 2015.

PLC Example – Farmer Rob N. Hood elects PLC on 750 base acres of corn. His updated payment yield history is 165 bushels per acre. During the 2014 marketing year, the average price for corn is $3.45. His total PLC payment is calculated by taking his yield (165) times the difference between the reference price (3.70) and actual MYA price $3.45 or $.25 times 750 acres times 85% (payment rate) or $26,297. ARC Example – Farmer Rob N. Hood also elects ARC-CO on 750 acres of corn (these elections are on a farm-by-farm basis and a farmer can have multiple farms). The Olympic average yield for this county is 159 bushels per acre. The Olympic average price for 2009-2013 is $5.29. The actual county yield for 2014 is 165 bushels and the average MYA price is $3.45. Benchmark revenue is calculated by taking the Olympic average yield of 159 times the Olympic average price of $5.29 or $841.11. The maximum payment is 10% of this number or $84.11. Actual county revenue is based upon the yield of 165 times the MYA price of $3.45. This equals $569.25. The difference is $271.86, however, the maximum payment is $84.11, therefore Farmer Hood will receive $84.11 times 750 acres times 85% or $53,620.

10. Dairy producers are allowed to hedge up to 90% of their historical production base by reference to margin based upon the US average All-Milk Price less an average feed cost comprised of the price for three major commodities:

a. Corn b. Soybean Meal c. Alfalfa Hay

The margins that can be covered start at $4 per cwt and go to a maximum of $8 per cwt in 50 cent increments. Premiums for elected coverage levels of 4 million pounds or less have a much lower premium. Minimum elected levels are 25% of historical production which is updated each year by the average growth in milk production (for 2015 about 1%).

B. Adjusted Gross Income Limitations

1. The old farm bill had three levels of AGI limitations

a. For program payments, you first had an average farm income limitation of $750,000,

b. Second, you had an average limitation of non-farm income of $500,000

c. Conservation Reserve Program (CRP) payments had an AGI limitation of $1 million.

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2. The new farm bill has eliminated these three limitations and replaced it with one overall

$900,000 limitation.

3. The average calculation has a one-year delay. Therefore, payments received in 2017 would be based upon the average of AGI for 2013, 2014 and 2015.

4. AGI limitations are placed on both the entity and then the owners of the entity. For example, assume a corporation receives $100,000 of PLC payments during 2017. The AGI of the corporation is $350,000; therefore, it is entitled to the full payment. However, one of the 25% owners of the corporation has average AGI of $1.25 million, therefore, $25,000 of the payment for the corporation is disallowed ($100,000 times 25%).

5. Short-year calculations of average AGI can lead to additional complications. It is our

understanding from the National FSA offices that if an entity changes its year-end, that the average AGI calculations would require the entity to perform those calculations based upon that new elected year-end.

For example, assume a C corporation had an October 31, 2015 year-end and then elects to change to a calendar year-end due to electing S status. This would require the corporation for the calendar year ended December 31, 2016 to compute AGI for the years ended December 31, 2012, 13 and 14 even though the entity did not file any income tax returns for those particular fiscal years. Whole Farm Crop Insurance has similar rules for short-year entities.

7. The FSA manual had a quirk that was fixed in February, 2017 regarding calculation of AGI for S corporations and LLCs taxed as a partnership. A regular C corporation reports AGI based upon bottom line income reported on Page 1 of Form 1120. An S corporation and LLC taxed as a partnership also reports AGI based upon bottom line income reported on page 1 of the respective income tax form. Previously, this resulted in the AGI calculations not incorporating any income or deductions listed on Schedule K. Therefore, since the Section 179 has been as high as $500,000 (indexed for inflation) for the last few years, many farmers may get a letter from the FSA indicating their AGI limits have been exceeded and program payments must be refunded back to the FSA.

As an example, assume the Pioneer Farm Corporation (an S corporation) received $125,000 of payments during 2015. The base years for calculating average AGI are 2011, 12 and 13. Each year, the corporation reported $1 million of net income on Page 1 of Form 1120S and flowed through a Section 179 deduction of $500,000 on Schedule K. Almost all CPAs and accountants would treat this entities AGI as $500,000, however, FSA had treated AGI as $1 million and require the payment of $125,000 to be refunded.

8. FSA updated their manuals in February 2017 to allow Section 179 to be deducted in all situations. Any new AGI calculations should deduct Section 179 for all entities. However, if previous payments were disallowed due strictly to Section 179, you may want to touch base with the local FSA office to determine if they can be reissued. The guidance on this is conflicting among local offices.

9. A spreadsheet for determining AGI limitations for 2014 (you can update to reflect year of

calculation) is provided at the end of this section. Remember with married couples, these calculations are determined at the individual level, of if filing a joint return, you will

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need to allocate income to the farmer and his/her spouse if both are enrolled with FSA.

C. FSA Entity Planning Strategies

1. For smaller producers, the selection of an entity for FSA purposes will likely not matter. With a $125,000 limitation, most farmers would need to farm at least 3-4,000 acres of corn, soybeans or other similar crops. Therefore, it is highly unlikely that the single payment limitation for smaller producers will come into play.

2. For medium size and larger producers, care must be taken. In these cases, a structure incorporating some type of partnership or joint-venture is likely needed. To provide additional creditor protection a partnership comprised of single-member LLCs may be the best option. Setting up a structure that is best for income and SE tax purposes to save perhaps $15,000 in SE tax that potentially costs the farm operation $375,000 of program payments may not be the best overall solution.

3. Additionally, for larger operations that have several commodities and use Whole Farm

Crop Insurance, having multiple entities may enhance their risk coverage. That topic is beyond the scope of this seminar.

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2010 2011 2012

Average AGI Limitations Worksheet Per Tax Per Tax Per Tax

Return Return Return

Form 1040; AGI equals Form 1040, Line 37

Wages - - -

Interest income - - -

Dividend income - - -

Schedule C - - -

Schedule D--nonfarm - - -

Other gains, Form 4797 - - -

Pensions, annuities - - -

Schedule E, page 1 - - -

Schedule F - - -

K-1 ordinary - - -

- - -

Social security - - -

Other income - - -

NOL - - -

HSA - - -

1/2 SE tax - - -

Retirement plans - - -

SE health insurance - - -

IRA - - -

DPAD - - -

Other adjustments - - -

Form 1040, Line 37 - - -

Calculations Section

Average Adjusted Gross Income -

If the result of Step A is greater than $900,000,

the participant is ineligible for 2014 program payments no

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SALE OF A DECEDENT’S PERSONAL RESIDENCE

Upon death, an executor may face the need to dispose of a decedent’s personal residence. The starting point

is to determine the basis of the residence under the IRS standard: FMV as of the date of the decedent’s death

under the willing buyer-willing seller test. The FMV is determined based largely on sales of comparable

properties and requires more than a simple market analysis by a real estate agent.

If the decedent was the first spouse to die, a determination of how the residence was titled at death must be

made. For a residence held in joint tenancy or tenancy in common, only the value of the decedent’s share of

the residence is included in the decedent’s estate and receives a basis step-up to FMV under IRC §1014.

For joint tenancies involving only spouses, the property is treated at the death of the first spouse as belonging

50% to each spouse for federal estate tax purposes.90 This is known as the “fractional share” rule. Thus, half

of the value is taxed at the death of the first spouse and half receives a new income tax basis. However, in

1992, the Sixth Circuit Court of Appeals applied the consideration-furnished rule to a husband-wife joint

tenancy who included the entire value of land in the estate of the first spouse to die.91 The full value was

subject to federal estate tax but was covered by the 100% federal estate tax marital deduction. The entire

property received a new income tax basis, which was the objective of the surviving spouse. Other federal

courts have reached the same conclusion.

If the residence is community property, the decedent’s entire interest receives a basis step-up to FMV. If the

residence is held in joint tenancy with rights of survivorship, the decedent’s interest is passed by the

survivorship designation to the designated survivor.

Observation. If a surviving spouse sells the marital home shortly after the first spouse’s

death, the survivor often realizes a loss largely due to the expenses incurred from the sale. If

the survivor realizes a gain, the survivor is eligible for the $250,000 exclusion of gain under

IRC §121. That exclusion is a maximum of $500,000 if the sale occurs within two years of

the first spouse’s death.

RESIDENCE HELD IN REVOCABLE TRUST

A revocable trust is a common estate-planning tool. A decedent’s personal residence held in a revocable trust

and passed to a surviving spouse upon the first spouse’s death under the terms of the trust continues to be

held in a trust. The house receives a full step-up (or down) in basis to the current FMV at the death of the

surviving spouse. If a house is distributed outright to a beneficiary and the beneficiary immediately sells the

home, any loss is generally a nondeductible personal loss unless the home is first converted to a rental property

before it is sold.

RESIDENCE SOLD BY ESTATE OR TRUST

If the residence must be sold by the estate or trust to pay debts or to satisfy cash distributions to beneficiaries,

any loss on the sale might be deductible. That loss could potentially offset other income of the trust or estate,

or it could flow through to the beneficiaries. However, the IRS’s position is that an estate or a trust cannot

claim such a loss unless the residence is a rental property or is converted to a rental property before it is sold.

This position has not been widely supported by the courts, which have determined that a trust or estate can

claim such a loss if no beneficiaries use the home as a residence after the decedent’s death and before it is

sold.

90 IRC §2040(b).

91 Gallenstein v. U.S., 975 F.2d 286 (6th Cir. 1992).

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The “Structure” Question and Self-Employment Tax

A. Background.

1. All states have adopted the Limited Liability Partnership (LLP) and Limited Liability Company (LLC) forms of entity. All states allow family farms or small farming entities to utilize these forms of business structure (but beware of the specific definitions within various state statutes that may restrict the use of limited liability entities to certain family farm and other non-investor farming arrangements).

2. Single member entities.

a. Under the entity classification regulations, a single member domestic entity, owned by an individual, that does not elect to be taxed as a corporation is treated as a proprietorship, and its separate existence is disregarded for income tax purposes [Reg. 301.7701-3(b)]. In the case of an LLC owned by a single corporation or partnership, the entity is treated as a branch or division of the owner.

b. If a pass-through entity has two or more owners, the default classification is to treat the entity as a partnership.

3. Business income allocated to general partners of a partnership is generally subject to SE tax, even if flowing to a partner who does not participate in operations [Reg. 1.1402(a)-2(g)].

4. With respect to the imposition of self-employment tax, the Internal Revenue Code only addresses the classic limited partnership, in which there is both a general partnership interest and a limited partnership interest.

a. A general partner receives pass-through self-employment income [Sec. 1402(a)].

b. A limited partner is exempt from SE tax on limited partner earnings [Sec. 1402(a)(13)].

c. These provisions, enacted in 1977, were clarified by Committee Report language holding that a limited partner would be exempt from SE tax, but general partners would continue to be covered [Comm. Rpt., P.L. 95-216, 1977].

5. The IRS issued several drafts of proposed regulations in the mid-1990s, to address the SE tax as it applied to LLP and LLC holders.

a. The most recent draft consisted of various amendments to Reg. 1.1402(a)-2, issued as REG-209824-96 of 1/13/97.

b. These regulations were somewhat controversial, and Congress briefly entered the discussion by declaring a moratorium from 1997 through June 30, 1998. This moratorium prohibited any regulations relating to the definition of a limited partner for SE tax purposes from becoming final before July 1, 1998 [Conf. Comm. Rpt., P.L. 105-34, 1997].

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c. Following the expiration of that moratorium, there has been no further guidance from either Congress or the IRS. Accordingly, the early 1997 proposed regulations represent the latest authority on when income flowing out of an LLC or LLP should be considered as SE income.

B. Analysis of IRS proposed regulations.

1. Guaranteed payments.

a. To the extent a limited liability holder (either an LLC member or an LLP partner) receives a guaranteed payment for services, the law is clear that this payment is subject to self-employment (“SE”) tax [Sec. 1402(a)(13); Prop. Reg. 1.1402(a)-2(g)].

b. Guaranteed payments for services or capital would always appear to be subject to SE tax, even if paid to an individual holding a limited liability interest.

2. The proposed regulations hold that a limited liability partner is subject to SE tax under any one of three situations:

a. The individual has personal liability for the debts of or claims against the partnership by reason of being a partner or member;

b. The individual has authority under the state statute under which the partnership is formed to contract on behalf of the partnership (i.e., the individual has management authority); or

c. The individual participated in the entity’s trade or business for more than 500 hours during the entity’s taxable year [Prop. Reg. 1.1402(a)-2(h)(2)].

d. Commentary: The first two of these three criteria impose SE treatment for attributes that historically tie to general partner status rather than limited partner status, and thus appear to have reasonable foundation. The third criteria of the proposed regulations (the 500 hour involvement test) is the one aspect that lacks any prior underpinnings in the law.

3. In addition, owners of service entities are subject to SE tax [Prop. Reg. 1.1402(a)-2(h)(5)].

a. The proposed regulations take the position that a service member in a service limited liability entity is always subject to SE tax, regardless of the class of ownership interest.

b. A service member is one who provides other than de minimis services to the entity (with no definition of hours or other clarification in the regulations).

c. A service entity is one engaged in the standard professional service fields (health, law, engineering, architecture, accounting, actuarial science, or consulting). Thus, the IRS position is that a service entity cannot shield its active members from SE tax by use of a limited liability entity which operated under partnership tax status. A farming management consulting or management services entity would face these rules.

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d. Commentary: To provide a shield from SE tax on pass-through income from a consulting or service entity, an S corporation would be necessary.

4. Commentary: If all partners have full and equal management authority, the same as if they were general partners, it is difficult to argue that the LLC or LLP designation under state law somehow converted those members to the equivalent of true limited partners for SE tax protection.

C. Entity structuring opportunities to reduce exposure to SE tax.

1. Use of a manager-managed LLC with two classes of membership provides SE tax savings to the non-managing members.

a. A manager-managed LLC may provide separate classes of membership for managers (who have the authority to bind the LLC under contract) and non-managers (who have no such authority).

1) Both classes would default to provide limited liability protection to the members in their capacity as members.

2) Personal guarantees, making certain debts recourse to the member, do not violate the provision stated above with regard to personal liability, because such exposure is not due to the status of being a member.

b. Non-managers who do not meet the 500 hour involvement test are not subject to SE tax, except to the extent of guaranteed payments received.

c. Non-managers who exceed the 500 hour test are not subject to SE tax if:

1) Non-managers own a “substantial continuing interest” in the class of interest; and

2) The individual’s rights and obligations with respect to that class are identical to the rights and obligations of that specific class held by persons who satisfy the general definition of “limited partner” (i.e., non-manager, less than 500 hours).

d. Commentary: Managers are subject to SE tax on income from that interest. If there are non-managers who spend less than 500 hours with the LLC and such members own at least 20% of the interests in the LLC, those non-managers who spend more than 500 hours are not subject to SE tax on the pass-through income, but are subject to SE tax on the guaranteed payments [Prop. Reg. 1.1402(a)-2(h)(4)].

2. Use of the manager-managed LLC form, with the taxpayer holding both manager and non-manager interests that may be bifurcated.

a. Individuals with non-manager interests who spend less than 500 hours with the LLC must own at least 20% of the LLC interests.

b. The taxpayer owns a class of non-manager interests identical to those held by the other non-managers and also owns a manager interest.

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c. Observation: This exception allows the individual who holds both manager and nonmanager interests to be exempt from SE tax on the nonmanager interest [Prop. Reg. 1.1402(a)-2(h)(3)]. The taxpayer is subject to SE tax on the pass-through income and guaranteed payment of the manager interest.

3. Use of the investment form of operation.

a. All of the interests of the LLC may be owned by nonmanagers, naming a third party non-owner as the manager.

b. Some or all of the investors may work for the third-party manager.

1) The manager may be a corporation (S or C) owned in part or in full by the investors in the LLC.

2) A reasonable management fee is paid to the manager.

3) Reasonable compensation is paid by the manager to those providing services to the manager in furtherance of the LLC’s business activities.

c. No SE tax is allocated to the owners of the LLC, in that none of the owners are providing services to the LLC. They provide services to the manager.

4. Other structuring concepts.

a. The manager is provided a 1% manager interest, for which guaranteed payments are provided for services rendered.

1) Non-managers working less than 500 hours are subject to SE tax only on guaranteed payments.

2) Non-managers working more than 500 hours are subject to SE tax only on guaranteed payments if the non-managers who work less than 500 hours make up at least 20% of the membership.

Example 1 Bifurcation of interests

Beanstalk LLC is an operating farm owned by Jack and Jill, who are married to each other. Jill is not active in the

farming operation but is an equal owner. Because Jill does not work more than 500 hours in the farm and she

holds at least 20% of the ownership, Jack’s membership interest could be structured as manager and non-

manager units. Jack is provided a 2% manager interest for which he will also receive guaranteed payments,

reasonable for the labor and management provided to the LLC. This interest will be subject to SE tax, as will

guaranteed payments received by Jack for his services. Jack and Jill will each own 49% non-manager interests.

Result: The bottom-line income of the LLC will be shared pro rata according to these percentages, with the 98%

non-manager interests exempt from SE tax.

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b. The manager is provided a larger interest in the LLC. This larger interest provides the reward to the manager for the services rendered to the LLC, without requiring a guaranteed payment.

1) In this scenario, managers and non-managers own interests commensurate with their investment (these are non-manager interests), with the managers also receiving manager interests as reward for their services.

2) The managers recognize SE income on the pass-through income associated with the manager interests.

3) All non-manager interests are not subject to SE tax, except to the extent of guaranteed payments.

Example 2 Profits interest provided to manager

Hansel and Gretel own and operate Gingerbread LLC, a dryland wheat farm. Although they own everything 50-

50, Gretel operates the farm; Hansel is a full-time house builder. He devotes minimal time to the farming

operation. In structuring the LLC ownership, they determine that Gretel should receive a 40% profits interest for

her management and labor provided to the farm. Remaining profits will be split 50-50 between the owners;

Gretel and Hansel each received 30% non-manager interests in the LLC for the contribution of equipment and

other tangible assets to the LLC. No guaranteed payments will be paid, as the members determined that the

profits interest represents reasonable compensation for the labor and management provided.

Result: 40% of the bottom line of the LLC will be subject to SE tax for Gretel’s profits interest as manager. Because

Hansel, who is not active in the LLC, owns at least 20% of the LLC interests, the non-manager interests are not

subject to SE tax.

c. The above two exceptions allow the LLC member to receive a return on investment in the LLC without being subject to SE tax, and to be subject to SE tax for services rendered to the LLC.

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5. Summary.

a. The LLC has potential for limiting SE pass-through income, as an LLC can generally be drafted in a manner where some members have management/SE status and others do not. There are at least three ways (and many permutations) in which SE tax savings may be structured. All require manager-managed LLC status under state law.

b. This separation of management authority is not available in most states with respect to the LLP.

c. While the proposed regulations remain controversial and met resistance from Congress, they do represent the latest authority on when income flowing out of an LLC or LLP should be considered as SE income. Caution should be exercised in taking a position inconsistent with these regulations.

D. NIIT application to Manager-Managed LLCs

1. A non-manager’s interest in a manager managed LLC is normally considered passive and thus is subject to the net investment income tax (“NIIT”) [1411(c)(2)(A)].

a. However, a spouse may take into account the material participation of a spouse who is the manager [469(h)(5)].

b. Thus, if the manager spouse has material participation, then all non-manager interest(s) owned by both spouses will not be subject to NIIT.

2. Commentary: Careful structuring of the manager managed LLC may allow for minimal SE tax and the elimination of all NIIT on the income of the LLC operations. This structure can produce a better tax result than use of an S corporation with land rental income.

Example 3 Use of LLC to minimize SE and NIIT

Ricky farms and owns 2,000 acres as a sole proprietor. This farm usually generates about $500,000 of net income and his resulting SE tax is about $30,000 each year.

If Ricky formed an S corporation and cash rented the land to the corporation for $400,000, and took a salary of $75,000, then his net payroll tax cost would be about $11,000. This is a reduction in SE tax of about $19,000 compared to proprietorship status. However, starting in 2013, at least $250,000 of his cash rent income would be subject to NIIT at an annual cost of about $9,500.

Ricky and Lucy, his spouse, decide to create a manager managed LLC to own the farm operation and land. Ricky will have a 2% manager’s interest and a 49% non-manager’s interest and Lucy will own a 49% non-manager’s interest. The LLC will pay Ricky a guaranteed payment sufficient to net him $75,000 subject to SE

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tax and the remainder of the LLC income will flow to Ricky and Lucy without any SE tax burden. Additionally, all of his and Lucy’s non-manager interest is exempt from NIIT because this income is not considered passive due to his material participation as a manager.

Therefore, Ricky and Lucy have reduced their SE tax burden from approximately $30,000 to $11,000 and eliminated the NIIT tax burden of $9,500.

E. Husband-wife partnership reportable as proprietorships.

1. An elected qualified joint venture (“QJV”) is not treated as a partnership. Instead, each spouse reports a share of the income or loss as a sole proprietorship, subject to SE tax [Sec. 761(f)].

2. A QJV involves the conduct of a trade or business if:

a. The only members of the joint venture are a husband and wife who file a joint return;

b. Both spouses materially participate in the business (within the meaning of the Section 469 passive activity rules, but considering each spouse independently); and

c. Both spouses elect the application of the QJV rule.

3. Commentary: This provision has the advantage of allowing a husband-wife co-owned entity to avoid the separate filing of a partnership return. However, the requirement that both spouses must materially participate separately in the business may significantly restrict its utilization.

4. IRS guidance on QJV election.

a. IRS guidance indicates that the QJV election is made by each spouse reporting the respective interests in the joint venture on a separate Schedule F, with each spouse also reporting a respective net income share on Schedule SE.

1) Once elected, the QJV status can only be revoked with IRS permission as long as the spouses meet the requirements for the election.

2) Separate employer identification numbers (“EIN”) are not required unless otherwise required for excise, employment, etc. taxes. Either spouse may report and pay employment taxes due on the wages of employees using the EIN from that spouse’s sole proprietorship.

3) If the spouses had been filing a partnership, the partnership’s EIN may not be used by either spouse.

b. Commentary: There does not seem to be any requirement that the income and deduction items be split 50%-50% between each spouse. Rather, the IRS instructions suggest that the split is “in accordance with your respective interests in the venture.”

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c. The IRS instructions for Schedule E state if the spouses are the only members of a jointly owned and operated rental real estate business and they file a joint return, they may elect QJV treatment.

1) The mere joint ownership of property that is not a trade or business does not qualify for the QJV election. In such case, a partnership return is also not required.

2) Rental real estate income is generally not SE income and generally is subject to passive loss limitations.

3) Electing QJV status does not alter the application of SE tax or passive loss limitation rules [IRS Schedule E instructions].

d. Warning: In guidance on its website, the IRS states that the QJV election is not allowed for a business owned and operated by spouses through a limited liability company (LLC) or other state law entity (such as a general or limited partnership or LLP). This guidance would require a husband-wife LLC or partnership to file a Form 1065. However, Rev. Proc. 84-35 exempts partnerships with 10 or fewer individual partners from the penalty for failure to file a partnership return if all income has been properly reported in the individual returns of the partners (based upon Sec. 6231(a)(1)(B)).

e. Commentary: The QJV election has no affect on an entity owned exclusively by a husband and wife in a community property state. Under Rev. Proc. 2002-69, a husband-wife owned entity in a community property state may be treated either as a proprietorship or partnership.

Farm Corporations: Tax-Free Formation Issues

A. The basics of a tax-free incorporation.

1. To accomplish a tax-free transfer of assets into a corporation in exchange for stock, three conditions are imposed by Section 351:

a. The incorporator transfers property into the corporation (as opposed to receiving stock for past or future services);

b. The corporation issues solely stock to the incorporator (not debt instruments or bonds); and

c. The incorporators (i.e., collectively those who transferred property) are in control of the corporation immediately after the transfer, with control defined as at least 80% of the voting stock and at least 80% of all classes of stock.

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2. Section 351 is not an elective statute. Rather, tax-free status occurs by meeting the three conditions of the statute as summarized above. As a result of meeting Section 351:

a. The basis of assets in the hands of the incorporator carries over to the transferee corporation [Sec. 362].

b. The holding period of property carries over from the incorporator to the corporation [Sec. 1223(2)].

c. The basis of the stock received by the incorporator is the adjusted tax basis of the properties transferred to the corporation [Sec. 358]. The adjusted tax basis of properties transferred to the corporation is reduced by liabilities of the incorporator transferred to or assumed by the corporation.

d. The holding period of the incorporator’s stock is determined by reference to the holding period of the assets transferred to the corporation [Sec. 1223(1)].

e. Caution: Inventory and other non-capital assets do not qualify for the “tacking on” of the holding period. Accordingly, to qualify for long-term capital gain upon the sale of stock, the incorporator in a typical farm incorporation will need to hold the stock at least 12 months [Rev. Rul. 62-140].

B. Transfer of liabilities to a corporation upon formation.

1. In general, the transfer of liabilities to a corporation in connection with the transfer of property under Section 351 does not result in gain recognition to the incorporator [Sec. 357(a)].

2. If the corporation assumes liabilities of an incorporator that are in excess of the adjusted tax basis of the assets transferred by that incorporator, the excess is recognized as taxable gain to the incorporator [Sec. 357(c)].

a. This test is applied per incorporator.

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b. The computation is made by aggregating the adjusted tax basis of all assets against all liabilities from the incorporator.

c. Liabilities for this purpose do not include those that give rise to a deduction when paid. Thus, accrued expenses of a cash method incorporator are not considered liabilities for purposes of the excess liability problem [Sec. 357(c)(3)].

d. According to the IRS, transferring a personal promissory note to the corporation does not provide an incorporator with additional basis [Rev. Rul. 68-629].

1) The courts have been mixed on the issue of whether a taxpayer’s note may provide basis in an incorporation.

a) In Alderman (55 TC 662, 1971), the Tax Court determined that a taxpayer’s note, given to a corporation to provide basis, in fact had a basis of zero. The note was not considered to increase the basis of assets for purposes of Sec. 357(c).

b) However, a 1989 Second Circuit decision reversed a Tax Court opinion, and held that a transferring shareholder’s personal note should be considered to have basis for this purpose [Lessinger v. Comm., 872 F2d 519, CA-2, 1989, 89-1 USTC 9254].

2) A more recent decision in the Ninth Circuit, also reversing the Tax Court, concluded that a note contributed to a corporation had basis.

a) In Peracchi, the Ninth Circuit observed that the note was enforceable by the corporation, and that the note was likely to be enforced or called by either the corporation or its creditors, due to the lack of capital within the corporate entity [Peracchi v. Comm., 143 F3d 487, CA-9, 1998, 98-1 USTC 50,274].

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e. When gain is triggered under the excess liability rule, it represents phantom income in the sense that no cash has been generated by the taxpayer to help pay the tax. The taxable event has been triggered simply by the transfer of business assets to a new entity subject to debt greater than basis.

f. When a farm incorporation is involved in an excess liability problem, many of the assets transferred by the incorporators produce ordinary income rather than favorable capital gain. The character of the income is determined as if the assets transferred were sold.

g. It is imperative that before entering into an incorporation transaction involving a cash method farmer, any liabilities to be transferred to the corporation must be carefully compared with the adjusted tax basis of the assets transferred by each incorporator. Many very profitable farming proprietorships, for tax deferral reasons, have incurred operating loans to allow prepaid expenses to reduce proprietor (or partnership) income. When an attempt is made to incorporate, the liabilities often exceed the adjusted tax basis of the assets.

C. Section 357(d) debt assumption rules.

1. Nonrecourse debts of the proprietor associated with assets transferred to the corporation are assumed to be transferred to the corporation unless the transferor holds other assets subject to the debt, these other assets are not transferred to the corporation, and the transferor agrees to be subject to the debt.

2. A recourse liability is treated as having been assumed if the corporation has agreed to, and is expected to, satisfy the liability, whether or not the transferor has been relieved of the liability.

a. If the corporation does not agree to satisfy the liability, and in fact does not satisfy the liability, the recourse debt is not treated as having been transferred to the corporation. Permission of the lender is not required.

b. Commentary: The parties (corporation and proprietor) should agree in the corporate documents which debts of the transferor are being assumed and disclose such assumption in the Section 351 statement to be attached to the parties’ tax returns.

3. To the extent debt is retained by the transferor (proprietor), cash flow to the transferor in the form of wages, dividends, rents on real property held outside the corporation, etc. will be needed to service the debt.

D. Tax avoidance liability assumption.

1. If the assumption of liabilities during incorporation has a purpose to avoid federal income tax or lacks a bona fide business purpose, then the liabilities assumed by the corporation are treated as boot paid to the incorporator [Sec. 357(b)].

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2. Liabilities created shortly before incorporation and transferred to the corporation will face IRS scrutiny [Weaver, 32 TC 411, 1959; Thompson v. Campbell, 64-2 USTC 9659].

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3. A farm proprietor who borrowed from a bank for personal purposes shortly before incorporation, and then transferred the bank debt to the corporation at formation, was treated as receiving boot under Sec. 351(b) [John M. Harrison, TC Memo 1982-211].

E. Farm incorporation case study.

1. Case study facts.

a. Your client is Terry Treflan, age 55, and his wife is Tina. Terry has been operating as a farm proprietor, but it has been continuously more difficult to control his Form 1040 income each year. The Treflan’s son, Tim, has been back in the family farming business, employed by his father, for about six years. Terry has indicated that it is time to begin a transition of his farm operation to Tim, but he is confused about the best method for bringing Tim into ownership and accomplishing a transition plan. Terry and Tina have three other children, all of whom are employed off the farm and will have no future involvement in the family farm business.

Terry and Tina’s net worth statement contains the following assets and liabilities:

ATB FMV

Cash and investments $ 150,000 $ 150,000 Farm inventory – 500,000 Machinery and equipment 200,000 600,000 Real estate: Farmland and buildings and residence 800,000 3,000,000

Total Assets $ 1,150,000 $ 4,250,000

Debt: Operating (250,000)

Real estate (600,000)

Net Worth $ 3,400,000

2. Issue 1: What assets would be moved into the corporation and what tax issues might be involved with this decision?

a. Sec. 357(c) excess liabilities.

ATB

FMV

Inventory $ – $ 500,000 M&E 200,000 600,000 Operating Debt (250,000) (250,000)

$ (50,000) $ 850,000

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b. Possible solutions to $50,000 excess liability problem.

1) Add cash or other assets with basis of at least $50,000.

2) Hold back $50,000 of operating debt in accordance with Sec. 357(d), to be retired personally (but recognize that this will require additional compensation or other income out of the corporation to service the debt retained personally).

3) Add cooperative patronage equity that has basis, but is a deferred asset in terms of cash flow and current value.

3. Issue 2: Discuss various strategies for dealing with the family residence, assuming the farming operation is to be incorporated.

a. Transfer residence to the corporation?

1) The residence becomes fully depreciable and operating expenses of the household are deductible if Section 119 employer-provided lodging has sufficient business purpose.

2) Consider severing the residence from the land, so that no farmland is placed within the corporation.

a) Inquire as to the legal possibility of creating a long-term ground lease for the land under the house, severing the dwelling from the ground for legal purposes in the transfer to the corporation.

b) Local zoning ordinances may prevent legal title to be transferred.

c) At the end of the ground lease term, the dwelling transfers out of the corporation tax-free under Sec. 109.

d) The ground lease should be of sufficient term for the corporation to receive the benefit of its investment.

e) Continued ownership for at least two years after the termination of the lease and ownership by the individual should satisfy the Section 121 requirements (but see the discussion later in this topic).

b. Transfer building site and house to corporation.

1) Caution: Ownership of the residence by the corporation prevents later use of the Section 121 personal residence gain exclusion.

2) Distributing appreciated land and residence will trigger corporate gain, resulting

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in double tax.

c. Lease residence to the corporation?

2) Additional source of non-SE income for the shareholder from the corporation.

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1) Section 121 exclusion partially available in future if the house is converted to personal use more than 24 months prior to sale. But the ratio of time of nonqualified (business) use of the residence on or after January 1, 2009 to the time of total ownership is not eligible for the Section 121 exclusion [Sec. 121(b)(5)].

2) Deductions other than interest and taxes are not permitted against the rental income (rental of residence to employer for use by employee) [Sec. 280A(c)(6)].

3) Rent income would be nonpassive (self-rental regulation) and not subject to net investment income tax [Sec. 1411].

4) Personally-owned residence allows deductible interest on home equity loans up to $100,000.

d. Construct new house in the corporation.

1) Lease the underlying ground to the corporation under a long-term lease (perhaps exceeding the 20-year cost recovery period for farm buildings).

2) Corporation constructs the house.

3) For the adventuresome, if completed by the end of 2020, the residence should qualify for 50% bonus depreciation.

4. Issue 3: Assets for nonfarming children?

a. Segregate assets that can be converted to cash or to a stream of income for nonfarm children.

1) Parents retain land; lease to corporation.

a) Later sell land to successor son?

b) Transfer land into FLP and give limited units to non-farm heirs.

2) Make annual discounted gifts of stock to successor until Terry and Tina’s ownership has been reduced to a percentage that reflects their desires as to the discounted purchase price for Tim, and then sell or redeem the balance of the stock.

3) Example: Terry and Tina decide that the farm corporation, containing operating assets (inventory, equipment and related debt) with a net value of $850,000, should be sold to Terry for no more than $500,000. As this target

represents about 60% of the total market value, Terry and Tina will make gifts of

stock to Tim that represent about $350,000 in value, or about 40% of the stock,

before entering into a stock sale transaction for 60% of the stock for

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$500,000.

b. Additional points.

1) Control of farming operation (not necessarily ownership of farmland) should be the primary objective with successor son.

2) While parents’ assets today are virtually all invested in the farm, forming the corporation and accomplishing a stock redemption at their retirement will convert part of their equity to non-farm investments.

3) Successor son generally will acquire the active operation/corporation first, and only secondly move to purchase the land from parents or a family limited partnership. The successor son may need to be educated on the point that access to the land is more important than direct ownership. From a cash flow standpoint, land can generally be leased at about 5% of market value, while debt retirement generally requires cash flow of 10%-12% of FMV.

Ownership Transition Strategies

A. Using a corporate stock redemption to retire the stock of senior generation.

1. Retirement of proprietor/partner vs. corporate shareholder.

a. In an unincorporated farming business, the retiring owner faces harsh tax consequences upon sale. Raised inventory such as grain and livestock and depreciable property (other than 20 year life general purpose farm buildings) are all subject to ordinary income recognition. Any Section 1245 depreciation recapture is ineligible for installment method reporting.

b. Conversely, in an incorporated farming operation, the sale of stock produces favorable 15%/20% capital gain reporting combined with installment method deferral.

c. From the younger generation/buyer’s standpoint, the purchase of assets directly from a proprietor or the purchase of a partnership interest with a Section 743/Section 754 basis step-up election provides increased tax deductions. However, the basis allocable to depreciable property results in deferred deductions, whereas the seller must recognize gain immediately due to Section 1245 depreciation recapture.

d. The seller of corporate stock receives capital gain treatment, whether via direct sale to the producer or via a stock redemption. But a stock redemption is also advantageous to the junior generation/successor due to the ability to fund the nondeductible stock acquisition with tax efficient corporate earnings (i.e., earnings generated by the corporation at the low 15% corporate rate).

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2. Advantages of corporate stock redemption.

a. Provides a mechanism for removal of the after-tax wealth accumulation that the corporation has built up using the 15% rates, or will build up in the future using the 15% rates if an installment redemption payout is used.

b. Allows full tax deductibility of the interest expense within the corporation (vs. potential investment interest expense limit under Sec. 163(d) if a junior shareholder individually purchases stock).

c. Avoids the extra payroll tax burden that would occur if the junior shareholder withdrew compensation in order to personally acquire the stock from the senior shareholder.

3. Potential disadvantages of corporate stock redemption.

a. Junior shareholder does not receive an increase in stock basis, even though a significant gain may have been reported by the senior shareholder as a result of the redemption.

b. The senior shareholder's stock must be completely redeemed to achieve capital gain status and installment treatment under Sec. 302(b)(3). This locks in a total value to the senior shareholder at the point of retirement (vs. gradual sales of incremental blocks of stock at increasing values).

c. As a condition of accomplishing a complete redemption in a family corporation, the senior shareholder must waive the family attribution rules by agreeing to have no involvement in the corporation as a consultant, employee, or director for a 10-year duration. This prevents consulting salaries or director fees during retirement years.

d. Commentary: The enactment in the 2003 Tax Act of a 15% top individual tax rate on dividend income has eliminated much of the risk of a corporate stock redemption failing to qualify for capital gain status. If a stock redemption fails the Sec. 302(b) “sale or exchange” test, it is recharacterized as a dividend. In view of the fact that the dividend tax rate is now the same as the capital gain tax rate, the major detriment to dividend status is the inability to use the stockholder’s basis as an offset in calculating the gain, and also the inability to qualify for Section 453 installment sale treatment.

4. Mechanics of a complete stock redemption [Sec. 302(b)(3)].

a. In order to achieve capital gain sale treatment upon the redemption of the senior shareholder, the shareholder must surrender all stock in a complete redemption, although this surrender may be in exchange for an installment note payable over a period of years.

b. If the remaining shareholders are related to the departing shareholder under the family attribution rules, the "complete termination" rule can only be met if the departing shareholder is able to meet the criteria for waiver of family attribution:

1) The redeemed shareholder may not have an interest in the corporation after the

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redemption, other than as a landlord and as a creditor. As a result, the redeemed shareholder may not be an officer, employee, director, or consultant to the corporation, nor receive employee fringe benefits. Specifically, the IRS has ruled that a post-redemption consulting arrangement is a prohibited interest [Rev. Rul. 70-104]. But in Lynch v. Comm. [83 TC 597, 1984], the Tax Court held that occasional consulting services and continuation of medical insurance benefits did not cause a family corporation redemption to be treated as a dividend.

2) Caution: The IRS, in a private ruling, indicated that it had located no authority addressing whether a redeemed shareholder seeking to waive family attribution may continue to receive fringe benefits from the corporation following the redemption [FSA 200203021]. However, this FSA did not identify the Lynch decision as an authority addressing this issue. The Tax Court opinion in Lynch was reversed at the Ninth Circuit, but the reversal related to a continuing consulting arrangement by Lynch; there was no appellate court commentary on the lower court’s interpretation of the fringe benefit question.

3) The redeemed shareholder may not acquire any interest in the corporation, other than by bequest or inheritance, within 10 years from the date of the stock redemption.

4) The redeemed shareholder must attach an agreement to the tax return, consenting to notify the IRS of any acquisition of a prohibited interest in the corporation within the 10-year period subsequent to the redemption [Sec. 302(c)(2)].

5. Complete redemption and spousal health insurance fringe benefit.

a. The Tax Court approved capital gain treatment and installment method reporting for the shareholder of a closely-held corporation whose stock was completely redeemed, even though the redeemed shareholder’s spouse continued to be employed by the company and continued to receive employer-provided family medical insurance coverage [Richard E. and Mary Ann Hurst v. Comm., 124 TC No. 2, 2/3/2005].

b. The IRS argued that the redeemed shareholder and his spouse had retained prohibited interests in the corporation through her continued employment and medical benefits, through the lease of the real estate to the corporation, and through a series of collateralization agreements to assure payment on the stock installment note, the employment contract and the lease. However, the court found that the landlord relationship and the collateralization agreements were not prohibited relationships, particularly in view of the fact that the collateralization agreements and lease terms were comparable to arrangements between unrelated parties. Further, the employment of the shareholder’s spouse was not prohibited, and there was no evidence that the redeemed shareholder was involved in the business through his spouse’s continued employment.

c. The only adjustment made by the Tax Court was to impute the benefit of the corporate-provided health insurance as compensation to the redeemed shareholder’s spouse. The couple’s son was a 51% shareholder of the corporation, which operated in S status, and accordingly the spouse was considered a more-than-2% S shareholder for health insurance fringe benefit purposes. Currently, the offsetting 100% self-employed health

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insurance deduction would be available to the shareholder, but at the time of this case, only a 40% offset was permitted.

d. Commentary: Prior to entering into the stock redemption, the individual taxpayer in this case owned 100% of the stock. The redemption was accomplished in a “bootstrap” arrangement, under which the shareholder sold 10% of the stock to three key employees (with 51% of that block of stock sold to his son). The remaining 90% of the stock was simultaneously redeemed by the corporation using a 15-year installment note. At the same time, the individual rented real estate to the corporation under a new 15-year lease, and his spouse signed a 10- year employment contract that provided a small salary and family health insurance coverage.

6. Stock transfers within 10 years prior to redemption.

a. Sec. 302(c)(2)(B) contains anti-abuse restrictions, holding that capital gain treatment is not available if there have been family transfers of stock within 10 years prior to the redemption.

1) Specifically, the statute provides that the redeemed shareholder must not have made any tax avoidance dispositions of stock within the 10-year period prior to the redemption, such as gifts to a related individual who still owns the stock at the time of the redemption.

b. However, this statute also has an escape clause that allows the family attribution to be waived, if the prior transfer did not have the avoidance of federal income tax as one of its principal purposes.

c. The IRS has ruled that a parent, who owns all of the stock of a family corporation and makes gifts to a child who is a successor in the business as part of the parent's plan to retire from the business, has met the "no tax avoidance" exception, and may enter into a complete redemption using the waiver of attribution rules [Rev. Rul. 77-293].

B. Using a dividend to assist in retiring a family corporation shareholder.

1. The 15%/20% dividend rate presents an opportunity to extract cash from a family corporation to a retiring shareholder without meeting the constraining rules of a corporate stock redemption discussed above.

2. Partial redemption taxed as a dividend.

a. In a family-owned corporation, a partial redemption inevitably results in dividend tax treatment (i.e., family attribution applies to partial redemptions, and the deemed attribution of stock owned by other family members prevents qualification for “sale or exchange” treatment under the substantially disproportionate redemption rules that otherwise might make a partial redemption the equivalent of a capital gain result).

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b. A partial redemption allows a departing senior shareholder to receive significant cash from the corporation in a disproportionate manner to the other shareholders, without meeting the complete redemption rules discussed above that require elimination of continuing salaries and fringe benefits.

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c. If a shareholder has low stock basis, there will be little difference in the tax result between a dividend and a capital gain, provided the tax law continues to provide equivalent rates for dividend income and long-term capital gain to an individual taxpayer.

d. The retiring shareholder can achieve installment treatment by selectively having shares redeemed annually to achieve a targeted cash flow and dividend income result.

3. Issuing a dividend from a closely-held family farm corporation.

a. A mature family farm corporation that no longer needs its annual retained income and cash flow for expansion or debt retirement purposes might consider removing surplus cash and investments via a dividend to shareholders.

b. Commentary: The use of the low internal 15% corporate income tax rate of a C corporation, followed by a distribution to the individual shareholder taxable as either a dividend (or a capital gain upon liquidation) represents double taxation.

Example 1 Disproportionate redemption as a dividend

X Corp, a C corporation, is 70% owned by Sr. and 30% by Jr., who are related as parent and

child. Sr. is approaching retirement age, and both are interested in reducing Sr.’s ownership in

the corporation. However, when they investigated the possibility of having X Corp redeem some

or all of Sr.’s stock a number of years ago, they learned that any partial redemption of Sr.’s stock

would be taxable as an ordinary income dividend. Only if Sr. accomplished a complete redemption

of stock, and agreed to have no involvement with the corporation as an employee, director,

consultant, or stockholder for 10 years could capital gain treatment be achieved [IRC Secs.

302(b)(3) and 302(c)(2)(A)].

However, as a result of the current equivalency of capital gain and dividend taxation, X Corp may

accomplish a partial redemption of Sr.’s stock at a 15% or 20% rate to Sr. X Corp might

accomplish this using excess liquidity, or it may issue an installment note to Sr. However, if a note

is utilized, the dividend tax treatment causes the note to be taxable in the current year at its fair

Example 2 Dividend issued by family farm corporation

Treflan Farms, Inc., a family farm C corporation owned by Tom Treflan and his spouse, Teri,

has consistently been profitable over its 25 year operating history. The corporation is holding

about $400,000 in liquid investments, because the corporate retention of about $50,000 of taxable

income each year has resulted in the corporation accumulating funds beyond its operating capital

and equipment replacement needs. Tom and his tax advisor have targeted this excess liquidity

for a future capital gain redemption or liquidation when Tom retires. However, in view of the

15%/20% dividend rate, Treflan Farms can issue a dividend that is taxed at capital gain rates to

Tom, without concern as to qualifying for favorable redemption or liquidation capital gain status.

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However, taxing the earnings in this manner can be tax efficient, as it represents an overall

marginal rate of 28%, calculated as follows:

C corporation income $ 1.00

Less federal corporate tax at 15% (.15) Excess

income for distribution .85

Less individual dividend or capital gain rate at 15% (.13)

Net after-tax amount to owner $ .72

c. Caution: Not adequately planning for current year income and liquidation will create a considerably higher level of double taxation. Corporate income taxed at 25% and individual capital gain at 23.8% computes to a double tax rate of 42.85%

4. Using a dividend to remove C corporation E&P to allow S corporation rental status.

a. S corporations that previously operated in C corporation status may also benefit from distributing C corporation Accumulated Earnings and Profits (AE&P) as a dividend, taxable at the 15%/20% rate to shareholders. To facilitate this action, Sec. 1368(e)(3) allows an S corporation to make an election to distribute accumulated earnings and profits before the S corporation Accumulated Adjustments Account (AAA). Also, if the S corporation has pre-1983 Previously Taxed Income (PTI), an election can be made to distribute the accumulated earnings and profits before both PTI and AAA.

b. This ability to remove C corporation AE&P is particularly important where the S corporation is no longer operating a significant active trade or business, and as a result is facing exposure to the Section 1375 35% tax on excess passive net investment income, and possible termination of S status under Sec. 1362(d)(3). Both the excess passive net income tax and termination because of passive net income are conditioned upon the S corporation having former C corporation AE&P. Thus, removing the AE&P at the dividend tax rate to the shareholder, can eliminate these issues for the S corporation.

c. This opportunity can be particularly important for a farming and ranching S corporation that previously operated in C status and has appreciated real estate trapped within the S corporation. If active farming on the part of the S corporation ceases (such as at the retirement of the principal shareholder-employee), the S corporation faces an excess passive net income risk with respect to cash rent income on the farmland. In the past, this risk was typically avoided by structuring crop share leases, or cash rent leases that attempted to reach active rental status (see Rev. Rul. 61-112 and PLRs 200002031 and 200002033). Now, rather than face the risk of an IRS argument that the rental arrangement was not active (defined as the S corporation providing either significant services to the tenant or incurring substantial costs under the lease arrangement per Reg. 1.1362-2(c)(5)(ii)(B)), the S corporation can simply electively pay out its former C corporation AE&P at the shareholder’s dividend rate, and be free of this issue.

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Example 3 Elective dividend by S corporation to remove old C corporation AE&P

Rayco Farms, Inc. is a family farm S corporation owned by Ray and Rita. Several years ago,

Ray retired, and the land within the S corporation has been leased to neighboring farmers. Rayco

formerly operated in C status, and has $150,000 of former C corporation accumulated earnings

and profits (AE&P). Ray has been advised that his S corporation faces a Sec. 1375 excess

passive net income tax issue, and also faces possible termination unless its lease arrangements

can be construed as providing significant services or incurring substantial costs, so as to be

deemed active rather than passive leases under Sec. 1362. Ray would prefer to have his S

corporation rent the farmland on a cash rent arrangement, rather than incur the management

involvement of crop share leases. Rayco could make an election under Sec. 1368 to first distribute

its $150,000 of AE&P to the shareholders, Ray and Rita, before any AAA S corporation

distributions for the year. They would be taxed at the dividend rate on this distribution. If Rayco

lacked the cash to make the entire $150,000 distribution, the corporation may make a deemed

dividend election under Reg. 1.1368-1(f)(3). Under this election, the corporation is considered to

have distributed all of its AE&P to the shareholders, who in turn have contributed back to the

corporation in a manner that increases stock basis. Thus, with the increased stock basis, Ray and

Rita may extract the $150,000 in future years without additional taxation, as S corporation cash

flow permits. Further, the removal of the AE&P allows Rayco to collect passive rental income (as

well as other passive and portfolio income such as interest and dividends) without a Sec. 1375

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C. Using a divisive reorganization to split up a family farming business.

1. Under Sec. 355(a), a corporation owning two active businesses may spin-off one of those businesses into a separate corporation, distributing the stock of that corporation to its shareholders in a nonrecognition transaction.

2. To meet this tax-free divisive reorganization result, the following requirements must be met:

a. The distributing corporation and the spun-off corporation must be engaged, immediately after the distribution, in the active conduct of a trade or business (a rental activity is not considered an active business for this purpose);

b. Each trade or business has been actively conducted throughout the five-year period ending on the date of the reorganization; and

c. Neither business activity has been acquired in a transaction in which gain or loss was recognized, in whole or in part, within the prior five-year period [Sec. 355(b)].

d. The corporation may be split vertically (each resulting corporation receiving similar assets, but still accomplishing a business purpose) or horizontally (with one corporation receiving farming assets and the other corporation receiving processing assets).

e. There must not be a plan for 50% or more of either corporation to be sold within two years of the division. A plan to dispose of stock outside the two-year window is suspect [Sec. 355(e)].

f. In addition, the regulations require that a Section 355 divisive reorganization must be motivated, in whole or substantial part, by a corporate business purpose rather than a shareholder purpose [Reg. 1.355-2(b)].

3. Family farm corporation divisive reorganization approved.

a. A family farming operation was owned 25% each by a father, a mother, and their two children.

b. The corporation's active farming operation was conducted primarily by the two adult children. One child operated the livestock portion of the farming business and the other child operated the grain farming enterprise.

1) The two children disagreed on the direction and expansion of the farming business. The son, who operated the livestock business, intended to expand and incur significant corporate debt to do so. The daughter, who operated the grain business, preferred to sell the livestock business.

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2) Also, there was evidence of disharmony between the son and the daughter's husband that further aggravated the development of a consistent business strategy and family harmony.

c. As a result, the IRS was asked to rule on a divisive reorganization, in which the livestock business would be transferred to a corporation owned by the parents and the son, while the grain portion of the business would be retained within a corporation owned by the parents and the daughter. After the reorganization, the parents would own 50% of the outstanding stock of each corporation, with the son owning the balance of the livestock corporation and the daughter owning the balance of the grain corporation.

d. The IRS ruled that this reorganization was motivated by substantial nontax business reasons, and accordingly met the Section 355 tax-free divisive reorganization rules. Although this reorganization advanced the personal estate planning goals of the father and mother and promoted family harmony, substantial business reasons intertwined with the separation of the two siblings from the single business activity formerly conducted by the corporation [Rev. Rul. 2003-52].

D. Strategies for the inequality issue: The farm business to on-farm heirs and insufficient assets for off-farm heirs.

1. Most farm business operators, when considering the value of inventory, machinery, and farm real estate, have virtually all of their net worth in their farming enterprise. If there is one on-farm heir as a successor, and other off-farm children who are not successors to active farm ownership and operation, the inequality issue and the transfer of the farm business can appear to be an insurmountable obstacle.

2. Separation of the business and real estate.

a. A common strategy is to transfer the business to the on-farm successor through the use of a C corporation or S corporation or partnership, using gift and sale strategies with respect to the stock or ownership units.

b. The farm real estate is often retained by the elder generation for lease to the business through their retirement years.

1) That real estate is often bequeathed to all children, for lease to the on-farm heir or business entity.

a) This may jeopardize the ability of the on-farm heir to lease the land and continue the operation, as well as eventually lead to disputes among the children regarding the annual lease value or sale price of the land.

b) Long-term leases with renewal provisions, surviving the death of the elder generation, may reduce this concern.

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2) Alternatively, during retirement years or at death, the parents can transfer the land into a family LLC or limited partnership (generically, “FLP”), which leases the land and serves as the continuing entity for subsequent lease after the death of the parents. Management control of the FLP typically is held only by those active in the farming business, but operation of the FLP is subject to the terms of the partnership agreement.

c. Lifetime vs. testamentary transfer of land.

1) To the extent lifetime gifts are made of either land or FLP units, the historical

land tax cost or basis is unchanged (i.e., tax basis carries over on a gift). This

increases the possibility of a larger capital gain to the heir, if the asset is

subsequently sold.

d. On the other hand, to the extent land or FLP units are owned at death, the asset is valued at market value in the decedent’s estate, and receives a step-up in the tax basis equal to this market value when passed to the heirs [Sec. 1014(a)]. The valuation in the estate may incur a 40% federal estate tax, but there is no capital gain if that asset is sold shortly after the death/step-up in basis.

e. Strategy?

1) If the estate net worth is under $5.25 million per person (2013 exemption), no Federal estate tax will be incurred. Therefore, retain the land through the estate to accomplish a step-up in tax basis before the transfer to farm successor or to an FLP. This avoids any capital gain tax if one heir sells to another or to an outsider after the estate.

2) If the estate net worth is over the exemption, use lifetime gifts to diminish the net worth and decrease the 40% estate tax.

3. Summary: Avoiding a 40% estate tax at a cost of a 20% capital gain tax is efficient!

4. Possible adjustment of will.

a. There is usually significant discounting of the value of the farm assets, particularly the operating machinery and inventories, when transitioned to the on-farm successor (i.e., the transition is a combination gift and sale).

b. Recognizing the significant gift that often occurs in these transactions, the parents may need to equalize that lifetime transfer of value by diminishing the share to the on-farm heir in testamentary transfers.

c. A mechanism for accomplishing this is to adjust the will of the parents to eliminate the on-farm successor from a share of the inheritance, recognizing that significant lifetime transfers occurred to that child.

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5. Use of Family LLCs or Limited Partnerships.

a. The parents, as contributors of the farm land to the FLP, initially would receive 100% of both the managing and non-managing units in the FLP.

b. The non-managing or non-voting units become the subject of gradual gifts to the children, and are capable of discounting due to lack of voting and lack of liquidity associated with those units.

c. The managing units are generally only a very small percentage of equity ownership, such as 1%. But those units control the FLP, and determine who leases the FLP land, at what rental rate, and when land is sold and its sale terms (but do so subject to terms within the FLP document). Those units will typically be owned by the on-farm family members, or at least a majority of the units will be owned by those family members.

d. It is imperative that cash distributions out of the partnership be proportional to unit or percentage ownership in the partnership.

e. The IRS has attacked FLPs using the Section 2036 retained life estate argument with respect to the managing or voting control units. Accordingly, many tax advisors today recommend that parents do not have voting control of the FLP, but rather share that with an adult child so that the parents cannot unilaterally control the distributions from the FLP or the possible liquidation of the FLP.

f. Commentary: Recognize that the greater the lifetime gifting of the FLP units to children, the greater the portion of the farming rent income that will flow directly to the children rather than to the parents.

g. Caution: FLPs are complex, in that they require detailed legal drafting of the entity agreement. The agreement will address issues such as voting and nonvoting member unit rights, and define the family wishes with respect to leasing of the farmland from the entity, as well as the ability to purchase the farmland from the entity. There is also the need to define the ability of each owner to exit, and what restrictions will be applied in terms of sale price or extended payout terms for any owners that desire to exit prior to liquidation of the entity. Also, at formation of the entity, it is necessary to secure appraisals of both the underlying real estate and the discount features of the agreement, in order to accomplish proper valuation of the gifts of units (i.e., two appraisals). Finally, to assure that each owner has properly bargained for their interest in the entity, the initial limited units acquired by each child should be purchased (e.g., each child acquires a few limited units for $5,000 of cash).

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Long Term Care Planning

Issues

• 88 million Americans will be 65 and older by 2050+

• Costs: ^

o Home Health Aide: $38-58,000

o Assisted Living: $30-55,000

o Nursing Home

▪ Semi-private room: $63-80,000

▪ Private room: $66-95,000

+Robert Johnson Wood Foundation (2014)

^Gary A. Hachfield, Long-Term Health Care Planning, University of Minnesota Extension, May 2014

• Medicaid financed 49% of long-term care spending in 2004

• Medicare financed 19%

• Out of pocket payments financed 19% (~ $37 billion)

• Long-term care insurance accounted for 7%*

o Only about 6-8 million people with policies

o Average premium - $2,283**

*Fact sheet, Georgetown University Long-Term Care Financing Project, January 2007

**Medicaid: A Program of Last Resort People Who Need Long-Term Services and Supports, AARP Public

Policy Institute, May 2013

1.

Long Term Care Planning

• Asset protection that complies with Medicaid spend down requirements

o Deficit Reduction Act (2006) increased look back to 5 years (most states have implemented)

o Resources available to “wait-out” the look-back period

o Be careful of penalties for transfers – apply on date of application

Medicaid Eligibility

• $2,000 or less of countable resources

2.

• Spouse at home gets to keep some assets

o Spousal Minimum – at least $24,180 in 2017

o Maximum – half of all countable assets, up to a total of $120,900 in 2017

3.

• Income limit is $3,022.50 per month in 2017 (maximum)

4.

• Countable resources:

o Cash account

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o Jointly owned accounts

o Investment accounts

o Life insurance greater than $1,500 in cash value

o Boats, motor home, etc. except one vehicle

o Non-homestead real estate

o Pension with lump sum option

o Trusts in which applicant has an interest

o Personal property for investment

5.

• Unavailable assets:

o Gifts made more than 5 years before application

o Irrevocable pre-paid burials

o Jointly held assets (other than spouse) [lien will apply after death]

o Life estate (after August 1,2003)

o Irrevocable trusts if established before July 2005

o Current litigation may allow irrevocable trusts established on or after July 1, 2005, where

five years have passed before applying for assistance

6.

• Excluded assets:

o Primary residence and contiguous acres

o One vehicle

o Personal property used regularly or with cultural or religious significance

o Income producing assets to meet spouse allowance or business property

o Life insurance with less than $1,500 of cash value

7.

• The following documents should be completed before capacity issues arise:

o Durable power of attorney

o Health care power of attorney

o Living will

8.

• Long-term care insurance?

o Value of Assets Excluding Primary Residence

▪ Less than $30,000 – premiums might cost more than assets protected

▪ $30- 75,000 – consider whether justified

▪ $75,000+ - may be appropriate to consider

9.

• Additional Type

o Long-Term Care Partnership

▪ Private insurance approved by state

▪ Iowa offers this (other states may as well) – allows dollar for dollar asset protection

• If policy pays $200,000; then can keep $200,000 of assets and still qualify for

Medicaid assistance

▪ Inflation protections based on age at time of purchase

▪ Tax deductible (itemized health cost)

▪ May be reciprocity with other states

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TAXABLE INCOME OF TRUSTS AND ESTATES

RETURN FILING AND SELECTION OF TAX YEAR

When Is A Return Required? Upon a decedent’s death, the decedent’s assets become property of the decedent’s

estate. Any income those assets generate is also part of the estate and may trigger the requirement to file an estate

income tax return.

Observation. Examples of assets that would generate income to the decedent’s estate include savings accounts,

CDs, stocks, bonds, mutual funds and rental property.

IRS Form 1041 is required if the estate generates more than $600 in annual gross income.

Note. The decedent and the decedent’s estate are separate taxable entities. Before filing Form 1041, the executor

will need to obtain a tax ID number for the estate. The application made on Form SS-4, and the estate’s tax ID

number is called an “employer identification number,” or EIN, and comes in the format 12-345678X. An application

for the number can be made online. It can also be applied for via fax or regular mail. Form SS-4 will ask for the

year end of the trust or estate.

Tax Year Determination. For calendar year estates and trusts, Form 1041 and Schedule(s) K-1 (which are used

to report distributions to beneficiaries and the IRS) are to be filed on or before April 15 of the year immediately

following the year of death. For fiscal year estates and trusts, Form 1041 is to be filed by the 15th day of the fourth

month following the close of the tax year. If more time is needed to file the estate return, an automatic five-month

extension of time to file can be applied for via IRS Form 7004.

The executor or personal representative may elect any year end provided it ends on the last day of the month and

does not exceed 12 months in length. The election of a year end is made by the filing of the initial estate income

tax return. An executor (or trustee) may select any year end that accommodates the needs of the estate. Common

considerations for determining the year end include the ability to defer income to the next tax year, managing tax

rates, managing the capacity to pay tax (particularly if the estate will be open or the trust will be administered over

a longer period of time), and minimizing the number of returns that need to be filed.

How the Tax Is Computed

The taxable income of an estate or trust is computed the same way that it is for individuals, with certain

modifications.92

Observation. For an individual, gross income is reduced by the cost of producing that income. The result is

adjusted gross income (AGI). AGI is reduced by certain other deductions to reach taxable income. A tax table or

rate schedule is then applied to taxable income with the resulting tax reduced by applicable credits. The same

computational scheme is applied to estates and trusts. What is gross income to an individual is gross income to an

92 See, e.g., I.R.C. §§67(e); 641(b).

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estate or trust.93 Expenses that an individual could deduct are generally deductible by estates and trusts.94 AGI for

a trust, for example, is only computed for limited purposes under I.R.C. §67(e) but it is determined in the same

manner as that prescribed for determining the AGI of individuals.

Trust and estate taxable income is modified in several ways:

• Trusts that are required to distribute all of their income currently are entitled to a deduction for a personal

exemption of $300.95 For all other trusts, the personal deduction is limited to $100. Estates get a $600

exemption.

• Estates and trusts are not entitled to the standard deduction.96

• In general, estates and trusts must deduct distributions to beneficiaries when determining taxable income,

but only to the extent of distributable net income (DNI) as determined under I.R.C. §643.

• A trust is not entitled to a charitable deduction under I.R.C. §170, but amounts that are paid via the terms

of a trust or an estate for public charitable purposes are deductible by both estates and trusts. In addition,

amounts that are “permanently set aside” are deductible by estates and certain trusts.97

• Estates and trusts can deduct “miscellaneous itemized deductions” to the extent that such deductions exceed

two percent of the trust’s AGI.98 But, I.R.C. §67(e) provides that an estate or trust, in arriving at AGI, is

entitled to a deduction for 100 percent of the “costs which are paid or incurred if the property were not held

in such trust or estate.”

PASSIVE ACTIVITY LOSS LIMITATIONS

I.R.C. §469 generally limits deductions and credits derived from passive activities to the amount of income derived

from all passive activities. This loss limitation rule applies to estates and trusts, but there are some unique

applications of the rule to estates and trusts.

An activity is generally deemed to be passive if it involves the conduct of any trade or business and the taxpayer

does not materially participate in the activity.99 According to the IRS, an estate or trust is treated as materially

participating in an activity if an executor or fiduciary, in his or her capacity as such, is involved in operations of the

activity on a regular, continuous, and substantial basis.

Note. For a grantor trust, material participation is determined at the grantor level.

While the IRS position is that only the trustee of the trust can satisfy the material participation tests of I.R.C. §469,

this position has been rejected by the one federal district court that has ruled on the issue.100 In 2014, the U.S. Tax

93 See., e.g., Treas. Reg. §1.641(a)-2. 94 I.R.C. §641(b). For example, these expenses would include court costs, attorney and fiduciary fees, taxes, etc. See Treas. Reg. §1.212-

1(i); 1.641(b)-1; I.R.C. §164 95 I.R.C. §642(b). 96 I.R.C. §63(c)(6)(D). 97 I.R.C. §642(c). 98 I.R.C. §67(a). 99 I.R.C. §469(c)(1). However, passive activities do not include working interests in oil and gas properties “which the taxpayer holds

directly or through an entity which does not limit the liability of the taxpayer with respect to such interest. I.R.C. §469(c)(3). 100 Mattie Carter Trust v. U.S., 256 F.Supp.2d 536 (N.D. Tex. 2003). the IRS, while not appealing the court’s opinion, continued to assert its

judicially rejected position.

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Court rejected the IRS’s position.101 The Tax Court held that the conduct of the trustees acting in the capacity of

trustees counts toward the material participation test as well as the conduct of the trustees as employees. The Tax

Court also implied that the conduct of non-trustee employees would count toward the material participation test.

Rental activities are considered to be passive, regardless of whether the taxpayer materially participates. However,

for an estate’s tax years that end less than two years after the date of the decedent’s death, up to $25,000 of the

passive activity losses attributable to all rental real estate activities in which the decedent actively participated before

death are allowed as deductions.102 Any unused losses and/or credits are deemed “suspended” passive activity

losses for the year and are carried forward indefinitely.

Note. The $25,000 offset for rental real estate activities is to be reduced by the amount of the exemption “allowable

to the surviving spouse of the decedent for the tax year ending with or within the taxable year of the estate.”103

Other Points Involving Passive Losses

• Losses from passive activities are first subject to the “at-risk” rules of I.R.C. §465. Thus, if the losses are

deductible under the at-risk rules, the passive activity rules then apply.

• Portfolio income of an estate or trust must be accounted for separately and may not be offset by losses from

passive activities.104

• If a trust or estate distributes its entire interest in a passive activity to a beneficiary, the basis of the property

is increased (no deduction allowed) by the amount of any suspended losses generated by that passive

activity. Gain or loss to the trust or estate and the basis of the property to the beneficiary is then determined

under the rules set forth in I.R.C. §643(e).105

TAX RATE SCHEDULE

Compressed bracket rates apply to estate and trust income that is not distributed to beneficiaries. Below is the tax

rate table for 2017:

If taxable income is: The tax is: Not over $2,500 15% of the taxable income

Over $2,500 but not over $6,000 $382.50 plus 25% of the excess over $2,500

Over $6,000 but not over $9,150 $1,245 plus 28% of the excess over $5,900

Over $9,150 but not over $12,500 $2,127 plus 33% of the excess over $9,050

Over $12,500106 $3,232.50 plus 39.6% of the excess over $12,300

Note. Generally, net long-term capital gains are taxed at a maximum rate of 20 percent.107

101 Frank Aragona Trust v. Comm’r, 142 TC 9 (Mar. 27, 2014). 102 I.R.C. §469(i). 103 I.R.C. §469(i)(4)(B). 104 Portfolio income generally includes interest, dividends, royalties not derived in the ordinary course of business, and income from

annuities. I.R.C. §469(e). 105 I.R.C. §469(j)(12). 106 For taxable income above $12,500, the additional 3.8 percent tax of I.R.C. §1411 applies. 107 I.R.C. §1(h).

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TAX RETURN OBLIGATIONS

An estate executor must file Form 1041 for the estate if the estate has gross income for its tax year of $600 or

more.108 A trustee must file Form 1041 for the trust each year in which the trust has “any taxable income” or “gross

income of $600 or over, regardless of the amount of taxable income.”109 An executor of an estate can elect to file

the estate’s income tax returns on a calendar or fiscal year basis.110 However, a trustee must use a calendar year

when filing a trust’s tax returns.

Special Rule for Revocable Trusts. Revocable trusts, at the time of the decedent (grantor’s) death, may elect to

be treated and taxed as part of the decedent’s estate for income tax purposes for two years after the decedent’s death

if no federal estate tax return is necessary, or for a period ending six months after the conclusion of any proceeding

relating to the decedent’s federal estate tax return.111 If the decedent had multiple revocable trusts, they can be

combined with the decedent’s estate and a consolidated income tax return as an estate is filed for the combined

entities. In this instance, both the executor and the trustee must indicate that consolidated reporting has been

elected.112

ALTERNATIVE MINIMUM TAX

The alternative minimum tax (AMT) applies to trusts and estates. The lowest applicable AMT rate is 26 percent

and the maximum is 28 percent.113 Trusts and estates are entitled to a $22,500 exemption.114 The exemption is

phased out if the trust or estate has alternative minimum taxable income (AMTI) that exceeds $75,000, with the

phase out rate set at $.25 per $1 of AMTI exceeding $75,000.115

ESTIMATED INCOME TAX PAYMENTS

Trusts and estates must make quarterly estimated income tax payments in the same manner as individuals except

that estates and revocable trusts are exempt from making estimated payments during the first two taxable years.116

For estates, estimates tax payments must be made on a quarterly basis for tax years that end two or more years after

the date of the decedent’s death. The rule is the same for revocable trusts that receive the grantor’s residuary estate

under a pour-over will or, if no will is admitted to probate, to a trust that is primarily responsible for paying the

decedent’s debts, taxes and administration expenses.117

Example: George Knight died on December 15, 2016. His will provided that “I give all of my property to the

Trustee of the Knight Family Revocable Living Trust, which I created on August 5, 1989.” The trust reports its

income on a calendar year basis, but the executor of George’s estate elected to report the estate’s income on a fiscal

year ending November 30. For estimated tax purposes, no estimated income tax payments are required for the fiscal

years ending on November 30, 2017 and November 30, 2018. With respect to the trust, estimated income tax

108 I.R.C. §6012(a)(3). 109 I.R.C. §6012(a)(4). 110 I.R.C. §441(b)(1). 111 I.R.C. §645. 112 I.R.C. §645(a). An election to consolidate is irrevocable once it is made. I.R.C. §645(c). 113 I.R.C. §55(b)(1)(A). 114 I.R.C. §55(d)(1)(C)(ii). 115 I.R.C. §55(d)(3)(C). 116 I.R.C. §6654(l)(2). 117 I.R.C. §6654(l)(2).

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payments are not required for the trust tax years ending December 31, 2016, and December 31, 2017, but estimated

tax payments are required for the trust tax year ending December 31, 2018.

Note. The penalties for underpayment of quarterly estimated income tax apply to fiduciaries as well as individuals.

Under I.R.C. §643(g)(1)(a), “the trustee may elect to treat any portion of a payment of estimated tax made by such

trust for any taxable year of the trust as a payment made by a beneficiary of such trust.” The election must be made

“on or before the 65 th day after the close of the taxable year of the trust.” Estates may also make this election but

only in the “taxable year of the trust.” Estates may also make this election, but only in the “taxable year reasonably

expected to be the last taxable year” of the estate. Thus, an estate may find itself in the position of claiming a refund

of an overpayment of estimated taxes in a year other than its final year while the estate’s beneficiaries will incur an

underpayment penalty in the same year as a result of receiving a distribution from the estate during that year and

not taking the distribution into account for estimated income tax purposes.

When a trust elects to attribute the estimated income tax payment to the trust beneficiary, the payment made by the

trust “is treated as a payment of estimated tax made by such beneficiary January 15 following the taxable year.”118

The amount of tax attributed to the beneficiary is treated as a distribution by the trust (and is deductible by the trust

in computing its income tax liability) and as taxable income to the beneficiary.119

BASIS CONSIDERATIONS

In-Kind Distributions. Under I.R.C. §643(e), the basis of property that is distributed in-kind is the “adjusted basis

of such property in the hands of the estate or trust immediately before the distribution, adjusted for…any gain or

loss recognized to the estate or trust on the distribution.” But, whether gain or loss is recognized by the estate or

trust is optional. The estate or trust can make an election. Thus, an estate or trust has the option of treating an in-

kind distribution as if it had been sold to the distributee at fair market value. That means that the estate or trust

would recognize gain for appreciated property, and loss if the distributed property’s value has declined.120 But,

I.R.C. §267(b) prevents a trust from deducting losses on in-kind distributions and the basis of such property carries

over to the distributee.

Note. An election under I.R.C. §643(e) applies to all distributions that a trust or an estate makes during the tax

year. The election is made on the estate or trust’s return for the tax year.121 However, the election does not apply

if the trust or estate has no DNI or the cash distributed from the estate or trust “soaks up” the DNI.

Specific Bequests. I.R.C. §643(e) has no application to property that is distributed in-kind to satisfy a specific

bequest.122 Thus, the basis of such property to the beneficiary is the same as the estate or trust. In essence, the

transaction is treated as a sale or exchange

Sale or Exchange. When appreciated property is distributed in-kind to satisfy a pecuniary bequest (the gift of a

specific sum of money), the distribution is treated as a sale or exchange by the trust or estate.123 The transaction is

treated as if the executor/trustee distributed cash and the beneficiary purchased the property with the cash. If there

is a loss on the transaction, an estate can recognize the loss, but a trust cannot.

118 I.R.C. §643(g)(1)(C)(ii). 119 I.R.C. §§651, 661. 120 The distribution of loss property carries out DNI only to the extent of the property’s fair market value. In the case of an estate, the

distribute will assume the basis of the property in the hands of the estate unless the estate elects to recognize the loss. 121 I.R.C. §643€(3)(B). 122 I.R.C. §643(e)(4). The requirements of I.R.C. §663(a) must be satisfied. 123 Treas. Reg. §1.661(a)-2(f)(1).

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Observation. If a decedent funded revocable trust during life and directed the trustee (under the terms of the trust)

to distribute a pecuniary bequest to the surviving spouse, and there is a loss on the transaction, the trust cannot claim

the loss. However, the trustee could sell the loss property, realize the loss for income tax purposes, and satisfy the

surviving spouse’s pecuniary bequest with cash.

SALE OF THE DECEDENT’S PERSONAL RESIDENCE

Upon death, the executor may face the need to dispose of the decedent’s personal residence. The starting point will

be to determine the basis of the residence under the IRS standard - fair market value as of the date of the decedent’s

death under the willing buyer-willing seller test. That is based largely on sales of comparable properties, and

requires more than a simple market analysis by a real estate agent.

If the decedent was the first of the two spouses to die, a determination of how the residence was titled at death will

need to be made. For a residence held in joint tenancy or tenancy in common, only the value of the decedent’s

share of the residence will be included in the decedent’s estate and receive a basis step-up to fair market value under

I.R.C. §1014.

Note. For joint tenancies involving only a husband and wife, the property is treated at the first death as belonging

50 percent to each spouse for federal estate tax purposes.124 This is known as the “fractional share” rule. Thus, one-

half of the value is taxed at the death of the first spouse to die and one-half receives a new income tax basis.

However, in 1992 the Sixth Circuit Court of Appeals applied the consideration furnished rule to a husband-wife

joint tenancy with the entire value of land acquired before 1977 included in the estate of the first spouse to die.125

The full value was subject to federal estate tax, but was covered by the 100 percent federal estate tax marital

deduction. The entire property received a new income tax basis which was the objective of the surviving spouse.

Other federal courts have reached the same conclusion.

If the residence is community property, the decedent’s entire interest will receive a basis step-up to fair market

value. If the residence is held in joint tenancy with rights of survivorship, the decedent’s interest passed by the

survivorship designation to the designated survivor.

Observation. If a surviving spouse sells the marital home shortly after the first spouse’s death, the survivor will

often realize a loss largely due to the expenses incurred with respect to the sale. If the survivor realizes a gain,

then, the survivor is eligible for the $250,000 exclusion of gain under I.R.C. §121. That exclusion is a maximum

of $500,000 if the sale occurs within two years of the first spouse’s death.

OTHER POINTS

A revocable trust is a common estate planning tool. If the decedent’s personal residence was held in a revocable

trust and passed to the surviving spouse upon the first spouse’s death under the terms of the trust to continue to be

held in trust, the house receives a full step-up (or down) in basis to the current fair market value at the death of the

surviving spouse. If the house is distributed outright to a beneficiary (or beneficiaries) and then the beneficiary

immediately sells the home, a loss generally be a nondeductible personal loss unless the home is first converted to

a rental property before it is sold.

If the residence must be sold by the estate or trust to pay debts or to satisfy cash distributions to beneficiaries, any

loss on the sale might be deductible. That loss could potentially offset other income of the trust or estate, or it

could flow through to the beneficiaries. However, the IRS position is that an estate or a trust cannot claim such a

124 I.R.C. § 2040(b). 125 Gallenstein v. United States, 975 F.2d 286 (6th Cir. 1992).

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loss unless the residence is a rental property or is converted to a rental property before it is sold. This position has

not been widely supported by the courts which have determined that a trust or estate can claim such a loss if no

beneficiaries use the home as a residence after the decedent’s death and before it is sold.

TERMINATION OF ESTATES AND TRUSTS

TIMING

Once the administration of an estate is finished or a trust is deemed to be terminated for federal income tax purposes,

the income of the estate or trust is taxable to the beneficiaries even though it has not been distributed to those

beneficiaries.

• Whether a trust has been terminated depends on whether the trust property has, in fact, been distributed to

the trust beneficiaries.126

• The period of administration of an estate is the “period actually required…to perform the ordinary duties

of administration.”127

EXCESS DEDUCTIONS

If an estate or a trust, in its last tax year, incurs tax deductible expenses that exceeds the income of the estate or the

trust, excess deductions result.128 The personal exemption and any charitable deductions are not counted in the

excess deduction computation. Any excess deductions flow through to the beneficiaries of the estate or trust and

are available as itemized deductions on the income tax return of the beneficiaries for the beneficiary’s tax year in

which the estate or trust tax year ended.

Note. Estate administration expenses are deductible in computing the federal estate tax or the estate’s income tax,

such expenses are not deductible for both purposes.129

NET OPERATING LOSSES130

The net operating loss (NOL) deduction available to estates and trusts is computed in similar fashion to NOLs for

individuals. However, since the NOL computation is a measurement of “economic business loss”, NOLs tend to

be fairly uncommon for estates and trusts. This is true because NOLs can only result when business activities are

conducted within the entity. Estates are more likely to experience NOLs than trusts, since estates more frequently

must deal with the closing of a business entity on behalf of a decedent.

NOL Computation

126 Treas. Reg. §1.641(b)-3(b). 127 Treas. Reg. §1.641(b)-3(a). Sometimes, issues arise with IRS as to whether the “period of administration” in I.R.C. §641(a)(3) is the

period actually consumed as opposed to a reasonable time (as IRS asserts). See, e.g., Brown v. United States, 890 F.2d 1329 (5th Cir.

1989). 128 I.R.C. §642(h)(2). 129 I.R.C. §642(g). 130 This section is adapted from the 2026 Iowa Bar Association Tax Manual by A. David Bibler, et al., and is used with

permission.

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As one experiences in computing individual NOLs, certain expenses deducted on the fiduciary income tax return

may be allocable partially to business income and partially to non-business income. Examples would be real estate

taxes, interest expense, legal fees, court costs, etc. Only the portion of these expenses allocable to business income

can generate an NOL.

One of the most likely sources to generate a fiduciary NOL are legal fees paid during the course of probate

administration. In calculating a fiduciary NOL, the assets of the estate must be examined to determine what portion

of these fees relates to business income and what portion to non-business income.

Note: An NOL cannot be generated by fiduciary fees since a fiduciary’s administrative responsibilities to the estate

or trust do not constitute an active trade or business for purposes of IRC §172.

Example: John Stevens, a retired farmer, died on October 5, 2015. At the time of his death, his Estate was

comprised of several tracts of farm real estate (operated on a crop-share basis), several life insurance policies upon

which John had retained ownership, and an investment portfolio comprised of stock, mutual funds, CD’s and

annuities. The first fiduciary income tax return filed for John’s Estate (10-5-15 through 9-30-16) reflected taxable

income of $18,500 upon which the Estate had paid federal and state income taxes.

The second fiduciary income tax return (10-1-16 through 9-30-17) for the estate reflects the following income and

expense information:

Interest income $ 1,196

Capital gain (Sch. D) - sale of farm equipment 752

Net farm income (Form 4835/Sch. E) 1,636

Form 4797 (§1245 recapture) 1,021 $4,605

Real estate taxes (farm) $ 140

Legal fees (probate adm.) 12,236

Court costs (adm.) 1,735 (14,111)

Adjusted total income (loss) $ ( 9,506)

Less: Exemption 600

TAXABLE INCOME (LOSS) $ (10,106)

Since the Estate will report a net loss for the second fiduciary income tax period (10-1-16 through 9-30-17), a net

operating loss computation should be prepared to determine if a NOL exists that could be carried back to the first

fiduciary return filed for the estate for refund purposes.

Claim for Refund. If the estate or trust elects to carryback a net operating loss, it can file a claim for refund by

using either Form 1045 or an amended Form 1041 under rules similar to those set forth for individual taxpayers.

Generally, an NOL can be carried back two years and forward 20 years. The estate or trust may also elect to forego

the carryback of the NOL.131

Note: The special carryback periods related to certain types of losses also apply to activities of estates and trusts

(e.g. casualty and theft losses (3 years); farm losses (5 years), etc.). The temporary 5-year carryback period available

for tax years ending in 2008 or 2009 also applied to fiduciary NOLs.

131 IRC Sec. 172 (b)(3).

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NOL Carryback – Effect on Beneficiaries. NOL carrybacks may have the effect of reducing distributable net

income (DNI) previously reported by income beneficiaries. Thus, when an NOL carryback occurs, income

beneficiaries may be entitled to a refund on their individual return since the income amount previously included in

their gross income from the carryback year would be limited to the estates/trusts’ DNI after application of the NOL

carryback.132 The correction in DNI applicable to the beneficiary will be reflected on an amended Schedule K-1

when the estate/trust prepares its Form 1045/Form 1040X to carryback its NOL.

Note. Income beneficiaries must file an amended return within three years of the due date of the return (including

extensions) of the taxable year of the NOL (i.e. a 2013 refund claim resulting from a 2014 calendar year estate/trust

NOL carryback generally must be filed by April 15, 2018 if the 2014 estate/trust return was not extended).

Example. In 2014, the Sam White Trust had DNI of $35,000 which it distributed to Sam’s wife, Mildred, the

Trust’s sole beneficiary. In 2016, the Trust sustained a $20,000 NOL which it carried back to 2015. The carryback

results in the Trust’s DNI for 2015 being reduced to $15,000. Mildred may file an amended return (Form 1040X)

to claim a refund based on the reduction in taxable DNI reported on the Trust’s fiduciary income tax return after

the NOL carryback (original return = $35,000 taxable income; after NOL carryback = $15,000 taxable income).

Mildred will attach her amended Schedule K-1 to Form 1040X to substantiate her claim.

Unused NOLs Upon Termination of and Estate or Trust. Any unused NOL carryovers existing upon termination

of an estate/trust pass through to the beneficiaries of the estate or trust upon termination.133 The unused NOL

carryovers retain their character as NOLs on the beneficiaries’ individual return and can be utilized against the

beneficiaries’ individual income over any remaining carryover life. If the final tax year of the estate/trust is the last

tax year to which an NOL can be carried over (e.g. year 20 under current carryover rules), any remaining NOL will

constitute an excess deduction on termination.134

The ”Two-Percent” Rule

In general, “excess deductions” in the final year of an estate or trust are miscellaneous itemized deductions as

defined in I.R.C. §67(b) in the hands of a beneficiary. However, it is possible that excess deductions that are

allocated to a beneficiary would be allowed only to the extent that the aggregate of the deductions exceeds two

percent of adjusted gross income. I.R.C. §67(e), however, provides that the two-percent rule is not applicable to

“deductions for costs which are paid or incurred in connection with the administration of an estate or trust and

would not have been incurred if such property were not held in trust or estate.”

In 2008, the U.S. Supreme Court in Knight v. Commissioner,135 provided a rather broad test for the exception for

the two-percent floor for trusts and estates. The Court’s test is whether the expense at issue is "commonly" or

"customarily" incurred outside of a trust or an estate. If so, then the two percent floor applies and the exception

does not. In Knight, the Court reasoned that because investment advisory fees are commonly incurred by

individuals (and not just trusts and estates), they do not come within the exception to the 2-percent floor rule (i.e.,

the two-percent floor limitation applies). But, the Court noted that it is possible that some types of advisory fees

may exclusively relate to trusts and estates, in which case the two-percent floor would not apply. However,

incurring advisory fees simply to comply with fiduciary "prudent investor" rules is not enough to escape the two-

percent floor.

Shortly after the Supreme Court issued its opinion in Knight, the Treasury issued proposed regulations which then

132 Rev. Rul. 61-20, 1961-1 C.B. 248. 133 I.R.C. §642(h). 134 Treas. Reg. §1.642(h)-2(b). 135 128 S. Ct. 782 (2008).

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became final regulations effective on or after May 9, 2014.136 Under the general rule,137 a cost incurred in

defending a claim against a trust or an estate is commonly and ordinarily incurred by an individual, but not if the

claim challenges the trust’s validity, administration or existence.

The Final Regulations detail five specific areas of costs:

• Ownership costs that a trust or an estate incurs because of its ownership of property are deemed to be

expenses that an individual owner would incur.138

• Certain tax preparation fees will not be subject to the 2 percent floor. Those fees include preparation fees

for estate tax returns, GSTT returns, fiduciary income tax returns and a decedent’s final individual income

tax return.139 But, the cost of preparing all other types of returns is subject to the 2 percent floor.

• Investment advisory fees are generally subject to the 2 percent floor, but in certain situations

the excess portion of the fee will not be subject to the 2 percent floor.140 Those situations include

incremental costs of investment advice that goes beyond what a normal investor would be charged. The

regulation explains this as advice that is rendered to an estate or a trust caused by an unusual investment

objective or a need for balancing of the interests of the parties that makes a reasonable comparison with

individual investors improper.141 In this situation, it is the excess portion of the fee (i.e., the amount that

normally wouldn’t be charged) that is not subject to the two percent floor.

• Certain types of appraisal fees are not subject to the 2 percent floor. These include FMV appraisals at date

of death or at the alternate valuation date (six months after death); appraisals to peg value when making

trust distributions; and appraisals required for return preparation (estate, trust or GSTT).142 All other

appraisal fees are deemed to be those that an individual would incur, including insurance-based

appraisals.143

• Certain fiduciary expenses are specifically listed as not subject to the 2 percent limitation include (1) probate

court fees and costs; (2) fiduciary bond premiums; (3) costs of providing notice to creditors and/or heirs;

(4) costs of providing certified copies of the decedent’s death certificate; and (5) costs of maintaining

fiduciary accounts.144

• As for bundled fees, the Final Regulations deal specifically with fees that could end up with “mixed”

treatment. If a single fee is paid that covers costs that are not subject to the 2 percent floor and others that

are, the fee must be allocated between the two types of costs.145 For fees that are not charged on an hourly

basis, just the portion of the expense that relates to investment advice is subject to the 2 percent limitation.146

The Final Regulations also state that any payments made to third parties out of a bundled fee that would

have been subject to the 2 percent limitation if paid directly by an estate or trust are not subject to

108 TD 9664. 79 Fed. Reg. 26626-26620 (May 9, 2014). These regulations would have applied beginning January 1, 2015, to a trust created

or an estate of a decedent dying after May 8, 2014. However, IRS later postponed the effective date such that the rules apply to taxpayers

whose tax years begin on or after January 1, 2015. TD 9664 79 Fed. Reg. 41636 (Jul. 17, 2014). 137 Treas. Reg. §1.67-4(b)(1). 138 Treas. Reg. §1.67-4(b)(2). 139 Treas. Reg. §1.67-4(b)(3). 140 Treas. Reg. §1.67-4(b)(4). 141 Id. 142 Treas. Reg. §1.67-4(b)(5). 143 Id. 144 Treas. Reg. §1.67-4(b)(6). 145 Treas. Reg. 1.67-4(c)(1). The regulation points out that fiduciary fees, attorney fees and accountant fees may be subject to “mixed”

treatment. 146 Treas. Reg. §1.67-4(c)(2). Apparently, a detailed parsing of the fee is necessary for a fee that is charged on an hourly basis.

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allocation.147 Similarly, no allocation is necessary for expenses assessed by a payee of the bundled fee for

services that are commonly or customarily incurred by an individual.148

Note. The Final Regulations specify that any reasonable method can be used to allocate fees between those subject

to the two-percent floor and those that are not.149 But, certain factors are listed that can aid in making the allocation.

Executor/Administrator Fees Received

An executor (or trust administrator) must include fees paid to them from an estate or trust in their gross income. If

the executor is not in the trade or business of being an executor (determined under the regular, continuous and

substantial standard), the fees should be reported on the executor’s Form 1040, line 21. If the executor is in the trade

or business of being an executor, the fees received from the estate should be reported as self-employment income

on Schedule C, or Schedule C-EZ, of the executor’s Form 1040.

If the trust or estate operates a trade or business and the executor (or trustee), materially participates in the trade or

business in their fiduciary capacity, any fees received that relate to the operation of the trade or business must be

reported as self-employment income on Schedule C (or Schedule C-EZ) of the executor/administrator’s Form

1040.

VALUATION DISCOUNTING VIA FAMILY LIMITED PARTNERSHIPS

OVERVIEW

Another tool in the succession planning toolbox is the use of valuation discounts. Discounting is a well-recognized

concept by the Tax Court and other federal courts and is commonplace in the context of closely-held businesses

with respect to lifetime transfers of interests in the business or transfers at death. ‘Discounts from fair market value

in the range of 30-45 percent (combined) are common for minority interests and lack of marketability in closely-

held entities.150

While discounting can apply to interests in corporations, one of the most common vehicles for discounting is the

family limited partnership (FLP). The principal objective of an FLP is to carry on a closely-held business where

management and control are important. FLPs have non-tax advantages, but a significant tax advantage is the

transfer of present value as well as future appreciation with reduced transfer tax.151 Commonly in many family

businesses, the parents contribute most of the partnership assets in exchange for general and limited partnership

interests. The nature of the partnership interest and whether the transfer creates an assignee interest (an interest

where giving the holder the right to income from the interest, but not ownership of the interest) with the assignee

becoming a partner only upon the consent of the other partners, as well as state law and provisions in the partnership

agreement that restrict liquidation and transfer of the partnership interest can result in discounts from the underlying

partnership asset value.

147 Treas. Reg. §1.67-4(c)(3). 148 Id. 149 Treas. Reg. §1.67-4(c)(4). 150 See Estate of Watts, T.C. Memo. 1985-595 (35% discount of 15% partnership interest for non-marketability for federal estate tax

purposes); Peracchio v. Comr., T.C. Memo. 2003-280 (gifts of FLP interests discounted 6 percent for minority interest and 25 percent for

lack of marketability).

151 See, e.g., Estate of Kelley v. Comr., T.C. Memo, 2005-235 (FLP interest valued under net asset value method with 35 percent discount).

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Observation. As use of FLPs has expanded, so has the focus of the IRS on methods to avoid or reduce the discounts.

In general, FLPs have withstood IRS attack and produce significant transfer tax savings. But, there are numerous

traps for the unwary.

In a typical scenario, the parents that own a family business establish an FLP with the interest of the general

partnership totaling 10% of the company's value and the limited partnership's interest totaling 90%. Each year, both

parents give each child limited-partnership shares with a market value not to exceed the gift tax annual exclusion

amount. In this way, the parents progressively transfer business ownership to their children consistent with the

present interest annual exclusion for gift tax purposes, and significantly lessen or eliminate estate taxes at death.

Even if the limited partners (children) together own 99% of the company, the general partner (parents) will retain

all control and the general partner is the only partnership interest with unlimited liability.

IRS has successfully limited or eliminated valuation discounts upon a finding of certain factors, such as formation

shortly before death where the sole purpose for formation was to avoid estate tax or depress asset values with

nothing of substance changed as a result of the formation. But, while an FLP formed without a business purpose

may be ignored for income tax purposes, lack of business purpose should not prevent an FLP from being given

effect for transfer tax purposes, thereby producing valuation discounts if it is formed in accordance with state law

and the entity structure is respected.

Note. The legislative history of Chapter 14 (IRC §§2701-2704) indicates that the Congress intended ordinary

minority and marketability valuation discounts to be respected, even in a family context.152

On the valuation issue, of particular concern is IRC § 2703. Under IRC §2703(a)(2), the value of property for

transfer tax purposes is determined without regard to any restrictions on the right to use property, but exempts a

restriction that is a bona fide business arrangement, is not a device to transfer property to family members for less

than full consideration, and has terms comparable to those in an arm’s-length transaction. Much of the litigation in

this area has involved FLPs and various restrictive agreements, but taxpayers have been able to succeed in situations

where a legitimate business purpose can be established, and personal assets are kept out of the entity.

Note: Discounts based on restrictive agreements were allowed prior to enactment of the “freeze” rules that went

into effect on October 8, 1990. Now, it is much harder to achieve discounts via a restrictive agreement such as a

buy-sell agreement. Now, to depress value of transferred interests, a buy-sell agreement must constitute a bona fide

business arrangement, not be a device to transfer property to family members for less than full and adequate

consideration, and have arm’s lengths terms.

Also, when an interest in a corporation or partnership is transferred to a family member, and the transferor and

family members hold, immediately before the transfer, control of the entity. In such instances, any applicable

restrictions (such as a restriction on liquidating the entity that the transferor and family members can collectively

remove) are disregarded in valuing the transferred interest.153 But, under I.R.C. §2704(b)(3), the term “applicable

restriction” does not include any restriction imposed by federal or state law.

Observation. It is important to form the entity in a jurisdiction where state law backs-up liquidation and

dissolution provisions of the partnership agreement for I.R.C. §2704(b) purposes

While the technical aspects of IRC §§2703 and 2704 are important, and must be satisfied, the more basic planning

aspects that establish the tax benefits of an FLP must not be overlooked:

152 See Omnibus Budget Reconciliation Act of 1990, Pub. L. No. 101-580, section 11602a; H.R. Conf. Rept. No. 101-964. But see, Estate

of Bongard v. Comr., 124 T.C. 95 (2005)(for estate tax purposes, these must be a legitimate and significant non-tax reason for creating the

FLP). 153 The regulations provide that an applicable restriction is a limitation on the ability to liquidate the entity that is more restrictive than the

restriction that would apply under state law in the absence of the restriction. Treas. Reg. §§25.2704(a).

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• The parties must follow all requirements set forth in state law and the partnership agreement in all actions

taken with respect to the partnership;

• The general partner must retain only those rights and powers normally associated with a general

partnership interest under state law (no extraordinary powers);

• The partnership must hold only business or investment assets, and not assets for the personal use of the

general partner, and;

• The general partner must report all partnership actions to the limited partners; and

• The limited partners must act to assure that the general partners do not exercise broader authorities over

partnership affairs than those granted under state law and the partnership agreement.

FLPs AND THE IRC§2036 PROBLEM

IRC § 2036(a)(1) provides that the gross estate includes the value of property previously transferred by the decedent

if the decedent retained the possession or enjoyment of, or the right to the income from, the transferred property.

IRC §2036(a)(2) includes in the gross estate property previously transferred by the decedent if the decedent retained

the right, either alone or in conjunction with any person, to designate the persons who are to possess or enjoy the

transferred property or its income. Thus, IRS may claim that, because a general partner (or majority shareholder)

controls partnership distributions, a transferred partnership interest by that partner should be taxed in that partner’s

estate due to IRC §2036(a)(2).

In the typical FLP scenario, the parents establish the FLP, gift the limited partnership interests to their children and

the parents (or parent) are the general partners. In this situation, if the general partners have the discretionary right

to determine the amount and timing of the distributions of cash or other assets, rather than the distributions being

mandatory under the terms of the partnership agreement, the IRS could argue that the general partners (who have

transferred interests to the limited partners, their children) have retained the right to designate the persons who shall

enjoy the income from the property, which was transferred.

Note. An exception to the inclusion rules exists for transfers made pursuant to a bona fide sale for an adequate

and full consideration in money or money’s worth.

Observation. The “purpose clause” in the partnership agreement is critical. The clause can either be drafted as a

one sentence general statement or it may take up an entire page. Neither type of clause is either correct or

incorrect. What is critical is that the actual reasons for creating the partnership are more important than what the

agreement says. Although, if the reasons for creating the partnership are explained in great detail, the stated

reasons should be consistent with the actual purposes and not be simply a list of possible partnership purposes.

From a succession planning perspective, it may be best for one parent to be the transferor of the limited partnership

interests and the other to be the general partner. For example, both parents could make contributions to the

partnership in the necessary amounts so that one parent receives a 1 percent general partnership interest and the

other parent receives the 99 percent limited partnership interest. The parent holding the limited partnership interest

then makes gifts of the limited partnership interests to the children (or their trusts). The other parent is able to retain

control of the “family assets” while the parent holding the limited partnership interest is the transferor of the

interests. Unlike IRC §672(e), which treats the grantor as holding the powers of the grantor’s spouse, IRC §2036

does not have a similar provision. Thus, if one spouse is able to retain control of the partnership and the other

spouse is the transferor of the limited partnership interests, then IRC §2036 should not be applicable.

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The Use of Formula (Defined Value) Clauses for Gifting/Transferring Assets. Formula clauses are used by

taxpayers to avoid unintended gift, estate and generation-skipping transfer tax (GSTT) consequences when

transferring property. The estate tax version utilizes the clause in a will or trust, and involves the decedent leaving

a set dollar amount of the estate to the decedent’s children (or specific beneficiaries) with the residuary estate

passing to a charitable organization.154 The portion passing to the charity qualifies for the estate tax charitable

deduction and, thus, puts a “lid” on the amount of estate tax owed. The technique can be very beneficial in

minimizing tax on transfer of assets from one generation to the next where family business assets that are difficult

to value are involved.

Observation. This could be a particularly useful concept (especially for farm and ranch estates) if the

Administration succeeds in its present attempts to eliminate valuation discounts for closely-help business interests

or in its attempts to push through the Congress an increase in the federal estate tax.

The gift tax version works in a similar way by specifying via formula an amount of gifted property to be transferred

to family members (or specified non-family beneficiaries), with the balance passing to charity.155

Observation. Another benefit of the use of a formula clause is that can prevent the IRS from increasing estate or

gift tax by denying or diminishing valuation discounts. If the IRS succeeds in reducing a claimed valuation discount,

the enhanced value either passes to a charity (estate tax formula clause) or is transferred to a charity (gift tax formula

clause). The result is an enhanced charitable deduction on either Form 706 or Form 709, with no resulting increase

in tax.

Several recent cases have validated the use of formula clauses in the context of succession planning.

• In Estate of Christiansen v. Comr.,156 the United States Court of Appeals for the Eighth Circuit affirmed

the Tax Court in rejecting the IRS’s position of refusing to recognize “defined value” types of formula

clauses. In the case, a sole beneficiary of a South Dakota family ranching operation disclaimed all of the

estate (under a fractional formula) in excess of $6,350,000. The disclaimed assets passed 75 percent to a

charitable lead annuity trust and 25 percent to a foundation. The IRS and the estate agreed to increase the

value of the gross estate from $6.5 to $9.6 million by virtue of a reduction in the claimed valuation discount

in the deceased mother’s estate.157 As to the 25 percent passing to the charity, the IRS argued that a

charitable deduction should not be permitted for the increased value for two reasons because any increased

amount passing to the charity was contingent on future events – the final determination of the IRS of the

value of the transfer.158 In addition, the IRS claimed that the transfer violated public policy because it

diminished the incentive of the IRS to audit estate tax returns. The Tax Court and the Eighth Circuit rejected

both arguments.

Observation. The case is a significant taxpayer win validating the use of defined value transfers where the

transfer is made and allocated between a “taxable” and “non-taxable” portion based on gift or estate tax values

or based on agreement. The case is also important for transfers whereby the amount transferred is defined by

a formula referring to gift or estate tax values. A value “enhancement” by the IRS (typically by denying or

154 An alternative technique is for the estate plan to leave everything to a specific beneficiary with that beneficiary having the power to

disclaim whatever property the beneficiary desires to disclaim with the disclaimed property passing to charity.

155 Formula clauses come in two general types–a definition clause defines a transfer by reference to the value of a possibly larger, identified

property interest. and a savings clause retroactively adjusts the value of a transfer due to a subsequent valuation determination.

156 586 F.3d 1061 (8th Cir. 2009). 157 The Tax Court held that the disclaimer as to the 75% that passed to the CLAT did not satisfy all the technical disclaimer requirements

(so the estate owed estate tax on that portion of the increase value of the estate). The estate did not appeal that aspect of the case. 158 The IRS position was based on Rev. Rul. 86-41, 1986-1 C.B. 300.

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reducing a claimed valuation discount) works the same way that a standard marital deduction formula clause

works in a will or trust. Under such a clause, an increased value allocates a larger value to the surviving spouse

but does not generate additional estate tax. Until the Christiansen decision it was not certain whether courts

would uphold intervivos defined value transfers against a public policy attack (even though standard marital

deduction formula clauses in wills have operated in that same manner for decades).

• In Petter v. Comr.,159 the petitioner inherited several million dollars of UPS stock at the time it was a closely-

held company. The stock later doubled in value when UPS stock became publicly traded. Utilizing a part-

gift, part-sale transaction, the petitioner transferred her interests in an LLC to intentionally-defective trusts.

Pursuant to an agreement, a block of units in the LLC were first allocated to grantor trusts consistent with

the gift tax exclusion with the balance allocated to charities. The value of the LLC interests were allocated

based on value as determined by an appraiser, but the IRS claimed that the discount should be less and did

not respect the formula allocation provisions for gift tax purposes. The court held that the formula allocation

provision did not violate public policy. As a result, the gift tax charitable deduction was allowed for the

full value passing to charity based on the determination of value as finally determined by the IRS.

• In Hendrix v. Comr.,160 the taxpayer made a gift of a small amount to a charitable donee. The gift was in

the form of a fixed dollar amount of stock that was transferred to family trusts, with the excess passing to

the charity. The transfers to trust were structured as part gift/part sale transactions with only the excess of

the aggregate amount of the defined transfers to the trusts over the consideration that the trusts paid treated

as a gift. The IRS objected on the basis that the defined value formula clause was not bona fide because it

was not arm’s length. The Tax Court, however, disagreed. The court noted that the transfers to the trusts

did cause the trusts to incur economic and business risk. That was the case because if the value of the stock

as initially computed was undervalued, more shares would shift from the trusts to the charity.

• In Wandry v. Comr.,161 the taxpayer prevailed again in the utilization of a defined value clause that was

used to determine the fair market value of gifts for gift tax purposes. The formula referenced a fixed dollar

amount rather than a transfer of a fixed quantity of property. The taxpayers, a married couple, transferred

interests in their family LLC to their four children (worth $261,000 to each child) and five grandchildren

(in the amount of $11,000 to each grandchild). No residual beneficiary was specified if the IRS issued a

redetermination of value. But, the transfer document specified that if a subsequent IRS valuation

determination (or a court decision) changed the value of the gifted membership units, the number of the

gifted LLC units would be adjusted such that the same value as initially specified was being transferred to

child and grandchild. The IRS challenged the use of the defined value clause to transfer fixed dollar

amounts of LLC interests to the transferees. But, the Tax Court ruled that there is no public policy against

formula clauses that simply define the rights transferred without undoing prior transfers (as opposed to a

“savings clause”).

THE LIFE ESTATE/REMAINDER TRANSFER STRATEGY

OVERVIEW

The life estate/remainder is a common estate planning/succession planning strategy. It is a strategy that is often

integrated into a succession plan as a component of the plan, but is typically not the primary focus of a succession

plan. It is also a simple way to own property and move it from one generation to the next. It is a technique often

159 T.C. Memo. 2009-280. 160 T.C. Memo. 2011-133. 161 T.C. Memo. 2012-88.

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employed in relatively smaller-sized estates, sometimes on an informal basis. Thus, an understanding of the basics

of life estate/remainder arrangements is critical.

The life estate/remainder arrangement is a form of co-ownership that gives both the life tenant and the person or

persons holding the remainder interest certain rights to the property. The life tenant has a current right to possession

and the interest of the holder of the remainder interest has a right of possession upon the life tenant’s death.

CREATION AND PROPERTY SUBJECT TO A LIFE ESTATE

A life estate can be created by gift or sale (by virtue of a deed), at death under the terms of a will or trust, by state

law, or by a settlement agreement in divorce proceedings (or via court order). Most often, life estates are created

with respect to real property, but they can also be utilized with personal property and even intangible personal

property.

Tax Issues. As noted above, the life tenant has possession of the property subject to the life estate, and is entitled

to all of the income generated by the property. That means the normal tax consequences associated with property

ownership are enjoyed by the life tenant. For example, the life tenant is taxed on all of the income received from

the property and can deduct items attributable to the property such as real estate taxes, mortgage interest,

depreciation (if the property is depreciable) and depletion (if the life estate is acquired by purchase).

If life estate property is sold, its income tax basis must be apportioned between the life estate interest and the

remainder interest in proportion to the respective present values of the interests as determined by the IRS valuation

tables using the IRC §7520 rate in effect at the time of valuation.

The share of uniform basis allocable to each interest is adjusted over time. That plays out in the following ways:

• If the property is not sold during the life tenancy, the holder of the remainder interest receives the entire

income tax basis in the property.

• If only the life estate interest is sold, the life tenant’s portion of uniform basis is disregarded for purposes

of determining gain or loss.162 That means that the gain on sale will equal the amount realized on sale (the

sale proceeds). The gain would most likely be capital in nature.

Note. If the life estate property is a personal residence, both the holder of the life estate interest and the

remainder interest are potentially eligible for the IRC §121 gain exclusion, but would have to satisfy the two

out of five year use and occupancy requirement.

• If both the life estate interest and the remainder interest is sold during the life tenancy, the uniform basis of

the property and the sale proceeds must be allocated between the life estate interest and remainder interest

based on their respective values at the time of sale to determine gain or loss on the sale attributable to each

respective interest.163 The gain would most likely be capital gain.

• If the holder of the remainder interest sells the property after the life estate terminates, gain or loss on sale

is determined by subtracting the uniform basis in the property from the amount realized on sale. Income Tax Basis. It is important to understand the basis rules associated with life estate/remainder arrangements.

Basis is tied to how the life estate was created and acquired:

162 IRC §1001(e). 163 See Rev. Rul. 72-243, 1972-1 C.B. 233.

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• For a “granted” life estate/remainder arrangements that are created by will or trust, on the grantor’s death,

the property receives a basis in the hands of the recipient of the life estate equal to the fair market value at

the time of the grantor’s death.

• For “reserved” life estates (those created by deed where the grantor retains the life estate), the full value of

the property is included in the grantor’s gross estate at death with the holder of the remainder interest getting

a basis equal to fair market value at the time of death.

• A carryover basis applies to a life estate/remainder interest that is created by gift.

• For those interests that are purchased, a purchase price basis applies.

Note. To the extent that the life tenant takes depreciation during the life tenancy, the uniform basis in the

property is reduced accordingly.

Estate and Gift Tax. A transfer of a life estate during life by deed qualifies as a present interest gift (and qualifies

for the marital deduction if transferred to the transferor’s spouse), but gifts of successive life estate interests or

remainder interests are future interests that don’t qualify for the gift tax present interest annual exclusion. The

amount of the gift equals the present value of the interest in the property transferred as determined under the IRS

valuation tables using the IRC §7520 rate in effect at the date of the gift.

Note. While it is beyond the scope of the discussion here, if the grantor retains certain interests in the property and

gifts the other interests in the property to members of the grantor’s family, the special valuation rules of IRC §2702

apply.

For interests created by will or trust, the entire fair market value of the property will be included in the decedent’s

taxable estate or trust grantor for federal estate tax purposes. For granted interests where the grantor retains the life

estate, the full value of the property is included in the grantor’s taxable estate at death. A life estate to the spouse

at death does not qualify for the marital deduction unless it is in the form of a “qualified terminable interest property”

or “QTIP.”

Planning Points. The life estate/remainder arrangement is a very simple technique that involves minimal cost. It

also avoids probate because the property passes automatically to the holder of the remainder interest. The strategy

also protects the property from the creditors of the holders of the remainder interest during the term of the life estate.

But, creditors of remainder holders can reach “vested” remainder interests which can indirectly cause problems for

a life tenant wanting to sell or mortgage the property.164 In addition, in some states, the life estate/remainder

arrangement can provide some benefit in the event of the need for long-term care where a Medicaid benefit

application is filed. For benefit eligibility computational purposes, only the value of a retained life estate is counted

for eligibility purposes and subject to Medicaid recovery provisions at the recipient’s death.

Alternatively, the life estate/remainder strategy can spur conflicts between the life tenant and the holders of the

remainder interest. In addition, neither the life tenant nor the remainder holders can independently sell or mortgage

the property without the consent of the other.

164 A “vested” remainder is one that is certain to become possessory in the future.

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ESTATE AND GIFT TAX PLANNING WITH FORMULA AND PRICE

ADJUSTMENT CLAUSES

FORMULA CLAUSES (DEFINED)

Formula clause language is drafting language included in a will or trust that is designed to limit liability for estate

or gift tax purposes. If, upon audit, the IRS challenges the value of a transfer, the formula clause adjusts the amount

of the assets transferred to match a specified dollar value. Another way to define the clause is that it provides for a

reallocation of the transfer among a group of donees depending on the final determination of the value of the

property being transferred.

A formula clause is different from a “savings” clause. A savings clause allows the donor to “take back” property

after an adjustment. The courts generally have agreed with the IRS that a savings clause is void on public policy

grounds. But, the courts have approved formula clauses where “excess” amounts after an adjustment pass to one

or more charitable beneficiaries. In addition, the Tax Court has approved the use of a formula clause that did not

involve a charitable beneficiary. The IRS did not appeal the Tax Court’s decision, but does not agree with it.

KEY FORMULA/PRICE ADJUSTMENT CLAUSE CASES

In recent years, there have been several key cases involving the use and construction of formula/price adjustment

clauses.

• Comr. v. Procter, 142 F.2d 824 (4th Cir. 1944), cert. den. sub. nom., 323 U.S. 756 (1944)

In this case, the taxpayer created a trust containing an adjustment clause providing that if the IRS asserted

gift tax, the trust property, to the extent of the value of the gifted property, would remain the taxpayer’s

property. While the Tax Court upheld the clause with the result that gift tax could not be imposed, that

decision was reversed on appeal. Importantly, the appellate court held that this provision created “a

condition subsequent” and was “void and contrary to public policy.”

The court stated that the clause would

“…discourage the collection of the tax by the public officials charged with its collection, since

the only effect of an attempt to enforce the tax would be to defeat the gift. In the second place,

the effect of the condition would be to obstruct the administration of justice by requiring the

courts to pass upon a moot case. If the conditions were valid and the gift were held subject to

tax, the only effect of the holding would be to defeat the gift so that it would not be subject to

tax. . . . In the third place the condition is to the effect that the final judgment of a court is to

be held for naught because of the provision of an indenture necessarily before the court when

the judgment is rendered.”

The U.S. Supreme Court declined to review the appellate court’s opinion.

POST-PROCTOR CASES

After Procter, the Tax Court typically upheld IRS disallowances of other attempts to reverse completed transfers

in excess of the available gift tax exclusions. These decisions involved the use of “savings clauses.” Under a savings

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clause, if the final determination by IRS of the value of a gift exceeds the value originally claimed on the return,

the donee must issue a promissory note to the donor to reduce the value of the gift to the amount originally claimed.

The Tax Court generally did not approve this type of clause.

Harwood v. Comr., 82 T.C. 239 (1984)

In this case, the taxpayers utilized a family partnership to operate a logging and sawmill business started that the

grandfather founded. The grandmother gave a portion of her interest to her sons in exchange for an annuity, and

the sons later gave a portion to their sister and portions to their children, via trusts. Valuation issues abounded,

but the court determined that the taxpayers' "savings clause," asserting that any gift over the taxable limit would

revert to the donor, was void as against public policy.

Each of the trust agreements contained the following clause:

“Article First. Property subject to this instrument listed in Schedule "A" is referred to as the "trust estate" and

shall be held, administered, and distributed in accordance with this instrument. In the event that the value of the

partnership interest listed in Schedule "A" shall be finally determined to exceed $ 400,000 for purposes of

computing the California or United States Gift Tax, and in the opinion of the Attorney for the trustee a lower

value is not reasonably defendable, the trustee shall immediately execute a promissory note to the trustors in the

usual form at 6 percent interest in a principal amount equal to the difference between the value of such gift and

$ 400,000. The note shall carry interest and be effective as of the day of the gift.”

Ward v. Comr., 87 T.C. 78 (1986)

In this case, a married couple were embroiled in a battle with IRS over the value of gifts of land and stock in a

Florida cattle ranch that they gave given to their sons and daughters-in-law. A gift adjustment agreement was

involved under which the couple each conveyed 25 shares of ranch stock to each son but reserved the power to

revoke a part of each gift if it was "finally determined for Federal gift tax purposes" that the fair market value of

each share exceeded $2,000. Among other issues that the court determined, the court concluded that the gift

adjustment agreement was void and had no effect on the gift taxes otherwise due on the gifts of stock to petitioners'

sons. The court noted that the agreement purported to retroactively alter the amount of an otherwise completed

gift, and the effect of the agreement would be to obstruct the administration of justice.

Rev. Rul. 1986-41, 1986-1 C.B. 300

In this Revenue Ruling, IRS set forth its position on what it viewed as impermissible savings clauses. Under the

facts of the Rev. Rul., A transferred a one-half undivided interest in real property to B. Under the deed of transfer,

if the one-half interest were determined by the IRS to have a value for federal gift tax purposes in excess of $10,000,

B’s fractional interest would be reduced by effectively reconveying a fractional share back to A so that the value of

the gift equaled $10,000. Under an alternative scenario, there would not be any required reconveyance. Instead, B

would transfer consideration to A in the amount of the “excess” gift. Citing Procter, th IRS stated that neither clause

would be respected for gift tax purposes. IRS took the position that the purpose of the adjustment clauses was “not

to preserve or implement the original, bona fide intent of the parties, as in the case of a clause requiring a purchase

price adjustment based upon an appraisal by an independent third party . . . [but] to recharacterize the nature of the

transaction in the event of a future adjustment to A’s gift tax return by the Service.”

FSA 200122011 (Jun. 4, 2001)

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The IRS issued administrative guidance on the issue in F.S.A. 200122011 (Jun. 4, 2001). In the FSA, the IRS

applied the principles of Proctor to a formula clause (Proctor involved a savings clause), to conclude that the

formula clause was invalid because it recharacterized the transaction in a manner that would make it impossible for

any valuation increase resulting from a gift tax audit that generated a gift tax deficiency.

McCord v. Comr., 461 F.3d 614 (2006), rev’g., 120 T.C. 358 (2003).

This case involved the same facts (and parties) of the 2001 FSA. A married couple each held 41.17 percent of a

family limited partnership (FLP). They entered into an assignment agreement involving their children, GSTT trusts

for the children, and two charities. Under the agreement, the couple assigned all of their FLP rights to the assignees.

A formula clause in the agreement specified that the children and GSTT trusts were to receive portions of the gifted

interest having an aggregate FMV of just over $6.9 million. If the FMV of the gifted interest exceeded that amount,

then one child was to receive a portion of the gifted interest having a FMV equal to the excess, up to $134,000. If

any amount of the gifted interest remained after the allocation to the children, the trust and the two charities received

that portion to be allocated by the assignees.

The FMV of the assignee interest was determined to be $89,505. The agreement basically changed the dollar value

of what each donee received (based on appraisal of the FLP interests at the date of the gifts) into percentages of

FLP interests. Ultimately, the couple was entitled to a charitable deduction of $324,345.16. That was determined

by the FMV of the property of just over $7.36 million, less the amount given to the children ($6.9 million) and less

another slight amount given to another donee. The court upheld the defined value gift clause (e.g., “charitable lid”)

stating that the gifts were complete as of the date of the assignment.

Estate of Christiansen v. Comr., 586 F.3d 1061 (8th Cir. 2009), aff’g., 130 T.C. 1 (2008)

In this case, the decedent left her entire estate to her daughter (her only child), with the daughter having the right to

disclaim property. Any disclaimed property would pass 75 percent to a charitable lead annuity trust (CLAT) and 25

percent to a private foundation (a qualified charity) that the decedent had established. The trust had a 20-year term

and would pay an annuity of 7 percent of the corpus’s net fair market value at the time of the decedent’s death to

the foundation. At the end of the 20 years, if the daughter were still alive, she would receive the balance of the

property remaining in the trust. discounted value - slightly over $6.5 million. The daughter retained $6,350,000 -

an amount she believed would allow the family business to continue, as well as to provide for her and her own

family’s future, and disclaimed the balance. The disclaimer resulted in $40,555.80 passing to the Foundation and

$121,667.20 to the Trust. The decedent’s estate deducted the entire amount that passed to the Foundation, and the

part passing to the Trust that was equal to the present value of 7 percent of $121,667.20 per annum for 20 years.

The total deduction, therefore, was approximately $140,000. The disclaimer language coupled with the savings

clause laid a trap for IRS. If IRS, upon audit, succeeding in increasing the value of the decedent’s estate that effort

would result in an increase in the estate’s charitable deduction, without resulting in any additional estate tax.

The IRS did challenge the valuation of the decedent’s FLP interests, and reduced the FLP discounts by

approximately 35 percent. IRS also took the position that the daughter’s disclaimer was not “qualified” such that

none of the estate’s property passing to either the Trust or the Foundation generated a charitable deduction. The

parties settled the valuation issue before trial, stipulating that the fair market value of the decedent’s interest in

Christiansen Investments was $1,828,718.10, and that the decedent’s interest in MHC Land and Cattle was worth

$6,751,404.63. Coupled with the decedent’s other property interests, IRS valued the decedent’s estate at

$9,578,895.93 rather than the $6,512,223.20 the estate reported.

Here’s where the disclaimer language kicked in. As applied to the enhanced value of the estate assets, the disclaimer

resulted in property with a fair market value of $2,421,671.95 going to the Trust and property with a fair market

value of $807,223.98 going to the Foundation. The estate claimed an increased charitable deduction for the full

(enhanced) amount passing to the Foundation and also for the increased value of the Trust’s annuity interest.

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The Tax Court noted that the Regulation at issue (Treas. Reg. §20.2055-2(b)(1) was clear and unambiguous in that

it made no reference to the “existence or finality of an accounting valuation at the date of death or disclaimer.”

Instead, the court noted, the Regulation was couched in terms of the existence of a transfer as of the date of a

decedent’s death. In addition I.R.C. §2518 specifies that a qualified disclaimer relates back to the time of death by

allowing disclaimed amounts to pass as though the initial transfer had never occurred. On that point, the appellate

court (which affirmed the Tax Court on all points) noted that “all that remained following the disclaimer was the

valuation of the estate, and therefore, the value of the charitable donation.” Thus, the foundation’s right to receive

25 percent of any amount in excess of $6.35 million was certain as of the date of the decedent’s death. The appellate

court pointed out that IRS had “failed to distinguish between post-death events that change the actual value of an

asset or estate and events that occur post-death that are merely part of the legal or accounting process of determining

value at the time of death.” [emphasis added] Thus, contingencies that are beyond the process of determining value

result in disallowed deductions, but those that are part of the legal or accounting process of determining date-of-

death value are permissible. Indeed, the appellate court noted that Treas. Reg. §20.2055-2(e)(2)(vi)(a) specifies that

references to values “as finally determined for Federal estate tax purposes” are sufficiently certain to be considered

“determinable” for purposes of qualifying as a guaranteed annuity interest. That’s the language that was used in the

disclaimer. Therefore, the court reasoned the Regulation distinguishes between fixed, determinable amounts (the

disclaimer language at issue) from fluctuating formulas that depend on future conditions for their determination.

The appellate court also noted that while the disclaimer language at issue could discourage IRS from examining

estate tax returns, the court said that the IRS’ role is not simply to “maximize tax receipts,” but to enforce the tax

laws. Here, the drafting of the disclaimer was within the bounds of the statute and Regulation. In addition, the court

said the Congress never intended a policy that would provide incentives for the IRS to challenge and/or audit returns.

Estate of Petter v. Comr., 653 F.3d 1012 (9th Cir. 2011), aff’g., T.C. Memo. 2009-280

In this case, the U.S. Court of Appeals for the Ninth Circuit affirmed the Tax Court in sustaining a formula

adjustment clause that reallocated LLC units between charitable and non-charitable donees when the value of the

LLC units was later increased on audit. In 1982, a taxpayer inherited a large amount of United Parcel Service (UPS)

stock, which was worth millions of dollars. The taxpayer transferred a large amount of the UPS stock to an LLC

and then gifted membership units in the LLC to two intentionally defective grantor trusts. The amount gifted to

each trust was “one-half the minimum dollar amount that can pass free of federal gift tax by reason of Transferor’s

applicable exclusion amount allowed by Code Section 2010(c).” The transfer document also provided that if the

value of the units the trusts initially received were “finally determined for federal gift tax purposes” to exceed the

amount of the available unified credit, the trustees would transfer the excess units to the designated charity.

The Tax Court held that the formula clause was similar to the one in Christiansen. In upholding the validity of the

clause and rejecting the IRS’s public policy argument, the Tax Court stated:

“As in Christiansen, we find that this gift is not as susceptible to abuse as the Commissioner would

have us believe. Although, unlike Christiansen, there is no executor to act as a fiduciary, the terms

of this gift made the PFLLC [Petter Family LLC] managers themselves fiduciaries for the

foundations, meaning that they could effectively police the trusts for shady dealing such as

purposely low-ball appraisals leading to misallocated gifts. . . . We do not fear that we are passing

on a moot case; because of the potential sources of enforcement, we have little doubt that a

judgment adjusting the value of each unit will actually trigger a reallocation of the number of units

between the trusts and the foundation under the formula clause. So we are not issuing a merely

declaratory judgment.”

The Ninth Circuit, affirming the Tax Court, elaborated on the Tax Court’s reasoning:

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“[The] particular number of LLC units was the same when the units were first appraised as when

the IRS conducted its audit because the fair market value of an LLC unit at a particular time never

changes. Thus, the IRS’s determination that the LLC units had a greater fair market value than

what the Moss Adams [donor’s] appraisal said they had in no way grants the foundations rights to

receive additional units; rather, it merely ensures that the foundations receive those units they were

already entitled to receive. The number of LLC units the foundations were entitled to was capable

of mathematical determination from the outset, once the fair market value was known.”

Hendrix v. Comr., T.C. Memo. 2011-133

Here, the Tax Court again rejected the notion that formula clauses should be invalidated on public policy grounds.

The taxpayers executed an agreement assigning approximately $10,520,000 to a GSST trust, with the excess value

passing to a charitable foundation. The IRS issued a notice of deficiency contesting the valuation of the gifts and

the validity of the formula clauses. The Tax Court ruled that the gift tax returns’ valuations were correct and that

the formula clauses were valid. Therefore, the donors were entitled to the charitable deductions they had claimed

on their tax returns.

The Tax Court, in rejecting the IRS’s argument that the formula clauses violated public policy, stated:

“Here, unlike there [Procter], the formula clauses impose no condition subsequent that would

defeat the transfer. Moreover, as stated above, the formula clauses further the fundamental

public policy of encouraging gifts to charity. Recently, in Estate of Christiansen v.

Commissioner [citation omitted], we held that an essentially similar dollar-value formula

disclaimer was not contrary to public policy. We know of no legitimate reason to distinguish

the formula clauses from that disclaimer, and we decline to do so. We hold that the formula

clauses are not void as contrary to public policy.”

Wandry v. Comr., T.C. Memo. 2012-88, non-acq., A.O.D. 2012-04, I.R.B. 2012-46.

In this case, a married couple gifted units in their LLC in 2004 to their children and grandchildren by means of a

formula that fixed the number of LLC units to be gifted as of the date of the gift, with the value to be determined

based on the fair market value of the gifted units which would be determined sometime later based on an appraisal,

the IRS, or a court. In other words, the dollar value of each gift was established based on gift tax exclusions at the

time of the gifts, with the number of LLC units gifted to be based on the fair market value of the LLC as determined

later. The IRS challenged the gifts on the basis that they represented the transfer of a fixed percentage interest of

the LLC instead of a specified dollar value. The court upheld the formula clause because it simply involved the

allocation of LLC units among the parents and the donees. The parents could not re-claim the gifted units once the

gifts had been made if a higher unit value was established post-gift — they simply had defined the units gifted as

of the date of the gift. The IRS appealed to the U.S. Circuit Court of Appeals for the Tenth Circuit, but the IRS

voluntarily withdrew its appeal before the court could rule. Later, the IRS issued a non-acquiescence to the Tax

Court’s opinion.

Thoughts on Advising Clients. Based on the cases, advise to clients can take the following shape:

1. Formula clauses can be used to restrict value of non-marketable or difficult to value gifted property or

bequests so as to establish specified amounts.

2. The formula clause utilized in Wandry is relatively easy to implement, but IRS still views formula clauses

as improper and will likely challenge them when they can. This is particularly true when a charitable donee

is not involved.

3. If the client is inclined to benefit a charity, the type of formula clause used in Petter.

4. When drafting formula clauses, it is critical to ensure that the gift is complete when the transfer occurs.

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attorneys must make sure that the gift is deemed completed at the time of the transfer.

5. Always report the transfer on Form 706 or Form 709 (whichever is applicable). An accompanying

statement may be necessary explaining that it may be necessary to adjust

the quantity of property being transferred due to judicial (or IRS) redetermination of value.

6. Make sure the capital accounts of partnerships and LLCs match the transfer.

7. To avoid a Proctor-like challenge, transfer documents must not use any language that could be construed

as a savings clause that takes property back. There should always be an unambiguous intent to transfer a

set value of property rather than a percentage interest or number of membership units.

Payment of Federal Estate Tax For Ag Estates Utilizing the

Special Use Valuation or Installment Payment Provisions

Overview

Because of the increased estate tax exclusion amount ($5,430,000 for deaths in 2015), coupled with the

availability of "portability" between spouses, the vast majority of decedents’ estates are not subject to federal

estate tax. However, estates that are subject to estate taxes can face problems with having the necessary liquidity

to pay the federal estate taxes within 9 months of death, the due date for the federal estate tax return – Form 706.

Farm and ranch estates can face enormous liquidity issues due largely to the largest asset of the estate typically

being land. The liquidity problem has only been magnified in recent years with the run-up in land values (with a

leveling off in recent months). Sale of farm and ranch assets, such as land, may not be feasible in light of the

need to maintain the operation as an efficient operating entity. In addition, the family is usually not in favor of

selling any piece of the land to pay taxes or for any other reason. From a practical standpoint, it can be difficult to

complete a forced sale of farm assets (including land) within nine months of death (a six month extension is

possible) at a representative fair market value.

When working with an agricultural estate with illiquid assets, the planner has two significant tools that can be

used to minimize the impact of illiquidity. First, an election can be made to value real estate used in farming (or

other closely held businesses) at its "current use" value (subject to a limit) rather than valuing it at fair market

value at death in accordance with the "highest and best use" valuation standard.165 This “special use value”

election reduces the estate tax attributed to the farm/ranch land subject to the election.

Note. A cap is placed on the benefits of special use valuation which limits the maximum aggregate reduction in

the value of qualified real property attributable to the election. For deaths in 2017, the maximum value reduction

that can be achieved by making a special use value election is $1,120,000.166

Second, an illiquid estate can elect to pay the estate tax that is attributable to the estate’s closely-held business

assets in installments for up to 15 years, rather than having the entire estate tax come due nine months after

death.167

Special Use Valuation

Overview

165 I.R.C. §2032A. 166 Rev. Proc. 2014-61. 167 I.R.C. §6166.

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Under I.R.C. §2032A an estate may elect to value real property used in farming or other closely held businesses at

its "current use" for agricultural purposes rather than at its highest and best use. The provision, however, is very

complex and requires an estate with the right set of facts to be able to take advantage of the provision. Numerous

requirements must be satisfied by the decedent for a particular amount of time before death, by the estate at the time

of death and by the qualified heir(s) for ten years after death.

Note. For the purpose of determining whether the estate qualifies to make a special use valuation election, transfers

made within three years of death are included in the estate.168

Requirement for real estate. To qualify, the real estate must be: (1) located in the United States; (2) acquired

from or passed from the decedent to a qualified heir; and (3) used for a qualified use by the decedent or a member

of the decedent’s family for a certain amount of time before death and at the time of the decedent’s death.169 “Real

estate” for this purpose includes roads, buildings, and other structures and improvements functionally related to

farming or ranching.170

Fifty percent test. The farming or ranching property real and personal property must make up at least 50 percent

of the adjusted value of the gross estate, using fair market value figures, and that amount or more must pass to

qualified heirs.171 “Adjusted value” of real or personal property is defined as the fair market value less allowable

indebtedness attributable to the property. The farm residence is eligible real property if it is occupied on a regular

basis by the owner, tenant or an employee of the owner or tenant for the purpose of “operating or maintaining such

real property.” Personal property may be considered in meeting the 50 percent test only if it is used together with

the real property that is to be specially valued.

Twenty-five percent test. A second pre-death requirement is that the farmland itself must make up at least 25

percent of the gross estate less secured indebtedness.172 At least 25 percent of the adjusted value of the decedent’s

gross estate must be qualified farm real property that was acquired from or passed from the decedent to a qualified

heir. As such, the land itself must be a significant part of the total value of the estate.

Note. Importantly, the land subject to the election need not be placed on all of the real estate that comprises at

least 25 percent of the adjusted value of the gross estate.173 This allows the election to be placed on only the land

that provides the greatest likelihood that the qualified heir(s) will be able to satisfy the post-death requirements

and avoid recapture tax.

Pre-death qualified use test. The qualified use test (a.k.a. the equity interest test) requires the decedent or member

of the family to have had an equity interest in the farm operation at the time of death and for five or more of the last

eight years before death.174

168 I.R.C. §2035(c)(1), (2). 169 I.R.C. §2032A(b)(1). Because a “member of the family” can meet the qualified use test pre-death, the decedent, as a

landlord, could have either a crop/livestock share lease or a cash lease with a member of the family. 170 Treas. Reg. §20.2032A-3(b)(2). Thus, a residence on the real property occupied on a regular basis by the owner, lessee, or

an employee for the purpose of operating the farm or business is eligible for the election. I.R.C. §2032A(e)(3). 171 I.R.C. §2032A(b)(3)(A). 172 I.R.C. §2032A(b)(1)(B). 173 Finfrock v. United States, 860 F. Supp. 2d 651 (C.D. Ill. 2012)(Treas. Reg. Sec. 20.2032A-8(a)(2) invalid insofar as it

attempts to impose a non-statutory requirement that 25 percent of the adjusted value of the gross estate must consist of

farmland subject to the special use valuation election). 174 I.R.C. §2032A(a)(1), (b)(1)(C).

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Note. A cash rent lease does not produce an equity interest and is not permitted in the pre-death period except to

a member of the family or family-owned entity as farm tenant.175 The qualified use test requires that the decedent

or a member of the family bear the risks of production and the risks of price change. A landlord under a cash rent

lease does not bear the risks of production or the risks of price change.176

The qualified use test must be met in the instant prior to death, for five or more of the last eight years before death,

and after death during the 10-year post-death recapture period.

Material participation test. This test requires active involvement in the farm or ranch business by the decedent-to-

be or a member of the decedent-to-be’s family during five or more of the last eight years before the earlier of the

decedent-to-be’s retirement, disability or death. Surviving spouses, however, only have to provide active

management.177 The test can be satisfied through a crop-share lease with a great deal of involvement, a custom

farming operation or with a direct farming operation. But, a cash rent lease with the usual minimal involvement in

management cannot be used to satisfy the test. Nor can it be met with a non-material participation crop share lease.

The decedent-to-be or a member of the family (including an agent such as a farm manager who is also a family

member) must be quite active in making decisions. The material participation test is the principal gate excluding

inactive investors from eligibility for special use valuation. Under the statute, “material participation” is determined

in a manner similar to the way the term is used for purposes of imposition of Social Security tax on net earnings

from self-employment. If material participation is to be established under a crop share or livestock share lease, the

lease should be carefully drafted to show involvement in decision making sufficient for material participation.

Note. For leases, the lease should be in writing and contain provisions requiring landowner involvement in decisions

regarding: (1) cropping patterns and rotations; (2) fertilization levels; (3) participation (or nonparticipation) in federal

farm programs; (4) plans for insect and weed control; (5) soil and water conservation practices to be followed; (6)

building, fence and tile line repairs; (7) use of storage facilities; (8) crop marketing strategies; (9) tillage practices;

(10) seed varieties to be purchased; and (11) for livestock leases, the type of livestock to be produced, marketing

strategies and animal health plans. In addition, the activity under the lease should be substantial enough so that

whoever is responsible for meeting the test is reporting the income under the lease as self-employment income and

paying social security tax on it.

Ownership test. The real estate must have been owned by the decedent or a member of the family and held for a

qualified use during five or more years in the eight-year period ending with the decedent’s death.

Passing to the qualified heir test. As noted earlier, the 50 percent test requires that the farmland and farm personal

property must make up at least 50 percent of the adjusted value of the decedent’s gross estate. In addition, this amount

or more must pass to the qualified heir(s) instead of being sold at death.

Note. To satisfy this test, it may be necessary to delay sale of some of the farm or ranch personal property until after

the estate is closed or to obtain a court order for partial distribution of property from the estate to the qualified heirs

if early sale is desired.

A qualified heir must be a “member of the family” who acquired the property (or to whom the property passed) from

the decedent. The statutory definition of “member of the family” depends upon whether the appropriate measuring

175 However, a cash rent lease with a rent adjustment clause can satisfy the test. See, e.g., Schuneman v. United States, 783

F.2d 694 (7th Cir. 1986)(amount of rent varied based on crop prices and production levels). 176 Participation in federal farm programs involving the idling of land (such as the Conservation Reserve Program) has raised

questions concerning whether the qualified use test can be met on the idled land. Based on several IRS rulings in the late

1980s, it appears that an estate can still satisfy the qualified use test with respect to land idled under a federal farm program. 177 I.R.C. § 2032A(b)(1)(C)(ii).

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period is the pre-death period or the post-death recapture period. This is the case because the term “member of the

family” is utilized in special use valuation to determine (1) who can be a qualified heir; (2) who can provide material

participation before death; (3) who can meet the ownership and qualified use tests before death; (4) who can provide

material participation to avoid recapture after death; and (5) who can acquire qualified real property after death from

a qualified heir without triggering recapture. In the pre-death period, “member of the family” is determined in

accordance with one’s relationship to the decedent-to-be. After death, “member of the family” is determined in

accordance with one’s relationship to the qualified heir. Thus, it is important to keep in mind the importance of what

is called the “base person.” While the question of who is a family member is a uniform set of rules, the base person

depends upon the particular eligibility period. Before death, the decedent-to-be is the base person. After death, it is

the qualified heir. A member of the base person’s family includes all ancestors, the spouse, lineal descendants, lineal

descendants of the spouse, , lineal descendants of the parents, and the spouse of any lineal descendant. All of these

persons are members of the family and can be qualified heirs.

Present interest test. Elected property is deemed to pass to the qualified heir only if the qualified heir receives a

present interest in the property.178 The IRS position has been, with respect to life estate/remainder arrangements, that

if there was any possibility that the property could pass to a non-family member, then the test was not satisfied.

Several cases, however, have tempered such a harsh requirement.179 Also, for elected property left in trust for the

life of a beneficiary with the beneficiary having the authority to distribute income, as long as the income beneficiaries

are all family members, eligibility is preserved. Thus, property can be left in a discretionary trust where all of the

beneficiaries are family members.

Note. For elected land owned by a corporation, the transfer of stock in a corporation that has a history of no dividend

payment and severely restricts stock transfer might constitute the transfer of a future interest rather than a present

interest.

Note. Each person with an interest in the elected property must sign a written consent to personal liability for a

special recapture tax set forth in I.R.C. §2032A(c). This consent agreement is filed with Schedule A-1 during the

Notice of Election.

Rules for partnerships and corporations. For land owned by a partnership, the decedent must have had an interest

in a closely-held business.180 This requires 20 percent or more of the partnership’s total capital interest to be in the

decedent’s estate or the partnership must have had 15 or fewer partners. A similar rule applies to corporations.181

Twenty percent or more of the corporation’s voting stock must be in the estate or the corporation must have had 15

or fewer shareholders. In addition, the 50 percent test must be satisfied, as determined by looking through the entity

to determine ownership. Farm real estate or farm personal property must equal 50 percent or more of the gross

estate less secured indebtedness and must pass to qualified heirs. The farmland that the entity owns must also

satisfy the qualified use test. For all entities, all nonfarm property must be carved out. Only the equity interest in

the partnership or corporation will be eligible for special use valuation.182

Calculating Special Use Value

178 Treas. Reg. § 20.2032A-3(b)(1) (1981). 179 See, e.g., Estate of Davis v. Comm’r, 86 T.C. 1156 (1986); Estate of Clinard v. Comm’r, 86 T.C. 1180 (1986); Estate of

Pliske v. Comm’r, T.C.Memo. 1986-311 (1986); Estate of Thompson v. Comm’r, 864 F.2d 1128 (4th Cir. 1989). 180 I.R.C. §§ 2032A(g); 6166(b)(1)(B). 181 I.R.C. §§ 2032A(g); 6166(b)(1)(C). 182 See Ltr. Rul. 9220006, Jan. 29, 1992 (land represented by preferred stock eligible for special use valuation).

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There are two methods to calculate valuation. The "capitalization of rents" method is the most commonly used

approach.183 An alternative approach is the five-factor formula approach.184

Rent capitalization approach. This approach involves taking the average annual gross cash rent per acre minus

property tax on comparable land for the last five full calendar years before death and dividing the figure by the

average annual effective Farm Credit Bank (FCB) interest rate for the last five years. The IRS annually publishes

(usually in August or September) the FCB interest rate by FCB district.185

The estate arrives at the numerator by obtaining cash rent figures on comparable land. Thus, the estate looks for

cash rented land that is comparable to that of the decedent and obtains from those tracts the cash rent figure and the

property tax figure. IRS regulations identify ten factors to be used in determining what is “comparable” land.186

The ten factors are as follows:

1. In several mid-western states, productivity indexes are available that take into account soil properties and

weather conditions as the major influences on yield potential.

2. Whether soil depleting crops have been grown equally on the tracts being compared.

3. Soil conservation practices used on the tracts.

4. Flooding possibilities.

5. Slope of the land.

6. Carrying capacity for livestock, where appropriate.

7. Comparability of timber, if any.

8. Whether the tracts are unified or separate.

9. The number, type and condition of buildings as those factors affect “efficient management and use of

property and value per se.”

10. Availability and type of transportation facilities in terms of costs and proximity of the properties to local

markets.

Five-factor formula approach. If the estate can show that there are no cash-rent tracts that are comparable, or if

the estate representative elects, another procedure for arriving at special use value may be used. This approach is a

formula involving five factors.187 This approach can be used both for farmland and timberland as well as land used

in a nonagricultural business. The cash-rent capitalization approach is restricted to agricultural land. Nonfarm land

can use only the five-factor approach. Agricultural real estate can use both approaches.

Note. The five factors are capitalization of income, capitalization of rent, assessed value for property tax purposes,

comparable sales in the same geographical area, but without significant influence from metropolitan or resort areas,

and any other factor that will fairly value the property. If the 5-factor formula is utilized, the estate is vulnerable to

having each of the five factors challenged during an IRS estate tax audit. The five factor approach has been used

only infrequently.188

Making the Election

183 I.R.C. §2032A(e)(7) 184 I.R.C. §2032(e)(8). 185 For deaths in 2014, the FCB interest rates and districts were specified in Rev. Rul. 2014-21, I.R.B. 2014-34. 186 Treas. Reg. § 20.2032A-4(d). 187 The Tax Court has ruled that the five-factor approach is available by default if the estate fails to qualify for the rent

capitalization approach. Estate of Wineman v. Comm’r, T.C. Memo. 2000-193. 188 An example of use of the five factor approach in an agricultural setting can be found in Estate of Hughan v. Comm’r,

T.C.Memo. 1991-275 (primary issue for determination was how far from decedent’s property the estate needed to go to find

farmland sale prices unaffected by agricultural use).

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The election is made by filing a “Notice of Election along with decedent's estate tax return. In addition, the

practitioner should check "Yes" on Form 706, Part 3 – Elections by the Executor, line 2. The estate should also

file a Schedule A-1 and provide the 14 items of information listed in Treas. Reg. § 20-2032A-8(a)(3). The estate

must also include copies of written appraisals of the fair market value of the real property; affidavits describing

the activities constituting material participation and the identity of the material participants; and a legal

description of the specially valued property.

Note: Once made, the special use valuation election is irrevocable.189 The estate can, however, alter the method

used to specially value the qualified real property after the election.

The following is a checklist for making the election:

• Complete Form 706, Schedule A-1

• Election for I.R.C. §2032A,

• Notice of election

• Agreement to special valuation (consent agreement)

• Affidavit re material participation

• Descriptive calculation of special use value

• Appraisal of qualified real property

• Appraisal of comparable real property

Protective Election. A protective election should be made if the estate is uncertain whether it will qualify for the

election due to valuation by the due date of Form 706. The protective election preserves the possibility of making

the special use valuation election on an amended Form 706.190 The protective election allows an automatic six-

month extension from the due date, provided that corrective action is taken by filing, within the six-month

extension period, an original or amended return containing the protective election and by reporting all income for

all affected years. Like the normal election, a protective election requires the decedent's name and TIN, a

description of the relevant qualified use, and a listing of the items of property used in a qualified use that also pass

to qualified heirs.

Note: If a protective election is filed, it must be filed with the fair market value estate tax return. A protective

election cannot be filed which claims the benefits of an actual election.191

If a protective election is filed and it is later determined that the estate qualifies for special use valuation, the

estate must file an additional notice of election within 60 days after the date of determination. An amended Form

706 and Schedule A-1 should be used to file the notice of election.

Special Lien

A special estate tax lien is imposed on all qualified farm or closely-held business real property for which a special

use value election has been made.192 The lien arises at the time the election is filed and continues until the

potential liability for recapture ceases, the qualified heir dies or the tax benefit is recaptured.193 The amount of the

lien is the adjusted tax difference with respect to the estate (the excess of what would have been the estate tax

189 I.R.C. §2032A(d)(1); Treas. Reg. §20.2032A-8(a)(1). 190 Treas. Reg. §20.2032A-8(b). 191 Tech. Adv. Memo. 8421005 ( ). 192 I.R.C. § 6324B. 193 CCA Ltr. Rul. 200119053 (Mar. 16, 2001) (lien not released until determination made that no recapture event has

occurred during recapture period).

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liability if the I.R.C. §2032A election had not been made).194 The lien will be released upon the expiration of the

10-year recapture period if there is not further potential for liability.195

Note. The lien does not take priority over property taxes, mechanic’s liens for repair or improvement of the

property, security interests for the construction or improvement of real property. The lien also does not have

priority over loans made for regular production financing such as raising or harvesting a crop or the raising of

livestock.

Recapture Tax

Just as numerous requirements must be satisfied for a decedent’s estate to be eligible for special use valuation,

numerous requirements must be satisfied post-death. The period during which these post-death rules must be

satisfied is known as the “recapture period.” The recapture period is 10 years plus any additional time corresponding

to how much of a two-year pre-death qualified use grace period was utilized. So at the present time, estates in

which a special use valuation election is made are subjected to a 10-year period (after death or after the end of the

two-year grace period) during which they will have to pay back all the tax benefits if any eligibility rule is violated.

A recapture agreement must be signed by each person in being (born and ascertainable) who has an interest (whether

or not in possession) in any property subject to the special use valuation election. The recapture agreement identifies

the property subject to the election, and also denotes the income tax basis of the property for estate tax purposes as

the special use value. The amount also becomes the income tax basis of the property in the hands of the heirs.196 In

the agreement, the qualified heir (or heirs) consent(s) to personal liability in case a disqualifying event occurs during

the recapture period. As for the other parties signing the agreement, they consent to the collection of any additional

estate tax imposed in the event of a recapture triggering event.

The amount of the recapture tax is the lesser of: (1) the adjusted tax difference attributable to such interest; (2) the

excess of the amount realized with respect to the interest over use value (if disposed of by sale or exchange at arm's

length); or (3) the excess of fair market value of the property over the use value (if disposed of by other than arm's

length). However, in any event, the recapture tax is limited to the gain on sale. If the property is sold for its fair

market value and such price has dropped to or below the special use value, there is no recapture. If the elected land

is disposed of other than by sale or exchange at arm’s length, the excess of fair market value over special use value

is the recaptured amount.

Note. The recapture tax is due six months after the date of the disposition or cessation of the qualified use, using

Form 706-A, and it is not eligible for deferral under I.R.C. §6166.

Events that trigger recapture.

• Transfer outside the family. Recapture occurs if a qualified heir disposes of the land to persons other

than “members of the family” of the qualified heir during the recapture period, such as to an investor or

developer.197 However, exceptions do exist for certain like-kind exchanges and the government’s exercise

194 I.R.C. § 6324B(d). 195 Chief Counsel Adv. 200119053 ( ). 196 In Van Alen v. Comm’r, T.C. Memo. 2013-235, the court held that the special use value pegs the income tax basis in the

heirs hands pursuant to I.R.C. §1014(a)(3), and upheld that value as reported on the recapture agreement against the heirs

under the doctrine of consistency. 197 I.R.C. § 2032A(c). See, e.g., Ltr. Rul. 9642055, July 24, 1996 (qualified heir’s sale of elected land was not disqualifying

disposition where sale was to lineal descendants of decedent).

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of its eminent domain power.198 In addition, partial dispositions lead to partial recapture. But, recapture

does not occur on tax-free transfer of real estate to a partnership or corporation if the qualified heir retains

the same interest in the partnership share or corporate stock as the individual held in the property given up,

the firm is a closely-held business, and the partnership or corporation consents to recapture tax upon a

recapture-triggering event.

• Lack of material participation. Recapture occurs if there is absence of material participation for more

than three years in any eight year period ending after death.199 The qualified heir or a member of the

qualified heir’s family must maintain material participation during the recapture period. However, active

management is enough for surviving spouses, full-time students, persons under age 21 and those who are

disabled.

• Change in use. Recapture is also triggered if there is a change in use of the elected property. Just as a sale

or other transfer outside the family during the recapture period triggers recapture tax, the development of

the property or change to any use other than farm use triggers recapture.

• No qualified use. The post-death qualified use test must be satisfied for the entire length of the recapture

period, except for a two-year grace period immediately following death. However, the rental of land on a

“net cash basis” by a lineal descendant of the decedent to a member of the family of the lineal descendant

does not cause recapture.200

Note. The death of the qualified heir does not cause recapture.201 Death eliminates the possibility of recapture as

to the decedent’s property. If there are multiple qualified heirs, the interests of surviving qualified heirs are not

removed from the possibility of recapture. For interests devised to qualified heirs in life estate/remainder form,

recapture does not end short of the recapture period unless the holders of all interests die.

Installment Payment of Federal Estate Tax

Overview

a. Purpose: Section 6166 allows the deferral of federal estate tax that is attributable to a closely held business

interest. The deferral can be up to 14 years from the estate tax return due date (in effect, approximately 15 years).

b. Advantages of Deferring Payment:

time value of money;

the ability to permit income generated after death to assist the estate in meeting its estate tax liabilities;

the ability to retain an asset which the beneficiaries prefer to keep and not sell; and

the removal of the need to force a sale of an illiquid asset at an inopportune time.

c. Initial Post-Mortem Determinations:

(1) Does the estate qualify for § 6166?

(2) Is the family committed to holding the business interests until estate tax is paid?

(3) Is the potential lien requirement financially possible and responsible?

198 See, e.g., Ltr. Rul. 9604018, Oct. 30, 1995 (elected land exchanged for unimproved land held by college and to be used for

farming; no cash or other property used in the exchange). 199 I.R.C. § 2032A(c)(6)(B). 200 A legally adopted child is treated the same as a “child of such individual by blood” for purposes of the 1997 cash rent rule. 201 I.R.C. § 2032A(c)(1).

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(4) Is this the most advantages way to pay the estate tax?

B. Qualification

a. Business Interest Must Equal At Least 35% of Decedent's Estate

i. "If the value of an interest in a closely held business…exceeds 35 percent of the adjusted gross estate, the

executor may elect to pay part or all of the tax imposed by section 2001 in 2 or more (but not exceeding 10) equal

installments." IRC § 6166(a)(1).

ii. Adjusted Gross Estate: value of the gross estate reduced by allowable deductions under §§ 2053, 2054.

iii. A farming business includes the value of residential buildings and improvements that are occupied on a

regular basis by the owner or lessee or employees for purposes of operating or maintaining the farm. § 6166(b)(3).

b. Closely Held Business

i. The determination of whether an estate includes an "interest in a closely held business" is made immediately

before the decedent's death.

ii. The interest in a closely held business includes an entity carrying on a trade or business in the form of a

proprietorship, partnership, or a corporation.

iii. Partnership Rules:

(1) 20 percent or more of the total capital interest in such partnership is included in determining the gross estate of

the decedent, or

(2) such partnership had 45 or fewer partners

iv. Corporation Rules:

(1) 20 percent or more in value of the voting stock of such corporation is included in determining the gross estate

of the decedent, or

(2) such corporation had 45 or fewer shareholders.

v. Note: An estate that owns interest in two or more closely held business can aggregate those interests in order to

qualify. If 20% or more of the total value of each business is held by an estate, the aggregate of all such holdings

is treated as an interest in a single closely held business for purposes of qualification.

c. Passive Assets

i. Passive investments and passive assets are not included as part of the interest. § 6166(b)(9)(A). Passive assets

"means any asset other than an asset used in carrying on a trade or business." IRC § 6166(b)(9)(B). It also include

any stock in another corporation unless it is deemed to be held by the decedent by reason of the holding company

election and the stock qualified as exceeding 35% of the adjusted gross estate. § 5155(b)(9)(B)(ii).

ii. Note: Real estate held primarily for investment purposes will not qualify.

iii. Potential Problem Areas: net cash rental of farm real property; crop-sharing arrangement; family member

managing the farm when owner retires or becomes incompetent; and holding companies.

d. Timing of Payments

i. Interest Payments: interest only is be paid annually for the first five years of deferral. IRC § 6166(f)(1). After

that five-year period, interest and principal is due in equal payments.

ii. Installment Payments: If election is made, the first installment shall be paid on or before the date selected by

the executor which cannot be more than 5 years after the date tax is due. IRC § 6166(a)(3).

e. Security

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i. Bond: IRS may require security for the remaining estate tax owed to qualify for an extension. § 6166(k)(1). The

estate may elect to provide a performance bond under § 6165 or place a lien on the property as required by §

6324A.

1. It can be very difficult, if not impossible, to obtain a commercial bond as security. The premium cost of such

can be prohibitive. The amount of the bond must be equal to the amount of the deferred estate tax plus the interest

being deferred. Internal Revenue Manual 5.5.6.6.

2. The only practical alternative, in most circumstances, is to provide the IRS with a lien on the farmland found in

the estate. If elected, the lRS will use Lien Form 668-J.

ii. Lien: If real property is pledged as collateral, the estate must provide a preliminary title report on the property

pledged. The report must provide a legal description and reflect any encumbrances on the property. File Form

13925 "Notice of Election of and Agreement to Special Lien" with the IRS. The lien attaches and continues for 10

years unless the estate tax is paid or it becomes unenforceable. Note: The IRS does not need to file a notice of lien

because this special estate tax lien is not subject to § 6323(a) relating to notice.

iii. The matter of the IRS lien should not be taken lightly. If the property described on Form 668-J turns out to be

insufficient to pay the estate tax in full, then any other property that remains attached by the IRC section 6324(a)

lien and/or the IRC section 6321 liens are subject to enforcement action. Distributees of the estate can also be held

liable as transferees. Internal Revenue Manual 5.5.6.6.

iv. Section 6166(g) sets forth the rules for determining when an estate forfeits the right to continue to defer the

payment of the estate tax under 6166. There are four situations that can accelerate the deferred obligation:

1. A disposition of the business interest, or withdrawal of 50% or more of the value of the interest in the business.

2. A default in the payment of the installment amounts or interest

3. A violation of a lien condition under 6324A,

a. If the value of the property secured by the lien becomes less than the amount of the unpaid deferred taxes plus

interest, the IRS may request additional security. If such is not provided within 90 days of demand, the remaining

installments due are accelerated under 6166(g).

4. If the estate has "undistributed net income" in any taxable year after the due date for the first installment

payment of federal estate tax, the estate must pay an amount equal to the undistributed net income in liquidation

of the unpaid portion of the federal estate tax otherwise eligible to be paid in installments in the future.

6166(g)(2).

D. Calculation

a. For an estate of a decedent dying in calendar year 2017, the estate attributable to the first $1,490,000 of

the closely held business interest will bear the favorable interest rate of 2%.

b. The excess over the 2% portion bears interest at a rate equal to 40% of the interest rate applicable to underpayments of tax.

c. Note: Interest is compounded daily.

E. Make the Election

a. Form 706 – Check "Yes" on Line 3, Part 3. The IRS has not created a separate form for the election. The estate

should, however, attach a notice of election with the following information:

i. decedent's name and taxpayer identification number;

ii. amount of tax to be paid in installments;

iii. date selected for payment of the first installment;

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iv. number of annual installments;

v. properties shown which constitute the closely held business interest; and

vi. facts which form basis for conclusion that estate qualifies.

b. A "late election" procedure can be utilized in the case of certain deficiency determinations made after the filing

of the estate tax return. 6166(h)(1).

i. The deficiency cannot be due to negligence, intentional disregard of rules and regulations, or fraud.

F. Consequences

a. Nondeductibility: Interest on estate taxes deferred under § 6166 is nondeductible for estate or income tax

purposes under § 2053.

b. Forfeiture: As noted above, failure to satisfy ongoing obligations and qualification results in acceleration of the

tax. The executor should plan for such a possibility and have funds for the payment of tax, should that occur.

i. Ex: A distribution, sale, exchange, or other disposition of 50% of more of the value of the decedent's interest in

the closely held business will accelerate. § 6166(g).

ii. Ex: The failure to pay any unpaid tax by its due date (including any extension of time) will accelerate the

payment of the unpaid tax. § 6166(g)(3).

iii. Ex: Violation of a lien condition under § 6324A (reduction in value of the secured assets).

G. Alternative to § 6166 – Graegin Loans

a. Under § 2053(a)(2), an estate may borrow funds to pay the estate tax and deduction the interest payment as a

cost of administration.

b. Estate of Graegin v. Commissioner

i. In Estate of Graegin v. Commissioner, the United State Tax Court held that the interest on a note was deductible

as a cost of administration. T.C. Memo 1988-477, 56 T.C.M. (CCH) 387 (1988). The estate lacked liquid assets

with which to pay estate taxes. Graegin Corporation, a subsidiary of a closely held corporation in which Graegin

owned stock, loaned the estate over $200,000 for the tax. The subsidiary executed a note with an interest rate of

fifteen percent. On the federal estate tax return, the estate deducted the amount of the single interest payment that

was due upon maturity of the note as an administration expense.

ii. To deduct interest expenses for administration expenses, the expense must be actually and necessarily incurred.

The court had previously held that projected interest payments were deductible for estate tax purposes as

administration expenses. Id. at 11 (citing Estate of Bahr v. Comm'r, 68 T.C. 74 (1977)).

iii. The court relied on the following considerations: testimony that the loan was necessary; reasonableness of loan

terms; approval of expenses by state probate court; existence of unrelated 3% shareholder in family business;

estate lacked liquidity; and estate had to borrow money to avoid forced sale.

iv. The court found that because the estate's assets were illiquid, the loan and corresponding interest expenses

were "actually and necessarily incurred." Id. at 12. The court determined that the similar identity of debtor and

creditor regarding the loan did not vitiate its status as a loan for purposes of § 2053. The court held that the

interest was properly deductible as an administrative expense.

c. Aftermath

i. In Litigation Guideline Memorandum TL-65, the IRS acknowledged that the use of the Graegin method is

somewhat fact dependent. The IRS will challenge deductions for balloon payments, when:

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1. there is doubt as to the bona fid nature of the indebtedness,

2. the liability for interest is not certain for a reasonably estimable amount, or

3. a convincing argument can be made that there is no necessity for the borrowing.

ii. PLR 199903038 & 199952039 affirmed that whether an interest expenses is necessary is a factual

determination.

d. Evidence to Support a Graegin Loan

i. Note should be written;

ii. Note should bear a market rate of interest;

iii. Note should be for a specific term and explicitly prohibit prepayment;

iv. Care should be taken if the entire amount payable under the note is a balloon payment at the end of the term;

v. Any payments called for under the notes should be made timely;

vi. Best to have the illiquid assets serve as security for the Graegin loan;

vii. Estate must be able to demonstrate that it was actually necessary for it to borrow in order to meet its

obligations (including estate taxes, funeral expenses, administration expenses, and debts of the decedent); and

viii. Estate must be able to demonstrate that it did not have sufficient liquidity to meet its obligations except for

entering into the loan transaction.

IV. Conclusion

A. Interplay Between § 6166 & § 2032A

a. Electing special use valuation under § 2032A may decrease the value of the decedent's interest for the purposes

of the 35% test under § 6166. In this situation, compare the benefits of each election before making the special

use valuation election.

b. Example: An estate that qualifies under § 6166 elects to value assets under § 2032A. Seven years after death,

the qualified heir sells the qualified real property to an unrelated party. Additional tax will be imposed under §

2032A (because they will lose the special valuation because they disposed of the property to someone other than a

qualified heir) and there will be an acceleration under § 6166(g) of the estate tax deferred (because they disposed

of the property).

c. Example: Same facts, if the qualified heir sells the property to another qualified heir, there will be no additional

tax imposed under § 2032A. There will, however, be an acceleration under § 6166(g).

d. Example: Same facts, except the qualified heir ceases to use the property for a qualified use. Here, there will be

additional tax imposed under § 2032A, but there will be no acceleration of the deferred estate tax under § 6166(g).

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FARM SUCCESSION PLANNING VEHICLES

At its core, succession planning is a process for identifying and developing people with the potential to fill key

leadership positions in a business. Succession planning increases the availability of experienced and capable

employees that are prepared to assume these key roles as they become available. Succession planning is more than

simply finding a replacement for current generation leaders. It involves a series of steps integrated into estate and

business planning to produce an effective leadership transition to individuals interested in and capable of taking

over the business.

Many business and personal issues must be considered. Ultimately, the succession plan could take one of several

forms including a sale to a third party, a sale to a family member, or a reorganization of the business to facilitate

transfer to family members.

Observation. Succession planning combines certain elements of estate planning and business

planning. In other words, aspects of a succession plan are also present in the estate and business

plan.

The manner in which a farming business is organized and structured can minimize taxes and simultaneously

maximize farm program payment limitations. This can be a particularly important consideration when economic

conditions are challenging. Balancing liability concerns with tax minimization and, at the same time, finding the

optimal structure for purposes of farm program payment limitations is a significant factor in farm and ranch estate,

business, and succession planning. Additionally, planning often involves minimizing the impact of the net

investment income tax202 (NIIT) and self-employment (SE) tax.

This section compares two popular entity choices that are utilized for business succession purposes: the family

limited partnership (FLP) and the limited liability company (LLC).

FAMILY LIMITED PARTNERSHIP

An FLP is a limited liability business entity created and governed by state law. It is generally composed of two or

more family members and is typically utilized to reduce income and transfer taxes, act as a vehicle to distribute

assets to family heirs while keeping control of the business, ensure continued family ownership of the business, and

provide liability protection for all of the limited partners.

There are several key distinguishing characteristics of an FLP.

• The FLP interests are held by family members (or entities controlled by family members). These typically

include spouses, ancestors, lineal descendants, and trusts established on behalf of such family members.

• A member holding a general partner interst is entitled to reasonable compensation for work done on behalf

of the FLP. These payments are not deemed to be distributions and are beyond the reach of judgment

creditors. Limited partners take no part in FLP decisionmaking and cannot demand distributions, can only

sell or assign their interests with the consent of the general partners and cannot force a liquidation.

• FLP income, gain, loss, deductions or credits can be allocated to a partner disproportionately in whatever

manner the FLP desires. It is not tied to the capital contributions of any particular partner.

202 IRC §1411. The tax is 3.8% of net investment income over a threshold of $200,000 for single persons or $250,000 for

married persons filing jointly.

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• The FLP owns income-producing family business property or investment property (not personal assets) and

must be created for a business purpose.

• All formalities of existence must be observed. These include executing a written agreement that establishes

the rights and duties of the partners; filing all the necessary certificates and documents with the state;

obtaining all necessary licenses and permits; obtaining a federal identification number; opening new

accounts in the FLP’s name; transferring title to the assets contributed to the FLP; amending any existing

contracts to reflect the FLP as the real party in interest; filing annual federal, state and local reports;

maintaining all formalities of existence; not commingling partnership assets with the personal assets of any

individual partner; keeping appropriate business records; including income from the FLP interest on

personal income tax returns annually.

Note. The transfer of an FLP interest must be “bona fide.” That means it serves a substantial

business or other non-tax purpose.203 But, even if the FLP is validly formed and properly

recognized for federal estate tax purposes, the FLP can be disregarded if there is deemed to be an

“implied understanding” at the time of formation that the transferor(s) would retain enjoyment and

economic benefit of the transferred assets for life.204

Initial Considerations and Procedure

An FLP is formed by family members who transfer property in return for an ownership interest in the capital and

profits of the FLP. At least one family member must be designated as the general partner (or a corporation could

be established as the general partner). The general partner manages and controls the FLP business and decides if

and when FLP income will be distribued and in what amount. In return for that high degree of control, the general

partner(s) is (are) personally liable for any creditor judgment that is not satisfied from FLP assets. Thus, income is

retained in the FLP at the sole discretion of the general partner(s) and the general partner(s) have complete control

over the daily operations of the business. Conversely, because a limited partner has no say in how the business is

operated,the personal liability of the limited partner is limited to the value of that partner’s capital account

(generally, the amount of capital the partner contributed to the FLP).

There are a couple of common approaches in FLP formation and utilization.

• Often, an FLP is formed by the senior generation with those persons becoming the general partners and the

remaining interests being established as limited partner interests. Those interests are then typically gifted

to the younger generation.

• As an alternative, an FLP could be created by spouses transferring assets to the entity in return for FLP

interests. Under this approach, one spouse would receive a 99 % limited partnership interest and the other

spouse a 1% general partner interest. The spouse holding the limited partnership interest could then make

annual exclusion gifts of the limited partnership interests to the children (or their trusts). The other parent

would retain control of the “family assets” while the parent holding the limited partnership interest is the

transferor of the interests.

Note. IRC §2036 does not have a provision similar to IRC §672(e), in which the grantor is treated

as holding the powers of the grantor’s spouse. Thus, if one spouse retains control of the partnership

and the other spouse is the transferor of the limited partnership interests, then §2036 should not

apply.

203 See, e.g., In re Turner, 335 B.R. 140 (Bankr. N.D. Cal. 2005). 204 See, e.g., Estate of Thompson, 382 F.3d 367 (3d Cir. 2004).

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Even though the general partner controls the FLP, the general partner interest can benefit from substantial valuation

discounts due to its minority interest.

Note. The general partner should own at least 1% of the FLP. Anything less will raise IRS scrutiny.

Example. Bob is 55 and owns a farming operation. His wife, Stella, died in 2014. All of the assets were

titled in Bob’s name. Thus, Stella’s estate was very small and the unused exclusion of $5 million was

“ported” over to Bob. The farming business has expanded over the years and now is comprised of 1,000

acres of farmland valued at $10,000,000, and other assets (livestock, buildings and equipment, etc.) valued

at $3,000,000. His three sons (ages 27, 24 and 18) work with him in the farming business. Bob’s objective

is for the farming operation to continue to be operated by the family into subsequent generations. He would

like to transfer ownership of some of the farming business to his sons, now before the assets appreciate

further in value. However, Bob does have some concern that his son’s may not be fully experienced and

ready to manage the farming operation. Bob also wants to protect the sons against personal liability that

could arise in connection with the business. After consulting with his attorney, Bob decides to have the

attorney draw up an FLP agreement.

The terms of the FLP agreement designate Bob as the general partner with a one % ownership interest. The sons

are designated as the limited partners, each having a 33 % limited partner interest. Bob transfers the land, farm

equipment and some livestock to the FLP, and each son contributes cash and additional livestock and equipment.

All other formalities for formation of the FLP are completed. Bob then gifts 99 % of the FLP to his sons (33 % to

each son), reports the gifts and pays the gift tax (using exclusion and unified credit to substantially offset the gift

tax). Bob continues to run the farming operation until he is 65, at which point he is comfortable that the sons can

manage the farming operation on their own. Up until age 65, Bob filed the required annual reports with the state

and followed all necessary FLP formalities. Bob, distributed FLP income annually – one % to himself and 33 %

to each son. By shifting most of the income to the sons that are in a lower tax bracket than Bob, the family (on a

collective basis) saves income tax.

Upon turning age 65, the partners vote to name the oldest son (now age 37) as the general partner and Bob’s interest

is changed to be a limited partner interest. Bob then retires. The value of the business continued to increase over

the years, but that appreciation in value would escape taxation in Bob’s estate inasmuch as only one % of the FLP

value at the time of Bob’s death would be included in Bob’s estate for estate tax purposes.

Advantages of an FLP

An FLP isgenerally taxed like a general partnership. There is no corporate-level tax and taxes are not imposed on

assets passing from the FLP to the partners (unlike an S corporation). . Thus, the FLP is not recognized as a

taxpayer, and the income of the FLP passes through to the partners based on their ownership interest. The partners

report the FLP income on their individual income tax returns and must pay any tax owed. Income is allocated to

each partner to the extent of the partner’s share attributable to their capital (or pro rata share).

Example. Tom established an FLP with his children, Tammy and Faye. Tom contributed $40,000 to the

FLP ($20,000 for himself (50 % ) and $10,000 each to Tammy and Faye (25 % each). If the FLP has

$100,000 of income (assume no expenses), Tom will be taxed on $50,000 of the income (50 % ) and Tammy

and Faye will be taxed on $25,000 each (25 % each).

Note. The general partner is entitled to a management fee for services rendered, reflected as a

guaranteed payment, which is taxable to the general partner as ordinary income.

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Observation. The FLP can be an attractive vehicle if a transfer of interests to family members in

a lower tax bracket is desired. Transfers of FLP interests can also be made to minor children if

they are competent to manage their own property and participate in FLP activities. But, such

transfers are typically made in trust on behalf of the minor. Also, unearned income of children

under age 18 (and in certain cases up to age 23) may be subject to the “kiddie tax” and thus be

taxable at the parents’ income tax rate.

Avoidance of Transfer Taxes. Another advantage of an FLP is that it can help avoid transfer taxes - estate

tax, gift tax and generation skipping transfer tax. Transfer tax avoidance is accomplished in three ways:

1. Removal of future asset appreciation. The distribution of assets among family members via the FLP will

freeze the current value and keep any future asset appreciation out of the estate at the time of death. While

gift tax or GSTT may have to be paid upon the transfer of the assets to the FLP, that amount is likely to be

less than the tax on a higher value in the future.

2. Utilization of the present interest annual exclusion for gift tax purposes. While gifts of FLP interests are

subject to gift tax, the tax can be minimized or eliminated by taking advantage of the present interest annual

exclusion, presently $14,000 per donee per year.

Note. To take advantage of the present interest annual exclusion for gifts of FLP interests, the FLP

agreement must be properly drafted and cannot place too many restrictions on the limited partner

donee to presently derive some economic benefit from the gift. The limited partner needs some

ability to reach the gift when it is given. Too many restrictions could cause the IRS to determine

that the gift is of a future interest which would cause the disallowance of the annual exclusion.205

This is a particular concern if the gift of the FLP interest is in trust. To qualify for the present

interest annual exclusion, the trust must be structured to include Crummey withdrawal rights.206

Such rights will give the beneficiaries of the trust (the limited partners) the unrestricted right to

demand, for a reasonable period of time, any amounts placed in the trust. That will cause the

transfer of the FLP interests to the trust to qualify for the present interest annual exclusion. It does

not matter that the demand right will not be exercised.

3. Facilitation of the use of valuation discounts for both gift and estate tax purposes. The transferor of the

FLP interests can discount the value of the FLP interests that are gifted because of the restricted rights of

the limited partner (in accordance with the FLP agreement). These restrictions may include the inability to

transfer the interest, the inability to withdraw from the FLP, and the inability to participate in management

of the FLP. These restrictions result in a business value that is significantly less than the value of the

underlying assets, typically up to 35 % less than fair market value.207 The discount is available for gift,

estate and GSTT purposes and is comprised of a minority interest discount (inability to force distributions

or liquidation or dissolution of the FLP) and a lack of marketability discount (inability to sell or transfer the

FLP interest).

205 See, e.g., Hackl v. Comr., 118 T.C. 279 (2002), aff’d., 335 F.3d 664 (7th Cir. 2003). But see Estate of Purdue v. Comr.,

T.C. Memo. 2015-249 (gifts to a family LLC qualified for the present interest annual exclusion). 206 The concept originated with the case of Crummey v. Comr., 397 F.2d 81 (9th Cir. 1968). Crummey withdrawal rights

allow the trust beneficiaries to withdraw gifts made to the trust for a limited period of time. The withdrawal right allows gifts

to the trust to qualify for the federal gift tax annual exclusion. 207 See e.g., Estate of Watts, T.C. Memo. 1985-595 (35 % discount of 15 % partnership interest for non-marketability for

federal estate tax purposes); Peracchia v. Comr., T.C. Memo. 2003-280 (gifts of FLP interests discounted by six % for

minority interest and 25 % for lack of marketability). Estate of Kelley v. Comr., T.C. Memo. 2005-235 (FLP interest valued

under net asset value method with 35 % discount).

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Note. The IRS may seek to offset valuation discounts by asserting a control premium on FLP

interests associated with control of the entity or the ability to swing control one way or the other..

The IRS theory is that centralized control increases the value of the business. Also, the IRS has

had success in challenging valuation discounts upon the finding of certain factors, particularly

formation shortly before death solely to avoid estate tax or depress asset values. However, the

existence and size of a control premium is heavily fact dependent with the key question being how

much the value of the entity can be enhanced.

Transfer of Assets yet Maintenance of Control. Another advantage of an FLP is that it allows the

senior generation of the family to distribute assets currently and simultaneously maintain control over those assets

by being the general partner with as little as a 1 % interest in the FLP. This can allow the general partner to control

cash flow, income distribution, asset investment and all other management decisions.

Caution. IRC § 2036(a)(1) provides that the gross estate includes the value of property previously

transferred by the decedent if the decedent retained the possession or enjoyment of, or the right to

the income from, the transferred property. IRC §2036(a)(2) includes in the gross estate property

previously transferred by the decedent if the decedent retained the right, either alone or in

conjunction with any person, to designate the persons who are to possess or enjoy the transferred

property or its income. Thus, pursuant to §2036(a)(2), the IRS may claim that because a general

partner controls partnership distributions, a transferred partnership interest should be taxed in the

general partner’s estate.

In the typical FLP scenario, the parents establish the FLP with themselves as the general partners

and gift the limited partnership interests to their children. In this situation, if the general partners

have the discretionary right to determine the amount and timing of the distributions of cash or other

assets, rather than the distributions being mandatory under the terms of the partnership agreement,

the IRS could argue that the general partners (who have transferred interests to the limited partners)

have retained the right to designate the persons who will enjoy the income from the transferred

property.208

Consolidation of Family Assets. An FLP also keeps the family business in the family, with the limited

partner interests restricted by the terms of the partnership agreement. Such restrictions typically include the inability

of the limited partner to transfer an FLP interest unless the other partners are first given the opportunity to purchase

(or refuse) the interest. This virtually guarantees that non-family members will not own any of the business interests.

These agreements (buy-sell agreements and rights of first refusal) must constitute a bona fide arrangement, not be

a device to transfer property to family members for less than full and adequate consideration, and have arm’s length

terms. An agreement structured in this manner will produce discounts from fair market value for transferred

interests that are subject to the agreement.

Provision for Nonbusiness Heirs. The FLP can also provide for children not in the family business and

allow for an even distribution of the estate among all family members, farm and non-farm. The limited partner

interest of a non-farm heir can allow that heir to derive an economic benefit from the income distributions made

from time to time without being involved in the day-to-day operation of the business.

Asset Protection. The FLP can also serve as an asset protection device. This is particularly the case for the

limited partners. A limited partner has no ownership over the assets contributed to the FLP, thus the creditor’s

ability to attach those assets is severely limited. In general, a court order (called a “charging order”) would be

required to reach a limited partner interest, and even if the order is granted, the creditor only receives the right to

208 An exception exists for transfers made pursuant to a bona fide sale for adequate and full consideration.

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FLP income to pay the partner’s debt until the debt is paid off. The creditor still does not reach the FLP assets.209

However, a general partner does not receive the same creditor protection unless the general partner interest is

structured as a corporation.

Note. Establishing a corporation as the general partner should be approached with care. It cannot

be established as merely a sham to avoid liability. If it is, IRS and/or the courts could ignore it and

pierce the corporate veil. To avoid this from happening, the corporation must be kept separate from

the FLP. Funds and/or assets must not be commingled between the FLP and the corporation, and

all formalities must be observed to maintain the corporate status such as keeping records and

minutes, holding directors and shareholders’ meetings and filing annual reports.

Other advantages:

• Flexibility. The FLP can also provide flexibility because the FLP agreement can be amended by vote in

accordance with the FLP agreement.

• Consolidation of assets. The assets of both the general and limited partners are consolidated in the FLP.

That can provide for simplification in the management of the family business assets which could lead to

cost savings. In addition, the management of the assets and related investments can be managed by

professional, if desired.

• Minimization or elimination of probate. Assets may be transferred to the FLP and the ownership interests

may be transferred to others, with only the FLP interest owned at death being subject to probate. Upon

death, the FLP continues to operate under the terms of the FLP agreement, ensuring continuity of the

business without any disruption caused by death of an owner. Relatedly, an FLP will also typically avoid

the need for an ancillary probate (probate in the non-domiciliary state) at the FLP interest owner’s death.

Most states treat FLP interests as personal property even if the FLP owns real estate. To the extent probate

is avoided, privacy is maintained.

• Partnership accounting rules. The rules surrounding partnership accounting, while complicated, are

relatively flexible.

• Ease of gifting. The FLP structure does provide a mechanism that can make it easier for periodic gifting to

facilitate estate and tax planning goals.

Disadvantages of an FLP

While there are distinct advantage to using an FLP in the estate and business succession planning context, those

advantages should be weighed against potential drawbacks. The disadvantages of using an FLP can include the

following:

• An FLP is a complex form of business organization that requires competent legal and tax consultation to

establish and maintain. Thus, the cost of formation could be relatively higher than other forms of doing

business.

209 The limited partnership agreement and state law are crucial with respect to charging orders. Also, a charging order could

put a creditor in a difficult position because tax is owed on a partner’s share of entity profits even if they are not distributed.

Thus, a creditor could get pinned with a tax liability, but no income flowing from the partnership to pay the obligation.

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• Unlimited liability of the general partners.210

• Ineligibility of FLP members for many of the tax-free fringe benefits that employees are eligible for.

• The gifts of FLP interests must be carefully planned to not trigger unexpected estate, gift or GSTT liability.

• Establishing and FLP can be costly in terms of the legal work necessary to draft the FLP agreement,

changing title to assets, appraiser fees,211 state and local filing fees, and tax accounting fees.

• There could be additional complications in community property states. In community property states,

guaranteed payments (compensation income) from an FLP are treated as community property. However,

FLP income distributed at the discretion of the general partner(s) is classified as separate property.

THE LIMITED LIABILITY COMPANY

An LLC is a hybrid business organization that mixes elements of corporations, partnerships, and sole

proprietorships. Because an LLC is a separate legal entity, each owner (also called a member) of an LLC has limited

liability like a stockholder of a corporation. LLCs allow any entity, including individuals, partnerships, trusts,

estates, corporations, or other LLCs to be owners. They also do not restrict the number of members, and provide

the tax advantages of a partnership, such as the pass-through of taxable income and losses.

LLCs are also not subject to the formalities that are typically imposed upon corporations, such as producing annual

reports, holding director meetings, and meeting shareholder requirements. In addition, profit and loss can be

allocated differently than ownership or partnership interests. Unlike corporations, which must distribute profits in

proportion to each of the shareholder's ownership of shares, LLC members may distribute profits in any manner

they want without regard to each member's capital contribution.

Note. LLCs are recognized legal entities in all 50 states and the District of Columbia, and every

state now permits one-owner LLCs (though some states tax LLCs like a corporation). Finally, with

IRS "check-the-box" regulations, a business that is currently a sole proprietorship can change to an

LLC with no federal tax consequences.

The key to a successful LLC is the operating agreement. The operating agreement governs the ownership rights of

property contributed to the LLC to facilitate succession planning goals and objectives. Under the LLC operating

agreement, members can have ownership rights without any concern about the partition rights of other members

and the agreement can severely restrict remedies available to creditors of any particular member. Likewise, the

operating agreement can also prevent ownership of LLC interests from passing to former spouses, unrelated parties

and creditors.

210 However, slightly over one-half of states have enacted legislation allowing the formation of a limited liability limited

partnership (LLLP), which is typically accomplished by converting an existing limited partnership to an LLLP. In an LLLP,

any general partner has limited liability for the debts and obligations of the limited partnership that arise while the LLLP

election is in place. In addition, some states (such as California) that do not have a statute authorizing on LLLP will

recognize LLLPs formed under the laws of another state. Also, while Illinois does not authorize LLLPs by statute, it does

allow the formation of an LLLP under the Revised Uniform Limited Partnership Act. 211 The key to FLP valuation discounts is the proper valuation of FLP interests that are transferred by gift or at death, without

regard to the ownership of other interests in the entity by family members. The appraiser must disregard the fact that the

recipient of the minority interest may, in fact, have control of the entity, when the interest that is currently transferred is

combined with the interests owned by other family members. The only issue for the appraiser is what a willing buyer would

pay for the interest that is transferred if that were the only interest the buyer owned in the entity.

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Management Structure and Self-Employment Tax

Member-Managed LLC. An LLC may be member-managed or manager-managed. By default, state LLC

statutes treat LLCs as member-managed. The owners of the LLC are responsible for managing the company in a

member-managed LLC. Thus, all of the members are treated as general partners and have self-employment tax

liability on their respective distributive shares.

Manager-Managed LLC. A manager-managed LLC is operated by managers who are appointed to run the

company. Manager-managed LLCs are designated as such in the LLC formation documents or the LLC operating

agreement, and operate in a similar fashion to a corporation that has a board of directors to control the company's

affairs. A manager-managed LLC has at least one member that takes a passive role in terms of operating the

company. That feature can provide self-employment tax savings while maintaining limited liability. In addition,

the managers of the LLC can be members, but they don’t have to be.212 However, only the designated manager (or

managers) in a manager-managed LLC has self-employment tax liability on their distributive share of LLC earnings.

Thus, a manager-managed LLC may provide separate classes of membership for managers (who have the

authority to bind the LLC under a contract) and non-managers (who have no such authority). From an SE tax

perspective, the use of a manager-managed LLC with two classes of membership provides SE tax savings to

the non-managing members.

Note. Both the manger interest and the non-manager interest provide liability protection to the

members in their capacity as members.

Self-Employment Tax and NIIT Implications. In general, income that is subject to self-employment tax

is not subject to the NIIT effective for tax years beginning after 2012.213 With respect to an LLC, business income

allocated to the general partners of an LLC taxed as a partnership is generally subject to self-employment tax even

if it flows to a partner who does not participate in the operations of the LLC.214 There is no guidance on the self-

employment tax treatment of income flowing to LLC (and limited liability partnership (LLP)) owners who do not

participate in the operations of the business. However, to the extent a limited liability owner (either an LLC member

or an LLP partner) receives a guaranteed payment for services, the law is clear that this payment is subject to self-

employment tax. Thus, guaranteed payments for services or capital would always appear to be subject to self-

employment tax, even if paid to an individual holding a limited liability interest. Presumably, LLC members (in an

LLC that is taxed as a partnership) have self-employment tax liability on their distributive share unless the member

is a treated as a limited partner.215

In the 1990s, the Treasury Department issued proposed regulations in an attempt to clarify the self-employment tax

status of LLC members.216 The proposed regulations were withdrawn in early 1997 and new proposed regulations

were issued. Under the 1997 proposed regulations, a partnership (or LLC taxed as a partnership) member is subject

to self-employment tax under any one of three circumstances.217

212 In a manager-managed LLC, unless state law provides otherwise, a manager can be an entity such as an LLC or a

corporation. 213 IRC §1411. 214 Treas. Reg. §1.1402(a)-2(g). 215 IRC §1402(a)(13); Prop. Treas. Reg. §1402(a)-2(g). IRC §1402(a)(13) specifies that the distributive share of a limited

partner in a limited partnership is not subject to self-employment tax. 216 59 Fed. Reg. 67,253 (Dec. 29, 1994). 217 Prop. Treas. Reg. §1.1402(a)-2(h)(2). The IRS is bound by any proposed regulation that a taxpayer reasonably relies

upon. See Elkins v. Comr., 81 T.C. 669 (1983). Also, a taxpayer that reasonably relies on a proposed regulation will

avoid taxpayer penalties. See United States v. Boyle, 469 U.S. 241 (1985). The same is true for a tax practitioner.

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10. The individual has personal liability for the debts of, or claims against, the partnership by reason of being a partner or member.

11. The individual has authority under the statutes of the state in which the partnership is formed to contract on behalf of the partnership (i.e., the individual has management authority).

12. The individual participated in the entity’s trade or business for more than 500 hours during the entity’s taxable year.218

If an LLC member in a manager-managed LLC is treated under the proposed regulations as being subject to self-

employment tax on their distributive share, there remain two possible exceptions by which the member can still be

treated as a limited partner and avoid self-employment tax. Both exceptions are tied to the fact that a manager-

managed LLC may provide separate classes of membership for managers (who have the authority to bind the LLC

under a contract) and non-managers (who have no such authority). The first exception applies if the members who

didn’t meet the tests of the proposed regulations (i.e., are mere investors) own a “substantial continuing interest” in

a specific class of interests in the LLC, and these members’ rights and obligations in that class of interests are the

same as the rights and obligations that other members (who do meet the requirements of the proposed regulations)

hold in that class.219 A “substantial interest” requires an ownership interest in a class of interest exceeding 20 %

.220 The second exception applies to those members who don’t satisfy the 500-hour test of the proposed regulations.

In other words, the member participates in the LLC business for more than 500 hours during the entity’s taxable

year. Such a person can still be treated as a limited partner (and escape self-employment tax on their distributive

share) if there are other members that meet the requirements of the first exception.

To Summarize. Non-managers who do not meet the 500-hour participation test are not subject

to SE tax, except to the extent of any guaranteed payments they receive. Non-managers who

exceed the 500-hour test are s t i l l not subject to SE tax if they own a substantial continuing

interest (i.e., at least 20%) in a class of interest and the individual’s rights and obligations of that

class are identical to those held by persons who satisfy the general definition of limited partner

(i.e., less than 500 hours for a non-manager).

LLC managing-members are subject to SE tax on income from that interest. If there are non-managers who spend

less than 500 hours with the LLC and such members own at least 20 % of the LLC interests, those non-managers

who spend more than 500 hours are not subject to SE tax on the pass-through income, but are subject to SE tax on

the guaranteed payments.221

It is possible to structure a manager-managed LLC with the taxpayer holding both manager and non-manager

interests. In this type of structure, individuals with non-manager interests who spend less than 500 hours with the

LLC must own at least 20% of the LLC interests. As a result, the individual who holds both manager and non-

manager interests is exempt from SE tax on the non-manager interest,222 but remains subject to SE tax on the pass-

through income and guaranteed payments of the manager interest.

Structuring the Manager-Managed LLC. In an LLC that is structured to minimize self-employment tax

and avoid the NIIT, all of the LLC interests can be owned by non-managers (investors) with a third party non-owner

named as manager. In this structure, some or all of the investors may work on behalf of the manager. The manager

could be an S corporation or a C corporation, with the LLC investors owning part or all of the corporation. The

218 This is not to be confused with the 500-hour test for material participation under the passive activity rules of IRC §469. 219 Prop. Treas. Reg. §1.1402(a)-2(h)(3). 220 Prop. Treas. Reg. §1.1402(a)-2(h)(6). 221 Prop. Treas. Reg. §1.1402(a)-2(h)(4). 222 Prop. Treas. Reg. §1.1402(a)-2(h)(3).

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manager must be paid a reasonable management fee and the LLC owners who provide services to the LLC must be

paid reasonable compensation from the corporation (the manager). The LLC owners who do not render services to

the LLC do not have income that is subject to self-employment tax.

Summary points:

• LLC non-managers working fewer than 500 hours annually are subject to self-employment tax only on

guaranteed payments.

• Non-managers who work more than 500 hours annually are subject to self-employment tax only on

guaranteed payments if the non-managers who work fewer than 500 hours annually make up at least 20%

of the membership.

• Although the managers and non-managers own interests commensurate with their investment (i.e., non-

manager interests), the managers also receive manager interests as a reward for their services.

• Managers recognize self-employment income on the pass-through income associated with the manager

interests.

Note. With respect to the NIIT, there is a special rule that comes into play when spouses are involved.

While a non-manager’s interest in a manager-managed LLC is normally considered passive and is

subject to the NIIT,223 a spouse may take into account the material participation of a spouse who is

the manager.224 Thus, if the manager spouse materially participates, then all non-manager

interest(s) owned by both spouses avoid the NIIT. That gives even more power to the manager-

managed LLC with bifurcated interests.

Entity Structuring and Farm Program Benefits

Under the 2014 Farm Bill, the per-person payment limitation in $125,000. That’s the general rule. Peanut growers

are allowed an additional $125,000 payment limitation, and the spouse of a farmer is entitled to an additional

$125,000 payment limit if the spouse is enrolled at the local Farm Service Agency (FSA) office. These payment

limits are applied at both the entity level and then the individual level (up to four levels of ownership). Thus, general

partnerships and joint ventures have no payment limits. Instead, the payment limit is calculated at the individual

level. However, an entity that limits the liability of its shareholders/members is limited to one payment limitation.

That means that the single payment limit is then split equally between the shareholders/members.

To be eligible for a payment limit, an adjusted gross income (AGI) limitation must not be exceeded. That limitation

is $900,000. The AGI limitation is an average of the three prior years, with a one-year delay. In other words, farm

program payments received in 2015 are based off of the average of AGI for 2011, 2012 and 2013.

The AGI limitation applies to both the entity and the owners of the entity.

Example 1. Assume that FarmCo receives $100,000 of farm program payments in 2015. FarmCo’s AGI

is $850,000. Thus, FarmCo is entitled to a full payment limitation. But, if one of FarmCo’s owners has

AGI that exceeds the $900,000 threshold, a portion of FarmCo’s payment limit will be disallowed in

proportion to that shareholder’s % age ownership. So, if the shareholder with income exceeding the

223 IRC §1411(c)(2)(A). 224 IRC §469(h)(5).

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$900,000 threshold owns 25 % of FarmCo, FarmCo’s $100,000 of farm program payment benefits will be

reduced by $25,000.

From an FSA entity planning standpoint, the type of entity structure utilized to maximize payment limits will depend

on the size/income of the operation.

• For smaller producers, entity choice for FSA purposes is largely irrelevant. Given that the limitation is

$125,000 and that payments are made either based on price or revenue (according to various formulas),

current economic conditions in agriculture indicate that most Midwestern farms would have to farm

somewhere between 3,000 and 4,000 acres before the $125,000 payment limit would be reached. Thus, for

smaller producers, the payment limit is not likely to apply and the manner in which the farming business is

structured is not a factor.

• For larger operations, the general partnership or joint venture form is likely to be ideal for FSA purposes.

If creditor protection or limited liability is desired, the partnership could be made up of single-member

LLCs. For further tax benefits, the general partnership’s partners could consist of manager-manager LLCs

with bifurcated interests.

FLP/LLC – COMPARISON SUMMARY

Some additional points can be made on the comparison between FLPs and LLCs:

• Both the FLP and the LLC allow interests to be transferred rather than assets. The ease of transferability

of entity interests can be an important aspect of succession planning. The transfer of interests in the entity

is often restricted by contractual agreement such as a buy-sell agreement or stock transfer agreement.

• Multiple member LLCs that are taxed as partnerships avoid the potential double taxation that can apply

upon corporate liquidation and sale of assets but still provide liability protection.225

• A major advantage (as compared to a corporation) of FLPs and LLCs taxed as partnerships is that the assets,

with some planning, can be distributed tax-free. If the assets are sold, there is a single tax at the partner

level and not the partnership level.

225 For an LLC taxed as a partnership, each LLC member is treated as a partner for tax purposes. Schedule K-1 (Form 1065)

for each member is attached to the LLC’s Form 1065 and is issued to each member.

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FINAL REGULATIONS ON THE NET INVESTMENT INCOME TAX

The net investment income tax (NIIT) is a 3.8% additional tax for individuals with adjusted gross income (AGI)

above a threshold level. The threshold level is:

$200,000 for single and head of household (HoH) taxpayers ,

$250,000 for married couples filing jointly (MFJ) and qualifying widows(ers), and

$125,000 for married couples filing separately (MFS).

Net investment income (NII) for this purpose includes the following.

Interest

Dividends

Annuities

Rents

Royalties

Passive income from a trade or business activity

Income from the trade or business of trading in financial instruments

Income from the trade or business of trading in commodities

Gains from the sales of assets (unless associated with trade or business income for a materially

participating taxpayer)

Certain deductions are allowed to reduce NII. Final regulations (along with new proposed regulations) were issued

in late November 2013.

Note. For more information about the calculation of the NIIT and NII, see the 2014 University of

Illinois Federal Tax Workbook, Volume A, Chapter 3: Affordable Care Act Update.

Self-Rentals and Grouped Rentals

Many farming operations involve the rental of an asset (or assets) to another entity in which the taxpayer

materially participates. Under the final regulations, any rent income that is classified as nonpassive under

either of the following provisions is not considered investment income.

1. Self-rental income (Rents received by a taxpayer from property that is rented for use in a trade or business

activity in which the taxpayer materially participates)

Property properly grouped as an economic unit under the provisions of Treas. Reg. §1.469-4(d)(1)

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Any resulting gain from asset sales from either of these activities is not considered investment income. Under the

final regulations, if the rental property was properly grouped with a materially participating activity or if it was self-

rental property, none of the gain is subject to the NIIT.

Note. The self-rental rule is important in agriculture and allows rental activities to be structured to

avoid the NIIT in many situations. However, custom farming arrangements result in passive income

to the landowner. The activity of the agent (farm management company or other individual that is

farming the land) is not imputed to the landowner for purposes of IRC §469.

Example 2. Able Farmer operates his farm as a sole proprietorship and rents land from LandCo LLC, which

he owns with his wife. The cash rent income that flows from the LLC is considered nonpassive income to

Able because the land owned by LandCo is rented to Able’s farming activity and he materially participates

in that farming activity. The cash rent is self-rental income and is considered nonpassive income for

purposes of both income tax and the NIIT.226

Example. Amber’s farming operation, Amberwaves Company, is a C corporation. Amberwaves cash rents

farmland owned by an LLC that Amber also owns. The cash rent is self-rental income and is considered

nonpassive income for purposes of both income tax and the NIIT.227

Example. Bob’s farming operation, Greenway, Inc., is an S corporation that cash rents farmland from an

LLC that Bob also owns. The cash rental income is considered nonpassive self-rental income. Bob could

also make an election to group the LLC and Greenway, Inc. as a single material participation activity. As a

result, all income or loss would not be subject to any passive loss restrictions and would not be subject to

the NIIT.228

For farmers that materially participate in a farming operation but have income from other activities in which they

do not materially participate, a grouping election can be made so that all of the activities are treated as a single

activity producing active business income not subject to the NIIT.229

Example. George’s corn farming business is conducted through his S corporation. George is an employee

of the S corporation and participates full time in the farming activities of the corporation. The corn raised

by the S corporation’s activities is sold to an ethanol plant, which is also an S corporation. George has an

ownership interest in the ethanol plant, but does not participate in any of the ethanol plant’s activities. The

income that the ethanol plant generates is passive to George; thus, the NIIT would potentially apply to

George’s income from his investment in the ethanol plant. However, George can make a grouping election

if he satisfies the conditions of Treas. Reg. §1.469-4(d)(1) to treat the two S corporations as a single activity.

The election will allow George to be deemed as materially participating in the activities of the ethanol plant

by virtue of his participation in the farming activities. Consequently, George’s income from the ethanol

plant will not be subject to the NIIT.

Regroupings. The final regulations address when a taxpayer can redo a grouping election because of the NIIT.

The proposed regulations indicate that a taxpayer could revise any grouping election in the first year that the

taxpayer:

226 Any resulting gain from the sale of assets would be nonpassive.

227 Any resulting gain from the sale of assets would be nonpassive.

228 Any resulting gain from the sale of assets would be nonpassive.

229 Treas. Reg. §1.469-4(c).

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Meets the income threshold requirements for the NIIT, and

Has investment income.

Both tests must be met.

The final regulations retain these same regrouping provisions.230 However, they provide additional clarification

regarding amended tax returns and examinations. If a taxpayer had properly made a regrouping election and it was

later determined that adjustments required an amended tax return that either reduced gross income below the

threshold level or eliminated investment income, then the taxpayer is required to undo the regrouping election and

is bound by this until both tests apply in the future. Conversely, if a taxpayer had not made a regrouping election

because their income was under the threshold level but additional income was determined after filing the original

return, the taxpayer is allowed to make a regrouping election at that time. When an examination of a taxpayer’s

records results in a redetermination of income, then the taxpayer is subject to the same provisions.

Example. Guy Wire is a single taxpayer with Schedule F income of $175,000 and interest income of

$20,000 for 2013. His total income of $195,000 is under the threshold level for the NIIT. Thus, Guy is not

allowed to make any regrouping elections in 2013. Later, it is determined that $10,000 of additional farm

income was not reported on the original return. When the amended tax return is prepared, Guy can make a

regrouping election at that time because his gross income now exceeds the threshold amount. Guy will then

be bound by that election for subsequent years.

Relief for Self-Charged Interest Income

Treas. Reg. §1.469-7 provides that in the case of self-charged items of interest income received from a

nonpassive entity, the amount of interest income excluded from NII is the taxpayer’s allocable share of

the nonpassive deduction.

Example. Evan Keel owns 90% of Farmco, Inc., an S corporation in which he materially participates.

During the year, Evan loaned Farmco $300,000 and received $20,000 of interest income. Consequently,

$18,000 ($20,000 × 90%) of the interest that Evan receives is excluded from investment income. He only

reports $2,000 of interest income as investment income.

Note. If the self-charged interest was deducted in arriving at self-employment (SE) income at the

entity level, then all of the self-charged interest is treated as investment income. That is a relevant

consideration when the entity involved is an LLC. Interest paid by an LLC reduces the SE income

of the LLC.

Net Losses Can Offset Other Investment Income

Under proposed regulations, losses from the sale of assets could only be used to offset gains from the sale

of assets. For NIIT purposes, if a net loss resulted after netting gains and losses, the loss could not be used.

Although the final regulations essentially retained the same language of the original proposed regulations

regarding limiting net losses to zero, Treas. Reg. §1.1411-4(d)(2) was added, which allows a net capital

loss deduction of $3,000 to offset other investment income.

230 TD 9644

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Note. For individuals, when capital losses exceed capital gains, up to $3,000 ($1,500 for MFS

taxpayers) can be used to reduce other types of income. Any amount of net capital losses in excess

of $3,000 is carried forward to future years.

The final regulations add new Treas. Reg. §1.1411-4(f)(4), which essentially states that any losses in excess of gains

may now be used to offset other types of NII, but only to the extent that the losses are used to currently reduce the

taxpayer’s taxable income. This does not mean that a net loss can be created. However, any losses that exceed net

gains and are currently allowable in determining taxable income can be used to reduce other items of NII.

Example. In 2014, Sara sells IBM stock for a $15,000 loss. The stock also generated $5,000 of dividend

income during the year. She has no other gains or losses or investment income for the year. Thus, Sara can

deduct $3,000 of the capital losses against other income for the 2014 tax year. Sara’s NII is $2,000 ($5,000

of dividend income − $3,000 capital loss allowed).

Example. Ron invested in an ethanol plant that usually generates $100,000 of passive income every year.

However, in 2013, in addition to the $100,000 of passive ordinary income, the ethanol plant sold some

assets for a net IRC §1231 loss of $100,000. For income tax purposes, Ron can offset the $100,000 of §1231

losses against his $100,000 of passive income for net taxable income of zero. The loss is also fully allowed,

which results in NIIT of zero.

A net operating loss (NOL) can partially offset investment income. Because NOLs are computed and carried over

each year, a separate ratio must be determined for each year. The portion of an NOL that is deductible against

investment income (the IRC §1411 NOL) is calculated by first determining the applicable portion of the NOL for

each loss year.

Note. Essentially, the taxpayer must determine two NOLs for any loss year. First, the regular NOL

computed under IRC §172 is determined. Second, the §1411 NOL that arises only from NII sources

is then determined. This NOL is then divided into the regular NOL to arrive at a factor for that loss

year.

Sale of Farmland and the NIIT

Capital gain income can trigger the application of the NIIT. However, if the capital gain is attributable to the sale

of a capital asset that is used in a trade or business in which the taxpayer materially participates, the NIIT does not

apply. For purposes of the NIIT, material participation is determined in accordance with the passive loss rules of

IRC §469.

Note. For more information about the passive loss rules, see the 2014 University of Illinois Federal

Tax Workbook, Volume B, Chapter 4: Passive Activities.

If an active farmer sells a tract of land from their farming operation, the capital gain recognized on the sale is not

subject to the NIIT. However, whether the NIIT applies to the sale of farmland by a retired farmer or a surviving

spouse is not so easy to determine. There are two approaches to determining whether the NIIT applies to such sales.

1. The IRC §469(f)(3) approach

2. The IRC §469 approach

IRC §469(h)(3) Approach. IRC §469(h)(3) provides that “a taxpayer shall be treated as materially participating in

any farming activity for a taxable year if paragraph (4) or (5) of IRC §2032A(b) would cause the requirements of

IRC §2032A(b)(1)(C)(ii) to be met with respect to real property used in such activity if such taxpayer had died

during the taxable year.” The requirements of §2032A(b)(1)(C)(ii) are met if the decedent or a member of the

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decedent’s family materially participated in the farming activity five or more years during the eight years preceding

the decedent’s death. In applying the five-out-of-eight-year rule, the taxpayer may disregard periods in which the

decedent was retired or disabled.231 If the five-out-of-eight year rule is met with regard to a deceased taxpayer, it is

deemed to be met with regard to the taxpayer’s surviving spouse, provided that the surviving spouse actively

manages the farming activity when the spouse is not retired or disabled.232

To summarize, a retired farmer is considered to be materially participating in a farming activity if the retired farmer

is:

Continually receiving social security benefits or is disabled, and

Materially participated in the farming activity for at least five of the last eight years immediately preceding the

earlier of death, disability, or retirement (defined as receipt of social security benefits).

The five-out-of-eight-year test, once satisfied by a farmer, is deemed to be satisfied by the farmer’s surviving spouse

if the surviving spouse is receiving social security. Until the time at which the surviving spouse begins to receive

social security benefits, the surviving spouse must only actively participate in the farming operation to meet the

material participation test.

“Normal” IRC §469 Approach. IRC §469(h)(3) concerns the recharacterization of a farming activity, but not the

recharacterization of a rental activity. Thus, if a retired farmer is no longer farming but is engaged in a rental activity,

§469(h)(3) does not apply and the normal material participation tests under §469 apply. The only one of those tests

that is likely to have any potential application in the context of a retired farmer is whether the taxpayer materially

participated in the farming activity for at least five of the previous 10 years immediately preceding the sale. This

approach would cause more transactions to be subject to NIIT.

Sale of Land Held in Trust. When farmland that has been held in trust is sold, the IRS position is that only the trustee

of the trust can satisfy the material participation tests of §469. This position has been rejected by the one federal

district court that has ruled on the issue,233 but the IRS, while not appealing the court’s opinion, continued to assert

its judicially rejected position.

In early 2014, the U.S. Tax Court rejected the IRS’s position.234 The Tax Court held that the conduct of the trustees

acting in the capacity of trustees counts toward the material participation test as well as the conduct of the trustees

as employees. The Tax Court also implied that the conduct of nontrustee employees would count toward the material

participation test.

Trading in Commodities and the NIIT

The NIIT applies to a trade or business of trading in financial instruments or trading in commodities.235 The

definition of commodities for purposes of the NIIT236 includes the following.

Actively traded personal property237

231 IRC §2032A(b)(4). 232 IRC §2032A(b)(5). 233 Mattie Carter Trust v. U.S., 256 F.Supp.2d 536 (N.D. Tex. 2003). 234 Frank Aragona Trust v. Comm’r, 142 TC 9 (Mar. 27, 2014). 235 Treas. Reg. §1.1411-5(a)(2). 236 IRC §475(e)(2). 237 See IRC §1092(d)(1).

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Any option, forward contract, futures contract, short position, and any similar instrument in a covered

commodity238

A hedge with respect to such commodity

To be subject to the NIIT, the taxpayer must be engaged in the trade or business of trading in commodities.

For taxpayers that are owners of pass-through entities, that determination is made at the entity level.239 For taxpayers

that are directly engaged in a trade or business, the determination of whether the taxpayer is engaged in the trade or

business of trading in commodities is determined at the owner level. Thus, a sole proprietor farmer’s income from

hedging activity or the hedging income of a farming entity structured as a pass-through entity is not subject to the

NIIT. This is because the farmer or entity is engaged in the trade or business of farming and not the trade or business

of trading in commodities.

Hedging gains for a farmer are, therefore, not subject to the NIIT. However, if the farmer’s commodity trading

activity does not satisfy the definition of hedging, the resulting income or loss is speculative in nature.

Note. Speculative income from trading in commodities is subject to the NIIT under IRC

§1411(c)(1)(A)(iii). That Code section says that the NIIT applies to net gains attributable to the

disposition of property other than property held in a trade or business in which the taxpayer

materially participates. The speculative gains and losses get the standard 60% long-term capital

gain (or loss) and 40% short-term capital gain (or loss)240 treatment. The additional 3.8% NIIT also

applies.

ENTITY PLANNING ISSUES AND THE ADDITIONAL TAXES UNDER ACA

In addition to the tax of 3.8% on certain passive income (the NIIT), the ACA also increased the Medicare tax rate

from 2.9% to 3.8% for certain taxpayers. This additional 0.9% tax is often referred to as the additional Medicare

tax. The additional Medicare tax is imposed on taxpayers with wages and/or SE income above the same threshold

amount that applies for purposes of the NIIT.

From an estate planning, business planning, and succession planning perspective, the NIIT and the additional

Medicare tax have implications for trusts and may encourage many entities to adopt the pass-through tax treatment

provided by partnerships, LLCs, and S corporations.

Note. For more information about the additional Medicare tax, see the 2014 University of Illinois

Federal Tax Workbook, Volume A, Chapter 3: Affordable Care Act Update.

Trusts

Under proposed regulations, the NIIT threshold for trusts is the top tax rate bracket ($11,950 for 2013 and $12,150

for 2014). The NIIT applies to the lesser of undistributed NII or the excess of the trust’s AGI over the threshold.

The regulations allocate investment income between distributed and undistributed income under the usual trust

allocation rules. Electing small business trusts (ESBT) must combine their S corporation and non-S corporation

income for purposes of computing the tax.241 For charitable remainder trusts, the proposed regulations treat part of

the distributions as investment income.242

238 IRC §475(e)(2)(C). 239 Treas. Reg. §1.1411-4(2)(b)(2)(ii). 240 IRC §1256. 241 Prop. Treas. Reg. §1.1411-3(c)(1)(ii).

242 Prop. Treas. Reg. §1.1411-3(c)(2).

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Note. For more information about the application of the NIIT to trusts, see the 2014 University of

Illinois Federal Tax Workbook, Volume A, Chapter 3: Affordable Care Act Update.

Note. Foreign estate and trusts are not normally subject to the NIIT. The proposed regulations state

that the IRS will subject U.S. beneficiaries to the NIIT on their share of distributed investment

income.

Pass-Through Entities

Although pass-through entities are not subject to the additional Medicare tax, individuals, trusts, and estates that

are direct or indirect owners may be subject to taxation on the allocable portion of income and gain derived from

these entities. Taxpayers must include the additional Medicare tax in determining their estimated tax payments.243

Partnerships

Although the NIIT does not apply to income from a trade or business conducted by a partnership (other than passive

income), income, gain, or loss on working capital is not considered to be derived from a trade or business and is

subject to the NIIT.244 Gain or loss from a disposition of a partnership interest is included in a partner's NII only to

the extent of the net gain or loss the partner would take into account if the partnership sold all its property for fair

market value (FMV) immediately before the disposition of the partnership interest.245 This means that if a taxpayer

materially participates in a partnership with trade or business income, the taxpayer will have SE income that is

potentially subject to the additional Medicare tax of 0.9% and the standard Medicare tax of 2.9%. If the taxpayer

does not materially participate in the partnership, the taxpayer’s share of partnership income will potentially be

subject to the NIIT.

S Corporations

S corporation income reported on Schedule K-1, Shareholder’s Share of Income, Deductions, Credits, etc., is not

subject to SE tax. In addition, the NIIT does not apply to business income earned by active S corporation

shareholders, even if their income is over the threshold amounts. The NIIT does apply, however, to the income of

passive shareholders in an S corporation. Generally, an S corporation is favored over a partnership because active

S corporation shareholders can avoid both the SE tax and the NIIT.

Limited Liability Companies

In general, income that is subject to SE tax is not subject to the NIIT. With respect to an LLC, business income

allocated to the general partners of an LLC taxed as a partnership is generally subject to SE tax even if it flows to a

partner who does not participate in the operations of the LLC.246 There is no guidance on the SE tax treatment of

income flowing to LLC (and limited liability partnership (LLP)) owners who do not participate in the operations of

the business. However, to the extent a limited liability owner (either an LLC member or an LLP partner) receives a

guaranteed payment for services, the law is clear that this payment is subject to SE tax.247 Thus, guaranteed

payments for services or capital would always appear to be subject to SE tax, even if paid to an individual holding

a limited liability interest. Proposed regulations hold that a limited liability partner is subject to SE tax under any

one of three circumstances.248

243 IRC §6654.

244 IRC §1411(c)(3).

245 IRC §1411(c)(4).

246 Treas. Reg. §1.1402(a)-2(g).

247 IRC §1402(a)(13); Prop. Treas. Reg. §1.1402(a)-2(g).

248 Prop. Treas. Reg. §1.1402(a)-2(h)(2).

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13. The individual has personal liability for the debts of, or claims against, the partnership by reason of being

a partner or member.

14. The individual has authority under the statutes of the state in which the partnership is formed to contract on

behalf of the partnership (i.e., the individual has management authority).

15. The individual participated in the entity’s trade or business for more than 500 hours during the entity’s

taxable year.

Manager-Managed LLC. An LLC may be member-managed or manager-managed. The owners of the LLC

are responsible for managing the company in a member-managed LLC. A manager-managed LLC is operated by

managers who are appointed to run the company. Manager-managed LLCs operate in a similar fashion to a

corporation that has a board of directors to control the company's affairs. LLC members that adopt a manager-

managed structure may prefer to take a more passive role in terms of operating the company. By hiring third-party

managers, the members of the company can concentrate on building the business, as opposed to addressing the

needs of the LLC on a daily basis.

A manager-managed LLC may provide separate classes of membership for managers (who have the authority to

bind the LLC under a contract) and nonmanagers (who have no such authority). From an SE tax perspective, the

use of a manager-managed LLC with two classes of membership provides SE tax savings to the nonmanaging

members.

Note. Both classes provide limited liability protection to the members in their capacity as members.

Nonmanagers who do not meet the 500-hour participation test are not subject to SE tax, except to the extent of any

guaranteed payments they receive. Nonmanagers who exceed the 500-hour test are not subject to SE tax if they own

a substantial continuing interest (i.e., at least 20%) in a class of interest and the individual’s rights and obligations

of that class are identical to those held by persons who satisfy the general definition of limited partner (i.e., less

than 500 hours for a nonmanager).

Note. Managers are subject to SE tax on income from that interest. If there are nonmanagers who

spend less than 500 hours with the LLC and such members own at least 20% of the interests in the

LLC, those nonmanagers who spend more than 500 hours are not subject to SE tax on the pass-

through income but are subject to SE tax on the guaranteed payments.249

It is possible to structure a manager-managed LLC with the taxpayer holding both manager and nonmanager

interests. In this type of structure, individuals with nonmanager interests who spend less than 500 hours with the

LLC must own at least 20% of the LLC interests.

Note. This exception allows the individual who holds both manager and nonmanager interests to

be exempt from SE tax on the nonmanager interest.250 The taxpayer is subject to SE tax on the pass-

through income and guaranteed payments of the manager interest.

Structuring the Manager-Managed LLC. In an LLC that is structured to minimize SE tax and avoid

the NIIT, all of the LLC interests can be owned by nonmanagers (investors) with a third party non-owner named as

manager and some or all of the investors working on behalf of the manager. The manager could be an S corporation

249 Prop. Treas. Reg. §1.1402(a)-2(h)(4).

250 Prop. Treas. Reg. §1.1402(a)-2(h)(3).

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or a C corporation, with the LLC investors owning part or all of the corporation. The manager must be paid a

reasonable management fee and the LLC owners who provide services to the LLC must be paid reasonable

compensation. The LLC owners who do not render services to the LLC do not have income that is subject to SE

tax. The manager earns a 1% manager interest for the services rendered to the LLC, which generates a guaranteed

payment. The guaranteed payment is subject to SE tax.

In summary, LLC nonmanagers working less than 500 hours annually are subject to SE tax only on guaranteed

payments. Nonmanagers who work more than 500 hours annually are subject to SE tax only on guaranteed payments

if the nonmanagers who work less than 500 hours annually make up at least 20% of the membership. Although the

managers and nonmanagers own interests commensurate with their investment (i.e., nonmanager interests), the

managers also receive manager interests as a reward for their services. Managers recognize SE income on the pass-

through income associated with the manager interests. All nonmanager interests are not subject to SE tax, except

guaranteed payments.

With respect to the NIIT, a nonmanager’s interest in a manager-managed LLC is normally considered passive and

is subject to the NIIT.251 However, a spouse may take into account the material participation of a spouse who is the

manager.252 Thus, if the manager spouse materially participates, then all nonmanager interest(s) owned by both

spouses avoid the NIIT.

Other Situations

Other farming arrangements may give rise to the possibility of farm income being subjected to the NIIT.

These arrangements include hiring a farm manager and using multiple entities.

Hired Farm Manager. Not infrequently, farm owners utilize farm management companies to perform

all of the day-to-day management of the farm. The share of the farm income that the owner receives is

potentially subject to the NIIT as passive income. The activity of the agent (farm management company)

is not imputed to the principal (farm owner) for NIIT material participation purposes.

Multiple Entities. Farmers sometimes structure their farming businesses in multiple entities for estate

and business planning purposes. For instance, a farmer may own an operational entity that contains the

business operational assets and rent land to it that is owned by a different entity (or is owned individually).

For land that is owned jointly by a married couple (either as joint tenants or as tenants in common) when

the farming spouse pays the nonfarm spouse rent to reflect the nonfarm spouse’s one-half interest, a

question arises as to whether the NIIT applies to the rental income. The rental of property to the farming

spouse’s business in which the farmer materially participates is a self-rental that is not subject to the NIIT.

Because the spouses are considered to be a unit for the regular passive loss rules, the rental income is not

passive income in the hands of the non-farming spouse.

Manager-Managed LLC. An LLC may be member-managed or manager-managed. The owners of the

LLC are responsible for managing the company in a member-managed LLC. A manager-managed LLC is operated by managers who are appointed to run the company. Manager-managed LLCs operate in a similar fashion to a corporation that has a board of directors to control the company's affairs. LLC members that adopt a manager-managed structure may prefer to take a more passive role in terms of operating the company.

251 IRC §1411(c)(2)(A).

252 IRC §469(h)(5).

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By hiring third-party managers, the members of the company can concentrate on building the business, as opposed

to addressing the needs of the LLC on a daily basis.

A manager-managed LLC may provide separate classes of membership for managers (who have the

authority to bind the LLC under a contract) and nonmanagers (who have no such authority). From an SE tax

perspective, the use of a manager-managed LLC with two classes of membership provides SE tax savings to

the nonmanaging members.

Nonmanagers who do not meet the 500-hour participation test are not subject to SE tax, except to the extent

of any guaranteed payments they receive. Nonmanagers who exceed the 500-hour test are not subject to SE

tax if they own a substantial continuing interest (i.e., at least 20%) in a class of interest and the individual’s

rights and obligations of that class are identical to those held by persons who satisfy the general definition of

limited partner (i.e., less than 500 hours for a nonmanager).

It is possible to structure a manager-managed LLC with the taxpayer holding both manager and nonmanager

interests. In this type of structure, individuals with nonmanager interests who spend less than 500 hours with the

LLC must own at least 20% of the LLC interests.

Structuring the Manager-Managed LLC. In an LLC that is structured to minimize SE tax and

avoid the NIIT, all of the LLC interests can be owned by nonmanagers (investors) with a third party non-owner named as manager and some or all of the investors working on behalf of the manager. The manager could be an S corporation or a C corporation, with the LLC investors owning part or all of the corporation. The manager must be paid a reasonable management fee and the LLC owners who provide services to the LLC must be paid reasonable compensation. The LLC owners who do not render services to the LLC do not have income that is subject to SE tax. The manager earns a 1% manager interest for the services rendered to the LLC,

which generates a guaranteed payment. The guaranteed payment is subject to SE tax.

Note. Both classes provide limited liability protection to the members in their capacity as

members.

Note. Managers are subject to SE tax on income from that interest. If there are nonmanagers who spend less than 500 hours with the LLC and such members own at least 20% of the interests in the LLC, those nonmanagers who spend more than 500 hours are not subject to SE tax on the pass-through income but are subject to SE tax on the

guaranteed payments.25

Note. This exception allows the individual who holds both manager and nonmanager

interests to be exempt from SE tax on the nonmanager interest.26

The taxpayer is subject to SE tax on the pass-through income and guaranteed payments of the manager interest.

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In summary, LLC nonmanagers working less than 500 hours annually are subject to SE tax only

on guaranteed payments. Nonmanagers who work more than 500 hours annually are subject to SE tax

only on guaranteed payments if the nonmanagers who work less than 500 hours annually make up at

least 20% of the membership. Although the managers and nonmanagers own interests commensurate

with their investment (i.e., nonmanager interests), the managers also receive manager interests as a

reward for their services. Managers recognize SE income on the pass-through income associated with

the manager interests. All nonmanager interests are not subject to SE tax, except guaranteed payments.

With respect to the NIIT, a nonmanager’s interest in a manager-managed LLC is normally considered passive and is subject to the NIIT.

However, a spouse may take into account the material participation of

a spouse who is the manager. Thus, if the manager spouse materially participates, then all nonmanager

interest(s) owned by both spouses avoid the NIIT.

Use of GRATs and IDGTs For Wealth Transfer and Business

Succession

In General

A business owner and other high-wealth individuals may be able to successfully transfer business

interests and/or investment wealth to a successive generation by use of a Grantor Retained Annuity Trust

(GRAT) and/or an Intentionally Defective Grantor Trust (IDGT). Both the GRAT and the IDGT allow

the grantor to “freeze” the value of the transferred assets253 while simultaneously providing the grantor

with a cash flow stream for a specified time period.

IDGT – Defined

An IDGT is a specially designed irrevocable grantor trust that is designed to avoid any retained interests

or powers in the grantor that would result in the inclusion of the trust’s assets in the grantor’s gross estate

upon the grantor’s death. For federal income tax purposes, the trust is designed as a wholly grantor trust

as to the grantor under I.R.C. §671.254 Thus, a sale (or other transaction) between the trust and the grantor

are not income tax events, and the trust’s income, losses, deductions and credits are reported by the

grantor on the grantor’s individual income tax return.

Observation. The trust is “defective” because the seller (grantor) and the trust are treated as the same

taxpayer for income tax purposes. However, an IDGT is defective for income tax purposes only - the

trust and transfers to the trust are respected for federal estate and gift tax purposes. The “defective”

nature of the trust meant that the grantor does not have gain on the sale of the assets to the trust, is not

taxed on the interest payments received from the trust, has no capital gain if the note payments are paid to

the grantor in-kind and makes the trust an eligible S corporation shareholder.255

The IDGT Transaction

253 The “freeze” derives from the ability to capitalize on the mismatch between interest rates used to value transfers

and the actual anticipated performance of the transferred asset. 254 Under the terms of the IDGT, the grantor (or a third party) retains certain powers that cause the trust to be treated

as a grantor trust for income tax purposes. However, such retained powers do not cause the trust assets to be

included in the grantor’s estate. 255 Rev. Rul. 85-13, 1985-1 C.B. 184; I.R.C. §1361(c)(2)(A)(i).

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The IDGT technique involves the grantor selling highly-appreciating or high income-producing assets to

the IDGT for fair market value in exchange for an installment note.256 The IDGT transaction is structured

so that a completed gift occurs for gift tax purposes, with no resulting income tax consequences.257 The

trust language is carefully drafted to provide the grantor with sufficient retained control over the trust to

trigger the grantor trust rules for income tax purposes, but insufficient control to cause inclusion in the

grantor’s estate. It is a popular estate planning technique for shifting large amounts of wealth to heirs and

creating estate tax benefits because the value of the assets that the grantor transfers to the trust exceeds the

value of the assets that are included in the grantor’s estate at death. It is generally viewed as an “estate

freeze” technique.

Note. Interest on the installment note is set at the Applicable Federal Rate for the month of the transfer

that represents the length of the note’s term.258 Given the current low interest rates, it is reasonable for

the grantor to expect to receive a total return on the IDGT assets that exceeds the rate of interest. Indeed,

if the income/growth rate on the assets sold to the IDGT is greater than the interest rate on the installment

note taken back by the grantor, the “excess” growth/income is passed on to the trust beneficiaries free of

any gift, estate and/or Generation Skipping Transfer Tax (GSTT).

The IDGT technique became popular after the IRS issued a favorable letter ruling in 1995259 that took the

position that I.R.C. §2701 would not apply because a debt instrument is not an applicable retained

interest.260 The IRS, in the same letter ruling also stated that a debt instrument is not a term interest,

which meant that I.R.C. §2702 would not apply.261

Pros and Cons of IDGTs

An IDGT has the effect of freezing the value of the appreciation on assets that are sold to it in the

grantor’s estate at the low interest rate on the installment note payable. Additionally, as previously noted,

there are no capital gain taxes due on the installment note, and the income on the installment note is not

taxable to the grantor. Because the grantor pays the income tax on the trust income, that has the effect of

leaving more assets in the IDGT for the remainder beneficiaries. Likewise, valuation adjustments

(discounts) increase the effectiveness of the sale for estate tax purposes.

On the downside, if the grantor dies during the term of the installment note, the note is included in the

grantor’s estate. Also, there is no stepped-up basis in trust-owned assets upon the grantor’s death.

Because trust income is taxable to the grantor during the grantor’s life, the grantor could experience a

256 The grantor should make an initial “seed” gift of at least 10 percent of the total transfer value to the trust so that

the trust has sufficient capital to make its payments to the grantor. 257 Because the transfer is a completed gift, the trust receives a carryover basis in the gifted assets. 258 The installment note can call for interest-only payments for a period of time and a balloon payment at the end, or

it may require interest and principal payments. 259 Priv. Ltr. Rul. 9535026 (May 31, 1995). 260 I.R.C. §2701 applies to transfers of interests in a corporation or a partnership to a family member if the transferor

or family member holds and “applicable retained interest” in the entity immediately after the transfer. However, an

“applicable retained interest” is not a creditor interest in bona fide debt. 261 If the seller transfers a remainder interest in assets to a trust and retains a term equity interest in the income,

I.R.C. §2702 applies which results in a taxable gift of the full value of the property sold. For instance, a sale in

return for an interest only note with a balloon payment at the end of the term would result in a payment stream that

would not be a qualified annuity interest because the last payment would represent an increase of more than 120

percent over the amount of the previous payments. See Hatcher and Manigualt, “Using Beneficiary Guarantees in

Defective Grantor Trusts,” 92 Journal of Taxation 152 (Mar. 2000).

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cash flow problem if there grantor does not earn sufficient income. In addition, there is possible gift and

estate tax exposure if insufficient assets are used to fund the trust.

Proper Structuring of the Sale to the IDGT

As noted above, the installment note must constitute bona fide debt. That is the key to the IDGT

transaction from an income tax and estate planning or business succession standpoint. If the debt

amounts to an equity interest, then I.R.C. §§2701-2702 apply and a large gift taxable gift could be created

or the transferred assets will end up being included in the grantor’s estate.262 I.R.C. §2036 causes

inclusion in the grantor’s estate of property the grantor transfers during life for less than adequate and full

consideration if the grantor retained for life the possession or enjoyment of the transferred property or the

right to the income from the property, or retained the right to designate the persons who shall possess or

enjoy the property or the income from it. In the context of an IDGT, if the installment note represents

bona fide debt, the grantor does not retain any interest in the property transferred to the IDGT and the

transferred property is not included in the grantor’s estate at its date-of-death value.

All of the tax benefits of an IDGT turn on whether the installment note is bona fide debt. Thus, it is

critical to structure the transaction properly to minimize the risk of the IRS taking the position that the

note constitutes equity for gift or estate tax purposes. That can be accomplished by observing all

formalities of a sale to an unrelated party, providing sufficient seed money, having the beneficiaries

personally guarantee a small portion of the amount to be paid under the note, not tying the note payments

to the return on the IDGT assets, actually following the scheduled note payments in terms of timing and

amount, making the note payable from the trust corpus, not allowing the grantor control over the property

sold to the IDGT, and keeping the term of the note relatively short. These are all indicia that the note

represents bona fide debt.

Administrative Issues with IDGT’s

An IDGT is treated as a separate legal entity. Thus, a separate bank account is opened for the IDGT in

order to receive the “seed” gift and annual cash inflows and outflows.263 An amortization schedule will

need to be maintained between the IDGT and the grantor, as well as annual books and records of the trust.

GRAT - Defined

A GRAT is an irrevocable trust to which assets (those that are likely to appreciate in value at a rate

exceeding the rate applied to the annual annuity payment the GRAT will make)264 are transferred and the

262 In Karmazin v. Comr., T.C. Docket No. 2127-03 (2003), the IRS took the position that I.R.C. §§2701 and 2702

applied to the sale of limited partnership interests to the trust which would cause them to have no value for federal

gift tax purposes on the theory that the notes the grantor received were equity instead of debt. The case was settled

before trial on terms favorable to the taxpayer with the parties agreeing that neither I.R.C. §2701 or I.R.C. §2702

applied. However, IRS resurrected the same arguments in Estate of Woelbing v. Comr., T.C. Docket No. 30261-13

(filed Dec. 26, 2013). The parties settled the case before trial with a stipulated decision entered on Mar. 25, 2016

that resulted in no additional gift or estate tax. The total amount of the gift tax, estate tax, and penalties at issue was

$152 million. 263 The grantor’s Social Security number is used for the bank account. 264 Preferred assets to transfer to a GRAT include marketable securities, real estate, Subchapter S corporate stock,

closely-held C corporate stock, and FLP interests, for example.

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grantor receives the right to a fixed annuity payment for a term of years,265 with the remainder

beneficiaries receiving any remaining assets at the end of the GRAT term.266 The annuity payment can

be structured to remain the same each year or it can increase up to 120 percent annually. However, once

the annuity is established, additional property cannot be added to the GRAT.267

Observation. A GRAT can accomplish two important estate planning objectives. The GRAT technique

“freezes” the value of the senior family member’s highly appreciated assets at today’s value, and provides

the senior family member with an annuity payment for a term of years. Thus, the GRAT can deliver

benefits without potential transfer tax disadvantages. The present low interest rate environment makes

GRATs more attractive.

Technical Requirements

A GRAT must make at least one annuity payment every 12-month period that is paid to an annuitant from

either the GRAT’s income or principal. There is a 105-day window within which the GRAT can satisfy

the annual annuity payment requirement. The window runs from the GRAT creation date.268 Notes

cannot be used to fund annuity payments, and the trustee cannot prepay the annuity amount or make

payments to any person other than the annuitant during the qualified interest term.

A GRAT is subject to a fixed amount requirement that takes the form of either a fixed dollar amount or a

fixed percentage of the initial fair market value of the property transferred to the trust. There is also a

formula adjustment requirement that is tied to the fixed value of the trust assets as finally determined for

gift tax purposes. The provision must require adjustment of the annuity amount.

Note. From a financial accounting standpoint, the GRAT is a separate legal entity. The GRAT’s bank

account is established using the grantor’s social security number as the I.D. number. Annual accounting

is required, including a balance sheet and an income statement.

Tax Consequences of Creating, Funding, Administering and Terminating a GRAT

For income tax purposes, the GRAT is treated as a grantor trust because, by definition, the retained

interest exceeds five percent of the value of the trust at the time the trust is created.269 Thus, there is no

gain or loss to the grantor on the transfer of property to the GRAT in exchange for the annuity.270

265 The fixed payment is typically a percentage of the asset’s initial fair market value computed so as to not trigger

gift tax. 266 The term of the annuity is fixed in the instrument and is either tied to the annuitant’s life, a specified term of

years or a term that is the shorter of the two. 267 If an additional contribution is made, the trust no longer qualifies as a GRAT and the granter will be deemed to

have made a current gift of the trust assets to the remainder beneficiaries. 268 Date of creation is largely a state law issue and could be the date of signing of the GRAT or the date of funding.

In any event, if the required annuity amount is not distributed within the window period, the failure is deemed to be

an additional disqualifying contribution to the GRAT 269 I.R.C. §673. Also, under I.R.C. §674, the grantor is treated as the owner of any portion of the trust over which

the grantor controls beneficial enjoyment or corpus or income, exercisable by the grantor or a non-adverse party or

both, without the consent of any adverse party. There are exceptions to this general rule, however, that are

contained in I.R.C. §674(b). 270 There can be issues, however, if there is debt on the property transferred to the GRAT that exceeds the property’s

basis. Also, there can be an issue with partnership “negative basis” (i.e., the partner’s share of partnership liabilities

exceeds the partner’s share of the tax basis in the partnership assets).

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Because the trust is a grantor trust, the grantor is taxed on trust income, including interest, dividends,

rents and royalties, as well as pass-through income from business entity ownership. The grantor also can

claim the GRAT’s deductions. However, the grantor is not taxed on annuity payments, and transactions

between the GRAT and the grantor are ignored for income tax purposes. A significant tax benefit of a

GRAT is that the sale of the asset between the grantor and the GRAT does not trigger any taxable gain or

loss. The transaction is treated as a tax-free installment sale of the asset. Also, the GRAT is permitted to

hold “S” corporation stock as the trust is a permitted S corporation shareholder.

Note. Because a GRAT is treated as a grantor trust, the GRAT assets can grow without the burden of

income taxes.

For gift tax purposes, the value of the gift equals the value of the property transferred to the GRAT less

the value of the grantor’s retained annuity interest. In essence, the transferred assets are treated as a gift

of the present value of the remainder interest in the property. That allows asset appreciation to be shifted

(net of the assumed interest rate that is used to compute present value) from the grantor’s generation to

the next generation.

Note. If the GRAT underperforms (i.e., the GRAT assets fail to appreciate at a higher rate than the

interest rate of the annuity payment), the GRAT can sell its assets back to the grantor with no income tax

consequences (assuming the GRAT is a wholly-owned grantor trust.271 Then, the repurchased property

can be placed in a new GRAT with a lower annuity payment. The original GRAT would then pay out its

remaining cash and collapse.

It is possible to “zero-out” the gift value so there is no taxable gift. An interest rate formula determined

by I.R.C. §7520 is used to calculate the value of the remainder interest. If the income and appreciation of

the trust assets exceed the I.R.C. §7520 rate, assets remain at the end of the GRAT term that will pass to

the GRAT beneficiaries.

Note. Given current low interest rates, a GRAT can effectively transfer wealth to the subsequent

generation with little or no gift tax consequences.

Example. Bob, age 60, transferred $1 million to a GRAT in June of 2016 and would like to retain an

annuity for seven years. Bob has previously made large taxable gifts that have utilized his applicable

exclusion, so it is important to him that gift value of the $1 million transfer be “zeroed-out.”

Accordingly, based on a June 2016 AFR of 1.8% Bob would need to receive an annuity payment of

$153,327.10. Assuming that the GRAT assets earn 3% income annually and grow at a rate of 5%, the

trust will have assets worth $350,920.07 at the end of the seven-year term. Those assets will pass to the

GRAT beneficiaries.272 The value of the gift that Bob made to the GRAT will be valued at less than $1.

Observation. Even though, in the example, the value of the gift was less than $1, Bob should report the

gift on a timely filed Form 709 to trigger the running of the statute of limitations for gift tax assessment

purposes.273 A copy of the trust should be attached along with a description of contributed assets, the

271 Rev. Rul. 85-13, 1985-1 C.B. 184. 272 There is no taxable gift that is triggered upon the transfer, but the remainder beneficiaries take the donor’s basis

in the property – a carryover basis rule applies. The IRS also will not challenge the GRAT strategy if the value of

the property has changed. 273 Treas. Reg. §301.6501(c)-1(f)(4) allows the disclosure of a “non-gift” to start the statute of limitations on any

claim by the IRS that a transfer had a gift element.

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value of the assets (including appraisals) and a statement describing how the value of the gift was

determined.

The grantor’s payment of taxes is not treated as a gift to the trust remainder beneficiaries.274 Also, if the

trustee reimburses (or has the power to reimburse) the grantor for the grantor’s payment of income tax,

the reimbursement (or the discretion to reimburse) does not cause inclusion of the trust assets in the

grantor’s estate.275

For GSTT purposes, appreciation on the GRAT’s assets is suspended during the term of the GRAT

because the grantor can only allocate GSTT exemption to the GRAT’s assets only after the GRAT term

expires based on the value of assets at that time.276 The determination of whether the transfer to the

beneficiaries is subject to the GSTT (i.e., whether the beneficiary of the trust is a skip person) is made

based upon the relationships at the time the trust is created, rather than when the trust interest ends.

Example. Sarah contributed $10 million of assets to a GRAT and retained an annuity payment that

essentially zeroed-out the gift by having a present value of $9,999,999. At the end of the GRAT term, the

remaining GRAT assets were worth $5 million. Thus, Sarah transferred $5 million of assets via a $1 gift.

Sarah established a GRAT remainder trust for the benefit of her grandchildren. At the end of the initial

GRAT’s term, Sarah will need to allocate $5 million of GSTT exemption to shelter the remainder trust

from the GSTT.277

Observation. If Sarah named only her surviving children as the GRAT remainder beneficiaries, she

could “equalize” the treatment of children of a predeceased child, for example, in her will or revocable

trust. Such a transfer would be exempt from GSTT under the predeceased parent rule of I.R.C. §2651(e).

Death of Grantor During GRAT Term

If the grantor dies before the end of the GRAT term, a portion (or all) of the GRAT is included in the

grantor’s gross estate. The amount included in the grantor’s estate is the lesser of the fair market value of

the GRAT’s assets as of the grantor’s date of death or the amount of principal needed to pay the GRAT

annuity into perpetuity (which is determined by dividing the GRAT annuity by the I.R.C. §7520 rate in

effect during the month of the grantor’s death).278

Example. Bubba dies in June 2016 with $700,000 of assets held in a 10-year GRAT. At the time the

GRAT was created in June of 2008 with a contribution of $1.5 million, the annuity was calculated to be

$183,098.70 per year (based on an interest rate of 3.8 percent and a zeroed-out gift). The amount

included in Bubba’s gross estate would be the lesser of $700,000 (the FMV of the GRAT assets at the

274 Rev. Rul. 2004-64, 2004-27 I.R.B. 7. If, however, the trust (or local law) requires the trust to reimburse the

grantor for income tax the grantor pays that is attributable to trust income, the full value of the trust’s assets is

includible in the grantor’s gross estate under I.R.C. §2036(a)(1). But, if the trust instrument (or applicable law)

gives the trustee the discretion to reimburse the grantor for that portion of the grantor’s income tax liability, the

existence of that discretion, by itself (whether or not exercised) will not cause the value of the trust assets to be

included in the grantor’s gross estate. 275 The GRAT trustee should be independent from the grantor. 276 I.R.C. §2642(f). 277 The remainder trust will be deemed to be a GSTT trust and Sarah’s exemption will be automatically allocated to

the trust at the end of the initial GRAT’s term. That is the case unless Sarah elects otherwise on a timely filed Form

709. 278 Rev. Rul. 82-105, 1982-1 C.B. 133.

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time of death) or $10,172,150 (the value of the GRAT annuity paid into perpetuity ($183,098.70/.018)).

Thus, the amount included in Bubba’s estate would be $700,000.

Note. To minimize the risk of assets being included in the grantor’s estate, shorter GRAT terms are

generally selected for older individuals.279

GRAT Advantages and Disadvantages

To summarize the above discussion here is a brief listing of advantages and disadvantages of a GRAT:

Advantages:

• Reduced gift tax cost as compared to a direct gift;

• Grantor trust status;

• Grantor can borrow funds from the GRAT and the GRAT can borrow money from third

parties;280

• GRAT term can safely be as short as two years.

Disadvantages:

• Upon formation, some of the grantor’s applicable exclusion might be utilized;

• The grantor must survive the GRAT term. If that doesn’t happen, at least a portion of the GRAT

assets become part of the grantor’s gross estate;

• No GSTT exemption can be allocated to the GRAT during the GRAT term, thereby making the

GRAT strategy ineffective for avoiding GSTT if a direct gift to GRAT beneficiaries would be

subject to the GSTT.

• Notes or other forms of indebtedness cannot be used to satisfy the required annuity payments;

• Grantor continues to pay income taxes on all of the GRAT’s income that is earned during the

GRAT term.

279 There is no restriction in the law as to how long a GRAT term must be. Kerr v. Comr., 113 T.C. 449 (1999),

aff’d., 292 F.3d 490 (5th Cir. 2002) involved a GRAT with a term of 366 days, and there is no indication in the

court’s opinion that the term was challenged. In Priv. Ltr. Rul. 9239015 (Jun. 25, 1992), the IRS blessed a GRAT

with a two-year term. See also Walton v. Comr., 115 T.C. 589 (2000). 280 When borrowing from third parties is outstanding at the time the GRAT ceases to be a grantor trust, IRS takes the

position that the grantor realizes income in the amount of the borrowing. Tech. Adv. Memo. 200010010 (Nov. 23,

1999).

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Portability Planning

An election can be made under which the amount of the estate tax applicable exclusion that is not used in

the estate of the first spouse to die is available to be used in the estate of the surviving spouse. This process

is referred to as “portability.” The amount available to be “ported” to the estate of the surviving spouse is

the deceased spouse’s unused exclusion (DSUE). Before portability,

Portability of the DSUE has become a key aspect of post-2012 estate planning. The Treasury Department

issued proposed and temporary regulations addressing the DSUE under IRC §§2010(c)(2)(B) and

2010(c)(4) on June 15, 2012. The proposed regulations applied until June 15, 2015, and were then replaced

with final regulations.

Note. The inherited DSUE amount is available to the surviving spouse as of the date of

the deceased spouse's death. It is applied to gifts and the estate of the surviving spouse

before their own exemption is used. Accordingly, the surviving spouse may use the DSUE

amount to shelter lifetime gifts from gift tax or to reduce the estate tax liability of the

surviving spouse's estate at death.

The portability election must be made on a timely filed Form 706 for the first spouse to die.281 This also

applies for nontaxable estates and the return is due by the same deadline (including extensions) as taxable

estates. The election is revocable until the deadline for filing the return expires.

While an affirmative election is required by statute, part 6 of Form 706 (which is entirely dedicated to the

portability election, the DSUE calculation, and roll forward of the DSUE amount) provides that "a decedent

with a surviving spouse elects portability of the DSUE amount, if any, by completing and timely-filing the

Form 706. No further action is required to elect portability…."282 This election, therefore, is made by default

if there is a DSUE amount and an estate tax return is filed (as long as the box in section A of part 6 is not

checked affirmatively electing out of portability.)

Note. In Rev. Proc. 2014-18,283 the IRS provides a simplified method for certain estates to

obtain an extended time to make the portability election. The relief for making a late

portability election applies if the decedent died in 2011, 2012, or 2013 and was a U.S.

citizen or resident at the time of death. Also, the decedent's estate must not have been

required to file a federal estate tax return and did not file such a return within the 9-month

deadline (or within an extended timeframe if an extension was involved). If those

requirements are satisfied, the Form 706 can be filed to make the portability election on or

before December 31, 2014 and the Rev. Proc. should be noted at the top of the form.

The regulations allow the surviving spouse to use the DSUE before the deceased spouse’s return is filed

(and before the amount of the DSUE is established). However, the DSUE amount is subject to audit until

the statute of limitations runs on the surviving spouse’s estate tax return.284 However, the regulations do not

address whether a presumption of survivorship can be established. If a married couple was able to establish

such a presumption that would be recognized under state law, the spouse deemed as the survivor could use

the DSUE amount of the other spouse. This would allow a spouse with more wealth to use the DSUE from

281 IRC §2010(c)(5)(A).

282 See Form 706.

283 Rev. Proc. 2014-18, 2014-7 IRB 513.

284 Temp. Treas. Reg. §§20.2010-3T(c)(1); 25.2505-2T(d)(1).

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the less wealthy spouse when simultaneous deaths occur. Alternatively, property could be transferred via a

qualified terminable interest property (QTIP) trust to the spouse with less wealth for the benefit of the

wealthier spouse’s children. Either way, the DSUE of the less wealthy spouse should be sheltered.

Requirements of Form 706. IRC §2010(c)(5) requires that the DSUE election be made by filing a

“complete and properly-prepared” Form 706. Temp. Treas. Reg. §20.2010-2T(a)(7)(ii)(A) permits the

“appointed” executor who is not otherwise required to file an estate tax return to use the executor's "best

estimate" of the value of certain property, and then report on Form 706 the gross amount in aggregate,

rounded up to the nearest $250,000.

Note. Treas. Reg. §20.2010-2T(a)(7)(ii) sets forth “simplified reporting” for particular

assets on Form 706, which allows for good faith estimates. The simplified reporting rules

apply to estates that do not otherwise have a filing requirement under IRC §6018(a). This

means that if the gross estate exceeds the basic exclusion amount ($5.49 million in 2017),

simplified reporting is not applicable.

The availability of simplified reporting is available only for marital and charitable deduction property

(under IRC §§2056, 2056A, and 2055) but not to such property if the following conditions apply.

• The value of the property involved “relates to, affects, or is needed to determine the value passing

from the decedent to another recipient; the value of the property is needed to determine the estate's

eligibility for alternate valuation, special use valuation estate tax deferral, “or other provision of the

Code.”

• “[L]ess than the entire value of an interest in property includible in the decedent’s gross estate is

marital deduction property or charitable deduction property.”

• A partial QTIP election or a partial disclaimer is made with respect to the property that results in

less than all of the subject property qualifying for the marital or charitable deduction.

Assets reported under the simplified method are to be listed on the applicable Form 706 schedule without

any value listed in the column for "Value at date of death."285 The sum of the asset values included in the

return under the simplified method are rounded up to the next $250,000 increment and reported on lines 10

and 23 of part 5 of Form 706 (as assets subject to the special rule of Treas. Reg. §20.2010-2T(a)(7)(ii)).

In addition to listing the assets on the appropriate schedules, the Temporary Regulations require that the

following must be included for each asset.

2. Property description

3. Evidence of ownership of the property (i.e., a copy of a deed or account statement)

4. Evidence of the beneficiary of the property (i.e., copy of beneficiary statement)

5. Information necessary to establish that the property qualifies for the marital or charitable deduction

(i.e., copy of the trust or will)

Note. These documentation requirements are not contained in the Form 706 instructions,

but the regulations require the reporting of these items. Example 1 under Treas. Reg.

§20.2010-2T(a)(7)(ii) provides that a return is properly filed if it includes such

285 See instructions for Form 706.

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documentation and proof of ownership. The question is whether this means, at least by

implication, that a return is not properly filed if it does not contain such documentation.

The statute of limitations for assessing additional tax on the estate tax return is the later of three years from

the date of filing or two years from the date the tax was paid. However, the IRS can examine the DSUE

amount at any time during the period of the limitations as it applies to the estate of the deceased spouse.

Temp. Treas. Reg. §§20.2010-2T(d) and 3T(d) allows the IRS to examine the estate and gift tax returns of

each of the decedent's predeceased spouses. Any materials relevant to the calculation of the DSUE amount,

including the estate tax (and gift tax) returns of each deceased spouse, can be examined. Thus, a surviving

spouse needs to retain appraisals, work papers, documentation supporting the good-faith estimate, and all

intervening estate and gift tax returns to substantiate the DSUE amount.

Note. The election to utilize portability allows the IRS an extended timeframe to question

valuations. The use of a bypass/credit shelter trust that accomplishes the same result for

many clients, does not. This is an important consideration for estate planners.

Role for Traditional Bypass/Credit Shelter Trusts. Portability, at least in theory, can allow the

surviving spouse’s estate to benefit from a step-up in basis with little (and possibly zero) transfer tax cost.

While traditional bypass/credit shelter trust estate plans still have merit, for many clients (married couples

whose total net worth does not exceed twice the applicable exclusion), relying on portability means that it

is not possible to “overstuff” the marital portion of the surviving spouse’s estate. This could become a

bigger issue in future years as the applicable exclusion amount grows with inflation, this strategy will allow

for even greater funding of the marital portion of the estate with minimal (or no) gifts. However, a key

point is that for existing plans utilizing the traditional bypass/credit shelter approach, it is probably not

worth redoing the estate plan simply because of portability unless there are extenuating circumstances or

the client has other goals and objectives that need to be dealt with in a revised estate plan.

For wealthy clients with large estates that are above the applicable exclusion (or are expected to be at the

time of death), one planning option might be to use the DSUE in the surviving spouse’s estate to fund a

contribution to an IDGT. The DSUE is applied against a surviving spouse’s taxable gift first before reducing

the surviving spouse’s applicable exclusion amount. Thus, an IDGT would provide the same estate tax

benefits as the by-pass trust but the assets would be taxed to the surviving spouse as a grantor trust.

Therefore, the trust assets would appreciate outside of the surviving spouse’s estate.

Note. Portability planning is slightly less appealing to couples in community property

states because, as discussed later, all community property gets a step-up in basis at the first

spouse’s death.

Portability Arbitrage. A surviving spouse can utilize multiple DSUEs by outliving multiple spouses

when the DSUE election is made in each of those spouse’s estates. The surviving spouse must gift the

DSUE of the last deceased spouse before the next spouse dies.

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POTPOURRI

C Corporation Penalty Taxes – Time To Dust-Off and Review?

Overview

C corporations were all the rage in agriculture in the 1960s and 1970s. Many farming operations

were structured that way in those decades and farmland was placed inside them. However, with

the advent of limited liability companies in the late 1970s in Wyoming and Colorado (and, later,

all states) and other unique entity forms, and a change in the tax law in 1986, they became less

popular. 2017, however, could be the start of renewed interest in the C corporate form. A primary

driver of what might cause some to reconsider the use of the C corporation is that President-elect

Trump campaigned in part on reducing the corporate tax rate. Similarly, in the summer of 2016,

the U.S. House Ways and Means Committee released a proposed “blueprint” for tax reform that

also contained a lower corporate tax rate. If that happens, the use of C corporations may be back

in vogue to a greater extent than presently.

If C corporations do gain in popularity, there are a couple of C corporate “penalty” taxes that

practitioners need to remember are lurking in the background. In addition, a recent IRS Chief

Counsel Advice (C.C.A. 201653017 (Sept. 8, 2016)) illustrates that the IRS hasn’t forgotten that

these penalty taxes exist.

Accumulated Earnings Tax

The accumulated earnings (AE) tax is in addition to a corporation's regular income tax. I.R.C.

§531. The AE tax is designed to prevent a corporation from being used to shield its shareholders

from the individual income tax through accumulation of earnings and profits, and applies to

“accumulated taxable income” of the corporation (taxable income, with certain adjustments. I.R.C.

§535). There is substantial motivation, even in farm and ranch corporations, not to declare

dividends because of their unfavorable tax treatment. Dividends are taxed twice, once when they

are earned by the corporation and again when corporate earnings are distributed as dividends to

the shareholders. This provides a disincentive for agricultural corporations (and other

corporations) to make dividend distributions. Consequently, this leads to a build-up of earnings

and profits within the corporation.

The AE tax (at a rate of 20 percent) applies only to amounts unreasonably accumulated during the

taxable year. Indeed, the computation of “accumulated taxable income” is a function of the

reasonable needs of the business. So, the real issue is the extent to which corporate earnings and

profits can accumulate before triggering application of the accumulated earnings tax. To that end,

the statute provides for an AE credit which specifies that all corporations are permitted to

accumulate earnings and profits of $250,000 without imposition of the tax. I.R.C. §535(c)(2)(A).

However, the credit operates to ensure that service corporations (fields of health, law, engineering,

architecture, accounting, actuarial science, performing arts and consulting) only have $150,000

leeway. I.R.C. §535(c)(2)(B). But, remember, not every corporation that exceeds $250,000 (or

$150,000) of accumulated earnings and profits will trigger application of the accumulated earnings

tax. That’s because the tax applies only if a particular corporation has accumulated more than

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$250,000 (or $150,000) in earnings and profits and the accumulation is beyond the reasonable

needs of the business.

Reasonable business needs. For agricultural corporations, it is important that legitimate business

reasons for accumulating earnings and profits in excess of $250,000 be sufficiently documented

in annual meeting minutes and other corporate documentation. IRS regulations concede that some

accumulations may be proper, and agricultural corporations should try to base their need for

accumulating earnings and profits on the IRS guidelines. Treas. Reg. §1.537-2(b). For instance,

an acceptable reason for accumulation is to expand the business through the purchase of land, the

building of a confinement unit or the acquisition of additional machinery or equipment. Similarly,

earnings and profits may be accumulated to retire debt, hire additional people, provide necessary

working capital, or to provide for investments or loans to suppliers or customers in order to keep

their business. Conversely, the IRS specifically targets some accumulations as being improper.

Treas. Reg. §1.537-2(c). These include loans to shareholders or expenditures of funds for the

benefit of shareholders, loans with no reasonable relationship to the business, loans to controlled

corporations carrying on a different business, investments unrelated to the business and

accumulations for unrealistic hazards. Thus, while there are many legitimate business reasons for

accumulating excess earnings and profits, there are certain illegitimate reasons for excess

accumulations which will trigger application of the accumulated earnings tax.

This all means that it is very important that the corporation's annual meeting minutes document a

plan for utilization of accumulated earnings and profits. For example, in Gustafson's Dairy, Inc.

v. Comm'r, T.C. Memo. 1997-519, the AE tax was found not applicable to a fourth-generation dairy

operation with one of the largest herds in United States at one location. The corporation had

accumulations of $4.6 million for herd expansion, $1.6 million for pollution control, $8.2 million

to purchase equipment and vehicles, $2 million to buy land, $3.3 million to retire a debenture, and

$1.1 million to self-insure against loss of herd. The court found those accumulations to be

reasonable particularly because the dairy had specific, definite or feasible plans to use the

accumulations, which were documented in corporate records. Those corporate records (minutes)

also showed how the corporation computed its working capital needs. The key point is that the

corporation had a specific plan for the use of corporate earnings and profits, knew its working

capital needs, and wasn’t simply trying to avoid tax.

Personal Holding Company (PHC) Tax

The other penalty tax applicable to C corporations is the PHC tax. I.R.C. §§541-547. This tax is

imposed when the corporation is used as a personal investor. The PHC tax of 20 percent for tax

years after 2012 is levied on undistributed PHC income (taxable income less dividends actually

paid, federal taxes paid, excess charitable contributions, and net capital gains).

To be a PHC, two tests must be met. The first test is an ownership test, and is satisfied if five or

fewer people own more than 50 percent of the corporate stock during the last half of the taxable

year. Most farming and ranching operations automatically meet this test. The second test is an

income test and is satisfied if 60 percent or more of the corporation's adjusted ordinary gross

income (reduced by production costs) comes from passive investment sources. See, e.g., Tech.

Adv. Memo. 200022001 (Nov. 2, 1991).

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The potential problem of rental income. Rental income is included in adjusted ordinary gross

income unless adjusted rental income is at least 50 percent of adjusted ordinary gross income, and

dividends for the taxable year equal or exceed the amount (if any) by which the corporation's non-

rent personal holding company income for that year exceeds 10 percent of its ordinary gross

income. In other words, if the mixture of rental income and other passive income sources exceed

10 percent and the rental income exceeds 50 percent, the PHC tax could be triggered. Thus,

farming and ranching corporations engaged predominantly in rental activity may escape

application of the PHC tax. But if the corporation's non-rent personal holding company income

(dividends, interests, royalties and annuities) is substantial, the corporation must make taxable

dividend distributions to avoid imposition of the PHC tax. Thus, for corporations owning

agricultural land that is cash rented out and the corporation's only passive income source is cash

rent, there is no PHC tax problem.

For many farm and ranch corporations, the problem of being a PHC is serious. A common scenario

is for a farmer or rancher to retire with a tenant or child continuing to farm or ranch the land and

pay rent. If the operation has been incorporated, the receipt of rents could cause the corporation

to be a PHC. In this situation, it is critical to have the proper type of lease to avoid imposition of

the PHC tax. For example, in Webster Corporation v. Comr., 25 T.C.55 (1955), the IRS argued

that a farm corporation had become a personal holding company. The IRS lost, but only because

the lease was a material participation crop share lease and substantial services were being provided

by a farm manager. The farm manager's activities were imputed to the corporation as land owner.

The court held that income under such a lease was business income and not rental income.

However, if the lease is not a material participation share lease, then the landlord receives rent.

Certainly, fixed cash rents will be treated as rent. If the corporation receives only rental income,

the rents are not PHC income. But if the corporation also receives other forms of investment

income, the rents can be converted into personal holding company income.

In the typical farm or ranch corporation setting, there is usually a mixture of rental income and

other passive income sources. Over time, the corporation typically builds up a balance in the

corporate treasury from the rental income and then invests that money which produces income

from other passive sources. As a result, there is, at some point in time, a mixture of rental income

and other passive income sources that will eventually trigger application of the personal holding

company tax. For farming and ranching operations structured as multiple entities, this is one of

the major reasons why the landholding entity should not be a C corporation. The only income that

a landholding C corporation entity will have initially is rental income. However, the tendency to

invest the buildup of rental income over time will most likely trigger application of the personal

holding company tax down the road.

Taxable income

Finally, a limiting factor in both of these taxes is taxable income. If the corporation doesn’t have

taxable income, it isn’t accumulating earnings and is not subject to the AE tax. Also, corporations

without taxable income are usually not subject to the PHC tax. Use Form 1120, Schedule PH, as a

guide.

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Conclusion

A more favorable tax climate for C corporations could spawn renewed interest in their formation

and usage. But, remember the penalty taxes that can apply. The IRS hasn’t forgotten them, as

illustrated by that recent Chief Counsel Advice. That Chief Counsel Advice referenced earlier

also points out that that the AE tax can apply even though the corporation is illiquid. It doesn’t

depend on the amount of cash available for distribution. It’s based on accumulated taxable income

and is not based on the corporation’s liquid assets. In addition, IRS noted, I.R.C. §565 contains

consent dividend procedures that a corporation can use to allow the payment of a deemed dividend

when a corporation is illiquid. In any event, both the AE tax and the PHC tax are penalty taxes

that will be strictly construed. There is no wiggle-room.

So, remember the possible penalty taxes and plan accordingly when utilizing a C corporation.

Disinheriting a Spouse – Can It Be Done?

Overview

You might be surprised to know that the issue does come up from time to time. I vividly remember

an estate planning conference I had with a married couple when I was in full-time practice. When

I was one on one with the husband, he commented to me that he wanted to cut his wife out of

everything. He was serious, and it presented some interesting representation issues. After the

initial shock of the question, I was able to make a few points that seemingly changed his mind.

But, can a spouse be disinherited? While generally the answer is “no,” there are some things that

can be done (at least in some states) that can seriously diminish what a spouse receives upon death.

It’s important to have a basic understanding of how this can happen, and a recent court opinion

illustrates the point.

Spousal Rights

First things first – spousal rights largely depend on state law. With that in mind, when a person

executes a will, they have the ability to say who gets their property upon their death – with a major

exception. That exception is designed to protect a surviving spouse. The surviving spouse can’t

be intentionally disinherited, unless they have signed a prenuptial or postnuptial agreement (in

states where those are recognized).

In some states, the extent to which the surviving spouse is protected depends on the length of the

marriage, or whether the couple had children born of the marriage, or whether the deceased spouse

had “probatable” assets. Further complicating matters, some states are “community property”

states. In these states, the surviving spouse automatically gets one-half of the couple’s

“community property” (basically, property acquired during marriage while domiciled in a

community property state). Other states follow the Uniform Probate Code (UPC). In these states,

the surviving spouse can automatically take a portion of the deceased spouse’s probate estate, non-

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probate property and property that is titled in the name of either spouse. Yet other states follow

only part of the UPC and allow the surviving spouse to make an election to take part of the deceased

spouse’s probate estate and a portion of the non-probate assets. Still other states don’t follow the

UPC and limit a disinherited spouse to take only a part of the deceased spouse’s probate estate.

So, if there aren’t any probate assets (basically, assets that don’t have a beneficiary designation or

survivorship feature) the surviving spouse is at risk of receiving little to nothing. In these states,

for example, the use of a revocable living trust (coupled with a “pourover” will) can be used to

hold what would otherwise be probate assets to avoid probate and a claim of the surviving spouse.

Of course, there are nuances in each state’s law, but the above comments paint a picture of how a

surviving spouse can be left a limited to non-existent inheritance.

Recent Case

A recent court opinion from Iowa highlights how a spouse can be, at least partially, disinherited.

In In re Estate of Gantner III, No. 16-1028, 2017 Iowa Sup. LEXIS 40 (Iowa Sup. Ct. Apr. 21,

2017), the decedent died, leaving a surviving spouse and two daughters. The marriage was a

second marriage for both spouses and they had only been married a few months when the husband,

an investment advisor, died accidentally. His will provided for the distribution of his personal

property and established a trust for the benefit of his daughters. In addition, 90 percent of the

residue of the estate was to be distributed to the daughters. In accordance with her rights under

state law, the surviving spouse filed for an elective share of the estate and requested a spousal

support allowance of $4,000 per month. The daughters resisted the surviving spouse’s application

for spousal support, claiming that the decedent’s retirement accounts (two IRAs and a SEP IRA)

were not subject to the spousal allowance because they were not part of the decedent’s probate

estate. The IRAs were traditional, pre-tax, self-employed IRA plans and executed spousal consent

forms were provided to the court. However, the issue that the surviving spouse had consented to

the beneficiary designations was never brought up as a defense to the statutory claim for a spousal

allowance. The focus was solely on a provision in state law.

The probate court determined that the decedent’s probate estate would not have had enough assets

to pay a spousal allowance without the retirement accounts included. The surviving spouse

claimed that the retirement accounts should have been included in the probate estate for purposes

of spousal support based on Iowa Code §633D8.1 that provides that “a transfer at death of a

security registered in beneficiary form is not effective against the estate of the deceased sole

owner…to the extent…needed to pay…statutory allowances to the surviving spouse.” The

surviving spouse argued that because the funds in the accounts were likely mutual funds or index

funds, that the accounts should be “securities” within the statutory meaning. The daughters

disagreed on the basis that the Uniform Iowa Securities Act excludes any interest in a pension or

welfare plan subject to ERISA. The probate court ruled for the daughters on the basis that the

retirement accounts were not available for spousal support because they were not probate assets

and became the personal property of the daughters at the time of their father’s death. The probate

court also noted that the Iowa legislature would have to take action to make beneficiary accounts

available to satisfy a spousal allowance.

On appeal, the Iowa Supreme Court affirmed. The court noted that the accounts were traditional

IRAs governed by I.R.C. §408 that pass outside of the probate estate under Iowa law and were not

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covered by Iowa Code §633D as a transfer-on-death security. The retirement accounts were not

“security” accounts merely because they contained securities. Rather, it is a custodial account that

does not actually transfer on death to anyone other than a spouse.

The point that the IRAs were traditional IRAs is a key one. Had they been “qualified plans”

(known as a “401k” plan), I.R.C. §417(a)(2) in conjunction with I.R.C. §401 requires the spouse’s

consent to not be named as a beneficiary. While the spouse had executed the necessary consent

forms to the decedent’s traditional IRAs (which the court didn’t focus on, instead focusing on state

law), had they been qualified plans, then the federal rules would have controlled and provided

greater protection for the surviving spouse.

Conclusion

Some state legislatures have taken action in recent years to protect spousal inheritance rights upon

death. In some state, for instance, no longer is it possible to use a revocable trust to effectively

disinherit a spouse. Other states, have modified the rules on transfer on death accounts or payable

on death accounts. In any event, knowing and understanding spousal inheritance rights is

something worth knowing about. There are many situations that can arise which could lead to the

rules becoming very important to a surviving spouse or, as in the case of the husband that asked

the question those many years ago, a spouse wanting to leave the surviving spouse little to nothing.

The Scope and Effect of the “Small Partnership Exception”

Overview

Every partnership (defined as a joint venture or any other unincorporated organization) that

conducts a business is required to file a return for each tax year that reports the items of gross

income and allowable deductions. I.R.C. §§761(a), 6031(a). If a partnership return is not timely

filed (including extensions) or is timely filed but is inadequate, a monthly penalty is triggered that

equals $200 times the number of partners during any part of the tax year for each month (or fraction

thereof) for which the failure continues. However, the penalty amount is capped at 12

months. Thus, for example, the monthly penalty for a 15-partner partnership would be $3,000 (15

x $200) capped at $36,000. Such an entity is also subject to rules enacted under the Tax Equity

and Fiscal Responsibility Act (TEFRA) of 1982. These rules established unified procedures for

the IRS examination of partnerships, rather than a separate examination of each partner.

An exception from the penalty for failing to file a partnership return and the TEFRA audit

procedures could apply for many small business partnerships and farming operations. However,

it is important to understand the scope of the exception, and what is still required of such entities

even if a partnership return is not filed. In many instances, such entities may find that simply filing

a partnership return in any event is a more practical approach.

Just exactly what is the “small partnership exception”? That’s the focus of today post.

Exception for Failure to File Partnership Return

The penalty for failure to file is assessed against the partnership. While there is not a statutory

exception to the penalty, it is not assessed if it can be shown that the failure to file was due to

reasonable cause. I.R.C. §6689(a). The taxpayer bears the burden to show reasonable cause based

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on the facts and circumstances of each situation. On the reasonable cause issue, the IRS, in Rev.

Proc. 84-35, 1984-1 C.B. 509, established an exception from the penalty for failing to file a

partnership return for a “small partnership.” Under the Rev. Proc., an entity that satisfies the

requirements to be a small partnership will be considered to meet the reasonable cause test and

will not be subject to the penalty imposed by I.R.C. §6698 for the failure to file a complete or

timely partnership return. However, the Rev. Proc. noted that each partner of the small partnership

must fully report their shares of the income, deductions and credits of the partnership on their

timely filed income tax returns.

So what is a small partnership? Under Rev. Proc. 84-35 (and I.R.C. §6231(a)(1)(B)), a “small

partnership” must satisfy six requirements:

• The partnership must be a domestic partnership;

• The partnership must have 10 or fewer partners;

• All of the partners must be natural persons (other than a nonresident alien), an estate of a

deceased partner, or C corporations;

• Each partner’s share of each partnership item must be the same as the partner’s share of every

other item;

• All of the partners must have timely filed their income tax returns; and

• All of the partners must establish that they reported their share of the income, deductions and

credits of the partnership on their timely filed income tax returns if the IRS requests.

Applying the Small Partnership Exception – Practitioner Problems

So how does the small partnership exception work in practice? Typically, the IRS will have

asserted the I.R.C. §6698 penalty for the failure to file a partnership return. The penalty can be

assessed before the partnership has an opportunity to assert reasonable cause or after the IRS has

considered and rejected the taxpayer’s claim. When that happens, the partnership must request

reconsideration of the penalty and establish that the small partnership exception applies so that

reasonable cause exists to excuse the failure to file a partnership return.

Throughout this process, the burden is on the taxpayer. That’s a key point. In most instances, the

partners will likely decide that it is simply easier to file a partnership return instead of potentially

getting the partnership into a situation where the partnership (and the partners) have to satisfy an

IRS request to establish that all of the partners have fully reported their shares of income,

deductions and credits on their own timely filed returns. As a result, the best approach for

practitioners to follow is to simply file a partnership return so as to avoid the possibility that IRS

would assert the $200/partner/month penalty and issue an assessment notice. IRS has the ability

to identify the non-filed partnership return from the TIN matching process. One thing that is for

sure is that clients do not appreciate getting an IRS assessment notice.

The Actual Relief of the Small Partnership Exception

Typically, the small partnership exception is limited in usefulness to those situations where the

partners are unaware of the partnership return filing requirement or are unaware that they have a

partnership for tax purposes, and the IRS asserts the penalty for failing to file a partnership

return. In those situations, the partnership can use the exception to show reasonable cause for the

failure to file a partnership return. But, even if the exception is deemed to apply, the IRS can

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require that the individual partners prove that they have properly reported all tax items on their

individual returns.

In addition, if the small partnership exception applies, it does not mean that the small partnership

is not a partnership for tax purposes. It only means that the small partnership is not subject to the

penalty for failure to file a partnership return and the TEFRA audit procedures.

Why does the “small partnership exception” only apply for TEFRA audit procedures and not the

entire Internal Revenue Code? It’s because the statutory definition of “small partnership”

contained in I.R.C. §6231(a)(1)(B) applies only in the context of “this subchapter.” “This

subchapter” means Subchapter C of Chapter 63 of the I.R.C. Chapter 63 is entitled, “Assessment.”

Thus, the exception for a small partnership only means that that IRS can determine the treatment

of a partnership item at the partner level, rather than being required to determine the treatment at

the partnership level. The subchapter does not contain any exception from a filing requirement.

By contrast, the rules for the filing of a partnership return (a “partnership” is defined in I.R.C.

§761, which is contained in Chapter 1) are found in Chapter 61, subchapter A – specifically I.R.C.

§6031. Because a “partnership” is defined in I.R.C. §761 for purposes of filing a return rather than

under I.R.C. §6231, and the requirement to file is contained in I.R.C. §6031, the small partnership

exception has no application for purposes of filing a partnership return. Thus, Rev. Proc. 84-35

states that if specific criteria are satisfied, there is no penalty for failure to file a timely or complete

partnership return. There is no blanket exception from filing a partnership return. A requirement

to meet this exception includes the partner timely reporting the share of partnership income,

deductions and credits on the partner’s tax return. Those amounts can’t be determined without the

partnership computing them, using accounting methods determined by the partnership and perhaps

the partnership making elections such as I.R.C. §179.

The small partnership exception does not apply outside of TEFRA. Any suggestion otherwise is

simply a misreading of the Internal Revenue Code.

Conclusion

The small partnership exception usually arises as an after-the-fact attempt at establishing

reasonable cause to avoid penalties for failure to file a partnership return. The exception was

enacted in 1982 as part of TEFRA to implement unified audit examination and litigation provisions

which centralize treatment of partnership taxation issues and ensure equal treatment of partners by

uniformly adjusting the tax liability of partners in a partnership. It is far from a way to escape

partnership tax complexity, and not a blanket exemption from the other requirements that apply to

all partnerships. The failure to file a partnership return could have significant consequences to the

small partnership. Ignoring Subchapter K also could have profound consequences, the least of

which is dealing with penalty notices.

Under the Balanced Budget Act of 2015 (BBA) (Pub. L. No. 114-74, §1101(a), 129 Stat. 584 (2015)),

new partnership audit rules are instituted effective for tax returns filed for tax years beginning on

or after January 1, 2018 (although a taxpayer can elect to have the BBA provisions apply to any

partnership return filed after the date of enactment (November 2, 2015). The BBA contains a

revised definition of a “small partnership” by including within the definition those partnerships

that are required to furnish 100 or fewer K-1s for the year. If a partnership fits within the definition

and desires to be excluded from the BBA provisions, it must make an election on a timely filed

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return and include the name and identification number of each partner. If the election is made, the

partnership will not be subject to the BBA audit provisions and the IRS will apply the audit

procedures for individual taxpayers. Thus, the partnership will be audited separately from each

partner and the TEFRA rules will not apply, and the reasonable cause defense to an IRS assertion

of penalties for failure to file a partnership return can be raised.

Discounting IRAs for Income Tax Liability?

Overview

On a daily basis, I field many questions from practitioners, farmers, ranchers, agribusiness

professional and others. Some areas of tax and ag law seem to generate more questions than others

and, of course, the facts behind each question often dictate the correct answer. But, sometimes a

question comes in that I have never had before. I recently got a new one – when valuing an

individual retirement account (IRA), is the potential federal income tax liability to the beneficiaries

to be considered?

Valuation discounting and IRAs, that’s today’s topic.

Discounting Basics

Valuation discounts have been in the news recently. Last fall the IRS issued new I.R.C. §2704

proposed regulations that could seriously impact the ability to generate valuation discounts for the

transfer of family-owned entities. While it doesn’t look likely now that the proposed regulations

will be finalized, if they do become finalized in their present form, they would largely eliminate

the ability to derive valuation discounts through various estate planning techniques.

Over the past few decades, valuation discounting through the use of family-owned business entities

has become a popular estate and gift tax planning technique. If structured properly, the courts

have routinely validated discounts ranging from 10 to 45 percent. Valuation discounting has

proven to be a very effective strategy for transferring wealth to subsequent generations. It is a

particularly useful technique with respect to the transfer of small family businesses and

farming/ranching operations. Similar, but lower, valuation discounts can also be achieved with

respect to the transfer of fractional interests in real estate.

The basic concept behind discounting is grounded in the IRS standard for determining value of a

transferred interest – the willing-buyer, willing-seller test. In other words, the fair market value of

property is the price it would changes hands at between a hypothetical willing-buyer and a willing-

seller, with neither party being under any compulsion to buy or sell. Under this standard, it is

immaterial whether the buyer and seller are related – it’s based on a hypothetical buyer and seller.

Thus, there is no attribution of ownership between family members that would change a minority

interest into a majority interest.

Discounting Possibilities

Family limited partnership (FLP). The principal objective of an FLP is to carry on a closely-

held business where management and control are important. FLPs have non-tax advantages, but

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a significant tax advantage is the transfer of present value as well as future appreciation with

reduced transfer tax. See, e.g., Estate of Kelley v. Comr., T.C. Memo, 2005-235. Commonly in

the ag setting, the parents contribute most of the partnership assets in exchange for general and

limited partnership interests. However, as the use of FLPs expanded, so did the focus of the IRS

on methods to avoid or reduce the discounts. In general, FLPs have withstood IRS attack and

produce significant transfer tax savings. But, there are numerous traps for the unwary. Formation

shortly before death can result in the FLP being disregarded for valuation purposes. See, e.g., Priv.

Ltr. Rul. 9719006 (Jan. 14, 1997); Priv. Ltr Rul. 9725002 (Mar. 3, 1997). Indeed, if the only

purpose behind the formation of a family limited partnership is to depress asset values, with

nothing of substance changed as a result of the formation, the restrictions imposed by the

partnership agreement are likely to be disregarded. See, e.g., F.S.A. 200049003 (Sept. 1, 2000).

There also should be a business purpose for the FLP’s formation. See, e.g., Estate of Bongard v.

Comr., 124 T.C. 95 (2005).

Corporate liquidation and built-in gain. Until 1998, the IRS disallowed discounts when valuing

interests in C corporations to reflect built-in capital gains tax. But, the courts then began focusing

on the level of the discount until, in 2007, a federal appellate court ruled that in determining the

estate tax value of holding company stock, the company’s value is to be reduced by the entire built-

in capital gain as of the date of death. Estate of Jelke III v. Comr., 507 F.3d 1317 (11th Cir. 2007).

Later, the Tax Court allowed a dollar-for-dollar discount for built-in gain. Estate of Litchfield v.

Comr., T.C. Memo. 2009-21; Estate of Jensen v. Comr., T.C. Memo. 2010-82. That makes sense.

When a buyer purchases C corporate stock, the value of the stock to the buyer is what it takes to

get cash in a liquidation. One of the “things” it takes is the payment of deferred income tax. The

discount reflects that.

Restricted Management Account. An alternative to the FLP is the restricted management

account (RMA). An RMA is an investment account where the investor gives up control of certain

assets to an investment manager for a certain period of time and the manager exclusively manages

the account assets. During the term of the account (as set forth in a written agreement), the investor

cannot make withdrawals, and transfer to family members are limited. Based on these restrictions,

the argument has been that the value of the assets in the RMA should be discounted for transfer

tax purposes. But, in 2008, IRS said that the restrictions in an RMA agreement do not result in

anything other than valuation of the account assets at fair market value. Rev. Rul. 2008-35, 2008-

2 C.B. 116.

Discounts for IRAs?

Back to the question at hand – can a discount from fair market value be taken for the potential

income tax liability to the beneficiaries of an IRA when the assets in the account are distributed to

them? The issue was presented to the Tax Court in Estate of Khan v. Comr., 125 T.C. 227 (2005).

The decedent died owning two IRAs. One IRA was valued at $1.4 million at the time of death and

the other one slightly over $1.2 million. The executor reduced the estate tax value of the accounts

by 21 percent and 22.5 percent respectively to reflect the anticipated income tax liability on

distribution to the beneficiaries. But, the court rejected the discounts because the inherent tax

liability cannot be passed on to a hypothetical buyer. On this point, the Tax Court followed the

lead of the Fifth Circuit in Smith v. United States, 391 F.3d 621 (5th Cir 2004), aff’g., 300 F. Supp.

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2d 474 (S.D. Tex. 2004) in noting that I.R.C. §691(c) provides for a deduction for estate tax that is

attributable to income in respect of a decedent (IRD), which IRAs are. That eliminates the

potential income tax inherent in assets that are also subject to estate tax, and serves as a statutory

substitute for the valuation discount. In other words, a hypothetical buyer would not take into

consideration the income tax liability of a beneficiary on the IRD because the hypothetical buyer

would not be paying the income tax on the gain involved. Thus, any additional reduction in estate

tax for potential income tax would not be appropriate. A marketability discount is also not

appropriate because there aren’t any restrictions barring the IRA assets from being distributed to

beneficiaries upon the account owner’s death. See, e.g., Priv. Ltr. Rul. 200247001 (Nov. 22, 2002).

Conclusion

While valuation discounts are still viable for minority interests and lack of marketability in closely-

held entities, valuation discounts are not available for assets that are IRD. That means that IRAs

and similar items of IRD will be valued at fair market value for transfer tax purposes. With an

IRA, the IRA doesn’t have a tax liability. The beneficiary does.