As 2012 comes to an end, “Uncertainty” is certainly the operative word for tax professionals. No one knows (as of this date) what the tax laws, including the estate, gift, and generation-skipping tax provisions, will be in 2013. The possible return to the tax laws as they existed before the 2001 Tax Act encouraged many to take advantage of the favorable laws in 2012 to give away large amounts of property. In the midst of the often hurried planning caused by the unclear tax landscape, the usual types of developments continued to occur. Courts issued opinions and the IRS continued to issue public and private rulings that affected many different areas of the field. Taking account of the numerous developments with respect to estate planning and estate, gift, generation-skipping, and fiduciary income taxation in 2012 and in what has become an annual tradition, below are the top ten developments as identified and explained by Ronald Aucutt, a McGuireWoods Partner and Leader of the firm’s Private Wealth Services Group. Ron is the editor of the Recent Developments materials that are presented each year at the Heckerling Institute on Estate Planning and no one is in a better position to review and opine on what are the top ten developments in estate planning and estate, gift, and generation-skipping taxation for 2012.
Number Ten: FLP Cases Still Driven by Facts – Mostly: Estate of Kelly v. Commissioner, T.C. Memo 2012-73
As long as the outcome of family limited partnership cases continues to be fact-specific, expert-specific, and sometimes even judge-specific, an FLP case is likely to be one of the ten most watched or most discussed developments of the year. In Estate of Kelly, for example, the Tax Court rejected an IRS challenge to a family limited partnership under section 2036, in one of the few cases to ever do so without invoking the “bona fide sale” exception, but on facts that would be difficult to duplicate.
“Bad” facts (for the estate) included the creation of the partnership by the creator-decedent’s children acting as her court-appointed guardians (arguably negating the notion that the partnership was needed for management), a purpose of ensuring an equal distribution of the decedent’s estate among her four children at her death (arguably a testamentary purpose), and the decedent’s retention of sole ownership of the corporate general partner, which was expected to receive a management fee (arguably an impermissible retained interest). In fact, in seeking court authority to implement the plan, the children represented that this arrangement would “ensure that the ward will be provided with adequate income to cover the ward’s probable expenses for support, care and maintenance for the remainder of the ward’s lifetime.”
This latter fact has been crucial in other FLP cases, where the IRS and the courts have viewed insufficient retained assets outside of the partnership as evidence, in effect, that the parties treated the partnership as a trust, with retained enjoyment. It is with good reason, however, that that argument is often regarded as overstatement. If the standard for comparison is an arm’s-length “investment,” then why isn’t it relevant that such arm’s-length investments are frequently (if not typically) made with the expectation that the investment will produce a return and that the investor might live off that return?
On the other hand, “good” facts for the Kelly estate included the astonishingly self-evident legitimacy of the asset-protection and risk-management purposes of the partnership, evidenced by dynamite blasting at quarries on the partnership property, an incident of a dump truck collision over which the decedent had been sued, and the discovery of bullets in a campfire site on the property. Like the similar 2012 case of Estate of Stone v. Commissioner, T.C. Memo 2012-48 (formation of partnership to manage and develop woodland parcels), this was not a garden-variety FLP holding marketable securities. It is hard to tell why the IRS permitted it to be litigated in the first place.
In contrast, in Keller v. United States, 697 F.3d 238 (5th Cir. 2012), aff’g 104 A.F.T.R. 2d 2009-6015 (S.D. Tex. 2009), the facts did not seem to matter at all. Keller is a case in the tradition of Church v. United States, 268 F.3d 1063 (5th Cir. 2001), respecting a family limited partnership even though the formation and funding of the partnership were not completed until after the decedent died. To be sure, the case did present compelling evidence of pre-death “intent,” and the Service’s case was apparently weakened by actions of its appraiser that the courts viewed as mistakes. But the notion that, in the administration of the estate tax, death does not matter is truly interesting.
Number Nine: Regulation on Partial Special Use Valuation Election Held Invalid Again. Finfrock v. United States, 109 A.F.T.R. 2d 2012-1439 (C.D. Ill. 2012)
Section 2032A allows an executor to value “qualified real property” at its current “qualified use” in farming or another trade or business, rather than its “highest and best use.” “Qualified real property” is defined in section 2032A(b)(1) with reference to the requirements that
- 50 percent or more of the adjusted value of the gross estate consists of the adjusted value of any property used in a qualified use that passes to a qualified member of the decedent’s family (section 2032A(b)(1)(A));
- 25 percent or more of the adjusted value of the gross estate consists of the adjusted value of such property that is real property (section 2032A(b)(1)(B)); and
- Such real property was owned and used by, and with material participation of, members of the decedent’s family during five years out of the eight-year period ending on the decedent’s death (section 2032A(b)(1)((C)).
Reg. §20.2032A-8(a)(2) (emphasis added) states that “[a]n election under section 2032A need not include all real property included in an estate which is eligible for special use valuation, but sufficient property [that is, 25 percent] to satisfy the threshold requirements of section 2032A(b)(1)(B) must be specially valued under the election .” In Miller v. United States, 680 F. Supp. 1269 (C.D. Ill. 1988), involving a decedent who died in 1983, a judge in the Central District of Illinois had held that the requirement that the special use election be made for real property representing at least 25 percent of the adjusted value of the gross estate was invalid, because there is no such requirement in the statute. The Miller court had held that Reg. §20.2032A-8(a)(2) is an “interpretive” regulation, entitled to less deference than a “legislative” regulation promulgated under a specific grant of rulemaking authority, noting that section 2032A(d)(1) specifically authorizes regulations regarding only the “manner” for making a special use election, and this regulation purports to add a substantive requirement.
In Finfrock, the IRS argued that the result should be different under the deference standard of Chevron v. Natural Resources Defense Council, 467 U.S. 837, 843 (1984), that if “the statute is silent or ambiguous with respect to the specific issue, the question for the court is whether the agency’s answer is based on a permissible construction of the statute,” a standard the Miller court had not applied. The court rejected that argument, finding that the statute is “neither silent nor ambiguous” in setting forth the requirements for a special use election, which do not include the requirement that, once eligible, an estate must elect special use valuation for real property representing at least 25 percent of the adjusted value of the gross estate. Therefore the court did not reach the issue of whether the regulation would be “a permissible construction of the statute” (which the executor had conceded) and, like the Miller court before it, held the regulation invalid.
It remains to be seen how durable the Finfrock holding is, or if the regulation will be tested outside of the Central District of Illinois. But it is always interesting when any court holds a Treasury regulation invalid.
Number Eight: Continued Crackdown on Questionable or Careless Donations of Historic Façade and Other Conservation Easements
No less than 16 cases in 2012 have addressed the availability and amount of an income tax deduction for a donation of an historic façade or other conservation easement. Kaufman v. Shulman, 687 F.3d 21 (1st Cir. 2012), vac’g and rem’g 134 T.C. 182 (2010), reh’g 136 T.C. 294 (2011); Scheidelman v. Commissioner, 682 F.3d 189 (2d Cir. 2012), vac’g & rem’g T.C. Memo 2010-151; Trout Ranch LLC v. Commissioner, 110 A.F.T.R. 2d 2012-5621 (10th Cir. Aug. 16, 2012), aff’g T.C. Memo 2010-283; Irby v. Commissioner, 139 T.C. No. 14 (2012); Mitchell v. Commissioner, 138 T.C. No. 16 (2012);Whitehouse Hotel Limited Partnership v. Commissioner, 139 T.C. No. 13 (2012), on rem’d from 615 F.3d 321 (5th Cir. 2010), vac’g and rem’g 131 T.C. 112 (2008); Averyt v. Commissioner, T.C. Memo 2012-198; Butler v. Commissioner, T.C. Memo 2012-72; Carpenter v. Commissioner, T.C. Memo 2012-1; Dunlap v. Commissioner, T.C. Memo 2012-126; Esgar Corp. v. Commissioner, T.C. Memo 2012-35; Minnick v. Commissioner, T.C. Memo 2012-345; Rothman v. Commissioner, T.C. Memo 2012-163, on reconsideration, T.C. Memo 2012-218;; Wall v. Commissioner, T.C. Memo 2012-169; Foster v. Commissioner, T.C. Summ. Op. 2012-90.
The facts and contexts of these cases vary, and the relative merits of the arguments vary. But the fact of continued intensive enforcement and litigation activity in this area is inescapable. Although the income tax deduction for a donation of an historic façade or other conservation easement can be significant, clients and their advisors need to be aware of the close scrutiny by the Service of these donations.
Indeed, care in making all significant charitable contributions is prudent, particularly in light of the fact that Congress has made certain procedural steps a part of the substantive requirements for the income tax deduction. For example, as 2012 developments also confirm, deductions for contributions that seem entirely proper as a matter of economic substance can be denied for the omission of a qualified appraisal (Mohamed v. Commissioner, T.C. Memo 2012-152) or even the failure to obtain a proper receipt stating that no goods or services were provided in exchange for the contribution ( Durden v. Commissioner, T.C. Memo 2012-140).
Number Seven: More Mystery About “Beneficiary-Owned” Trusts: Letter Ruling 201216034
This ruling involved a trust to which the grantor evidently expected to make gifts of S corporation stock. The beneficiary had the power to withdraw the entire value of each contribution, and that power lapsed annually at the rate of $5,000 or 5 percent of the value of the trust principal. The trustee also had a power to distribute income or principal to the beneficiary under an ascertainable standard. The trustee was the beneficiary.
The IRS respected the “beneficiary defective” status of the trust as owned by the beneficiary for income tax purposes and therefore eligible to hold the S corporation stock that the grantor intended to give to it. There are a number of surprises – some have viewed them as gaps – in the reasoning set forth in this ruling:
- The treatment of a totally lapsed withdrawal power as “partially released” for purposes of section 678(a)(2). The IRS has reached this conclusion a number of times. A likely rationale is that when the unlimited power lapsed and a power limited by an ascertainable standard continued, it was the same as a “partial” lapse of the difference between the before and after powers. And because the powerholder could have withdrawn the entire value but didn’t, it is the same as a “release,” as it would be for gift tax purposes under section 2514(e) but for the $5,000/5 percent exception. In this ruling, however, the path to that result has one more turn in it, because the beneficiary as such held no such power; the beneficiary held the power to make distributions subject to an ascertainable standard not as a beneficiary but only in the capacity as trustee. But the ruling does not emphasize that fact or address whether the ruling would be valid if the beneficiary ceased to serve as trustee.
- The beneficiary’s power of substitution that might make the grantor still the owner under sections 675(4)(C) and 678(b). The beneficiary’s power of substitution is very unusual, if not unprecedented, in this type of ruling. Although the law in this area is surprisingly unsettled, the beneficiary – “[o]rdinarily ... an adverse party” under Reg. §1.672(a)-1(b) – appears not to be “adverse” to his own exercise of the substitution power within the meaning of section 672(a) and Reg. §1.675-1(b)(4). In that case, the trust would be a grantor trust as to the original grantor under section 675(4)(C), and it is clear under section 678 that the beneficiary could not be treated as the owner. As usual, the ruling deferred final judgment under section 675(4)(C) until it could be determined on audit whether the substitution power is exercisable in a nonfiduciary capacity, which is a high bar for a beneficiary-trustee to clear under Reg. §1.675-1(b)(4). To gain the full benefit of the ruling, the beneficiary-trustee might have to reverse roles and argue that the power is exercisable only in a fiduciary capacity after all.
- The likelihood that the power to withdraw a monetary amount from the trust makes only a “portion” of the trust owned by the beneficiary as the trust corpus increases in value. This is probably the greatest uncertainty about the use of lapsing withdrawal powers to create a beneficiary-owned trust. The ruling describes the beneficiary’s withdrawal power following each contribution by the grantor as extending to “the entire value of the contribution.” If that represents a “fractional” withdrawal right that grows as the property grows in value, it will be hard for the annual $5,000/5 percent lapses to overcome the entire value of the trust property so as to keep that value out of the beneficiary’s gross estate. If it represents just a monetary amount, which seems most likely, less than the entire trust will be subject to the power or attributable to lapses of the power as the property grows in value. The ruling quotes Reg. §20.2041-3(d)(3), which addresses a hypothetical case in which, conveniently, “the principal of the trust fund … neither increased nor decreased in value prior to [the beneficiary’s] death.” But the ruling does not address the more typical case where that is not true, or at least cannot be presumed. And the ruling does not address the estate tax treatment of the trust.
The broader context in which beneficiary-owned trusts are most frequently mentioned these days involves the funding of a trust by a family member to permit the beneficiary to swap assets into the trust tax-free, or sell assets to the trust in a highly leveraged sale, and remove the assets and future appreciation from the beneficiary’s gross estate. Meanwhile, the beneficiary can retain a potential beneficial interest in the trust and some control over the trust, while being able to pay income tax on the trust’s income. Letter Ruling 201216034 was not such a case; it involved only a straightforward gift of S corporation stock. Although that might explain the Service’s willingness to rule, advisors should not rely on the conclusion of this ruling without trepidation.
But the questions raised above about this ruling will also apply in the broader context. The first two questions can be addressed when designing the trust. The third question remains a conundrum. It can be avoided, for example, by funding the trust with no more than $5,000 and permitting the entire withdrawal power to lapse before there is any change in value. But such nominal funding would place even more strain on the substantial leverage that would be required to make the transaction worthwhile. Letter Ruling 201216034 notwithstanding, the IRS has yet to weigh in.
Number Six: More Mystery About Incomplete-Gift Non-Grantor Trusts Too: Chief Counsel Advice 201208026
An Office of Chief Counsel Internal Revenue Service Memorandum dated September 28, 2011 (opened to public inspection on February 24, 2012, as CCA 201208026), concluded that donors had made a completed gift to a trust, despite their retention of what the CCA described as “a testamentary limited power to appoint so much of [the trust property] as would still be in the Trust at his or her death.” The CCA quoted Reg. §25.2511-2(b), the touchstone of most analysis to determine whether a donor has so parted with dominion and control as to have made the gift complete. Although it doesn’t say so, the CCA might have involved a “Delaware Intentionally Non-Grantor” (“DING”) Trust, in which the goal is to avoid grantor trust status, and thereby state income tax on the trust’s accumulated income, by requiring consent of adverse parties to all distributions during the grantor’s life.
In any event, the CCA was instantly controversial, as it seemed inconsistent with prior statements of the IRS, such as Letter Ruling 200148028, which had stated: “By reason of Grantor’s limited power of appointment, Grantor will have the power to change the beneficiaries of Trust. Therefore, for purposes of the gift tax, Grantor will continue to possess dominion and control over the property transferred to Trust and the irrevocable transfer to Trust will not be a completed gift.” Letter Rulings 200247013 and 200502014 had been similar. In all those rulings, however, unlike the CCA, the donors themselves had been permissible recipients of distributions during their lives. Therefore, as in Rev. Rul. 62-13, 1962 C.B. 180 (another authority that has been frequently cited in reaction to CCA 201208026), it could be said that “there is no assurance that anything of value will be paid to a beneficiary (or class of beneficiaries) other than the grantor.”
Because the CCA does not involve donors who themselves could receive distributions, it appears to have ventured into a fact pattern not addressed by previous rulings and not clearly covered by the reasoning of previous rulings. Because, like many CCAs, it was probably written in support of litigation or at least vigorous audit activity, it does not necessarily represent the Service’s final, balanced, and citable views. But it has attracted attention.
Number Five: The Administration’s Grantor Trust Proposal
The “General Explanations of the Administration’s Fiscal Year 2013 Revenue Proposals” (popularly called the “Greenbook”) was released on February 13, 2012, with seven proposals under the heading “Modify Estate and Gift Tax Provisions.” The sixth of those proposals, new this year, is labeled “Coordinate Certain Income and Transfer Tax Rules Applicable to Grantor Trusts” and has attracted a lot of attention and speculation. The Greenbook describes the proposal very succinctly:
To the extent that the income tax rules treat a grantor of a trust as an owner of the trust, the proposal would (1) include the assets of that trust in the gross estate of that grantor for estate tax purposes, (2) subject to gift tax any distribution from the trust to one or more beneficiaries during the grantor’s life, and (3) subject to gift tax the remaining trust assets at any time during the grantor’s life if the grantor ceases to be treated as an owner of the trust for income tax purposes.
That’s it. The cessation of grantor trust status would be subject to gift tax if it occurred during the grantor’s life or subject to estate tax if it occurred at the grantor’s death (as it must if grantor trust status has not ceased sooner). But that sweeping and startling formulation seems way too ambitious for the $910 million of tax revenue Treasury estimates it would raise over ten years. So no one outside of the Treasury Department knows for sure what this Greenbook proposal means. Nevertheless, who can ignore a proposal that might go to the core of much of current estate planning?
Number Four: Defined-Value Clause Upheld Without the Participation of Charity: Wandry v. Commissioner, T.C. Memo 2012-88, nonacq., 2012-46 I.R.B.
In Technical Advice Memorandum 8611004 (Nov. 15, 1985), the IRS approved the use of a “defined-value” gift of “such interest in X Partnership ... as has a fair market value of $13,000.” Such formulas can be useful in making gifts of hard-to-value assets such as undivided interests in real estate and membership units in family limited partnerships or LLCs, perhaps at no time more so than in the rush to complete large gifts of such assets at the end of 2012. But since 1985, the IRS has become less sympathetic and has challenged such audit-resistant formulas, often citing Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944), a case with unusual facts in which the court found a provision in a document of transfer that “the excess property hereby transferred which is deemed by [a] court to be subject to gift tax ... shall automatically be deemed not to be included in the conveyance” to be contrary to public policy because it would discourage the collection of tax, would require the courts to rule on a moot issue, and would seek to allow what in effect would be an impermissible declaratory judgment. See Technical Advice Memoranda 200122011, 200245053, and 200337012.
Most of the litigated cases have involved transfers of the donor’s entire interest or another clearly fixed interest, allocated among defined-value transfers to noncharitable beneficiaries and a transfer of the rest of the interest to charities. Taxpayers have consistently won those cases, from a tentative acknowledgment in Succession of McCord v. Commissioner, 461 F.3d 614 (5th Cir. 2006), rev’g 120 T.C. 358 (2003), to a disclaimer of a testamentary transfer in Estate of Christiansen v. Commissioner, 130 T.C. 1 (2008) (reviewed by the Court), aff’d, 586 F.3d 1061 (8th Cir. 2009), to a thorough exposition in a gift-sale context in Estate of Petter v. Commissioner, T.C. Memo 2009-280, to the similar case of Hendrix v. Commissioner, T.C. Memo 2011-133, which was appealable to the Fifth Circuit and in which the court relied heavily on McCord.
In Wandry v. Commissioner, T.C. Memo 2012-88, the donors, husband and wife, in 2004, each defined their gifts in a manner that was strikingly reminiscent of Technical Advice Memorandum 8611004, except for the dollar amounts:
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, a Colorado limited liability company, so that the fair market value of such Units for federal gift tax purposes shall be as follows: [Here each donor listed four children and five grandchildren with corresponding dollar amounts, totaling $1,099,000, which represented the $1,000,000 lifetime exclusion amount plus nine $11,000 annual exclusions.]
Although the number of Units gifted is fixed on the date of the gift, that number is based on the fair market value of the gifted Units, which cannot be known on the date of the gift but must be determined after such date based on all relevant information as of that date.
The court stressed the now familiar “distinction between a ‘savings clause’, which a taxpayer may not use to avoid [gift tax], and a ‘formula clause’, which is valid.... A savings clause is void because it creates a donor that tries ‘to take property back’.... On the other hand, a ‘formula clause’ is valid because it merely transfers a ‘fixed set of rights with uncertain value’.” The Tax Court then compared the Wandrys’ gifts with the facts in Petter and determined that the Wandrys’ gifts complied. Most interesting, the court said (emphasis added):
It is inconsequential that the adjustment clause reallocates membership units among petitioners and the donees rather than a charitable organization because the reallocations do not alter the transfers. On January 1, 2004, each donee was entitled to a predefined Norseman percentage interest expressed through a formula. The gift documents do not allow for petitioners to “take property back”. Rather, the gift documents correct the allocation of Norseman membership units among petitioners and the donees because the [appraisal] report understated Norseman’s value. The clauses at issue are valid formula clauses.
This is a fascinating comparison, because it equates the rights of the charitable foundations in Petter that were the “pourover” recipients of any value in excess of the defined values with the rights of the children and grandchildren in Wandry who were the primary recipients of the stated values themselves. In a way, the facts of Wandry were the reverse of the facts in Petter. The effect of the increased value in Petter was an increase in what the charitable foundations received, whereas the effect of the increased value in Wandry was a decrease in what the donees received. The analogs in Wandry to the charitable foundations in Petter were the donors themselves, who experienced an increase in what they retained as a result of the increases in value on audit.
It is also telling that in the court’s words the effect of the language in the gift documents was to “correct the allocation of Norseman membership units among petitioners and the donees because the [appraisal] report understated Norseman’s value.” Until Wandry, many observers had believed that the courts had approved not “formula transfers” but “formula allocations” of a clearly fixed transfer. In fact, the Wandry court used a variation of the word “allocate” five times to describe the determination of what was transferred and what was retained. But the “allocation” was between the donees and the original donors. “Allocation” to the donors looks a lot like retention by the donors, if not a way to “take property back.” The court did not acknowledge that tension, but continued to use “allocation” language to justify what in economic effect defined what was transferred by the donors, not merely how the transferred property was allocated among donees. Again, though, the overall context and thrust of the court’s analysis was that the donors had not sought “to take property back,” but had merely defined what was given on the date of the gift.
Thus, there is now a taxpayer victory in a defined value case that does not involve a “pourover” to charity of any excess value, which many observers have viewed as quite a breakthrough. The Wandry court concluded by again acknowledging the absence of a charity and saying that “[i]n Estate of Petter we cited Congress’ overall policy of encouraging gifts to charitable organizations. This factor contributed to our conclusion, but it was not determinative.”
The Government appealed Wandry to the Court of Appeals for the Tenth Circuit, but dropped the appeal on October 16, 2012. The IRS issued a nonacquiescence in Wandry on November 9, 2012. 2012-46 I.R.B.
The fairest summary of Wandry, as we have written before, is that it is undeniably significant for extending the scope of the decided cases beyond the context of a charitable pourover. Unlike the charitable cases, however, Wandry does not represent a consistent body of Tax Court and appellate court jurisprudence, and, as even the charitable cases show, the IRS does not approve of the defined-value technique. Because it is also fair to speculate that many year-end 2012 gifts have followed the pattern of a “ Wandry formula,” we should not be surprised to see future cases involving Wandry types of defined-value gifts.
Number Three: Constitutionality of the Federal Definition of Marriage To Be Considered by the Supreme Court: Windsor v. United States, 833 F. Supp. 2d 394 (S.D.N.Y.), aff’d, 699 F.3d 169 (2d Cir. 2012), cert. granted (No. 12-307, Dec. 7, 2012)
Few issues stir emotions like the clash between “marriage equality” and “traditional” marriage. The most prominent intersection of that issue with estate planning is the estate and gift tax marital deduction. Thus it was of great interest when a District Court, followed promptly by a Court of Appeals, held the definition of “spouse” in section 3 of the federal Defense of Marriage Act (DOMA) as “a person of the opposite sex who is a husband or wife” to be an unconstitutional denial of the equal protection of the laws.
The same-sex couple in Windsor were legally married in Canada and registered as domestic partners in New York, where they lived. One of them died before New York had changed its law to permit same-sex marriages, but at a time when many New York lower courts had recognized marriages performed under the laws of other jurisdictions. In rejecting the survivor’s claim for refund, the IRS denied an estate tax marital deduction. The Justice Department switched sides and opposed the DOMA definition because it viewed it as unconstitutional under a heightened standard of scrutiny. The DOMA definition and denial of the marital deduction were defended in court by counsel engaged by the Bipartisan Legal Advisory Group of the U.S. House of Representatives. The District Court sided with the survivor on June 6, 2012, and the Court of Appeals for the Second Circuit affirmed on October 18, 2012. The Supreme Court granted certiorari on December 7 in Windsor, as well as in the case of Hollingsworth v. Perry (No. 12-144) involving an equal protection challenge to California’s definition of marriage as the union of a man and a woman.
Neither Windsor nor even Perry is likely to reach the issue of a federal equal protection guarantee of the right of same-sex couples to marry. Indeed, the Supreme Court may have left the door open to disposing of Windsor without even reaching the DOMA definition. In an order dated December 11, the Court announced:
[Harvard Law School Thurgood Marshall Professor of Constitutional Law] Vicki C. Jackson, Esq., of Cambridge, Massachusetts, is invited to brief and argue this case, as amicus curiae, in support of the positions that the Executive Branch’s agreement with the court below that DOMA is unconstitutional deprives this Court of jurisdiction to decide this case, and that the Bipartisan Legal Advisory Group of the United States House of Representatives lacks Article III standing in this case.
Regardless of the outcome of Windsor, it is clear that this is a topic to be watched for years to come because of the significant impact on tax planning for same sex couples. In addition to the marital deduction, other notable tax benefits of marriage include gift-splitting (sections 2513(a) and 2652(a)(2)), non-recognition of gain (section 1041(a)), single counting as S corporation shareholders (section 1361(c)(1)), and of course joint income tax returns (section 6013). On the other hand, not being married can avoid, where it is unwelcome, “family” treatment for such purposes as the special valuation rules of chapter 14 (sections 2701(e)(1) and 2704(c)(2)), disallowance of losses (section 267(c)(4)), attribution of stock ownership (section 318(a)(1)), grantor trust treatment (sections 672(e) and 677(a)(1)), exceptions to stepped-up basis (section 1014(e)(1)(B)), and identification of disqualified persons with respect to private foundations (section 4946(d)).
This will also undoubtedly continue to be an issue to be addressed in drafting, because some clients will want dispositive provisions that are more restrictive, or more expansive, or in any event more personalized, than the law in this area has been or might become. And in that context, it may not be clear for a long time if a balance needs to be struck between testamentary freedom and public policy and, if so, how the balance will be struck.
Number Two: The Portability Regulations, T.D. 9593, 77 Fed. Reg. 36150 (June 18, 2012)
Section 303 of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Public Law 111-312), which President Obama signed into law on December 17, 2010 (thought in those days to have been late in the year!) amended section 2010 to provide for the portability of the unified credit between spouses. The legislation left many details to be filled in by regulations, and new section 2010(c)(6) grants Treasury specific rulemaking authority. Because portability became effective with respect to predeceased spouses who died on or after January 1, 2011, it was important for those regulations to be retroactive, and section 7805(b)(2) relaxes the general prohibition on retroactive tax regulations for regulations issued within 18 months of the date of enactment, or, in this case, by June 17, 2012, which was a Sunday. So how fitting it is in these times of fiscal cliff-hanging that temporary regulations (T.D. 9593, 77 Fed. Reg. 36150 (June 18, 2012)) and identical proposed regulations (REG-141832-11, id. at 36229) were released on Friday, June 15, 2012.
The regulations have been hailed as very workable and taxpayer-friendly. One exception is the disappointment that Reg. §20.2010-2T(a)(1)-(4) confirms that the portability election must be made on a timely filed estate tax return of the predeceased spouse, but the current statute is very rigid on this point and there seems little that the regulations could have done about it.
Reg. §20.2010-2T(a)(6) confirms that the election may be made by an appointed executor or administrator of, if there is none, “any person in actual or constructive possession of any property of the decedent.” This reflects the notion of what is often called a “statutory executor,” after the definition in section 2203. Such a “non-appointed executor” could (and often will) be the surviving spouse himself or herself.
In what is perhaps the most significant and welcome provision of the regulations, Reg. §20.2010-2T(a)(7)(ii) provides special rules for reporting the value of property on an estate tax return filed to elect portability but not otherwise required for estate tax purposes. The value of property qualifying for a marital or charitable deduction (which does not use any unified credit anyway) need not be stated, if the executor “exercises due diligence to estimate the fair market value of the gross estate.” Reg. §20.2010-2T(a)(7)(ii)(B). Pending the publication of instructions to the estate tax return, the regulations provided that this due diligence could be shown by provision of “the executor’s best estimate, rounded to the nearest $250,000,” of that value. When the instructions were published in October 2012, they modified this “nearest $250,000” convention only by requiring that the rounding always be up to the next highest multiple of $250,000. More rigorous valuation of marital or charitable deduction property is still needed in the case of formula bequests, partial disclaimers, partial QTIP elections, split-interest transfers, and eligibility for tax treatment that is affected by such values (for which Reg. §20.2010-2T(a)(7)(ii)(A)(2) cites sections 2032, 2032A, and 6166 as examples). But it is clear that in the paradigm case of a married couple with a home, modest tangible personal property, bank account, and perhaps an investment account – all possibly jointly owned – and life insurance and retirement benefits payable to the survivor, the requirements for completing an estate tax return to elect portability have been made relatively simple, especially considering that the surviving spouse is likely to be the “non-appointed executor” with respect to all the property.
The regulations brought more good news. Invoking “the principle that a statute should not be construed in a manner that renders a provision of that statute superfluous,” “the indicia of legislative intent reflected in the Technical Explanation and the General Explanation,” and “the express [rulemaking] authority granted by Congress in section 2010(c)(6) and 7805,” the preamble to the temporary regulations resolves the discrepancy between the statute and the legislative history (“the Example 3 problem”) by interpreting the reference in section 2010(c)(4)(B)(i) to the basic exclusion amount to mean the applicable exclusion amount. Reg. §20.2010-2T(c)(1)(ii)(A) reflects this interpretation.
More welcome news is in Reg. §§20.2010-3T(a) and 25.2505-2T(a), which confirm that the deceased spousal unused exclusion amount (called the “DSUE amount” by the regulations) of the last deceased spouse dying after 2010 is available both to the surviving spouse for gift tax purposes and to the surviving spouse’s estate for estate tax purposes. Neither remarriage nor divorce will affect that availability, but the death of a subsequent spouse will terminate the availability of the DSUE amount from the previous last deceased spouse. This is true no matter how much DSUE amount, if any, of the previous last deceased spouse is still unused, and whether or not the new last deceased spouse has any DSUE amount or whether or not the executor of the new last deceased spouse even made a portability election. To make that structure much more workable , Reg. §25.2505-2T(b) creates an ordering rule providing that when the surviving spouse makes a taxable gift, the DSUE amount of the last deceased spouse (at that time) is applied to the surviving spouse’s taxable gifts before the surviving spouse’s own basic exclusion amount. Reg. §§25.2505-2T(c) and 20.2010-3T(b) provide rules that retain the DSUE amounts of a previous last deceased spouse that the surviving spouse has used for previous gifts in the future calculations of either gift tax or estate tax, in order to accommodate the cumulative nature of those tax calculations. The effect of these rules is to permit a surviving spouse, by making gifts, to benefit from the DSUE amounts of more than one predeceased spouse.
The portability regulations are significant for two reasons. First, they ratify what is likely to fundamentally change the approach to estate planning for some married couples with significant but not huge combined estates. (And they were published only nine days after the District Court decided the Windsor case, which, if affirmed by the Supreme Court, would extend to same-sex married couples the federal tax benefits available to all married couples, including portability.) Second, they signify a serious commitment in the Internal Revenue Service and the Treasury Department to creating workable tax rules and addressing statutory challenges in a creative and user-friendly way, in accord with the stated objectives of the legislation.
Number One: Reserved!
If Congress acts before the end of 2012 to permanently, or even temporarily, clarify its intentions for the estate and gift taxes of the future, that will undoubtedly be the top estate tax development of the year. If Congress does not act before the end of 2012 and thereby ratifies our year-end rush to get gifts completed, then that will be the top estate tax development of the year.
In any event, the 2012 election has left us a Congress with demonstrated dislike for a high estate tax. In the House of Representatives, 208 Members elected to the 113th Congress (the 2013-2014 Congress) are among the 272 who voted for the “Death Tax Repeal Permanency Act of 2005” (H.R. 8) in April 2005 or the 222 cosponsors of the “Death Tax Repeal Permanency Act of 2011” (H.R. 1259) in the 112th Congress, two bills that, as the name suggests, proposed the complete and permanent repeal of the estate and GST taxes. Adding 46 other new Republicans (since 2005) results in 254 Members with possible no-tax or low-tax leanings.
Meanwhile, 60 Senators in the 113th Congress are among the 84 Senators who expressed support (in at least one of two separate votes) for a 35 percent rate and a $5 million exemption during consideration of the fiscal 2009 budget resolution in March 2008 or the 38 cosponsors of the Senate version of the “Death Tax Repeal Permanency Act of 2012” (S. 2242). Adding five other new Republicans (since 2008) results in 65 Senators with possible no-tax or low-tax leanings.
Elements of timing, packaging, and simple trade-offs make predictions of congressional action more inscrutable than simple math. But it is fair to say that in a stand-alone vote unaffected by either the politics or the fiscal implications of other important issues, Congress is unlikely to favor an estate tax more onerous than 2011 and 2012 law.