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The Section 2704 Valuation Rules and Their Impact on Advanced Estate

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Table of Contents

TABLE OF CONTENTS ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . II

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CONTINUING EDUCATION CREDITS INFORMATION ... . . . . . . . . . . . . . . . . . . . . . . . . . . V

CPA SIGN-IN SHEET & CERTIFICATE OF COMPLETION REQUEST ... . . . . VI

CFP SIGN-IN SHEET & CERTIFICATE OF COMPLETION REQUEST ... . . . VII

INSTRUCTIONS FOR REQUESTING CERTIFICATE OF COMPLETION . VIII

PROGRAM INFORMATION ... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ENCLOSED

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PROGRAM OUTLINE TIMES SESSION AND SPEAKERS

12:45 – 1:00 p.m. ET

Pre-Seminar Countdown

1:00 – 1:05 p.m.

Welcome and Introduction 1Source International

1:05 – 1:30 p.m.

Government Attempts to Limit Valuation Discounts, including Section 2704 The 2016 Election and Tax Reform Skip Fox McGuireWoods LLP

1:30 – 1:50 p.m.

Annual Exclusion and 250(e) Gifts Taxable Gifts Value-Shifting Gift Techniques Tom Abendroth Schiff Hardin LLP

1:50 – 2:00 p.m.

Questions and Answers

2:00 – 2:25 p.m.

Value-Shifting Gift Techniques (continued) FLPs and LLCs

Tom Abendroth Schiff Hardin, LLP

2:25 – 2:50 p.m.

Marital Deduction Planning Other Changes Due to Increased Exclusion Special Planning with Grantor Trust Status Skip Fox McGuireWoods LLP

2:50 – 3:00 p.m.

Questions and Answers Wrap-up


V

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The Section 2704 Valuation Rules and their Impact on Advanced Estate Planning Techniques

2017 Trust and Estate Planning Briefing Series

American Bankers Association Briefing/WebinarThursday, March 2, 20171:00 – 3:00 p.m. ET


Disclaimer

This Briefing will be recorded with permission and isfurnished for informational use only. Neither the speakers,contributors nor ABA is engaged in rendering legal norother expert professional services, for which outsidecompetent professionals should be sought. All statementsand opinions contained herein are the sole opinion of thespeakers and subject to change without notice. Receipt ofthis information constitutes your acceptance of these termsand conditions.

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2/27/2017

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Presenters

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• Thomas W. Abendroth, Partner, Schiff Hardin LLP

• Charles D. Fox IV, Partner, McGuireWoods, LLP


Agenda

• Government Attempts to Limit Valuation Discounts, including Section 2704

• The 2016 Election and Tax Reform

• Annual Exclusion and 2503(e) Gifts

• Taxable Gifts

• Value-Shifting Gift Techniques

• FLPs and LLCs

• Marital Deduction Planning

• Other Changes Due to Increased Exclusion

• Special Planning with Grantor Trust Status

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2/27/2017

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Government Attempts to Limit Valuation Discounts

• The Willing Buyer / Willing Seller Rule and Family Attribution

• Swing votes

• Section 2701, Special Valuation Rules for Applicable Retained Interests

• Section 2703, Certain Options and Transfer Restrictions Disregarded

• Section 2704, Treatment of Certain Lapsing Rights and Restrictions

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Pages 1-11


Government Attempts to Limit Valuation Discounts

• Prior Legislative Proposals

• Priority Guidance Plan for Section 2704 Regulations and Response

• Proposed Section 2704 Regulations

• Perceived Impact of Proposed Regulations and Reactions

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Pages 11-18

2/27/2017

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The 2016 Election and Tax Reform

• Ron Aucutt’s “Top Ten Estate Planning and Estate Tax Developments of 2016” discusses basic tax reform proposals and their prospects– House Republican’s Tax Reform “Blueprint” in June 2016– Serious talk of tax reform– Budget resolution – Budget reconciliation– Trump Administration unconventional – predictions are

difficult

• Conclusion– Will there be or not be permanent repeal of the estate tax?

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Pages 18-20


Variables in Tax Reform

• Too many variables to permit planners to anticipate the best planning options under a future new tax regime

• Open questions– Will the estate tax be repealed and basis step-up at death

retained?– Will Section 1014 basis step-up rules be replaced with

carryover basis at death (as in 2010) or with a Canadian style capital gains tax at death?

– Will the gift tax be retained, and, if so, with the current 40% rate and indexed $5 million applicable exclusion?

– Will the generation-skipping tax be fully repealed or retained for lifetime transfers?

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Pages 20-21

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Variables in Tax Reform

• Open questions (continued)– If generation-skipping tax is fully repealed, will previously created

irrevocable trusts (even non-exempt trusts) all become exempt from any generation-skipping tax?

– If the generation-skipping tax is fully repealed, will both old and new irrevocable trusts be treated as grandfathered if irrevocable when and if a new generation–skipping tax is later enacted?

– If estate tax is repealed and later restored how will pre-repeal marital trusts be treated? Will taxpayers have the option to designate a post-repeal QTIP marital trust as a non-QTIP (so it will not be included in a surviving spouse’s estate post reenactment)?

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Pages 20-21


Lifetime Planning Techniques

• Under current law, a well-advised taxpayer typically follows a particular sequence in making gifts– Annual exclusion and education and medical exclusion gifts– Lifetime exclusion gifts– Value-shifting and split interest gifts– Gifts that require payment of gift tax

• Opportunities to leverage the gifts using valuation discounts when transferring closely held assets– Use of limited partnerships and LLCs in planning– Section 2704 and the new proposed regulations

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Pages 21

2/27/2017

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Lifetime Planning Techniques

• Why engage in lifetime planning at all?– Do not undertake transfer that involves the planned payment of gift tax right now– Dangerous to assume that estate tax repeal will definitely occur, or if it does, that

it will be enacted soon– Should repeal occur, question to ask: “What can I accomplish to shelter assets in

case it comes back?”– If there is a gift tax, lifetime planning options likely will not change a lot, but

unique opportunities certainly will be likely– If there is no estate tax, but still a basis step-up at death, practitioners will want

to build into trusts mechanisms to trigger the basis step-up for a transferor who dies while there is no estate tax in effect

– Additional generation-skipping opportunities if the generation-skipping tax also has been repealed.

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Pages 21-22


Annual Exclusion and Section 2503(e) Gifts

• Annual Exclusion Gifts

• Transfer for Educational or Medical Expenses

• Planning in the Current Environment

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Pages 22-26

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Taxable Gifts and Use of the Applicable Exclusion

• Wealthy individuals have traditionally turned to larger taxable gifts and use of the applicable exclusion to move future appreciation out of their estates

• Planners must weigh the benefit of estate tax saving on future appreciation vs. the detriment of loss of basis step-up

• Planning in the current environment

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Pages 26-29


Value-Shifting Gift Techniques

• Several lifetime transfer techniques that work on the principle that the transferor’s assets will grow at a higher rate than is assumed by the IRS.

– Section 7520 Rate – Applicable Federal Rate

• AFR also is relevant in determining the value of a promissory note in lifetime transfers.

• 4 primary techniques that take advantage of these rules are:– Grantor Retained Annuity Trust– Charitable Lead Annuity Trust– Sale to a Grantor Trust– Loans to family members or grantor trusts


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Pages 29-39

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Value-Shifting and Disappearing Value

• Self-Canceling Installment Notes (SCINs)

• Private Annuities

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Pages 39-42



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FLPs and LLCs

• FLPs and LLCs– Family-owned limited partnership or (“FLP”) or limited liability

company (“LLC”) can be used as a vehicle for managing and controlling family assets

– LLC can be structured in much the same way as a limited partnership

– Non-Tax Planning Benefits– Valuation Discounts– Freeze Transactions– Frozen interests– Planning in the Current Environment

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Pages 43-47


Marital Deduction Planning

• Portability versus Credit Shelter Trust Planning

• What Produces the Best Overall Tax Results?

• Flexibility in Planning Options– Disclaimer Plan– Single Fund QTIP– Clayton QTIP– Modifying Formula Allocations


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Pages 47-53

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Other Changes Due to the Increased Exclusion

• Basis-Step Up Planning in Administering Trusts

• Eliminating Trusts

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Pages 53-56


Special Planning with Grantor Trust Status

• Supercharged Credit Shelter Trust

• Beneficiary Irrevocable Grantor Trust (“BING”)

• Delaware Irrevocable Nongrantor Trust (“DING”)

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Pages 56-59

2/27/2017

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The Section 2704 Valuation Rules and Their Effect on Advanced Estate Planning Techniques (Mar 2, 2017)

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American Bankers Association Briefing / Webinar

The Section 2704 Valuation Rules and their Impact on Advanced Estate Planning

Techniques

Thursday, March 2, 2017 1:00 p.m. to 3:00 p.m. E.T.

Charles D. Fox IV McGuireWoods LLP

Court Square Building 310 Fourth Street, NE, Suite 300 Charlottesville, Virginia 22902

(434) 977-2500 [email protected]

Thomas W. Abendroth Schiff Hardin LLP

233 S. Wacker Drive, Suite 6600 Chicago, Illinois 60606

(312) 258-5501 [email protected]

Copyright © 2017 by Schiff Hardin LLP and McGuireWoods LLP

CHARLES D. (“SKIP”) FOX IV is a partner in the Charlottesville office of

McGuireWoods LLP and chair of the firm’s Tax and Employee Benefits Department. Skip

concentrates his practice in estate planning, estate administration, trust law, and charitable

organizations. Skip has been on the faculty of the American Bankers Association’s National

Trust School and National Graduate Trust School since 1987. He was an Adjunct Professor at

Northwestern University School of Law where he taught from 1983 to 2005 and has been an

Adjunct Professor at the University of Virginia School of Law since 2006. He speaks extensively

around the country on estate planning topics and is the co-presenter of the long-running monthly

teleconference series on estate planning and fiduciary law issues sponsored by the American

Bankers Association. Skip has contributed articles to numerous publications and is a regular

columnist for the ABA Trust Newsletter on tax matters. He is the author or co-author of seven

books on estate planning topics. Skip is a Fellow and President-Elect of the American College

of Trust and Estate Counsel. Skip received his A.B. from Princeton, his M.A. from Yale, and his

J.D. from the University of Virginia. Skip’s wife, Beth, is a retired trust officer and they have

two sons, Quent and Elm.

THOMAS W. ABENDROTH is a partner in the Chicago law firm of Schiff Hardin LLP

and practice group leader of the firm’s Private Clients, Trusts and Estates Group. He

concentrates his practice in the fields of estate planning, federal taxation, and business

succession planning. Tom is a 1984 graduate of Northwestern University School of Law, and

received his undergraduate degree from Ripon College, where he currently serves on the Board

of Trustees. He has co-authored a two-volume treatise entitled Illinois Estate Planning, Will

Drafting and Estate Administration, and a chapter on sophisticated value-shifting techniques in

the book, Estate and Personal Financial Planning. He is co-editor of Estate Planning Strategies

After Estate Tax Reform: Insights and Analysis (CCH 2001). Tom has contributed numerous

articles to industry publications, and served on the Editorial Advisory Board for ABA Trusts &

Investments Magazine. He is a member of Duke University Estate Planning Council. Tom is a

frequent speaker on tax and estate planning topics at banks and professional organizations. In

addition, he is a co-presenter of a monthly teleconference series on estate planning issues

presented by the American Bankers Association. Tom has taught at the American Bankers

Association National Graduate Trust School since 1990. He is a Fellow of the American College

of Trust and Estate Counsel.

TABLE OF CONTENTS

Page

I. Introduction ........................................................................................................................ 1

II. Government Attempts to Limit Valuation Discounts ........................................................ 1

III. The 2016 Election and Tax Reform – Ron Aucutt’s Perspective .................................... 18

IV. Variables in Tax Reform .................................................................................................. 20

V. Lifetime Planning Techniques ......................................................................................... 21

VI. Annual Exclusion and Section 2503(e) Gifts................................................................... 22

VII. Taxable Gifts and Use of the Applicable Exclusion ........................................................ 26

VIII. Value Shifting Gift Techniques ....................................................................................... 29

IX. Value-Shifting and Disappearing Value .......................................................................... 39

X. FLPs and LLCs ................................................................................................................ 42

XI. Marital Deduction Planning ............................................................................................. 46

XII. Other Changes Due to the Increased Exclusion ............................................................... 53

XIII. Special Planning with Grantor Trust Status ..................................................................... 56

The Section 2704 Valuation Rules and their

Impact on Advanced Estate Planning Techniques

I. Introduction

A. For years, the Internal Revenue Code, Treasury Regulations and IRS rulings, as interpreted by the courts, have provided a framework within which one must operate when valuing an asset for transfer tax purposes. There are two basic rules that are the foundation of this framework:

1. Fair market value is the price at which the property would change hands between a hypothetical willing buyer and a hypothetical willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the facts. See Treas. Reg. §§ 20.2031-1(b), 20.2031-3.

2. The willing buyer and willing seller must negotiate their deal based on the relevant facts as they stood on the valuation date (the date of the transfer for gift tax purposes and generally the date of death for estate tax purposes).

B. The framework is firmly based in economic reality: what value would a willing buyer and willing seller agree on in the marketplace? However, Congress and the IRS always have been able to create exceptions to these rules that alter, or ignore, economic reality. The most recent attempt to do this was the proposed regulations under Section 2704 of the Code. These proposed regulations further the reach of Section 2704 in disregarding certain restrictions in the governing documents of family controlled entities.

C. This outline discusses the proposed regulations and their possible impact on estate planning. They also review the broader set of rules, past and present, that alter valuation reality for estate and gift tax purposes.

D. In light of the results of the 2016 elections, and the momentum that now exists for a repeal of the estate and gift tax, the materials also comment on the primary proposals for repeal and the planning ramifications.

II. Government Attempts to Limit Valuation Discounts

A. The Willing Buyer/Willing Seller Rule and Family Attribution

1. For many years, the IRS has tried to find ways to avoid application of the willing buyer/willing seller rule because it creates hypothetical buyers and sellers even in transactions that involve only family members. The IRS

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has contended that if an asset is family owned, the bundle of rights constituting ownership can be more easily manipulated, and various rights parceled out to family members, with confidence that the rights will not be exercised to the detriment of the other family members.

a. Thus, if a preferred stockholder has the ability to liquidate a family held company, but in so doing would jeopardize his carefully designed estate plan, the IRS has concluded that the liquidation right should not be taken into account in valuing the preferred stock. Ltr. Rul. 8401007 (Sept. 15, 1983).

b. Likewise, the IRS has successfully argued that the gift tax value of a class of common stock should be determined without regard to the possibility that another class of preferred stock will be converted into the common stock, when that conversion would be at variance with the donor’s estate plan. Wallace v. U.S., 82-1 USTC (CCH) ¶ 13,442 (D. Mass. 1981).

c. Although the IRS’ assumptions about family cooperation is accurate in many circumstances, any experienced wealth professional knows that it is far from a universal reality.

2. The IRS has generally been unable to sustain this approach consistently in the courts, but it has found some success through legislation, as discussed in the paragraphs on Sections 2701 to 2704, under Chapter 14 of the Code.

3. After many years of trying, however, the IRS reluctantly abandoned its “unity of ownership” or “family attribution” theory as it applies to minority discounts. The theory was set forth in Revenue Ruling 81-253, 1981-2 C.B. 187, in which the Service ruled that intra-family transfers of stock should be valued without minority discounts, because, absent evidence of family discord, there is a presumption that members of the family will share control.

a. Most courts rejected the Service’s argument that family members’ stock should be attributed to the shareholder whose stock is being valued. See, e.g., Estate of Bright v. U.S., 658 F.2d 999 (5th Cir. 1982); Minahan v. Comm’r, 88 T.C. 492 (1987); Ward v. Comm’r, 87 T.C. 78, 108 (1986); Estate of Andrews v. Comm’r, 79 T.C. 938, 956 (1982).

b. In Revenue Ruling 93-12, 1993-1 C.B., the IRS officially revoked Revenue Ruling 81-253. Revenue Ruling 93-12 holds that intra-family transfers of closely held stock are valued for estate and gift tax purposes without consideration of the fact that control of corporation rests in the family. The Ruling considers a hypothetical situation in which a parent transfers 100% of the stock

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of his corporation in five simultaneous gifts of 20% of the stock to each of his five children. The Ruling states that “[f]or estate and gift tax valuation purposes . . . a minority discount will not be disallowed solely because the transferred interest, when aggregated with interests held by family members, would be part of a controlling interest.”

B. Swing Votes

1. The IRS has tried to expand this concept by arguing that minority blocks of stock are sometimes entitled to much smaller discounts because they have “swing vote” powers – they could influence company actions by affiliating with another block of stock to exercise control. See Letter Ruling 9436005 (1994).

2. Usually, courts reject this assertion as speculative or inconsistent with the willing buyer/willing seller principle. See, e.g., Estate of Green v. Comm’r, T.C. Memo 2003-348 (2003) (IRS claim that 5% interest had “swing vote” influence too speculative); Estate of Wright v. Comm’r, T.C. Memo 1997-53 (1997) (Court rejects IRS attempt to apply premium to 23.8% interest in bank because of size of interest compared to other shareholders).

C. Section 2701, Special Valuation Rules for Applicable Retained Interests

1. Section 2701 generally provides that, where an individual transfers an equity interest in a family-controlled business (usually common stock or an equivalent partnership interest) to younger family members, and retains preferred stock or certain other senior equity interests in the business immediately after the transfer (called “applicable retained interests” or “ARIs”), the retained interest will normally be assigned a zero value for gift tax purposes unless it provides for cumulative preferred distribution rights (called “qualified payments”) or meets certain other requirements. If the retained preferred stock or other interest is assigned no value, the amount of its actual value will constitute an immediate gift from the transferor to the person receiving the common stock. Section 2701 applies to transfers occurring after October 8, 1990.

2. To determine whether Section 2701 applies to any given transaction and whether any exceptions are available, one must contend with a number of defined terms and meet several threshold requirements.

a. First, there must be a transfer of an equity interest in the corporation or partnership to or for the benefit of a “member of the transferor’s family.” This term includes the transferor’s spouse, lineal descendants of the transferor or the transferor’s spouse, and spouses of those descendants. IRC § 2701(e)(1).

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b. Second, immediately after the transfer, the transferor or an “applicable family member” must retain an interest in the entity. An applicable family member includes the transferor’s spouse, ancestors of the transferor or the transferor’s spouse, and the spouses of those ancestors. IRC § 2701(e)(2).

c. For purposes of the statute, an individual is treated as holding any interest to the extent that the interest is held indirectly by such person through a corporation, partnership, trust, or other entity.

3. The following two examples indicate how attribution of retained interests to the transferor may trigger the statute:

Example 1. Father owns all of the 100 outstanding shares of common stock of ABC, Inc., worth $500,000. Grandfather owns all of the 100 outstanding shares of noncumulative preferred stock, also worth $500,000. Father gives his common stock to Son after October 8, 1990. Under Section 2701, Grandfather’s preferred stock is given a value of zero in determining the amount of Father’s gift to Son. Thus, the amount of the gift to Son is $1,000,000. Note that this result would be the same whether Grandfather’s and Father’s stock interests were created by a recapitalization completed before or after October 8, 1990.

Example 2. An individual owns common stock of a closely held corporation, while a QTIP marital trust for the benefit of his mother owns noncumulative preferred stock. The common and preferred stock are each worth $500,000. The individual transfers all the common stock to his children. Under Section 2701, for purposes of the transfer, the preferred stock is deemed to have no value. Therefore, the individual has made a gift of $1,000,000 to his children.

4. A transfer for purposes of the statute is not limited to property law transfers or conveyances. It may include a redemption, recapitalization, contribution to capital, or other change in the structure of the entity if the taxpayer, or an applicable family member, receives an ARI pursuant thereto, or otherwise holds an ARI thereafter. IRC § 2701(e)(5).

a. Thus, for example, a conversion of one shareholder’s common stock to preferred stock, while the other shareholder continues to hold common stock, would be a transfer to which the section may apply. The regulations provide a number of additional examples. Treas. Reg. § 25.2701-1(b).

b. The formation of a new entity can be a transfer to which Section 2701 applies. The Senate Finance Committee Report on S. 3209 (which ultimately became Chapter 14) contains the following example:

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“father and son form a partnership to which each contributes capital and in which the father receives a preferred interest and the son receives a residual interest. [Section 2701] applies in determining whether, and the extent to which, the capital contributions result in a gift.”

5. As a third prerequisite to the application of Section 2701, the interest retained by the transferor or applicable family member must be an ARI. There are two types of ARIs, as defined by the regulations: extraordinary payment rights and distribution rights. Treas. Reg. § 25.2701-2(b).

a. An extraordinary payment right is any put, call, or conversion right, any right to compel liquidation, or any similar right, the exercise or nonexercise of which affects the value of the transferred interest.

b. Distribution rights are essentially a right to receive stock dividends or partnership income distributions. However, distribution rights do not include a guaranteed payment from a partnership under Code Section 707, a nonlapsing conversion right (that is, the right to convert into a fixed number or percentage of shares of the same class as the transferred interest), a right to distributions with respect to any “junior equity interest” (basically, common stock or other similar interests which participate in the growth of the entity and are not preferred as to distributions), or certain rights dubbed “mandatory payment rights” and “liquidation participatory rights.” See Treas. Reg. § 25.2701-2(b)(4).

c. Thus, for example, preferred stock may represent a distribution right, while common stock usually will not. An installment promissory note from the corporation generally will not represent a distribution right or be covered by Section 2701 unless it constitutes equity rather than debt.

6. In valuing the retained interest, extraordinary payment rights will be valued at zero unless they meet one of two exceptions. The first exception applies to any such right which must be exercised at a specific time and in a specific amount. The second exception applies to a right to convert into a fixed number or percentage of shares of the same class of stock (or partnership interest) as the transferred interest (or a class similar thereto but for nonlapsing differences in voting power), provided that the conversion right is nonlapsing, is subject to proportionate adjustments for splits, combinations, reclassifications, and similar capital changes in the entity, and is subject to compounding adjustments if not exercised. This type of conversion right is excepted because it will appreciate at the same rate as the transferred interest. In these cases, Section 2701 will not apply

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to these rights, which by implication would be valued under normal valuation principles.

7. If the transferor and applicable family members control the entity immediately before the transfer, a retained distribution right will be valued at zero unless it consists of the right to receive qualified payments.

a. A “qualified payment” is any dividend or partnership distribution payable on a periodic basis which is cumulative and determined either at a fixed rate or at a rate which bears a fixed relationship to a specified market interest rate. IRC § 2701(c)(3).

b. Thus, for example, preferred stock which provides for an 8 percent, cumulative annual dividend gives the owner a qualified payment right.

c. Control for these purposes means (1) with respect to a corporation, the holding of at least 50 percent (either by vote or value) of the stock, and (2) with respect to a partnership, the holding of at least 50 percent of the capital or profits interest, or in the case of a limited partnership, the holding of any interest as a general partner.

d. For these purposes only, special attribution rules treat the transferor as holding any interests held by siblings or lineal descendants. If the transferor and applicable family members did not possess the requisite control, or if the distribution right consists of the right to receive qualified payments, Section 2701 will normally not apply to value that right. Rather, by implication, that right is to be valued under normal gift tax valuation rules.

8. Even though a transfer occurs and rights in the entity are retained by the transferor or an applicable family member, Section 2701 will not apply to value the retained rights if one of the following three exceptions is met:

• Market quotations on an established securities market are readily available for either the transferred interest or the retained interest.

• The retained interest is of the same class as the transferred interest, such as where preferred stock is transferred and preferred stock of the same class is retained, or where a partnership interest is transferred where all items of income and loss are shared in the same proportion by all partnership interests.

• The retained interest is proportionally the same as the transferred interest, without regard to nonlapsing differences in voting power (or, for a partnership, nonlapsing differences with respect to management and limitations on liability, unless the transferor or an

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applicable family member has the right to alter the transferee’s liability with respect to the transferred property).

9. The last exception would apply, for example, where the retained and transferred interests consist of two classes of common stock that share in all distributions, liquidations, and other rights in the same ratio, regardless of which class was transferred or retained.

10. Section 2701 imposes some additional limitations on the valuation process. First, a special rule provides that a retained interest that confers both (1) an extraordinary payment right, and (2) a right to a qualified payment, is valued on the assumption that each right is exercised in a manner resulting in the lowest value for all such rights. IRC § 2701(a)(3)(B).

11. A second special rule will frustrate attempts to place only a nominal value on transferred common stock in a preferred stock recapitalization. This rule provides that if the transferred interest represents a “junior equity interest” (basically, common stock or an equivalent partnership interest), then in determining whether the transferor has made a gift under Section 2701, the value of all the junior equity interests in the entity can never be less than 10 percent of the sum of (l) the total equity of the entity, plus (2) the total indebtedness of the entity owed to the transferor and applicable family members. IRC § 2701(a)(4).

D. Section 2703, Certain Option and Transfer Restrictions Disregarded

1. Section 2703 addresses the treatment of transfer restrictions and options to purchase entity interests granted in the entity’s governing documents or by contract (such as a buy-sell agreement). Historically, no Code section governed the effect of such provisions on value. Rather, the general valuation principles under Sections 2031 (for estate tax purposes) and 2512 (for gift tax purposes) applied. The IRS has long recognized that the existence of a buy-sell agreement is one factor that should be considered in valuing a closely held business interest for estate tax purposes.

2. The courts consistently were willing to go further than the IRS in giving effect to buy-sell agreements. Indeed, a host of cases indicated that the price determined under the agreement fixed the estate tax value of the business interest if the factors present in Treas. Reg. § 20.2031-2(h) were present ((1) agreement represents a bona fide business arrangement, and (2) it is not a testamentary device), and the following additional requirements were met:

a. The agreement contained restrictions on disposition of the business interest which were binding during the owner’s life, as well as at death;

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b. The agreement obligated the owner’s estate or beneficiaries following death to sell the interest at the price established under the agreement, either without any choice or at the option of the other parties to the agreement; and

c. The price set in the agreement either was fixed, or determinable according to a formula, and was reasonable when the agreement was made.

3. Even in those situations where the facts do not support a conclusion that the agreement price was binding, a grandfathered agreement is a factor to take into account in valuing the interests subject to the agreement. See, e.g., Estate of H.A. True, Jr. v. Comm’r., 390 F.3d 1210 (10th Cir. 2004).

4. Section 2703, was enacted to override the case law. It creates a presumption that restrictions under a buy-sell agreement are ignored for transfer tax purposes. The rule applies to agreements entered into after October 8, 1990, and those that are substantially modified after that date. This rule can be avoided, and the value specified in the agreement may be recognized for estate tax purposes if the case law requirements are met plus additional requirements contained in the statute. The statute sets out the following three requirements:

• the agreement is a bona fide business arrangement;

• the agreement is not a device to transfer the business to members of the owner’s family for less than full and adequate consideration; and

• the terms of the agreement are comparable to similar arrangements entered into by persons in an arm’s-length transaction.

a. The bona fide business arrangement and not a testamentary device requirements are similar to those under the case law.

b. The key factor in satisfying the requirements is to have an agreement that is a “fair bargain,” comparable to what would have been entered into by unrelated business partners. The existing case law and regulations suggest that the method used to determine the price set in the agreement is an important element in this determination. A price determined by an appraiser will be far more likely to be treated at arm’s length than an arbitrary use of book value or another factor.

c. In addition, the price in the agreement is more likely to be accepted if the agreement requires that it be updated on a regular basis. This does not necessarily mean that annual updates are necessary. It

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may be commercially reasonable to have modifications to the price every two or three years.

5. The most difficult aspect of the Section 2703 rules is the apparent high burden placed on the taxpayer to establish that the agreement and its transfer and price restrictions, are “comparable to similar arrangements entered into by persons in an arm’s length transaction.” Treas. Reg. § 25.2703-1(b)(4).

a. The regulations state that the taxpayer does not establish this “by showing isolated comparables.” The IRS has asserted that general testimony as to accepted business practices is insufficient proof under the regulations. Rather, it is necessary to provide evidence of actual use of similar approaches in specific fact situations. Since there are no published studies of buy-sell agreement restrictions, this is virtually impossible to do.

b. In Estate of Amlie v. Commissioner, T.C. Memo 2006-76, the court suggested that the burden is not as high as the IRS asserts. There, the court accepted as persuasive the testimony of the estate’s expert, an attorney with extensive experience in the purchase and sale of non-marketable business interests. In response to IRS arguments that the attorney’s testimony was insufficient, the court stated:

“While the regulations caution against using ‘isolated comparables,’ we believe that in context the regulations delineate more of a safe harbor than an absolute requirement that multiple comparables be shown.”

6. Section 2703 is an especially dangerous provision in that it causes the price for closely held interests set in a buy-sell or option agreement among family members to rarely be binding for estate tax purposes. Yet, the agreement usually is binding for contractual purposes with the other owners. As a result, a family of a deceased shareholder can be hurt by a price in the agreement that is found to be substantially below fair market value.

EXAMPLE: Sister owns 1,000 shares of stock in XYZ Co., a family corporation. The other shareholders are her three siblings and a trust created by her parents. The stock is subject to a buy-sell agreement that gives the company an option to buy the stock at a shareholder’s death for $2,000 per share. The company exercises the right at sister’s death and pays her estate $2,000,000. The IRS determines that the fair market value of the stock for estate tax purposes is $3,500 per share. If sister is in a 48% combined federal and state estate tax bracket, the estate pays estate tax on the stock of $1,680,000, but receives only $2,000,000 for it. Sister’s family nets only $320,000 after estate tax.

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a. The agreement also can have a detrimental impact in an estate that will not incur a tax because of an optimum marital deduction plan.

b. Assume that in addition to the XYZ Co. stock, sister had other assets of $2,000,000 and that she died in 2008, survived by her husband and with an optimum marital deduction plan. Her executor may have anticipated allocating $2,000,000 to a marital trust and $2,000,000 to a family trust. Instead her estate allocation is as follows, given the effect of the buy-sell agreement and estate tax valuation of the stock:

Stock value passing to family under buy-sell: $1,500,000 Assets that pass to family trust: 500,000 Assets that pass to marital trust: 2,000,000

c. In effect, the provisions of the agreement waste $1,500,000 of sister’s exemption amount. If the spread between the agreement value and the estate tax value is large enough, it may cause an estate tax to be due in an optimum marital deduction plan.

E. Section 2704, Treatment of Certain Lapsing Rights and Restrictions

1. Section 2704 applies to any type of entity but was enacted specifically in response to unique provisions being included in partnership agreements, where there is much greater flexibility in creating different classes of equity. LLCs, which largely have emerged since 1990, are in the same category. Section 2704 has two parts.

a. Section 2704(a) provides that the lapse of a voting or liquidation right in a family controlled entity is itself treated as a transfer by the transferor, or by the decedent in the case of a lapse at death.

b. Section 2704(b) provides that certain “applicable restrictions” in a family controlled entity will be disregarded for valuation purposes.

2. Section 2704(b) is the primary valuation battleground.

a. An “applicable restriction” is defined as a restriction that limits the ability of the entity to liquidate, where the restriction either lapses after a transfer or the transferor and members of the transferor’s family, alone or collectively, can remove the restriction. IRC § 2704(b)(2)(B) and Treas. Reg. § 25.2704-2(b). An applicable restriction does not include “any restriction imposed, or required to be imposed, by state law.” IRC § 2704(b)(3)(B).

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b. Subparagraph (4) of the statute gives the Treasury the ability to add other types of restrictions to list of disregarded restrictions:

“(4) OTHER RESTRICTIONS – The Secretary may by regulations provide that other restrictions shall be disregarded in determining the value of the transfer of any interest in a corporation or partnership to a member of the transferor’s family, if such restriction has the effect of reducing the value of the transferred interest for purposes of this subtitle but does not ultimately reduce the value of such interest to the transferee.”

c. As the wording of this provision indicates, it is not an open

invitation for the IRS to write broad valuation regulations. It applies only to other restrictions not already covered in the core part of the statute, and only “if such restriction has the effect of reducing the value of the transferred interest . . . but does not ultimately reduce the value of such interests to the transferee.”

3. Section 2704(b) also focuses only on ignoring the delineated offending restrictions. As Richard Dees so capably explains in his letter to the Department of Treasury on potential changes to the Section 2704 regulations, this is why the regulations under Section 2704 exclude restrictions that are no more restrictive than state law.

4. Thus the classic case to which Section 2704(b) applies is the family controlled partnership that requires all the partners to consent to liquidation, created in a state where the statute requires two-third majority of the partners for liquidation. A taxpayer cannot create the partnership, transfer 5% to a trust for descendants, and claim a large valuation discount on her 95% interest at death based on inability to liquidate. However, if the taxpayer owned only a 55% interest, less than the ownership percentage required by state law to liquidate, a discount for lack of marketability based on the inability to liquidate would be justified.

5. The IRS advocated for an expansive reading of Section 2704(b) in Kerr v. Commissioner, 113 T.C. No. 30 (1999). It asked the court to ignore restrictions on liquidation and withdrawal in a partnership that had a fixed liquidation date of December 31, 2043. The service argued that Texas law did not require partnerships to have a fixed liquidation date, and that, in a partnership without a fixed liquidation, the restrictions were more restrictive than state law. The Tax Court rejected the argument.

F. Prior Legislative Proposals

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1. In May of 2009, the Obama Administration published its Fiscal Year 2010 Revenue Proposals (the “Greenbook”) and included proposed statutory changes to Section 2704(b).

2. The Greenbook proposal was to expand the reach of Section 2704(b) by creating new “disregarded restrictions” that would be ignored in valuing interests in a family controlled entity.

3. Instead of simply ignoring disregarded restrictions, the legislative proposal would substitute certain valuation assumptions for it. Thus, a limitation on a right to liquidate a holder’s interest that is more restrictive than a standard to be identified in the regulations would be ignored and replaced with another standard, not one necessarily tied to being no more restrictive than state law.

4. The proposal also stated that a limitation on a transferee’s ability to be admitted as a full partner would be a disregarded restriction.

5. Finally, in determining whether the members of the family could remove the restriction, certain interests in charities or non-family members, as identified in regulations, would be deemed held by the family.

6. Thus, the proposal not only would change the rules on disregarded restrictions, it would significantly expand the Treasury’s regulatory authority.

7. The proposal was dropped from the Greenbook starting with fiscal year 2014. No actual legislation was brought before Congress.

G. Priority Guidance Plan for Section 2704 Regulations and Response

1. At the same time, IRS Priority Guidance plans began to include an item on additional guidance on new regulations under Section 2704. As is often the case, the Section 2704 project languished on the list for many years.

2. Attendees of the May, 2015 meeting of the ABA Tax Section reported that a representative of the IRS Office of Tax Policy stated that the Section 2704(b) regulations would be issued in the near future, and reportedly would be similar to the Greenbook proposal.

3. On August 31, 2015, Richard Dees submitted a letter to Mark Mazur, Assistant Secretary of Tax Policy, and William J. Wilkins, Chief Council of the IRS, with the subject line “Possible New Regulations under Internal Revenue Code Section 2704(b)”. Mr. Dees prepared the letter with input from several other well-known transfer tax authorities, including Stacy Eastland and Dan Hastings.

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a. The letter provided a forceful argument that new regulations issued under the existing regulatory authority granted in Section 2704(b)(4) and which created rules similar to those in the Greenbook proposals would be inconsistent with the existing statutory language and therefore invalid.

b. Many practitioners suspect that the letter in fact caused the IRS to delay its issuance of proposed regulations, and caused the Service to rethink the project.

4. The gist of the letter’s argument is that, absent statutory changes, any regulations along the lines of the Greenbook proposal would be inconsistent with the statute’s origin and purpose, as reflected in the legislative history of Chapter 14, and would not be a reasonable extension of the regulatory authority Congress granted to the IRS under Section 2704(b)(4).

a. The Dees letter reviews legislative history going back to the passage and subsequent repeal of Chapter 14’s predecessor, Section 2036(c).

b. Based on this history, and case law on valuation of interests in family held entities, Dees makes clear that Section 2704(b) focused on ignoring certain restrictions but did not allow replacing such restrictions with other valuation assumptions.

c. Instead, it preserved the fundamental principle that the legal rights and interests inherent in property first are determined under state law. Hence, if a restriction written into a governing document is ignored under Section 2704(b), it is valued as if the restriction did not exist, which necessarily falls back on what property rights exist with respect to the interest under state law.

d. This principle is reflected in the statute, with its provision that an applicable restriction does not include “any restriction imposed, or required to be imposed, by any Federal or State law.” IRC § 2704(b)(3).

5. Dees notes that Congress never undertook an effort to write, much less consider for passage, any statutory revision to Section 2704. Therefore, it must be presumed that the congressional intent underlying the original statute continues.

6. Dees closes with two paragraphs that capture the force of his argument:

“The author has written this lengthy and detailed letter to make the case that Proposed Regulations under IRC Section 2704(b) are more likely to be invalid than valid if

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they reflect the Greenbook Proposal. The letter, however, does not stop with presenting the technical arguments against their validity. Rather, the letter also reminds its readers of the failed history and the enormous costs resulting from the IRS’ history of repeated failed efforts to accomplish similar objectives in other ways. Before Congress repealed Section 2036(c) retroactively, taxpayers, professionals, Congress, Treasury and the IRS expended substantial resources needlessly at an immeasurable cost. The government’s decision to keep the terms of Section 2704(b) out of the public debate prior to its enactment represents a costly missed opportunity to rationalize the valuation of partnership interests. The IRS litigated the validity of one example in the Chapter 14 regulations in Walton for eight years before the courts invalidated it. After implementing the legislative history of Chapter 14 for years after its enactment in 1990, the IRS reversed course in litigation only to lose in Kerr Estate. If Treasury and the IRS promulgate new regulations modeled on the Greenbook Proposal, this sad and costly history will likely repeat itself again.”

H. Proposed Section 2704 Regulations

1. The long-awaited proposed regulations finally were released on August 2, 2016. They surprised the estate planning and tax bars with their apparent breadth and the significant, fundamental changes they seemed to make.

2. As discussed further below, the IRS already is backing away from the legal community’s reading of the regulations. IRS representatives have said that they were surprised by how practitioners have interpreted the regulations.

3. Applicable Restrictions Redefined. Under current regulations, applicable restrictions are those restrictions on entity liquidation that are more restrictive than state law. The proposed regulations expand the definition of an applicable restriction, such that even state law defaults would be “applicable restrictions” – unless the law provided that they could not be modified, which is rare in practice. In addition, if a state’s law was mandatory, but the entity owners could select another state’s law, the restriction would be an applicable restriction.

4. Disregarded Restrictions. Like applicable restrictions, disregarded restrictions would be ignored in valuing an interest in an entity for estate and gift tax purposes. A disregarded restriction includes:

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a. Any restriction or limitation on the ability of the holder of an interest to liquidate or have his or her interest redeemed;

b. Any restriction limiting the amount received by the holder to less than a minimum value, defined as a pro rata share of the entity value reduced by certain outstanding obligations;

c. Any provision permitting deferral of redemption proceeds for more than six months; and

d. Any provision that permits repayment in anything other than cash or property. Notably, a promissory note is not considered “property” unless the entity is engaged in an active trade or business, the proceeds are not attributable to passive assets, the note is adequately secured and the note is issued at a market interest rate.

5. Lapse of Voting or Liquidation Rights Under 2704(a). In a surprising twist, the proposed regulations, which had been anticipated under the disregarded restriction provisions of section 2704(b), also make changes to the regulations under the lapsing voting or liquidation rights provisions of section 2704(a).

a. The statute (section 2704(a)(1)) provides: “A lapse of any voting or liquidation right in a corporation or partnership … shall be treated as a transfer.” The 1992 regulations (Reg. §25.2704-1(c)(1)) provide: “A transfer of an interest that results in the lapse of a liquidation right is not subject to this section if the rights with respect to the transferred interest are not restricted or eliminated.”

b. The proposed amendment to Reg. §25.2704-1(c)(1) provides:

The lapse of a voting or liquidation right as a result of the transfer of an interest within three years of the transferor’s death is treated as a lapse occurring on the transferor’s date of death, includible in the gross estate pursuant to section 2704(a).

c. This rule is intended to capture deathbed transfers that reduce a

transferor to less than a majority interest. If a transfer made within three years of death results in the lapse of a voting or liquidation right, the transferor’s gross estate will be increased by the value of that lost liquidation right.

d. This would occur, for example, if parent held 60 percent of the vote, transferred 10 percent to each of her two children (leaving her 40 percent), and subsequently passed away.

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e. Under the proposed regulations, if she passes away within three years after making the transfer, that “lost value” attributable to her liquidation power will be added to her taxable estate. This effectively creates a phantom asset in the estate – it will be taxed, but the tax must be paid from other assets of the estate.

I. Perceived Impact Proposed Regulations and Reactions

1. When read together, the proposed regulations appear to impose a new valuation regime, where the value of any owner’s interest in a corporation, partnership or LLC (even a 1% interest) must be determined as if there was no restriction on the owner being able to immediately redeem the interest or force liquidation of the entity, and be paid within 6 months.

a. Hence, commentators began referring to the proposed regulations creating a deemed “put right.”

b. However, the regulations fail to adequately explain what that altered reality would mean in terms of actually assigning a value to the interest. Did it mean actual liquidation value? In an investment LLC or LP, does that mean no discounts? How would this deemed put right apply in an operating business? How could a value be assigned to an interest based on undiscounted going concern value when the presumptions imposed create this deemed redemption or liquidation right?

2. Many commentators have focus on the fundamental inconsistency created by the regulations’ reference to a minimum value and their simultaneous reference to still applying normal valuation principles.

a. Section 25.2704-3(b)(l)(ii) of the proposed regulations includes as a “disregarded restriction” a “provision that limits or permits the limitation of the amount that may be received by the holder of an interest on liquidation or redemption of the interest to an amount that is less than a minimum value. The term minimum value means the interest’s share of the net value of the entity determined on the date of liquidation or redemption.” This sounds like an undiscounted value, one that ignores the minority or lack of marketability characteristics of the particular interest being valued.

b. The proposed regulation section goes on to say “The net value of the entity is the fair market value, as determined under Section 2031 or 2512 and the applicable regulations, of the property held by the entity, reduced by the outstanding obligations of the entity.”

c. An example later in the proposed regulations refers to valuing a limited partnership interest “under generally applicable valuation principles taking into account all relevant factors affecting value

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including the rights determined under the governing documents and local law and assuming that the disregarded restriction does not exist in the governing documents, local law, or otherwise.”

d. The challenge that practitioners and business appraisers have noted is that “applicable valuation principles” are intertwined with the restrictions that we supposedly must disregard. It is hard to separate the two. In his commentary on the proposed regulations, Christopher Mercer, of the valuation firm Mercer Capital, noted that under generally applicable valuation principles, business appraisers would be forced to issue appraisals that are specifically labeled as hypothetical.

3. Ron Aucutt has written in his “Top Ten Estate Planning and Estate Tax Developments of 2016” (McGuireWoods December 21, 2016) that there are a number of factors that would not be disregarded even under a broad pro-Service reading of the regulations:

• the risk that the holder of the interest may be unable to negotiate a favorable buyout,

• the risk a hypothetical willing buyer would incur in dealing with an unrelated family, and

• the lack of ability to control or influence the operations or investments of the entity as a going concern.

And, in the case of a family-owned operating business,

• the business plan, business environment, competition, illiquidity and the need for capital, unpredictability, and other obstacles to the business’s redemption of the interest,

• the existence or loss of a key person in the business,

• the fact that partial liquidation (redemption) makes a business not just smaller, but weaker and less competitive, and

• the fact that the managers or majority owners of the business therefore may owe a fiduciary duty to the other owners to view a partial liquidation as not in the best interests of the business or the other owners.

4. Treasury and IRS officials now have commented that practitioners are over-reacting and that the proposed regulations are not meant to eliminate minority discounts or significantly alter valuations for transfer tax purposes. Rather, they say, as Ron Aucutt put it, that the regulations are

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intended to address provisions that purport to artificially make the interest less marketable and artificially enhance the discounts justified by the real factors listed above. Treasury representatives have acknowledged that they will need to rework the regulations to address this misunderstanding. Given the volume of the written comments as well as comments at a December 1, 2016 hearing on the regulations, Treasury representatives have said they will need a significant amount of time to rework the regulations.

III. The 2016 Election and Tax Reform – Ron Aucutt’s Perspective

A. Ron Aucutt provides an excellent discussion of the basic tax reform proposals and their prospects in “Top Ten Estate Planning and Estate Tax Developments of 2016” (McGuireWoods December 21, 2016), largely reproduced below.

B. The House Republicans’ Tax Reform “Blueprint” of June 2016

1. On June 23, 2016, House Republicans, led by Ways and Means Committee Chairman Kevin Brady (R-TX) and Speaker Paul Ryan (R-WI), released “A Better Way: Our Vision for a Confident America,” which they called their “Blueprint” for tax reform. With new life gained from the 2016 election, this Blueprint is likely to be the principal vehicle for consideration of fundamental tax reform in 2017.

2. The Blueprint would collapse the seven individual income tax brackets into three (with rates of 12, 25, and 33 percent), increase the standard deduction, eliminate all itemized deductions except home mortgage interest and charitable contributions, repeal the alternative minimum tax, and “continue the current incentives for [retirement] savings” (presumably retaining the current treatment of “stretch IRAs”). On the business tax side, it would place a lot of emphasis on expensing capital investments, deny deductions for net interest expense, repeal the corporate alternative minimum tax, and limit the offset of carried-forward net operating losses to 90 percent of net taxable income determined without regard to the carryforward (thus leaving 10 percent of that current income still taxable despite the NOL carryforward, possibly a reaction to criticism of President-Elect Trump’s use of large NOLs reported during the campaign).

3. Regarding the estate tax, the Blueprint states simply:

“This Blueprint will repeal the estate and generation-skipping transfer taxes. This will eliminate the Death Tax, which can result in double, and potentially even triple, taxation on small businesses and family farms.”

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4. The omission of the gift tax is certainly deliberate.

5. The Trump Campaign website was equally brief in addressing transfer tax. It stated: The Trump Plan will repeal the death tax, but capital gains held until death and valued over $10 million will be subject to tax.

C. While tax reform is discussed almost every four years, and it is harder to do than it sometimes sounds, the talk this year is serious. With control of both Houses of Congress barely changed and the surprising capture of the White House, Republican leadership will be under enormous pressure to produce very significant tax legislation in 2017 by the August recess because now they can, and because, with no excuses left, they must. The June 2016 Blueprint summarized in Number Two of this Alert, which Ways and Means Chairman Kevin Brady has described as 80 percent in sync with President-Elect Trump’s campaign’s plan and to which the President-Elect’s transition team seems largely willing to defer, will be the likely vehicle.

D. It might be assumed that the Republican leadership would want some Democratic votes. After all, they made such a big deal of the enactment of the Affordable Care Act without a single Republican vote. But memories are short. In any event, it is not clear that the Republican leadership would want Democratic votes so much that they would try to get 60 total votes in the Senate to “call the question” on regular legislation. A few bipartisan votes are fine, but not so desirable that the leadership would really want to “negotiate” or to concede much to get them. That leaves the process of “budget reconciliation” as the likely process, especially for a clearly fiscal agenda like tax legislation. But while “reconciliation” famously does not need 60 votes in the Senate, the 60-vote requirement cannot be avoided just be using the label “reconciliation.” There must first be a “budget resolution,” setting out broad guidelines for the inputs of multiple committees that will be brought together and “reconciled.” If that budget resolution is not passed by March, or perhaps April, tax reform will be behind schedule.

E. Budget reconciliation can be used only once a year. It is limited to fiscal matters. And it is limited further by constraints like the impropriety of affecting budget outcomes beyond an arbitrary budget window – most recently ten years. We all remember (or have heard about) the peculiar one-year “repeal” of the estate tax that was enacted in budget reconciliation in 2001. Sunsets are not inevitable. There are workarounds. The Taxpayer Relief Act of 1997 was also enacted through budget reconciliation, with substantial permanent estate tax cuts. But both 1997 and 2001 presented much different fiscal environments. In June 2001, when the Economic Growth and Tax Relief Reconciliation Act of 2001 was enacted – before 9/11, Afghanistan, and Iraq – budget surpluses of trillions of dollars were forecast for the coming decade. EGTRRA included only a modest one and one-third trillion dollars of tax cuts! Today the forecasts are only more deficits.

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F. Predictions are hard. The Trump Administration, and the political tone it sets, will not be conventional. There are no useful behavioral baselines. The fiscal climate is grim. And Republican leaders have many priorities and many diverse and sometimes combative constituencies to which they have made many promises.

G. All anyone can do is guess. With that in mind:

1. The technical paths to permanent repeal of the estate tax are complicated and maybe risky to Republicans (especially to the extent they need Democratic support).

2. The unexpected surge of disillusioned middle-class voters that propelled President-Elect Trump to victory may not be very excited about the estate tax.

3. The attractiveness of repeal even to traditional supporters may be blunted by the prospect of having to keep the gift tax, or having to deal with a scary new capital gain or basis regime, and attempts to “have it all” will cost still more and look still more greedy.

H. Conclusion: Repeal of the estate tax in 2017, permanently or temporarily, would require political capital that the Republican leadership will probably decide to spend elsewhere. A compromise reduction of rates by 5 or 10 percent is possible, and even with high exemptions there might actually be some justification in tax policy for bringing transfer tax and income tax rates closer together. But that too would look expensive and possibly too greedy. All anyone can do is guess.

IV. Variables in Tax Reform

A. Until there is a firm, detailed proposal for repeal or reform of the estate, gift and generation-skipping taxes, there are too many variables to permit planners to anticipate the best planning options under a future new tax regime.

B. Consider, for example, the following list of open questions.

1. Will the estate tax be repealed and basis step-up at death retained?

2. Will the Section 1014 basis step-up rules be replaced with carryover basis at death (as in 2010) or with a Canadian style capital gains tax at death?

3. Will the gift tax be retained, and, if so, with the current 40% rate and indexed $5 million applicable exclusion?

4. Will the generation-skipping tax be fully repealed or retained for lifetime transfers?

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5. If the generation-skipping tax is fully repealed, will previously created irrevocable trusts (even non-exempt trusts) all become exempt from any generation-skipping tax?

6. If the generation-skipping tax is fully repealed, will both old and new irrevocable trusts be treated as grandfathered if irrevocable when and if a new generation-skipping tax is later enacted?

7. If the estate tax is repealed and later restored how will pre-repeal marital trusts be treated? Will taxpayers have the option to designate a post-repeal QTIP marital trust as non-QTIP (so it will not be included in a surviving spouse’s estate post reenactment)?

V. Lifetime Planning Techniques

A. Under current law, the sophisticated and well-advised taxpayer typically follows a particular sequence in making gifts, starting with those that have the least tax impact and are the easiest to implement, and then moving to gifts that have permanent tax consequences and/or involve more complex planning. That sequence typically is:

1. Annual exclusion (IRC §2503(b)) and education and medical exclusion (IRC §2503(e)) gifts;

2. Lifetime exclusion gifts;

3. Value-shifting and split interest gifts (Grantor Retained Annuity Trusts; Qualified Personal Residence Trusts; Sales to a grantor trust for a note; Loans; Charitable Lead Trusts; Partnership or LLC freezes); and

4. Gifts that require payment of gift tax.

B. With virtually all these gift techniques, there may be opportunities to leverage the gifts using valuation discounts when transferring closely held assets.

1. A fundamental goal in the use of limited partnerships and LLCs in planning has been to create valuation discounts for pools of assets for which such discounts might not otherwise exist (marketable securities, notes, real estate for example).

2. Section 2704, and the new proposed regulations under that section, are a direct response to this planning.

C. In light of the prospects for tax reform, an initial question raised by many clients is why engage in lifetime planning at all. If the estate tax is repealed, the need for lifetime transfers to reduce future estate tax goes away.

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1. The only lifetime planning that a taxpayer should not undertake right now is any transfer that involves the planned payment of gift tax. Most practitioners believe the gift tax will be preserved because of its role in minimizing transfers to reduce income tax. But it is not certain. Several bills introduced in Congress over the last few years called for repeal of both the estate tax and gift tax.

2. Beyond this, it is dangerous to assume that estate tax repeal will definitely occur, or if it does, that it will be enacted soon. As pointed out earlier in the materials, the Republicans have plans for broader tax reform, and it is difficult to know what will receive the highest priority and which goals may be sacrificed either because of budget constraints or in exchange for support of other initiatives. As asset values continue to rise, opportunities to shift appreciation will be lost for those taxpayers that sit on the sidelines.

3. Should repeal of the estate tax occur, the most important question that sophisticated taxpayers should ask is “What can I accomplish to shelter assets in case it comes back?”

4. If there still is a gift tax, the lifetime planning options likely will not change a lot, but there almost certainly will be some unique opportunities because the risk of estate inclusion and estate tax will be gone, if the transferor dies while repeal is still in place.

5. At the same time, if there is no estate tax but still a basis step-up at death, practitioners will want to build into trusts mechanisms to trigger the basis step-up for a transferor who dies while there is no estate tax in effect.

6. There will be additional generation-skipping opportunities if the generation-skipping tax also has been repealed.

VI. Annual Exclusion and Section 2503(e) Gifts

A. Annual Exclusion Gifts

1. The Internal Revenue Code currently provides an exclusion from gift tax for the first $10,000 (indexed for inflation) given to any donee in any year (IRC § 2503(b)). The annual exclusion amount is indexed in $1,000 increments. The indexed amount since 2013 has been $14,000. It is expected to rise to $15,000 in 2018.

2. If the individual is married, he or she can double the annual exclusion by gift-splitting — using one spouse’s funds and having the non-donor spouse consent to treat gifts made as being made one-half by each of the spouses (IRC § 2513). For purposes of the gift splitting rules, an

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individual is treated as the donor’s spouse if married at the time of the gift, and if he or she does not remarry during the remainder of the calendar year (IRC 2513(a)(1)).

a. Gift-splitting is an all or nothing proposition. The consent must apply to “all...gifts made during the calendar year by either while married to each other” (IRC § 2513(a)(2)). This is an important point that many couples and professionals do not realize. It is especially important in second marriages. Spouse readily may agree to split annual exclusion gifts to their respective children and/or families, but doing so also means that any taxable gifts during the year are split and both spouses’ applicable exclusions are used.

b. The only exception to this rule is that the gift cannot be split to the extent it is to or for the benefit of the spouse. If a donor makes a gift to an irrevocable trust of which the spouse is one of the beneficiaries, the gift cannot be split unless, at the time of the gift, the interests of the other beneficiaries are ascertainable and identifiable separate from the spouse’s interest (Treas. Reg. § 25.2513-1(b)(4)).

3. The benefits that can be derived from making $14,000 annual exclusion gifts should not be underestimated. In substantial estates, simple cash gifts of $14,000 can generate a federal estate tax savings of at least $5,600 for every transferee involved, assuming a 40% estate tax rate.

EXAMPLE: Frank has extensive assets and three children (two of whom are married) and five grandchildren. If Frank has an estate that would be taxed in the 40% bracket, gifts of $14,000 to each of the three children, to the spouses of the two married children, and to each of the five grandchildren would entail transfers of $140,000. These transfers would result in a federal estate tax savings of $56,000. If Frank continues this gift program for ten years, his taxable estate will be reduced by $1,400,000, saving $560,000.

4. In some families, it is not unusual for an elderly family member to have 20 or more living descendants. A donor with 25 descendants could transfer $350,000 per year, entirely tax free.

5. The annual exclusion is only available for gifts of present interests. Gifts of future interests, that is, gifts in which the donee’s absolute, unrestricted right to enjoyment of the property is deferred until some future time, do not qualify (see Treas. Req. § 25.2503-3(a)). The regulations state the rule as follows: “An unrestricted right to immediate use, possession, or enjoyment of property or the income from property (such as a life estate or term certain) is a present interest in property.” This means that many gifts

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in trust do not qualify for the annual exclusion unless the trust is properly structured.

a. An annual exclusion is available for gifts made to qualifying annual exclusion trusts. These trusts, known as minor exclusion trusts, or 2503(c) trusts, after the tax code provision authorizing them (IRC § 2503(c)), must provide that the principal or income may be used for the benefit of the minor beneficiary before he reaches age twenty-one, and, to the extent that the property is not so expended, it must pass to him outright (or be available for withdrawal) at that time.

b. The other type of trust that can be used to qualify a gift for all or part of the annual exclusion is a Crummey power trust. The trust derives its name from the court case that established its effectiveness (Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968)).

6. In Revenue Ruling 76-360, 1976-2 C.B. 298, the IRS ruled that the donor’s transfer of non-income-producing stock to his children did not qualify for the annual exclusion. The stock was subject to agreements that prohibited the donees from selling, pledging or otherwise disposing of the stock for two years. Those restrictions and the absence of any income lead the IRS to conclude that a gift of the stock was not a gift of a present interest.

a. In Hackl v. Commissioner, 118 T.C. 279 (2002), aff’d, 335 F.3d 664 (7th Cir. 2003), the court ruled that gifts of member interests in an LLC (Treeco) that held timberland did not qualify as gifts of present interests because of the lack of income and limited rights of the donees. Other Tax Court cases have followed this case where the rights of the recipients of LLC or LP interests were limited.

b. Based on these cases, it is important that the entity terms not be too restrictive with respect to transfers of interests, and that some income be distributed.

7. As a result of changes enacted in 1988, annual exclusion gifts that benefit multiple generations are not automatically exempt from GST tax. For transfers on or before March 31, 1988, a gift that qualified for the annual exclusion for gift tax purposes also was GST exempt. The 1988 changes limited this exempt treatment to (i) outright direct skip gifts (including custodial gifts) that qualify for the gift tax annual exclusion; and (ii) only certain direct skip annual exclusion gifts in trust.

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a. If the direct skip gift is in trust, it will be a nontaxable gift only if the trust is for a single beneficiary and the trust property will be included in that beneficiary’s gross estate for federal estate tax purposes if the trust is still in existence at the beneficiary’s death.

b. Because of these changes, an individual no longer can avoid GST tax by making annual exclusion gifts to Crummey trusts or irrevocable insurance trusts with Crummey powers that benefit multiple generations, unless GST exemption is allocated.

B. Transfer For Educational Or Medical Expenses

1. Tuition payments made directly to an educational organization on behalf of a person, and payments for a person’s medical care made directly to the provider are not treated as taxable gifts (IRC §2503(e)). This can be an important exclusion for planning purposes. For example, grandparents who already take full advantage of the annual exclusion for gifts to grandchildren can make additional tax-free transfers by paying their grandchildren’s tuition for private school or college. In the case of both educational and medical expenses, the payment must be made directly to the provider.

2. The education expense exclusion is limited to tuition. Tuition means the amount of money required for enrollment. It includes tuition for part-time students. It does not cover books, supplies, room and board or similar expenses (see Treas. Reg. §25.2503-6(b)(2)(3)).

3. To constitute a qualifying transfer, the payment of tuition must be to an educational organization described in Section 170(b)(1)(A)(ii)(see IRC § 2503(e)(2)(A)). Section 170(b)(1)(A)(ii) defines an educational organization as one that normally maintains a regular faculty and curriculum and has a regularly enrolled body of students in attendance at the place where the educational activities are being carried on (Treas. Reg. § 1.170A-9(b)(1)). The presentation of formal instruction must be the primary function of the organization.

4. Qualifying medical expenses are defined by reference to Code Section 213(d) (see IRC § 2503(e)(2)(B)). The exclusion applies to payments for (i) the diagnosis, cure, mitigation, treatment or prevention of disease, (ii) the purpose of affecting any structure or function of the body, or (iii) transportation primary for and essential to medical care. (Treas. Reg. § 25.2503-6(b)(3)). Payments for medical insurance are covered.

C. Planning in the Current Environment

1. As noted above, annual exclusion gifts and Section 2503(e) transfers can be extremely effective ways to reduce one’s estate on an annual basis without using any exclusions that are limited in amount.

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2. Regardless of tax benefits, they also are an easy way to make one’s wealth available to descendants. Many clients use annual exclusion gifts to supplement the income of children and grandchildren. That will not change if the estate tax is repealed.

3. If the GST tax is repealed, then the current limitations on what annual exclusion gifts are also excluded from the GST tax rules will disappear and clients will be able to make broader use of long-term trusts funded in part with annual exclusion gifts.

4. For those clients who use the annual exclusion to make gifts of family business interests or interests in family investment entities, the Section 2704 proposed regulations, if finalized, may reduce how much can be transferred in a given year. Clients who make these gifts should consider using formula gifts (a Wandry-type provision) if the new regulations are finalized, especially for the time period during which everyone is working out (or litigating) the extent of the impact of the regulations.

5. Planning around payments of taxation or medical expenses will remain largely unchanged.

VII. Taxable Gifts and Use of the Applicable Exclusion

A. Wealthy individuals have traditionally turned to larger taxable gifts and use of the applicable exclusion to move future appreciation out of their estates.

1. The increase in the applicable exclusion to $5,000,000 plus meant that individuals and couples could move significant amounts out of their estates without any current tax – in fact in many cases more than they would be willing to give up.

2. The increased exclusion, and enactment of portability, has resulted in some commentators suggesting that the applicable exclusion should not be used during life. Instead, it should be preserved to provide basis step-up at death, with techniques such as GRATs and sales for a note used to transfer appreciation during life. See, e.g., Paul S. Lee, “Venn Diagrams: Meet Me at the Intersection of Estate and Income Tax,” 48th Annual Heckerling Institute on Estate Planning, at 2-17 (2014).

3. This point of view derives from the fact that, the shelter provided by the applicable exclusion amount does not exclude the property transferred from the transfer tax system. Because the unified estate and gift tax system adds adjusted taxable gifts back to an individual’s estate at death, the value of the property transferred by taxable gift at the time of the transfer does not escape tax.

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4. Because the value of the taxable gift itself is not excluded from the estate tax calculation, the primary benefit of a taxable gift is removing the future appreciation of and earnings from the gifted property from one’s estate.

EXAMPLE: Fred transfers $1,000,000 of stock to an irrevocable trust. Ten years later, when Fred dies, the stock still is worth $1,000,000. The stock does not pay a dividend. On Fred’s estate tax return, $1,000,000 of adjusted taxable gifts is added to his taxable estate to determine the tentative tax base. Fred did not save any transfer taxes by making the gift.

EXAMPLE: Gretchen transfers $1,000,000 of stock to an irrevocable trust. Over ten years, the stock provides an average total return of 6% per year after tax. When Gretchen dies in year ten, the trust holds $1,790,848. A total of $790,848 escaped tax in Gretchen’s estate, saving $316,336 (40% of $790,848).

5. Any property transferred by gift retains the tax basis it had in the transferor’s hands. IRC § 1015. Any property included in a decedent’s estate of course receives a step-up in basis. IRC § 1014.

a. These rules lead to the common advice that higher basis assets are the best ones to transfer by gift.

b. Given the federal capital gains tax rate, compared to the estate tax rate, the lack of a basis step-up should not stop someone from making a taxable gift. However, it is a relevant factor for an older client or one in poor health. In either case, the asset may not appreciate much between the date of the gift and the transferor’s death. If the donee is likely to sell the asset, it may be better to have it pass through the decedent’s estate rather than give it away.

EXAMPLE: Linda, age 90, makes a taxable gift to her daughter of $500,000 of stock with a $50,000 basis. Linda dies two years later. The stock has appreciated to $570,000. The $70,000 escaped tax in Linda’s estate saving $28,000. Linda’s daughter sells the stock shortly after her mother’s death. She incurs $520,000 of gain, and pays at least $104,000 of income tax due to the sale (assuming a 20% capital gains tax and no 3.8% surtax).

6. If the property transferred is an asset the donee will retain for a long time, such as a vacation property, then the basis should be much less of a factor. Other factors include the ability of the donee to defer any gain (such as through a like-kind exchange) or offset gain with accumulated capital loss carry forwards.

7. This principle is nothing more than a current expression of the fundamental principle that the sooner one uses the exclusion the better. Obviously many individuals cannot afford to give away $1,000,000 during

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life. For those that can, the advantages of using the exemption early can be substantial.

EXAMPLE: Paul and Peter are twins and partners in a family partnership. Each of their interests is currently worth $4,000,000. Paul transfers away one-fourth of his interest ($1,000,000) to an irrevocable trust for his children. Peter decides not to make a similar gift. Ten years later, Peter reconsiders and decides to make a taxable gift to use $1,000,000 of his lifetime exemption. The partnership assets have grown an average of 7% per year during the 10-year period. The trust Paul created now holds $1,967,150. By using his exemption when he did, Paul moved an additional $967,150 out of his estate. Put another way, because he waited, Peter can transfer only about 12.7% of his partnership interest out of his estate with a $1,000,000 gift.

8. State tax laws also may impact the overall analysis. In states like New York and California, the combined federal and state capital gains tax rate is very high, approaching 40%. On the other hand, in states with a state death tax and no gift tax, 100% of lifetime gifts escape the state death tax.

B. Planning in the Current Environment

1. To reiterate a prior point, clients who have appreciating assets and decide to sit on the sidelines hoping for repeal are missing opportunities to transfer appreciation out of their estates.

2. Estate planning practitioners should consider including provisions in trusts that will receive applicable exclusion gifts to trigger including the assets in the transferor’s estate if the estate tax is repealed and basis step-up at death is preserved. If there is a carry-over basis regime after tax reform, it may not matter.

3. As with annual exclusion gifts, if closely-held stock or LLC or LP interests are being transferred, and the Section 2704 regulations are finalized, the use of formula gift clauses will help in dealing with valuation uncertainty.

4. Grantor trusts should continue to be the preferred recipient for larger gifts. A client who wants to transfer value during life will be more successful if he or she remains responsible for the income taxes on trust assets. A grantor trust also allows the grantor to easily swap out low-basis assets for other assets of equal value, if there is a basis step-up at death.

5. If both the estate tax and gift tax are repealed, then other, more complex, lifetime transfer techniques will become irrelevant. But the high net worth client with appropriate skepticism about the permanence of repeal will look to make significant direct gifts of excess wealth in trust for his or her descendants.

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a. Planners could craft additional controls that the grantor could retain (of the type that under current law would cause Sections 2036 or 2038 to apply) but which could be turned off if it appears a new estate tax will be enacted.

b. For the appropriate client, some wild planning could be implemented if there was a period with no gift tax or estate tax.

EXAMPLE: An extremely high net worth individual, Jane, is comfortable transferring half her wealth into long-term trusts for descendants. She does this, and then transfers the other half of her wealth into trusts for her children. Her children in turn exercise lifetime powers over the trusts to transfer most of it to modified trusts of which Jane is the primary beneficiary. Jane has a 4% unitrust payout (enough to fully support her lifestyle) and a right to distributions for health and support in the discretion of the trustee. Her estate is effectively zero, should the estate tax come back.

VIII. Value Shifting Gift Techniques

A. There are several lifetime transfer techniques that work on the principle that the transferor’s assets will grow at a higher rate than is assumed by the IRS. The IRS has two primary rules that create an assumed rate of return for transfer tax purposes.

1. Section 7520 Rate. For administrative convenience, the IRS publishes tables for determining the fair market value of a life estate, an income interest for a term of years, a noninsurance annuity interest, a remainder interest, and a reversionary interest.

a. In determining a present value, the tables incorporate certain mortality assumptions, and assume a fixed rate of return for assets. Since 1988, the assumed rate of return is adjusted monthly. It is commonly referred to as the “Section 7520 rate.” The Section 7520 rate is 120 percent of the applicable federal mid-term rate in effect under Code Section 1274(d)(1) for the month, rounded to the nearest two-tenths of 1 percent.

b. The Section 7520 rate is determined by reference to yields of U.S. Treasury obligations, and is therefore tied to the financial markets. In January, 2001, the rate fell under 7%, to 6.8%. Since January 2001, it has remained under 7%. The August 2007 rate was 6.2% and it has been under 6% ever since. From June 2011 until now (March 2017), it has been under 3%.

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2. Applicable Federal Rate. Likewise, in lending transactions, the key rate for income and transfer tax purposes is the applicable federal rate (“AFR”) referred to above. Interest is adequate if it at least equals the AFR. The AFR is set monthly. There are actually three AFRs, depending on the term of the loan:

Short-Term AFR Mid-Term AFR Long-Term AFR

Term

Not over 3 years Over 3 years to 9 years Over 9 years

March 2017 AFR (Annual)

1.01% 2.05% 2.78%

In addition to publishing the monthly AFRs based on annual payments or compounding, the IRS publishes the rates based on semi-annual, quarterly, or monthly payments or compounding.

B. The AFR also is relevant in determining whether a promissory note issued in an installment sale bears sufficient interest to support the face value of the note. If the interest rate is insufficient, the face value of the note will be discounted in determining its value (as is true with any fixed-return obligation). For this purpose, the IRS has taken the position, which was accepted by the Tax Court, that a note must state interest at least equal to the relevant AFR to avoid being discounted. See Frazee v. Commissioner, 98 T.C. 554 (1992).

1. The Treasury Regulations provide even stronger support. Section 25.2512-4 states: “The fair market value of notes, secured or unsecured, is presumed to be the amount of unpaid principal, plus accrued interest to the date of the gift, unless the donor establishes a lower value.”

2. Section 7872 and the proposed gift regulations thereunder reinforce this by providing that a term loan is not a below-market loan if the amount loaned does not exceed the present value of all the payments due under the loan, which it will not if the interest is at or above AFR.

3. Finally, proposed Treas. Reg. § 25.2512-8 states that, in determining whether a transfer is for insufficient consideration, if a buyer in a sale has issued a debt instrument as part of the consideration, then the debt instrument should be valued as provided in Treas. Reg. § 1.1012-2. Treas. Reg. § 1.1012-2(b)(1) states that the value of a debt instrument which has adequate stated interest (that is, interest at least at the AFR) is its face amount.

4. Thus, in installment sale transactions, estate planners look to the AFR as the floor on the interest rate that can be used.

C. The four primary techniques that take advantage of these rules are:

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1. Grantor Retained Annuity Trust;

2. Charitable Lead Annuity Trust;

3. Sale to a Grantor Trust; and

4. Loans to family member or grantor trusts.

In each case, these techniques work to shift value because assets outperform the rate of return assumed by the IRS. In this regard, all also have economic risk. If the assets transferred (or purchased with the loan) do not appreciate, or depreciate, the techniques will fail.

D. Grantor Retained Annuity Trusts

1. A GRAT is an irrevocable trust in which the grantor retains the right to receive a fixed dollar amount annually for a set term of years. At the end of that period, any remaining property passes as provided in the trust, either outright to designated beneficiaries or in further trust for their benefit. For a GRAT to be successful, the grantor must survive the annuity term. If the granter dies during the term, except in extraordinary cases, the entire value of the GRAT will be included in the grantor’s estate.

2. The transfer of property to a GRAT constitutes a gift equal to the total value of the property transferred to the trust, less the value of the retained annuity interest. The value of the annuity interest is determined using the valuation tables under Section 7520 and the applicable interest rate for the month of the transfer. Most taxpayers structure the trust so it is a “zero-out GRAT.” By structuring the GRAT so the value of the annuity equals the value of the property transferred, the taxpayer can avoid using applicable exclusion or paying gift tax.

EXAMPLE. When the Section 7520 rate is 2.2%, an individual creates a two-year GRAT and funds it with $5,000,000 of stock that has a current price of $25 per share. He retains the right to receive an annuity of 51.6556% each year for the two years. The value of the annuity is $5,000,000, and the gift when the individual creates the trust is zero. If the stock increases to $30 per share after one year, and $36 per share at the end of two years (a 20% increase each year), there will be $1,517,884 left in the GRAT at the end of the two years to pass to children tax-free:

Initial Value of Stock: $5,000,000 End Year 1 Value 6,000,000 Annuity to Grantor: (2,582,780) Beginning Year 2 Value $3,417,220

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End Year 2 Value: $4,100,664 Annuity to Grantor: (2,582,780) Property Remaining for Children: $1,517,884

3. A GRAT can be any term of years. Often it is advantageous to use a short

term – two years or three years. The property transferred to a two-year GRAT needs to sustain a high growth rate for only a short period of time for the GRAT to be successful. If the property does not appreciate as anticipated, it all is returned to the grantor in the annuity payments. The grantor then can create a new GRAT.

4. If a short term GRAT is used, it is better to isolate separate stocks in separate trusts so that the losers do not pull down the winners.

5. The annuity does not have to be an equal amount each year. It can be defined as a fixed initial amount, increased by up to 20% in each subsequent year.

6. A GRAT should be treated as a grantor trust with respect to all trust income. This is an important additional benefit. It means that a GRAT can be funded with stock or partnership interests or real estate, and that asset can be paid back to the grantor to satisfy the annuity obligation without the distribution of the asset being treated as a sale.

7. At the end of the annuity term, the property in the GRAT can be distributed outright to the grantor’s children or other beneficiaries, or retained in trust. One advantage of retaining the property in trust is that the grantor’s spouse can be a beneficiary, thereby permitting the couple to have some access to the property during the spouse’s life and causing the trust to continue to be a grantor trust.

8. GRATs have a significant advantage over other gifting techniques because of the ability to define the retained interest as a percentage of the initial value of the gifted property “as finally determined for federal gift tax purposes”. Thus, if the gift value is doubled, so is the retained annuity, and there is little or no increase in the amount of the gift.

9. A GRAT cannot, by itself, be used to leverage generation-skipping transfers. Under Code Section 2642(f), applicable to transfers made after September 25, 1985, an individual is prevented from allocating GST exemption to lifetime transfers of property during the period that such property would be included in the individual’s gross estate (other than by reason of Code Section 2035) if the individual died. Only at the end of this “estate tax inclusion period” (referred to as an ETIP) will the allocation of exemption be effective, based on the property’s value at the close of this period (or, if a timely allocation is not made after the estate tax inclusion period ends, then at the time of later allocation).

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E. Charitable Lead Trusts

1. A charitable lead trust, or CLT, is sometimes used to try to accomplish the same benefits as a GRAT in situations where the client has a strong interest in also benefiting charity. With a CLT, the charitable beneficiaries receive a stated amount each year for a specified term of years or for the life or lives of an individual or individuals, and at the end of the period the remaining corpus is distributed to or in trust for the grantor’s descendants or other noncharitable beneficiaries.

2. As with charitable remainder trusts, lead trusts may be one of two types--either an annuity trust (“CLAT”), in which the charitable beneficiary receives a sum certain, or a unitrust (“CLUT”), in which the charity receives a fixed percentage of the value of the trust property. A CLAT can be structured as a zero-out gift, with the charitable annuity equaling the value of the property transferred.

3. The lead trust is very flexible; it may allow the trustee discretion in determining which charities will receive payments, or it can provide for specific charities. There is no minimum payout for a charitable lead trust, and it can be for any term of years. The trust may be created irrevocably during life or at death. The annuity or unitrust payment can be structured in any way (fixed, increasing or varied).

4. Upon creating the trust, the grantor makes a gift to charity of the present value of the charity’s right to receive trust payments. This gift qualifies for the federal gift tax charitable deduction. Generally, when the grantor creates the trust, he or she will not receive an income tax charitable deduction.

a. One exception is where the CLT is a grantor trust, in which the trust income is taxable to the grantor under the applicable income tax rules. In this case, the grantor is entitled to claim an income tax charitable deduction in the taxable year in which the trust is created for the present value of the annuity interest.

b. The deduction will, however, be subject to a limitation of 30 percent of the grantor’s contribution base (20 percent if long-term capital gain property is used to fund the trust) because contributions to a charitable lead trust are treated as “for the use of” the charitable donees. Treas. Reg. § 1.170A-8(a)(2).

c. In addition, the income of the trust in the years after its creation will be taxable to the grantor, with no further charitable deduction allowed, even though the trust actually distributes the income to charity.

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5. If the CLT is not a grantor trust, the grantor will not receive any income tax charitable deduction for the amounts paid to charity, either when the trust is created or subsequently. However, the income generated by the trust’s assets will be removed from the grantor’s gross income. Thus, the income tax effect on the grantor will be equivalent to his receiving an income tax charitable deduction each year, but without the applicable percentage limitations for contributions.

6. The primary appeal of a CLT is the potential transfer tax benefit that can be obtained while fulfilling pre-existing charitable giving goals. A CLAT can be structured so that the value of the remainder interest is zero like a zero-out GRAT.

EXAMPLE: If an individual transfers $1,000,000 to a CLAT to pay one or more charities a $83,770 annuity each year for 15 years, and the Section 7520 rate at the time is 3%, the annuity interest will be valued at $1,000,000 for gift tax purposes, and the trust remainder will be zero. If the trust earns 5%, then $271,290 will remain at the end of the term and will pass to the remainder beneficiary at the end of the annuity term free of gift tax. If the trust earns 7% annually, almost $654,000 will remain after 15 years.

7. Generation-skipping is also difficult with a CLAT. Effective for trusts created after October 13, 1987, Code Section 2642(e) provides that the generation-skipping applicable fraction for a CLAT shall be a fraction whose numerator is the “adjusted GST exemption” and whose denominator is the value of the trust property immediately after the termination of the charitable interest.

a. The “adjusted GST exemption” is defined as an amount equal to the GST exemption allocated to the trust when it is created, compounded annually over the charitable term at the interest rate used to determine the value of the charitable interest under the applicable valuation tables.

EXAMPLE: An individual creates a $1 million CLAT trust to pay an annual annuity of $80,000 to charity for 10 years, and to pay the trust principal remaining at the end of that period to his grandchildren. Assume that the Section 7520 rate used to value the transfer is 4%. Under the valuation tables, the gift tax value of the charitable gift is $648,870, and the gift tax value of the remainder is $351,130. If the individual allocates $351,130 of GST exemption to the trust, the adjusted GST exemption at the end of the annuity term would be $519,760 ($351,130 compounded at 4% annually for 10 years).

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b. If the value of the trust principal at the end of the charitable term does not exceed the adjusted GST exemption, the trust will be entirely sheltered from GST tax, and there will be no tax when the property passes to the grandchildren. However, if the trust principal has remained at $1 million, or has appreciated to a greater amount, then the trust will not be entirely GST exempt. If the individual is still living at that time and has sufficient additional GST exemption left, he could make an additional allocation of GST exemption to the trust and avoid the shortfall. Otherwise, GST tax will be incurred when the charitable term expires.

F. Sale to “Intentionally Defective” Grantor Trust

1. The sale to an “Intentionally Defective” Grantor Trust (that is a trust purposefully made a grantor trust) combines the long-recognized advantages of a sale in exchange for a promissory note with the benefits of a grantor trust. Since a grantor trust is not treated as a separate taxpayer for income tax purposes, the transaction is not treated as a sale for tax purposes and the resulting capital gain from the sale, and the interest charges, are eliminated.

EXAMPLE: Carl creates an irrevocable gift trust and funds it with a gift of $1,000,000. The trust is structured as a grantor trust. Carl then sells a $5,000,000 asset to the trust for a 15-year installment note, bearing an interest rate of 2.58% (the applicable long-term AFR) with a balloon payment due at the end of the term. The trust asset produces a return of about 5% per year. The trust pays the interest of $129,000 each year. At the end of 15 years, the trust will have a value of $9,689,930, or $4,689,930 after repayment of the note.

2. Valuation of the property sold. In a sale transaction, the asset being sold usually will not be publicly-traded and therefore will be subject to valuation uncertainties.

a. The first step in avoiding a gift due to IRS revaluation of the property is to obtain a well-written appraisal of the asset and any applicable valuation discounts.

b. The next logical step in minimizing valuation risk is to build into the transaction some form of adjustment clause that resets the transaction terms in response to changes in the value of the asset. The ability to use an adjustment provision has been a rapidly evolving area of the law in the past six years.

c. The IRS traditionally has challenged any adjustment provision as a savings clause that is against public policy. See Comm’r. v.

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Proctor, 142 F. 2d 824 (4th Cir. 1944), cert. denied, 323 U.S. 756 (1944); Rev. Rul. 86-41, 1986-1 C.B. 300.

d. The legal landscape changed in 2006. Practitioners began structuring adjustment clauses based on McCord v. Comm’r, 461 F.3d 614 (5th Cir. 2006). There the taxpayers made gifts of a defined dollar amount of interests in a limited partnership to their children and trusts, with any limited partnership interests in excess of the defined dollar amount going to charity. On audit, they successfully argued that the IRS’ proposed increases in value could only have the effect of shifting more property to charity, rather than causing an additional gift.

e. In the latest Tax Court case, Wandry v. Comm’r, T.C. Memo 2012-88, the taxpayer used a simple formula transfer clause:

“I hereby assign and transfer as gifts, effective as of January 1, 2004, a sufficient number of my Units as a Member of Norseman Capital, LLC … so that the fair market value of such units for federal gift tax purposes shall be as follows: … Kenneth D. Wandry … $261,000 …”

A list of donees and gift amounts followed.

f. The court rejected the application of the public policy reasoning of Procter and concluded that the parents made gifts of specific dollar values of units. The court made a distinction between a formula clause that might result in a later adjustment and a savings clause that sought to unwind or adjust gifts that were of a fixed number of shares or units.

3. Valuation and attributes of the promissory note. – If the note is not given arm’s length attributes, or the trust that is purchaser of the asset does not have sufficient independent assets, the IRS could argue the note has a value that is less than face value. This would result in a gift.

a. As noted earlier, the IRS would need to overcome regulatory presumptions about the face value of the note, but that is not insurmountable if the taxpayers structure the transaction in a manner that would never be done in arm’s length transactions.

b. In the alternative, the IRS could claim the note is not really debt, and if the grantor dies while the note is outstanding, it could treat the transfer as a gift with retained interest in the trust, resulting in application of Section 2036.

c. Many tax professionals recommend that the trust should be separately funded with assets having a value equal to at least 10%

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of the purchase price in the installment sale, in order to minimize the likelihood of the IRS claiming a gift occurs. See Letter Ruling 9535026, where the IRS suggested that a minimum of 10% equity in the trust would give validity to the transaction.

d. This creates a possible limit on the size of the transaction. If a client wants to sell a $30 million interest in a company to a grantor trust, he arguably should first fund the trust with a gift of $3 million. The client may not have that much exclusion remaining.

e. Some practitioners use guarantees to support the legitimacy of the transaction and the value of the note. For example, a child with financial resources who is a beneficiary of the trust that acquires the asset could guarantee payment of the note to the trust.

(i) In some cases, a guarantee is used instead of seed money.

(ii) More frequently, it is used to support the seed gift, or where the grantor does not have enough gift exclusion remaining to provide an adequate seed gift.

4. Income tax consequences of death of grantor. If the grantor dies while the note is outstanding, the IRS could treat the conversion of the trust to a non-grantor trust as a taxable event.

a. There is authority supporting the conclusion that the grantor’s death is a taxable event for income tax purposes. This conclusion is based on the authority that treats a termination of grantor trust status during the grantor’s life as a taxable event. See Treas. Reg. §1.1001-2(c), Example 5; Madorin v. Comm’r., 84 T.C. 667 (1985); Rev. Rul. 77-402, 1977-2 C.B. 222.

b. Many practitioners have concluded that the death of the grantor should not be treated as a taxable event. For an extensive discussion of this issue, see Blattmachr, Gans, and Jacobson, “Income Tax Effects of Termination of Grantor Trust Status by Reasons of the Grantor’s Death”, 97 J. Tax’n 149 (Sept. 2002) (hereafter “Income Tax Effects of Termination”).

c. It is clear that regardless of the treatment of the transaction from capital gain purposes, interest payments made after the death of the grantor will be taxable to the recipient.

d. The risk of a taxable event at the death of the grantor can be avoided if the note is fully paid during the grantor’s life. An extremely long-term note or a note with a balloon principal payment is less likely to be paid in full while the grantor is alive.

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This of course means that the risk of confronting one of these tax issues is greater.

5. Generation-Skipping. An individual can engage in generation-skipping tax planning with a sale to a grantor trust by allocating GST exemption to the trust. If an individual gifts $500,000 to a grantor trust, and then sells $5,000,000 worth of stock in exchange for a note from the trust, she would need to allocate only $500,000 of GST exemption to the trust, an amount sufficient to cover the initial gift.

G. Low-Interest or Interest-Free Loans

1. A simple way for a client to take advantage of a low interest rate environment is to lend funds at the AFR to a child, grandchild or trust for the benefit of one or more descendants, to enable the recipient to take advantage of investment opportunities with a potential for high returns.

EXAMPLE: Clara creates an irrevocable grantor trust for the benefit of her descendants. Clara makes a $1,000,000 taxable gift to the trust which she splits with her spouse, and which uses a portion of their applicable exclusion amounts. They allocate GST exemption to completely exempt the trust. Thus, after the gift, they have a $1,000,000 trust that is completely exempt from gift, estate and GST taxes. Several months later, Clara lends an additional $2,000,000 to the trust for a 5-year note bearing interest at 1.67% annually (the mid-term AFR). The principal is due in a balloon payment at the end of the term.

2. The trust has obtained $2,000,000 of investment capital at a rate less than what is available commercially.

a. The annual interest cost for the loan is $33,400 (1.67% of $2,000,000), or $167,000 in total over three years.

b. If the trust invests the $2,000,000 and earns a return of 7% annually over 5 years, it will earn over $105,000 per year on the spread. (This is in addition to earnings on the original $1,000,000 corpus received by gift.)

c. After the repayment of principal after 5 years, the trust will have $613,025 remaining from the loaned funds, plus the $1,000,000 originally given to the trust plus investment earnings on that $1,000,000.

3. If the trust is structured as a grantor trust, the grantor will be responsible for all income taxes on income generated by the trust. In addition, the annual interest payments on the loan will not be taxable income to the grantor. In the foregoing example, the annual $33,400 of interest payments to Clara will not be taxable income to Clara.

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4. A client should not make a loan to a grantor trust that has no other assets. The same principles apply here as apply in the installment sale context. If the trust has no other assets, there is a risk that the IRS could treat the loan as not bona fide and recharacterize it.

H. Planning in the Current Environment

1. Taxpayers frequently use GRATs and sales to an IDGT with closely-held assets.

a. As previously discussed, a formula transfer clause will help with possible valuation adjustments that may be more unpredictable if the Section 2704 regulations are finalized.

b. But GRATs are even better. A zero-out GRAT will always result in no gift. If the value of the assets transferred to the GRAT is adjusted on audit, the amount of the annuity will change, but not the amount of the gift.

c. For situations where the client has the available funds, large cash loans avoid the Section 2704 issues entirely.

2. If the estate tax is repealed, these techniques will continue to provide benefits for those clients who want to shift value out of their estates, should the estate tax be re-enacted at a later date.

3. As discussed previously, any type of planning that involves grantor trusts generally will create more options for the client. In particular, grantor trust facilitates having the grantor swap assets and take back low-basis assets, if there is still a basis step-up after tax reform.

IX. Value-Shifting and Disappearing Value

A. Self-Canceling Installment Notes (SCINs). A SCIN - a note having a fixed term but which terminates by its terms at the seller’s death – is a hybrid using the installment approach to determine the maximum payments to be made by the buyer and using the private annuity approach (discussed later in these materials) on cessation of payments if the seller dies before all payments have been made.

1. The seller in a SCIN transaction can enjoy the same potential estate and gift tax savings as the transferor in a private annuity. The SCIN can be used to shift excess appreciation to the heirs of the seller. If the seller dies before the end of the term of the note, the SCIN can produce significant estate tax savings.

EXAMPLE: Mother, age 60, sells property worth $2 million to her daughter for a 10-year SCIN. Daughter agrees to pay mother $300,000 a

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year for 10 years, which reflects the $2 million value with an interest rate premium for the self-canceling feature. Mother dies after receiving only two payments. As a result, mother has received $600,000 in note payments and removed $2 million of property, plus appreciation, from her estate. If mother is in the 40% marginal estate tax bracket, then the transaction has reduced the estate by $560,000 ($2 million minus $600,000 in installment payments x 40% federal estate tax rate), not taking account of appreciation.

2. Another possible advantage to a SCIN is as a retirement planning device. The SCIN can allow younger generation family members to supplement a parent’s retirement income without gift tax. Because of the premium required on a SCIN, the payments in a SCIN would generally exceed payments under conventional installment sales or private annuities. This can provide a larger amount of income for older family members in their retirement years.

3. To avoid a gift, the self-canceling feature should provide a premium to the seller. See Moss v. Comm’r, 74 T.C. 1239 (1980).

a. The premium may be reflected either in the interest rate or in the purchase price and other terms.

b. Using separate counsel or valuation professionals helps substantiate the premium as a bargained-for element of the transaction.

c. Several valuation programs provide recommendations on the amount of the premium, based on the term of the note and life expectancy of a person the same age as the seller.

EXAMPLE: Carlos sells a $5,000,000 asset to an irrevocable trust he created for a 15-year self-cancelling installment note, with amortized payments. Carlos is age 70 at the time of the transfer. Using the NumberCruncher program produced by Leimberg & LeClair, Inc., if the parties choose to reflect the premium in the interest rate, the note should pay interest at a rate of 4.837% rather than 2.64%. If the parties choose to reflect the premium in the purchase price, the principal amount of the note should be $5,838,519 rather than $5,000,000.

4. The IRS challenged the valuation of a SCIN in the recently settled docketed Tax Court case, Estate of Davidson v. Comm’r. The SCIN in that case was an interest-only note with a balloon payment. The IRS asserted that taxpayers could not rely on the actuarial factors embodied in the Section 7520 tables to determine premiums; that the tables apply only to the valuation of life estates, annuities, and remainder interests, not to

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promissory notes. The application of a pure willing buyer-willing seller analysis for SCINs would significantly complicate their use.

B. Private Annuities. A private annuity involves a transfer of property by the individual to a related party in return for a promise to pay a fixed periodic sum for the rest of the individual’s lifetime. The value of the transferred property will be removed from the individual’s estate because he has no interest in it at death. No part of the uncollected annuity will be included in the estate either, since the transferee’s payment obligation terminates at the individual’s death.

1. In a typical private annuity transaction, a senior family member will exchange appreciated property, such as stock in a closely held company for the unsecured promise of younger family members to pay a periodic stream of fixed payments. The payments are to be made over the lifetime of the transferor or for a specific period of time.

EXAMPLE: Richard owns stock in his closely held company worth $2 million. Richard is age 70 and in good health. Richard’s life expectancy is 15.5 years. His son, Sam, buys the stock from Richard for a private annuity under which, to avoid gift tax consequences to Richard, Sam agrees to pay Richard $228,728 each year. Richard unexpectedly dies three years later of a heart attack. At that time, Richard had received $686,184 in annuity payments. Consequently, $1,313,816 of the value of the stock (plus any appreciation after the annuity transaction was entered into) escapes estate tax in Richard’s estate. This saves $525,520 in federal estate tax at a 40% rate.

2. Until 2006, the capital gain on the sale of an asset for a private annuity was deferred, as it is in an installment sale. At the annuitant’s death, any remaining capital gain was not taxed (and the purchaser did not achieve a full increase in basis for the property).

3. That treatment changed with the issuance of new proposed regulations under §1.72 and §1.1001-1(j), which require the immediate recognition of all gain at the time of the sale. The proposed regulations are effective for private annuity sales entered into after October 12, 2006. There was an extended effective date for sales completed by April 18, 2007, if the issuer of the annuity contract was an individual, the contract was unsecured, and the property purchased is not resold within two years.

EXAMPLE: Using the same facts in the example above, if Richard’s basis in the $2,000,000 of stock is $100,000 at the time of the sale in exchange for the private annuity, he will have to pay capital gains tax on $1.9 million for the year of the sale. At a 20% rate, the capital gains tax is $380,000.

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4. It is possible to structure a private annuity transaction with a grantor trust, thereby avoiding the immediate recognition of capital gain. The use of a grantor trust as the party to a private annuity does present one significant challenge. The IRS valuation rules require special computations if an annuity is payable from a trust or other limited fund that, using the applicable Section 7520 rate, would be exhausted before the end of the period for payment of the annuity, assuming the annuitant lives for the entire period. In the case of a life annuity, the assumption that must be applied is that the annuitant will live to age 110. See Treas. Reg. §25.7520-3(b)(2).

a. If the special computation applies, the annuity must be valued using a term of years that is based on when the fund hypothetically would exhaust itself.

b. The net effect of the computation is that it will cause the value of the annuity to be less than the value of the property transferred, with the difference being treated as a gift.

c. Because of the age 110 assumption, a grantor trust that does not have significant independent assets before the private annuity transaction will exhaust itself under the IRS tables. For example, if Carl, at age 62, sold a $1,000,000 asset to a grantor trust in exchange for a private annuity, and the applicable Section 7520 rate was 5.80%, the trust would have to already own $521,380 of other assets for it to avoid the exhaustion test.

5. It is most appropriate to consider the private annuity technique where the life expectancy of the business owner may be shorter than average. If the individual outlives his expected lifespan, the amount paid to him (and included in his estate) may exceed the value of the property.

6. However, if the transferor is in extremely poor health at the time of the transaction, the regulations may preclude the use of the standard actuarial tables. The regulations preclude use of the IRS tables if the individual is “terminally ill.” Treas. Reg. §25.7520-3(b)(3).

a. An individual who is known to have an incurable illness or other deteriorating physical condition is considered terminally ill if there is at least a 50% probability that the individual will die within one year. Treas. Reg. §25.7520-3(b)(3).

b. However, if the individual survives for 18 months or longer after the date of the transaction, that individual is presumed not to have been terminally ill at the date of the transaction unless the contrary is established by clear and convincing evidence. Treas. Reg. §25.7520-3(b)(3).

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X. FLPs and LLCs

A. Over the past 25 years, individuals and families increasingly have been using a family-owned limited partnership or limited liability company (“LLC”) as a vehicle for managing and controlling family assets.

1. A typical family partnership is a limited partnership with one or more general partners and limited partners.

2. Usually, the parents act as general partners of the partnership or own a controlling interest in a corporate general partner. As general partners, the parents manage the partnership and make all investment and business decisions relating to the partnership assets. The general partnership interest usually is given nominal value, with the bulk of the partnership equity being limited partnership interests.

3. Initially, the parents receive both general partnership interests and limited partnership interests. Thereafter, the parents can transfer their limited partnership interests to the children.

EXAMPLE: Parent transfers $10,000 of his $1,000,000 of real estate, cash and securities to his children. Parent contributes the remaining $990,000 of investments to a newly formed partnership, to which the children contribute their $10,000. Parent receives a general partnership (GP) interest worth $10,000 and limited partnership (LP) interests with a net asset value of $980,000. The children receive $10,000 of LP interests. Parent make gifts over time of the $980,000 of LP interests to children.

B. An LLC can be structured in much the same way as a limited partnership. The parents or one of them, often act as Manager and thereby control the decision-making. Initially, the parents receive the bulk of the LLC member interests. Over time, they can transfer most or all of those interests to their children. The LLC can provide an attractive alternative to the use of a partnership, especially where there is a desire to limit the personal liability of all the participants in the entity without having to create a separate entity for the general partner.

C. Non-Tax Estate Planning Benefits

1. The FLP or LLC addresses the problems faced by many individuals who may be in a financial position that would permit them to gift property to children, but who are reluctant to do so because they are unwilling to give up management and control of the property, or do not want children to own the property directly.

2. The FLP or LLC interests represent a right to a share in the entity income and capital, but grant no voice in management of the entity. This structure permits an individual to make gifts of FLP or LLC interests to his spouse, children, and (eventually) more remote descendants, without transferring

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the underlying assets. As general partner of the partnership or manager of the LLC, the individual can continue to exercise control over the transferred interests.

3. The partnership or LLC agreement also can restrict the ability of any recipient of interests to make further transfers of those interests, by limiting the persons to whom any transfer could be made during life or at death, and the amount that the entity would be willing to pay a partner upon liquidation of his or her interest. These restrictions, combined with the charging order state law provisions applicable to partnership and LLCs, will help ensure that the interests are kept in the family and will help protect the underlying assets from potential creditors of a child, or from a spouse of a child in a failed marriage.

D. Valuation Discounts

1. FLPs and LLCs also have been used to obtain additional valuation discounts. As with interests in a closely held corporation, there is no ready market for closely-held interests in a limited partnership or LLC. By their very nature, limited partnership interests do not participate in management of the partnership and therefore lack control. These characteristics of a limited partnership interest make it less valuable than the assets transferred upon formation of the partnership. The same principles apply to a minority LLC member, or an LLC member who holds non-voting interests.

2. In effect, one can transfer assets to a partnership or LLC in order to create a closely held business and take advantage of discounts where they otherwise would not be available. The benefit of these discounts, of course, is that they enable an individual to give away more property.

EXAMPLE: After creating a partnership with $1,000,000 of real estate, cash and securities, Parent gifts $980,000 of LP interests to his children. He discounts those interests by 35% to reflect their lack of marketability and control. This enables Parent to transfer the LP interests for $637,000, and possibly shelter the entire gift with applicable credit amount and annual exclusions.

3. In order to support valuation discounts in limited partnerships and LLCs, practitioners build restrictions into the documents that limit an individual partner’s or member’s rights.

a. A typical family partnership or LLC will eliminate any right of a partner or member to withdraw, and will provide that the entity can be liquidated only with the approval of a super-majority or all of the partners or members.

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b. State law generally supports these restrictions by making them the default under applicable limited partnership and LLC statutes, if the governing agreement does not provide otherwise.

4. The proposed Section 2704 regulations were drafted primarily in response to these restrictions. As previously discussed, it is not clear how much the regulations would impact the size of discounts.

E. Freeze Transactions. A limited partnership or LLC also may be used to shift future growth in the value of assets to younger generations, permitting that growth to escape transfer tax, while at the same time permitting an individual to retain the income from those assets.

1. This is done by creating an entity with two basic types of interests, (i) those that have a fixed value but a preferred cash flow (“frozen interests”), and (ii) those that share in all future appreciation (“growth interests”). In a typical partnership or LLC structured as a freeze, Parents retain the frozen interests and give the growth interests to their children or grandchildren, either immediately or over time. The goal is to transfer all or substantially all of the growth interests, because as the underlying partnership or LLC assets appreciate, that appreciation is allocated only to the growth interests. If descendants hold all of the growth interests, they will benefit from all appreciation of assets, without any transfer tax cost.

2. As discussed previously, a freeze partnership or LLC must comply with Section 2701 to avoid additional gift tax consequences. This means that the preferred “dividend” on a frozen interest be cumulative and fixed at a market rate. However, any income from the partnership or LLC in excess of the required return, as well as all growth of entity assets, would pass to the Parents’ children as holders of the growth partnership interests. Because a partnership or LLC is a flow-through entity for income tax purposes, pretax earnings can be used to support the preferred payments on the frozen interest.

EXAMPLE: Parents form a LLC with $20 million of real estate and marketable securities. The assets produce a current, pretax yield of 5% annually and appreciation of 6% annually. The frozen interests will receive a preferred right to income (the “preferred yield”) equal to 8% of their initial fair market value. If the LLC is formed with assets that provide a 5% cash return, then the LLC will produce $1 million of cash flow initially ($20 million x 5%). If the frozen interests must pay an 8% preferred yield, then up to $12.5 million of frozen interests can be created (because $12.5 million x 8% = $1 million). Therefore, in this example, the LLC would issue up to $12.5 million of frozen interests, and $7.5 million of growth interests. Parents would then make a gift of all or part of the growth interests to their descendants or trusts for their benefit.

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3. Partially offsetting the benefit of this shift in appreciation is the fact that Parents are receiving annual preferred income payments, which will increase their estates. In addition, the growth partners are giving up most of the current return on their investment in the entity, at least in the initial years, in order to satisfy the preferred income payments to the frozen partners. These facts have to be taken into account in determining the overall economic benefits from a partnership freeze. However, as long as the benefits which the owners of the growth interests receive from the entity, in the form of appreciation and excess income, exceed the income lost to the frozen interests, the owners of the growth interests generally will benefit overall from the arrangement.

F. It may be desirable to create frozen interests even if the family is not interested in a freeze per se. Frozen interests can be used to maintain a stream of income for the senior family members even after they give away most of the equity in the partnership.

EXAMPLE: Assume that the assets in a $1 million partnership produce net income of about $40,000 per year. Parent is willing to give away a substantial portion of his growth interests but wants to maintain an income stream of about $30,000 per year. Instead of creating $980,000 of growth LP interests, Parent can retain $300,000 of frozen LP interests that give him a preferred return of 10% annually and $680,000 of growth LP interests. He can gift the growth interests to his children and retain $30,000 of cash flow.

G. Planning in the Current Environment

1. The primary question for families that use limited partnerships and LLCs is will the Section 2704 regulations ever be finalized. Many commentators doubt the White House and current Congress will allow it to happen. However, if the gift tax is retained, then a case can be made for wanting to have updated regulations for lifetime transfers of partnership and LLC interests.

2. A secondary question is what impact final regulations will have on valuation discounts. Invariably the IRS will believe the regulations will have a greater dampening impact on discounts than taxpayers do. It will take some time for valuation disputes to work their way through the courts and for courts to provide greater certainty.

a. Clients who wish to make significant transfers of LLC or partnership interests should do so now, in the more taxpayer friendly and better understood current environment.

b. If regulations are finalized, risk adverse taxpayers may want to hold off on significant transfers, and let others be the litigation guinea pigs.

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3. For many families, limited partnerships and LLCs serve critical roles as family investment vehicles. That will continue to be so even if the estate tax is repealed.

XI. Marital Deduction Planning

A. Portability versus Credit Shelter Trust Planning

1. The increase in the applicable exclusion amount to the $5,000,000 plus level, together with portability of the exclusion amount have changed the dynamics of marital deduction planning.

2. No longer is it the case that a wealthy married couple’s estate plan will always use a credit shelter trust as the receptacle for the deceased spouse’s applicable exclusion amount.

3. For many couples, a marital gift or marital trust receiving 100% of the residuary assets, coupled with portability is equally or more attractive. It provides several possible benefits:

a. Simplicity.

b. Additional basis step-up at the second death.

c. Better for depreciating assets, especially retirement accounts and IRAs.

d. Avoids having to fund credit shelter trusts with undesirable assets (IRAs, primary residence).

4. Credit shelter trust planning still will be preferred in many situations.

a. It is a superior shelter for future growth in asset values, no matter how great, than portability (with a fixed DSUE amount).

b. It facilitates GST planning.

c. The benefits of a credit shelter trust are not lost if the surviving spouse remarries, whereas the DSUE amount can be lost.

d. It is a more effective way to deal with second marriage situations, with children from a prior marriage.

B. What Produces the Best Overall Tax Result?

1. Several trust and estate practitioners and investment firms have conducted mathematical analyses of the benefits of a traditional marital/nonmarital

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estate plan versus relying completely on portability. The studies focus on the trade-off of estate tax savings versus lost step-up in basis.

a. The outcome of the comparison depends on the assumptions made regarding the size of the estates, the asset growth following the first death, how much of the gain is realized during the surviving spouse’s life, and how long the surviving spouse lives.

b. Not surprisingly, in estates well under the spouses’ combined exclusion amounts, portability is superior from a purely tax standpoint, because of the certainty of a full income tax basis step-up at the second death. However, the impact of state estate tax can change the result. In most cases, it is important to shelter the state exclusion amount from estate tax at the first death.

c. In estates that are close to twice the exclusion amount, portability may be better if the surviving spouse dies within five or six years of the first spouse. However, depending on assumptions about asset growth, if the surviving spouse lives for a longer period, the appreciation of the assets against a fixed DSUE amount creates a higher estate tax, and overall worse result, than there would be using a credit shelter trust.

d. In many of the scenarios, the benefit of one alternative over the other tends to be relatively small - about 3% to 5% of the value of the assets after 10 years.

2. The outcomes reinforce the conclusion that, in light of the many variables that could impact the outcome, it is very difficult to predict at the time an estate plan is being drafted whether to rely on portability or use a traditional marital/nonmarital estate plan.

3. For clients where portability might be a superior option, the estate planner can choose a plan that defers the decision to use portability until after the first spouse’s death. The estate planner will have much better information on all the factors that can impact a decision, including the surviving spouse’s age and health, the children’s needs, the current estate tax and income tax rates, the mix of assets and their growth potential, and whether the clients reside in a state with a state estate tax.

C. Flexibility in Planning Options

In creating an estate plan that defers the decision on portability, there are three primary options to choose among:

1. Disclaimer plan. The estate plan leaves the assets of the first spouse to die outright or in a marital trust to the surviving spouse, but provides that if the surviving spouse disclaims, the assets will pass to a credit shelter trust.

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The credit shelter trust could be for the sole benefit of the surviving spouse or for spouse and descendants.

a. The danger with this option is that the surviving spouse fails to disclaim, even when it would be advantageous to do so.

b. The surviving spouse also could be disabled. An agent under a power of attorney, assuming he or she has the authority to disclaim on behalf of the spouse, may be reluctant to do so.

c. The attorney also needs to make sure the spouse does not take actions post-mortem that constitute acceptance of the decedent’s property.

2. Single Fund QTIP. The plan leaves all the assets to a QTIP trust for the surviving spouse. The executor for the deceased spouse then can choose to elect the marital deduction for the trust and rely on portability, or not to make the QTIP election for all or a portion of the trust.

a. The trustee of the QTIP trust usually is given the power to sever the trust into elected and non-elected portions.

b. This plan puts the decision in the hands of the executor, who may be best suited to make the decision. It allows for the decision to be made up to 15 months after the date of death, rather than nine months with a disclaimer.

c. Some practitioners have expressed concern that the QTIP option may not be available due to Rev. Proc. 2001-38, 2001-1 C.B. 1335, which allows a taxpayer to ask to treat a QTIP election as null and void if unnecessary to reduce estate tax. The service has indicated informally that it will not use Rev. Proc. 2001-38 against taxpayers.

3. Clayton QTIP. This is not a different kind of QTIP trust, rather it is an add-on to traditional QTIP. In addition to the QTIP trust, the estate plan can contain provisions for a credit shelter trust. If there is a non-elected portion of the QTIP trust, the trustee can elect to allocate it to the credit shelter trust, thereby creating a trust for spouse and descendants. This option is based on Estate of Clayton v. Comm., 976 F.2d 1486 (5th Cir. 1992), where the court invalidated a Treasury Regulation that stated that a trust would not qualify for QTIP treatment if the allocation of property to it was contingent on making the election. Other cases followed, and the Treasury changed the regulation to conform to the court ruling. See Treas. Reg. § 20.2056(b)-7.

a. This option is superior to the disclaimer approach in that the surviving spouse can retain powers of appointment over the credit

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shelter trust. He or she cannot do that in a credit shelter trust funded by a disclaimer.

b. The decision to allocate the non-elected portion of the QTIP to another trust should not be made by the surviving spouse. If the spouse is executor or trustee, there should be provisions to allow an independent co-fiduciary to make the decision.

c. An estate plan that allocates the trust residue to a Clayton QTIP with a credit shelter trust option will look very much like a traditional A/B estate plan. As the clauses below reflect, the primary change is to the allocation language at the first death.

SAMPLE ALLOCATION AT DEATH PROVISION:

ARTICLE I Allocation at Death

As of my death, but after providing for the payment of any debts, taxes, and administration and other expenses, as provided later in this instrument, the trustee shall administer the balance of the trust principal (including property to which the trustee may be entitled from any other source, and subject to any specific allocation applicable to such property pursuant to the exercise of a power of appointment or otherwise) as follows:

A. First, the trustee shall distribute any tangible personal property that is then held hereunder pursuant to the terms of my will then in effect (and any memorandum separate from my will that I may leave), such terms being incorporated herein by reference. If no will of mine is admitted to probate in any jurisdiction within three months after my death, the trustee may rely upon any instrument the trustee reasonably believes to be my last will or such memorandum for purposes of making this distribution.

B. Finally, the trustee shall administer the balance of that trust principal as follows:

1. If my spouse survives me, the trustee shall allocate the trust principal to the Marital Trust, to be administered in the manner provided in subsequent Articles of this instrument; provided, however, that the trustee shall allocate to the Family Trust that portion of the trust principal which is (i) effectively disclaimed by my spouse, or (ii) allocated pursuant to subparagraph 2 of paragraph A of the Marital Trust Administration provisions of this instrument with respect to principal for which no qualified terminable interest property election is made; or

2. If my spouse does not survive me, the trustee shall allocate the entire trust principal to the Family Trust, to be administered in the manner provided in a subsequent Article of this instrument.

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SAMPLE MARITAL TRUST ADMINISTRATIVE PROVISION:

ARTICLE II Marital Trust Administrative Provisions

A. My executor (as that term is used in Section 2056(b)(7) of the Code) may elect to have a specific portion or all of the Marital Trust (referred to as a “marital portion”) treated as qualified terminable interest property for federal or state estate tax purposes. If one or more portions of the Marital Trust are subject to different elections, each portion shall be expressed as a fraction, and the value of each portion at any time may be determined by multiplying the value of the Marital Trust at that time by the fraction then in effect for that portion. The trustee may charge a discretionary distribution all to one portion, or to more than one portion, by adjusting each fraction, first by restating it so that the numerator is the value of each portion and the denominator is the value of the marital portion and of the Marital Trust, in each case immediately before the distribution, and then by subtracting the amount of each distribution charged to a portion from the numerator of the fraction for that portion and subtracting the total of all distributions from each denominator, except that the numerator shall not be reduced below zero. Alternatively, as of the date of my death, the trustee may:

1. Divide the Marital Trust into separate trusts, representing the fractional portions for which different elections apply, and administer them as separate trusts hereunder (but subject to a common set of provisions); or

2. Allocate the fractional portion for which no qualified terminable interest property election was made to the Family Trust, to be administered as a part thereof; provided, however, that neither my spouse nor a primary remainder beneficiary of the Marital Trust, if acting as a trustee thereof, shall exercise this power.

B. The allocation to the Marital Trust if my spouse survives me and the provisions of paragraph A of this Article are intended to give the personal representative of my estate the option to shelter property from estate tax at my death using the federal applicable exclusion or a state estate tax exclusion, or to rely on the election under Code Section 2010(c) and use of the deceased spousal unused exclusion amount. I request that the personal representative of my estate consider these options fully, and the trustee consider allocating any non-elected portion of the Marital Trust to the Family Trust.

D. Modifying Formula Allocations

1. A client who has not updated his or her estate plan in 10 or more years may have marital formula or GST formula provisions that no longer make sense.

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2. In a standard A/B estate plan, for a client with an estate of $3-5 million, the failure to convert to a single fund QTIP or other portability based plan is not the end of the world. The formula will allocate all the property to the credit shelter trust, and some opportunity for a basis step-up at the second death may be lost. But the trust is still for the primary benefit of the spouse and his or her needs will be taken care of.

3. Some clients’ plans left all of the credit shelter amount directly to the children, or to a trust in which the surviving spouse’s rights were limited. This may have made sense when the exclusion was $600,000 or $1,000,000 and constituted a quarter or less of the decedent’s estate. With the current exclusion, the plan may leave the spouse with inadequate means of support.

4. Likewise, a common plan for many clients was to provide that all assets that can be sheltered from GST tax at the surviving spouse’s death will be retained in trusts for the children and their families, while all other assets will be distributed to the children.

a. There were numerous variations on the plan. The non-GST share may be distributed outright to the children, or it may be held in trusts over which each child has withdrawal rights at designated ages. The non-GST share may remain in longer-term trusts, but each child designated as trustee and given substantial discretionary authority.

b. The plan fit the client’s goals when the GST exemption was $1,000,000. With the increase in the GST exemption to $5,000,000, indexed for inflation, formula allocations that are based on the maximum amount of GST exempt property available in many cases will no longer carry out the clients’ expectations.

E. Planning in the Current Environment

1. Marital deduction planning will not be meaningfully impacted by new Section 2704 regulations. Valuation issues do impact both planning and post-death funding decisions, but new regulations will not fundamentally change the approach of planners.

2. Repeal of the estate tax of course has an enormous potential impact.

3. Much of the preceding discussion on the case of credit shelter planning versus portability planning is equally relevant in a no estate tax environment.

a. If no estate tax exists at the first spouse’s death, there is strong motivation for high net worth individuals to place assets in a trust

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that will not be taxable at the surviving spouse’s death should an estate tax return.

b. On the other hand, if it is clear that there will be no estate tax at the surviving spouse’s death too, and the basis step-up is preserved, a disposition that would allow for a basis step-up is best.

c. A Clayton QTIP estate plan might be the best way to retain flexibility during this time of uncertainty. It should be coupled with provisions that would facilitate basis step-up, if that is still available. This is discussed in the next section.

XII. Other Changes Due to the Increased Exclusion

A. Basis-Step Up Planning in Administering Trusts

1. The increased applicable exclusion and GST exemption has resulted in other new, and seemingly radical, thinking. Many of the ideas discussed in this Section also are relevant if the estate and generation-skipping taxes are repealed, as the Trump Administration and House Republican tax blueprint are proposing.

2. The higher exclusion increases the number of situations where a family member who is an existing beneficiary of a trust will have a taxable estate significantly less than the applicable exclusion.

3. If the trust has appreciated assets, it may be desirable to distribute those assets to the primary beneficiary of the trust, in order to obtain a basis step-up for the assets at the beneficiary’s death.

4. This of course raises a host of fiduciary issues.

a. The distribution must fit under the trust’s distribution standard.

b. The trustee must be confident that any asset distributed to a beneficiary will pass according to the same plan as is embodied in the original trust.

c. If the beneficiary has a power of appointment over the trust anyway, it will be easier to get comfortable with a distribution.

5. The planning will be most comfortable with surviving spouses where the couple has parallel estate plans. If it is late in the surviving spouse’s life and he or she has not remarried, the disposition under a credit shelter trust most likely will be identical to the disposition under the surviving spouse’s plan.

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EXAMPLE: David and his children are the beneficiaries of a $2,000,000 credit shelter trust created at the death of David’s wife, Dolores, in 2001. David and Dolores have parallel estate plans, which create trusts for their children and descendants at the second death. David’s separate estate is worth about $3,000,000. The credit shelter trust contains several large appreciated stock positions, with a combined value of about $800,000 and a combined basis of $200,000. The trust permits an independent trustee to make distributions to David for any purpose the independent trustee determines is appropriate. The trustee distributes the $800,000 of stock to David, who contributes it to his revocable trust. At David’s death, the stock receives a step-up in basis.

6. If an existing trust does not have a broad distribution standard, the opportunity for this type of planning may be more limited. One option might be a nonjudicial settlement agreement, in states that have adopted the Uniform Trust Code or its nonjudicial agreement provisions. The spouse, adult descendants and trustee could agree that the distribution should be made. A court normally would have the power to allow such a distribution, so it should be achievable by nonjudicial agreement.

7. For new trusts, estate planning attorneys should consider adding a provision to give the independent trustee the ability to make such distributions. It could be specific to tax-motivated distributions or part of a general “best interests” standard.

SAMPLE TRUST PROVISION:

The term “best interests” is not defined because I intend to give the independent trustee unfettered discretion in determining what is in a beneficiary’s best interests, subject only to the requirement that this discretion not be exercised in bad faith; and a best interests distribution may include distributions of income or assets for the purpose of reducing income taxes, where consistent with the trustee’s fiduciary obligations to income and primary remainder beneficiaries of the trust, and the plan of disposition contained in the trust.

8. Another option is to create some form of general power of appointment, such as one limited to the creditors of the beneficiary’s estate.

a. This could be done in a manner similar to what is done with non GST exempt trusts, where an independent trustee or trust protector has the ability to grant the power to a beneficiary or take it away.

b. Some writers have suggested that a formula or general power of appointment could be created. See, e.g., Zaritsky, “Portability: Getting Ready for Game Time,” ACTEC 2011 Summer Meeting, at 10-21.

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c. A formula or power presents significant drafting challenges. For a thorough discussion of the issues, see the materials added by Richard S. Franklin to “Clinical Trials With Portability,” 48th Annual Heckerling Institute on Estate Planning (Special Session 2014) presented by Richard S. Franklin, Lester B. Law and Thomas W. Abendroth.

d. A viable alternative is to use the trust protector power to grant a general power of appointment, with the idea that it would be possible to fine-tune its use through a trust severance power.

EXAMPLE: Jonas is the primary beneficiary of an irrevocable trust that has several highly appreciated assets. Jonas is in his 80’s and in bad health. His estate will total about $2,500,000, and the beneficiaries are his descendants, who also are remainder beneficiaries of the trust. The trustee, Jonas and his family agree that it would make sense to get two highly appreciated assets, worth about $2,000,000 total, in Jonas’ estate. The trustee uses a trust severance power to separate those two assets into a separate identical trust. The trust protector activates a power in Jonas over that separate trust to appoint the creditors of his estate.

B. Eliminating Trusts

1. Some clients whose estates now will be entirely sheltered from estate tax may ask about terminating existing irrevocable trusts they have created. While this may seem sensible from a narrow tax perspective, the client needs to consider other factors.

a. Property that has been set aside in an irrevocable trust for a period of time is probably protected from creditors, of both the grantor and the beneficiaries.

b. If the grantor already used exclusion or GST exemption to transfer the asset, the client should not waste those exclusions. If Congress later reduces the exclusion, or the asset begins to appreciate significantly, the client will regret having given up the shelter he or she had.

2. A client may be particularly tempted to terminate an irrevocable insurance trust. He or she may find the annual Crummey notice requirements to be inconvenient, and may question the need for the insurance at all.

3. If the decision is made to drop the insurance, then it admittedly may make sense to terminate the trust. This is particularly true if the cash value was low, and continuing to administer the trust is uneconomical.

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4. If the policy is being kept, then consider the option of no longer sending Crummey notices. The premium payments would use lifetime exclusion, but for many clients the amount would be significantly less than the annual inflation increase.

5. One drawback is that the client would need to file gift tax returns each year. If the current funding of the trust does not require gift-splitting, the client may not be filing returns currently.

XIII. Special Planning with Grantor Trust Status

A. Under the current transfer tax and income tax system, there are many benefits from having irrevocable trusts that are grantor trusts. If the estate tax is repealed, income tax benefits in trusts likely will take an even greater importance. The techniques discussed in this section may be relevant.

B. Supercharged Credit Shelter Trust1

1. The goal behind a supercharged credit shelter trust is to increase the effectiveness of a credit shelter trust for transfer tax purposes by making it a grantor trust as to the surviving spouse.

2. This allows the trust to continue to have the same benefits that a grantor trust does during the life of the grantor.

3. The supercharged credit shelter trust starts as a lifetime QTIP trust created by one spouse in a couple for the other spouse.

a. During the life of the beneficiary spouse, the trust operates as a marital trust, paying all the income to that spouse.

b. The trust is treated as a grantor trust for income tax purposes because the spouse is a beneficiary. IRC § 677.

4. On the death of the beneficiary, the trust is included in that spouse’s estate and the trust property (or that portion equal to the deceased spouse’s remaining applicable exclusion amount) can pass to a credit shelter trust for the grantor spouse. The trust continues as a grantor trust for that grantor spouse. See Treas. Reg. 1.671-2(e)(5).

5. The goal of course is to have the spouse most likely to survive create the lifetime QTIP trust. Each spouse could create a lifetime trust for the other,

1 The “Supercharged Credit Shelter Trust” is a service mark of Jonathan G. Blattmachr,

Mitchell M. Gans, and Diana S. C. Zeydel. They first advanced the concept in various articles and presentations.

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and vary the terms sufficiently to avoid possible application of the reciprocal trust principles. In that case, only one trust ultimately will be supercharged.

C. Beneficiary Irrevocable Grantor Trust (“BING”)

1. As alluded to earlier in the outline, the Beneficiary Irrevocable Grantor Trust is designed to take advantage of the provisions of Section 678 of the Code which make the beneficiary of a trust the grantor for income tax purposes under certain circumstances.

a. Section 678(a) provides that a person other than the grantor will be treated as the owner of any portion of a trust with respect to which that person has a power of withdrawal or previously had such a power and partially released or modified it, assuming the person continues to have interests in the trust that would cause an actual grantor to be treated as the grantor under Sections 671-677.

b. The IRS has repeatedly applied Section 678 to the Crummey trusts, and maintained the position that the beneficiary becomes the grantor of the trust for income tax purposes to the extent of the portion of the trust attributable to lapsed Crummey powers.

2. A wealthy taxpayer can take advantage of these rules by having a parent or other family member create a Crummey trust for the taxpayer. The trust can be funded over a few years with $5,000 gifts, subject to a Crummey power in the wealthy beneficiary. The Crummey power lapses, and the beneficiary treats the trust as taxable to him or her.

EXAMPLE. John is an entrepreneur with a significant estate. John’s mother creates a trust for John and his descendants in November and funds it with $5,000 gifts in November and January of the following year. The gifts are subject to a Crummey right of withdrawal in John. The trust is treated as subject to Section 678, and the income is reportable by John on his Form 1040.

3. John now can sell property to the trust in an installment sale, with the tax attributes being identical to any sale to an IDGT. However, John also maintains a beneficial interest in trust. Furthermore, the trust continues as a grantor trust as to him for his life, long after his mother is deceased.

EXAMPLE. In June of year two of the trust, John sells $5,000,000 of stock in a venture capital entity to the trust in exchange for a $5,000,000 note. The sale is treated as a sale to a grantor trust. The entity liquidates 5 years later and pays out $10,000,000 to the trust. The trust repays the note.

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4. As noted earlier, the transaction is possibly subject to IRS attack because the trust is under-capitalized at the time of the sale. Guarantees would need to be provided to address this risk.

5. In addition, there is much greater risk to the transaction if the IRS is successful in arguing that the property transferred has a greater value. If John is treated as making a gift to the trust, Section 2036 will apply because he also is a beneficiary.

D. Delaware Irrevocable Nongrantor Trust (“DING”)

1. The IRS has been asked to rule repeatedly on the income and gift tax consequences of a trust intended to be an incomplete gift, non-grantor trust. A trust of this nature is commonly referred to as a Delaware incomplete gift non-grantor trust or “DING,” if created under Delaware law, or a Nevada incomplete gift non-grantor trust or “NING,” if created under Nevada law.)

a. As its name implies, a DING or a NING is structured to be a non-grantor trust for income tax purposes that is funded by transfers from the grantor that are incomplete gifts for gift tax purposes. Assuming the trust is established in a state that doesn’t tax the income accumulated in the trust (like Delaware or Nevada), the trust will avoid state income taxes as long as the state of residence of the grantor or beneficiaries doesn’t subject the trust’s income (or accumulated income) to tax. Moreover, if structured and administered properly, the trust property should be protected from the grantor’s creditors.

b. The DING or the NING allows a grantor to achieve both of these benefits while still being able to receive discretionary distributions of trust property and without paying gift tax (or using any gift tax exemption) on the transfer of property to the trust. A gift from the grantor will be complete upon a subsequent distribution from the trust to a beneficiary other than the grantor, and whatever property remains in the trust will be subject to estate tax at the grantor’s death.

c. A DING or NING is particularly attractive for a highly appreciated asset in anticipation of sale of that asset. For example, the founder of a business that is going to be sold may face hundreds of thousands or even hundreds of millions of dollars of capital gain because he or she has so little basis. Avoiding state income tax on those gains can be a significant benefit.

2. The IRS does not appear to be closely scrutinizing these trusts. They are issuing frequent rulings approving them. See, e.g. Ltr. Ruls. 201440008 –

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201440012 (Oct. 3, 2014); Ltr. Ruls 201436008 – 201436032 (Sept. 5, 2014); Ltr. Ruls. 201430003 – 201430007 (July 26, 2014); Ltr. Ruls. 201410001 – 201410010 (March 7, 2014).

a. The Service may view these trusts as beneficial to the bottom line. A non-grantor trust may pay slightly more tax than an individual taxpayer.

b. States are that the ones that lose tax dollars from these trusts. New York passed legislation, effective for income earned on or after January 1, 2014 (unless the trust was liquidated before June 1, 2014) to treat such trusts as grantor trusts for New York income tax purposes.

3. The key in creating an effective DING or NING is to structure distribution provisions that leave the grantor with enough control so that the initial transfer to the trust is not a completed gift, but there is sufficient involvement of parties adverse to the grantor to avoid the grantor trust rules. For example, the trust would permit distributions to the grantor or the other designated beneficiaries as follows:

a. The trustee must distribute to the grantor or a beneficiary at the direction of a majority of a distribution committee, with the grantor’s written consent;

b. The trustee must distribute to the grantor or a beneficiary at the unanimous direction of the distribution committee;

c. The grantor, in a non-fiduciary capacity, may distribute to any beneficiary for health, maintenance, support or education.

4. The initial distribution committee was the grantor, her children and her stepchildren. The committee always must have at least two members other than the grantor.

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Duties and Powers of a Trustee

Estate and Guardian Administration

Estate Planning to Achieve Client Goals

Estate Planning for Charitable Giving

Estate Planning for the Marital Deduction

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