Keith Codron's Trusts & Estates Law

Thursday, July 22, 2010

Estate Tax Update

On June 17, 2010, the U.S. House of Representatives passed H.R. 5297, the Small Business Jobs and Credit Act of 2010 (commonly referred to as the "Small Business Jobs Bill").

In the last few weeks, since H.R. 5297 was passed, Senate Minority Whip Jon Kyl (R-Arizona) and Senator Blanche L. Lincoln (D-Arkansas) have been working on a plan concerning the future of the estate tax.  Together they have advanced a proposal requiring the Senate Finance Committee to amend H.R. 5297 so as to permanently set the federal estate tax rate at thirty-five percent (35%) and raise the estate tax exemption amount to five million dollars ($5,000,000), the exemption level to be phased in over a 10-year period and indexed for inflation.

The Kyl-Lincoln proposal would also provide for a "stepped-up" cost basis for inherited assets, as existed in prior tax years, and would instruct the Senate Finance Committee to offset the difference in revenue loss resulting from their proposal as compared to the Obama administration's proposal. [The administration has proposed a 45% estate tax rate coupled with a $3.5 million exemption amount.]

Yesterday, July 20, 2010, the U.S. Senate prepared to resume consideration of H.R. 5297, with the goal of completing work on the Senate version by the end of this week. However, Senate Majority Leader Harry Reid (D-Nevada) is expected to disallow most amendments to the House bill, specifically including the estate tax proposal of Senators Kyl and Lincoln. Senator Kyl told reporters yesterday that, whereas Senator Reid did not want to address any estate tax issues at this time, he (Kyl) and Senator Lincoln were looking at other options for moving their proposal forward. Stay tuned.

INQUIRIES

For additional information please contact the writer, Keith Codron, toll-free, at (800) 497-0864, or via email at keith@octrustlawyer.com.

Mr. Codron, whose office is located in Orange County, California, welcomes your comments and questions.

 

Saturday, July 03, 2010

New IRS Regulations Coming for Foreign Trusts

Fearful that foreign trusts are being used by "the rich" for tax evasion purposes, IRS is hard at work drafting new proposed regulations covering income tax reporting and filing requirements involving offshore trusts.

This disclosure was just made, on June 22, at a Washington, D.C. Bar program dealing with international tax issues pertaining to high net worth individuals. At the meeting, an IRS official, M. Grace Fleeman, who is a senior technical reviewer in the international division of the Associate Chief Counsel's office, admitted that the regulations will be aimed squarely at foreign trusts having U.S. beneficiaries who are taxable on the trust's distributable net income. 

Earlier this year Congress passed Public Law 111-147, the Hiring Incentives to Restore Employment ("HIRE") Act, which was signed by President Obama on March 18, 2010. Although mostly focused on creating domestic jobs, this law includes several provisions on foreign trusts and foreign financial accounts. While many of the foreign trust tax issues date back to 1996 legislation, and have been on the government's enforcement radar screen for more than a decade, IRS, in light of the 2010 legislation, has decided to include the foreign trust provisions of the HIRE Act in its pending regulations project. The tax official told the group of lawyers in Washington, D.C. that she hopes the IRS will have finished drafting the proposed regulations within the next six months.

The HIRE Act added a presumption, under Internal Revenue Code Section 679(d), which treats a foreign trust receiving property from a U.S. person as automatically having a U.S. beneficiary.  Another provision of the HIRE Act, codified at IRC §643(i), provides for the taxation of trust property used without compensation. Thus, by way of example, a loan of cash or marketable securities from the foreign trust to a U.S. grantor or U.S. beneficiary of that trust would be treated as a taxable distribution.

In response to questions from the program participants, the IRS official stated that the new regulations will address requirements for preparing Form 3520 [Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts], and for withholding, as well as the tax consequences of a distribution by a trust which has no distributable net income.  Furthermore, she said, the regulations will discuss foreign trust reporting requirements under IRC §6048, penalties for inadequate reporting under IRC §6677, and, under IRC §6039F, the reporting of large gifts received from foreign persons.

We will have to wait and see how the new regulations unfold, but one thing is very clear: IRS, in particular, and the Obama administration, in general, strongly dislike the use of offshore trusts by high net worth individuals residing in the United States and wish to discourage the use of such trusts by making tax compliance as burdensome and onerous as possible.

INQUIRIES
For additional information please contact the writer, Keith Codron, toll-free, at (800) 497-0864, or via email at keith@octrustlawyer.com. Mr. Codron, whose main office is located in Orange County, California, welcomes your comments and questions.


 

Thursday, May 20, 2010

Inconsistent Testamentary Instruments

A recent case from Alameda County, California, highlights why it is so important to be clear and unambiguous when drafting testamentary instruments, especially where there are inconsistent dispositive provisions between the documents.

FACTS
In September, 2002, Bud Krusi, a widower, executed a revocable trust and pour-over will. Bud was the father of four adult children: Paul, Peter, Karl and Joan. Bud nominated his son, Paul, to serve as successor trustee of the trust. Attached to the back of the trust instrument was an Exhibit 'A' which referenced the following assets owned by the trust: (1) Bud's 100% interest in the closely-held corporation operating the Krusi family business; (2) a parcel of commercial real estate on which the family business was located; (3) a parcel of residential real estate; and (4) various investment accounts at financial institutions. The assets listed on Exhibit 'A' were properly transferred to the trust at the time of its creation. The trust instrument provided that after Bud's death the residential real property and its furnishings were to be distributed to his son, Paul, and one, Sarah Gersper, and that the remaining trust assets were to be distributed in equal shares to Paul, Peter and Joan (or to their surviving issue by right of representation).  Bud's son, Karl, and all of his lineal descendants were expressly disinherited. As settlor Bud retained the right to revoke the trust, in whole or in part, or to amend any of its provisions, in either case by means of a signed written instrument delivered to the trustee during Bud's lifetime.

Under the contemporaneous pour-over will, Bud devised to the trust the remainder of his estate, including tangible personal property, such as household goods, automobiles or personal effects, to be added to the trust corpus and thereafter held, administered and distributed in accordance with the terms of the trust.

In September, 2007, just seven months prior to his death, Bud executed a new will, the preamble of which contained boilerplate language stating that all of Bud's previous wills and codicils were thereby revoked.  Under the 2007 will, Bud's business partner, Barbara Simi ("Bobbie"), was named as executor and given a 51% interest in both the family business and the parcel of commercial real estate on which the business was located, making her the largest single beneficiary under the 2007 will.  The 2007 will explained that it was Bud's intention to give Bobbie a controlling interest in the family business in the event that any disagreements might later arise with respect to the conduct of the business. In a separate provision of the 2007 will, Bud stated his intention to give the remainder of his estate to his surviving issue by right of representation.  The 2007 will made no reference to the 2002 trust.

Bud died on March 7, 2008. Four days later, on March 11, 2008, Bobbie filed a petition with the probate court seeking a declaratory judgment that Bud, by making the 2007 will, intended to dispose of all his assets as part of a new estate plan and effectively revoked the 2002 trust in its entirety (not merely carving out the 51% interests in the business assets), and that, as a consequence, the record titles of the various assets held in the trust should be ordered changed to show title in Bobbie's name as executor of the 2007 will.  Decedent's son, Paul, in his capacity as trustee of the trust, filed an objection to Bobbie's petition, contending that the 2007 will did not revoke the 2002 trust in its entirety. Paul argued that, notwithstanding that the 2007 will was inconsistent with the 2002 trust in certain particulars (i.e., the disposition of a 51% interest in the family business and associated real estate), that fact did not, by itself, constitute clear and convincing evidence that Bud intended to revoke the trust as to those assets.  

TRIAL COURT DECISION
The trial court held that Bud's 2007 will amended, modified or revoked the 2002 trust, but only with regard to a 51% interest in the family business and a 51% interest in the associated real estate, finding that the 2007 will did not contain a clear and unambiguous manifestation of Bud's intent to revoke the trust in its entirety. In other words, the court held that the effect of the 2007 will on the 2002 trust was limited to the amendment, modification or revocation required with respect to the specific trust assets mentioned in the 2007 will; the other assets in the 2002 trust, including the remaining 49% interest in the family business and associated real estate, were unaffected by the 2007 will and thus were to pass equally to Paul, Peter and Joan (except for the residential real estate, which was devised to Paul and Sarah). Bobbie appealed the trial court's ruling.

APPELLATE COURT DECISION
The appellate court affirmed the trial court's decision, stating that the pivotal question in this case is the extent to which the distribution provided for under the 2002 trust should be deemed to have been changed by the provisions of the 2007 will. Like the lower court, the appellate court could not find any clear and unambiguous manifestation of Bud Krusi's intent to revoke the 2002 trust in its entirety.  The words of the boilerplate preamble in the 2007 will, regarding revocation of all prior wills and codicils, do not, by themselves, reflect an intention to revoke any other kind of testamentary instrument, such as a trust.

COMMENT
Had the terms of the 2002 trust stated that the instrument could only be amended, modified or revoked by a signed written instrument other than a will or a codicil, Bobbie would have been entitled to take nothing and decedent's children would have been entitled to the entire estate. This, in my opinion, is how the 2002 trust should have been drafted.  Just a few words inserted at the right place in the document by a careful draftsman can mean the difference between your heirs receiving millions of dollars or receiving best wishes.

INQUIRIES
For additional information please contact the writer, Keith Codron, toll-free, at (800) 497-0864, or via email at keith@octrustlawyer.com. Mr. Codron, whose main office is located in Orange County, California, welcomes your comments and questions.

 

Wednesday, May 12, 2010

New 3.8% Medicare Surtax on Unearned Income

The Health Care Care and Education Reconciliation Act of 2010 (H.R. 4872), was passed by Congress on March 25, 2010, and signed into law by President Obama on March 30, 2010. H.R. 4872 amended the previously enacted Patient Protection and Affordable Care Act of 2010 (Public Law 111-148), which President Obama signed on March 23, 2010. Taken together, the two laws represent a massive overhaul of the nation's health insurance and delivery systems, and include more than $400 billion in new taxes on employers and individuals. In this posting I will examine one of the more controversial provisions of the health care reform package, namely, the 3.8% surtax on unearned income which is to be used to help fund Medicare benefits in the future. It is estimated that, when the 3.8% unearned income Medicare surtax is added to the new law's additional 0.9% Medicare payroll tax, fully $210.2 billion in extra taxes will have been raised by the federal government over the period, 2013 to 2019, inclusive. The new provision, which takes effect in 2013, is officially known as the Unearned Income Medicare Contributions Tax ["UIMCT"].

The UIMCT broadens the Medicare tax base for higher-income taxpayers by imposing a 3.8% surtax on the lesser of: (1) "net investment income"; or (2) the excess of adjusted gross income [AGI], increased by any foreign earned income otherwise excluded from AGI, over the taxpayer's threshold amount. For single and head-of-household taxpayers the threshold amount is $200,000. For married couples filing a joint return, and surviving spouses, the threshold amount is $250,000.  For a married person filing a separate return the threshold amount is $125,000. Neither the $250,000 threshold amount nor the $200,000 threshold amount is indexed for inflation.

The term, "net investment income," includes interest, dividends, royalties, rents and capital gains, less deductions properly allocable thereto. However, the term does not include income earned from a trade or business unless the business is considered a passive activity for income tax purposes. Furthermore, net investment income does not include distributions from qualified retirement plans, such as employer-sponsored defined benefit plans, profit sharing plans, money purchase plans, ESOPs, 401(k) plans, 403(b) plans or 457(b) plans, nor does such term include distributions from an individual retirement account (IRA) or tax-exempt municipal bond.

Inasmuch as the UIMCT applies only to taxable income, the tax-deferred nature of annuities and cash value life insurance will not be affected by the new law until such time as the taxpayer receives a distribution from the annuity contract or insurance policy which would otherwise constitute taxable income, and may not be subject to the UIMCT at all if the individual's income does not exceed the applicable threshold amount.  By contrast, income from savings accounts or portfolio investments which are not tax-deferred will be impacted immediately to the extent that interest, dividends or capital gains cause an individual's AGI to exceed the applicable threshold amount.

The UIMCT will also apply to estates and trusts, except for charitable remainder and other tax-exempt trusts. Taxable estates and trusts will pay the 3.8% UIMCT on the lesser of: (1) their undistributed net investment income for the tax year; or (2) any excess of their AGI over the dollar amount at which the highest tax bracket for estates and trusts begins for the tax year (currently $11,200), but subject to inflation adjustment each year.

INQUIRIES
For additional information please contact the writer, Keith Codron, toll-free, at (800) 497-0864, or via email at keith@octrustlawyer.com. Mr. Codron, whose main office is located in Orange County, California, welcomes your inquiries and comments.

Tuesday, May 04, 2010

Whose Mortgage Deduction Is It, Anyway?

SUMMARY

As a general rule, in order for interest payments on a home mortgage loan to be deductible, the indebtedness must be the taxpayer's own obligation and not that of another person.  Section 1.163-1(b) of the federal income tax regulations states: "Interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by such mortgage, may be deducted as interest on his indebtedness."  Where the taxpayer acquires real property "subject to" a mortgage and is thus not personally liable for repayment of the indebtedness, a deduction is still allowable as long as the taxpayer can establish a legal or equitable ownership interest in the encumbered property.  Legal or equitable ownership rests, in turn, on whether one has assumed the "benefits and burdens" of property ownership.

In a recent memorandum decision of the United States Tax Court, Anthony J. Adams v. Commissioner (4/13/2010), TC Memo 2010-72, 99 T.C.M. 1305, a taxpayer was found to have assumed the benefits and burdens of ownership of real property held in the name of an irrevocable, short-term trust created by unrelated third-party trustors for the benefit of taxpayer and others as part of a promotional easy-financing and asset protection arrangement.  Accordingly, taxpayer was entitled to deduct home loan interest payments made by the trustee with respect to the trustors' mortgage obligation.

FACTS

In 2003, sellers, Michael and Zina Gedz, conveyed their residence to an irrevocable 5-year trust, assigning beneficial interests therein to the taxpayer and certain others.  Trustors named an independent corporate trustee to hold legal title to the property, along with the proceeds and profits therefrom, for the use, possession and enjoyment of taxpayer and the other beneficiaries. The trust agreement provided that the beneficiaries' interests were to consist solely of the following: (1) a power of direction to authorize the trustee to deal with the trust property; (2) the right to receive or direct the disposition of proceeds from the property, such as from rents, mortgage refinancings or sales; (3) the right to purchase, lease, manage and control the property; and (4) the obligation to pay for expenses and disbursements relating to the property, including homeowners' insurance.  All earnings, gains, proceeds and expenses of the trust were to be allocated among the beneficiaries in accordance with their respective percentages of beneficial interests.

The trust agreement further provided that the beneficiaries' rights to the proceeds from the trust property were to be deemed personal property, and that the beneficiaries would not possess any right, title or interest in or to the real property itself, neither legal nor equitable. However, the beneficiaries did have a right of first refusal to purchase the real property, a right which taxpayers did not exercise due to a decline in the property's market value. Furthermore, no beneficiary could assign its beneficial interest in the trust without the consent of a majority of the beneficiaries.  

This arrangement was promoted to the taxpayer as a way to realize the benefits of home ownership without having to qualify for a bank loan and without the property's being subject to creditors' claims.  An upfront payment of $320,000 was required from taxpayer for the purchase of a 50% beneficial interest in the trust.  Taxpayer occupied the residence pursuant to an occupancy agreement which required him to pay monthly rent to the trustee of $2,900, an amount equal to the sum of principal and income payments owing monthly on the property's mortgage.  By contrast, the fair rental value of the residence was only between $1,500 and $1,600 per month during this time.  While living at the home, taxpayer made substantial repairs and improvements to the property, which he paid for out of his own pocket, including landscaping, replacing the home's cedar deck, and installing a new garage door opener and glass block windows.

The escrow account statements from which the mortgage payments were made showed the trustors, Mr. & Mrs. Gedz, as the mortgagees (borrowers) on the loan, and so did the annual tax statement for Mortgage Interest Paid, IRS Form 1098.  Nevertheless, for the years of his occupancy, taxpayer claimed the mortgage interest deduction for the portion of his "rental" payments to the trustee attributable to the mortgage interest paid by the trust to the bank.  On audit, IRS, relying on the above-cited income tax regulation, disallowed taxpayer's mortgage interest deduction based on the fact that the loan giving rise to the interest payment was not the legal or equitable obligation of the taxpayer's, but rather that of the trustors.

TAX COURT DECISION

The Tax Court disagreed with IRS, holding that, on balance, taxpayer had indeed assumed the benefits and burdens of ownership with respect to the real property owned by the trust.  The Tax Court based its decision on the following findings: (1) taxpayer had a duty to repair or maintain the property; (2) taxpayer was responsible for keeping the property adequately insured; (3) taxpayer had a duty to pay taxes, assessments and other charges levied on the property; (4) taxpayer had a right to the property's proceeds from rents, refinancings and sales; (5) taxpayer had a right to obtain legal title at any time by paying the balance of the purchase price; (6) taxpayer bore some risk of loss if the property declined in value, which it did; and (7) taxpayer agreed to pay the mortgage's principal and interest under the occupancy and beneficiary agreements entered into with the trustee.  The Court reasoned that these 7 factors outweighed the factors against establishing taxpayer's benefits and burdens of ownership, which included the following: (1) taxpayer could elect not to exercise his right of first refusal to purchase the property, choosing instead to simply walk away from the property at the end of the 5-year trust term; (2) taxpayer had to enter into an occupancy agreement with the trustee in order to use, possess or enjoy the property; and (3) under the terms of the beneficiary and occupancy agreements, taxpayer was prohibited from making any material alterations or improvements to the property without first obtaining certain consents.

INQUIRIES

For additional information please contact the writer, Keith Codron, toll-free, at (800) 497-0864, or via email at keith@octrustlawyer.com.  Mr. Codron welcomes your inquiries and comments.

 

Sunday, April 18, 2010

Valuation Discounts for Gifts of Limited Partnership Interests Reduced

SUMMARY
The U.S. Court of Appeals for the Eighth Circuit has affirmed a decision of the U.S. Tax Court in sharply reducing valuation discounts claimed by a married couple with respect to the transfer of limited partnership (LP) interests gifted to their daughters. Holman v. Commissioner (8th Cir. 4/7/2010), 2010-1 USTC ¶60,592, aff'g 130 TC 170. The 8th Circuit agreed with the Tax Court's holding that, in calculating the value of the gifted LP interests, only small discounts were allowable for lack of control and lack of marketability, even though the limited partnership agreement contained significant limitations on the power of the limited partners to manage the LP or to transfer their interests, including a restrictive buy-sell provision permitting the general partners (parents) to redistribute LP interests if an impermissible transfer were to be made.

FACTS

Taxpayers, Thomas H. Holman, Jr. and Kim Holman, owned a large number of shares of common stock in Dell, Inc., a publicly traded corporation ("Dell"), this as a result of Tom's having been an employee of Dell for many years. Tom and Kim created an LP and funded it with Dell stock. Thereafter, in 1999, 2000 and 2001, the couple gifted minority interests in the LP to their daughters, as limited partners, retaining management control over the entity as general partners.

In filing their gift tax returns for the years in question, the couple discounted the value of the transferred LP interests by 49%, claiming lack-of-marketability and minority-interest adjustments based on the restrictive provisions set forth in the LP agreement, including the transfer restriction, and asserting that such restrictions would depress the value of the LP interests relative to the value of the underlying assets of the LP, the Dell stock. In doing so, taxpayers claimed a value for the gifted interests which was substantially below the market value of the underlying Dell stock.

On audit, IRS challenged taxpayers' gift tax returns for the years in question. IRS characterized the intrafamily transfers as gifts of Dell stock rather than as gifts of LP interests, and disregarded the LP agreement's transfer restrictions for valuation purposes based on §2703 of the Internal Revenue Code. IRS conceded that lack-of-marketability and minority-interest discounts were applicable, but argued that the overall discount should be much smaller than that claimed by taxpayers: 28% relative to the then-prevailing market price of Dell stock.

TAX COURT DECISION
The Tax Court held that the gifts were indeed gifts of LP interests, not of Dell stock, and that IRS had correctly applied Tax Code §2703 in disregarding the LP agreement's transfer restrictions. However, the Tax Court applied much smaller lack-of-marketability and minority-interest discounts than those claimed by taxpayers, noting that the LP held only highly liquid, easy-to-value assets and that the LP agreement contained a consensual dissolution provision.  As a result, the Tax Court accepted lack-of-marketability valuation discounts for each of the years in question of just 12.5%, and minority-interest valuation discounts of just 4.63% to 14.34% (i.e., discounts that were even lower than those proposed by IRS). Taxpayers' stated purposes in creating the structure, to wit, estate planning, tax reduction, wealth transference, spendthrift protection and money management education, were held not to be bona fide business purposes for the transfer restrictions provided for in the LP agreement. The Court of Appeals took notice of the fact that the Tax Court, when it determined the appropriate discount for the LP interests, had considered what a rational economic actor would deem appropriate and had not ascribed personal or noneconomic motivations to the hypothetical purchaser; the Tax Court did not base its determination of the valuation discount on what might be acceptable to a family member.

INQUIRIES
For additional information please contact the writer, Keith Codron, toll-free, at (800) 497-0864, or via email at keith@octrustlawyer.com. Mr. Codron welcomes your inquiries.

 

Tuesday, April 13, 2010

9th Circuit Holds ERISA Spousal Protection Requirements Inapplicable to IRAs

According to a recent federal appeals court decision, a surviving spouse who was not named as a beneficiary of her deceased husband's IRA had no rights in or to that IRA, notwithstanding that the IRA was funded by an indirect rollover from an ERISA-qualified retirement plan providing for spousal protection, where the rollover from the qualified plan occurred prior to the spouse's marriage to decedent.  Charles Schwab & Co., Inc. v. Debickero (9th Cir. 2010), 593 F.3d 916, 2010-1 USTC ¶50,180.

Section 205 of the Employee Retirement Income Security Act of 1974 ("ERISA"), as amended by the Retirement Equity Act of 1984, provides that "in the case of a vested participant who dies before the annuity starting date and who has a surviving spouse, a qualified preretirement survivor annuity shall be provided to the surviving spouse of such participant." [29 U.S.C. §1055(a)(2)].  As applied to a 401(k) plan, this requirement generally means that the surviving spouse is entitled to the entire plan balance as a matter of right, absent the spouse's written consent to waive that right.

Wayne Wilson ("Wilson") was employed by Siemens/GTE and participated in the company's 401(k) plan, an ERISA-qualified retirement plan.  Wilson's participation in the plan terminated when he left Siemens, in 1992, to work for another company.  In 1994, Wilson elected to close his Siemens 401(k) account and take a lump sum distribution, which he rolled over to an IRA with the investment firm, Smith Barney. In 2000, Wilson married Katherine Chandler ("Chandler"), a woman with whom he had been living since 1990.  In 2002, Wilson opened another IRA, this time with Charles Schwab & Co. ("Schwab"). Wilson funded the Schwab IRA by transferring to it approximately half of the proceeds from his Smith Barney IRA. Despite his marriage to Chandler, Wilson named his four adult children from his previous marriage as primary beneficiaries of the Schwab IRA, telling Schwab personnel that he was divorced. In 2005, at the age of 65, Wilson unexpectedly died, survived by his children and Chandler. Because he died at the age of 65, Wilson had not yet reached the required beginning date for taking required minimum distributions from his IRA.

Decedent's adult children and Chandler asserted competing claims to the Schwab IRA. As a result, Schwab filed an interpleader action in federal district court naming Chandler and the children as co-defendants.  Chandler then filed a cross-claim against the children, asserting that the surviving spouse protections under ERISA continued to apply to the 401(k) benefits even after they were rolled over to the IRA, and that, therefore, she, alone, as Wilson's surviving spouse, was entitled to the Schwab IRA. On cross-motions for summary judgment the trial court ruled in favor of Wilson's children, finding it significant that Wilson and Chandler were not married until several years after Wilson ended his participation in the Siemens 401(k) plan, and rejecting Chandler's argument that the surviving spouse protections under ERISA continued to apply even after the funds were rolled over to an independently managed IRA.

The trial court's ruling was affirmed by the U.S. Court of Appeals for the Ninth Circuit, which held as follows: "Although Wilson was at one time a participant in an employee benefit plan subject to ERISA's protections and limitations, ERISA ceased to apply when, long before his marriage to Chandler, Wilson terminated his participation in the employee benefit plan and transferred the proceeds to an independent IRA." [593 F.3d at 919].  The appellate court reasoned that insofar as the Schwab IRA was established and maintained by Wilson personally, and not by his former employer or any employee organization of his former employer, the IRA fell outside the spousal protection rules of ERISA.  The court noted that IRAs are specifically excluded from ERISA's participation and vesting provisions, which include the joint and survivor annuity requirements, and concluded that "it is beside the point that the IRA proceeds originated as employee benefits within an ERISA-qualified plan." [Id.]

For additional information please contact the writer, Keith Codron, toll-free, at (800) 497-0864, or via email at keith@octrustlawyer.com. Mr. Codron welcomes your inquiries.

Monday, April 05, 2010

New 10-Year Minimum Requirement for Grantor Retained Annuity Trusts

On March 24, 2010, by a vote of 246-178, the U.S. House of Representatives passed H.R. 4849, the Small Business and Infrastructure Jobs Tax Act of 2010.  All Republicans voted against this bill, the stated purpose of which is to provide tax relief and infrastructure incentives to small businesses. As with most government assistance programs, this bill will cost a lot of money. In order to help offset that cost, the bill contains a seemingly innocuous and easily overlooked revenue raising provision aimed squarely at limiting the tax benefits of grantor retained annuity trusts ("GRATs"). These irrevocable term-certain trusts are one of the favorite transfer tax reduction tools used by advanced estate planners, particularly those attorneys servicing the needs of high net worth business owners, key executives, professional practitioners and investors.

If the bill becomes law the following new restrictions will be added to Section 2702 of the Tax Code, effective as of the date of enactment of the legislation: (1) GRATs will be required to have a minimum term of ten years; and (2) annuity payments from a GRAT will not be permitted to decrease during the first ten years of the trust.  As with any GRAT, failure to outlive the term may cause the trust's assets to be includible in the grantor's taxable estate, thereby defeating the transfer tax reduction objective in creating the GRAT. Under current tax law there is no minimum required term for a GRAT; in general, the older the grantor the shorter the term selected for the GRAT.

Final passage of this legislation would effectively eliminate GRATs as a viable estate planning strategy for older age clients who may not outlive the required minimum term of 10 years.  Furthermore, for older age clients this legislation would limit the use of a GRAT as a roll-out strategy for life insurance financing techniques, such as premium financing or split-dollar arrangements.

Assuming the bill becomes law, clients may have a very limited timeframe in which to implement shorter-term GRATs so as to reduce their federal transfer tax bite.

For additional information please contact the blog writer, Keith Codron, toll-free, at (800) 497-0864, or email him at keith@octrustlawyer.com.

Wednesday, March 31, 2010

Too Restrictive Operating Agreement Leads to Loss of Gift Tax Exclusion

A federal district court in Indianapolis recently held that the annual gift tax exclusion did not apply to taxpayers' gifts to their children of membership interests in a family-owned limited liability company. The court found that, based on certain restrictive provisions in the LLC's operating agreement, the membership interests represented "future interests" rather than "present interests" in the entity's assets.

The distinction between a present interest and a future interest lies in whether the donee has an unrestricted and unqualified right to the immediate use, possession and enjoyment of the gifted property, or the income therefrom (i.e., a substantial present economic benefit in the gifted property), or, on the contrary, whether such right is postponed or limited in its effectiveness to some future date or time. Gifts of remainders, reversions, executory interests and similar beneficial rights, whether vested or contingent, the use, possession and enjoyment of which, or the income from which, can only be had at some future date or time, represent gifts of future interests in property.

Under federal law, a taxpayer is entitled to an exemption from gift tax with respect to the first $1 million of taxable gifts made over the course of one's lifetime, computed cumulatively on a calendar year basis. Once the $1 million exemption is fully depleted, the tax rate is a flat 35% of a gift's value. Unlike the federal estate tax, the gift tax is not repealed for 2010 or any other year. In determining the amount of a donor's "taxable gifts" for each calendar year period, the first $13,000 of money or other property given to a donee in that calendar year is excluded, provided that the gift is of a present interest. [The annual exclusion amount is indexed for inflation.] A future interest in money or other property does not qualify for the annual gift tax exclusion under §2503(b) of the Tax Code. As a result, a gift of a future interest is deemed a taxable gift in its entirety and causes a depletion of the donor's $1 million lifetime exemption, in whole or in part, whereas a gift of a present interest is deemed a taxable gift only to the extent that the value of the gift exceeds $13,000 per donee per calendar year.

In the Indiana case, Fisher v. United States [S.D. Indiana, 2010-1 USTC ¶60,588 (3/11/2010)], a married couple transferred minority, non-controlling membership interests in their LLC to each of their 7 children.  The taxpayer-donors retained full management control over the LLC, the principal asset of which was an extremely valuable parcel of undeveloped beachfront land bordering Lake Michigan. When taxpayers filed their gift tax returns they claimed the annual exclusion pertaining to each such transfer. However, upon audit of those returns IRS claimed that the gifts were of future interests and assessed the Fishers a gift tax deficiency in the amount of $625,986! The Fishers paid the deficiency and filed a claim for refund in federal district court, alleging, among other things, that the transferred interests in the LLC were gifts of present interests.

The district court held in favor of IRS, stating that the membership interests received by taxpayers' children constituted a future interest, not a present interest, and that, consequently, no annual exclusion would be allowed.  The court based its decision on the following three factors: (1) the children's membership interests did not confer on them a substantial present economic benefit in the LLC's property because, under the operating agreement, the children's right to receive distributions of capital proceeds, whenever such distributions might occur, was subject to a number of contingencies, all of which were within the exclusive discretion of taxpayers as general managers of the LLC; (2) under the operating agreement there was no indication that an unrestricted right to use, possess or enjoy the LLC's property was in fact transferred to the children, and, in any event, the children's right to use, possess or enjoy beachfront land, without more, did not confer on them a substantial economic benefit in the LLC; and (3) although it was claimed that the Fisher children had the right to unilaterally transfer their membership interests in the LLC, under the operating agreement they could do so only if certain conditions were satisfied (such as the fact that the LLC had a right of first refusal if any purchase offers were made), conditions which effectively prevented the children from transferring their interests for immediate value, even to their own family members.

For further information about this or any other blog on this web site, please contact the writer, Keith Codron, toll-free, at (800) 497-0864, or via email at keith@octrustlawyer.com.

Tuesday, March 23, 2010

The Importance of Proper Vesting on Deeds

A recent Tax Court decision in favor of IRS highlights the critical importance of proper grantee-vesting on deeds and other instruments of transfer, and the potentially dire tax consequences of improper vesting.  The case involved the joint interest of a decedent's predeceased spouse in two parcels of real property, an interest that was held to be includible in decedent's gross estate for federal estate tax purposes. Because the transfer deeds creating the joint interest in each property did not expressly state the manner in which the spouses were to hold title, such interest was treated by the Tax Court as a tenancy by the entirety, which, under applicable state law, cannot be devised under a will.

In 1968, Oscar Goldberg, a resident of New York, acquired from his mother a fractional interest in each of two parcels of real property.

In 1977, Oscar, desiring to hold title to the property jointly with his wife, Judith, executed a deed transferring his fractional interest in each property as follows: "to Oscar Goldberg and Judith Goldberg, as wife" (sic). The property interests remained titled in that manner until after Judith's death.

In 2001, Judith died testate, and her will did not explicity mention either of the properties. Judith's will simply split her estate between Oscar and a family trust.

On December 31, 2001, Oscar, acting as executor of his wife's estate, executed a deed on behalf of the estate purportedly conveying to the family trust his wife's one-half interest in the properties.

In 2004, Oscar died. On the federal estate tax return filed for Oscar, his son, Mitchell, acting as executor, included only half the value of Oscar's interest in the properties as part of Oscar's gross estate, believing that the other half belonged to Oscar's predeceased wife, Judith. IRS, however, claimed that the entire interest in each property, not just half, was includible in Oscar's gross estate for federal estate tax purposes, and determined a deficiency against Oscar's estate in the whopping sum of $384,432.96.  IRS based its position on the fact that Oscar's 1977 transfer deed to himself and his wife had created a tenancy by the entirety between the spouses, such that Oscar automatically became the full owner of the property interests once Judith died, notwithstanding any provision in Judith's will to the contrary. In other words, if, in fact, a tenancy by the entirety existed under N.Y. state law, the property interests were not devisable under Judith's will.

On February 16, 2010, in a memorandum decision entitled, Estate of Oscar Goldberg, deceased, Mitchell D. Goldberg, Executor, v. Commissioner [T.C. Memo 2010-26, 99 T.C.M. 1120], the U.S. Tax Court held that IRS was indeed correct.  The Tax Court looked to the laws of New York governing trusts and estates, and ruled that the wording used in the 1977 transfer deed to vest title in the grantees created a tenancy by the entirety between Oscar and Judith. As a result, upon Judith's death, Oscar, as the surviving spouse, succeeded by operation of law to Judith's half of the property interests, becoming the owner again of his original (full) fractional interest in the properties. The purported transfer of property interests to the family trust by Judith's estate, on 12/31/2001, was null and void because Judith's tenancy-by-the-entirety interests were not subject to devise under her will.  Furthermore, because the 1977 transfer deed, on its face, clearly and unambiguously created a tenancy by the entirety under applicable state law, the Tax Court could not consider extrinsic ("parol") evidence to interpret what, if any, Oscar's intent may have been in wording the deed in the manner that he did.

To learn how the 1977 deed should have been worded in order to avoid this unfortunate result, please contact the writer, Keith Codron, Esq., at (800) 497-0864, or email him at keith@octrustlawyer.com.