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
[email protected] [email protected] @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
6
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
7
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
9
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
10
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
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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
28
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.
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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.
64
§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.
147
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.