2021 Tax & Legal Seminar Binder by Arizona Community Foundation

FRIDAY NOVEMBER 5, 2021 CO -SPONSORS

BENEFACTOR

PRESENTER: STEVE AKERS

FRIDAY, NOVEMBER 5, 2021

PROGRAM AGENDA 7:30 to 7:45 Login to Cvent Virtual Attendee Hub

7:45 to 8:00 Opening remarks and speaker introduction

8:00 to 9:00 Sophisticated Transfer Planning Strategies for 2021 (Part 1)

9:00 to 9:10 Break

9:10 to 10:10 Sophisticated Transfer Planning Strategies for 2021 (Part 2) Structuring Trustee Powers to Avoid a Tax Catastrophe (Part 1)

10:10 to 10:20 Break

10:20 to 11:20 Structuring Trustee Powers to Avoid a Tax Catastrophe (Part 2)

11:20 to 11:30 Break

11:30 to 12:30 Estate Planning Current Developments and Hot Topics

12:30 Closing remarks

PRESENTING SPONSORS

BENEFACTOR

BOK FINANCIAL PRIVATE WEALTH FENNEMORE.

TECHNOLOGY

DIAMOND FINEMARK NATIONAL BANK & TRUST

HIRTLE CALLAGHAN & CO. TRUSTBANK

CONTENTS 01

Jewish Community Foundation Arizona Community Foundation PAGES 4-7

02 2021 Tax & Legal Planning Committee and Sponsors PAGES 8-47

Sophisticated Transfer Planning Strategies for 2021 PAGES 52-109

05 Structuring Trustee Powers to Avoid a Tax Catastrophe (or Twenty Things You Need

to Know About Selecting Trustee and Structuring Trustee Powers)

PAGES 110-322

03 Steve Aker’s Detailed Timed Agenda PAGES 48-51

06 Estate Planning Current Developments and Hot Topics PAGES 323-474

SEE YOU NEXT YEAR 2022 Tax & Legal Seminar Wednesday, November 2

Building a permanent source of ﬁnancial support for a vibrant, enduring Jewish community.

Board of Directors

Professional Leadership

Lee Eisinberg, Chair

Richard Kasper

Francine Coles Bradley Dimond

Sheryl Quen Director of Grants and Communications

Nora Feinberg Alan Gold Neil Goldstein Neal Kurn, Honorary Director Rebecca Light

Rachel Rabinovich Director of Special Projects LIFE & LEGACYTM Program Director

Deborah Miller Andrew Plattner Virginie Polster

Andrea Cohen Director of Youth Philanthropy

Sandy Rife Robert Roos, Immediate Past Chair Donald Schon

Donna Corcoran Director of Finance and Operations

Ernie Muntner Administrative Assistant

12701 North Scottsdale Road, Suite 202 | Scottsdale, Arizona 85254

FOR PROFESSIONAL ADVISORS Building a permanent source of nancial support for a vibrant, enduring Jewish community. History of the Jewish Community Foundation of Greater Phoenix The Jewish Community Foundation of Greater Phoenix was established in 1972 with the vision of ensuring that future generations will inherit a thriving Jewish community. We work with individuals, families and organizations to create personal charitable legacies rooted in Jewish tradition and values, to grow and sustain a vibrant, enduring Jewish community. We are proud of the strong relationships we have built with financial and estate planning professionals, who share a common belief in the value of charitable giving. These professionals often are among our best referral sources, because of the trust and confidence they have earned from their clients. Likewise, donors often consult us when they need a referral for qualified professional services. Because of the value we place on these important relationships, the Foundation offers a number of services to the professional advisory community.

GiftLaw GiftLaw is a free electronic resource, which complements the services of the Foundation’s experienced staff, and is accessible through our website. It offers planned giving calculations, the latest information on IRS private letter rulings, and well-researched, expert articles on current trends. Weekly updates are delivered via email, ensuring that you never miss news and analysis that may be critical to your practice.

Tax & Legal Seminar The region's most respected program for financial planning, tax and estate planning professionals, the annual Tax & Legal Seminar presents nationally recognized speakers on the latest trends and developments in tax, estate planning, and charitable giving. Attendees receive up to four hours of well-priced continuing education credits and the opportunity to network with hundreds of professionals who register annually. This program has been presented by the Jewish Community Foundation since 1993, and in partnership with the Arizona Community Foundation since 2001.

Professional Advisory Committee Professionals in the fields of law, accounting, financial and insurance services meet over breakfast four to five times annually. Committee members learn about stimulating topics of mutual interest, and are exposed to the Foundation’s work and the work of our community partners. Committee members have an opportunity to discuss recent developments in their own professional practices with a trusted group of professional peers.

Professional Consultation The Jewish Community Foundation offers personal advice and information to suit the individual needs of your clients, including custom illustrations of the charitable and financial implications of your clients’ various tax and charitable planning options. We are glad to be a confidential resource to you and your clients, at your convenience.

5 Phone: 480.699.1717 | Fax: 480.699.1807 | Email: info@jcfphoenix.org | www.jcfphoenix.org

The Arizona Community Foundation has over 40 years of experience partnering with individuals, families, and organizations who wish to give back to their community. We make sure our donors have the expert guidance and flexible options that best suit their style of giving. We partner with professional advisor firms across the state to provide personal service and helpful resources to meet their clients’ charitable goals. Some of the services we offer to our partners and their clients include:

Tax planning.

Local connections.

Education events.

Donor advised funds.

Dedicated support.

Investment management.

ACF will work directly with you and your clients to understand charitable interests, overall strategy, and goals for giving, while also ensuring their choices maximize available tax benefits.

With this cost-effective alternative to a private foundation, your clients can take advantage of available tax deductions when they contribute cash, stock, or appreciated assets to their named fund while making grant recommendations that align with their goals.

With six affiliate offices across the state, ACF has a strong and comprehensive network of local resources to help your clients identify nonprofit organizations and projects that align with their charitable goals and interests.

Your clients will receive a dedicated relationship manager who serve as their main point of contact to ensure that their charitable goals are accomplished. ACF will work directly with them to support local, national, or international causes.

ACF hosts a wide range of convenings and events on important social, cultural, and community topics for donors and community members. We also host seminars for professional advisors with opportunities to earn continuing education credit.

When charitable assets meet a certain threshold, donors may continue to work with their existing wealth advisor to manage the investment of assets held in ACF funds.

Our network of professional advisor partners is always growing. If you’re interested in connecting with us, give us a call at 602.381.1400.

BOARD OF DIRECTORS Robbin M. Coulon, Esq., chair Leezie Kim, Esq., vice chair Heidi Jannenga, PT, DPT, ATC/L, secretary Rufus Glasper, Ph.D., CPA, treasurer Benito Almanza Jim Ameduri Lon Babby Noreen Bishop Mark C. Bohn, Esq. Tony Bolazina Danny L. Bryant Gwen Calhoun Javier Cárdenas, MD Shelley Cohn, past chair Mark Feldman, CPA, CFP

Charley Freericks Patricia Garcia Duarte Xavier Gutierrez Neil H. Hiller, Esq. Leonardo Loo Marianne Cracchiolo Mago Tammy McLeod Ann Drummond Melsheimer Jacob Moore Richard Morrison Don Opatrny Essen Otu Mi-Ai Parrish Barbara A. Poley Armando Roman, CPA/PFS, MBA Eve Ross, JD Gerald Bisgrove, past chair

Ron Butler, past chair Jack Davis, past chair Robert M. Delgado, past chair Bennett Dorrance, past chair Stephen O. Evans, immediate past chair Bert Getz, chairman emeritus Marilyn Harris, past chair William J. Hodges, CPA/PFS, past chair Neal H. Kurn, Esq., past chair Richard H. Silverman, past chair Richard B. Snell, past chair Richard H. Whitney, Esq., past chair Steve G. Seleznow, president & CEO

2021 PROFESSIONAL ADVISORY BOARD We rely on our Professional Advisory Board to provide the Arizona Community Foundation with strategic planning, guidance, and oversight. Trish Stark, chair Yaser Ali, Esq. Ellen Steele Allare, CLU®, ChFC®, past chair emeritus Stephen Barber MacAuley Beloney Brenda A. Blunt, CPA Mark C. Bohn, CPA, Esq., past chair emeritus Linda H. Bowers, JD, AEP®, CFP®, CEPA®, past chair emeritus Sergio Càrdenas David L. Case, Esq. Stephen S. Case, Esq., past chair emeritus Theresa E. Chacopulos, CFP® Beth S. Cohn, Esq. Valarie Donnelly Russell S. Duerksen, Esq., Rita A. Eisenfeld, past chair emeritus

John B. Even, Esq. Jana Flager, Esq. Russell S. Goldstein, CFP®, CAP®, CSRIC, immediate past chair Brent M. Gunderson, Esq. Carrie L. Hall, CLU®, CFP® Victoria Harris, CPA Mary Ann Hennelly-Favata, CFP® William J. Hodges, CPA, past chair emeritus Scott M. Horn, CPA Charles J. Inderieden, CPA, PFS Jill Iurato, CRPS Lindsey A. Jackson, Esq. Lynton M. Kotzin, CPA, CFA® Gregory M. Kruzel, Esq., past chair emeritus Neal H. Kurn, Esq., emeritus T. James Lee, Esq. W. John Lischer, emeritus

Miranda Lumer, Esq. Thomas Maguire, CPA Jeffrey M. Manley, Esq. Denise M. McClain, Esq., past chair emeritus T. Troy McNemar, Esq. Jonathon M. Morrison, Esq. Mahes Prasad, AIF Angelica F. Prescod, AAMS Neil E. Robbins, CLU®, ChFC® James W. Ryan, Esq., past chair emeritus Abbie S. Shindler, Esq. Christopher P. Siegle, Esq. Verne Smith, CLU®, ChFC® Mary Taylor Huntley, CFP® Michael J. Tucker, Esq. Benjamin Voelker, CFP®, CPWA® David K. Walser, CPA, PFS Kris Yamano, JD, MBA Paul E. Yates, FSA, CLU® 7

2021 PLANNING COMMITTEE

Thank you to the committee of dedicated legal, accounting, financial planning professionals, and life underwriters who volunteer their time and expertise to both the Arizona Community Foundation and the Jewish Community Foundation. You are vital to the success of this annual seminar.

We offer special thanks to our Seminar Leadership: Teresa Coin, Esq., Chair BOK Financial Private Wealth

T.J. Ryan, Esq., Vice Chair Frazer Ryan Goldberg & Arnold LLP

Brenda Ann Blunt, CPA, CGMA Eide Bailly LLP Dieter G. Bollmann First Financial Equity Corporation Linda H. Bowers, JD, AEP®, CFP®, CEPA®, Past Chair Northern Trust Adam M. Brooks, CFP®, Past Chair ABLE Financial Group, LLC Kelley L. Cathie, Esq. Braun Siler Kruzel PC Susan M. Ciupak, Esq. Beth S. Cohn, Esq. Jaburg & Wilk, P.C. John B. Even, Esq. Schmitt Schneck Even & Williams, PC J. Noland Franz, Esq. Buchalter, a Professional Law Corporation Terri A. Hardy Bonhams Victoria C. Harris, CPA, Past Chair Hunter Hagan & Company, Ltd. Stephen Hart, CPA Stephen Hart PLLC Katie Hill, CTFA, AEP® First Western Trust Daniel Hulsizer, JD, CPA Warner, Angle, Hallam, Jackson & Formanek PLC Erin B. Itkoe, CPA/PFS, CFP® AEP® Tarbox Family Office Lindsey A. Jackson, JD FineMark National Bank and Trust Brad Jepson, CFP®, CTFA, ChFC The Northern Trust Company Grant Kamin, CFP® Desert Financial Wealth Management Elena Kohn ArtFortune LLC Kimberly C. Kur, JD, CAP® Arizona Community Foundation Miranda K. Lumer, JD Denise E. McClain, Esq., Past Chair Hirtle Callaghan & Co. James Sean McGettigan, CPA/PFS, CFP®, CGMA Stoker Ostler Deborah W. Miller, Esq., Past Chair Deborah W. Miller PLLC

Shawn Parker, CPC, QPA MGKS Kristel K. Patton, Esq. Empowered Legacy Planning Brian Poe, CFP®, ChFC®, AEP® Versant Capital Management Debra J. Polly, Esq. Sherman & Howard L.L.C. Christy Ray, JD, LLM First International Bank and Trust Eliza Daley Read Mangum, Wall, Stoops & Warden, PLLC Jeff A. Schlichting, CPA Eide Bailly LLP Darin Shebesta, CFP®, AIF® Jackson/Roskelley Wealth Advisors, Inc. Abbie S. Shindler, Esq. Buchalter, a Professional Law Corporation Christopher P. Siegle, Esq., LL.M, AEP® J.P. Morgan Private Bank Curtis L. Smith Capital Wealth Alliance, LLC Lisa Sullivan, CTFA, CWS, AEP®, CSOP® TrustBank Allyson J. Teply, Esq. Sacks Tierney P.A. Michelle Margolies Tran, Esq. Clark Hill PLC Stephanie F. Tribe, Esq. Fennemore. Jeanne Vatterott-Gale, Esq. Hunt & Gale Thomas C. Waite, CFP®, CWS® Schwab Private Client Investment Advisory, Inc. Pamela Wheeler, EA, Past Chair Henry+Horne Trevor S. Whiting, JD, LLM, MBA Dana Whiting Law, PLLC Farrah H. Whitworth, CPA Globe Corporation Keith Wibel, CFA® Capital Insight Partners, LLC Kris Yamano, JD, MBA Crewe Advisors, LLC Paul E. Yates, FSA, CLU® Cohn Financial Group

We gratefully acknowledge these contributors for their generous support of the 2021 Tax & Legal Seminar

BENEFACTOR

TECHNOLOGY FRAZER RYAN GOLDBERG & ARNOLD LLP

DIAMOND

PLATINUM

GOLD

BOK FINANCIAL PRIVATE WEALTH BESSEMER TRUST EIDE BAILLY LLP FENNEMORE. CATHOLIC EDUCATION ARIZONA ESTATE MANAGEMENT SERVICES FINEMARK NATIONAL DYER BREGMAN & FERRIS, PLLC MGKS BANK & TRUST FIRST INTERNATIONAL BANK & TRUST RYLEY CARLOCK & APPLEWHITE/ HIRTLE CALLAGHAN & CO. WEALTH MANAGEMENT MCNEMAR LAW OFFICES, P.C. TRUSTBANK HENRY+HORNE TFO PHOENIX KOTZIN VALUATION PARTNERS, A PART OF J.S. HELD LLC NORTHERN TRUST TARBOX FAMILY OFFICE ZIA TRUST, INC.

PATRONS AASK-Aid to Adoption for Special Kids A New Leaf ABLE Financial Group, LLC Arizona Bank & Trust Ballard Spahr LLP BMO Private Wealth Management Boyer Bohn p.c. Braun Siler Kruzel PC Capital Insight Partners, LLC CAPTRUST

Crewe Advisors, LLC Dana Whiting Law, PLLC Dickinson Wright, PLLC Gesher Disability Resources Hunter Hagan & Company, Ltd. J.P. Morgan Private Bank Jaburg Wilk Jewish Tuition Organization Lohman Company, PLLC

Benefit Financial Services Group Berk Law Group Cohn Financial Group Teresa Coin, Esq. Deborah W. Miller, PLLC First Financial Equity Corporation First Western Trust

Holland & Knight Hunt & Gale Jackson/Roskelley Wealth Advisors, Inc. Jewish Free Loan John Even of Schmitt Schneck Even & Williams, P.C. Mack Business Appraisals, LLC

MidFirst Private Wealth Management RSM US LLP Sacks Tierney Sherman & Howard L.L.C. Stoker Ostler Wealth Advisors Sunflower Bank Wealth Management Versant Capital Management Warner, Angle, Hallam, Jackson & Formanek PLC

SUPPORTERS James Sean McGettigan, CPA/PFS, CFP®, GMA Stephen Hart PLLC Strategic Wealth Advisors, LLC T&T Estate Services, LLC Wallace, Plese + Dreher, LLP

FRIENDS Brenda Ann Blunt, CPA, CGMA Linda H. Bowers, JD, AEP®, CFP®, CEPA® Victoria C. Harris, CPA Erin B. Itkoe, CPA/PFS, CFP® AEP® Lindsey A. Jackson, J.D. Grant Kamin, CFP®

Denise E. McClain, Esq. Kristel K. Patton, Esq. Brian Poe, CFP®, ChFC®, AEP® Abbie S. Shindler, Esq. Christopher P. Siegle, Esq., LL.M, AEP®

Lisa Sullivan, AEP® CSOP® CTFA® CWS® Michelle Margolies Tran, Esq. Thomas C. Waite, CFP®, CWS® Farrah H. Whitworth, CPA Keith Wibel, CPA

SEE YOU NEXT YEAR!

WEDNESDAY NOVEMBER 2, 2022

Featuring Keynote Speaker Joshua S. Rubenstein In this role as Partner and National Chair, Private Wealth for the widely respected firm Katten Muchin Rosenman LLP, Josh brings a variety of important services under one roof for high-net-worth individuals. He offers integrated planning, administration and litigation counseling for individuals, their estates and their businesses, all of it designed to preserve wealth over generations. Josh has been practicing in the field for more than 35 years and is involved with a number of industry and community organizations, including the American Law Institute Estate Planning Advisory Board, the American College of Trust and Estate Counsel Foundation, and The American College of Trust and Estate Counsel.

How Will You Assure Jewish Tomorrows? Make Plans Today to Pass on Your Values

480.699.1717 jcfphoenix.org

“

Working with ACF has been one of the true highlights of my 38 years in the investment industry. James P. Marten, CIMA Managing Director, Wealth Management Advisor, Merrill Lynch

”

Partner with charitable experts to do more for your clients. Call or click: 602.381.1400 or azfoundation.org 12

ABBOT DOWNING IS PLEASED TO SUPPORT THE 2021 TAX AND LEGAL SEMINAR

Abbot Downing helps build lasting legacies for and endowments. We collaborate with clients and their advisors to manage the full impact of wealth. The result is a finely crafted strategy designed to deliver desired results and a meaningful legacy for future generations. Drawing on the global resources of Wells Fargo, opportunities not widely available, including: • ASSET MANAGEMENT • LEGACY AND WEALTH PLANNING • INSTITUTE FOR FAMILY CULTURE • TRUST, FIDUCIARY, AND ADMINISTRATIVE SERVICES • PRIVATE BANKING • FOUNDATIONS AND ENDOWMENTS

To learn more, contact Eric Williams, Managing Director at eric.williams@abbotdowning.com or 415-509-6857.

Abbot Downing, a Wells Fargo business, provides products and services through Wells Fargo Bank, N.A., and its various

Adam Baker, Jason Ray, Albin Littell, Teresa Coin, Sharon Cohen, and Ashley Wittneben

Proud To Be Part Of Arizona’s Past, Present And Future

480.596.4353 | www.bokfinancial.com

BOK Financial® is a trademark of BOKF, NA. Member FDIC. Equal Housing Lender

YOUR FAMILY AND FRIENDS

WILL ALWAYS REMEMBER YOU. Your Financial Legacy Is Safe With Us.

Proud Supporters of the Arizona Community Foundation and the Jewish Community Foundation. At Fennemore, you’ll be in the trusted hands of one of the largest private client and estate planning practices in the American west. We represent individuals, families, busines owners, non-profits and trust companies in a broad range of sophisticated trust, estate, litigation, business and tax matters. For more information on how to put Fennemore to work for you, please contact Stephanie Tribe, chair of our trusts and estates law practice:

(602) 916-5325 stribe@fennemorelaw.com

fennemorelaw.com ExpectMORE

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A R IZON A T RUS T & INV ES TM E NT TE A M

FineMark National Bank & Trust delivers exceptional client service and offers customized solutions to help individuals and families reach their goals and build lasting legacies for generations to come. FineMark’s comprehensive wealth management services include: ▪ Asset Management

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GAINEY RANCH 7600 E. Doubletree Ranch Road, Suite 100 Scottsdale, AZ 85258

DC RANCH 20909 N. 90th Place, Suite 102 Scottsdale, AZ 85255

480-607-4860

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To learn more, please contact Lindsey Jackson at ljackson@finemarkbank.com or 480-607-4882 www.finemarkbank.com Member FDIC • Equal Housing Lender Trust and investment services are not FDIC insured, are not guaranteed by the bank and may lose value.

We are proud to sponsor the Tax and Legal Seminar and support the great work of the Arizona Community Foundation and the Jewish Community Foundation. “We exist to serve our clients with passionate, powerful, informed advocacy. Our why is defined by client trust; it inspires us to dig deeper, to never settle, to innovate and to negotiate on behalf of clients.” -Jon Hirtle, Executive Chairman

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Since 1988, Hirtle Callaghan has been serving as a trusted investment partner to families and foundations. Your success is at the heart of our mission. With each client in mind, we design and manage a complete, custom investment program that reflects our best ideas across a global, diverse opportunity set. The result is a holistic investment strategy created to meet your investment goals and establish a meaningful legacy.

Investment Solutions for a Complex World www.hirtlecallaghan.com To learn more, contact Denise McClain, Director, at dmcclain@hirtlecallaghan.com or (480) 436-4982. 18

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Our answers are clear and concise: we are privately owned and independent; we only focus on private wealth management; our interests are aligned because our clients, owners, and employees invest side-by-side; our relationship managers are rewarded for their client service, not sales; and our portfolio managers are measured on long-term performance, not assets under management. These key principles have guided our ﬁrm since its founding. Bessemer Trust is a multifamily o∞ce that has served individuals and families of substantial wealth for more than 110 years. Through comprehensive investment management, wealth planning, and family o∞ce services, we help clients achieve peace of mind for generations. To learn more, please contact Taylor Heininger, Regional Director, at 213-330-8566, or visit us at Bessemer.com.

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We provide legal services in the following areas and are available for collaborations or referrals Estate Planning | Probate | Trust Administration Disputed Inheritances | Undue Influence and Exploitation Litigation Nursing Home Abuse and Wrongful Death | Guardianships Conservatorships | Special Needs Planning | Veterans Disability

Providing legal services to the community for over 50 years.

3411 N. 5th Ave., Suite 300, Phoenix, AZ 85013 Phone: (602) 254-6008 | www.dbfazlaw.com

Kotzin Valuation Partners is now a part of J.S. Held, a multidisciplinary consulting firm providing specialized technical, scientific, financial, and advisory services. As part of J.S. Held, we will continue to deliver defensible business valuations and superior client service. We are excited to enhance our local client resources through access to J.S. Held’s team of diverse global experts. Our expertise includes:

Valuation Advisory Services

Financial Investigations

Construction Claims & Disputes

Global Investigations

Environmental, Health & Safety

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Equipment

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Expert Services

Surety

Forensics

For more information, call Lynton Kotzin or Don Wenk at 602-544-3550

Learn more at JSHELD.com and KOTZINVALUATION.com J.S. Held and its affiliates and subsidiaries are not a certified public accounting firm and do not provide audit, attest, or any other public accounting services. J.S. Held is not a law firm and does not provide legal advice. All rights reserved.

EXPERIENCE

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northerntrust.com/wealthadvisor

THE NEXT LEVEL OF WEALTH MANAGEMENT

BETTER PORTFOLIO MANAGEMENT Transparent, tax-aware, and low-cost, our portfolios are built to take maximum advantage of the returns of each asset class. Clear reporting and 24/7 visibility of the details and daily performance provide accountability.

SMARTER WEALTH MANAGEMENT From a comprehensive review of your property/casualty insurance to cash flow projections, tax, retirement, and estate planning, we cover it all.

FAMILY OFFICE SERVICES Families with complex situations, complicated transactions, and extraordinary wealth will benefit from our fully coordinated and integrated approach, which includes tax preparation, family education, and legacy planning.

PHOENIX, AZ

NEWPORT BEACH, CA

645 East Missouri Ave, Suite 270 Phoenix, AZ 85012

500 Newport Center Drive, Suite 500 Newport Beach, CA 92660

(949) 721 - 2330

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Proud Supporters of the 2021 Arizona Tax & Legal Seminar

Zia Trust, Inc.

“ The Advisors’ Trust Company®”

OUR SERVICES TRUST ADMINISTRATION

ESTATE SETTLEMENT

OTHER FIDUCIARY SERVICES

Why Zia Trust? As a corporate trustee it is our duty to be objective and free up families from the burden and conflicts that arise in managing family estate and financial matters. We are focused entirely on serving as trustee of your trust. We do not cross-sell anything, and we are not obligated to such things as proprietary bank investments or mutual funds, or in house Investment Advisors.

•Independent from banks and financial institutions •$1.5+ billion assets in trust or custody •Regulated by Arizona trust company laws •13 Trust Officers with diverse backgrounds

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ziatrust.com

602.633.7999 800.996.9000

dlong@ziatrust.com rzaslow@ziatrust.com

DREAMING DOING Wealth planning shouldn’t distract clients from the moments that matter most. Eide Bailly’s Wealth Planning Team works closely with industry advisors to offer well-rounded solutions and a holistic perspective. Together, we can offer the support clients need to feel confident in their future and live in the moment.

What inspires you, inspires us. 480.315.1040 | eidebailly.com

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6530 North 16th Street, Phoenix, AZ 85016 P | 602.944.1515

www.mgks.com

You’re Unique. Your Estate & Tax Planning Should Be Too.

T. Troy McNemar Estate Planning & Trust Administration 602.440.4813 / 602.265.3971 TMcNemar@rcalaw.com / Law@McNemar.com

John C. Lemaster Probate Litigation Ryley Carlock & Applewhite 602.440.4831 JLemaster@rcalaw.com

W John Lischer Estate Planning & Trust Administration Ryley Carlock & Applewhite 602.440.4817 JLischer@rcalaw.com

Jason L. Cassidy Probate Litigation Ryley Carlock & Applewhite 602.440.4812 JCassidy@rcalaw.com

James O. Ehinger Probate Litigation Ryley Carlock & Applewhite 602.440.4837 JEhinger@rcalaw.com

Patrick P. Degnan Tax Planning Ryley Carlock & Applewhite 602.440.4892 PDegnan@rcalaw.com

Ryley Carlock & Applewhite / McNemar Law Offices, P.C.

Distinctive Solutions RCAlaw.com Phoenix Office | 3200 North Central Avenue, Suite 1600 | Phoenix, AZ 85012 | 602.440.4800 | www.rcalaw.com

Helping Families by Connecting Wealth and Purpose®. It’s what we do. 602.466.2611 | www.tfophoenix.com TFO Phoenix, Inc. is registered as an investment advisor with the SEC and only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. SEC registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the advisor has attained a particular level of skill or ability. 181-2021-08

WEALTH PLANNING | INVESTMENT ADVICE | TAX | FINANCIAL EDUCATION | ESTATE PLANNING

shout out to your clients that a tax credit donation to a new leaf helps families

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ABLE Financial Group's unbiased and independent advice can help you with:

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Wells Fargo Advisors Financial Network are not tax or legal advisors. Investment products and services are offered through Wells Fargo Advisors Financial Network, LLC (WFAFN), Member FINRA/SIPC. ABLE Financial Group, LLC is a separate entity from WFAFN.

LOCAL PARTNERS. LIMITLESS POTENTIAL. At Arizona Bank & Trust, our local Wealth Advisory Service team specializes in providing wealth management solutions for individuals, families, business owners, and organizations. Our advisors bring a high level of expertise and experience to each client relationship while working in collaboration with their professional advisors. Ask us about: • Personalized wealth and estate planning • Strategic investment management • Customized retirement plan services • Trust, fiduciary and administrative services

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section 03 2021 Tax & Legal Seminar -- Timed Agenda Steve R. Akers November 5, 2021 Sophisticated Transfer Planning Strategies for 2021 8:00 – 8:20 (20 minutes)

I. A. B. C.

8:20– 8:40 (20 minutes)

II. III. A. B. C.

8:40 – 9:00 (20 minutes)

D. E. F. G. H.

Legislative Proposals For the 99.5 Percent Act Deemed Realization Proposals in Treasury’s Explanation of Fiscal Year 2022 Budget Proposals (“Greenbook”) Fiscal Year 2022 Budget Reconciliation, Ways & Means Committee Draft Proposal (Income Tax Measures, Transfer Tax Measures) Planning Considerations Regarding Deemed Realization Proposals Planning Implications of House Ways & Means Committee Proposal Exclusion Reduction Valuation Discounts, §2031(d) Grantor Trust Estate Inclusion and Gift Treatment, §2901 Income Tax Treatment of Transactions Between Deemed Owner and Grantor Trust, Proposed §1602 Immediate Actions Preceding Date of Enactment Sales Involving Grantor Trusts and Grantor’s Spouse Future Planning With Nongrantor Trusts Gifts to “Lock In” Use of Increased Gift Exclusion

Break (10 minutes) 9:10 – 9:20 (10 minutes)

9:20 – 9:40 (20 minutes)

D. E.

F. G.

Gift Suitability Analysis Overview of Gifting Opportunity Approaches, Particularly For Clients Who Want Some Type of Continued Access to Gift Assets Spousal Lifetime Access Trust (SLAT) Planning Multiple “Non-Reciprocal” Trusts

Using Trust Protectors for Additional Flexibility

Summary: Proposed legislation may result in the largest paradigm shift for estate planning professional in decades. Proposed and planning implications are explored. Transfer planning approaches especially relevant for the remainder of 2021 are addressed.

Structuring Trustee Powers to Avoid a Tax Catastrophe (or Twenty Things You Need to Know About Selecting Trustee and Structuring Trustee Powers) 9:40 – 9:50 (10 minutes)

I. A. B. II. A.

Non-Tax Factors Personal Attributes of Trustee Bifurcated Co-Trustee Powers Donor Tax Issues Gift Tax Issues 1. Incomplete Gift 2. Retained Right to Receive Distributions 3. Powers to Change Beneficial Interests

9:50 – 10:10 (20 minutes)

Estate Tax Issues 1. Who is the “Grantor” 2. Retained Beneficial Interest in Donor 3. Retained Beneficial Interest in Donor 4. Retained Administrative and Management Powers 5. Trustee Removal and Appointment Powers

10:20 – 10:35 (15 minutes)

Federal Income Tax Issues 1. Foreign Trust Status 2. Grantor Trust—Trust Provisions that Cause Grantor Trust Status 3. Structure to Give Beneficiary Power of Withdrawal Rather Than Having Stated Termination Date During Grantor’s Lifetime

10:35 – 11:00 (25 minutes)

III. Beneficiary Tax Issues A. Gift Tax Issues 1. Exercise Limited Power of Appointment Standard 2. Gift by Beneficiary If Fail to Exercise Rights 3. Beneficiary/Trustee Makes Distribution to Another Under Discretionary Standard B. Estate Tax Issues – Dispositive Powers 1. Section 2041—General Rules 2. Independent Trustee With Complete Discretion 3. Beneficiary as Co-Trustee 4. Beneficiary as Trustee—Distributions to Self as Beneficiary

Break (10 minutes)

11:00 – 11:20 (20 minutes)

5. Beneficiary as Trustee—Effect of Authority to Satisfy Trustee’s Support Obligations; The Upjohn Issue C. Estate Tax—Management/Administrative Powers D. Trustee Removal and Appointment Powers E. Income Tax Issues IV. Savings Clauses V. Creditor Issues

Summary: Central to the design of estate plans involving trusts, the presentation addresses powers and interests that can be held by donors and beneficiaries as trustees or otherwise without causing gift or estate tax concerns for the donors and beneficiaries. It also summarizes how to design trusts as nongrantor trusts because that may become essential under proposed legislation. Break (10 minutes)

Estate Planning Current Developments and Hot Topics 11:30 – 11:45 (15 minutes)

I. II. III.

11:45 – 12:00 (15 minutes)

IV.

Planning Developments with Deemed Owner Trusts Under Section 678

Family Limited Partnership and LLC Planning Developments

VI.

Estate of Moore v. Commissioner (§2036, §2043 Consideration Offset, Formula Charitable Transfer)

VII.

Nelson v. Commissioner (Transfer Based on Appraised Values, Discounts, Multi-Tier Discounts) Dickinson v. Commissioner (Charitable Gift Followed by Redemption Not Treated as Anticipatory Assignment of Income

VIII.

12:00 – 12:15 (15 minutes)

Treasury-IRS Priority Guidance Plan and Miscellaneous IRS Guidance Fixing Mistakes, Retractive Reversions Tax Effects of Early Trust Terminations and Commutations of Spouse’s Interest in QTIP Trust

IX.

Taylor Lohmeyer Law Firm P.L.L.C. v. United States, Doe Summons Upheld to Determine Identity of Law Firm’s Clients)

Estate of Warne v. Commissioner (Estate Tax Charitable Deduction Based on Value Passing to Each Donee)

XI. XII.

Estate of Michael Jackson v. Commissioner (Valuation of Publicity Rights, Undervaluation Penalties) Estate of Morrissette v. Commissioner (Intergenerational Split Dollar Life Insurance, Undervaluation Penalties)

Summary: Important planning implications of various important developments over the past year are addressed, including IRS guidance, surprising tax effects of early trust terminations, planning issues for LLCs, defined value clauses, charitable gifts of closely held stock, valuation of publicity rights, intergenerational split dollar life insurance, and undervaluation penalties. Total time of Instruction = 4 hours (240 minutes)

Speaker Biography: Steve R. Akers [J.D. University of Texas] is Senior Fiduciary Counsel at Bessemer Trust . Prior to joining the Georgia State faculty in 2012, he was on the faculty at the University of Washington School of Law in Seattle for 13 years. During his tenure at the University of Washington, he was a fivetime recipient of the Philip A. Trautman Professor of the Year award from the School of Law’s Student Bar Association. Professor Donaldson served for two years as Associate Dean for Academic Administration and for six years as the Director of the law school’s Graduate Program in Taxation. He teaches a number of tax and estate planning courses, as well as courses in the areas of property, commercial law and professional responsibility. Professor Donaldson is an Academic Fellow of the American College of Trust and Estate Counsel (ACTEC) and a member of the Bar in Washington, Oregon, and Arizona. Among his scholarly works, he is a coauthor of the popular West casebook, Federal Income Tax: A Contemporary Approach, and a co-author of the Price on Contemporary Estate Planning treatise published by Wolters Kluwer. Professor Donaldson has served as the Harry R. Horrow Visiting Professor of International Law at Northwestern University and a Visiting Assistant Professor at the University of Florida Levin College of Law.

section 04

Sophisticated Transfer Planning Strategies for 2021 October 2021

Steve R. Akers Senior Fiduciary Counsel Bessemer Trust 300 Crescent Court, Suite 800 Dallas, TX 75201 214-981-9407 akers@bessemer.com www.bessemer.com

Table of Contents Introduction ....................................................................................................................................................... 1 Items 1-4 are summaries of legislative proposals currently under consideration and planning implications specifically in light of those proposals ...................................................................................... 1 1. “For the 99.5 Percent Act” and Administration’s Deemed Realization Proposals ....................................... 1 9. Fiscal Year 2022 Budget Reconciliation ...................................................................................................... 7 3. Planning Considerations Regarding Deemed Realization Proposals .......................................................... 10 4. Planning Implications of Ways and Means Committee Reconciliation Proposal ........................................ 13 Items 5-17 are summaries general transfer planning considerations for the balance of 2021.................. 24 5. Window of Opportunity ............................................................................................................................ 24 6. Planning for Flexibility............................................................................................................................... 24 7. Defined Value Transfers ........................................................................................................................... 24 8. Gift Suitability Analysis ............................................................................................................................. 25 9. Transfers with Possible Continued Benefit for Grantor or Grantor’s Spouse; Sales to Grantor Trusts ....... 25 10. Overview of Gifting Opportunity Approaches, Particularly for Clients Who Want Some Type of Continued Access to Gift Assets ..................................................................................................................... 26 11. Transfers with Possible Continued Benefit for Grantor or Grantor’s Spouse; Sales to Grantor Trusts .... 27 12. Trust for Settlor’s Spouse as Discretionary Beneficiary (SLATs); Possible Inclusion of Settlor as Discretionary Beneficiary Following Spouse’s Death or at Some Other Time ........................................... 27 13. Trust for Settlor as Discretionary Beneficiary (DAPT); Possible Inclusion of Settlor as Discretionary Beneficiary at Some Later Time ............................................................................................................... 35 14. Multiple “Non-Reciprocal” Trusts ............................................................................................................. 41 15. GST Planning Considerations.................................................................................................................... 43 16. Gifts to “Lock In” Use of Increased Gift Exclusion................................................................................ 43 17. Basis Adjustment Planning ................................................................................................................... 46 Items 18-31 address using trust protectors to provide additional flexibility for irrevocable trust documents, particularly in light of planning in a period of heightened uncertainty. This information is, in part, a summary of comments from a panel discussion by David Arthur Diamond, Nancy C. Hughes, and Margaret G. Lodise at the ACTEC Annual Meeting in 2021 ................................................................. 47 18. General Description; Overview of Reasons for Using Trust Protectors ..................................................... 47 19. Historical Uses of Trust Protectors ........................................................................................................... 47 20. Trust Protector Statutory Authority ........................................................................................................... 47 21. Special Power of Appointment – “Poor Person‘s Decanting Power“ ........................................................ 48 22. Common Powers of a Trust Protector ...................................................................................................... 48 23. Sample Clause with Expansive Trust Protector Provisions........................................................................ 48 24. Who to Name? ......................................................................................................................................... 49 25. Should the Trust Protector be a Fiduciary? ............................................................................................... 50 26. Succession of Trust Protector Position ..................................................................................................... 51 27. Insurance for Trust Protectors .................................................................................................................. 51 28. Compensation .......................................................................................................................................... 51 29. Potential Tax Attacks If Facts Reflect That Settlor Retains Tax-Sensitive Powers Indirectly Through Actions of a Trust Protector .................................................................................................................................. 51 30. Case Law Discussion of Trust Protectors ................................................................................................. 52 31. Trust Protector Planning – Best Practices ................................................................................................. 54

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Copyright © 2021 Bessemer Trust Company, N.A. All rights reserved. October 8, 2021 Important Information Regarding This Summary This summary is for your general information. The discussion of any estate planning alternatives and other observations herein are not intended as legal or tax advice and do not take into account the particular estate planning objectives, financial situation or needs of individual clients. This summary is based upon information obtained from various sources that Bessemer believes to be reliable, but Bessemer makes no representation or warranty with respect to the accuracy or completeness of such information. Views expressed herein are current only as of the date indicated, and are subject to change without notice. Forecasts may not be realized due to a variety of factors, including changes in law, regulation, interest rates, and inflation.

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Introduction Many transfer planning strategies are available. This paper focuses on transfer planning strategies for late 2021, in light of legislative uncertainties. Legislative proposals, effective date considerations, the possibility of adverse income tax consequences from current transfers, and the desire to make use of the large $11.7 million gift exclusion while it exists (even for clients who really don’t want to make large gifts) are all prominent in current transfer planning considerations. This paper makes no attempt to cover a wide variety of transfer planning alternatives generally, but focuses on planning issues that many planners are grappling with in 2021. Steve Gorin (attorney in St. Louis) poses this puzzler: Suppose you go to a bank, hand the teller 4 nickels and ask for 2 coins back in an even swap. Suppose you take those two coins and slide them across the table. What do you call that action on the table? The legislative changes currently proposed and being considered in the House, will result in an enormous paradigm shift for estate planning professionals. Planning alternatives that we have been the central focus of transfer planning for decades will no longer work. Planners will return to the days of old (meaning 25-30 years ago) when trusts were traditionally structured to be nongrantor trusts (and very careful planning is required to assure that a trust is not a grantor trust). (Puzzler answer: pair of dimes shift) CAUTION: All the provisions in the proposed legislation are in flux and subject to likely changes at this point – in the House, in the Senate, and in the conference between the House and Senate if their versions differ. One is reminded of the Mark Twain quip: “When Congress is in session, no American is safe.” Or Will Rogers: “This country has come to feel the same when Congress is in session as when the baby gets hold of a hammer.” Take heed!

Items 1-4 are summaries of legislative proposals currently under consideration and planning implications specifically in light of those proposals 1.

“For the 99.5 Percent Act” and Administration’s Deemed Realization Proposals a.

“For the 99.8 Percent Act”(2019) and “For the 99.5 Percent Act” (2021). Senator Sanders on January 31, 2019 introduced S. 309, titled “For the 99.8 Percent Act,” and on March 25, 2021 introduced S. 994, titled “For the 99.5 Percent Act.” The 2019 and 2021 proposals are very similar (identical in most respects); the differences are described below. A companion bill (H.R. 2576) was introduced in the House on April 15, 2021, by Congressman Jimmy Gomez (D-California), and a similar bill was introduced in the House in 2019. Senator Sanders has introduced similar bills since 2010. These proposals would reduce the basic exclusion amount to $3.5 million (not indexed) for estate tax purposes and to $1.0 million (not indexed) for gift tax purposes and increase the rates: 45% on estates between $3.5 and $10 million, 50% on $10 million - $50 million, 55% on $50 million - $1 billion, and 77% (2019 proposal)/65% (2021 proposal) over $1 billion. (The GST tax rate is not specifically addressed, so presumably it would be the highest marginal estate tax rate of 77% under §2641(a)(1), with a $3.5 million GST exemption.) These amendments apply to estates of decedents dying, and generation-skipping transfers and gifts made, after December 31, 2021. The 2021 bill is available here. In addition, the bill would make major dramatic changes to the transfer tax system including: •

Adding a statutory anti-clawback provision for both estate and gift taxes (included in the 2019 proposal, removed from the 2021 proposal);

•

Increasing the potential reduction of the value for family farm and business property under the §2032A special use valuation rules from $1.19 million currently to $3 million (indexed for inflation going forward); applicable to estates of decedents dying, and gifts made, after December 31, 2021 (in the 2021 proposal);

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•

Increasing the potential estate tax deduction for conservation easements from $500,000 to $2 million (but not exceeding 60% of the net value of the property); applicable to estates of decedents dying, and gifts made, after December 31, 2021 (in the 2021 proposal);

•

Extending basis consistency provisions (and accompanying reporting requirements) to gifts (included in the 2019 proposal, removed from the 2021 proposal);

•

Disallowing a step-up in basis for property held in a grantor trust of which the transferor is considered the owner “if, after the transfer of … property to the trust, such property is not includible in the gross estate of the transferor…” (added in the 2021 proposal); this provision applies to transfers after the date of enactment; (observe that the provision is not clear whether it applies to sales or exchanges with grantor trusts, this provision does not appear to apply to §678 deemed owner trusts, and the provision does not appear to apply to sales from one spouse to a grantor trust that is a grantor trust as to the other spouse);

•

Valuing entities by treating nonbusiness assets and passive assets as owned directly by the owners (and valuing them without valuation discounts), with look-through rules for at least 10% subsidiary entities; applicable to transfers after the date of enactment;

•

Eliminating minority discounts and (in the 2021 proposal) lack of marketability discounts for any entity in which the transferor, transferee, and members of their families either control or own a majority ownership (by value) of the entity (proposals restricting valuation discounts for family-held assets that were first introduced in the Clinton Administration); applicable to transfers after the date of enactment;

•

10-year minimum term for GRATs and maximum term of life expectancy of the annuitant plus ten years, with a remainder interest valued at the greater of 25% of the amount contributed to the GRAT or $500,000 (up to the value of property in the trust); applicable to transfers after the date of enactment;

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Major changes for grantor trusts (under new §2901) – –

§2901(a)(1), Estate inclusion in grantor’s gross estate;

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§2901(a)(2), Distributions are treated as gifts from the grantor;

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§2901(a)(3), Gift of entire trust if it ceases to be a grantor trust during the grantor’s life;

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Those three rules apply for (1) grantor trusts of which the grantor is the deemed owner, and (2) third-party deemed owner trusts (§678 trusts) to the extent the deemed owner has sold assets to the trust in a non-recognition transaction, including the property sold to the trust, all income, appreciation and reinvestments thereof, net of consideration received by the deemed owner in the sale transaction;

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The initial gift to the trust is also a gift, but a reduction will apply in the amount of gifts or estate inclusion deemed to occur (under the first three rules) by the amount of the initial gift;

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Any estate tax imposed by new §2901 would be a liability of the trust (but the bill has no details about how the amount of estate tax attributable to §2901 would be determined);

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The 2021 proposal eliminates an exception for trusts that do not have as a significant purpose the avoidance of transfer taxes, as determined by regulations or other guidance from the Treasury;

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These rules apply to trusts created on or after the date of enactment, and to the portion of prior trusts attributable to post-date-of-enactment “contributions” (which does not explicitly include sales) to the trust and attributable to post-date-of-enactment sales in nonrecognition transactions with a deemed owner trust under §678;

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Observe that this may result in estate inclusion of ILITs (unless the trust is structured as a non-grantor trust) created after the date of enactment, or the portion of an ILIT

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attributable to post-date-of-enactment contributions to the trust (for example, to make premium payments). See Michael Geeraerts & Jim Magner, Alternative Life Insurance Ownership Structures if Congress Takes a Swing at ILITs Using New Code Section 2901, LEIMBERG ESTATE PLANNING NEWSLETTER #2865 (Feb. 22, 2021). •

Regardless of GST exemption allocated to a trust, a trust will have a GST inclusion ratio of 1 (i.e., fully subject to the GST tax) unless “the date of termination of such trust is not greater than 50 years after the date on which such trust is created”; this provision applies to postdate-of-enactment trusts, and prior trusts would have the inclusion ratio reset to one 50 years after the date of enactment; the provision is more aggressive than the Obama Administration proposal which had a limit of 90 rather than 50 years, and which merely reset the inclusion ratio to one after the 90-year term rather than applying an inclusion ratio of one from the outset if the trust did not have to terminate within the maximum allowed time; and

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The annual exclusion is “simplified” by providing a $10,000 (indexed) exclusion not requiring a present interest (but still requiring an identification of donees), but each donor is subject to an annual limit of twice that amount (2 times the current $15,000 amount, or $30,000) for gifts in trust, gifts of interests in pass-through entities, transfers subject to a prohibition on sale, or any other transfer that cannot be liquidated immediately by the donee (without regard to withdrawal or put rights).

The Joint Committee on Taxation estimates that the 2021 proposed Act would raise $429.6 billion of revenue over 10 years. This bill is significant; these are proposals that have been suggested by others from time to time but have not been reduced to statutory text that can be pulled off the “shelf” to incorporate into whatever other legislation happens to be popular at the time. If any of these provisions are included in an infrastructure/tax reform reconciliation bill later this year, a significant possibility exists of adoption of such provisions (with a date of enactment effective date for most of the provisions other than the rate and exemption amount changes). These proposals are far-reaching. Remember 2012? The mad rush could be even more chaotic if this bill starts getting serious consideration. For a much more detailed discussion of the specific provisions in the 2019 proposal, see Ron Aucutt’s “Top Ten” Estate Planning and Estate Tax Developments of 2019 (January 2020), with detailed analysis, (found here and available at www.bessemertrust.com/for-professionalpartners/advisor-insights). See also Reed Easton, For the 99.5% Act: End of Traditional Planning Techniques, ESTATE PLANNING (July 2021). b.

Deemed Realization Proposals in Treasury’s Explanation of Fiscal Year 2022 Budget Proposals (“Greenbook”). The following summary in this Item 1.b of the deemed realization proposal in the Fiscal Year 2022 Greenbook by Ronald D. Aucutt is included with his permission. Whether The American Families Plan called for a deemed realization at death system was unclear based on the Fact Sheet that the White House released on April 28, 2021, but the FY 2022 Greenbook provides a detailed description of the deemed realization taxing regime. The Treasury Department released its “General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals” (popularly called the “Greenbook”) on May 28, 2021, available at https://home.treasury.gov/system/files/131/General-Explanations-FY2022.pdf. It proposes no changes to the estate and gift taxes. Following up proposals announced in the Administration’s “American Families Plan” on April 28, 2021, and citing the need to “reduce economic disparities among Americans,” the Greenbook (at pages 60-62) includes proposals to increase the top marginal individual income tax rate to 39.6 percent (as it was before the 2017 Tax Act), effective January 1, 2022, and to tax capital gains at the same rate as ordinary income for taxpayers with adjusted gross income greater than $1 million, effective “for gains required to be recognized after the date of announcement” (presumably April 28, 2021).

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The Greenbook (at pages 62-64) also provides details focusing and clarifying the proposal for the “deemed realization” of capital gains foreshadowed by the Obama Administration’s Greenbooks for Fiscal Years 2016 (Feb. 2, 2015, pages 156-57) and 2017 (Feb. 9, 2016, pages 155-56), by President Biden’s campaign, by Representative Bill Pascrell’s H.R. 2286, and by Senator Van Hollen’s “discussion draft” of the Sensible Taxation and Equity Promotion (“STEP”) Act of 2021 (with its January 2, 2021 proposed effective date). That Greenbook proposal is summarized as follows: (1) Effective Date. The proposal would take effect on January 1, 2022, like H.R. 2286. But it would apply to pre-2022 appreciation; there would be no “fresh start” as, for example, in the 1976 carryover basis legislation. (2) Realization Events. Gain would be explicitly recognized on transfers by gift or at death, equal to the excess of an asset’s fair market value on the date of the gift or death over the donor’s or decedent’s basis in that asset. Losses obviously would also be recognized if basis exceeds fair market value because the Greenbook refers to “the use of capital losses … from transfers at death” as an offset. The Greenbook does not mention holding periods or distinguish short-term and long-term gain. The Greenbook also does not specifically incorporate the alternate valuation date for transfers at death, although it does state generally that a transfer “would be valued using the methodologies used for gift or estate tax purposes.” (3) Taxpayer, Return, and Deductibility. The Greenbook states that the gain would be reported “on the Federal gift or estate tax return or on a separate capital gains return.” Reassuringly, however, the Greenbook confirms that the gain “would be taxable income to the decedent” and, consistently with that characterization, explicitly adds that “the tax imposed on gains deemed realized at death would be deductible on the estate tax return of the decedent’s estate (if any).” This means that the combined income and estate tax on the appreciation would be 39.6% (income tax) + (40% x [1 - .396]) (estate tax) = 63.76%. (4) Exclusion for Tangible Personal Property. “[T]angible personal property such as household furnishings and personal effects (excluding collectibles, such as art)” would be exempt. There is no mention of explicit application to property held for investment as in H.R. 2286 or property related to the production of income as in the STEP Act. (5) Exclusion for Transfers to Spouses. The Greenbook would exempt “[t]ransfers by a decedent to a U.S. spouse,” without explicitly exempting lifetime gifts to a spouse as both H.R. 2286 and the STEP Act do. There is no elaboration of the term “U.S. spouse” (for example, citizen or resident), and there are no special provisions targeted to spousal trusts. Typically the effect of exempting transfers to spouses will be simply to defer the application of the deemed realization rules until the spouse’s disposition of the asset or the spouse’s death. (6) Exclusion for Transfers to Charity. The Greenbook would exempt transfers to charity. But it adds that “[t]he transfer of appreciated assets to a split-interest trust would generate a taxable capital gain, with an exclusion allowed for the charity’s share of the gain based on the charity’s share of the value transferred as determined for gift or estate tax purposes.” This will require further elaboration. In addition, the Greenbook does not clarify the effect of applying the ordinary income rate to capital gains on §170(e)(1), which reduces the amount of any charitable contribution by, among other things, the amount of gain that would not have been long-term capital gain if the property had been sold at its fair market value. The green book is unclear about the effect of taxing capital gains by high-income individuals at ordinary rates on the amount of the deduction to which an individual would be entitled if the property were contributed to a charity. The proposal may simply raise the tax rate on gain from property that would otherwise have been subject to the preferential rate on long-term capital gain, without changing the character of property. On the other hand, consistent with the purpose of section 170(e)(1), the proposal could be read to limit the amount of the deduction to the basis of property in the hands of the donor. Lawrence M. Axelrod, The Dying Art of Donating Appreciated Property, TAX NOTES (Aug. 30, 2021).

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(7) Other Exclusions. The Greenbook proposes a single unified exclusion of capital gains for transfers both by gift and at death of $1 million per person, indexed for inflation after 2022 and “portable to the decedent’s surviving spouse under the same rules that apply to portability for estate and gift tax purposes.” The Greenbook adds that this would “mak[e] the exclusion effectively $2 million per married couple,” without explaining exactly how that would be accomplished for lifetime gifts when there has been no “decedent” or “surviving spouse.” The Greenbook does not address whether the use of the exclusion for lifetime gifts is mandatory or elective. To the extent that exclusion applies, the Greenbook proposes to retain the current basis rules under sections 1014 and 1015. Thus, to that extent, “[t]he recipient’s basis in property received by reason of the decedent’s death would be the property’s fair market value at the decedent’s death” (presumably subject to the consistent basis rules of section 1014(f) added in 2015), and the basis of property received by gift would be the donor’s basis in that property at the time of the gift. To the extent the exclusion does not apply, the recipient, whether of a gift or at death, will receive a basis equal to the fair market value used to determine the gain. The Greenbook leaves for further elaboration the manner in which those adjustments to basis would be allocated among multiple assets in a case of a lifetime gift or gifts where some but not all the gain realized under this proposal is sheltered by the exclusion. In addition, the Greenbook confirms that the exclusion of $250,000 per person of gain from the sale or exchange of a taxpayer’s principal residence under section 121 would apply to the gain realized under this proposal with respect to all residences, and it adds that that exclusion would be made “portable to the decedent’s surviving spouse.” In this case the application to lifetime gifts may be less of an issue, because section 121(b)(2) itself doubles the exclusion to $500,000 for joint returns involving jointly used residences. The Greenbook also confirms that the exclusion under current law for capital gain on certain small business stock under section 1202 would apply. (8) Netting of Gains and Losses. For transfers at death, capital losses and carryforwards would be allowed as offsets against capital gains and up to $3,000 of ordinary income, mirroring the current income tax rules in sections 1211 and 1212. There is no mention of relaxing the relatedparty loss rules of section 267 as there is in both H.R. 2286 and the STEP Act, but it seems very unlikely that it would be omitted from any provision for taking losses into account at death, where transfers to related parties are the norm. The proposal does not address using losses and carryforwards against the deemed realization of capital gains on lifetime gifts. (9) Valuation. As noted above, the Greenbook contemplates that a transfer generally “would be valued using the methodologies used for gift or estate tax purposes.” But the Greenbook adds that “a transferred partial interest would be its proportional share of the fair market value of the entire property.” In other words, no discounts. The Greenbook does not indicate whether “partial interest” is meant to be limited to undivided interests such as in tenancies-in-common, or whether it might include nonmarketable interests in entities like partnerships, limited liability companies, and corporations. Surely it would not include, for example, publicly traded stock, but attention in drafting might be required to confirm that. The AICPA on August 24, 2021 sent a letter to Congressional leaders criticizing various aspects of the deemed realization proposal, and in particular criticizing this proportional-share-of-full-value valuation provision because it is inconsistent with well-established valuation principles, and a partial owner often does not have “adequate insights or access to information that would allow for a determination of FMV of the entire property” and could not provide “any reasonable and supportable value of the partial interest.” (10) Special Rules for Trusts and Entities. Generally mirroring H.R. 2286 and the STEP Act, the Greenbook provides that transfers into, and distributions in kind from, a trust would be recognition events, unless the trust is a grantor trust deemed wholly owned and revocable by what the Greenbook calls “the donor.” There is no mention of “grandfathering” irrevocable trusts in existence on the date of enactment, and therefore this Greenbook feature would www.bessemertrust.com/for-professional-partners/advisor-insights

apparently apply to distributions of appreciated assets to both current and successive or remainder beneficiaries of preexisting trusts, including, for example, both the grantor and the remainder beneficiaries of a pre-2022 GRAT. With regard to revocable trusts, the deemed owner would recognize gain on the unrealized appreciation in any asset distributed (unless in discharge of the deemed owner’s obligation) to anyone other than the deemed owner or the deemed owner’s “U.S. spouse” (again undefined), and on the unrealized appreciation in all the assets in the trust when the deemed owner dies or the trust otherwise becomes irrevocable. But the Greenbook goes a lot farther. The rules about transfers into and distributions in kind from a trust also apply to a “partnership” or “other non-corporate entity.” This looks like a far reach, but the Greenbook does not explain further. The Greenbook also states: Gain on unrealized appreciation also would be recognized by a trust, partnership, or other noncorporate entity that is the owner of property if that property has not been the subject of a recognition event within the prior 90 years, with such testing period beginning on January 1, 1940. The first possible recognition event for any taxpayer under this provision would thus be December 31, 2030.

Ninety years for periodic “mark-to-market” treatment of trust assets is a surprising departure from the somewhat similar rules in H.R. 2286 (30 years) and the STEP Act (21 years), but it again would apply to assets of partnerships and other entities. And again the Greenbook does not explain further. Because 90 years from January 1, 1940, is January 1 (not December 31), 2030, it appears that the Greenbook contemplates recognition only at the end of the year, but the Greenbook does not clarify that. (11) Deferral of Tax. The Greenbook reprises the Obama Administration’s Fiscal Year 2016 and 2017 proposals that “[p]ayment of tax on the appreciation of certain family-owned and -operated businesses would not be due until the interest in the business is sold or the business ceases to be family-owned and operated.” Providing that the payment of tax is not “due” (rather than merely providing for a section 6166-like “extension of time for payment”) implies at a minimum that there would be no interest charged (which can otherwise be a big problem, even for the nomore-than-14-year deferral of section 6166). The implementing statutory language might also provide that the realization event itself is deferred until ownership or operation of the business passes outside the family. That could increase the amount of tax if there is more appreciation, but it could also prevent the payment of tax to the extent the value of the business declines (which sometimes happens after the death of a key owner). That approach would apparently also tax the realization event at whatever the tax rates happen to be at the time. But if the cessation of family ownership results from the family’s sale of the business, that postponed realization approach would be the same as current law in subjecting any sale like that to tax, except apparently for the loss of a stepped-up basis at intervening deaths. The enactment of this proposal or any close variation of it in a tightly divided Congress is by no means certain, and the long-term durability of such a provision enacted in such a political climate would not be guaranteed. That could create special challenges in cases where a tax on the succession of the family businesses is nominally imposed, but is suspended for many years, decades, or even generations. And of course the statutory language implementing this Greenbook proposal should be expected to include definitions of a “business,” “family-owned,” and “family-operated,” as well as rules for the identification of assets that should be excluded from the deferral because they are not used in the business, and such rules might also create or aggravate challenges over a long-term suspension. In addition, like the STEP Act and the Obama Administration Greenbooks (and broader than H.R. 2286), the Greenbook proposal would allow “a 15-year fixed-rate payment plan for the tax on appreciated assets transferred at death, other than liquid assets such as publicly traded financial assets and other than businesses for which the deferral election is made.” Details about start dates and interest rates are not provided, but the proposal might resemble the STEP Act’s www.bessemertrust.com/for-professional-partners/advisor-insights

proposed section 6168, which in turn resembles section 6166 without the 35-percent-of-grossestate requirement to qualify, with an interest rate equal to 45 percent of the normal annual rate as in section 6601(j)(1)(B), but without the “2-percent portion” as in section 6601(j)(1)(A). As in H.R. 2286 and the STEP Act, the IRS would be authorized to require reasonable security at any time from any person and in any form acceptable to the IRS. (12) Administrative Provisions. Following the Obama Administration Greenbooks, with a few additions, the Greenbook envisions (but without details) a number of other legislation features, covering topics such as a deduction for the full cost of related appraisals, the imposition of liens, the waiver of penalties for underpayment of estimated tax attributable to deemed realization of gains at death (which, of course, could not have been foreseeable), a right of recovery of the tax on unrealized gains, rules to determine who selects the return to be filed, consistency in valuation for transfer and income tax purposes, and coordination of the changes to reflect that the recipient would have a basis in the property equal to the value on which the capital gains tax is computed. (13) Regulations. Treasury would be granted authority to issue any regulations necessary or appropriate to implement the proposal, including reporting requirements that could permit reporting on the decedent’s final income tax return, which would be especially useful if an estate tax return is not otherwise required to be filed. In a tacit acknowledgment of the harshness of proceeding with such a proposal without a “fresh start” for basis as in 1976, the Greenbook explicitly contemplates that the regulations will include “rules and safe harbors for determining the basis of assets in cases where complete records are unavailable.” (14) Revenue Estimate. Taxing capital gains at the same rate as ordinary income for taxpayers with adjusted gross income greater than $1 million and the proposed “deemed realization” of capital gains together are estimated to raise $322.485 billion over the next 10 fiscal years. This includes $1.241 billion estimated for Fiscal Year 2021, which ends September 30, 2021. That presumably results from the proposed retroactive effective date for taxing capital gains at the same rates as ordinary income, but evidently also contemplates increased estimated income tax payments by September 30. (This is the only proposal in the Greenbook that is estimated to have an effect on revenues in Fiscal Year 2021.) Overall, the tax increases proposed by the Greenbook are estimated to raise revenue over the next 10 fiscal years by about $3.6 trillion. 2.

Fiscal Year 2022 Budget Reconciliation The following summary in this Item 2 by Ronald D. Aucutt of the FY 2022 Budget reconciliation process and Ways and Means Committee proposal is included with Mr. Aucutt’s permission. a.

Budget Resolution. On August 24, 2021, the House of Representatives agreed to the Senate-approved Concurrent Resolution on the Budget for Fiscal Year 2022 (S. Con. Res. 14), establishing in principle spending priorities of about $3.5 trillion for the fiscal year beginning October 1, 2021, and ending September 30, 2022. The votes were strictly partisan. In the Senate on August 11 the vote was 50-49, with all Democrats in favor and all Republicans opposed except Senator Mike Rounds (R-SD), who did not vote. In the House on August 24 the vote was 220-212, with all Democrats in favor and all Republicans opposed. The resolution left the House Ways and Means Committee and the Senate Finance Committee with flexibility to develop tax changes to pay for the contemplated expenditures.

Ways and Means Committee Action. On September 15, 2021, the House Ways and Means Committee approved the “Build Back Better Act” (H.R. 5376), a package of tax changes pursuant to the budget resolution. Only one Democratic member of the Committee, Rep. Stephanie Murphy (D-FL), joined all the Republicans in voting against it. The bill now is on the House floor, while we wait for a corresponding consideration of

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revenue proposals by the Senate Finance Committee. The Ways and Means Committee’s bill includes the following: (1) No Deemed Realization. The Ways and Means Committee has omitted any deemed realization proposals like those made in the current Congress and in the Administration’s Fiscal Year 2022 Greenbook (see Item 1.b above). (2) Early Sunset for Doubled Basic Exclusion Amount. The sunset of the 2017 Tax Act’s doubling of the $5 million basic exclusion amount (indexed for inflation since 2012) would be accelerated from January 1, 2026, to January 1, 2022. Thus, the basic exclusion amount would return to $5 million, indexed for inflation since 2012, which the Joint Committee on Taxation (JCT) staff projects would be $6,020,000 for 2022. This is estimated to raise $54 billion over ten years. (3) Closer Alignment of Grantor Trust and Transfer Tax Rules. The bill approved by the Ways and Means Committee would create a new chapter 16, consisting solely of a new section 2901, effectively linking the grantor trust rules and the transfer tax rules so that a trust designed as a grantor trust would continue to be exposed to gift or estate tax with respect to the grantor. Thus the bill picks up, with some significant changes, the proposals in section 8 of Senator Sanders’ “For the 99.5 Percent Act” (discussed in Item 1.a above), which in turn track the Obama Administration Greenbooks. With respect to a trust or portion of a trust that is not otherwise includable in the grantor’s gross estate and is funded on or after the date of enactment (either upon initial formation or by a contribution to an existing trust), section 2901 would (a) include the value of the assets of such portion in the grantor’s gross estate for estate tax purposes, (b) subject to gift tax any distribution from such portion to one or more beneficiaries during the grantor’s life, other than distributions to the grantor or the grantor’s spouse or in discharge of an obligation of the grantor, and (c) treat as a gift by the grantor, subject to gift tax, all assets of such portion at any time during the grantor’s life if the grantor ceases to be treated as the owner of such portion for income tax purposes. Unlike the “For the 99.5 Percent Act,” this proposal would apply only to “any portion of a trust with respect to which the grantor is the deemed owner.” It omits the additional explicit application in the “For the 99.5 Percent Act” to the extent a deemed owner engages in a leveraged “sale, exchange, or comparable transaction with the trust” that appears to have been aimed at the technique known as a “Beneficiary Defective Inheritor’s Trust” (“BDIT”). The creation of, or addition to, such a grantor trust would not escape gift tax, but, in determining future gift or estate taxes upon one of the events described in paragraphs (a), (b), and (c) above, “amounts treated previously as taxable gifts” would be “account[ed] for” with a “proper adjustment.” (4) Certain Sales Between Deemed Owned Trust and Deemed Owner. Going a step beyond the “For the 99.5 Percent Act,” the bill would add a new section 1062 providing: In the case of any transfer of property between a trust and a person who is the deemed owner of the trust (or portion thereof), such treatment of the person as the owner of the trust shall be disregarded in determining whether the transfer is a sale or exchange for purposes of this chapter.

The result would be that gain would be recognized by the deemed owner or by the trust, as the case may be, or possibly by both of them (in the case of a substitution of assets or other in-kind exchange, for example). Rev. Rul. 85-13, 1985-1 C.B. 184, the hinge on which almost all grantor trust planning swings, would be nullified. The new rule would not apply to a trust that is fully revocable by the deemed owner. The bill would also amend section 267 to disallow losses between “[a] grantor trust and the person treated as the owner.” www.bessemertrust.com/for-professional-partners/advisor-insights

Like the closer alignment of grantor trust and transfer tax rules in section 2901, this rule, as written, would apparently apply only to a trust created, and any portion of an existing trust attributable to a contribution made, on or after the date of enactment. The Report of the Committee on Budget to Accompany HR 5376 (“House Report”) states that the new provision “is intended to be effective for sales and other dispositions after the date of enactment” – that is, regardless of when the trust was created or funded – but it adds in a footnote that “[a] technical correction may be necessary to reflect this intent.” This provision and section 2901 together are estimated to raise $8 billion over ten years. (5) Valuation of Certain Nonbusiness Assets in Entities. In a proposal traceable at least to the Reagan and Clinton Administrations and virtually identical to section 6 of Senator Sanders’ “For the 99.5 Percent Act,” the Ways and Means Committee bill would in effect require the valuation of nonbusiness assets in an entity by a look-through method. The proposal would add a new section 2031(d)(1) to the Code, applicable to transfers (by gift or upon death) after the date of enactment, to read as follows: (d) VALUATION RULES FOR CERTAIN TRANSFERS OF NONBUSINESS ASSETS—For purposes of this chapter [estate tax] and chapter 12 [gift tax]— (1) IN GENERAL—In the case of the transfer of any interest in an entity other than an interest which is actively traded (within the meaning of section 1092) [see, e.g., Reg. §1.1092(d)-1(a) & (b)]— (A) the value of any nonbusiness assets held by the entity with respect to such interest shall be determined as if the transferor had transferred such assets directly to the transferee (and no valuation discount shall be allowed with respect to such nonbusiness assets), and (B) such nonbusiness assets shall not be taken into account in determining the value of the interest in the entity.

Like the “For the 99.5 Percent Act,” the proposal includes detailed rules about “passive assets” that might be used in a business and “look-thru rules” for entities that are at least 10 percent owned by another entity. The proposal also adds a broad grant of regulatory authority, specifically including the issues of whether a passive asset is used in the active conduct of a trade or business or is held as part of the reasonably required working capital needs of a trade or business. This proposal is estimated to raise $20 billion over ten years. Unlike the “For the 99.5 Percent Act,” however, the proposal does not also include a general prohibition on “minority discounts” in family owned or controlled entities, a prohibition that in the “For the 99.5 Percent Act” (see Item 1.a above) is not limited to “nonbusiness” entities or assets and thus would arguably have a much broader and harsher impact on family businesses. (6) Increased Benefit of Special Use Valuation. In contrast to the preceding provisions that would make the estate and gift tax more burdensome, the Ways and Means Committee bill, effective January 1, 2022, would increase the cap on the “special use” reduction in the estate tax value under section 2032A of real property used in family farms and other family businesses, which currently is $750,000 indexed for inflation since 1998 ($1,190,000 in 2021). Such an increase has often been offered by lawmakers opposed to across-the-board repeal or reduction of the estate tax as a way to target relief to the family farms and businesses that are often cited as justifications for such repeal or reduction. But, unlike section 3 of Senator Sanders’ “For the 99.5 Percent Act” (see Item 1.a above), which would increase the limitation to only $3 million, indexed for inflation going forward, the Ways and Means Committee proposal would raise the limitation to $11.7 million (which happens to be the current basic exclusion amount), indexed going forward. This is estimated to decrease revenues by $317 million over ten years. (7) Other Income Tax Proposals. (a) Individual Income Tax Rates. Beginning January 1, 2022, the 39.6 percent top individual income tax rate, suspended for eight years by the 2017 Tax Act, would be reinstated for taxable incomes over $400,000 ($450,000 for joint returns and surviving spouses) and $12,500 indexed (projected by the JCT staff to be $13,450 in 2022) for trusts and estates. In www.bessemertrust.com/for-professional-partners/advisor-insights

addition, a 3 percent surtax would be applied to “modified adjusted gross income” over $5 million for individuals and $100,000 for trusts and estates. (b) Capital Gain Tax Rates. The rate of income tax on capital gains would be increased from 20 percent to 25 percent to the extent the taxpayer is subject to the reinstated 39.6 percent top rate – that is, for taxable incomes over $400,000 ($450,000 for joint returns and surviving spouses and $12,500 indexed for trusts and estates). Notably, this provision is designed to take effect on September 14, 2021, with an exception for gains recognized in 2021 pursuant to written binding contracts entered into before September 14, 2021. (c) Corporate Income Tax Rates. Beginning January 1, 2022, the 21 percent corporate income tax rate would be retained for taxable income from $400,000 to $5 million, but it would be lowered to 18 percent on the first $400,000 of taxable income and raised to 26.5 percent on the amount of taxable income in excess of $5 million. (d) Expansion of Tax on Net Investment Income. Beginning January 1, 2022, the 3.8 percent tax on net investment income would be expanded by effectively eliminating the “trade or business” exception in section 1411(c)(1)(A) for individuals with modified adjusted gross income over $400,000 ($500,000 for joint returns and surviving spouses) and for trusts and estates with adjusted gross income in excess of the threshold for the highest income tax bracket for trusts and estates (projected by the JCT staff to be $13,450 in 2022). (e) Limitation of Qualified Business Income Deduction. Beginning January 1, 2022, the qualified business income deduction of section 199A (added by the 2017 Tax Act) would be capped at $400,000 for individuals ($500,000 for joint returns and surviving spouses) and $10,000 for trusts and estates. 3.

Planning Considerations Regarding Deemed Realization Proposals a.

Overview Summary of Treatment of Trusts at the Settlor’s Death Under the Deemed Realization Proposals. The following discussion is all VERY complicated, and subject to interpretation of the Code language (and the description in the Greenbook). (1) House Bill, H.R. 2286. (a) Grantor Trusts Not in Estate and Nongrantor Trusts. Under H.R. 2286, there would be no deemed realization for assets in a grantor trust not includible in the grantor’s gross estate or any nongrantor trust at the death of the grantor unless there is a “distribution of trust assets (including to another trust).” Proposed §1261(c)(3). Therefore, if the trust continues in the same trust for the grantor’s descendants, there would be no deemed realization at death. But if trust assets pass to new separate trusts for the grantor’s descendants, there would be deemed realization at the grantor’s death. If a transfer triggering a deemed sale of a trust asset under §1261(a) has not occurred within 30 years, a deemed realization event would occur for specific assets in the trust every 30 years (or on January 1, 2022 if the asset has been held continuously in trust for more than 30 years on that date). Apparently, this provision applies for each individual trust asset, thus requiring tracking of the holding periods of all trust assets. (b) Grantor Trusts Includible in Gross Estate. For assets in a grantor trust that is includible in the grantor’s gross estate, there would be a deemed realization event at the grantor’s death, even if the assets remain in the same trust. Proposed §1261(c)(1)(B). It seems ironic that assets in a grantor trust includible in the estate would have a deemed realization at the grantor’s death, but assets in a grantor trust not includible in the gross estate would not necessarily have a deemed realization event at the grantor’s death. (2) Senate Proposal, STEP Act. Under Senator Van Hollen’s proposed STEP Act draft, there would be a deemed realization of assets in a grantor trust (whether or not includible in the grantor’s gross estate) at the grantor’s death. Proposed §1261(b)(1)(B). For nongrantor trusts, there would not be deemed realization at the death of the grantor, but a deemed realization event

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might occur if the asset is “transferred … in trust” to another trust at the grantor’s death. See Proposed §1261(a). In any event, a deemed realization event would occur every 21 years (with property in a trust created before January 1, 2006 being first treated as sold on December 31, 2026). (3) Greenbook Proposal. Under the Greenbook description, grantor trusts and nongrantor trusts are treated the same (except for revocable grantor trusts). There is no automatic deemed realization at the grantor’s death, but there would be a deemed realization if a trust asset is “distributed.” So, if the assets remain in the same trust for the grantor’s descendants (i.e., a pot trust for multiple beneficiaries), there would be no deemed realization, but if the assets pass to new separate trusts for the grantor’s descendants, there would be a deemed realization. A deemed sale of assets in a trust would occur every 90 years if there has been no deemed sale of those particular assets within the prior 90 years (the testing period begins on January 1, 1940 and the first such “90-year deemed sale” would be December 31, 2030). This apparently applies on an asset-by-asset basis. (4) Increased Use of Pot Trusts or Separate Trusts for Grandchildren. The various proposals have varying rules for when the death of the settlor will result in a deemed sale of trust assets in different trust situations. For those situations in which a deemed sale does not occur unless assets are transferred from the trust (including to a new trust), using “pot trusts” for multiple generations may avoid having trusts terminate at the death of the settlor or for a trust beneficiary to avoid a deemed sale. An alternative approach for a client with grandchildren who is creating a new trust is to use a separate trust for each grandchild (of which the grandchild’s parent and the grandchild would be discretionary beneficiaries) so that at the death of the client or of the client’s child who is the parent of the client’s grandchildren there would be no distribution to a new trust, but the assets could simply remain in each separate grandchild’s trust for each respective grandchild. (That would be a very unusual plan structured to anticipate provisions that we don’t know will ever be enacted. Complications would arise in providing equitable treatment for any grandchildren born after the grandchildren’s trusts are created.) b.

Impact of Deemed Realization Proposals on Traditional Trust Planning. The deemed realization proposals are controversial, and adoption of a deemed realization approach seems unlikely considering the ultra-thin Democratic voting margin in the Senate. Even so, planners are considering whether current trust planning should be adjusted to address the rather substantial income tax impact that the proposals could have on trusts being planned currently. For example, under the FY 2022 Greenbook proposal, transfers to or distributions in kind from trusts (including grantor trusts other than “revocable” grantor trusts) would be deemed realization events. The income tax ramifications of the proposal may gut many of the traditional transfer planning techniques planners have used – even though the Administration’s proposal does not directly address estate and gift taxes. The following are examples of issues that planners are considering currently in light of these proposals. •

Combined Income and Estate Tax. The combined income and estate tax for a deemed realization at death can be quite substantial. The net combined income and estate tax cost on the deemed realization of gain (assuming the $1 million exclusion has been utilized elsewhere) is 66.04%. The income tax is 43.4% (including the 3.8% NII tax) and the estate tax is 40% times the remaining 56.6% after paying the income tax, or 22.64%, resulting in a combined income and estate tax of 66.04%.

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Combined Income and Gift Tax. The combined income and gift tax for a deemed realization on making a gift is even higher because the income tax may not be deducted in determining the gift tax (the proposal does not include an explicit deduction of the amount of the income tax in determining the gift tax). The income tax on the deemed realization of gain is 43.4% (assuming the $1 million exclusion has been utilized elsewhere) and the gift tax is 40%, for a combined income and gift tax of 83.4%. Furthermore, carryover basis would apply to the

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extent that the deemed gain on the gift is sheltered by the $1 million exclusion. But that is not the end of this complicated story regarding the tax effects of deemed realization resulting from gifts. •

At the donor’s death (which could be decades later), the 43.4% income tax is excluded from the gross estate, thus reducing the estate tax by 40% x 43.4%, or 17.36%. Thus, the net overall tax resulting from the gift is 83.4% (income and gift tax) – 17.36% (estate tax savings), or 66.04% (the same as the combined income and estate tax for a deemed realization at death). But the 17.4% estate tax savings may not occur for many years (or decades).

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The Greenbook proposes granting “a right of recovery of the tax on unrealized gains,” so a net gift analysis might apply with the income tax being subtracted from the amount of the gift – if the recovery of income tax can offset the amount of a gift for gift tax purposes. This would result in the same combined income and gift tax (66.04%) as the combined income and estate tax for deemed realization at death.

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The right of recovery raises the possibility of an additional gift if the donor does not demand the reimbursement.

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Long-Term Pot Trusts. Perhaps place more emphasis on longer-term pot trusts rather than traditional trusts that terminate and split into separate trusts for descendants with the death of each generation (though each of the assets in the long-term pot trust would be deemed to be sold 90 years after the date the respective asset was acquired by the grantor under the Greenbrook proposal, 30 years after the trust acquired the asset under the House proposal, or 21 years after the establishment of the trust (but no earlier than December 31, 2026) under the Senate proposal). Query whether pot trusts with separate shares could be used to avoid the deemed realization that would otherwise occur when trusts split into separate trusts for descendants?

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Separate Trusts for Grandchildren. Another approach may be to create separate trusts for each grandchild, as described in Item 3.a.(6) above, to avoid having a deemed sale at the death of the settlor or of the child of the settlor who is the parent of the grandchild.

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Contribute Now to Beat Effective Date. An advantage of creating trusts now is that appreciated assets going into the trust would not trigger gain on the funding of the trust (whereas funding trusts with appreciated property next year might be very expensive from an income tax standpoint).

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Sales to or Exercises of Substitution Powers With Grantor Trusts. Sales to grantor trusts or the exercise of substitution powers after 2021 would appear to be realization events as to the grantor for assets going into the trust (because a “transfer” to a trust results in a deemed realization). It is not clear whether there would also be a deemed sale of assets passing from the trust in the sale or substitution transaction. (Under the Greenbook proposal and the Senate proposal, a deemed sale occurs upon “distributions” from the trust, and a purchase by the trust would not seem to be the same as a trust distribution. In contrast, under the House proposal, a deemed sale occurs upon a “transfer” from the trust.)

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Exercise Substitution Powers Now to Beat Effective Date. Consider exercising substitution powers with existing trusts prior to any legislation being enacted if the trusts would be making large distributions in the near future -- especially for GRATs that would otherwise need to distribute appreciated assets the following year or years in satisfaction of annuity payments.

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GRATs. GRATs would likely be a thing of the past; contributions of appreciated assets to the trust would trigger gain and distribution of in kind assets in satisfaction of annuity payments and the distribution of in kind assets at the end of the GRAT term to remainder trusts or remainder beneficiaries would also trigger gain.

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Decanting. Decantings to new trusts may be realization events.

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Formula General Powers of Appointment. Be careful about including formula general powers of appointment in trusts -- they might also result in deemed realization events upon the exercise or lapse of the general power.

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Flexibility. Building in as much flexibility as possible into irrevocable trusts may be more important than ever (for example, using trust protectors with very broad amendment powers).

Planning Implications of Ways and Means Committee Reconciliation Proposal a.

Exclusion Reduction. The proposal to accelerate the sunset of the $10 million indexed exclusion amount from 2026 to January 1, 2022 has resulted in a rush to take advantage of the large ($11.7 million in 2021) exclusion amount before it may be reduced in 2022 to $5 million indexed (estimated to be $6,020,000 or $6,030,000). This is a window of opportunity that may be lost forever (or at least until Congress meets again) once the calendar rolls to 2022. (1) Many More Taxpayers Subject to Estate Tax. The large decrease in the exclusion amount means that many more individuals will have to pay estate tax than in the past. Couples with assets in the $12 - $24 million range will become subject to having to pay estate tax when they previously thought the large exclusion amount would cover their estates, and their current plans may not contemplate the necessity for liquidity to pay estate tax. Estate plans will need to be reviewed. Clients who dropped life insurance coverage thinking they would not have to pay estate tax with a $10 million indexed exclusion amount may need to rethink their liquidity needs. Clients who previously thought they had no estate tax concerns may again consider transfer planning alternatives to reduce their estate tax liability. They may consider acquiring more life insurance (in an ILIT) or transferring existing policies to an ILIT. (2) Window of Opportunity Confirmed by Anti-Abuse Regulation. Most important, the anticlawback regulation (Reg. §20.2010-1(c)) confirms that a window of opportunity exists for transfer planning before the basic exclusion amount (BEA) reverts to $5 million indexed. “[T]he increased BEA is a ‘use or lose’ benefit that is available to a decedent who survives the increased BEA period only to the extent the decedent “used it” by making gifts during the increased BEA period.” Preamble to Final Regulation at 4. If an individual gives $11 million now, and dies after the BEA is $6.0 million, under the anticlawback regulation the BEA for estate tax purposes is the larger of the $6.0 million amount at death or the $11 million amount applied against gifts, so the BEA covers the $11 million adjusted taxable gift and no gift or estate tax is owed on the $11 million. On the other hand, if the individual retains the $11 million asset until death, the $11 million is included in the gross estate but the BEA is only $6.0 million (plus any further inflation adjustments), and estate tax is owed on the remaining $5.0 million. (3) No “Off-the-Top” Use of Increased BEA; Many Individuals Unable to Utilize Window of Opportunity. The two different places in the preamble to the final regulation confirm that the IRS does not adopt a rule allowing “donors to utilize the increase in the BEA without being deemed to have utilized the base BEA, so that the base BEA would remain available for transfers made after 2025.” Preamble to Final Regulation at 8. This means that an individual would have to make a very large gift to use the “bonus exclusion,” and many individuals will not be able to make any use of the bonus exclusion during the 2021 window of opportunity. A gift of $6 million in 2021would merely mean that in 2022 the individual had already used $6 million of his or her then $6,020,000 exclusion amount. For example, a couple with $16 million would owe estate tax after 2021 on the excess over their combined then $12 million exclusion amounts. But that couple likely would not be comfortable with either spouse making a $10 or $11 million gift in 2021 to utilize a significant portion of their bonus exclusion amount. (4) Be Cautious About Using Gift Splitting. Consider not making the split gift election, so that all gifts come from one spouse, utilizing that spouse’s excess exclusion amount that is available

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until 2026 (or 2022 if the current proposal is adopted). For this purpose, it is better for one spouse to make an $11 million gift than for both spouses to make $5.5 million gifts. If the parties anticipate that the split gift election will be made, consider having the donor’s spouse contractually agree to consent to the election at the time the gift is made (in case a divorce occurs before the gift tax return is filed in which event the donor’s spouse might express reluctance to consent to gift splitting). (5) Portability; Impact of Decrease in BEA on DSUE Amount. The final regulation clarifies that “a DSUE amount elected during the increased BEA period will not be reduced as a result of the sunset of the increased BEA.” Preamble to Final Regulation at 5. Examples 3 and 4 of the final regulation confirms this result. Reg. §20.2010-1(c)(2)(iii)Exs.3-4. (6) Ordering Rule Requiring Use of DSUE Before Increased BEA. If a surviving spouse has a DSUE amount from a predeceased spouse, the individual would generally prefer to apply the increased BEA to gifts made when the increased BEA is available (because, as discussed above, use of the increased BEA is a “use or lose” proposition), with the individual continuing to hold the DSUE amount, but that is not permissible. The preamble to the final regulation reminds that the portability final regulations require that “any DSUE amount available to the decedent for [a] calendar period is deemed to be applied to the decedent’s gifts before any of the decedent’s BEA is applied to those gifts (citing Reg. §§20.2010-3(b) & 25.2505-2(b)). Preamble to Final Regulation at 6). Example 4 of the final regulation reiterates that result. Reg. §20.20101(c)(2)(iv)Ex.4. (7) Post-Gift Inflation Adjustments. The final regulation confirms that inflation adjustments to the BEA after the time that gifts are made cannot be used after the increased BEA period under the special rule for avoiding clawback until after the inflation adjustments have increased the BEA to the amount of BEA applied against gifts during the increased BEA period. (8) Application of Increased GST Exemption to Prior Gifts. Because of the wording of the effective date provision in the 2017 Tax Act, technical issues existed as to whether someone could allocate increased GST exemption to transfers that were made before 2018. Several commenters asked the IRS to confirm that the increased GST exemption during the increased BEA period can be applied to gifts made before 2018. The preamble to the final regulation states that this issue is beyond the scope of these regulations, but the IRS made its position clear: “There is nothing in the statute that would indicate that the sunset of the increased BEA would have any impact on allocations of the GST exemption available during the increased BEA period (citing the Joint Committee on Taxation “bluebook” for its interpretation of the 2017 Act as allowing “a late allocation of GST exemption (increased by the increase in the BEA)”). The American Bar Association Tax Section has requested the IRS to confirm this conclusion in official guidance. b.

Valuation Discounts, §2031(d). (1) Statutory Provision. The proposed new §2031(d) values transfers of interests in entities as if any nonbusiness assets in the entity were transferred directly “and no valuation discount shall be allowed with respect to such nonbusiness assets.” This provision primarily targets family limited partnerships or LLCs holding only passive investment assets, and would prevent such interests from being discounted for gift and estate tax purposes (the House Report says it should also apply for purposes of chapters 13 (GST tax), 14 (special valuation rules), and 15 (transfers from expatriates, but a technical correction may be necessary to reflect that intent). The new provision would apply to transfers after the date of enactment. The proposal also restricts “tiered entity discounts” by applying the provision to all entities in which a taxpayer owns at least a 10% ownership interest. (2) Consider Entity Transfers. Clients with existing FLPs or LLCs owning primarily passive investment assets should consider making any desired transfers in the entity before the date of enactment. Alternatively, clients may want to contribute investment assets to an entity with transfer restrictions and make current transfers of interests in the entity in order to take

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advantage of discounts that now apply. Discounts of 15 to 40 percent are often allowed (the House Report has a good summary of the current case law regarding discounts and states that minority discounts are often 15 to 40 percent and lack of marketability discounts are often 20 to 30 percent). (3) Date of Enactment Effective Date. This is one of the provisions in the House Ways and Means Committee bill that has a date of enactment effective date, not January 1, 2022. (4) Marital or Charitable Deduction Mismatch? After the date of enactment, hopefully the valuation provision applies for purposes of valuing marital and charitable deductions as well as for determining the value of gross estates and gifts. The statute applies “for the purposes of [chapter 11] and chapter 12” which includes the marital and charitable deduction sections for estate and gift tax purposes, so the valuation provision should apply to the marital and charitable deduction sections. Otherwise, the marital or charitable deduction may not offset the gross estate or gift amount. This creates the anomalous situation, though, in which a marital or charitable deduction is allowed in an amount that exceeds the actual value passing to the spouse or charity, but those anomalies will exist in a world that uses artificial values for tax purposes. Assuming the provision applies for marital and charitable deduction purposes, this change would avoid the Estate of Warne v. Commissioner (T.C. Memo. 2021-17) situation to reduce the available marital or charitable deduction for interests passing to multiple charities or interests split between a spouse and a charity or charities (as to transfers of interests in entities with nonbusiness assets). c.

Grantor Trust Estate Inclusion and Gift Treatment, §2901. (1) Statutory Provision. Proposed §2901 will cause assets in grantor trusts to be in the grantor’s (or perhaps any deemed owner’s, see Item 4.c.(3) below) gross estate, and will treat distributions from the trust to anyone other than the deemed owner or the deemed owner’s spouse) as a gift, and will treat the entire trust as a gift when the trust ceases to be a grantor trust. An adjustment will be made for “amounts treated previously as taxable gifts.” This proposed statute is very similar to a proposal in the “For the 99.5 Percent Act” proposed by Senator Sanders. (Interestingly, §2901 would be in a newly created Chapter 16 of Subtitle B of the Code.) (2) Hits Many Planning Alternatives. Many transfer planning alternatives involve grantor trusts, and this new provision would cause those trusts subject to §2901 under the effective date rule (discussed below) to be in the grantor’s estate or to be subject to gift treatment when distributions are made or if the trust ceases to be a grantor trust. This would include irrevocable life insurance trusts (ILITs), spousal lifetime access trusts (SLATs), grantor retained annuity trusts (GRATs), qualified personal residence trusts (QPRTs), “intentionally defective grantor trusts” (IDGTs), charitable lead annuity trusts (CLATs) taxed as grantor trusts, and qualified subchapter S trusts (QSSTs). As discussed below, it may apply to Crummey trusts in some situations. (3) Applicable Only for Grantors and Not Other Deemed Owners? Proposed §2901(a) begins “In the case of any portion of a trust with respect to which the grantor is the deemed owner--.”That wording literally says that the statute does not apply to all deemed owners but only to a trust of which the grantor is the deemed owner. The rest of the statute just refers to deemed owners, and the statute has a specific definition of a deemed owner, but that just seems to be a way of referencing a grantor who is a deemed owner under the grantor trust rules of §673-§677 rather than just referring any “grantor” of a trust. Furthermore, it would seem strange to include trust assets in a beneficiary’s gross estate when the beneficiary never owned or made a taxable transfer of the assets. The proposed §2901 is very similar to the proposed §2901 in Senator Sanders’ “For the 99.5 Percent Act,” but that proposal more explicitly stated that it applied to the portion of a trust with respect to which the grantor is the deemed owner and the portion of the trust to which a person who is not the grantor is a deemed owner and has engaged in a sale, exchange or comparable transaction with the trust.

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If the statute applies only to grantors, third-party deemed owners of trusts would not be subject to having grantor trust assets included in their estates. In that event, BDITs and BDOTs (trusts that are taxable to third-party deemed owners under §678) and QSSTs (taxable to the shareholder as a third-party under §678 by reason of §1361(d)(1)(B)) may become particularly favorable planning vehicles. (4) Crummey Trust Concerns. If §2901 will apply to all deemed owners, and not just grantors, a significant risk exists for Crummey trusts. The IRS generally treats the holder of a Crummey power as the owner of the portion of the trust represented by the withdrawal power under §678(a)(1) while the power exists and under §678(a)(2) after the power lapses if the power holder has interests or powers that would cause §§671-677 to apply if such person were the grantor of the trust (and that is typically satisfied by the reference to §677 if the power holder is also a beneficiary of the trust). See Ltr. Ruls. 201216034, 200949012, 200011058, 200011054 200011056, 199942037, & 199935046. (A technical concern with the IRS’s position as to “lapsed” powers is that §678(a)(2) confers grantor trust status following the “release or modification” of a withdrawal power. A “release” requires an affirmative act whereas a “lapse” is a result of a passive nonexercise of a power. Furthermore, the gift and estate tax statutes make a distinction between lapses and releases.) Section 678(b) says that the original grantor trust rules applicable to the original grantor take precedence over treating a beneficiary with a withdrawal power as the owner of the trust; however that applies only “with respect to a power over income” and a Crummey withdrawal power is a power over principal. Nevertheless, the IRS has issued numerous private letter rulings saying that the grantor power trumps the Crummey power holder. E.g., Ltr. Rul. 200942020. Even if the grantor-owner treatment trumps the beneficiary-owner treatment, what happens when the grantor dies? Is the grantor trust treatment as to the beneficiary resurrected? At one time, the IRS issued a private letter ruling saying that the beneficiary would become the owner, but it later withdrew that portion of the ruling. Letter Ruling 9321050, revoking 9026036 on the §678 issue. In any event, when the trust is no longer a grantor trust as to the grantor, beneficiaries who hold withdrawal rights (§678(a)(1)) or who have had withdrawal rights that have lapsed (§678(a)(2)) may be treated as deemed owners of the trust as to the portion attributable to their withdrawal rights, and subject to gross estate inclusion as to that portion and subject to gift treatment as to any distributions to anyone other than the deemed owner or his or her spouse. This concern could apply to pre-enactment trusts if the effective date is interpreted to apply to any trusts that become grantor trusts as to a deemed owner after the enactment date. (5) Effective Date. Proposed §2901 (as well as the new proposed §1062 addressing the income tax effects of transactions between the grantor trust and the deemed owner) applies (1) to trusts created on or after the date of the enactment of this Act, and (2) to any portion of a trust established before the date of the enactment of this Act which is attributable to a contribution made on or after such date.

(a) Created After Date of Enactment. The new provisions apply to trust “created on or after the date of enactment.” •

Receptacle Trusts. How does this provision apply to trusts that are created after the date of enactment under the terms of a pre-enactment trust agreement? For example, the grandfathered grantor trust may be a “pot trust” for all children and provide that when the youngest child is age 35, the trust will be split into separate trusts for all children. Or it may be a SLAT that gives a trust protector the ability to split the trusts into separate trusts with the spouse and each separate child as a beneficiary of the separate trusts. When the new trust is formed, it is a new trust for state law purposes. Will the new trusts be treated as having been “created on or after the date of enactment for purposes of this effective date provision? If so, it would be helpful if trusts provide flexibility for someone (perhaps a trust protector) to delay the creation of new receptacle trusts under the trust agreement.

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New Grantor Trust. What if an existing nongrantor trust converts to a grantor trust after the date of enactment? Will that be treated as a trust created after the date of enactment because it becomes a grantor trust after the date of enactment? If so, this legislation crates a huge trap for the unwary (discussed in Item 4.c.(9) below.

(b) “Contribution” After Date of Enactment. A portion of any pre-existing trust created and funded before the date of enactment (a “grandfathered grantor trust”) may become subject to proposed §2901 and §1062 – that portion “attributable to a contribution” after the date of enactment. That word “contribution” is unusual. Transfer tax statutes often have effective dates based on the date of “transfers.” A “contribution” connotes sometime more restrictive than “transfers.” Many would interpret that word as having connotations of a gift more so than a “transfer,” which literally simply applies to any transfer. Of course, if the intent merely was to refer to gifts, the statute could have used the word “gift.” At this point, substantial uncertainty applies as to whether sales or transfers for full consideration are treated as “contributions” to the trust that would cause a portion of the trust to become subject to proposed §2901 and §1062. Examples of transfers to the trust that could arguably be treated as “contributions” include •

sales,

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making a loan or selling assets or exercising substitution powers for a note the does not result in a gift under §7872 but is nevertheless more favorable to the borrower/purchaser than a commercially reasonable loan,

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swaps under substitution powers,

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payments on an installment note or other loan payments,

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in-kind payments with appreciated assets in satisfaction of a pecuniary obligation (including in-kind GRAT payments),

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settling a derivative transaction,

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lease or rental payments under a pre-existing lease (or under a post-enactment lease),

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making interest payments on existing loans, or

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the deemed owner’s payment of income taxes on the trust’s income (which is the liability of the deemed owner under the grantor trust rules).

Until this issue is definitively clarified through clarified statutory language or IRS guidance, planners will be very careful not to make additional transfers to a grandfathered grantor trust for less than full consideration. That would apply to sales to the trust by the grantor or deemed owner as well as the exercise of substitution powers. If a “contribution” is interpreted as being some transfer for less than full consideration, the gift element would likely be treated as a contribution, and the portion of the trust attributable to that gift element would be subject to proposed §2901 and §1062. (6) Defined Value Transfers. Because of the “contribution made on or after” the date of enactment effective date rule, sales and swaps under substitution powers involving assets that have any degree of valuation uncertainty will likely utilize Wandry or other defined value provisions to help guard against any inadvertent post-enactment “contribution” to the trust. (7) ILIT Contributions. The proposal creates an enormous problem for existing irrevocable life insurance trusts (ILITs). ILITs are typically grantor trusts. The grantor is treated as the owner of any portion of the trust whose income may be applied to the payment of premiums of policies of insurance on the life of the grantor or the grantor’s spouse, unless an adverse party must consent to such payment. §677(a)(3). The statute may not be applied in its incredibly broad literal manner, but the only relevant case law is from 1939-1944 cases and address predecessor statutory provisions. Little guidance exists from the IRS, but the case law and guidance (including www.bessemertrust.com/for-professional-partners/advisor-insights

Rev. Rul. 66-313) suggests that the grantor may be taxed on any income used to pay premiums, perhaps even if the trust prohibits the trustee from using trust income to pay premiums for life insurance on the grantor ‘s life. See Letter Ruling 8839008. If future contributions are made to pay future premiums, the portion of the trust that would be included in the decedent’s estate is unclear. One alternative may be to try to convert the trust to a nongrantor trust, by requiring an adverse party to consent to paying insurance premiums, but converting the trust to a grantor trust after the date of enactment would result in a gift of the value of the trust assets. (An issue may also exist as to who would be adverse regarding the particular issue of paying insurance premiums.) Another alternative is to fund the trust with significant liquid assets before the date of enactment in order for the trust to pay future premiums. (It is not clear how that would work for group insurance where the premiums are paid directly by the employer.) Loans from other trusts to make premium payments may also be an alternative, but the loan may have to be structured as a commercially reasonable loan (rather than using an unsecured AFR loan) to assure that no gift element exists. Converting to a split dollar arrangement may be possible in some situations. In effect, this is a private premium financing approach, with the client lending funds to the ILIT as a split-dollar loan. Again, consider whether an AFR loan is sufficient to avoid being treated as a “contribution.” With any loan alternative, consider how the loan will ultimately be repaid. Restructuring the policy to a paid-up policy with a lower death benefit may be possible to avoid the need for future contributions. (8) Tax Reimbursement. None of the existing estate tax reimbursement statutes appear to apply to assets included in a decedent’s gross estate under §2901. See §2207 (powers of appointment), §2207A (QTIP property), §2207B (§2036 inclusion). (Perhaps creative arguments could be made to apply §2036 to the trust so the trust assets would be includable under §2036 rather than §2901, in which event §2207B would apply, but be careful not to trigger estate inclusion for all trust assets if only a portion of the trust assets would otherwise be includable under §2901.) The estate tax attributable to grantor trust assets includible in a decedent’s estate would typically be payable from the decedent’s residuary estate rather than being paid from the trust assets, unless a tax reimbursement clause in the will provides otherwise. This could result in a major disruption of the estate plan. Estate tax reimbursement clauses in wills should be reviewed going forward to make sure they are general enough to apply to any trust assets that are includable in the decedent’s gross estate. (9) Critical Tax Policy Concern -- Trust That Inadvertently Becomes Grantor Trust. A postenactment nongrantor trust may subsequently become a grantor trust. For example, various tests under §674 depend upon who is the trustee. If a trustee resigns and another trustee is appointed that inadvertently causes the trust to be a grantor trust, will that be treated as a trust created after the date of enactment because it becomes a grantor trust after the date of enactment? And then if another change of trustee causes the trust to become a nongrantor trust again, will that cessation of grantor trust status cause the value of all the trust assets to be subject to gift tax? That creates a huge trap for the unwary. Indeed, many future estate tax audits may focus not on valuation or §2036 issues but on whether a particular trust is a grantor trust due to inadvertent factors. Converting the estate tax system to a “gotcha” system is terrible tax policy. In addition, the grantor trust provisions essentially prohibit making lifetime transfers for the benefit of an individual’s spouse, at least without requiring the consent of other beneficiaries (i.e., the client’s children), which most clients are unwilling to do. People typically like to make sure that their spouses are well taken care of, and this tax provision frustrates that very common estate planning goal. www.bessemertrust.com/for-professional-partners/advisor-insights

(10) Effect if Grantor Trust Only As to Income? What if the trust is converted to a grantor trust only as to the trust income? (Some of the grantor trust provisions apply only as to trust income or only as to trust principal.) What portion of the trust would be included in the gross estate or be subject to gift treatment when distributions are made? Proposed §2901(a) begins “[i]n the case of any portion of a trust with respect to which the grantor is the deemed owner –.” The remaining substantive provisions of §2901(a)(1) repeatedly refer to “such portion.” If the grantor is the deemed owner only as to trust income, what portion of the trust is included in the gross estate, particularly if the trust is invested in assets that produce little trust accounting income (or even little current taxable income)? d.

Income Tax Treatment of Transactions Between Deemed Owner and Grantor Trust, Proposed §1062. (1) Statutory Provision. Proposed §1062 provides that if a transfer occurs between a deemed owner and a trust, the treatment of the person as the deemed owner is disregarded in determining whether there is a sale or exchange. In effect, this provision overrides Rev. Rul. 8513, 1985-1 C.B. 184, which ruled that the grantor’s receipt of shares of stock from a trust in exchange for a promissory note was not a sale for income tax purposes “because the grantor is treated as the owner of the shares both before and after the sale.” House Report at 1280. (2) Clearly Applies to Deemed Owners. Proposed §1062 does not even include the word “grantor” in the statutory provision. It clearly applies to all deemed owners of a trust under the grantor trust rules (technically referred to in the in the statute as “subpart E of part 1 of subchapter J”). (3) Just Impacts Sale or Exchange Treatment, Not Interest or Rent. The only effect of the new provision is whether a transaction will be treated as a sale or exchange. Therefore, the provision should not treat interest or rent payments as taxable income to the recipient party. (4) Effective Date. The same statutory effective date provision applies to §1062 as for §2901, as discussed in Item 4.c.(5) above. The same concerns exist about what “contributions” to the trust will cause a portion of the trust no longer to be a pre-enactment grantor trust, and as to that portion of the trust, sale or exchange treatment could result from a transfer even though it is between the trust and a deemed owner. In addition, the House Report suggests that post-enactment transfers between a pre-enactment grantor trust and a deemed owner can result in recognition as a sale or exchange, even though the transfer may not result in the trust losing its status as a grandfathered pre-enactment grantor trust. The House Report adds this gloss to the meaning of the effective date provision. The provision is generally effective for (1) trusts created on or after the date of enactment and (2) any portion of a trust established before the date of enactment that is attributable to a contribution made on or after such date. The portion of the provision relating to sales and exchanges between a deemed

owner and a grantor trust is intended to be effective for sales and other dispositions after the date of enactment. House Report at 1282-83 (emphasis added).

(The House Report adds in footnote 935 that “[a] technical correction may be necessary to reflect this intent.”) The highlighted sentence might be viewed as merely reiterating the statutory provision (which applies to contributions after the date of enactment), but it refers to “sales” after the date of enactment, not “contributions.” The intent appears to be that transactions after the date of enactment can be treated as sales for income tax purposes even though the transaction is with a pre-enactment grantor trust. The sentence clearly applies just to §1062 and not also to §2901. Apparently, the effect of such a sale transaction is merely to treat that particular sale as a sale for income tax purposes and not to cause the trust to lose its grandfathered grantor trust status either for purposes of §2901 or as to §1062 for other transactions. (5) Sales Between Trust and Deemed Owner. Sales between the trust and the deemed owner would clearly be covered by the House Report comment. The parties could recognize gain for income tax purposes to the extent the amount received by that party exceeds that party’s basis www.bessemertrust.com/for-professional-partners/advisor-insights

in what was exchanged. (As discussed above in Item 4.c.(6), a Wandry clause or other defined value provision should be used to help assure that the sale has no gift element.) (6) Making Payments After Date of Enactment on a Pre-Enactment Installment Note. Note payments on a pre-enactment installment note may cause gain to be recognized (if the original purchase price exceeded the basis of the assets that were originally sold). One might argue that the note payment is not a sale or exchange, and the House Report language says that §1062 would apply to “sales or other dispositions after the date of enactment.” Steve Gorin (attorney in St. Louis) believes that payments on a pre-enactment note will not be subject to proposed §1062 because loan modification regulations provide that a payment in cash according to existing note terms is not a sale or exchange (see Reg. §1.1001-3(c)(1)(ii) (alteration according to the terms of a debt instrument is not a taxable modification), §1.1001-3(e)(3) (change in timing of payments can be a taxable modification), and because the payment does not violate the spirit of the legislative change, which generally is to restrict transfers of appreciating assets to grantor trusts. However, the IRS may contend that the payment should be given the same treatment as if it were not between a trust and a deemed owner, resulting in the gain element attributable to that note payment being recognized for income tax purposes. If making a note payment after the date of enactment causes recognition of gain, will the grantor trust be able to adjust its basis in the purchased property by the amount of that gain recognition? If not, double taxation of the same gain will ultimate occur when the trust sells the property. (7) Making Note Payments Before Date of Enactment. Note payments from the grantor trust made before the date of enactment would not generate gain. Another advantage of making some note payments before the date of enactment would apply in case the grantor trust status should terminate before the note is fully paid. The general income tax treatment of an installment sale to a grantor trust is that a sale does not exist for tax purposes until the trust is no longer a grantor trust. Steve Gorin (an attorney in St. Louis) points out that when that happens, the sale price is the remaining note balance. Therefore, gain is avoided after a grantor trust is no longer a grantor trust as long as the note has paid down to the point that its balance is no greater than the basis of the trust assets when grantor trust treatment terminates. Another planning alternative for planning in case the grantor trust status terminates before the note is paid is to swap high basis assets into the trust before the date of enactment. When grantor trust status terminates, the sale occurs for income tax purposes, and if the basis of the trust assets exceeds the note balance at that time, no gain results. (But swapping high basis assets into the trust might result in the trust no longer holding the favored highly appreciating assets.) (8) “Kenan” Transactions; “Immunizing” GRATs. Distributions of property in kind from trusts or estates that are in satisfaction of pecuniary bequests or pecuniary amounts are treated as taxable sales or exchanges, and gains or losses may result. Reg. §1.661(a)-2(f)(1); Kenan v. Commissioner, 114 F.2d 217 (2nd Cir. 1940). A classic example would be the distribution of an appreciated asset by a GRAT in satisfaction of the pecuniary annuity payment amount if the annuity amounts exceed the basis of the distributed asset. Under the House Report comment, such a transaction after the date of enactment can result in the grantor trust recognizing gain even though the transaction is between a trust and the deemed owner (and even though the trust is a grandfathered grantor trust). The gain would be recognized by the grantor trust. There is nothing in the statute or House Report to change the normal result that the grantor would owe the income tax attributable to that gain of the grantor trust. One alternative to avoid the Kenan gain by a GRAT when making annuity payments would be for the grantor to exercise a substitution power prior to date of enactment to acquire the low basis assets in return for cash (or other high basis assets), which the trust could use to make the www.bessemertrust.com/for-professional-partners/advisor-insights

annuity payment. (The disadvantage would be removing the highly appreciating assets from the GRAT; the grantor could re-substitute the highly appreciating assets back into the GRAT if the proposed §1062 is not enacted.) If the grantor does not have sufficient cash to make that swap, the grantor could borrow cash from a bank, purchase the appreciated assets from the GRAT for cash, which the trust would later pay to the grantor in satisfaction of annuity payments, which the grantor would use to repay the bank. If the grantor instead merely gives a note to the trust to acquire the GRAT’s highly appreciated assets before the date of enactment, the tax treatment is unclear. The note may have a low (or zero basis) and the GRAT may recognize gain when it is treated as “selling” the low basis note to the grantor in satisfaction of the pecuniary GRAT obligation. That result is not clear though; if the trust recognizes gain on the in-kind payment of the annuity with the note, double taxation of the same gain would occur when the grantor subsequently sells the appreciated asset unless the basis of that asset in the hands of the grantor is somehow adjusted as a result of the trust’s recognition of gain on the in-kind annuity payment. (9) Current GRAT Transactions. Be wary of entering into GRAT transactions currently with assets that may have substantial (or hopefully, explosive) appreciation. The GRAT transaction may assure that the appreciation that occurs by the time annuity payments are due would have to be recognized as the payments are made. This may violate a “do no harm” goal of planners. (10) Electing Out of Installment Treatment. Could the trust elect out of installment sale treatment and treat the sale transaction as a “closed transaction” before the date of enactment when transactions between the grantor trust and deemed owner would not cause the recognition of gain? Apparently, there is no ability to elect out of installment sale treatment for a transaction that is not treated as a sale or exchange (when the deemed owner and trust are treated as the same taxpayer). (11) Settling Derivative. Settling a derivative transaction arguably is merely the satisfaction of a contractual obligation of a prior transaction and is not a post-enactment sale or exchange. e.

Immediate Actions Preceding Date of Enactment. Most of the planning ideas listed in this subsection have been discussed above. They are aggregated in this subsection to assist the planner in focusing on the most urgent actions. (All of these comments assume that that the effective date provisions do not change from those in H.R. 5376 as it was introduced.) (1) Create and Fund Grantor Trusts; Flexibility. In light of the continuing legislative uncertainty, build in as much flexibility as possible (for example, using trust protectors with very broad amendment powers). (2) Most Transfers of Interests in Entities With Nonbusiness Assets. If an individual has been considering making gifts or sales of interests in an entity with nonbusiness assets (or has been considering creating an entity with nonbusiness assets for and making transfers of interests in the new entity), take action before the date of enactment. The new valuation restrictions apply to transfers after the date of enactment. (3) Grandfathered Grantor Trusts. •

Sell assets to grandfathered trust (note payments made after the date of enactment may cause gain recognition, but should not cause the trust to become “ungrandfathered”)

•

Exercise substitution powers to shift liquid assets that can be used to make payments instead of using appreciated assets to avoid Kenan gain to the trust if note payments should have to be made with appreciated assets.

(4) Existing Sale Transactions. Consider making note payments currently when they can be made without recognizing gains. If the goal is to leave the favored-highly appreciating (and highly appreciated) asset in the trust, the trust may consider borrowing from a bank to generate the cash to make the payment. www.bessemertrust.com/for-professional-partners/advisor-insights

(5) Existing GRATs. Swap high basis assets (such as cash) into the trust so the trust can make future annuity payments without recognizing Kenan gain. If necessary, the grantor may borrow from a bank to generate the necessary cash for effectuating the swap. (6) New GRATs. Be wary that entering into a new GRAT currently may lock in a necessity of gain recognition when the GRAT has to make the annuity payments with appreciated assets. (7) ILITs. Make additional gifts to the trust for it to make future premium payments or restructure the policy to reduce future premium payments. Consider taking steps to convert the trust to a nongrantor trust before the date of enactment (which probably would require getting the consent of an adverse party before making premium payments – but who would be adverse as to that decision?) If an existing policy will be transferred to an ILIT because the owner will become subject to the estate tax considering the lower exclusion amounts, considering selling the policy to the ILIT to avoid the §2035 three-year rule. A sale of the policy should be made to a grantor trust (to avoid transfer for value problems under §101), and the sale should be made before the date of enactment to avoid having the sale treated as a sale or exchange. (8) Derivatives. Consider closing derivative transactions early, before the date of enactment. (9) Prepare Documentation Allowing Irrevocable Transfer to Become Effective on Very Short Notice. Once planners know the final provisions in any tax changes, as agreed upon by the Senate and House of Representatives, planners may only have a short period of time (perhaps only days) to implement transfers with full knowledge of the terms of any tax changes. Do not wait to prepare documents until that time. Have transfer and trust documents prepared and ready to be signed. Or even have the documents signed, with a provision that the transfer is revocable until the transferor signs and delivers a short document relinquishing the right of revocation. f.

Sales Involving Grantor Trusts and Grantor’s Spouse. A possible approach for utilizing a grandfathered grantor trust after the date of enactment might be to combine the planning with a transaction with the grantor’s spouse. For example, W could sell an asset to H’s grandfathered grantor trust. That would not be a transfer between a trust and the deemed owner (so §1062 should not apply), but the sale should be protected by §1041. Also, §2901 should not be triggered, either for inclusion in H’s estate (because the sale from W is not a “contribution” so the trust is still grandfathered from §2901 as to the grantor), or in W’s estate (W is neither the grantor nor the deemed owner of H’s grantor trust so §2901 should not apply to W even if the trust is a postenactment grantor trust as to H). A similar alternative may be a sale from W to a BDIT for H created by H’s parents, and that might work even for a BDIT created after date of enactment. Section 2901 may not apply to H (on the theory that §2901 only applies to a grantor and not any deemed owner). The sale by W should not invoke §1062 because it is not a transfer between a trust and the deemed owner.

Future Planning With Nongrantor Trusts. If the proposed grantor trust provisions are enacted, future transfer planning will be with nongrantor trusts. (1) Structuring Trusts as Nongrantor Trusts. Planners will have to carefully structure trusts so they are nongrantor trusts. (For example, no one can hold an inter vivos power of appointment who is not an adverse party. See §674(a) & §674(b)(2).) Trust administration should be monitored to assure that no actions are taken that would convert the trust (or a portion of the trust ) to a grantor trust (such as paying a premium of life insurance on the grantor’s life). Consider including prohibitions on any actions that would cause the trust to be a nongrantor trust, treating such actions as void ab initio. For a brief summary of planning considerations for structuring a nongrantor trust— Use one of the following exceptions under §674(b):

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(1) Use independent trustees (no more than half of whom are related or subordinate parties) and give them the authority to distribute assets among a designated class of beneficiaries. (2) Use a trustee other than the grantor or grantor’s spouse, whose distribution powers are limited by a reasonably definite external standard. (3) With no limitation on who is the trustee—as to corpus use a reasonably definite distribution standard (or have separate shares for the beneficiaries), and as to income, either have (i) a vested trust for a single beneficiary, (ii) provide that the income must ultimately pass to current income beneficiaries in irrevocably specified shares, or (iii) provide that on termination the assets may be appointed to appointees (other than the grantor or grantor’s estate) if the trust is reasonably expected to terminate during the current beneficiary’s lifetime. (4) Use an adverse party as trustee (which causes the general rule of §674(a) not to apply). Even if one of those exceptions is satisfied, also make sure (1) that no one who is not an adverse party holds an inter vivos power of appointment, (2) that the trust is not a foreign trust, and (3) that none of the proscribed administrative powers in §675 are present. Also, the trust will be a grantor trust if the trust may make distributions to the grantor or grantor’s spouse (probably only as to trust income) or if premium payments may be made on life insurance on the life of the grantor or grantor’s spouse (probably only as to the amount of premiums actually paid during the year), unless such distributions or payments must be approved by an adverse party. (2) Trustee Changes. Be very careful when trustee changes are made, due to trustee resignations or otherwise. Carefully review the provisions of §674 to assure than an exception to the general rule of §674(a) applies in all circumstances (as to both income and principal). (3) Installment Sales. Installment sales with nongrantor trusts can continue to be very effective. The grantor will have to recognize gain to the extent that the purchase price exceeds the basis of the assets that are sold to the trust. Discounted assets (for example, fractional interests in real estate or interests in entities with business assets) may have enough discount that the fair market value of the interest (i.e., the purchase price) does not greatly exceed the seller’s basis in the asset. •

An installment sale to the trust can defer the seller’s recognition of gain until note payments are made.

•

The purchasing trust acquires an immediate basis in the purchased assets equal to the full purchase price (which can be used currently for depreciation purposes).

•

As long as the trust, as a related party purchaser, does not resell the assets within two years, a subsequent sale by the nongrantor trust would not accelerate gain to the original seller/deemed owner on the original note given by the nongrantor trust. The gain on the first sale can continue to be deferred under the installment method. See §453(e).

•

A special interest charge (generally 3% plus the applicable AFR, e.g., 5% if the AFR is 2%) is imposed each year on the sales in each year in excess of $5 million. Spouses are separate taxpayers for this purpose even if they file joint returns. For example, if H and W each sell assets to the nongrantor trust for a $5 million for two separate $5 million notes in December and repeats that in January of the following year, they will have sold assets for $20 million of notes with deferred gain with no exposure to the special interest charge. §453A.

(4) Other Traditional Wealth Shifting Alternatives. Other traditionally used strategies for shifting wealth could be used by with nongrantor trust. For example, the trust could co-invest with the parent in start-up entities or take advantage of other excellent investment opportunities. www.bessemertrust.com/for-professional-partners/advisor-insights

Items 5-17 are summaries of general transfer planning considerations for the balance of 2021 5.

Window of Opportunity The proposed reduction of the gift exclusion amount to about $6 million in 2022 creates a window of opportunity for transfer planning in the balance of 2021 to take advantage of the current $11.7 million gift exclusion amount. Planners may be very busy handling a rush of clients wanting to take advantage of this window of opportunity. See Item 4.a.(1) above.

Planning for Flexibility In light of the remaining inherent uncertainty regarding whether the basic exclusion amount will be reduced back to $5 million (indexed) after 2021 and whether the proposed §2901 and §1062 will be enacted or whether a deemed realization system will be enacted, bringing major planning changes for grantor trusts, building in flexibility to trust arrangements will be important. For example, the flexibility to defer having a trust split into separate trusts may be very helpful. Consider alternatives for adding flexibility into trust instruments using any of the transfer planning strategies described below. Some of the ways of adding considerable flexibility are: •

using nontaxable powers of appointment;

•

providing broad distribution standards by independent trustees;

•

granting substitution powers to the settlor;

•

authorizing trust decanting (which may be available under state statutes); and

•

providing special modification powers to trust protectors (see Items 18-31 below regarding planning issues with using trust protectors).

For a terrific resource addressing a wide variety of planning alternatives during times of such uncertainty, see Carlyn McCaffrey & Jonathan Blattmachr, The Estate Planning Tsunami of 2020, ESTATE PLANNING (Nov. 2020). 7.

Defined Value Transfers a.

Significance of Defined Value Transfers. If the gift exclusion amount is reduced to $5 million (indexed) in 2022, the lower exclusion amount will mean that more transfers are likely to be close to the exclusion amount. If the IRS is successful in contesting the value, a taxable gift could result. Defined value clauses may become more important for that reason. More importantly, if proposed §2901 and §1062 are passed, defined value clauses will be used in sale transactions with grandfathered grantor trusts to guard against having an inadvertent gift element in the sale, resulting in an additional “contribution” to the trust and causing an attributable portion of the trust to become subject to §2901 and §1062. For a more detailed discussion of defined value clauses, see Item 14 of the Current Developments and Hot Topics Summary (December 2017) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights.

“Two-Tiered Wandry Arrangement.” Planners vary as to whether they prefer a “Wandry approach” (transferring that number of units equal to $X as finally determined for federal gift tax purposes) or a “price adjustment approach” (transfer of a set number of units for a specified value but with a price adjustment provision based on the value as finally determined for federal gift tax purposes). An approach that combines the Wandry approach and a price adjustment approach has been described as a “two-tiered Wandry” arrangement. The client would make a traditional Wandry transfer of that number of units that is anticipated to be worth the desired transfer amount (which could either be a gift or a sale), but with a provision that if those units are finally determined for federal gift tax purposes to be worth a higher value, a note would be given for the excess amount. That approach was used in True v. Commissioner, Tax Court Docket No. 21896-16, and H.A. True III v. Commissioner, Tax Court Docket No. 21897-16 (petitions filed October 11, 2016).( For a more detailed discussion of True v. Commissioner, see Item 11.n of Estate Planning Current

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Developments and Hot Topics (December 2019) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights.) The two-tiered Wandry arrangement is described as follows. This could consist of a traditional Wandry transfer followed by the simultaneous sale of any shares (or other assets) left by the Wandry adjustment clause if the clause is triggered. In other words, the transferor makes a gift of a specified value of the shares of the entity, believing that all of the transferor’s interest in the entity is equal to the value being transferred. In the event that the shares are re-valued on audit (such that the value that the transferor sought to transfer does not cover all of the shares), the transferor will have sold shares that exceed the intended gift value. The second tier of the double Wandry arrangement could consist of a second sale of any shares, effective as of the same date as the primary Wandry sale, that remain by operation of the Wandry arrangement in the selling taxpayer or trust’s hands. The price for this second sale, if any, could be for a price equal to the gift tax value as finally determined. The sale would be supported by a note upon which interest accrues from closing and is required to be made current within a specified time period, e.g., 90-days of the final determination. Apropos to 2020 transfers, the concern over dramatic estate tax changes may have well encouraged many practitioners to utilize the two-tier Wandry clause as future transfers might not qualify for discounts, etc. if the law changes. Further, using a two-tier Wandry transfer may both protect against an unintended gift tax and simultaneously avoid a Powell challenge for estate inclusion. In Powell, the taxpayer “in conjunction with others” retained control over the FLP interests transferred resulting in estate inclusion. With a traditional application of a Wandry clause interests in an entity could remain in the transferor’s control resulting in a Powell challenge. Using the two-tier Wandry may avoid that, and do so at a time in the law before discounts might be restricted or eliminated by a Biden Administration. For the most part, these types of arrangements would rely on grantor trusts, so that, in the event that the Wandry problem clause is triggered, the transferor could avoid an income tax – and possibly income tax interest and penalties – for a sale transaction deemed to have occurred on the date when the original gift was made.

Joy Matak, Steven Gorin & Martin Shenkman, 2020 Planning Means a Busy 2021 Gift Tax Return Season, LEIMBERG ESTATE PLANNING NEWSLETTERS #2858 (February 2, 2021). The Matak, Gorin & Shenkman article includes excellent suggested detailed disclosures for reporting a two-tiered Wandry transfer on a gift tax return and income tax return (including Schedule K-1 disclosures). 8.

Gift Suitability Analysis Barry Nelson (an attorney in North Miami Beach, Florida) suggests the following factors for considering if a particular client is a candidate for transfer planning alternatives: (1) Possibility of future appreciation. (2) Current cost basis. (3) Willingness to defend gift tax audit. (4) Willingness to pay fees to implement gift transactions. (5) Willingness to give up assets. (6) Desire to protect assets from future creditors. (7) Willingness to manage assets actively so that over time there no significant disparity will exist between fair market value and basis of the assets. (8) Whether gift assets will be sold vs. retained long term. (9) Knowing that the donor can keep the ability to reacquire the asset for equivalent value and possibly avoid losing a basis step-up at death. (10) Willingness to pay income taxes on the grantor trust, with the understanding that this obligation can be ended when desired.

Transfers with Possible Continued Benefit for Grantor or Grantor’s Spouse; Sales to Grantor Trusts Couples making gifts of a large portion of their $10 million (indexed) applicable exclusion amount will likely want some kind of potential access to or potential cash flow from the transferred funds. Various planning alternatives for providing some benefit or continued payments to the grantor and/or the grantor’s spouse

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are discussed in more detail in Items 14-25 of the Current Developments and Hot Topics Summary (December 2013) found here and available at www.bessemertrust.com/for-professionalpartners/advisor-insights. Also, a preferred partnership freeze strategy is discussed in Item 3.q. of the Estate Planning Current Developments Summary (December 2018) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. One of the straight-forward alternatives of retaining continued benefit is a sale to grantor trust transaction. The seller would continue to receive benefit from the note payments. For an excellent overview of planning with grantor trusts, the effects of sales to grantor trusts, and the effects of exercising substitution powers to accomplish a basis adjustment at death on the re-acquired assets, see Matthew S. Beard, Curing Basis Discrepancy: Sales and Substitutions of Trust Property, TAX NOTES (Nov. 4, 2020); Monte A. Jackel, Grantor Trust Ownership: What Does It Mean?, TAX NOTES (April 13, 2020). 10. Overview of Gifting Opportunity Approaches, Particularly for Clients Who Want Some Type of Continued Access to Gift Assets The following is a list of gifting approaches, in order of increasing aggressiveness and/or complexity, particularly for clients who want some type of continued access to gift assets. a.

Annual Exclusion/Tuition Gifts. Gifts up to the gift tax annual exclusion and the tuition and medical expense exclusion. Such gifts could be outright, to custodianships for minors, or to trusts ((§2503(c) trusts or Crummey trusts.)

Traditional Trust Gifts for Descendants (or Other Third Party Beneficiaries). More significant gifts to trusts with neither the settlor nor settlor’s spouse as a present or future possible beneficiary, regardless of any reversal in financial position.

Trust With Settlor’s Spouse as Discretionary Beneficiary (Sometimes Referred to as Spousal Lifetime Access Trust, or “SLAT”). Gifts to a trust with the settlor’s spouse (and possibly children) as discretionary beneficiaries; at death of the spouse, the assets would be held for descendants.

Trust With Settlor’s Spouse as Discretionary Beneficiary (SLAT) or That Might Eventually Include Settlor As Discretionary Beneficiary. Gifts to a trust with the settlor’s spouse (and possibly children) as discretionary beneficiaries; at death of the spouse, the spouse may decide to have all or some of the assets pass into a trust with the settlor as a discretionary beneficiary (depending on whether DAPT legislation or a statute reversing the “relation back doctrine” applies to the continuing trust for the settlor).

Trust With Settlor’s Spouse as Discretionary Beneficiary (SLAT) That Eventually Eliminates Spouse As Beneficiary If Spouse’s Net Worth Exceeds Specified Amount. Gifts to a trust with the settlor’s spouse (and possibly children) as discretionary beneficiaries; at a predetermined future date, the assets will be distributed outright or in trust for descendants only if the settlor’s net worth is at least a specified value determined at the creation of the original trust.

Trust With Settlor as Discretionary Beneficiary (Sometimes Referred to as Domestic Asset Protection Trust, or DAPT). Gifts to a trust in which the settlor (and others, if desired) are discretionary beneficiaries if DAPT legislation applies to the trust. (Estate inclusion may nevertheless result if the trustee makes frequent distributions to the settlor or the IRS can otherwise establish the existence of a prearrangement that the settlor would receive distributions.)

Trust of Which Third Party Has Power to Add Settlor as Discretionary Beneficiary in the Future. Gifts to a trust in which others are discretionary beneficiaries, but a third party has the discretion to add the settlor as a discretionary beneficiary after a specified period of time if DAPT legislation applies to the trust. See Abigail O’Connor, Mitchell Gans & Jonathan Blattmachr, SPATs: A Flexible Asset Protection Alternative to DAPTs, 46 ESTATE PLANNING 3 (Feb. 2019).

Inter Vivos QTIP Trust for Settlor’s Spouse. If estate tax savings are not a concern, gift to an inter vivos QTIP trust for the settlor’s spouse, retaining the right to be a discretionary beneficiary if the spouse predeceases the settlor. An inter vivos QTIP trust might also be an alternative for one spouse to make a gift in a way that would utilize the donee spouse’s estate exclusion amount.

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If a large QTIP exists for a beneficiary, one way of making a large gift to utilize the large gift exclusion amount before it is reduced, but without giving up the right to substantial economic benefits, is to make a §2519 deemed transfer, discussed in Item 16.d below and which is discussed in Item 3.j.(8) of the Estate Planning Current Developments Summary (December 2018) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. i.

Similar But Non-Reciprocal Trusts. All of the above alternatives might be combined with the settlor’s spouse making a gift to a similar, but not identical, trust.

11. Transfers with Possible Continued Benefit for Grantor or Grantor’s Spouse; Sales to Grantor Trusts Couples making gifts of a large portion of their $10 million (indexed) applicable exclusion amount will likely want some kind of potential access to or potential cash flow from the transferred funds. Various planning alternatives for providing some benefit or continued payments to the grantor and/or the grantor’s spouse are discussed in more detail in Items 14-25 of the Current Developments and Hot Topics Summary (December 2013) found here and available at www.bessemertrust.com/for-professionalpartners/advisor-insights. Also, a preferred partnership freeze strategy is discussed in Item 3.q. of the Estate Planning Current Developments Summary (December 2018) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. One of the straight-forward alternatives of retaining continued benefit is a sale to grantor trust transaction. The seller would continue to receive benefit from the note payments. For an excellent overview of planning with grantor trusts, the effects of sales to grantor trusts, and the effects of exercising substitution powers to accomplish a basis adjustment at death on the re-acquired assets, see Matthew S. Beard, Curing Basis Discrepancy: Sales and Substitutions of Trust Property, TAX NOTES (Nov. 4, 2020); Monte A. Jackel, Grantor Trust Ownership: What Does It Mean?, TAX NOTES (April 13, 2020). 12. Trust for Settlor’s Spouse as Discretionary Beneficiary (SLATs); Possible Inclusion of Settlor as Discretionary Beneficiary Following Spouse’s Death or at Some Other Time The settlor may wish to make gifts in a way that the settlor’s spouse (or the settlor) could retain some use of the assets in case needed as a “rainy day” fund. A popular way of using the increased gift exemption may be for a settlor to make gifts to a “lifetime credit shelter trust” for the benefit of the settlor’s spouse (and possibly children). The trust could be designed to give as much control and flexibility as possible to the surviving spouse without creating tax or creditor concerns. The trust could still be used for the “marital unit” if the client has concerns that large gifts may unduly impoverish the settlor and his or her spouse, but the assets would not be included in the gross estates of the settlor or the settlor’s spouse. Such a trust would likely be a grantor trust as to the grantor under §677 (unless the consent of an adverse party were required for distributions to the spouse). a.

Trust Terms. The trust would include the settlor’s spouse as a discretionary beneficiary, containing very similar terms as a standard credit shelter trust created under a will. The trust may allow very broad control to the spouse but still not be included in the donee-spouse’s estate for estate tax purposes and hopefully will be protected against claims of both the settlor’s and spouse’s creditors. In some ways, this is the ideal kind of trust for the spouse. Possible terms could include the following: •

The donor’s spouse could be a discretionary beneficiary (perhaps with children as secondary beneficiaries or as the primary beneficiaries).

•

The spouse could be the trustee (distributions that the spouse could make to himself or herself would be limited to HEMS).

•

Provide that no distributions could be made that would satisfy the settlor’s legal obligation of support (and if distributions are made to the donee-spouse, preferably the spouse should use those distributions for things other than basic support needs to remove any inference that the funds are actually being used for the settlor’s benefit).

•

The spouse could have a “5 or 5” annual withdrawal power.

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•

The spouse could have limited power of appointment (exercisable at death or in life).

•

In case the donee-spouse predeceases the settlor, the power of appointment could be broad enough to appoint the assets back to a trust for the settlor. (Exercising the power of appointment in the donee-spouse’s will to include the settlor-spouse as a discretionary beneficiary should not cause inclusion in the settlor-spouse’s estate under §2036(a)(1) if there was no pre-arrangement, but that might not prevent the settlor-spouse’s creditors from being able to reach the trust assets depending on state law (as discussed in Item 12.f below), which itself could trigger estate inclusion for the original settlor-spouse. The power of appointment should provide that it cannot be exercised in a manner that would grant the original settlor a power of appointment over the assets to avoid triggering §2038 inclusion in the settlor’s estate. See Item 12.b.(2) below.

•

A “trust protector” or some independent party could be given the discretion to add the settlor of the trust at some time in the future (perhaps after a number of years or after the donor is no longer married to the donee-spouse or only if the applicable state law has a DAPT statute). Alternatively, a third party could have a power of appointment broad enough to include the settlor as a discretionary beneficiary (which could similarly be subject to conditions, if desired). See Abigail O’Connor, Mitchell Gans & Jonathan Blattmachr, SPATs: A Flexible Asset Protection Alternative to DAPTs, 46 ESTATE PLANNING 3 (Feb. 2019). Absolutely no understanding (or even implied agreement) should exist with the protector about how the power would be exercised. Issues regarding having a donor as discretionary beneficiary of a trust are addressed in detail in Item 13 below.

•

Another way of addressing the case where the donee-spouse predeceases the donor would be to have some life insurance on the donee-spouse payable to the settlor or a trust for the settlor that has substantially different terms than this trust.

•

Another way still of addressing a divorce or the donee-spouse predeceasing the settlor would be authorize the trustee to make loans to the grantor. Loans to the settlor are more tax efficient than distributions so that the gift exclusion amount that was allocated to the gift is not wasted, and no interest income will result for loans to the grantor if the trust is a grantor trust.

•

If the settlor were concerned about how the donee-spouse might exercise the power of appointment, the instrument could provide that the power of appointment could be exercised by the spouse only with the consent of a non-adverse third party (such as the settlor’s sibling), and the instrument could even provide that the third person’s consent would be required in order for the donee-spouse to change an exercise of the power of appointment.

•

To address the possibility of a divorce, in which event the settlor-spouse may not want the donee-spouse to continue as a beneficiary, the trust could define the “spouse” to be the person to whom the grantor is married at the time without causing estate inclusion in the settlor’s estate (sometimes referred to as a “floating spouse” approach). See Estate of Tully Jr. v. United States, 528 F.2d 1401 (Ct. Cl. 1976) (power to alter death benefit plan by terminating employment or divorcing wife not a §2038(a)(1) power); Rev. Rul. 80-255, 1980-2 C.B. 272 (including settlor’s after-born and after-adopted children as additional beneficiaries is not the retention of a power to change beneficial interests under §§2036(a)(2) or 2038). Therefore, the trust could also be available for the benefit of a new spouse. Also, the settlor and donee-spouse may enter into an agreement that the gift will be taken into consideration in any property settlement incident to a divorce.

•

If the settlor gets to the point that the settlor really needs to be a beneficiary of the trust and wants the spouse to exercise the power of appointment, estate taxes may be the least of the settlor’s concerns.

Consider including a tax reimbursement clause but only if, under state law, such clause will not cause the trust to be available to the settlor’s creditors. Non-DAPT states with these statutes include Arizona, Florida, Kentucky, Maryland, New Jersey, North Carolina, Oregon, New York, and Texas. E.g., TEX. PROP. CODE §112.035(d)(1) (a settlor is not considered a beneficiary of a trust solely because a trustee other than the settlor “is authorized under the trust instrument to par or reimburse the settlor www.bessemertrust.com/for-professional-partners/advisor-insights

for, or pay directly to the taxing authorities, any tax on trust income or principal that is payable by the settlor under the law imposing the tax”); see Rev. Rul. 2004-64. b.

Completed Gift for Gift Tax Purposes. Despite the fact that the property may eventually be returned to the donor, the transfer is a completed gift, because the donor has so parted with dominion and control as to leave him in no power to change its disposition whether for his own benefit or for the benefit of another. Reg. § 25.2511-2(b). Also, the donor has retained no power to revest beneficial title to the property in himself, which also makes a gift incomplete. Reg. § 25.2511-2(c). Letter Ruling 9141027 held that a transfer to an irrevocable trust for the donor’s spouse was a completed gift even though the spouse had a special testamentary power of appointment to appoint the assets to a trust for the benefit of the donor, and even though the IRS found that an implied agreement existed between the spouses that the donee spouse would in fact execute a codicil to her will appointing the trust assets to a trust for the benefit of the donor. However, to assure that the initial transfer is treated as a completed gift, there should be no express or implied agreement regarding the exercise of the power of appointment. Furthermore, if a creditor of the donor could reach the trust assets, the gift would be incomplete. Until the power of appointment is exercised appointing some interest in the property to the creditor, a creditor arguably would have no rights in the trust property. However, if the spouse holds an inter vivos power of appointment and if the donor’s creditor is also a creditor of the spouse, underlying state law may afford creditors rights to the property, since the spouse would have the current power to appoint the property in a manner that would satisfy the donor’s and spouse’s creditors. To avoid this argument, the spouse should not hold an inter vivos power of appointment, or at least should be restricted from the appointing the property in a manner that would have the effect of satisfying the spouse’s creditors.

Application of Section 2702. If the gift is complete, does §2702 apply in valuing the gift? Section 2702 should not apply, because the spouse will not have held an interest in the transferred property, both before and after the transfer. Ltr. Rul. 9141027.

Inclusion in Spouse’s Estate. Whether the trust is included in the spouse’s estate depends on whether, under traditional planning principles, the spouse has a power over the trust that is taxable under Section 2041. Two letter rulings in 1991 addressed situations in which the donee-spouse had a power of appointment to appoint the trust property back to the donor. In Letter Ruling 9140068, the transfer was to an inter vivos QTIP trust, and the trust assets were includible in the donee spouse’s estate under Section 2044. In Letter Ruling 9141027, the transfer was to a trust that was not included in the spouse’s estate. Letter Ruling 9128005 involved an outright transfer from husband to wife, where the wife, on the same day as the gift, executed a codicil leaving the property back to a trust for the husband if she predeceased him. The property was obviously included in her gross estate.

Inclusion in Donor’s Estate. The main issues are whether the trust assets are included in the donor’s gross estate, (1) if the donor predeceases the spouse, or (2) if the spouse predeceases and in fact appoints the trust property to a trust for the benefit of the donor. The possibility of a beneficiary exercising a power of appointment for the benefit of the grantor (or grantor’s spouse) applies beyond just SLATs. Trusts for descendants or other beneficiaries may grant a beneficiary a power of appointment broad enough to allow appointing the assets to a trust that may benefit the grantor or the grantor’s spouse; the same general issues apply. (1) Potential Application of Section 2036. Section 2036(a)(1) includes in a decedent’s gross estate the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer by trust or otherwise, under which the decedent has retained for the decedent’s life or for any period which does not in fact end before the decedent’s death the possession or enjoyment of, or the right to the income from the property. Has the donor retained an interest in the trust, if the spouse must later exercise the power to leave the assets back to the donor? Regulation § 20.2036-1(c)(1) provides that an interest or a right is treated as being retained or reserved if at the time of the transfer there was an understanding, express or implied, that the interest or right would later be conferred.

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The regulations address such a contingency with respect to Sections 2038 and 2036(a)(2), dealing with powers that the donor could regain upon the occurrence of contingencies, but does not address the effect of such a contingency under Section 2036(a)(1), which is the relevant section. Reg. § 20.2038-1(a)(3) & 1(b), § 20.2036-1(b)(3). The issue is especially sensitive if the donee-spouse exercises a testamentary limited power of appointment to appoint the assets into a trust of which the settlor-spouse is a discretionary beneficiary. The IRS might argue that §2036 could apply in the settlor’s estate if it could establish an implied agreement that the donee-spouse would leave the donated assets back into a trust for the benefit of the settlor-spouse. This is analogous to situations in which one spouse makes a gift to the other spouse, and the other spouse bequeaths the property back into a trust for the benefit of the original settlor spouse. See Estate of Skifter v. Commissioner, 56 T.C. 1190, at 1200 n.5 (19172), aff’d 468 F.2d 699, 703 (2d Cir. 1972)(life insurance policy transferred to wife and bequeathed back to trust for husband with husband as trustee at wife’s death not includible in husband’s estate under §2042, reasoning that §§2036 and 2038 would not have applied if an asset other than a life insurance policy had been the subject of the transfer; Tax Court and circuit court both emphasized that if the transfer and bequest were part of a prearranged plan, estate inclusion would have resulted, noting that the bequest back to the husband was made “long after he had divested himself of all interest in the policies”); Estate of Sinclaire v. Commissioner, 13 T.C. 742 (1949)(predecessor to §2036 and 2038 applied where decedent gave assets to her father, who transferred the assets the following day to a trust providing decedent with a life interest and power to appoint the remainder interests); Rev. Rul. 84-179, 1984-2 C.B. 195 (§2036 did not apply because decedent’s transfer to the donee and the bequest back to the decedent in trust were unrelated and not part of a prearranged plan); Gen. Couns. Mem. 38,751 (June 12, 1981) (indication that step transaction doctrine will be applied if the decedent’s transfer and the donee’s bequest for the benefit of the decedent were part of a prearranged plan, and in particular that cases where the donee’s transfer occurs shortly after the decedent’s initial transfer would invoke the doctrine); see generally Gans, Blattmachr & Bramwell, Estate Tax Exemption Portability: What Should the IRS Do? And What Should Planners Do in the Interim?, 42 REAL PROP., PROB. & TR. J. 413, 432-33 (2007). To the extent possible, structure the transfer to remove the inferences of such an implied agreement (by allowing the passage of time, not transferring all assets, having the donee-spouse actually exercise a power of appointment rather than just allowing assets to pass back into trust for donor under trust default provisions, etc.). There is a specific exception in the QTIP regulations providing that the §2036/2038 issue does not apply for gifts to an inter vivos QTIP trust, where the assets are left back into a bypass trust for the benefit of the donor spouse. Reg. §§25.2523(f)-1(d)(1) & 25.2523(f)-1(f) Exs. 10-11. However, those examples would not apply because the rationale in them is that there will be estate inclusion in the donee-spouse’s estate under §2044. The primary issue regarding inclusion in the settlor-spouse’s estate under §2036 is whether an implied agreement existed that the power of appointment would be exercised to include the settlor-spouse as a discretionary beneficiary. Prof. Jeffrey Pennell once summarized: “I think, frankly, it would be difficult for the government to make that case, but of course you could leave a trail of documents -- a smoking gun – that could allow the government to say this was all part of a prearrangement, and that conceivably could get you into §2036.” Various other possible restrictions would help bolster the argument that the spouse’s power of appointment would not cause an estate inclusion problem for the donor. The actual exercise of the power, or even more conservatively, the manner in which the power of appointment could be exercised in favor of the donor-spouse, could be limited in the following possible ways. The appointment for the donor could be limited to payments for the health, support and maintenance of the donor. (Observe, however, that there are no cases suggesting an ascertainable standard exception for Section 2036(a)(1) like there are for Sections 2036(a)(2) and 2038.) Additionally, the permissible trust could require that distributions could be made to the grantor only after other income and assets of the donor had been exhausted, so that A’s creditors could not reach the property. www.bessemertrust.com/for-professional-partners/advisor-insights

If case law subsequently becomes clear that the mere existence of the power causes estate inclusion problems for the original donor, the donee-spouse could release the power of appointment, but the release would have to occur more than 3 years before the donor’s death under section 2035. (2) Potential Application of §2038. Section 2038 can apply to an ability to alter, amend, revoke, or terminate that exists in the trust at the death of the decedent – it did not have to be retained at the outset. So in exercising the non-general power of appointment, the donee-spouse must be careful not to give the settlor-spouse anything that would rise to the level of a right to alter, amend, revoke, or terminate. For example, the settlor could not have a testamentary power of appointment by reason of the exercise. In addition, if creditors can reach the assets in a trust to which assets have been appointed by the donee-spouse under the reasoning of the relation back doctrine (discussed below), that could create a §2038 problem, even if no implied agreement regarding how the donee-spouse would exercise the power of appointment existed at the time of the original transfer. Although various cases have held that assets in a trust that can be reached by the settlor’s creditors are in the settlor’s gross estate under §2036 [e.g., Estate of Paxton v. Commissioner, 86 T.C. 785 (1986)], some cases have also suggested that inclusion may also result under §2038. E.g., Outwin v. Commissioner, 76 T.C. 153 (1981) (trustee could make distributions to grantor in its absolute and uncontrolled discretion, but only with consent of grantor’s spouse; gift incomplete because grantor’s creditors could reach trust assets, and dictum that grantor’s ability to secure the economic benefit of the trust assets by borrowing and relegating creditors to those assets for repayment may well trigger inclusion of the property in the grantor’s gross estate under §2036(a)(1) or §2038(a)(1)). f.

Creditor Rights Issue. (1) Creditor Concerns If Settlor Becomes Beneficiary of SLAT. A totally separate issue is that, despite the tax rules, for state law purposes the settlor to the lifetime credit shelter trust may be treated as the settlor of the continuing trust for his or her benefit after the death of the doneespouse if the settlor-spouse has been added as a discretionary beneficiary. Therefore, for state law purposes, some possibility exists that the trust may be treated as a “self-settled trust” and subject to claims of the settlor’s creditors. This would seem to turn on what has been called the “relation back doctrine.” The power of appointment is “conceived to be merely an authority to the power holder to do an act for the creator of the power.” Donative Transfers vol. 2 §§11.124.4, in RESTATEMENT (SECOND) OF PROPERTY 4 (1986). Therefore, the donee-spouse, in exercising the power of appointment, is acting for the “creator of the power,” so the original settlor-spouse is treated as having made the appointment into a trust for the settlor-spouse’s benefit. Little discussion of this doctrine exists, however, in the context of creditor’s claims. Barry Nelson observes that “none of the reported cases regarding the Relation Back Doctrine address its application to the settlor of a QTIP or SLAT who receives trust assets upon the death of the donee-spouse through the exercise of a non-general power of appointment.” Barry Nelson, Asset Protection & Estate Planning – Why Not Have Both?, 2012 UNIV. MIAMI HECKERLING INST. ON EST. PLANNING ch. 17, ¶ 1701.2[B] (2012). After discussing the relation back doctrine in this context, one commentator concludes, “Thus, it is not clear that a court would actually hold that it was a transfer from the settlor to a trust for his own benefit through a power holder’s discretionary exercise of a power of appointment, but it is a risk.” Alexander Bove, Using the Power of Appointment to Protect Assets – More Power Than You Ever Imagined, 36 ACTEC L.J. 333, 337 (2010). See also Watterson v. Edgerly, 40 Md. App. 230, 388 A.2d 934 (1978) (husband gave assets to wife and next day wife signed will leaving assets to trust for husband; held that the trust was protected from husband’s creditors under the trust spendthrift clause). Nineteen states are domestic asset protection trust (DAPT) states, (Alaska, Connecticut, Delaware, Hawaii, Indiana, Michigan, Mississippi, Missouri, Nevada, New Hampshire, Ohio,

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Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia, West Virginia, and Wyoming). The creditor issue is not a problem in those states because a settlor’s creditors cannot reach assets in a properly structured “self-settled” trust that may be distributed to the settlor under a discretionary standard. In addition, at least eighteen states have statutes that address this situation in the context of initial transfers to an inter vivos QTIP trust, as opposed to transfers to a lifetime credit shelter trust. Those states include Arizona, Arkansas, Delaware, Florida, Georgia, Kentucky, Maryland, Michigan, New Hampshire, North Carolina, Ohio, Oregon, South Carolina, Tennessee, Texas, Virginia, Wisconsin, and Wyoming. The Arizona, Maryland, Michigan, Ohio, and Texas statutes also address the issue for all inter vivos trusts initially created for the settlor’s spouse (including the lifetime credit shelter trust strategy discussed in this subparagraph) where the assets end up in a trust for the original settlor-spouse. E.g., ARIZ. REV. STAT. §14-10505(E-F); OHIO REV. CODE §5805.06(B)(3)(a); TEX. PROP. CODE §§112.035(d)(2) (settlor becomes beneficiary under exercise of power of appointment by a third party), 112.035(g)(1) (marital trust after death of settlor’s spouse), 112.035(g)(2) (any irrevocable trust after death of settlor’s spouse), 112.035(g)(3) (reciprocal trusts for spouses). For a discussion of and citations to these statutes, see David Shaftel, Twelfth ACTEC Comparison of the Domestic Asset Protection Trust Statutes, (August 2019) (available at http://www.shaftellaw.com/dave.html). (2) Gross Estate Inclusion for Settlor In Light of Creditor Access? If the settlor’s creditors can reach the trust assets, that would cause inclusion in the settlor’s estate for estate tax purposes under §2036 if the IRS could establish the existence of an implied agreement that the spouse would exercise the limited power of appointment to appoint the assets into a trust for the settlor’s benefit, which creates the creditor’s rights problem. However, at least one case (Outwin v. Commissioner, 76 T.C. 153 (1981)) also states that §2038 could apply if the settlor’s creditors can reach the trust assets, and §2038 does not require an implied agreement of a retained interest at the time the gift is originally made, but only looks to conditions that exist at the settlor’s death. Accordingly, it may be important to exercise the limited power of appointment to establish a new trust in a “self-settled trust state” or a state that has passed a law similar to the Arizona, Maryland, Michigan, Ohio and Texas statutes discussed in Item 12.f.(1) above. However, even using a “self-settled trust state” for the new trust provides no absolute protection if the settlor does not reside in that state; the settlor’s state of domicile may refuse to recognize the asset protection features of the new trust on public policy grounds. The state of the settlor’s residence may assert that public policy prevents using an asset protection trust in another state. The conflict of laws issue as to creditor access to trust assets is discussed in detail in Item 13.b below. (3) Planning Considerations in Light of Creditor Concerns. If the state does not have a DAPT statute or a statute negating the “relation back” doctrine, consider not including the original settlor as a discretionary beneficiary directly, but giving a trust protector the power to add (or delete) the original settlor as a discretionary beneficiary. In addition to avoiding estate inclusion, the trust also provides protection against creditors, elder financial abuse, and identity theft. Over time, the trust can accumulate to significant values (because it is a grantor trust, the client will pay income taxes on the trust income out of other assets) and can provide a source of funding for retirement years. The client may not be overly concerned with actual creditor issues, but that could raise tax issues at that point. If there is an implied agreement that the original donee spouse will exercise the power of appointment in this way, that could raise a §2036(a)(1) concern. The implied agreement issue can likely be avoided by allowing some time to elapse before the power of appointment is exercised. But a §2038 issue may also apply, and keep in mind that §2038 does not require retention at the time of the original gift. The issue under §2038 is whether, at death, the donor has the power to “alter, amend, revoke, or terminate” the trust. To avoid §2038 inclusion if the settlor’s creditors can reach the trust assets, having an ascertainable standard may satisfy the “definite external standard” exception that has been www.bessemertrust.com/for-professional-partners/advisor-insights

recognized by the IRS (Rev. Rul. 73-143, 1973-1 C.B. 407) and various courts for avoiding §2038. E.g., Jennings v. Smith, 161 F.2d 74 (2d Cir. 1947); Estate of Ford v. Commissioner, 53 T.C. 114 (1969), nonacq. 1978-2 C.B. 3, aff’d per curiam, 450 F.2d 878 (2d Cir. 1971); Estate of Wier v. Commissioner, 17 T.C. 409 (1951), acq. 1952-1 C.B. 4 (addressing predecessor of §2036(a)(2) and §2038; “the education, maintenance and support” and “in the manner appropriate to her station in life”). However, including an ascertainable standard may give a beneficiary’s creditors better arguments for reaching the trust assets (but the client may not be concerned with actual creditor concerns). Another possible defense is that there are precious few cases applying this relation back doctrine in the creditor situation, so maybe the potential creditor issue is not a problem at all under the relation-back doctrine. A planning alternative to minimize the risk of estate inclusion for the donor spouse is for the original donee spouse to appoint the assets to a trust that merely gives a party the power to add the settlor as a discretionary beneficiary or perhaps that gives a third party a power to appoint assets to the settlor. The potential creditor issue will never arise if the settlor is never added as a discretionary beneficiary, and the settlor may never need to be a potential discretionary beneficiary of the trust assets. If the rainy day arises and there really is a need, it may well be that estate tax problems are the least of the settlor’s concerns at that point. To maximize the creditor protection feature of SLATs (i) the trustee should have the ability to sprinkle distributions among various beneficiaries, (ii) at least one independent trustee should consent to distributions, (iii) any named trust protector should be someone other than the settlor, and (iv) the trustee should be authorized to permit beneficiaries to use assets (rather than having to make distributions for them to enjoy benefits of the trust). g.

Gift From One Spouse to SLAT With Split Gift Treatment. Instead of having each spouse make $10 million gifts, some planners have suggested that one spouse could give the entire $20 million to a trust having the other spouse as a discretionary beneficiary. The other spouse would make the split gift election, which treats him or her as the transferor for gift and GST tax purposes (meaning that the spouse’s gift and GST exemption could be used) but NOT for estate tax purposes. Therefore, the assets would not generally be included in the spouse’s gross estate for estate tax purposes even though he or she was a discretionary beneficiary. The problem with this approach is that split gift treatment is not allowed if the consenting spouse is a beneficiary of the trust unless the spouse’s interest in the trust is ascertainable, severable, and de minimis. See Rev. Rul. 56-439, 1956-2 C.B. 605; Wang v. Commissioner, T.C. Memo. 1972-143 (no split gift election allowed where consenting spouse’s interest in trust receiving gift assets was not ascertainable); Robertson v. Commissioner, 26 T.C. 246 (1956) (gift splitting allowed for full amount transferred); see generally Diana Zeydel, GiftSplitting -- A Boondoggle or a Bad Idea? A Comprehensive Look at the Rules, 106 J. TAX’N 334 (June 2007). Interestingly, Letter Ruling 200130030 allowed gift splitting for the full amount of the transfer without discussing the value [in particular, that it had no value] of the donee spouse’s severable interest). While the amount that can qualify for gift splitting may be limited for gift purposes, the regulations appear to provide that if any portion of the transfer qualifies for gift splitting, a full one-half of the transferred amount shall be treated as having been transferred by the consenting spouse for GST purposes. Reg. §26.2652-1(a)(4). For a more complete discussion of the relevant cases and letter rulings, see Item 5.k.(3) in the December 2012 “Estate Planning Current Developments and Hot Topics” found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. Gift splitting should be allowed in full if: •

Distributions of both income and principal to the donee-spouse are subject to an ascertainable standard of distribution under §2514, preferably a standard based upon the spouse’s accustomed standard of living;

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•

The trustee must consider other resources available to the spouse before exercising its discretion to distribute income or principal to the spouse; and

•

The resources that are, and are expected to be, available to the spouse for the remainder of his or her lifetime are sufficient to meet the spouse’s living expenses, such that the likelihood that the trustee will need to exercise its discretion to distribute income or principal to the spouse is so remote as to be negligible.

Planning for Complications Arising From Divorce From Spouse-Beneficiary. The 2017 Tax Act provides that alimony payments will not be deductible and will not be income to the recipient. In addition, §682 is repealed; that section provided that if one spouse created a grantor trust for the benefit of the other spouse, following the divorce the trust income would not be taxed to the grantorspouse under the grantor trust rules to the extent of any fiduciary accounting income that the doneespouse is “entitled to receive.” The repeal of §682 is particularly troublesome, in part because §672(e) treats a grantor as holding any power or interest held by an individual who was the spouse of the grantor at the time of the creation of such power or interest, so the ex-spouse’s interest as a beneficiary arguably might be sufficient to trigger grantor trust status under §677 even following the divorce (but see ACTEC comments filed with the IRS on July 2, 2018 suggesting the possibility of a contrary result). For an excellent discussion of planning and drafting suggestions for SLATs in light of the repeal of §682, see Laurel Stephenson, A Second Look at SLATs in Light of the Repeal of I.R.C § 682, 56 REAL ESTATE, PROBATE, AND TRUST LAW REPORTER (State Bar of Texas Real Estate, Probate and Trust Law Section August 2018). The article suggests that Section 682 might not have been applicable to SLATs providing for discretionary payments to the grantor’s spouse because §682 applies to the income of a trust that the spouse “is entitled to receive,” and the spouse has no entitlement to the income of a discretionary trust. Planning suggestions include (i) address whether to eliminate or give some third party the ability to eliminate the grantor’s spouse as a beneficiary following a divorce, (ii) negotiate in the divorce for how income taxes will be paid on trust income, and/or (iii) provide for reimbursement of the grantor’s income taxes on trust income by a mandate in the trust agreement or at the discretion of an independent fiduciary or in a marital settlement agreement. The amount to be reimbursed may depend on a variety of factors including the distribution standard and whether the spouse will likely receive a distribution of all trust income following a divorce. For a trust with other discretionary beneficiaries, the trustee might make distributions to beneficiaries other than the exspouse; the trust would still be a grantor trust but at least no income distributions would benefit the ex-spouse. Other commentators have discussed planning considerations as well in light of this important change. George Karibjanian, Richard Franklin & Lester Law, Alimony, Prenuptial Agreements, and Trusts Under the 2017 Tax Act, BNA ESTATES GIFTS & TRUSTS J. (May 10, 2018); Justin Miller, Tax Reform Could Make Divorce a Lot More Taxing, ACTEC 2018 FALL MEETING SEMINAR (2018). Prior to its repeal, §682 did not define “income” or clarify whether it refers only to fiduciary accounting income or also includes capital gains. If capital gains are not distributed to the spouse, §682 probably did not apply to them. If capital gains are allocated to income or are included in DNI and are distributed to the spouse, §682 likely does apply. See Barry Nelson & Richard Franklin, Inter Vivos QTIP Trusts Could Have Unanticipated Income Tax Results to Donor Post-Divorce, LISI ESTATE PLANNING NEWSLETTER #2244 (Sept. 15, 2014). The repeal of §682 not only suggests changes when drafting SLATs, but also increases the importance of involving estate planning advisers in divorce planning. George Karibjanian, Richard Franklin & Lester Law, Alimony, Prenuptial Agreements, and Trusts Under the 2017 Tax Act, BNA ESTATES GIFTS & TRUSTS J. (May 10, 2018)

Potential Conflict of Interest Between Spouses. An often-neglected issue with SLAT planning is the potential for conflicts of interest between the spouses. Should the spouses be represented by independent counsel? What if the donee-spouse sues for divorce soon after the mega-SLAT is funded? If only one spouse creates for the other spouse, a substantial shift of “marital property” may result. Aside from thee tax complications raised by the repeal of §682, the client may be very unhappy

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with the planner if the planner has not discussed the potential for potential divorce or marital property issues following the creation of the SLAT. j.

Special Planning Considerations for SLATs. •

Avoid the reciprocal trust issue by making only one spouse a beneficiary, at least initially.

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Using a SLAT prevents gift splitting if the spouse’s interest is not severable and ascertainable, (see Item 12.g above)

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The SLAT provides a benefit only while the donee-spouse is living and married to the grantor.

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Consider an agreement of the spouses that the gift will be taken into consideration in any property settlement incident to a divorce.

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Consider life insurance on the donee-spouse in case the donee-spouse dies before the grantor.

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Give the donee-spouse a limited testamentary power of appointment exercisable in favor of the grantor (but carefully consider §2036 and creditors’ rights against the settlor before the doneespouse exercises the power of appointment).

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The grantor may exercise a power of substitution (e.g., for a long-term AFR note) if the parties divorce so that the settlor would have the ability to re-acquire favored assets in the trust.

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The step transaction doctrine may treat the donee-spouse as a grantor if transfers were made by the donee-spouse to the grantor shortly before the grantor funded the trust.

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If the SLAT is funded by the grantor with a residence, can the grantor reside in the residence without paying rent? (Presumably yes, under the reasoning of various §2036 cases that a settlor’s continuing to live with his spouse is not considered an implied agreement of retained enjoyment.) If the settlor pays rent, is it a gift? (Presumably not.)

•

The various planning considerations discussed for DAPTs in Item 13.e below also apply for the trust with respect to provisions about adding the settlor as a discretionary beneficiary. For example, use the laws of a DAPT state, or at least use the laws of a state with favorable legislation negating the “relation back” doctrine to help resolve the creditor issue (which, in turn, is an estate tax issue if the SLAT assets are appointed to a trust for the settlor’s benefit).

13. Trust for Settlor as Discretionary Beneficiary (DAPT); Possible Inclusion of Settlor as Discretionary Beneficiary at Some Later Time A settlor might create a trust naming the settlor directly as a discretionary beneficiary, with the possibility of it serving as a “rainy day fund” in the unlikely event that financial calamities occur, without triggering §2036(a)(1) (a transfer with an implied agreement of retained enjoyment). This only works, though, if local law does not allow the settlor’s creditors to reach the trust as a result of the settlor’s status as a beneficiary (or else the gift would not be a completed gift and the assets would be included in the settlor’s gross estate for estate tax purposes, as discussed in Item 13.d below). Self-settled trusts (sometimes referred to as domestic asset protection trusts, or DAPTs) may be considered in jurisdictions that allow distributions to the settlor in the discretion of an independent trustee without subjecting the trust to claims of the settlor’s creditors. The state law issue about creditor access is vitally important if the settlor is named directly as a discretionary beneficiary, and this creditor access issue is discussed in some detail below before discussing the tax effects and planning considerations for DAPTs.

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Domestic Asset Protection Trust (DAPT) Statutes – Overview. Alaska was the first state to adopt domestic asset protection trust (DAPT) legislation 22 years ago, providing that a settlor’s creditors would not be able to reach trust assets merely because the settlor was a discretionary beneficiary of the trust, if the trust met certain requirements. (Missouri practitioners point out that Missouri had DAPT legislation before Alaska, but dicta in a bankruptcy case undermined confidence in the statute.) Some form of DAPT legislation now exists in 19 states (the two newest states are Indiana and Connecticut): Alaska, Connecticut, Delaware, Hawaii, Indiana, Michigan, Mississippi, Missouri, Nevada, New Hampshire, Ohio, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia, West Virginia, and Wyoming. Those 19 states cover over 20% of the United States population. Nine additional states have recognized some limited version of self-settled trust creditor protections, such as for inter vivos spousal QTIP trusts that may remain in trust for the benefit of the original settlor after the spouse’s death. For an excellent summary of the 19 DAPT statutes, see David Shaftel, Twelfth ACTEC Comparison of the Domestic Asset Protection Trust Statutes (updated through August 2019) (available at http://www.shaftellaw.com/dave.html). A significant uncertainty about DAPTs is the extent to which a resident in a state that does not have DAPT legislation can create a trust under the laws of a DAPT state and still enjoy protection of the spendthrift clause. To date, no case has recognized protection against the non-resident settlor’s creditors. Various cases (some of which are discussed below) have not recognized protection, but they have generally involved egregious fraudulent transfers that would not be allowed protection under the state DAPT statute in any event. Comment 8 to §4 of the Uniform Voidable Transactions Act (UVTA) suggests that transferring assets from a non-DAPT jurisdiction to a self-settled trust in a DAPT jurisdiction would be a voidable transaction and would not be entitled to spendthrift protection. For further discussion about Comment 8 and the UVTA, see Items 48-50 of the ACTEC 2017 Fall Meeting Musings found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights.

Conflict of Laws Issues; Especially Important If Settlor in One State Creates a DAPT Under Another State’s DAPT Laws. A primary issue that has arisen in cases addressing DAPTs is the conflict of laws issue as to whether the law of the DAPT state where the trust is sitused or the laws of the debtor’s state will apply. For example, Waldron v. Huber (In re Huber), was a bankruptcy case concluding that Washington (the debtor’s state) had a strong public policy against asset protection for self-settled trusts and applied the law of Washington rather than Alaska. In re Huber, 2013 WL 2154218 (Bankr. W.D. Wash. 2013) (Washington real estate developer created Alaska asset protection trust in 2008 when he was aware of the collapsing housing market and that his prospects for repaying loans was fragile at best; trust was found to be a fraudulent transfer voidable under both §544(b)(1) [state law fraudulent transfers] and §548(e) [transfer made within 10 years of filing petition for bankruptcy to a self-settled trust or similar device if made with actual intent to defraud creditors]; trust also held invalid under conflict of laws analysis because even though the choice of law designated in the trust is upheld if it has a substantial relation to the trust considering factors such as the state of the settlor’s or trustee’s domicile, the location of the trust assets, and the location of the beneficiaries, in this case the trust had its most significant relationship with Washington and Washington has a strong public policy against self-settled “asset protection trusts,” citing §270 of Restatement (Second) of Conflict of Laws). Section 270 of the Restatement (Second) of Conflict of Laws states: “An inter vivos trust in movables is valid if valid under the law of the state designated by the settlor to govern the validity of the trust, provided that the application of its law does not violate a strong public policy of the state with which the trust has its most significant relationship.” In Huber, the court determined that Washington, not Alaska, had the most substantial relationship to the trust by looking at various factors. Section 273 of the Restatement addresses immovables and does not include the strong public policy exception, but the court did not even mention §273.

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In Wells Fargo v. Retterath, 928 N.W.2d 1 (Iowa 2019), the Iowa Supreme Court addressed the validity of a charging order against an Iowa LLC that was created by Florida residents. If Florida law applied, the LLC interest would be tenancy by the entireties property and not available to satisfy debts of one of the tenants individually. While the title of intangible assets will normally be based on the law of the domicile of the owners, the law of the jurisdiction where an LLC is located should be applied regarding the enforceability of a charging order against the LLC. That state is the state with the “most significant contacts.” Another example of a case that raises concern about trying to rely on laws of a jurisdiction outside the state of the settlor-beneficiary’s residence is Rush University Medical Center v. Sessions, 2012 Ill. 112906 (2012), in which the Illinois Supreme Court held that a decedent’s creditors could reach assets that had been transferred to a Cook Islands trust. That case involved an egregious fact situation in which an individual transferred almost all of his assets to a Cook Islands trust of which the settlor was a discretionary beneficiary, knowing that he had made a large charitable pledge and that his remaining assets would not be sufficient for his estate to satisfy the pledge. The court did not address which jurisdiction’s law should apply under relevant conflict of laws principles, but held that the state’s passage of a fraudulent conveyance statute did not supersede Illinois common law principles allowing the creditors of a settlor to reach trust assets to the extent that the trust assets could be distributed to the settlor. In Rush University, the Cook Islands trust owned real estate in Illinois that had sufficient value to satisfy the judgment, so apparently there was no issue about having to enforce the judgment in the Cook Islands. Another case that limited the effectiveness of an Alaska DAPT against a creditor from the settlor’s state, but did not discuss the conflict of laws issues, is Toni I Trust v. Wacker, 413 P.3d 1199 (Alaska 2018). The facts are outrageously egregious, but the Alaska Supreme Court ultimately held that an Alaska statute cannot bar a Montana creditor from bringing a claim under Montana law against a Montana debtor over property located in Montana, just because the property had been assigned to an Alaska trust. The court held that the exclusive jurisdiction provision in the Alaska DAPT statute is unconstitutional. For a more detailed discussion of the Toni I Trust case, see Item 28.b. of Estate Planning Current Developments and Hot Topics (December 2019) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. See also In re Rensin (Bankruptcy Court held that Cook Islands trust, of which grantor was the primary beneficiary, was subject to Florida law as a matter of public policy); In re Herbert M. Zukerhorn, BAP No. NC-11-1506, U.S. Bankruptcy Appellate Panel of the Ninth Circuit (Dec. 19, 2012) (dictum). c.

Full Faith and Credit. No case has yet addressed whether a judgment in one state will be entitled to “full faith and credit” in an enforcement against a DAPT in another state (a DAPT state) where the trust is located. A similar issue was raised, though, in In the Matter of Cleopatra Cameron Gift Trust, which reasoned that the Full Faith and Credit Clause does not apply to the manner for enforcing judgments of another jurisdiction. See Item 17 of Heckerling Musings 2020 and Estate Planning Current Developments (March 2020) found here and available at www.bessemertrust.com/forprofessional-partners/advisor-insights for a more detailed discussion of the Cleopatra Cameron Gift Trust case, including a discussion of whether the court has personal jurisdiction over the trustee.

Transfer Tax Consequences of DAPTs. (1) Completed Gift. Cases have recognized that transfers to trusts can be completed gifts, even if the settlor is a potential discretionary beneficiary, if the settlor’s creditors cannot reach the trust. E.g., Outwin v. Commissioner, 76 T.C. 153, 162-65 (1981) (gift to trust incomplete if creditors can reach trust assets); Herzog v. Commissioner, 116 F.2d 591 (2d Cir. 1941) (gift to trust is completed gift if state law provides that settlor-beneficiary’s creditors could not reach the trust corpus or income). The IRS has acknowledged that a transfer to a DAPT can be a completed gift even though the asset may be distributed back to the settlor in the trustee’s discretion. Rev. Rul. 76-103 (”If and when the grantor’s dominion and control of the trust assets ceases, such as by the trustee’s

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decision to move the situs of the trust to a State where the grantor’s creditors cannot reach the trust assets, then the gift is complete for Federal gift tax purposes under the rule set forth in §25.2511-2”). See also PLRs 200944002, 9837007, & 9332006, discussed immediately below regarding estate inclusion. (2) Estate Inclusion. If a grantor makes a transfer and retains the right to the income from the property or the property itself, §2036 may cause estate inclusion of the transferred asset. Several cases have held that the ability of a settlor’s creditors to reach the assets will be deemed to be retained use and enjoyment of the transferred assets for purposes of §2036. (Paxton v Commissioner, German Estate v. U.S., Outwin Estate v. Commissioner, Paolozzi v. Commissioner). As discussed in Item 12.e.(2) above, §2038 may also apply. For further discussion of those cases and §2036 issues surrounding the use of self-settled trusts, see Item 5.l of the December 2012 “Estate Planning Current Developments and Hot Topics” found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. Several IRS private rulings have discussed whether §2036 will apply if the trustee has the discretion to make distributions to the settlor but state law does not permit the settlor’s creditors to reach the trust assets under a DAPT statute. Letter Ruling 9332006 involved a transfer to a foreign trust, and the ruling concluded that the transfer was a completed gift and that assets were not included in the settlor’s gross estate. In Letter Ruling 9837007 the IRS expressly refused to rule that whether assets in an Alaska DAPT would be excluded from the settlor’s estate, presumably because the IRS viewed that determination as dependent upon the facts and circumstances existing at the settlor’s death. Letter Ruling 200944002, which also addressed an Alaska DAPT, similarly refused to rule as to whether the trustee’s discretion to distribute trust assets to the settlor, when combined with other facts (such as, but not limited to, an understanding or pre-existing arrangement), may cause inclusion in the settlor’s gross estate under §2036. Letter Ruling 200944002 recognized that “the trustee’s discretionary authority to distribute income and/or principal to Grantor, does not, by itself, cause the Trust corpus to be includible in Grantor’s gross estate under §2036.” However, the ruling expressly declined to give an unqualified ruling and noted that the discretionary authority to make distributions to the grantor “combined with other facts (such as, but not limited to an understanding or pre-existing arrangement between Grantor and trustee regarding the exercise of this discretion) may cause inclusion of Trust’s assets in Grantor’s gross estate for federal estate tax purposes under §2036.” The PLR cited the tax reimbursement revenue ruling, Rev. Rul. 2004-64, which ruled that a trustee’s discretion to reimburse a grantor for income taxes attributable to grantor trust income, would not by itself constitute a retained interest causing inclusion under §2036, but other facts, combined with the settlor’s possibility of receiving tax reimbursement payments, could cause estate inclusion if (i) an understanding or prearrangement existed as to how the trustee would exercise such discretion, (ii) state law subjected the trust assets to claims of the settlor’s creditors, or (iii) the settlor retained the power to remove and replace the trustee with someone related or subordinate. Beginning in late 2011, the IRS has informally told other parties requesting similar rulings that it is not willing to issue further similar rulings. (3) Effect of Lingering Temporary Potential Creditor Access. DAPT statutes typically allow preexisting creditors to reach trust assets if the gift to the trust was a fraudulent conveyance, and also allow certain “exception creditors” (such as for alimony, child support, property division, and sometimes tort claims in existence before the funding of the trust) to reach trust assets, with limitations on the timing and amount of such claims. Under the Uniform Voidable Transactions Act, “voidable transfers” can be reached by creditors within the time specified in the statute, and future creditors may set aside transfers made with actual intent to hinder, delay or defraud the creditor within one year following their discovery of the transfer (known as the “discovery period”). In addition, all DAPTs are subject to the federal bankruptcy law clawback if the settlor files bankruptcy within 10 years of funding a DAPT. www.bessemertrust.com/for-professional-partners/advisor-insights

Does the possibility of a creditor being able to reach the assets mean that the gift is incomplete and estate inclusion results until the period of such contingencies has passed? The IRS reportedly has informally expressed some concern with issuing further rulings about Alaska DAPTs because of the bankruptcy clawback provision. According to counsel, the Service appears to be troubled by commentary about the Mortensen Alaska bankruptcy case. Battley v. Mortensen, Adv. D.Alaska, No. A09-90036-DMD (2011) allowed the bankruptcy trustee to recover assets transferred to an Alaska “self-settled trust” under the 10-year “clawback” provisions of §548(e) of the Bankruptcy Code. Personnel at the Service reportedly said that PLR 200944002 probably wouldn’t have been issued if they were looking at it now and that the Service since has declined other Alaska ruling requests. Presumably, such contingencies for a settlor’s creditors to reach assets in DAPTs do not cause incomplete gift treatment or estate inclusion. (Indeed, ALL gifts could be subject to such treatment in case the gift turned out to be a fraudulent transfer.) Planners are unaware of any case in which the IRS has argued that these contingencies cause a gift to be incomplete or cause estate inclusion. Even so, as to the 10-year clawback Bankruptcy Code provision, consider using a jurisdiction in which the DAPT statute provides that the DAPT restrictions are enforceable under nonbankruptcy law of the state so that the clawback provision in the Bankruptcy Code would not apply. (States with DAPT statutes that are enforceable under nonbankruptcy law are Connecticut, Missouri, Nevada, Virginia, and West Virginia.) e.

Planning Considerations for Minimizing Incomplete Gift and Estate Tax §2036 Concerns. Set expectations with the client that these trusts are not 100% fool proof as to the incomplete gift argument or the §2036 estate inclusion issue. (1) Use Laws of DAPT State. Creating the trust under the laws of a self-settled trust state is essential if a self-settled trust is being created. If the settlor is not a resident of a DAPT state, whether incorporating the law of a DAPT state will work is uncertain. (2) “Springing DAPT;” Settlor Not a Current Beneficiary But Third Person With Power to Add Settlor as Discretionary Beneficiary; “SPATs.” Use a “springing DAPT,” a trust in which others are discretionary beneficiaries, but a third party has the discretion in a non-fiduciary capacity to add the settlor (or alternatively “any descendant of the settlor’s grandparents”) as a discretionary beneficiary after a specified period of time, but to be most conservative, the provision would add that the settlor could be added only if DAPT legislation applies to the trust. See Abigail O’Connor, Mitchell Gans & Jonathan Blattmachr, SPATs: A Flexible Asset Protection Alternative to DAPTs, 46 ESTATE PLANNING 3 (Feb. 2019). (An inter vivos power of appointment in a non-adverse party would cause the trust to be a grantor trust.) (3) Power to Remove Settlor as Beneficiary. A third party could have the power to remove the settlor-spouse as a beneficiary (if the settlor has been added as a beneficiary at some point). That power could be exercised when the settlor is near death. Whether a retained enjoyment exists under §2036 is tested at the moment of death, and §2035 should not apply because the settlor has nothing to do with removing himself or herself as beneficiary (as long as no prearrangement exists). See Tech. Adv. Memo. 199935003 (§2035 will apply if pre-planned arrangement). One panelist observes that most clients will not be comfortable with some third party having the power to remove them as a discretionary beneficiary. (4) Avoid Distributions to Settlor as Beneficiary Unless Absolutely Needed; Inherent PreArrangement/Implied Agreement Issue; Consider Loans or Splitting Trusts. A §2036 concern may arise if the settlor ever needs distributions from the trust and distributions are made to the settlor. That might give rise to at least an argument by the IRS of a pre-arrangement or implied agreement that distributions would be made when requested. Of course, if the settlor gets to the point of needing distributions from the trust, estate tax concerns may be the least of the settlor’s worries.

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Consider making loans rather than distributions to the settlor-beneficiary. Charge interest and treat the loan as a bona fide loan. (Because the trust is a grantor trust, the interest paid by the settlor to the grantor trust will not be taxable income.) If distributions must be made to the settlor from the trust, consider splitting the trust (decanting, nonjudicial settlement agreement, judicial modification, trust protector modification, etc.) into two trusts, one of which permits discretionary distributions to the settlor and the other of which does not. The §2036 risk might then exist only as to the continuing trust of which the settlor is a discretionary beneficiary. (5) Power to Add Settlor-Spouse as Discretionary Beneficiary Only if “Act of Independent Significance” Exists. Provide that an independent third party (such as a trust protector could add the settlor as a discretionary beneficiary only upon the occurrence of an “act of independent significance,” such as the death of the settlor’s spouse or the settlor’s net worth falling under a dollar amount (that is far less that the settlor’s current net worth). That could help establish the absence of any “retained” benefit includable under §2036. (6) After No Longer Married. Consider, for married clients, excluding the settlor as a beneficiary as long as he or she is married. (This is a corollary of the preceding paragraph, if divorce is considered as an act of independent significance. A “contrived” divorce may not succeed for this purpose, but any divorce could have significant adverse tax effects, such as the loss of an estate tax marital deduction, so divorce may be viewed in particular circumstances as an act of independent significance.) (7) Settlor Cannot Be Added as Discretionary Beneficiary For At Least Ten Years. Consider providing that the power to add the settlor as a discretionary beneficiary could not be exercised for at least ten years from the last funding of the trust. This addresses any concern with respect to an open period of limitations under §548(e) of the Bankruptcy Code. (8) Trustee Selection. The trust must have at least a resident trustee in the state whose DAPT laws are being used, but the settlor could appoint others (e.g. advisory committee) to make investment or distribution decisions. The trustee should not be related or subservient to the settlor. (9) Trust Protector. A trust protector (who should be a non-adverse party) can have the power to discharge trustees, make certain trust amendments if necessary, the power to add the settlor as a discretionary beneficiary, etc. (10) Change of Situs. A change of situs provision allows for subsequent changes if laws or circumstances change. (11) General Asset Protection Provisions. Other asset protection provisions such as anti-duress clauses and flee clauses can be incorporated into the trust. (12) Termination Power. Termination powers could be given to the trustee or a trust protector if continuation of the trust is not in the settlor-beneficiary's best interests. (13) Spendthrift Provision. Include a spendthrift provision to protect trust assets from the beneficiary's creditors/former spouses. (14) Combination with Separate Entity. An asset protection trust can be combined with a limited partnership or limited liability company in order to permit investment management and control of the trust assets to continue in the settlor without jeopardizing the nature of the transfer as a completed gift. •

Discount Planning. The structure may provide lack of marketability and lack of control discounts on the transfer of limited partnership/membership interests to the trust, thereby permitting the transfer of real value in excess of the amount subject to taxation.

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•

Separate Entity Structure Adds Another Layer of Protection. Using a separate entity structure will provide an additional layer of protection between third party creditors and the trust.

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Charging Order as Only Remedy? In the unlikely event of trust creditors, enforcement of a judgment will be limited to a charging order against the trust's limited partnership or limited liability company interest if the trust assets are owned in an entity.

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Increased Contacts with State. Use of a limited partnership or limited liability company formed in the DAPT state will increase the settlor's contacts with that state, further justifying the application of that state's law to the claims of any creditor of the settlor.

(15) Other Split Interest Trusts Following Trust Term. An asset protection trust can be combined with any split-interest gift in trust (i.e., a QPRT, GRAT, or CLT), in order that the settlor may continue to have discretionary access to the transferred property after the initial term of the trust has expired. (16) Life Insurance on Settlor’s Life. An asset protection trust can be used to own the settlor's life insurance policies in the same manner as an irrevocable life insurance trust. So long as the settlor does not retain incidents of ownership in the transferred policies he can be a discretionary beneficiary, thereby permitting distributions of cash value to the settlor. See PLR 9434028. 14. Multiple “Non-Reciprocal” Trusts a.

Preferable If Only One Spouse Creates SLAT; Other Spouse Creates Trusts for Others. If clients are concerned about having enough retained assets as a “rainy day” fund in case of unexpected severe financial reverses, hopefully that concern can be accommodated by having only one spouse make a gift to a trust with the other spouse as a discretionary beneficiary. The gift by the other spouse would be to a trust with only descendants as beneficiaries, and that clearly avoids the reciprocal trust doctrine (although an issue could arise if the spouses serve as trustees of each other’s trust).

Both Spouses as Beneficiaries of Trust Created by Other Spouse; Reciprocal Trust Concern. Some clients may want to go further and have each of the spouses create SLATs for the other spouse; the issue would be whether such trusts could be structured to avoid the reciprocal trust doctrine and therefore avoid estate inclusion in both spouses’ estates. If A creates a trust for B and B creates a trust for A, and if the trusts have substantially identical terms and are “interrelated,” the trusts will be “uncrossed,” and each person will be treated as the grantor of the trust for his or her own benefit. United States v. Grace, 395 U.S. 316 (1969). In Grace, the trust terms were identical, the trusts were created 15 days apart, and the trusts were of equal value. The Court reasoned: Nor do we think it necessary to prove the existence of a tax-avoidance motive. As we have said above, standards of this sort, which rely on subjective factors, are rarely workable under the federal estate tax laws. Rather, we hold that application of the reciprocal trust doctrine requires only that the trusts be interrelated, and that the arrangement, to the extent of mutual value, leaves the settlors in approximately the same economic position as they would have been in had they created trusts naming themselves as life beneficiaries. (Emphasis added)

If the terms of the two trusts are not substantially identical, the reciprocal trust doctrine does not apply. See Estate of Levy v. Commissioner, 46 T.C.M. 910 (1983); PLR 200426008; but see Estate of Green v. United States, 68 F.3d 151 (6th Cir. 1995) (Jones, J. dissenting). c.

Possible Distinctions to Avoid Reciprocal Trust Doctrine. Possible distinctions that could be built into the trusts include the following. •

Create the trusts at different times (separated by months, not 15 days as in Grace).

•

Fund the trusts with different assets and different values (observe that Grace holds that just having different assets is not sufficient to avoid the doctrine, but it applies only to the extent of mutual value, Estate of Cole v. Commissioner, 140 F.2d 636 (8th Cir. 1944)).

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•

One trust allows distributions without any standard but the other trust imposes a HEMS standard.

•

One trust might require considering the beneficiary-spouse’s outside resources and the other would not.

•

One of the spouses would become a discretionary beneficiary only after the lapse of some specified time (say, 5 years) or on the occurrence of some event. For example, Letter Ruling 200426008 addresses trusts under which (i) husband would not become a beneficiary of wife’s trust until three years after wife’s death and then only if the husband’s net worth did not exceed a specified amount and his income from personal services was less than a specified amount, and (ii) wife had a “5 or 5” power of withdrawal from husband’s trust after their son’s death.

•

One trust includes the settlor’s spouse as a discretionary beneficiary but the other trust would merely give an independent party, perhaps after the passage of some specified time, the authority (not exercisable as a fiduciary) to add that settlor’s spouse as a discretionary beneficiary.

•

One trust allows conversion to a 5% unitrust but the other trust prohibits that.

•

Provide different termination dates and termination events.

•

Provide for different remainder beneficiaries upon termination of the trusts.

•

Include an inter vivos power of appointment in one trust and not the other (like in Levy).

•

Utilize different testamentary powers of appointment (maybe one trust has one and the other does not or perhaps there are different classes of permitted appointees or perhaps in one trust the power is exercisable only with the consent of a non-adverse party).

•

Use different trustees.

•

Structure different removal powers (one allows the grantor to remove and comply with Rev. Rul. 95-58 but the other puts removal powers in the hands of some third party).

Spouses as Secondary Beneficiaries. There may be an advantage to making the primary beneficiary the settlors’ children and/or grandchildren, and including each other only as secondary beneficiaries.

Differences Must be “Real.” In any event the differences need to be “real.” Additionally, the structure of the trusts is only part of the equation, and probably not the most important part. How the trusts are administered after they are created may be the most critical factor. Clients may want to make gifts to the trusts and then immediately start flowing cash out of the trusts to each other the same as they did before the trusts were created. If that is done, the IRS would likely argue the existence of a pre-arranged plan that the income or other benefits would come right back to the grantor, even if only indirectly through the spouse.

Spouses Not Reciprocal Trustees. Consider not having each of the spouses serve as trustee of the other’s trust. Reciprocal dispositive powers may be sufficient to invoke the reciprocal trust doctrine if the trusts are sufficiently interrelated; reciprocal economic interests may not be required. See Bischoff v. Commissioner, 69 T.C. 32 (1977); Exchange Bank & Trust v. United States, 694 F.2d 1261 (Fed. Cir. 1982). For a more complete discussion of the reciprocal trust doctrine, authorities holding that the reciprocal trust doctrine does not apply if there are substantial differences between trusts, authorities for applying the doctrine to reciprocal powers, and related creditors’ rights issues see Item 5.l of the December 2012 “Estate Planning Current Developments and Hot Topics” found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights.

Creditors’ Rights Issue? A possible concern with “non-reciprocal” trusts by each of the spouses for each other is that they may not be respected for state law purposes with respect to claims of creditors against the settlors. Cf. Security Trust Co. v. Sharp, 77 A.2d 543 (Del. Ct. Ch. New Castle 1950) (case did not involve a creditor attack on a reciprocal trust, but suggested in dictum that

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reciprocal trusts would be subject to attack by creditors). The Security Trust case was over 60 years ago, and locating any reported case in which creditors have attacked a reciprocal trust under this theory is difficult. State legislatures may address this issue. For example, Arizona and Texas statutes provide protection from a reciprocal trust attack when spouses create trusts for each other. ARIZ. REV. STAT. §1410505(E); TEX. PROP. CODE §112.035(g)(3). The possibility of creditors attacking reciprocal trusts should not be a problem if the trusts are created under the laws of states that have adopted DAPT provisions (as discussed in Item 2.yyyyy above). If the settlors’ creditors can reach the trust assets, that would cause inclusion in the settlors’ estates for estate tax purposes under §2036 (and possibly under §2038). 15. GST Planning Considerations a.

Cannot Ignore GST Tax. Even low-to-moderate wealth individuals cannot ignore the GST tax. Without proper allocation (either automatically or manually) of the GST exemption (currently $10 million indexed), trusts created by clients generally will be subject to the GST tax (currently 40%) at the death of the beneficiary unless the trust assets are included in the beneficiary’s gross estate.

Making Use of Large GST Exemption While It Exists. Grantors who have previously created irrevocable trusts that are not fully GST-exempt may want to allocate some of the increased GST exemption amount to the trust. The Bluebook for the 2017 Tax Act (published in December 2018 about a year after the Act was passed) has a detailed footnote saying that is permitted, and the preamble to the anti-clawback final regulation suggests that the IRS agrees. Allocating GST exemption to remainder trusts created after a GRAT terminates may be especially beneficial since GST exemption cannot be allocated to a GRAT until the end of the ETIP.

16. Gifts to “Lock In” Use of Increased Gift Exclusion Exercise caution before using any of the alternatives described in subparagraphs (1)-(6) below. The IRS is considering whether to adopt an anti-abuse exception to the anti-clawback regulation that would remove the effectiveness of these planning alternatives, as discussed in subparagraph (6) below (and that project has been added to the 2021-2022 Priority Guidance Plan). a.

Enhanced Grantor Retained Income Trust. For the client that is reluctant to relinquish substantial value, but wants to make a large gift to “lock in” use of the increased gift exclusion to take advantage of the window of opportunity, consider making a gift of an asset while retaining the income from or use of the asset (in a manner that does not satisfy §2702). The asset will be included at its date of death value in the gross estate under §2036(a)(1), but the date of gift value will not also be included in the estate tax calculation as an adjusted taxable gift. §2001(b) (last sentence). The effect is that the asset has been given to someone else, the date of death asset value is included in the gross estate, but at least the date of gift value is offset by the estate tax unified credit, which is increased by the amount of exclusion applied against lifetime gifts under the anti-clawback regulation if that amount exceeds the exclusion amount available at death (for example, because of a decrease in the basic exclusion amount in 2026). The post-gift appreciation in the asset is all that is effectively subject to estate tax. For a detailed discussion of this approach, see R. Eric Viehman, Using an Enhanced Grantor Retained Income Trust (E-GRIT) to Preserve the Basic Exclusion Amount, STATE BAR OF TEXAS 25TH ANNUAL ADVANCED ESTATE PLANNING STRATEGIES COURSE, ch. 4.7 (April 2019).

Promise to Make Gift; Gift of Legally Enforceable Note. Revenue Ruling 84-25 says that a gratuitous transfer of a legally binding promissory note is a completed gift. If the donor dies when the note is still outstanding, the estate is not entitled to a §2053 debt deduction for the note, because it was not contracted for full consideration. But the IRS reasoned in Rev. Rul. 84-25 that the assets that would be used to pay the note are still in the donor’s gross estate, so the gift of the note would not be an adjusted taxable gift to be added back into the estate tax calculation. §2001(b) (last sentence). The anti-clawback regulation would mean that the BEA at death would be large enough to cover prior gifts made after 1976, including the note. Therefore, the effect is that the donor would have taken

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advantage of the window of opportunity if the gifted note is a substantial part of the approximately $11 million gift exclusion amount. The mere gift of a promissory note typically is not legally binding, but the recipient could in principle give some form of consideration (such as agreeing to visit on Mother’s Day), which might cause the note to be enforceable. If the IRS were to pass a regulatory anti-abuse rule under the anti-clawback regulation for gifts that are included in the gross estate, the gift by promise would likely not get the benefit of the anti-clawback rule because the assets that will be needed to pay the liability are still in the gross estate. A planning alternative, if that were to occur, would be for the donor to pay the promised gift amount before death. See Katie Lynagh, Potential Anti-Abuse Rules May Limit Use of the Temporarily Increased Gift Tax Exclusion, BNA ESTATES, GIFTS & TRUSTS J. (May 14, 2020). c.

Transaction That Does Not Satisfy §2701. Another approach is making a transfer that intentionally fails to satisfy §2701. A donor would make a gift of a common interest in a partnership/LLC while retaining a preferred interest that does not meet the requirements of §2701. The effect under §2701 is that the preferred interest is treated as having a zero value (for example, because it is noncumulative). The donor would be treated under §2701 as making a gift equal to the donor’s entire interest in the entity. (The donor would need to have remaining gift exemption equal to the value of the interest in the entity to avoid having to pay gift tax.) At the donor’s death, the mitigation rule in Reg. §25.2701-5(a)(3) will reduce the donor’s estate value by the same amount by which the gift value was increased because of the zero value rule.

Section 2519 Deemed Transfer. Another planning possibility is to make a §2519 deemed transfer (if a large QTIP exists for the client’s benefit), which is discussed in Item 3.j.(8) of the Estate Planning Current Developments Summary (December 2018) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights.

Retained Income Trust. A retained income trust alternative (different than the alternative discussed in Item 16.a above) is discussed in Item 25 of the Current Developments and Hot Topics Summary (December 2013) found here and available at www.bessemertrust.com/for-professionalpartners/advisor-insights.

Possible Anti-Abuse Exception to Anti-Clawback Regulation; New York State Bar Association Tax Section Recommendation to IRS. Planners should be cautious in using the planning approaches described in Item 16.a-e above as a way of making use of the increased gift exclusion amount until we know whether the IRS adopts the recommendation not to extend the anti-clawback adjustment to gifts that are included in the gross estate or to situations in which assets have been valued under Chapter 14 (reserved in the November 2019 final regulation). The preamble to the anti-clawback final regulation notes that a commenter recommended that the anti-clawback rule be revised so that it would not apply to gifts that are included in the gross estate, such as gifts with retained life estates or with retained powers or interests or certain gifts “within the purview of chapter 14” (not identified in the preamble as gifts valued at a higher amount under §§2701 or 2702). The preamble concludes that although “such a provision is within the scope of the regulatory authority granted in section 2001(g)(2), such an anti-abuse provision would benefit from prior notice and comment. Accordingly, this issue will be reserved to allow further consideration of this comment.” The commenter referred to in the preamble was not identified in the preamble but was the New York State Bar Tax Section (cited below). For example, the enhanced grantor income trust would result in making use of the large current BEA even though the grantor would be able to receive all the trust income; this is clearly the result under the existing anti-clawback regulations. The preamble to the proposed regulations made clear that the increased BEA was applied for prior gifts “whether or not included in the gross estate.” (That approach has some support in the statutory language of §2001(b)(2) which, in the estate tax calculation process, provides for a subtraction of the hypothetical gift tax on all “gifts made by the decedent after December 31, 1976” not just on “adjusted taxable gifts,” which would exclude gifts that are includible in the gross estate (§2001 last sentence).) Will that change?

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Another approach, which would end up with gifts in the gross estate while still taking advantage of the window of opportunity, is making a gift by a legally enforceable note (described in Item 16.b above). If the donor dies before the note is paid, the assets that will be needed to pay the liability are still in the gross estate, and the same estate tax calculation applies so that the client would have taken advantage of the window of opportunity. A similar approach is making gifts valued under chapter 14 at different than fair market value (discussed in Item 16.c above). The New York State Bar Association Tax Section’s comments to the IRS regarding the anti-clawback regulation “brings to the attention” of the IRS that the approach of increasing the estate tax unified credit amount by exclusions applied against gifts that are later included in the gross estate (if those exclusions exceed the BEA available at death) “permit individuals to make relatively painless taxable gifts that lock in the increased exclusion amount, even though they retain beneficial access to the transferred property.” The comments point out that the same benefit may result from making a gift that is subject to treating a retained interest as being worth zero for gift tax purposes under §2702. The comments recommend that the estate tax unified credit amount not be increased by exclusions applied against gifts that are included in the gross estate. We recommend that Treasury and the Service consider proposing rules that would create exceptions to the favorable rule of the Proposed Regulations in the case of gifts that are included in the gross estate. Under this approach, if a decedent made a gift of property before 2026 and the gift is included in the gross estate, any increased basic exclusion amount used by the gift is not preserved at death. As the gift would be purged from the estate tax computation base under Section 2001(b), there is no concern about claw back of tax. Further, the property would be subject to the estate tax lien and the decedent’s executor would normally have a right to recover the share of estate taxes attributable to the property.

In addition, the comments point out a similar effect might result under §2701 from a gift of common stock while retaining preferred stock in the entity, which could leave the donor with “the right to earnings and income of the entity through the retention of preferred interests.” If the Service wishes “to limit the benefits of locking in temporarily increased exclusion amount,” the Section recommends “that the Treasury and Service study the problem further.” The NYSBA Tax Section comments are available at http://www.nysba.org/Sections/Tax/Tax_Section_Reports/Tax_Section_Reports_2019/1410_R eport.html. The 2021-2022 IRS Priority Guidance Plan adds the following project: “Regulations under §2010 addressing whether gifts that are includible in the gross estate should be excepted from the special rule of § 20.2010-1(c).” The addition of the project indicates that the IRS is actively considering the adoption of an anti-abuse rule (and suggests that it likely will adopt some kind of exception). Planners should be cautious in using these approaches as a way of making use of the increased gift exclusion amount until the IRS issues further guidance (or a proposed regulation). For an excellent discussion of planning alternatives that might be impacted by the anti-abuse rule, and planning considerations in light of the possibility of a future anti-abuse proposed regulation, see Katie Lynagh, Potential Anti-Abuse Rules May Limit Use of the Temporarily Increased Gift Tax Exclusion, BNA ESTATES, GIFTS & TRUSTS J. (May 14, 2020). For example, to guard against the possible issuance of such an anti-abuse rule, a possible planning alternative with a retained §2036 interest is to give a protector the ability to remove the grantor’s retained income interest (which arguably would not be subject to the three-year rule of §2035 because the donor would not be voluntarily releasing the retained interest, see PLRs 9032002 & 9109033, although a regulatory anti-abuse rule could conceivably address deathbed planning). g.

Locking in Use of GST Exemption. Clients might also lock in use of the “bonus GST exemption” before the GST exemption sunsets to $5 million (indexed) by making a transfer to a grantor retained income trust. The estate tax inclusion period (ETIP) during the period of the retained interest prevents the inclusion ratio from being determined during the ETIP, but does not appear to prevent GST exemption from being allocated. The GST tax regulations address the effect of allocating GST exemption prior to the end of the ETIP. Reg. §26.2632-1(c)(5) Exs. (1)-(2); §26.2642-1(b)(2)(i). However, the regulations do not specifically address the effect of a decline of the GST exemption

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during the ETIP. Also, if an anti-abuse rule is adopted regarding clawback of the estate and gift exclusion amount, will it also address similar alternatives making use of the GST exemption? 17. Basis Adjustment Planning Planning to leave open the flexibility to cause trust assets to be included in the gross estate of a trust beneficiary if the beneficiary has excess estate exclusion will continue to be important to permit a basis adjustment at the beneficiary’s death without generating any added estate tax. Four basic approaches can be used: (1) making distributions to the beneficiary (either pursuant to a wide discretionary distribution standard or under the exercise of a non-fiduciary nontaxable power of appointment, but beware that granting an inter vivos power of appointment exercisable during the settlor’s lifetime might cause the trust to be a grantor trust, see §§674(a), 674(b)(3)); (2) having someone grant a general power of appointment to the beneficiary (but consider including the broadest possible exculpatory clause for that person, and providing that the person has no authority to exercise the power until requested to consider exercising the discretion to grant the power by some designated persons or class of persons); (3) using a formula general power of appointment (perhaps adding that a non-adverse party could modify the power of appointment to add flexibility; structure the formula based on the lesser of the individual’s remaining GST exemption or applicable exclusion amount, and limit the formula to $10,000 less than that amount so that the existence of the general power of appointment will not require the powerholder’s estate to file an estate tax return); or (4) triggering the Delaware tax trap by the exercise of a nontaxable power of appointment to appoint the assets into a trust of which a beneficiary has a presently exercisable general power of appointment (see Kasey A. Place, Section 2041(A)(3): A Trap Not Easily Sprung, 55 REAL PROP., TR., & ESTATE LAW J. (Summer 2020)Blattmachr & Pennell, Using “Delaware Tax Trap” to Avoid Generation-Skipping Taxes, 68 J. TAX’N 242 (April 1988), updated and reprinted 24 REAL PROP. PROB. & TR. J. 75 (Spring 1989)). To limit the possible “inappropriate” exercise of a power of appointment, (i) grant a testamentary power that some independent person has the ability to remove before the powerholder dies or to revise the power (for example, to adjust a formula general power of appointment), (ii) specify that the power is exercisable only with the consent of some other non-adverse party (but not the grantor), see Reg. §20.2041-3(c)(2), Ex. 3, and (iii) limit the permissible appointees of the power (such as to persons related by blood, marriage, or adoption or to creditors). For an excellent discussion of the effect of a general power to appoint to creditors, and whether the power could be exercised only up to the amount of debt to a particular creditor, and the impact of that decision on the amount included in the gross estate under §2041, see Robert J. Kolasa, Creditor General Powers of Appointment, TRUSTS & ESTATES 16 (Feb. 2020). To the extent that general powers of appointment are used for basis adjustment purposes, bear in mind that the existence of the general power may have creditor effects, but the actual exercise of a testamentary general power of appointment may be more likely to subject the assets to the decedentbeneficiary’s creditors than if the general power is not exercised. Another alternative is to accomplish a basis adjustment by utilizing the otherwise unused exclusion amounts of parents or grandparents by grants of general powers of appointment with what has become known as “upstream planning.” See David A. Handler & Christiana Lazo, Senior Powers of Appointment, TRUSTS & ESTATES 14 (Sept. 2020). Upstream Planning is discussed Item 7.c of the Current Developments and Hot Topics Summary (December 2015) found here and available at www.bessemertrust.com/forprofessional-partners/advisor-insights. See Mickey Davis & Melissa Willms, All About That Basis: How Income Taxes Have Reshaped Estate Planning, ALI-CLE PLANNING TECHNIQUES FOR LARGE ESTATES (April 2018); Turney Berry, The “Hook” of Increased Income Tax Basis, TRUST & ESTATES 10 (April 2018).

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For a detailed discussion of various basis adjustment planning alternatives (including various form provisions), see Item 5 of the Estate Planning Current Developments Summary (December 2018) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. Items 18-31 address using trust protectors to provide additional flexibility for irrevocable trust documents, particularly in light of planning in a period of heightened uncertainty. This information is, in part, a summary of comments from a panel discussion by David Arthur Diamond, Nancy C. Hughes, and Margaret G. Lodise at the ACTEC Annual Meeting in 2021 18. General Description; Overview of Reasons for Using Trust Protectors Offshore trusts have historically used trust protectors, leading to growing use in the United States. A “trust protector” may be given “grantor-like” powers that can be very limited or very broad to make changes regarding the trust. The trust protector is a third party (not the settlor, trustee, or a beneficiary) who is given powers in the trust instrument designed to assist in carrying out the settlor’s intent. A wide variety of powers is possible—but the powers must be specifically described and granted in the trust instrument. Trust protectors do not have the general responsibility of “protecting” the trust—the “trust protector” term is simply the terminology used historically. A trust protector may be given the authority to take “settlor-type” actions that the settlor cannot retain directly for tax reasons. A trust protector can be a safety valve for “fixing“ old (or new) trusts. A trust modification or decanting could accomplish the same goal, but a trust protector can take these actions without involving courts, beneficiaries, or even the trustee. 19. Historical Uses of Trust Protectors The concept of trust protectors has been used historically, but without that name. Examples include holders of limited powers of appointment, trustee appointers, investment advisors, and distribution advisors. Trustees have been given the authority to amend charitable trusts or to modify trusts so that they can hold S corporation stock. Persons have been given the power to remove and appoint trustees. 20. Trust Protector Statutory Authority Section 808 of the Uniform Trust Code is entitled “Powers to Direct.” Section 808(d) provides that “a person, other than a beneficiary, who holds a power to direct is presumptively a fiduciary who, as such, is required to act in good faith with regard to the purposes of the trust and the interest of the beneficiaries.” Comments to §808 provide that the section ratifies the “use of trust protectors and advisers.” It explains that “Advisers” have been used for certain trustee functions and distinguishes trust protectors: “Trust protector,” a term largely associated with offshore trust practice, is more recent and usually connotes the grant of greater powers, sometimes including the power to amend or terminate the trust. Subsection (c) ratifies the recent trust to grant third person such broader powers.

The Comments have no further discussion specifically about trust protectors. The Uniform Trust Code has been adopted in a majority of states; some of them adopted §808 verbatim and others made slight changes. Some states also have separate statutes governing trust advisors and trust protectors, or sometimes just trust protectors. The authority and specific powers held by a trust protector are as described in the trust instrument, but statutes developed in various states in recent years provide clarity regarding the role or actions of trust protectors. A variety of the state directed trust statutes have language broad enough to apply to trust protectors as well. E.g., 12 DEL. C. §3313(f) (“For purposes of this section, the term ‘advisor’ shall include a ‘protector’”; a non-exclusive list of sample powers includes removing and appointing fiduciaries, modifying or amending the instrument for tax or other efficiency reasons, and modifying powers of appointment). Some states have enacted statutes addressing the powers of trust protectors specifically (including, among various others, Alaska, Delaware, Idaho, Illinois, Nevada, New Hampshire, South Dakota, Tennessee, and Wyoming) that list sample powers that trust protectors could hold. E.g., 760 ILL. www.bessemertrust.com/for-professional-partners/advisor-insights

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COMP. STAT. §16.3(d) (non-exclusive list of 10 sample powers that trust protectors could hold); NEV. REV. STAT. §163.5553 (non-exclusive list of 12 sample powers that trust protectors could hold). Almost all of the state statutes are default statutes—providing a list of possible powers but stating specifically it is not an exclusive list. Most of the statutes make clear that trust protectors only have powers that are specifically granted in the trust instrument. 21. Special Power of Appointment – “Poor Person‘s Decanting Power“ A non-fiduciary limited power of appointment to distribute property outright or in trust for a limited class of individuals is a brief and simple way of providing a way to “fix“ problems with trusts in light of changing circumstances. The trust might give an individual (usually a family member) a non-fiduciary power of appointment to redirect who will receive assets, to change the division of assets among beneficiaries, to change the trust terms, etc. Many years later the settlor’s children may be in a better position than the settlor to decide how the assets should be used for their respective children. “A fool on the spot is worth a genius two generations ago.” Also, the power of appointment is a “power of disappointment,” giving the powerholder a "stick" over other disgruntled and disruptive beneficiaries. An advantage of a non-fiduciary power of appointment is that persons exercising the power of appointment typically have no liability for the manner in which the power is exercised, even if the exercise disinherits a beneficiary. An example from Nancy Hughes (adapted from a provision by Louis Harrison, included with Nancy’s permission) is as follows: Power of Appointment by Special Power Holder. During my life, the trustee shall distribute the principal to any one or more of my spouse, my descendants, and the spouses of my descendants, or trusts for any of them, as the special power holder from time to time appoints during his or her life; provided that any such trust does not extend beyond the period permitted by any applicable rule of law relating to perpetuities. I name as the special power holder the following in the order named who is from time to time willing and able to act: (a) my friend and attorney, I. M. Ntrouble (b) my friend and accountant, Hert N. Meee.

The class could be expanded to include “descendants of the grantor’s parents” to be extremely broad. Be aware that granting someone an inter vivos limited power of appointment will likely result in the trust being a grantor trust (assuming its exercise is not subject to the approval of an adverse party). §§674(a), 674(b)(3) (exception for testamentary powers of appointment but not inter vivos powers of appointment). 22. Common Powers of a Trust Protector Trust protector powers related to the trustee may include the power to remove and replace trustees, to appoint additional trustees, to act as a tiebreaker, to provide advice or direction regarding discretionary distributions or regarding management actions, or to veto trustee decisions. Powers unrelated to the trustee include the power to change the trust situs or governing law, to terminate the trust under specified conditions, to amend the trust for any valid purpose such as to respond to changes in tax laws, or to alter the beneficial interests such as adding or removing beneficiaries. 23. Sample Clause with Expansive Trust Protector Provisions The following is an example of expansive trust protector powers from Nancy Hughes (included with her permission). She emphasizes that these should not be included as boilerplate provisions, but each power should be carefully considered in light of the worst-case situation of an abusive trust protector. ARTICLE 1 Trust Protector (a) Designation. I. M. Ntrouble shall be the initial Trust Protector. During my lifetime, [third party] may appoint any one or more qualified corporations, or any one or more individuals other than a Disqualified Person as to me, as the Trust www.bessemertrust.com/for-professional-partners/advisor-insights

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Protector, Co-Trust Protector, or successor Trust Protector of this trust or any separate trust created hereunder, to act with or to succeed the then acting Trust Protector consecutively or concurrently, in any stated combination, and on any stated contingency; provided that any such designation may be amended or revoked before the designee accepts office. The powers retained in this paragraph may be exercised by a signed instrument filed with the trust records, and any later instrument shall take precedence over an earlier instrument. (b) Powers of Trust Protector. The Trust Protector is not a fiduciary and as such, owes no fiduciary duty to the beneficiaries. The Trust Protector may exercise the following powers, in the sole discretion of the Trust Protector and upon such exercise, the Trustee shall follow the directions of the Trust Protector:

(i) To remove any then serving or appointed successor trustee without cause. (ii) To appoint successor trustees or co-trustees. (iii) To determine, upon the request of the Trustee, what constitutes reasonable compensation to the Trustee. (iv) To change the situs of the trust. (v) To change the governing law of the trust. (vi) To modify the trust and represent the interests of all beneficiaries of the trust, current, presumptive remainder, and contingent remainder.

(vii) To decant the trust to a new trust. (viii) To terminate the trust, in which case, the Trustee shall distribute the assets to the then current beneficiaries.

(ix) To direct the sale of [closely held asset] upon such price and terms as the Trust Protector determines. (x) To approve the concentration of [___%] of the trust investments in a single investment. (xi) To direct the distribution of [___%] of the trust assets to the current beneficiaries. (xii) To consolidate any trust held under this instrument with any other trust if the beneficiaries of the trusts are the same and the terms of the trusts are substantially similar.

(xiii) To divide a trust into two or more separate trusts or to segregate an addition to a trust as a separate trust. (xiv) To resign at any time by signed notice to the Trustee. (c) Release of Powers by Trust Protector. The Trust Protector at any time acting may, by written instrument delivered to the Trustee, irrevocably release any of the powers granted to the Trust Protector under this Article. If the Trust Protector irrevocably releases a power, such power shall thereafter no longer be exercisable by the Trust Protector or any successor Trust Protector. (d) Compensation of Trust Protector. The Trust Protector shall be paid reasonable compensation from time to time for his/her services as Trust Protector. (e) Exoneration of Trust Protector. The Trust Protector shall not be liable to any current or remainder beneficiaries unless the Trust Protector acts with reckless indifference to the trust purposes. (f) Exoneration of Trustee. The Trustee shall not be liable for following the directions of the Trust Protector unless the directions are manifestly contrary to the terms of the trust.

Disqualified Person. The term "Disqualified Person" hereunder shall mean me, any person who has contributed property to such trust, any beneficiary of such trust, the spouse of any beneficiary of such trust, and any individual or entity who would be considered a "related or subordinate party" under Code Section 672(c) as to any of the foregoing such persons, had such person been the grantor of such trust (including without limitation such person's spouse, father, mother, issue, brother, sister, or employee; a corporation in which the stock holdings of such person and the trust are significant from the viewpoint of voting control, and any employee of such corporation; and a subordinate employee of a corporation in which such person is an executive).

24. Who to Name? The trust protector must be someone the grantor “really really” trusts. A problem with appointing a trust protector is deciding who should serve in that role. The trustee is the most “trusted” person from the settlor’s point of view. Who can override that? The settlor needs “an even smarter and even more trusted person” to override the trust with the trust protector powers. www.bessemertrust.com/for-professional-partners/advisor-insights

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Persons that panelists have seen used as a trust protector include a college roommate, CFO of a closely held company, CPA, non-estate planning lawyer, and close personal friend. A concern is finding someone willing to serve, particularly if the protector acts in a fiduciary capacity considering potential liability for making broad changes to the trust. The trustee should not also be named as a trust protector, acting in a nonfiduciary capacity, as to some issues. How does that person balance interests to exercise powers held as a nonfiduciary without also considering her fiduciary duty to beneficiaries? Another alternative may be to name an entity as the trust protector. That may be a way for providing for succession of the protector. If an entity is used for liability protection, a thinly-funded LLC that has no economic substance might provide little protection; courts may look to the officers and directors for liability. If an appropriate trust protector cannot be identified when the trust instrument is signed, consider providing for the role of a trust protector in the trust instrument, but stating that it will be filled at a later date by the grantor, grantor’s spouse, adult beneficiaries, or other appropriate parties. 25. Should the Trust Protector be a Fiduciary? Statutes sometime address whether a trust protector acts in a fiduciary capacity. Most of the statutes addressing trust protectors provide that they are considered to act as a fiduciary unless the trust instrument provides otherwise (Delaware is an example of that approach). Taking the opposite approach, the South Dakota and Alaska statues provide that the trust protector is not a fiduciary unless the trust instrument provides otherwise. The Wyoming statute provides that trust protectors “are fiduciaries” to the extent of the powers, duties, and discretions granted to them in the trust instrument. In light of the variety in state law regarding whether protectors act as fiduciaries, the trust instrument should specify explicitly whether the protector acts in a fiduciary capacity. If the trust protector has the power to direct the trustee to take specified actions, the protector should act in a fiduciary capacity as to such powers. a.

Trust Advisor vs. Trust Protector. Some authorities distinguish trust advisors and trust protectors as having very different functions. Trust advisors have powers that are subsumed within the power of the trustee—they hold powers in a fiduciary capacity. Trust protectors are not fiduciaries, and they only have powers specifically granted to them in the trust instrument.

Trust Directors. Directed trust statutes address situations in which a third party has the power to direct the trustee to take certain actions. The general consensus is that directors, who are directing trustees to take actions, should act in a fiduciary capacity. Someone should be responsible in a fiduciary capacity for all trustee actions, and the trustee will want to know that the person directing the trustee to take action acts as a fiduciary. Directed trust statutes typically provide that a trustee has no liability for any loss caused by following the direction absent “willful misconduct” on the part of the trustee (or some other standard in a particular state statute). If the trustee is not liable for any loss, and if the party directing the trustee is not a fiduciary, where does the responsibility to the beneficiary lie?

Advise vs. Direction. Go for clarity. The trust instrument should make crystal clear whether the trustee is directed to follow certain types of directions, or whether the third party is merely advising the trustee but the decision is still up to the trustee’s discretion. If the protector is acting in an advisory role, a Reporter’s Note from the Restatement (Third) of Trusts §75 suggests that the trustee has a duty to consult with the protector before the trustee acts. Consider setting a dollar amount or percentage floor before the consultation requirement applies so the trustee may make day-to-day decisions without consulting the protector. One panelist concludes “the court will want to find someone to make responsible (and liable). If you give the protector powers that look like trustee powers, courts will hold them liable as a fiduciary.”

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Delineating Particular Powers That Are Exercised in a Fiduciary Capacity. Whether a trust protector’s authority is exercised as a fiduciary may likely depend on the type of action involved. Some powers must be exercised in a nonfiduciary capacity for tax reasons. For example, a substitution power must be exercised in a nonfiduciary capacity in order to be a grantor trust trigger. A power of a trust protector to terminate the substitution power or any other power that causes the trust to be a grantor trust might also be exercised in a nonfiduciary capacity. Some powers presumably could not be exercised in a fiduciary capacity, such as the power to add or exclude a beneficiary of a trust or changing the beneficial interests of beneficiaries. Exercising those types of power requires taking into account considerations other than just the interests of the current beneficiaries. Powers that do not change the beneficial interests of beneficiaries could be specified in the trust instrument as being held in either a fiduciary or nonfiduciary capacity.

Impact on Potential Liability of the Protector. A protector acting as a fiduciary will be held to a higher standard than a nonfiduciary. Indeed, a third person may be less willing to agree to act as trust protector if the person acts as a fiduciary. The planner might consider the settlor’s intent as to potential liability of the protector in determining whether to specify that the protector acts as a fiduciary. Settlors will typically want to minimize the risk for trust protectors. Even if the protector acts as a fiduciary, a very broad exculpatory provision could be included (to the extent allowed under state law). But whether the exculpatory clause will actually result in protecting the fiduciary will always be subject to some degree of uncertainty. Panelists had varying views about this issue. Some would generally provide that trust protectors are not fiduciaries in order to reduce the risk to them. Others would generally provide that protectors are fiduciaries and rely on exoneration in a trust instrument to exonerate the protector from liability except in the case of willful misconduct. One panelist advises that a protector should particularly be careful with holding a fiduciary power to direct the trustee regarding investments and investment concentrations, even with broad exoneration in the trust instrument.

Standard for Protector Liability. In any event the trust protector’s standard of liability should be clearly stated in the trust agreement to avoid uncertainty.

26. Succession of Trust Protector Position For very long-term trusts, having a procedure for appointing successor trust protectors is very important. 27. Insurance for Trust Protectors Insurance coverage is generally only for fiduciaries, but one panelist thinks insurance coverage for trust protectors acting in a nonfiduciary capacity is available. It is a cottage industry, and we will be seeing more of it. 28. Compensation Compensation should generally be provided for the trust protector, even if not acting in a fiduciary capacity. If the drafting attorney also serves as a trust protector with compensation, ethical duties may require that the client have independent advice as to that issue. 29. Potential Tax Attacks If Facts Reflect That Settlor Retains Tax-Sensitive Powers Indirectly Through Actions of a Trust Protector Long ago, the IRS tried to make a “de facto trustee” argument, treating a settlor as holding the powers of the trustee if the settlor exercised persuasive control over the trustee. Courts (including a U.S. Supreme Court case) rejected that “de facto trustee” argument. However, SEC v. Wyly raises concerns for estate planning advisors by treating settlors as the de facto trustee of a trust (albeit in an extreme fact situation in which the trustees always followed the settlors’ directions for over a decade). www.bessemertrust.com/for-professional-partners/advisor-insights

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SEC v. Wyly, 2014 WL 4792229 (S.D.N.Y. September 25, 2014) (Judge Scheindlin), is the determination of the “disgorgement” remedy in a securities law violation case by the billionaire Wyly brothers. The court based the amount of disgorgement largely on the amount of federal income taxes that the defendants avoided from the use of offshore trusts, after finding that the trusts were grantor trusts and that the defendants should have paid federal income taxes on all of the income from those trusts. The court determined in particular that the “independent trustee” exception in §674(c) did not apply even though the trustees were various Isle of Man professional management companies. Three close associates of the Wylys (the family attorney, the family office CFO, and the CFO of one of the Wyly entities) were trust protectors who had the power to replace the trustees. Throughout the trust administration, the Wylys expressed their requests to the trust protectors, who relayed them to the trustees, who always complied. There is a growing trend toward naming trust protectors with very broad powers, including the broad ability to amend trusts, change beneficial interests, veto or direct distributions, modify powers of appointment, change trustees, or terminate the trust—all in the name of providing flexibility to address changing circumstances, particularly for long-term trusts. The Wyly case points out how that could backfire if a pattern of “string-pulling” by the settlor occurs in practice with respect to the exercise of those very broad powers. Planners will not stop using trust protectors in the future because of Wyly but should be aware of potential tax risks that can arise if the broad trust protector powers are abused by overbearing settlors. 30. Case Law Discussion of Trust Protectors Relatively few cases have addressed trust protectors. Many of the cases that do exist are unreported, so cannot be cited as authority. Many of the cases that have discussed trust protectors have focused on whether the protector in the particular situation was acting as a fiduciary. a.

IMO Ronald J. Mount 2012 Irrevocable Dynasty Trust. This unreported Delaware case gave effect to the provision in the trust instrument that the trust protector served in a nonfiduciary capacity. IMO Ronald J. Mount 2012 Irrevocable Dynasty Trust U/A/D December 5, 2012, (2017 WL 4082886 (not reported in Atl. Rptr.) (Del. Ct. of Chancery 2012). “A settlor’s decision to allow the trust protector to serve in a non-fiduciary capacity is valid and will be enforced under Delaware law.” The court acknowledged but discounted a citation to a law review article arguing that a trust protector who is given broad powers has fiduciary duties even if the trust instrument says the trust protector is not a fiduciary.

Robert T. McLean Irrevocable Trust v. Patrick Davis, P.C. The attorney for a successful plaintiff in a personal injury lawsuit was named as trust protector of a trust that received the settlement proceeds. He had the power to remove the trustees and appoint successor trustees or trust protectors. When the original trustees resigned, the trust protector designated as successor trustees the attorneys who had referred the personal injury case (as well as other cases) to him. The family alleged that the trustees were wasting trust funds, and sued the trust protector for failing to monitor the actions of the trustee, failing to act when the trustees acted against the interests of the beneficiary, and giving his loyalty to the trustees rather than to the beneficiary. The trust protector sought summary judgment in part because he had no duty to supervise or direct the actions of the trustee. The court of appeals denied summary judgment, reasoning that since the trust agreement granted authority to the trust protector in a fiduciary capacity, the protector owed at least the basic fiduciary duties of undivided loyalty and confidentiality. Also, the limitation of liability in the trust agreement implies the existence of a duty of care and liability for actions taken in bad faith. Following a jury trial, the court granted a directed verdict in favor of the trust protector and the court of appeals affirmed, finding no basis for a breach of duty by the trust protector for various factual reasons. The court specifically addressed to whom the trust protector owed duties: An important question of material fact also exists in the instant case as to who this fiduciary duty of good faith is owed to. Appellant assumes it is owed to the Beneficiary, but the trust provision that created the position of Trust Protector does not explicitly indicate who or what is to be protected.… {I]t is possible that the Trust Protector’s fiduciary duties are owed to the trust itself.

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McLean v. Davis, 283 S.W.3d 786 (Mo. Ct. App. 2009), aff’d following remand, Robert T. McLean Irrevocable Trust u/a/d March 31, 1999 ex rel. McLean v. Ponder, 418 S.W.3d 482 (Mo. Ct. App. 2013). c.

Gowdy v. Cook. This case initially involved a trust protector, but the case ultimately did not address the protector. One lawyer of a firm was named as trustee and another was named as trust protector. Both were to receive fees in those capacities as well as traditional attorney fees. The trust included an exculpatory provision and a no contest provision. The initial beneficiary complained about conflicts of interest. The trust protector resigned but the trustee did not. The beneficiary sued for malpractice, breach of fiduciary duties, breach of duty of good faith and fair dealing, and negligence. The beneficiary also asked that the trust be decanted into a trust that removed the requirement in the original trust that a corporate trustee be appointed as successor if the beneficiaries removed the trustee. The court found no damages, defeating the claim for malpractice and breaches of duty, and held that the request for the decanting amounted to a violation of the no contest clause, thus disqualifying the beneficiary as a trust beneficiary. Gowdy v. Cook, 2020 WY 3, 455 P.3d 1201.

In re Eleanor Pierce (Marshall) Stevens Living Trust. This case, involving J. Howard Marshall, II (of Anna Nicole Smith notoriety), held that trust protectors are not inherently a violation of Louisiana’s public policy. The trust instrument authorized a trust protector to remove the trustee, which the trust protector did because of likely breaches of trust by the trustee. The trustee sued, complaining that Louisiana has no statute recognizing trust protectors and that making the trustee answerable to a trust protector violated public policy. The court held that the trust agreement was unambiguous that the protector could remove the trustee and cited a strong policy of supporting settlor intent. In re Eleanor Pierce (Marshall) Stevens Living Trust, 159 S.3d 1101 (La. App. 3 Circ. 2015).

Minassian v. Rachins. This case has had various determinations by the courts of appeal (in 2014 and 2018). The drafting lawyer serving as trust protector amended the trust in the middle of litigation between the widow-trustee and the children from a prior marriage over widow’s distributions to herself. The amendment favored the widow, and purportedly carried out the settlor’s intent to provide his wife with the lifestyle of being fans of horse racing and legal gambling, which they had enjoyed together. The amendment provided that on termination, the assets would pass to subsequent trusts, not directly to the children. The 2014 decision upheld the amendment, and remanded the case. Minassian v. Rachins, 152 So. 3d 719 (Fla. 4th DCA 2014). The children filed a new complaint, alleging dissipation of assets by the wife due to a gambling problem and included the trust protector as a defendant. The protector subsequently died, and the proceedings do not discuss any continuing liability by the protector. The court of appeals ultimately determined that, despite the amendment that appeared to accomplish the settlor’s intent of protecting the widow’s lifestyle, the children had, at a minimum, an equitable interest in any property in the trust. The trust was again remanded for further proceedings. Thus, the trust protector plan appears not to have worked, but the widow has enjoyed the trust’s assets for the intervening years and during the continuance of the legal proceedings. Rachins v. Minassian, 251 So. 3d 919 (Fla. 4th DCA 2018).

Carberry v. Kaltschmid. The trust agreement named a trust protector with the power to amend or modify the trust, to construe the trust in the event of an ambiguity, and to execute documents to carry out any protector or trustee power. The protector had “no duty to investigate the Trustee’s actions or inactions, to audit the trust’s books, to review the trust’s investments, or to evaluate the trust portfolio’s performance.” Two children were co-trustees, and one of them sought ex parte approval of a loan and approval to use the loan proceeds without the approval of a co-trustee. The protector sought a court order compelling a trust accounting, directing the trustees to communicate with the protector, and confirming the protector’s power to appoint an independent special trustee. The trial court found that the protector lacked standing to demand an accounting and the appellate court agreed. Carberry v. Kaltschmid, 2018 WL 2731898 (Ca. 1st Dist. 2018) (unpublished).

Matter of Trust for the Benefit of Hettrick. The trust instrument authorized the trust protector to remove and replace the trustee. The beneficiary of a special needs trust moved to Virginia, and the trust protector wanted to remove the New York trustees and replace them with a Virginia trustee, following approval of New York and Virginia courts of moving the trust situs to Virginia. The New York

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court refused to approve the removal of the New York trustees even though the court acknowledged that the protector had the power to remove the trustee without cause and nothing in the trust instrument prohibited changing the trust situs. The court noted that “the entire tenor of the Trust provisions of decedent’s Will indicate that New York law is to apply.” In effect, the court simply ignored the explicit authority of the trust protector under the trust agreement. Matter of Trust for the Benefit of Hettrick, 111 N.Y.S.3d 522, 61 Misc. 3d 1220(A) (Surrogate’s Court, NY Erie County Nov. 19, 2018) (unreported). 31. Trust Protector Planning – Best Practices The following summary of best practices is from a summary of a presentation at the 2015 Heckerling Institute on Estate Planning. (1) Use a trust protector only if necessary or desirable for particular purposes. (2) Never rely on state law but spell out in detail what powers are included. Do not just adopt a list of powers that may be included in a state statute because some of those powers are likely not appropriate for a particular situation. (3) Make clear in the trust instrument that the trust protector acts in a non-fiduciary capacity. If the protector acts in a fiduciary capacity, state very clearly what that means specifically in the context of the powers that the protector has. (4) Clearly and specifically describe the powers, duties and compensation of the protector. •

State whether the protector has a duty to monitor the trust situation continually or whether the protector is just in a stand-by mode until requested to act or until some event described in the instrument occurs.

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If the protector has a duty to monitor, provide that the protector has the right to receive information from the trustee that is appropriate to the monitoring function.

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Provide for compensation appropriate to the protector’s functions.

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Provide for appropriate exoneration of the trustee, the protector, or both with respect to actions taken or not taken by the protector.

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Describe the manner in which the protector’s powers are exercised. For example, if a protector has the power to remove and replace trustees, clarify whether the protector must monitor the trustee’s performance or just exercise its discretion when requested by a beneficiary.

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Provide that the protector has standing to enforce its powers in a court action.

(5) Use the appropriate name (protector rather than advisor [i.e., one who is carrying out or directing trustee functions as a fiduciary]—assuming that is the intent). (6) Do not mandate that the protector exercise its power (unless that is the settlor’s intent) but provide that the protector may exercise its powers in its sole and absolute discretion and that its decisions will be binding on all persons. (7) Specify the duty and liability of the protectors—for example that there is no liability absent bad faith or willful misconduct. In providing for the protection of the protector, specify who will pay the protector’s attorney fees if the protector is sued. (8) Clarify whether the protector has the right to receive information from the trustee and what information is intended. (9) Make clear that the term “protector” is just the name given to the person and that the protector does not have the function of “protecting” the trust generally. (10) The protector should discuss with the settlor what the settlor intends the protector to do and how to carry out its functions. The trustee should clarify what its role is with the protector in the wings and what information it should provide to the protector and at what times. www.bessemertrust.com/for-professional-partners/advisor-insights

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section 05

Trustee and Beneficiary Powers that Won’t Create a Tax Disaster

October 2021 Steve R. Akers Senior Fiduciary Counsel

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Probing Non-Tax Issues 1. Probe appropriate selection of trustee for non-tax factors

 Personal Attributes  Bifurcated Trustee Powers/ Directed Trusts  Clary Redd - “The Most Disrespected Decision in Estate Planning”

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Donor Issues-Gift Tax 2. Plan whether transfer will be a completed gift  Retained Right to Receive Distributions  Power to Change Beneficial Interests – Power to shift benefits causes incomplete gift – Unless ascertainable standard – Mere power to affect timing does not make gift incomplete

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Donor Issues-Estate Tax 3. If want to keep out of donor’s estate, donor not a beneficiary unless in DAPT state; Similarly, do not allow distributions satisfying the donor’s legal obligations.

 Who is the Grantor? – Reciprocal trusts – Indirect transfers

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Donor Issues-Estate Tax 3. If want to keep out of donor’s estate, donor not a beneficiary unless in DAPT state; Similarly, do not allow distributions satisfying the donor’s legal obligations.  Retained Beneficial Interest in the Grantor – §2036(a)(1) – Types of retained interests that cause inclusion – Grantor as mere discretionary beneficiary is also problematic because of creditor issues (unless in a domestic asset protection trust [“DAPT”] state) – Donee-spouse appointing assets back to original grantor 6

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Donor Issues-Estate Tax 4. Be careful with donor serving as trustee if the donor has powers over distributions  § 2036(a)(2)  § 2038  Dispositive Powers to Trigger Inclusion

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Donor Issues-Estate Tax 5. Limit ANY possibility of the donor serving as trustee (unless distributions are limited to a fixed determinable standard).  Ways that Clients Push – Joint powers – Joint powerholder can override – Veto power – Capacity in which power held is irrelevant – Someone else appoints donor as trustee before donor dies – Donor’s contingent power to appoint self upon triggering event outside donor’s control  Third Party Authority to Grant Limited Power of Appointment to Donor

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Donor Issues-Estate Tax 6. The donor may serve as trustee if an external determinable standard exists for distributions.  Determinable External Standard Exception – No statute or regulations – Revenue Ruling 73-143 – Many cases – But might the FLP §2036(a)(2) cases have an impact? 9

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Donor Issues-Estate Tax 7. The donor can have administrative powers that are subject to court control and fiduciary duties.  Key Issue: Subject to Court Review  U.S. v. Byrum, 408 U.S. (1972)  FLP Cases (including Powell v. Commissioner, 148 T.C. 392)  Substitution Powers

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Donor Issues-Estate Tax 8. Do not give the donor either of two prohibited powers.  Power to Vote Stock of a Controlled Corporation (§2036(b)) – Beware: §2036(b) has its own automatic three-year rule  Incidents of Ownership Over Life Insurance on Donor’s Life (§2042) – Even if just in a fiduciary capacity

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Donor Issues-Estate Tax 9. The donor can have broad trustee appointment and removal powers.  Appointment of Trustees – No power to appoint self (even if contingent) – Power to appoint successors OK – Power to add trustees ok (within limits)  Removal Power – Rev. Rul. 79-353 – But IRS lost Vak, Wall cases – Rev. Rul. 95-58

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Donor Issues-Income Tax 10. Avoid having foreign persons as ½ or more of trustees (unless desire foreign trust treatment).  Tax Concerns With Being a Foreign Trust  §§7701(a)(30)(E) & (31)(B) – U.S. courts able to exercise authority & exercise primary supervision – One or more U.S. persons have the authority to control all substantial decisions

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Donor Issues-Income Tax 11. Avoid or trigger the grantor trust rules  Effects of Grantor Trust – Grantor report income – Not a gift – Income tax reimbursement provision – Sale not recognition event (Rev. Rul. 85-13; Rev. Rul. 2007-13)

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Donor Issues-Income Tax 10. Avoid or trigger the grantor trust rules  Grantor Trust Trigger Powers – §674 (General rule, exceptions, and exceptions to exceptions) – Miscellaneous trigger powers: Grantor or spouse as beneficiary, power to pay life insurance premiums, actual borrowing by grantor or spouse, power to loan to grantor or grantor’s spouse without adequate interest or security, power of non-adverse party to add beneficiaries – Substitution power (§675(4)(C))  Incomplete Non-Grantor (“ING”) Trusts 15

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Beneficiary Issues-Gift Tax General Beneficiary Gift Issues  Key is Whether a Release of Exercise of a General Power of Appointment (§2514) – The ultimate Roach Motel: Very difficult to divest a general power of appointment once it exists without gift treatment  Exercise of Limited Power of Appointment May be a Gift (but Very Difficult to Value)  Failure to Exercise Rights

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Beneficiary Issues-Gift Tax 12. If the beneficiary is trustee, use an ascertainable standard on distributions to OTHER beneficiaries  Regulation §25.2511-1(g)(2) – Trustee with a beneficial interest – Who distributes to another under an ascertainable standard – Does not make a gift  Implication: Distribution by beneficiary-trustee to another WITHOUT an ascertainable standard IS a gift  No cases or rulings

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Beneficiary Issues-Estate Tax 13. Limit the beneficiary from serving as trustee if distributions to the beneficiary are not limited to an ascertainable standard.  Grantors: §§2036, 2038 -- Beneficiaries: §2041  Section 2041 General Rules – Gift if release or lapse (§2514); In estate if die holding GPA (§2041) – Joint power still includable unless adverse (Compare: for grantors, not help in avoiding §2036-2038 even if co-trustee is adverse) – Contingent power of appointment-Ok unless triggering event has occurred or is within beneficiary’s control (Compare: for grantors, inclusion under §2036(a)(2) even if the triggering event has not occurred) – Formula general power of appointment (Kurz case) – Third party power to grant GPA (but is that merely a general power that is deemed to exist “in conjunction with another person”?) – Reciprocal powers 18

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Beneficiary Issues-Estate Tax 14. The beneficiary can make distributions to himself or herself as trustee if distributions to the beneficiary are limited to an ascertainable standard.  §2041(b)(1)(A): “ascertainable standard relating to the health, education, support, or maintenance of the decedent”  Regulation refers to “support in reasonable comfort”, but do not use “comfort” standing alone to be safe  Many cases

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Beneficiary Issues-Estate Tax 15. Restrict the trustee from making distributions that would satisfy the trustee’s legal support obligations.  Power to distribute to satisfy the powerholder’s legal obligations is a general power of appointment, Reg. § § 20.2014-1(c)(1) & 25.25141(c)(1)  Problem can exist even if the trustee is not a beneficiary at all if the trustee’s dependents are beneficiaries – Rev. Rul. 79-154 – Upjohn v. U.S. (it was a §2503(c) case and not directly controlling as to this issue, but clauses to avoid the problem have become known as Upjohn clauses)

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Beneficiary Issues-Estate Tax 16. The beneficiary may have broad powers to appoint and remove trustees (like the donor).  Management Powers (Like donors, beneficiaries can have broad management powers without causing estate inclusion-within outer limits)  Scary TAM 9125002: Beneficiary may have general power of appointment even if decline to serve as trustee  But Rev. Rul. 74-492 (§ 2041 not applicable where elective share not exercised)  Power to Appoint Co-Trustee to Exercise Tax Sensitive Powers or to Appoint Successor Trustees  Removal Powers – Various PLRS extend Rev. Rul. 95-58 to beneficiaries

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Beneficiary Issues-Income Tax 17. Having a beneficiary as sole trustee MAY result in grantor trust treatment as to the beneficiary.  § 678(a)(1): “power, exercisable solely by himself, to vest the corpus or income from the trust in himself” – If sole trustee-beneficiary with an ascertainable standard, probably not a grantor trust, but unclear (conflicting PLRs)  BDITs  BDOTs

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Beneficiary Issues-Income Tax 18. Determine if appointing a trustee in a state will avoid or cause state income tax on undistributed income and gains.  Differences in how states define “resident trusts” – Some states determine if non-source undistributed trust income is taxed in that state based on the residency of the trustee or the place of administration  Example of avoiding state tax: NY does not tax a trust that has no NY trustee, NY assets, or NY source income. (So name a Delaware trustee, for example.) But NY in 2014 instituted a throwback tax when trust income accumulated after 2013 is later distributed to a NY beneficiary. (Most similar states do not have a throwback tax.)  Example of triggering a state tax: Various states impose state income tax on trusts based on whether the trustee is a resident of the state or if trust administration occurs in the state. (A prominent example is California.) 23

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Beneficiary Issues-Income Tax 18. Determine if appointing a trustee in a state will avoid or cause state income tax on undistributed income and gains.  Recent cases have held statutes that base taxation on the residency of the settlor when the will or trust was created or on residency of the beneficiary as unconstitutional (typically under the Due Process Clause).  U.S. Supreme Court weighs in: Kaestner 1992 Family Trust v. North Carolina Department of Revenue – Basing state taxation of trust solely on beneficiary’s residence in North Carolina on the facts of the case violates Due Process Clause – Supreme Court denied certiorari in William Fielding, Trustee of the Reid and Ann MacDonald Irrevocable GST Trust for Maria V. MacDonald, et al., v. Commissioner of Revenue (taxation based on settlor’s residence in Minnesota held unconstitutional) 24

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Miscellaneous Issues 19. Use a savings clause.  Many states have statutory savings clauses automatically limiting authority of beneficiary-trustee to an ascertainable standard  Estate of Trombetta v. Commissioner (T.C. Memo. 2013-234) refused to recognize such a statute to limit a donor’s authority for purposes of § §2036-2038  Belk v. Commissioner (774 F.3d 221) (conservation easement case) suggests that savings clauses protect against inadvertent or incidental violations but not violations to that go to the core of the transaction

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Miscellaneous Issues 20. Be wary of having a beneficiary as trustee with the authority to make distributions if there are any creditor concerns for the beneficiary.  Restatement (Third) of Trusts §60, Comment g: Creditor of trusteebeneficiary could reach as much of the trust as the trustee-beneficiary could distribute to himself.  Some bankruptcy cases where creditors of trustee-beneficiaries reached trust assets (but unusual situations)  Many state statutes recognize creditor protection for a beneficiary serving as trustee with an ascertainable standard on distributions. E.g., Uniform Trust Code §504; FL. Trust Code §736.0504(3); Tex. Prop. Code §112.035(f).

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Trustee and Beneficiary Powers that Won’t Create a Tax Disaster (or Twenty Things You Need to Know About Selecting a Trustee and Structuring Trustee Powers)

October, 2021

Steve R. Akers Bessemer Trust 300 Crescent Court, Suite 800 Dallas, Texas 75201 (214) 981-9407 akers@bessemer.com

Copyright © 2021 Bessemer Trust Company, N.A. All rights reserved. October 5, 2021 Important Information Regarding This Summary This summary is for your general information. The discussion of any estate planning alternatives and other observations herein are not intended as legal or tax advice and do not take into account the particular estate planning objectives, financial situation or needs of individual clients. This summary is based upon information obtained from various sources that Bessemer believes to be reliable, but Bessemer makes no representation or warranty with respect to the accuracy or completeness of such information and disclaims any liability in connection with the use of this information. Views expressed herein are current only as of the date indicated, and are subject to change without notice. Forecasts may not be realized due to a variety of factors, including changes in law, regulation, interest rates, and inflation.

TABLE OF CONTENTS I. NON-TAX FACTORS ......................................................................................................................... 1 A. Legal Capacity ................................................................................................................................. 1 ........................................................................................................................................................... 1. General Statutory Requirements ................................................................................................. 1 2. Requirements for Corporate Trustee ........................................................................................... 1 3. Requirements for a Foreign Corporate Fiduciary ....................................................................... 1 a. Reciprocity Requirement ...................................................................................................... 1 ..................................................................................................................................................... b. Filing Requirement ............................................................................................................... 2 c. Not Doing Business .............................................................................................................. 2 d. National Associations ........................................................................................................... 2 4. Charitable Corporation .............................................................................................................. 2 B. Personal Attributes of Trustee ......................................................................................................... 2 1. Judgment; Experience ............................................................................................................... 2 2. Impartiality; Objectivity; Lack of Conflict of Interest .............................................................. 2 a. Beneficiaries Having Conflicting Interests ......................................................................... 3 b. Avoiding Family Tension ................................................................................................... 3 3. Investment Sophistication; Track Record; Prudent Investor Act .............................................. 4 4. Permanence and Availability..................................................................................................... 4 5. Sensitivity to Individual Beneficiaries’ Needs .......................................................................... 4 6. Accounting; Tax Planning; Record-Keeping ............................................................................ 4 7. Fees............................................................................................................................................ 5 C. Likelihood of Self-Dealing Transactions .......................................................................................... 5 D. Situs Selection Issues........................................................................................................................ 7 E. Power to Allocate Gains to Income Under Section 104 ................................................................... 7 F. Ability of Beneficiary to Force Distributions.................................................................................... 7 G. Trust Protectors and Bifurcated Co-Trustee Powers........................................................................ 8 1. Directed Trusts .......................................................................................................................... 8 2. Bifurcated Co-Trustee Powers .................................................................................................. 9 3. Trust Protectors ....................................................................................................................... 11 H. Summary Personal Attributes Issues.............................................................................................. 12 II. DONOR TAX ISSUES ........................................................................................................................ 13 A. Gift Tax Issues ............................................................................................................................... 13 1. Incomplete Gift—Structure Planning Based on Donor’s Intent .............................................. 13 2. Retained Right to Receive Distributions ................................................................................. 13 a. Overview........................................................................................................................... 13 b. Summary of Selection of Trustee Issues as to Donor Retained Rights to Income In Order To Avoid Having Transfer Treated as Incomplete Gift……………………………………………………………………………………….14 3. Powers to Change Beneficial Interests .................................................................................... 15 a. Powers to Change Beneficial Enjoyment That Cause Incomplete Gift ............................ 15 b. Ascertainable Standard Exception .................................................................................... 16 c. Power to Affect Time or Manner of Enjoyment, But Not to Shift Among Beneficiaries ............................................................................................ 16 d. Power Exercisable In Conjunction With Others ............................................................... 16 e. Contingent Powers ............................................................................................................ 17

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Summary of Selection of Trustee Issues as to Retained Power to Change Beneficial Interests In Order to Avoid Having Transfer Treated as Incomplete Gift…………. 17 B. Estate Tax Issues ............................................................................................................................ 17 1. Who is the “Grantor”............................................................................................................... 17 a. Reciprocal Trust Doctrine ................................................................................................. 18 b. Indirect Transfers .............................................................................................................. 20 2. Retained Beneficial Interest in Donor ..................................................................................... 20 a. Statutory Provision--Section 2036(a)(1) ........................................................................... 20 b. Only Donative Transfers Are Subject to Section 2036 ..................................................... 20 c. Types of Retained Interests That Cause Estate Inclusion .................................................. 21 d. Settlor as Totally Discretionary Beneficiary ..................................................................... 24 e. Transfer to Spouse With a Potential of Having Spouse Appoint the Assets Back to Grantor .................................................................................. 29 f. Effect of Trustee Selection on Retained Right to Income................................................. 34 g. Summary of Trustee Selection Issues With Respect to Retained Beneficial Interests in Donor ........................................................................................................... 36 3. Retained Dispositive Powers in Donor.................................................................................... 36 a. Statutory Provision--Section 2036(a)(2) ........................................................................... 36 b. Statutory Provision—Section 2038................................................................................... 37 c. Dispositive Powers that Trigger Application .................................................................... 37 d. Similarities In Application of Sections 2036(a)(2) and 2038 ........................................... 39 e. Differences Between Section 2036(a)(2) and 2038 .......................................................... 40 f. Exception for Powers Held By Third Party Trustee ......................................................... 42 g. Ascertainable Standard Exception .................................................................................... 44 h. Summary of Planning for Ascertainable Standard Exception ................................... 47 i. Effect of Adding That Trustee Makes Decision “In His Sole Discretion” ....................... 48 j. Summary of Trustee Selection Issues With Respect to Grantor Powers Over Dispositive Provisions ............................................................... 48 4. Retained Administrative and Management Powers .................................................................. 49 a. Administrative Powers Can Affect Distributions ............................................................. 49 b. Key Issue: Is Exercise of Power Subject to Review By Court ......................................... 49 c. Supreme Court’s Pronouncement in Byrum ..................................................................... 50 d. Broad Powers to Allocate Between Income and Principal ............................................... 55 e. Broad Investment Authority ............................................................................................. 56 f. “All Powers As I Would Have If Trust Not Executed” .................................................... 56 g. Substitution Powers .................................................................................................. 56 h. Management Powers Over Partnership ............................................................................. 57 i. Effect of Exculpatory Clause Limiting Trustee’s Personal Liability ................................ 58 j. Effect of Guarantees. ........................................................................................................ 58 k. Administrative Powers That CANNOT Be Retained by Grantor ..................................... 59 (1) Voting Powers ............................................................................................................ 59 (2) Incidents of Ownership Over Life Insurance ............................................................. 60 l. Summary of Trustee Selection Issues With Respect to Administrative Powers ................................................................................. 61 5. Trustee Removal and Appointment Powers.............................................................................. 61 a. Power to Appoint Self at Any Time ................................................................................. 61 b. Contingent Power to Appoint Self as Successor Trustee .................................................. 61 c. Power to Appoint Self as Co-Trustee ............................................................................... 62 d. Veto Power ....................................................................................................................... 62 e. Power to Appoint a Series of Successor Trustees ............................................................. 62

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f. g. h. i. j.

Power to Add Co-Trustees (Not Including Self ................................................................ 62 Power to Remove and Replace Trustee—Sections 2036 and 2038 .................................. 62 Power to Remove and Replace Trustee—Section 2042 ................................................... 64 Disability of Grantor ......................................................................................................... 65 Summary of Selection of Trustee Issues Regarding Trustee Removal and Appointment Powers ............................................................................... 65 6. Special Trusts ............................................................................................................................ 65 a. Minor’s Trusts Under Section 2503(c............................................................................... 65 b. Special Needs Trust .......................................................................................................... 66 c. Qualified Domestic Trust.................................................................................................. 66 d. S Corporation .................................................................................................................... 66 e. Charitable Remainder Trust .............................................................................................. 67 f. Grantor Retained Annuity Trust (GRAT) ......................................................................... 67 g. Sales to Grantor Trusts ..................................................................................................... 68 C. Federal Income Tax Issues ............................................................................................................. 71 1. Foreign Trust Status and Effects ............................................................................................... 71 a. Tax Concerns With Being Foreign Trust .......................................................................... 71 b. Selection of Trustee Can Cause Foreign Trust Treatment ................................................ 72 c. Summary of Selection of Trustee Issues Regarding Foreign Trusts ........................... 72 2. Grantor Trust Rules—Effects of Grantor Trust Status ............................................................. 72 a. Grantor Report Income For Income Tax Purposes ........................................................... 72 b. Gift Tax Effects of Grantor’s Payment of Income Taxes on Trust’s Income ................... 73 c. Income Tax Reimbursement Provision ............................................................................. 73 d. S Corporation Shareholder................................................................................................ 74 e. Sales Between Trust and Grantor ..................................................................................... 74 f. Exclusion of Gain From Sale of Personal Residence ....................................................... 74 3. Grantor Trust—Trust Provisions that Cause Grantor Trust Status ........................................... 74 a. Power of Disposition by Related or Subordinate Parties Not Governed by Reasonably Definite External Standard ............................................................................ 74 (9) Summary of Trust Provisions to Trigger Grantor Trust Status Under Section 674 .............................................................................. 77 b. Power of a Non-Adverse Person to Distribute to or Accumulate Income for the Grantor or the Grantor’s Spouse ............................................................................ 78 c. Power of Non-Adverse Person to Use Income to Pay Life Insurance Premiums on Life of Grantor or Grantor’s Spouse ........................................................... 80 d. Actual Borrowing of Trust Funds by Grantor or Grantor’s Spouse Without Adequate Interest Or Security ............................................................................. 82 e. Power Exercisable in a Non-fiduciary Capacity to Reacquire Assets By Substituting Assets of Equivalent Value........................................................................... 83 f. Power of Non-Adverse Trustee to Make Loans to the Grantor and/or Grantor’s Spouse Without Adequate Security .................................................................. 91 g. Power of Non-Adverse Party to Add Beneficiaries .......................................................... 92 h. Inter Vivos Power of Appointment ................................................................................... 95 i. Foreign Grantor Trust ....................................................................................................... 95 j. Foreign Grantor................................................................................................................. 95 k. Converting Non-Grantor Trust to Grantor Trust............................................................... 95 l. Summary of Selection of Trustee Issues With Respect to Grantor Trust Rules ........................................................................................................ 96 m. Non Grantor Trusts With Grantor as Discretionary Beneficiary..................................... 96 4. Grantor Trust—Toggle Provisions.......................................................................................... 104 a. Desirability of Flexibility................................................................................................ 104

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b. General Guidelines to Maximize Flexibility................................................................... 104 c. Examples of Toggle Arrangements ................................................................................ 106 d. Income Tax Effects of Toggling Off Grantor Trust Status ............................................. 107 5. Grantor Trust Issues With Life Insurance Trusts .................................................................... 107 a. Transfer to Grantor Trust Does Not Violate Transfer for Value Rule; Rev. Rul. 2007-13 ........................................................................................................... 107 b. Reconfirming Position That Grantor Is Treated as Owner of Trust Assets For Income Tax Purposes ................................................................................................ 108 c. Advantages of Transferring Policies Between Trusts...................................................... 108 d. Planning Concerns With Transfers Between Trusts ........................................................ 109 e. Using Partnership to Assure Transfer for Value Rule Not Violated ............................... 109 f. Transfer to Insured (or Grantor Trust) Cleanses Prior Transfer for Value Problems ...... 109 g. Achieving Grantor Trust Status for Life Insurance Trusts .............................................. 109 6. Grantor Trusts With Split Purchase Transactions ................................................................. 110 7. Structure to Give Beneficiary Power of Withdrawal Rather Than Having Stated Termination Date During Grantor’s Lifetime ....................................................................... 110 8. Conversion From Nongrantor to Grantor Trust Status Not a Taxable Event; CCA 200923024 .................................................................................................................... 110 III. BENEFICIARY TAX ISSUES ....................................................................................................... 111 A. Gift Tax Issues .............................................................................................................................. 111 1. Exercise of General Power of Appointment ........................................................................... 111 2. Exercise Limited Power of Appointment................................................................................ 112 a. Mandatory Income Interest ............................................................................................. 112 b. Discretionary Beneficial Interest .................................................................................... 112 c. Summary........................................................................................................................ 113 3. Gift By Beneficiary If Fail to Exercise Rights ...................................................................... 113 4. Gift if Beneficiary/Trustee Makes Distribution to Another Under Discretionary Standard................................................................................................ 113 5. Gift if Beneficiary/Trustee Makes Distribution to Another Where Trustee’s Determination “Is Conclusive” .................................................................. 114 6. Gift if Beneficiary/Trustee Fails To Makes a Distribution to Himself.................................. 114 7. Summary of Application of Selection of Trustee to Gift Tax Issues ............................... 115 B. Estate Tax Issues—Dispositive Powers ........................................................................................ 115 1. Section 2041—General Rules ............................................................................................... 115 a. General Rule ................................................................................................................... 115 b. General Power of Appointment ...................................................................................... 115 c. Ascertainable Standard Exception .................................................................................. 116 d. Joint Power—Exercisable With Grantor ........................................................................ 116 e. Joint Power—Exercisable With Person With Adverse Interest ...................................... 116 f. Joint Power-Exercisable With Person Who is Potential Appointee................................ 116 g. Other Joint Powers .......................................................................................................... 117 h. Contingent General Powers of Appointment and Impact on Formula General Powers of Appointment..................................................................................... 117 i. Existence of General Power of Appointment Prior to Acceptance of Office as Trustee ............................................................................................................. 121 j. Effect of Incompetency of Power Holder ....................................................................... 121 k. Reciprocal Powers .......................................................................................................... 122 l. Creditor Impact on Holder of General Powers of Appointment ..................................... 122 2. Independent Trustee With Complete Discretion .................................................................... 124 a. General Rule—No General Power of Appointment ....................................................... 124 b. Power to Bring Judicial Action to Compel Trustee to Make Distributions .................... 125

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c. Giving Trustee Extremely Broad Discretion .................................................................. 125 3. Beneficiary as Co-Trustee...................................................................................................... 126 4. Beneficiary as Trustee—Distributions to Self as Beneficiary ............................................... 126 a. Ascertainable Standard Exception .................................................................................. 126 b. Regulations ..................................................................................................................... 126 c. Slight Difference in Language Can Be Critical .............................................................. 127 d. Two-Fold Analysis Approach; Combination of Clauses and Total Context of Standards Control, Not Presence of Single Words .............................. 127 e. Summary of Standards that Typically Are Not Ascertainable ........................................ 128 f. Example Cases and Rulings Finding Ascertainable Standard Exists.............................. 128 g. Example Cases and Rulings Finding That Ascertainable Standard Does Not Exist ............................................................................................... 1295 h. Rulings Related to Standard of Living............................................................................ 130 i. Rulings Related to “Emergency” Standard ..................................................................... 130 j. Possibility of Reformation .............................................................................................. 130 k. Effect of Providing that Trustee Must/May Consider Outside Resources ...................... 131 l. Small Trust Termination Provision................................................................................. 132 m. State Laws Limiting Discretionary Distributions for Self to an Ascertainable Standard .................................................................................................... 133 n. Planning Issues Regarding Distribution Standards ......................................................... 133 o. Creative Planning Strategy to Allow Beneficiary to Decide Whether to Retain Unfettered Control Over Trust or be Subject to Ascertainable Standard........................ 135 5. Beneficiary as Trustee—Effect of Authority to Satisfy Trustee’s Support Obligations; The Upjohn Issue .............................................................................................. 135 a. Regulations—Power to Discharge Decedent’s Obligation is Power Exercisable in Favor of Decedent.................................................................................... 135 b. The Illogical Disconnect ................................................................................................. 136 c. Upjohn ............................................................................................................................ 136 d. The Fix ............................................................................................................................ 136 6. Special Issues With Settlor’s Spouse as Trustee .................................................................... 137 a. Restrict Power to Distribute to Self to Ascertainable Standard ...................................... 137 b. Restrict Incidents of Ownership...................................................................................... 137 c. Restrict Power to Distribute to Minor Children or Otherwise in Satisfaction of Spouse’s Legal Obligations ..................................................................... 137 d. Spouse and Children as Discretionary Beneficiaries—Use Ascertainable Standard for Distributions to Children Also .................................................................... 137 e. Use Tax Savings Clause ................................................................................................. 137 f. Fiduciary Obligations ..................................................................................................... 137 g. Income Tax ..................................................................................................................... 138 h. QTIP Trusts..................................................................................................................... 138 i. Clayton Trusts ................................................................................................................. 138 j. Section 2503(c) Trusts .................................................................................................... 138 7. Summary of Selection of Trustee Issues Regarding Dispositive Powers Held by a Beneficiary ............................................................................................. 138 C. Estate Tax—Management/Administrative Powers ....................................................................... 139 1. The Issue ............................................................................................................................... 139 2. Regulations ............................................................................................................................ 139 3. Lack of Cases; Analogy to Section 2036-2038 Cases ........................................................... 139 4. Potentially Troublesome Powers ........................................................................................... 140 5. Income and Principal Allocations ......................................................................................... 140 6. Valuations; Non Pro Rata Distributions ................................................................................ 141

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7. 8. 9. 10. 11. 12.

Tax Elections ......................................................................................................................... 141 Power to Adjust Under Section 104 ...................................................................................... 142 Incidents of Ownership Over Life Insurance ........................................................................ 142 Beneficiary Consent to Trustee’s Administrative Actions .................................................... 142 Beneficiary Power to Veto Stock Sales ................................................................................. 142 Power to Borrow, Pledge Trust Property, Dispose or Property and Contract With Trust ............................................................................................................... 142 13. Summary of Selection of Trustee Issues Regarding Administrative Powers ........................................................................................................ 142

D. Trustee Removal and Appointment Powers................................................................................. 143 1. Overview; Analogy to Grantor Powers ................................................................................. 143 2. If Beneficiary-Trustee Declines to Accept Office as Trustee................................................ 143 3. Power to Appoint Self as Trustee .......................................................................................... 143 4. Power to Appoint Self as Trustee Under Limited Conditions That Have Not Yet Occurred 143 5. Power to Appoint Co-Trustee to Exercise Tax Sensitive Powers ......................................... 144 6. Power to Appoint Successor Trustee Other Than Self .......................................................... 144 7. Power to Veto Appointment of Independent Trustee ............................................................ 144 8. Power to Remove and Appoint Successor Other than Self ................................................... 144 a. Power to Remove For Cause........................................................................................... 144 b. Power to Remove Without Cause ................................................................................... 145 c. Power to Remove and Replace Trustee—Section 2042 ................................................. 145 9. Summary of Selection of Trustee Issues Regarding Removal and Appointment Powers ........................................................................................................... 145 E. Income Tax Issues........................................................................................................................ 146 1. Section 678—Income Taxed to Beneficiary As Owner Under Grantor Trust Rule ................................................................................................................. 146 a. Issue ................................................................................................................................ 146 b. Statute ............................................................................................................................. 146 c. Ascertainable Standard Exception Is Uncertain.............................................................. 146 d. Effect if Beneficiary-Sole Trustee Appoints Co-Trustee ................................................ 147 e. Distributions to Satisfy Trustee’s Support Obligation .................................................... 147 f. Effect of Disclaimer ........................................................................................................ 147 g. Treating Crummey Beneficiary as “Owner” of Trust Under §678 ................................. 147 h. IRS Has Reconfirmed Informal Rulings That Using Crummey Trust Does Not Invalidate “Wholly Owned” Status of Grantor ............................................................. 147 i. “Beneficiary Controlled Trust” (BDIT) .......................................................................... 149 j. Beneficiary Deemed Owner Trust (BDOT) ................................................................... 152 k. Sale of S Corporation Stock by Beneficiary to QSST .................................................... 154 2. State Income Tax Issues ........................................................................................................ 155 a. Brief Overview of State Taxation Approach .................................................................. 155 b. Resident vs. Nonresident Trusts ..................................................................................... 156 c. Constitutional Issues. ...................................................................................................... 158 IV. SAVINGS CLAUSES TO AVOID ADVERSE TAX EFFECTS FOR GRANTORS, BENEFICIARIES AND TRUSTEES ..................................................................... 162 A. Significance of Savings Clauses Regarding Tax Effects For Grantors, Beneficiaries and Trustees............................................................................................................ 162 B. IRS Recognizes Savings Clauses For Section 2041 Purposes ..................................................... 163 C. Miscellaneous Examples of Savings Clauses and Other Clauses Important to Achieve Tax Effects of Irrevocable Trusts .................................................................................. 163 1. Irrevocability ......................................................................................................................... 163

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2. 3. 4. 5.

Fiduciary Powers Only .......................................................................................................... 163 Settlor Prohibited From Serving as Trustee .......................................................................... 164 Prohibit Distributions Satisfying Support Obligations of Settlor Or Trustee ........................ 164 Limitations on Beneficiary-Trustee as to Distributions, Termination, Estimated Taxes, and Life Insurance..................................................................................... 164 6. Jerry Horn’s “Short-Form” Savings Clause .......................................................................... 165 7. Broad Comprehensive Catch-All Savings Clauses for Settlor and Beneficiary to Avoid Estate Inclusion and Grantor Trust Treatment .................................... 166 V. CREDITOR ISSUES ........................................................................................................................ 166 A. Self-Settled Trusts ........................................................................................................................ 166 B. Spendthrift Protection for Trust Beneficiaries .............................................................................. 166 1. Discretionary Trust ................................................................................................................ 167 2. Sprinkling Trust May Afford More Protection ..................................................................... 168 3. Allow Trustee to Change Beneficiary or “Hold-Back” Distributions to Maximize Protection .............................................................................................................. 168 4. Beneficiary as Trustee ........................................................................................................... 168 a. Same Person as Sole Trustee and Sole Beneficiary ........................................................ 168 b. A Beneficiary is Also Trustee ......................................................................................... 169 C. Summary of Selection of Trustee Issues With Respect to Creditors Rights ......................... 173 APPENDIX A - Broad Comprehensive Catch-All Savings Clauses for Settlor and Beneficiary to Avoid Estate Inclusion and Grantor Trust Treatment ......................................................................... 174 APPENDIX B Twenty Things You Have to Know About Selecting Trustees and Structuring the Powers of Trustees ........................................................................................................................... 178

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Trustee and Beneficiary Powers that Won’t Create a Tax Disaster Steve R. Akers Bessemer Trust Dallas, Texas This outline addresses tax and non-tax factors that should be considered in selection of a trustee or cotrustees and structuring the powers of trustees for various types of trusts. Clients typically like to keep as much control as possible, and often want to place as much control in their trust beneficiaries as possible. This desire must be balanced against management, tax, and creditor issues that may result in significant advantages in placing restrictions on the control of the donor or trust beneficiaries. This outline addresses trustee selection against the backdrop of a client’s desire to retain as many “strings” over the transfer as possible without causing the donor or beneficiaries to be “strung-up” by those other countervailing factors. As one court has expressed the issue, “the cost of holding onto the strings may prove to be a rope burn.” Old Colony Trust Co. v. U.S., 423 F.2d 601, 604 (1st Cir. 1970). I. NON-TAX FACTORS A. Legal Capacity. 1. General Statutory Requirements. A trustee must have legal capacity, and if the trustee is a corporation, it must have the power to act as a trustee. E.g., TEXAS TRUST CODE § 112.008(a). A beneficiary or settlor may generally serve as trustee. 2. Requirements for Corporate Trustee. Most states have limitations on corporations that have the authority to serve as trustee. For example, Section 3 of the Texas Probate Code defines a “corporate fiduciary” as a financial institution as defined by Section 201.101 of the Texas Finance Code, having trust powers, existing or doing business in Texas or another state, and being authorized by law to act under the order of any court of record without giving bond, as trustee, executor, or administrator. Under Section 201.101 of the Texas Finance Code, a financial institution includes a bank or trust company chartered under laws of the United States or any state. For a list of activities that does not require obtaining a charter to engage in trust business, see Section 182.021 of the Texas Finance Code. In Texas, corporations generally do not have serving as a fiduciary within the scope of their permissible purposes; provided that a non-profit corporation may serve as trustee of trusts of which the non-exempt corporation is named as a beneficiary. TEXAS BUS. ORGANIZATIONS CODE § 2.001 & 2.106 (2003); See TEX. FIN. CODE § 181.001 et. seq. 3. Requirements for a Foreign Corporate Fiduciary. Most states limit the ability of out-of-state entities serving as trustee. For example, a foreign corporation or other entity chartered or domiciled in another jurisdiction as a trust company or depository institution with trust powers may act as a trustee in Texas only as provided by Section 105A of the Texas Probate Code. (As discussed below, this provision apparently is overridden by the Supremacy Clause as to financial institutions that are organized as National Associations.) a. Reciprocity Requirement. Many states have statutes that adopt a reciprocal approach. For example, a Texas court can appoint a corporate fiduciary from another state (a “foreign corporate fiduciary”) as a fiduciary in Texas only if a Texas financial institution

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can be appointed under the laws of the state of the foreign fiduciary “to serve in like fiduciary capacity.” TEX. ESTATES CODE §§ 505.001 & 505.003. b. Filing Requirement. A foreign corporate fiduciary shall file with the Secretary of State of Texas (1) a copy of its charter, (2) an appointment of the Secretary of State as its resident agent for service of process, and (3) a designation of the agent who shall receive notices from the Secretary of State. TEX. ESTATES CODE §§ 505.004 & 505.005. c. Not Doing Business. A foreign fiduciary who satisfies the requirements of Section 105A is not deemed to be doing business in Texas for purposes of Section 8.01 of the Texas Business Corporation Act. d. National Associations. The Office of the Comptroller of the Currency takes the position that under the Supremacy Clause of the U.S. Constitution a national association can serve in any state without meeting any state requirements, including the modest filing requirements. See e.g., OCC Interp. Ltr. No. 872 (Dec. 1999) and OCC Interp. Ltr. No. 866 (Oct. 1999). 4. Charitable Corporation. A charitable corporation may serve as the trustee of a trust (1) of which the charity is a beneficiary, or (2) benefiting another charitable organization. TEX. BUS. ORGANIZATIONS CODE § 2.106 (2003)(a). A charity meeting those requirements has immunity from any suit alleging that the corporation's role as trustee constitutes engaging in the trust business in a manner requiring a state charter. TEX. BUS. ORGANIZATIONS CODE § 2.106 (2003)(b). B. Personal Attributes of Trustee. The personal attributes of the trustee should be of paramount importance in the selection process. All too often, the tax factors predominate, but the planner must not lose sight of the personal attribute factors. The fact that the trust works for tax purposes will be of little benefit if a poorly selected trustee dissipates the trust assets through poor administration of the trust. Serving as an executor or trustee is neither an honor, nor a game for beginners to play. Acting as an executor or trustee requires technical skills, experience, and an ability to deal with the family members involved. Nevertheless, clients often choose an executor and the trustee without fairly evaluating the needs of the estate or trust against the named fiduciary’s abilities to meet those needs. Schlesinger, Edward, Fifty-Two Questions to Ask Before Choosing Your Executor and Trustee, Successful Estate Planning Ideas and Method Service (1986).

Various personal attributes to be considered in selecting the trustee include sound judgment, impartiality (or desired partiality toward decedent's preferred beneficiaries), financial ability and responsibility, integrity and honesty, locality, permanence and continuity (particularly important for long-lived trusts), loyalty, trustworthiness, and experience as a trustee. Some of these attributes are explored in more detail. 1. Judgment; Experience. Attorneys are all too familiar with situations where trust assets have been dissipated due to the inexperience of the trustee. A good trustee can provide sound business judgment to the beneficiaries. 2. Impartiality; Objectivity; Lack of Conflict of Interest. The objectivity and lack of conflict of interest factor is very important in many family situations. Selecting an appropriate trustee

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can avoid conflict situations that may result in family tensions (or outright hostilities) that can never be repaired. a. Beneficiaries Having Conflicting Interests. In situations where the beneficiaries have conflicting interests (the classic case being a split-family situation, where the settlor’s spouse and children by a prior marriage are both involved as current or contingent beneficiaries.) One commentator suggests using an independent trustee in these types of situations: On our facts, the first thing that the estate planner should do is to convince the client to use the services of a truly independent trustee. In this respect, even though [certain approaches may] lessen the possibility of conflict between the client’s children and their stepmother, to a certain extent the objective will be undermined by having a child act as trustee. Because opinions will differ, there still will be circumstances in which the son-trustee does not accede to the stepmother’s requests, creating the possibility of a confrontation. This also might be the case if someone like a brother-in-law or other disinterested relative is appointed as trustee. The use of an independent fiduciary—perhaps a corporate fiduciary such as a bank—removes the opinions, the underlying distrust, the misunderstandings, and most of all the personalities from the decision-making process. Consequently, there is a better chance of achieving the desired cooperation between the family members. Tiernan, Creating an Amicable Estate Plan for the Decedent’s Children and the Second Spouse, 94 J. TAX’N (Feb. 2001).

b. Avoiding Family Tension. Stephen Leimberg has summarized the various interpersonal relationships that can be affected by using a family member as trustee: How will the trustee react when faced with a choice that favors him at the expense of other beneficiaries—or favors others at this expense? What are the intra-family implications of those choices? For instance, will he alienate one family member by (even properly) denying a distribution, or ingratiate himself to another by being liberal in his policy of making distributions? Can he say no to one child and yes to another without causing a never-ending family feud? A trustee who is also a family member may be forced by conscience or by duty to make choices injurious to the harmony of family relationships. Will the trustee (such as the grantor’s spouse) be subject to the influence of one or more children (or a second spouse or lover) to make distributions that may not be in the best interest of other beneficiaries? Is the family member-trustee easily persuaded or likely to show favoritism? The remarriage of a spouse or child who is named as trustee may result in less than impartial decisions—especially where the trustee has been given discretionary powers over trust income or principal—even if the new spouse is not included in the class of possible recipients. A child/trustee may take on the role of a parent to his or her remaining parent or siblings. This may be positive, but it also may result in an attempt to control the lives of family members through the family finances as if that person were a parent rather than a child. An independent professional trustee is not subject to such problems. Since the choice between no and yes may be one of the most important duties of a trustee, this ability of a professional trustee to be objective and impartial should be given high preference in the decision-making process. S. Leimberg, THE TOOLS AND TECHNIQUES OF ESTATE PLANNING 480 (11th ed. 1998).

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3. Investment Sophistication; Track Record; Prudent Investor Act. The investment sophistication of the trustee is important with respect to the investment growth of the trust. The trustee’s experience in various types of investments should be considered. For example, does the trustee have experience in the increasingly important area of alternative investments (private equity, venture capital, and hedge funds) to increase returns while reducing overall portfolio volatility? Under the Uniform Prudent Investor Act, which is being passed by many of the state legislatures, the trustee must evaluate the investments in the context of the entire trust and the risk and return objectives of the trust. In addition, the trustee has a duty to diversify the trust assets. Some commentators observe that the Prudent Investor Rule may increase the level of sophistication required of trustees. See Heisler & Butler, Trust Administration ch. 5 (Ill. Inst. For Continuing Legal Educ. 1999). 4. Permanence and Availability. Especially for long-term trusts, the long-term existence and availability of the trustee is important. Corporate trustees have the advantage of perpetual existence. The client should inquire, however, into the rate of turnover of the professional staff of the corporate trustee. Having someone available who can develop a long-term helpful relationship with the beneficiaries may be very important in many situations. “It is no big stretch to say that a warm, cooperative, known voice on the other end of the telephone line is probably more important to an elderly surviving spouse than an extra three percent of total return.” Karisch, Protecting the Surviving Spouse, 38th ANNUAL SW LEGAL FDN. WILLS & PROB INST. 18 (May 1999). Geographic availability of the trustee may also be important. Some individuals who are being considered as a possible trustee might be expected—over a long period of time—to move locations. Furthermore, beneficiaries may move to new locales, and the ability of the trustee to respond to geographic moves of the beneficiary should be considered. 5. Sensitivity to Individual Beneficiaries’ Needs. One of the important duties of a trustee is to make appropriate distributions to the trust beneficiaries, often within some degree of discretion. Being able to understand the beneficiaries and their circumstances is important. Some clients choose to use co-trustees, one of whom has experience in providing the myriad of fiduciary services, and one of whom has a personal relationship with the beneficiaries. In that situation, the co-trustees could be given exclusive responsibility for the administration vs. distribution responsibilities. However, even in that case, the client may want to have the trustee consent to distributions (with the obvious input of the related co-trustee), to get the benefits of having an objective voice who can “shield” the related individual from unreasonable requests for distributions. 6. Accounting; Tax Planning; Record-Keeping. Corporate fiduciaries have a definite advantage over nonprofessional individual trustees when considering the myriad accounting procedures, tax compliance, and tax planning opportunities that must be handled by a trustee. The level of sophistication, expertise, and experience that should be applied over the lifetime of any trust is one that few nonprofessionals can provide. This means that most family members will simply be incapable of fully understanding all of the problems that must be avoided and the availability and implications of the tax and property law elections that must be weighed. Even knowledgeable attorneys and accountants do not have the requisite practical day-to-day experience unless they practice solely in this field.

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It is possible and in many cases appropriate for a trustee to hire agents for advice and assistance. Most trustees will communicate regularly with outside attorneys and accountants. But planning policy and decisions must be made by the trustee; these are among the duties that cannot be delegated. . . . Will an untrained trustee know whom to call or if the advice received is both legally correct and practical? Will a nonprofessional understand the interplay between tax, trust, and property law well enough to interpret provisions in the trust and adequately inform beneficiaries about the tax and other legal effects of various choices? S. Leimberg, THE TOOLS AND TECHNIQUES OF ESTATE PLANNING 483 (11th ed. 1998).

The trust must maintain detailed records and reports typically are given to beneficiaries and the appropriate taxing authorities on a periodic basis. “This requires regular statements of the receipts, disbursements, and assets of the trust in an intelligible form, and careful long-term record storage.” Id. at 484. 7. Fees. Fees that will be charged by the trustee are a factor. However, the client should not be “penny-wise and pound-foolish.” Relatives, beneficiaries, business associates, and close friends will often serve as trustee without charging a fee. The grantor should be careful to determine whether the individual will properly carry out his duties and give sufficient attention to the administration of the trust. One is easily lured away from his responsibilities by more lucrative endeavors. “You get what you pay for.” Malouf, Choosing a Trustee: Old Problems, New Problems, A Few Solutions, at 5, Presentation to Dallas Estate Planning Council (January 1991).

Fees are often the primary reason that a client elects to use family members or friends as trustees rather than a professional fiduciary. There are certainly many situations in which it is appropriate to use carefully selected individuals as trustees. However, the clients should consider the long-term effects on the trust and balance all of the personal attribute factors in weighing whether to use a corporate fiduciary despite the fee differences. Where the trust is likely to be of substantial size, administration of the trust may require special confidence and expertise beyond the ability of any individual, whether a relative, friend or business colleague. For this and other reasons a corporate trustee is often selected. The use of a corporate fiduciary as an ‘independent trustee’ may be necessary to avoid adverse federal income or estate tax consequences. A corporate fiduciary presumably would bring special skills and competence to investment, tax and other matters of trust administration that would amply justify its commissions. Continuity is assured since the trusteeship would be unaffected by disability, death or other contingency by reasons of the corporate fiduciary’s perpetual existence. Although an individual named as trustee might be willing to serve without compensation, this savings might be offset by the need to retain and compensate attorneys, accountants, investment advisors and other agents. G.G. Bogert, G.T. Bogert & A. Hess, BOGERT’S TRUSTS AND TRUSTEES § 121 (2001).

C. Likelihood of Self-Dealing Transactions. In many situations, the overall plan will call for a trustee to purchase assets from related parties or affiliates. This brings into play the independence and lack of conflict personal attributes discussed in section I.B.2. above. In addition, legal restrictions on the ability of the trustee to enter into certain self-dealing transactions may be imposed if the trustee is also personally involved in the transaction. Many state statutes have restrictions on self-dealing transactions, but many of those restrictions may be waived in the trust instrument. For example, the Texas Trust Code prohibits a loan of trust funds to a trustee, affiliate or relative of a trustee (§ 113.052), a purchase or sale of trust property by or to a trustee, affiliate or relative of the trustee (§ 113.053), a sale of property from

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one trust to another trust having the same trustee (§ 113.054), and a purchase of the trustee’s securities (§ 113.055). The term “relative” includes a spouse, ancestor, descendant, brother or sister, or spouse of any of them. TEX. PROP. CODE § 111.004(13). In many situations, the settlor may want to relieve the trustee of self-dealing prohibitions if permitted by local law. In Texas, the trust instrument may alter self-dealing prohibitions that would otherwise apply under the Code. Previously, a corporate trustee could not be relieved from the self-dealing provisions in Section 113.052 (loan of funds to trustee or specified related parties) or Section 113.053 (purchase or sale of property from or to trustee or specified related parties), but amendments in 2007 allow the settlor to waive those prohibitions even for corporate trustees. TEX. PROP. CODE §§ 111.0035(b)(2), 114.005(a); TEX. FINANCE CODE § 197.005(b). The Texas Trust Code also addresses a corporate trustee making a temporary or permanent deposit of funds with itself. TEX. PROP. CODE § 113.007 (temporary deposit pending reinvestment) & 113.057 (permanent investments). The Texas Trust Code specifically authorizes a corporate trustee to employ an affiliate to provide brokerage, investment, or other account services for the trust and to permit the affiliate to charge a commission for its services. The statute requires that the amount charged by the affiliated be disclosed and not exceed the customary amount that is charged by the affiliate for comparable services to others. TEX. PROP. CODE § 113.053(f). In addition, restrictions are imposed on banks by the OCC, but Section 9.12 of Regulation 9 relieves a trustee from many self-dealing restrictions when the proposed action is authorized by applicable law. Despite the statutory provisions allowing waiver of self-dealing prohibitions on the trustee, there are some suggestions in cases that there may be public policy concerns that would limit the ability of the settlor to relieve a trustee of liability for future self-dealing transactions. See Langford v. Shamburger, 417 S.W.2d 438, 444 & 447 (Tex. Civ. App.—Ft. Worth 1967, writ ref’d n.r.e.) (dictum that “it would be contrary to the public policy of this state to permit the language of a trust instrument to authorize self-dealing by a trustee”; on rehearing, the court stated that the language of a trust instrument specifically authorizing self-dealing “could present a serious question of public policy”). See also Interfirst Bank Dallas, N.A. v. Risser, 739 S.W.2d 882 (Tex. Civ. App.—Texarkana 1987, no writ). However, the Texas Supreme Court has upheld an exculpatory clause, relying primarily on section 113.059 of the Texas Trust Code, which allows a settlor to relieve the trustee from a duty, liability or restriction contained in the Code, except that a corporate trustee may not allow lending or sales transactions with itself. Texas Commerce Bank, N.A. v. Grizzle, 96 S.W.3d 240 (Tex. 2002). The opinion does not address public policy concerns placing limits on the ability of a settlor to allow self-dealing transactions. The Texas legislature responded by amending section 113.059 to incorporate the provisions of the Restatement (Second) of Trusts § 222, which prohibit the enforcement of an exculpatory clause that would relieve a trustee of liability for a breach of trust committed in bad faith, intentionally or with reckless indifference to the interest of the beneficiary. In addition, the amendment makes clear that an exculpatory clause may not relieve the trustee for liability for any profit derived by the trustee from a breach of trust. Cases generally recognize that no matter how broad the trust instrument’s provisions are, the trustee will remain liable for a breach of trust committed in bad faith or with reckless indifference to the interest of the beneficiary. Restatement (Second) of Trusts § 170 Comment t.

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D. Situs Selection Issues. The situs of the trust may affect various important legal issues, including asset protection, state income taxation, and the application of the rule against perpetuities to the trust. If the client wishes to create a “Dynasty Asset Protection Trust” (i.e., a trust that is not subject to the rule against perpetuities and that is generally not subject to creditors claims against the settlor of the trust), it may be necessary to require that at all times there be sufficient trustees resident in the state whose law is being used. At least nineteen states have adopted varying approaches regarding “self-settled spendthrift trusts” (the two newest states are Indiana and Connecticut): Alaska, Connecticut, Delaware, Hawaii, Indiana, Michigan, Mississippi, Missouri, Nevada, New Hampshire, Ohio, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia, West Virginia and Wyoming. Those 19 states cover over 20% of the United States population. Laws in these states provide generally that trust assets are generally not subject to creditors’ claims of the settlor merely because the settlor is a discretionary beneficiary of the trust. These various states have differing provisions regarding trustee selection in order to take advantage of the state’s laws. For example, Rhode Island requires that all trustees be a resident or authorized to do business in that state. R.I. GEN. LAWS § 18-9.2-2(8)(I) (1999). Many of the statutes require that at least one trustee be a resident in their states. Many also require that at least some of the trust assets be located in or administered in the host jurisdiction. For an excellent summary of the 19 DAPT

statutes, see David Shaftel, Twelfth ACTEC Comparison of the Domestic Asset Protection Trust Statutes (updated through August 2019)(available at http://www.shaftellaw.com/dave.html).

E. Power to Allocate Gains to Income Under Section 104. Section 104 of the new Uniform Principal and Income Act (adopted in 1997 and last amended in 2018) and Section 203 of the Uniform Fiduciary Income and Principal Act (adopted in 2018) deal with the trustee’s “power to adjust”, a power to allocate capital gains to income in certain situations. If a trust provides for the mandatory distribution of all income, and if a trustee makes the decision to allocate some or all capital gains to income for a particular year, the decision directly impacts the amount to be distributed to the income beneficiary. Accordingly, section 104(c)(7)-(8) of the 1997 Act and section 203 203(e)(7) 2018 Act and most of the states adopting the provision stipulate that the discretion may only be exercised by an independent trustee. The Texas statute does not permit a beneficiary who is serving as a trustee to allocate gains to income under the statute. F. Ability of Beneficiary to Force Distributions. In some situations, a donor creates a trust to provide long-term management for the benefit of a spendthrift beneficiary. The donor should be aware that if standards for distributions are listed in the trust agreement, the beneficiary may go to court to force a trustee to make distributions within the prescribed standards. If a trust gives the trustee wide discretion in deciding to make distributions, without specified standards for exercising that discretion, the beneficiary will have a much more difficult time convincing a court to force the trustee to exercise its discretion in a particular manner. See Porter, Exercising Discretion in Dicretionary Trusts Great Expectations: Charles Dickens Diminished Expectations: Trust Beneficiary Managed Expectations: Trustee, 37TH ANNUAL HECKERLING INST. ON EST. PL. ¶ 1400 (2003). However, for tax reasons, wide discretion over distributions is usually only allowed for an independent trustee (i.e., someone other than a trust beneficiary). If a major goal of the donor in a particular situation is to provide long-term management for spendthrift beneficiaries, using an independent trustee with wide discretion over distributions may be preferable.

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G. Trust Protectors and Bifurcated Co-Trustee Powers. Trustee duties may be divided among various fiduciaries. State laws typically allow trustees to delegate certain trust duties and powers to agents. (The agent owes a duty of reasonable care, and the trustee must act prudently in making the delegation and monitor the agent’s performance.) UNIF. TRUST CODE §807; TEX. PROP. CODE §117.011; RESTATEMENT (THIRD) OF TRUSTS §9; UNIF. PRUDENT INVESTOR ACT §9; see also, John H. Langbein, Reversing the Nondelegation Rule of Trust-Investment Law, 59 MO. L. REV. 105 (1994). The authority of co-trustees to delegate responsibilities among themselves is much more limited. See UNIF. TRUST CODE §703(e) (delegation to a co-trustee of function the settlor reasonably expected the trustees to perform jointly not permitted). A settlor may provide for divided powers either by (i) providing a director to direct particular trustee actions, and (ii) having co-trustees with a bifurcation of their respective powers. A settlor may also appoint a “trust protector” with designated “grantor-like” powers that can be very broad powers to make changes regarding the trust. Trustee duties are being divided for various reasons. For trust directors or co-trustees with bifurcated responsibilities, reasons include specialization of skill sets or specialized assets. (There is significant jurisdictional competition for directed trusts or trusts with bifurcated co-trustees because state laws vary significantly to the extent that these provisions are respected.) For trust protectors, reasons include tax considerations, a desire to impose checks and balances, and the perceived need to adapt to change. The Uniform Directed Trust Act, promulgated in July 2017, addresses direction advisors and divided trusteeships. The project will likely result in a uniform act revision dealing with divided responsibilities among co-trustees or trust advisors. 1. Directed Trusts. A number of states have directed trust provisions, recognizing the authority of a third person to direct certain actions of the trustee. This may desirable, for example, if the settlor wants to designate someone with specialized knowledge about a particular asset (such as a closely held business) to direct actions with respect to the trust’s interest in that asset, and relieve the other co-trustee from responsibility for that asset. (A settlor might want a corporate trustee to be responsible for “investable assets” without being responsible for (or charging fees for) detailed oversight of a closely held business in which the trust owns an interest.) The state statutes vary to the extent to which the trustee may rely on that direction without liability. E.g., UNIF. TRUST CODE §808(b) (trustee may act in accordance with the direction “unless the attempted exercise is manifestly contrary to the terms of the trust or the trustee knows the attempted exercise would constitute a serious breach of a fiduciary duty that the person holding the power owes to the beneficiaries of the trust”); FLA. STAT. §736.0808(2) (similar to Uniform Trust Code provision). A third person may also be given the power to direct the modification or termination of the trust. E.g., UNIF. TRUST CODE §808(c); TEX. PROP. CODE §114.003(a).These statutes typically provide that the third person holding the direction power is “presumptively a fiduciary.” E.g., UNIF. TRUST CODE §808(d); TEX. PROP. CODE §114.003(c). Some state statutes provide broader authority for the trustee to act in reliance on directions from the advisor without liability, including Alaska, New Hampshire, Nevada, and South Dakota. E.g., ALASKA STAT. §13.36.375(c) (a “trustee ... required to follow the directions of the advisor is not liable, individually or as a fiduciary, to a beneficiary for a consequence of the trustee’s compliance with the advisor’s directions, regardless of the information available to the trustee, and the trustee does not have an obligation to review, inquire, investigate, or make recommendations or evaluations with respect to the exercise of a power of the trustee if the exercise of the power complies with the directions given to the trustee”). Other states provide a “willful” or “intentional” misconduct

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standard in determining when a trustee can be liable for complying with directions given by a direction advisor, including Delaware, Illinois, Texas, and Virginia. E.g., 12 DEL. C. §3313 (“then except in cases of willful misconduct on the part of the fiduciary so directed, the fiduciary shall not be liable for any loss resulting directly or indirectly from any such act”); 760 Ill. Comp. Stat. §16.3(f)(1) (willful misconduct); R. S. Mo. §456.8-808(8) (bad faith or reckless indifference); Tex. Prop. Code §114.0031(f)(“willful misconduct”). For a detailed listing of directed trust statutes, see Richard W. Nenno, State Directed Trust Statutes With Related Uniform Trust Code Statutes (2014), reprinted in seminar materials for ACTEC 2014 Fall Meeting. See generally Gilman, How and When to Use Trust Advisors Most Effectively, 35 EST. PLAN. 30 (Feb. 2008); Gilman, Effective Use of Trust Advisors Can Avoid Trustee Problems¸ 35 EST. PLAN. 18 (March 2008). Can these limitations on the ability to relieve the directed trustee of liability be overridden in the trust instrument? The comments to §808 of the Uniform Trust Code indicate that a settlor could relax those standards in the trust instrument: The provisions of this section may be altered in the terms of the trust. See Section 105. A settlor can provide that the trustee must accept the decision of the power holder without question. Or a settlor could provide that the holder of the power is not to be held to the standards of a fiduciary. Section 105 of the Uniform Trust Code, referenced in that comment, is the section listing what duties cannot be altered in the trust agreement. The comment suggests that §105 would not prohibit a trust instrument from overriding the manifestly contrary to terms of trust/serious breach of trust liability default standard of §808(b). The Uniform Directed Trust Act makes clear that it adopts the “willful misconduct” standard as a minimum standard of liability of the trustee that cannot be waived, similar to the approach of the Delaware Act. The Uniform Directed Trust Act provides that a “power of direction” includes a power over the “investment, management, or distribution of trust property or other matters of trust administration.” §2(5). A “trust director means a person that is granted a power of direction by the terms of a trust to the extent the power is exercisable while the person is not serving as trustee.” §2(9). The trust director “has the same fiduciary duty and liability in the exercise or nonexercise of the power” as a trustee or cotrustee in a like position and under similar circumstances. §8(a). A directed trustee must take reasonable action to comply with a direction given by a trust director except “to the extent that by complying the trustee would engage in willful misconduct.” §9(b). The “willful misconduct” standard of liability of the directed trustee for complying with directions from the trust director cannot be waived. §9(c)(1). 2. Bifurcated Co-Trustee Powers. Co-trustees have limited authority to split their duties and responsibilities. See UNIF. TRUST CODE §703(e) (delegation to a co-trustee of function the settlor reasonably expected the trustees to perform jointly not permitted). A comment to §703(e) explains that trustees should be encouraged to delegate functions they are not competent to perform. Subsection (e) is premised on the assumption that the settlor selected cotrustees for a specific reason and that this reason ought to control the scope of a permitted delegation to a cotrustee. … The exact extent to which a trustee may delegate functions to another trustee in a particular case will vary depending on the

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reasons the settlor decided to appoint cotrustees. The better practice is to address the division of functions in the terms of the trust, as allowed by Section 105. Absent an effective delegation of duties among co-trustees or a division of responsibilities in the trust agreement, all co-trustees generally have an obligation to participate in all elements of the trust administration. UNIF. TRUST CODE §703(c). Trustees generally take action by majority vote, but if a co-trustee disagrees with the decision made by the majority, that cotrustee may refuse to join in the action and avoid liability for the action except that each cotrustee must exercise reasonable care to prevent a co-trustee from committing a serious breach of trust and to compel a co-trustee to redress a serious breach of trust. UNIF. TRUST CODE §703(f)-(g); TEX. PROP. CODE §114.006(a)-(b). The co-trustee who disagrees with an action may nevertheless join in the action but dissent and avoid liability for the action unless it constitutes a “serious breach of trust.” UNIF. TRUST CODE §703(h); TEX. PROP. CODE §114.006(c). The trust agreement, however, may divide the responsibilities among co-trustees. For example, there may be an investment/administrative co-trustee and a distribution co-trustee; the sole authority and responsibility of the distribution co-trustee would be to make distribution decisions. The Uniform Trust Code provides that the terms of a trust generally control and can change the rules that would otherwise apply, as long as the trustee must act in good faith in accordance with the terms of the trust for the interests of its beneficiaries and as long as the trust terms are for the benefit of its beneficiaries and have a lawful purpose that is not contrary to public policy. UNIF. TRUST CODE §105(b). Section 105(b) lists other specific provisions that may not be modified, but dividing responsibilities among co-trustees is not listed as one of the prohibited modifications. A few states have adopted statutes that specifically address the ability of a settlor to divide the duties of co-trustees. The Alaska statute relieves the “excluded trustee” from any duty whatsoever with respect to responsibilities allocated to a co-trustee: Notwithstanding the other provisions of this section, if the terms of a trust instrument provide for the appointment of more than one trustee but confer on one or more of the trustees, to the exclusion of other trustees, the power to direct or prevent specified actions of other trustees, the excluded trustees shall act in accordance with the exercise of the power. An excluded trustee under this subsection is not liable, individually or as a fiduciary, for a consequence that results from complying with the exercise of the power, regardless of the information available to the excluded trustee. An excluded trustee does not have an obligation to review, inquire, investigate, or make recommendations or evaluations with respect to the exercise of the power. A trustee having the power is liable to the beneficiaries as a fiduciary with respect to the exercise of the power as if the excluded trustees were not in office and has the exclusive obligation to account to and to defend an action brought by the beneficiaries with respect to the exercise or the power. In this subsection, “power” means the power to direct or prevent specified actions by other trustees. ALASKA STAT. §13.36.072 (amended in 2013, applicable to pre-existing or subsequent trusts).

Other states have not been as expansive in relieving a co-trustee for all responsibility with respect to duties allocated to another co-trustee. For example, the Florida statute is similar to the Alaska statute, but provides that the excluded trustee is has no liability for actions allocated to another co-trustee “except in cases of willful misconduct on the part of the excluded trustee.” FLA. STAT. §736.0703. Some of the state statutes, such as Texas statute, do not address bifurcated trustee powers.

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The Uniform Directed Trust Act makes reference to the possibility of having bifurcated powers of cotrustees by incorporating all of the provisions regarding trust directors. Section 12 provides that “[T]he terms of a trust may relieve a cotrustee from duty and liability with respect to another co-trustee’s exercise or nonexercise of a power of the other cotrustee to the same extent that in a directed trust a directed trustee is relieved from duty and liability with respect to a trust director’s power of direction under Section 9 through 11.” The Comment to Section 12 makes clear that a settlor can divide the responsibilities of cotustees: This section allows a settlor to choose either fiduciary regime for a cotrusteeship – the traditional rules of co-trusteeship or the more permissive rules of a directed trusteeship. There seems little reason to prohibit a settlor from applying the fiduciary rules of this act to a cotrusteeship given that the settlor could choose the more permissive rules of a directed trusteeship by labeling one of the cotrustees as a trust director and another as a directed trustee. The rationale for permitting the terms of a trust to reduce the duty of a cotrustee that is subject to direction by another trustee is the same as the rationale for permitting the terms of a trust to reduce the duty of a directed trustee. In both instances, a trustee must act according to the directions from another person and therefore the other person, not the trustee, should bear the full fiduciary responsibility for the action. 3. Trust Protectors. A “trust protector” may be given “grantor-like” powers that can be very limited or very broad to make changes regarding the trust such as the power to modify or amend the trust agreement, change beneficial interests, veto or direct distributions, modify powers of appointment, change the trust situs, change trustees or advisors, terminate the trust, or appoint successors. Offshore trusts have historically used trust protectors, leading to growing use in the U.S. In one respect, many trusts have “trust protectors” to the extent that they authorize specified persons to remove and replace trustees, among other possible actions. A variety of the state directed trust statutes have language broad enough to apply to trust protectors as well. E.g., 12 DEL. C. §3313(f) (“For purposes of this section, the term “advisor’ shall include a “protector”; a non-exclusive list of example powers includes removing and appointing fiduciaries, modifying or amending the instrument for tax or other efficiency reasons, or modifying powers of appointment). A few states have enacted statutes addressing the powers of trust protectors specifically including Alaska, Delaware, Idaho, Illinois, Nevada, New Hampshire, South Dakota, and Wyoming) that list example powers that trust protectors could hold. E.g., 760 ILL. COMP. STAT. §16.3(d) (non-exclusive list of 10 example powers that trust protectors could hold); NEV. REV. STAT. §163.5553 (non-exclusive list of 12 example powers that trust protectors could hold). So far, there is little case law regarding the powers, liabilities or duties of trust protectors. E.g., McLean v. Davis, SD28613 (Missouri Court of Appeals 2009); 418 S.W.3d 482 (2013). See generally Lawrence A. Frolik, Trust Protectors: Why They Have Become “the Next Big Thing,” 50 REAL PROP., TR. & EST. L.J. 267 (Fall 2015)); Kathleen Sherby, In Protectors We Trust: The Nature and Effective Use of “trust Protectors” as Third Party Decision Makers, 49TH HECKERLING INST. ON EST PL., ch. 15 (2015); Richard Ausness, The Role of Trust Protectors in American Trust Law, 45 REAL PROP., TR. & EST. L.J. 319 (2010). A potential concern with giving extremely broad “grantor-like” powers to trust protectors is that abuse of the power by continued grantor “control” may result in adverse treatment: [T]he IRS may attempt to attack a trust protector arrangement where it believes the appointment has been used to allow a settlor to retain power over trust property that would otherwise subject the assets to estate tax inclusion under IRC § 2036 or IRC § 2038. For this

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reason, it is important that a trust protector remain an independent actor and not subject to the control of a settlor. While flagrant actions may, as always, open the door to attack as a sham, the appointment of a trust protector by itself should not subject trust property to inclusion. Jonathan C. Lurie & William R. Burford, Drafting Flexible Irrevocable Trusts, 33 ACTEC L.J. 86, 91-92 (Summer 2007).

As an example, SEC v. Wyly, 2014 WL 4792229 (S.D.N.Y. Sept. 25, 2014) was a securities law violation case in which the court determined that the amount of disgorgement would be based in part on the income taxes that the defendants avoided by an offshore trust structure. Trust protectors had the power to remove and replace independent trustees located in the Isle of Man. The court determined that the settlors controlled all decisions for the trust, by expressing their “recommendations” to trust protectors who relayed those recommendations to the trustee, who always did as instructed. The court determined that the independent trustee exception to the grantor trust rules under §674(c) did not apply even though the trustees were various Isle of Man professional management companies because the settlors in fact controlled all decisions. There is a growing trend toward naming trust protectors with very broad powers, including the broad ability to amend trusts, change beneficial interests, veto or direct distributions, modify powers of appointment, change trustees, or terminate the trust—all in the name of providing flexibility to address changing circumstances, particularly for long-term trusts. The Wyly case points out how that could backfire if a pattern of “string-pulling” by the settlor occurs in practice with respect to the exercise of those very broad powers. Planners will not stop using trust protectors in the future because of Wyly but should be aware of potential tax risks that can arise if the broad trust protector powers are abused by overbearing settlors. H. Summary Personal Attributes Issues. One commentator has observed that the “most disrespected decision in estate planning” is the selection of who will serve as trustee and as successor trustees. Charles A. Redd, The Most Disrespected Decision in Estate Planning, Trusts & Estates 13-14 (July 2014). Mr. Redd suggests various characteristics that should be considered. “Does the individual under consideration as trustee possess sufficient expertise and the necessary experience to do the job? … Is the proposed trustee independent, or does the proposed trustee have an inherent conflict of interest? … Does the trustee have an appropriate fiduciary demeanor? Trustees often must make difficult choices….[A] conclusion may please one or more beneficiaries while causing distress to others. To be successful, a trustee must possess the judgment to make prudent assessments and have the resolve to make and defend decisions in the face of possibly aggressive opposition. Will the trustee being considered be around long enough to see the job through? … Where’s the proposed trustee located? … Will the trustee expect to be paid? The cost of trust administration is an important factor. However, trust administration is never free. … Is the trustee accountable? … If a corporate fiduciary is serving or if an individual trustee is bonded (which is exceedingly difficult to accomplish), the answer is ‘yes.’ Otherwise, depending on the amounts of the losses, the answer could easily be ‘no.’ Critical Element. Designating initial and successor trustees is among the most critical elements of the estate-planning process. It’s often not treated as such but should be. The best

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estate planners understand this reality and skillfully guide their clients through a thoughtful and deliberate trustee selection process.” Id. II. DONOR TAX ISSUES A. Gift Tax Issues. 1. Incomplete Gift—Structure Planning Based on Donor’s Intent. The transfer to a trust may or may not be a completed gift, based on the terms of the trust and the identity of the trustee. The trust terms and trustee selection must be planned after taking into consideration whether the donor wishes to make a complete gift for gift tax purposes. If there is a completed gift initially, there could be immediate gift tax due, based on the size of the gift. However, if the gift is not complete initially, the assets--including subsequent appreciation--will still be included in the donor’s estate under Sections 2036-2038 of the Code of 1986 (hereafter, references to “Sections” will be to sections of the Internal Revenue Code of 1986, as amended) for estate tax purposes until the gift has been completed. If the gift is “completed” sometime after the initial transfer, the gift tax will be calculated based on the value of the assets when the gift is subsequently completed. Section 2511 of the Code applies the gift tax to “direct or indirect” gifts of all kinds of property whether in trust or otherwise. The regulations add that a gift may be complete even if, at the time it is made, “the identity of the donee may not … be known or ascertainable.” Treas. Reg. § 25.2511-2(a). The regulations provide that various retained interests or powers by the donor will result in a transfer being an incomplete gift until the retained interest or power is relinquished. As a result, certain powers retained by the donor as a trustee, or in some situations as a co-trustee, will result in a transfer not being treated as a completed gift for gift tax purposes. 2. Retained Right to Receive Distributions. a. Overview. A transfer is a completed gift only to the extent that the donor “has so parted with dominion and control as to leave in him no power to change its disposition, whether for his own benefit or for the benefit of another.” Treas. Reg. § 25.2511-2(b). Regulation § 25.2511-2(c) states that a gift is incomplete to the extent that the donor reserves the power to revest the property in himself. This power can be indirect, such as through the power to force a trustee to make distributions to the donor under a trustee’s power to make distributions that is limited by a fixed or ascertainable standard, which is enforceable by or on behalf of the donor. (The regulation refers to Regulation § 25.25111(g)(2) to determine what are “fixed or ascertainable standards.”) Such a transfer “is incomplete to the extent of the ascertainable value of any rights thus retained by the grantor.” Treas. Reg. § 25.2511-2(b). One case that considered the ascertainable standard exception for this purpose is Gramm v. Comm’r, 17 T.C. 1063 (1951). The court held that the discretion to make principal distributions to the settlor for “comfort, education, maintenance or support” did not constitute an ascertainable standard; so there was no completed gift. The court held that the transfer was not a completed gift because “there was no limitation as to the amount which could be withdrawn by the corporate trustee for the comfort, etc. of the decedent.” (This analysis may seem contrary to the Regulation, which would suggest that there is a completed gift if there is not an ascertainable standard that the donor can enforce.)

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If a trustee who is not the donor has absolute discretion over distributions to the donor and if the donor’s creditors cannot reach the transferred property, the gift is complete. Holz Estate v. Comm’r, 38 T.C. 37, 42 (1962), acq. 1962-2 C.B. 4; Rev. Rul. 76-103, 1976-1 C.B. 293 (gift not complete where trust permitted discretionary distributions to grantor and, under the controlling state law, the grantor’s creditors could reach the entire trust property; gift would become complete if trustee moved situs of the trust to a state where the grantor’s creditors cannot reach the trust assets). Several cases have specifically addressed that an incomplete gift results if creditors of the settlor/beneficiary can reach the trust assets. Outwin v. Comm’r, 76 T.C. 153 (1981); Hambleton v. Comm’r, 60 T.C. 558 (1973); Paolozzi v. Comm’r, 23 T.C. 182 (1954), acq. 1962-1 C.B. 4; but see Herzog v. Comm’r, 116 F.2d 591 (2d Cir. 1941) (gift complete despite creditor’s ability to reach trust assets). The IRS has ruled privately that a gift to an “Alaska Trust” (which could not be reached by the donor’s creditors) was a completed gift even though the trustee could in its discretion make distributions to the donor. Ltr. Rul. 9837007. Letter Ruling 200944002, which also apparently involved an Alaska trust, recognized that transfers to the trust are completed gifts, even though the grantor is a discretionary beneficiary, because he cannot revest beneficial title or change the beneficiaries. If a person transfers assets to a “self-settled” trust in a jurisdiction that does not allow creditors to reach the trust assets merely because the settlor is a discretionary beneficiary, the person may wish to create a pool of assets as a protected nest egg in the remote event of a severe financial reversal, but the person may not want to make a completed gift subject to gift taxes. A classic strategy that has been used by some planners in that situation is to provide that the settlor has a testamentary limited power of appointment to shift assets among a listed group of appointees. (However, that strategy by itself will likely no longer be used after the issuance of ILM 201208026, discussed in Section II.A.3.a of this outline, until there is further clarification of the incomplete gift issue.) A private letter ruling has addressed a transfer under which the donor’s spouse had a testamentary power of appointment to appoint the trust property back to the donor. The ruling held that a transfer to an irrevocable trust for the donor’s spouse was a completed gift even though the spouse had a special testamentary power of appointment to appoint the assets to a trust for the benefit of the donor, and even though the IRS found that an implied agreement existed between the spouses that the donee spouse would in fact execute a codicil to her will appointing the trust assets to a trust for the benefit of the donor. Ltr. Rul. 9141027. (To be more conservative, the planner should avoid having any express or implied agreement regarding the exercise of the power of appointment in such circumstances to avoid incomplete gift treatment.) b. Summary of Selection of Trustee Issues as to Donor Retained Rights to Income In Order To Avoid Having Transfer Treated as Incomplete Gift. If any distributions may be made to or for the donor’s benefit, there must be an independent trustee making the distribution decision, and there cannot be an ascertainable standard that allows the donor to compel a distribution. Furthermore, the donor cannot be a co-trustee participating in such decisions unless the other co-trustee has a substantial adverse interest in the disposition of the transferred property. Treas. Reg. § 25.2511-2(e). Even if there is an independent trustee or a co-trustee with an adverse interest, the trust should be located in a jurisdiction that recognizes

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spendthrift protection for self-settled trusts to assure that the retained discretionary interest does not cause the transfer to be treated as an incomplete gift because of the ability of the donor’s creditors to reach the trust assets. (In addition, as discussed below, the donor can have no power to shift benefits from one beneficiary to another.) 3. Powers to Change Beneficial Interests. a. Powers to Change Beneficial Enjoyment That Cause Incomplete Gift. A transfer is generally incomplete to the extent that the donor retains the power to change the interests of the beneficiaries among themselves. Treas. Reg. § 25.2511-2(c); Sanford Estate v. Comm’r, 308 U.S. 239 (1939). The following are examples of retained powers, which if held by the donor alone or in conjunction with another trustee who does not have a substantial adverse interest, will cause a transfer to be incomplete (unless the ascertainable exception applies, as described immediately below): • • • • •

The power to shift benefits from one beneficiary to another, such as through a “sprinkling” power; The power to add one or more beneficiaries of the trust; The power to remove one or more beneficiaries of the trust; The power to distribute or accumulate income, thus affecting the amount passing to another person who is the remainder beneficiary. Treas. Reg. § 25.2511-2(c) A provision that is often used to avoid having a completed gift is for the donor to retain a testamentary limited power of appointment to appoint the assets among a designated group of potential appointees. However, using retained testamentary limited powers of appointment is not an absolute way to avoid having a transfer to a trust treated as a completed gift if the grantor is not the sole beneficiary of the trust. In ILM 201208026 (issued by the IRS general counsel office) individuals made a gift to a trust, which provided that the trustee (the grantor’s son) could make distributions to a variety of beneficiaries (including a charity) for “health, education, maintenance, support … or for any other purposes.” The trust lasts for the grantors’ lives (unless the trust is sooner terminated by reason of distributions of all of its assets). The grantors retained testamentary limited powers of appointment. The ILM concluded that the entire transfer was a completed gift despite the grantor’s retained testamentary limited power of appointment. The ILM stated that the retained testamentary powers of appointment do cause the remainder interest to be an incomplete gift, but reasoned that the testamentary powers of appointment relate only to the remainder interest. During the grantors’ lifetimes, they had no ability to keep the trustee from making distributions among the potential trust beneficiaries—which might potentially include all of the trust assets. Therefore, the ILM reasoned that the gift was complete as to the “beneficial term interest” that existed before the grantors’ deaths—but was an incomplete gift as to the remainder interest. Furthermore, the ILM reasoned that §2702 applied, and because the retained interest (i.e., the interest passing to “applicable family members”) was not a qualified interest, it had to be valued at zero under §2702. Therefore, the completed gift of the term interest was the full value transferred to the trust.

If the trustee has any of these powers either alone or in conjunction with a non-adverse party (and if the ascertainable standard exception does not apply), the trustee must be

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someone other than the donor, and the donor must not have the power to have himself or herself appointed as trustee. b. Ascertainable Standard Exception. The regulations clarify that a power to change beneficial interests will not cause a transfer to be incomplete for gift tax purposes if the power is held in a fiduciary capacity and is subject to a “fixed and ascertainable standard.” Treas. Reg. § 25.2511-2(c) & 25.2511-2(g). If there is a fixed and ascertainable standard, the beneficiaries would have legal rights to force distributions according to the standard, thus divesting the donor of dominion and control over the transferred property. The regulations cited above do not give examples of what constitutes an ascertainable standard, but an analogous regulation (addressing powers by a trustee who has a beneficial interest in trust property) does provide details, including the requirement that the standard be such that the trustee is “legally accountable” for exercise of the power. The analogous regulation states that a power to distribute for the “education, support, maintenance, or health of the beneficiary; for his reasonable support and comfort; to enable him to maintain his accustomed standard of living; or to meet an emergency, would be such a standard.” Treas. Reg. § 25.2511-1(g)(2). There have been only a few cases addressing the ascertainable standard exception in connection with whether retained powers to change beneficial interests preclude treating a transfer as a completed gift. See McHugh v. U.S., 142 F. Supp. 927, 929 (Ct. Cl. 1956) (“to provide properly for the essential needs—such as food clothing, shelter and illness expenses” constituted ascertainable standard; transfer subject to such standard was a completed gift); Pyle v. U.S., 766 F.2d 1141 (7th Cir. 1985), rev’g 581 F. Supp. 252 (“necessary for her health, support, comfort and maintenance requirements” constituted ascertainable standard, based on an Illinois Supreme Court case holding that the word “comfort” created an ascertainable standard; transfer subject to such standard was a completed gift). In light of the ascertainable standard exception, purely administrative powers retained by the donor should have no gift tax effect. See Dodge, 50-5th T.M., Transfers With Retained Interests and Powers 93 (2002); cf. Byrum v. Comm’r, 408 U.S. 125 (1972) (no estate tax effects under Section 2038 of administrative powers held in a fiduciary capacity). (The Byrum case is discussed in detail in section II.B.4.c. of this outline.) c. Power to Affect Time or Manner of Enjoyment, But Not to Shift Among Beneficiaries. A gift is not considered incomplete merely because the donor reserves the power to change the manner or time of enjoyment, but not to shift benefits among beneficiaries. Treas. Reg. § 25.2511-2(d). Therefore, a retained power by the donor as trustee to distribute or accumulate income will not preclude a completed gift as long as there is only one beneficiary of the trust and all assets must eventually be distributed to the beneficiary or his estate. d. Power Exercisable In Conjunction With Others. If the donor has the power to change beneficial interests only in conjunction with another person who has a “substantial adverse interest in the disposition of the transferred property or the income therefrom,” the transfer will still be treated as a completed gift. Treas. Reg. § 25.2511-2(e). The regulations do not define a substantial adverse interest, but presumably the doctrines related to adverse parties for income tax purposes (I.R.C. § 672(a)) and powers of appointment (I.R.C. § 2041(b)(1)(C) & 2514(c)(3)) will apply. The interest of a beneficiary who is adversely affected by the decision to distribute or accumulate must be

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substantial in relation to the whole. See Paxton v. Comm’r, 57 T.C. 627 (1972), aff’d, 520 F.2d 923 (9th Cir. 1975) (3.8% interest not substantial); Paxton v. Comm’r, T.C. Memo. 1982-464 (1982) (9.9% interest not substantial); Comm’r v. Prouty, 115 F.2d 331 (1st Cir. 1940) (discretion to distribute or accumulate income for beneficiary for life, with remainder passing to the beneficiary’s issue as appointed by beneficiary’s will; beneficiary not hold a substantial adverse interest). The consent of a person who would otherwise have a substantial adverse interest will not be sufficient to preclude completed gift treatment if there is an agreement in advance regarding the person’s consent to exercise of the power by the donor. Camp v. Comm’r, 195 F.2d 999 (1st Cir. 1952); Schwarzenbach v. Comm’r, 4 T.C. 179 (1945). e. Contingent Powers. A donor is not deemed to retain a power that arises only upon a future contingency, even if the likelihood of the contingency can be calculated actuarially. Lasker v. Comm’r, 1 T.C. 208 (1942); TAM 8546001; PLR 8727031. For example, the mere possibility that the donor may become a trustee in the future (but outside the control of the donor) will not result in the donor being treated as holding the powers of the trustee for purposes of determining whether the transfer is a completed gift. Goldstein v. Comm’r, 37 T.C. 897 (1962), acq., 1964-1 C.B. (Part 1) 4; Rev. Rul. 54537, 1954-2 C.B. 316 (contingency in donor’s control, by removing the trustee and appointing himself as successor). f.

Summary of Selection of Trustee Issues as to Retained Power to Change Beneficial Interests In Order To Avoid Having Transfer Treated as Incomplete Gift. This paragraph summarizes powers that the donor can have (or not have) and still make a completed gift. If the donor is the trustee, the trustee cannot have the discretion to shift benefits among beneficiaries, unless the discretion is limited by a “fixed or ascertainable standard.” If the donor is a co-trustee or must consent to discretionary distributions that may shift benefits among beneficiaries, the other person must have a substantial adverse interest with respect to the discretion over the disposition of the transferred property. In that circumstance, the third party cannot have an express or implicit agreement regarding consent to the donor’s exercise of the discretionary power. The donor may be a possible future trustee, as long as the donor cannot control his substitution as trustee (such as through a power to remove and appoint himself as successor trustee.) The donor may serve as trustee if the trustee’s only discretion is to accelerate or delay distributions to a single beneficiary, with no ability to shift benefits in any way to any other persons.

B. Estate Tax Issues. 1. Who is the “Grantor”? Sections 2036 and 2038 may estate inclusion where certain interests or powers are retained by the grantor of a trust. Therefore, determining who is the “grantor” for this purpose is important. Generally, the person who makes an actual transfer, for state law purposes, to the trust is considered a grantor for this purpose. Heasty v. U.S., 239 F. Supp. 345 (D. Kan. 1965), aff’d, 370 F.2d 525 (10th Cir. 1966). There are several exceptions, in which transfers made by others will be attributed to a grantor. See generally Stephens, Maxfield, Lind & Calfree, Federal Estate & Gift Tax’n ¶ 4.08[7] (2001); Dodge, Transfers with Retained Interests and Powers, 50-5th T.M.. at 112-138 (2002).

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a. Reciprocal Trust Doctrine. If A creates a trust for B, and B creates a trust for A, and if the trusts have substantially identical terms and are “interrelated”, the trusts will be “uncrossed,” and each person will be treated as the grantor of the trust for his or her own benefit. United States v. Grace, 395 U.S. 316 (1969). In Grace, the trust terms were identical, the trusts were created at about the same time, and the trusts were of equal value. The Court reasoned: Nor do we think it necessary to prove the existence of a tax-avoidance motive. As we have said above, standards of this sort, which rely on subjective factors, are rarely workable under the federal estate tax laws. Rather, we hold that application of the reciprocal trust doctrine requires only that the trusts be interrelated, and that the arrangement, to the extent of mutual value, leaves the settlors in approximately the same economic position as they would have been in had they created trusts naming themselves as life beneficiaries. (emphasis added) Id.

If the terms of the two trusts are not substantially identical, the reciprocal trust doctrine does not apply. Estate of Levy v. Comm’r, 46 T.C.M. 910 (1983) (one trust gave broad inter vivos special power of appointment and other trust did not; IRS conceded that if the special lifetime power of appointment was valid under local New Jersey law the reciprocal trust doctrine could not apply; see detailed discussion of case based on conversations with counsel in the case by Mark Merric, The Doctrine of Reciprocal Trusts, LISI Archive #1282, April 24, 2008); Letter Ruling 200426008 (citation to and apparent acceptance of Estate of Levy; factual differences between the trusts included (a) power to withdraw specified amounts after one son’s death, and (b) several powers of appointment, effective at specified times, to appoint trust principal among an identified class of beneficiaries); but see Estate of Green v. United States, 68 F.3d 151 (6th Cir. 1995)(Jones, J. dissenting)(identity of beneficiaries is not a prerequisite to application of reciprocal trust doctrine; retained mutual powers to control timing of distributions should be sufficient to invoke the doctrine). If trusts of unequal value are reciprocal, the values to be included in either grantor’s estate under the reciprocal trust doctrine cannot exceed the value of the smallest trust. Estate of Cole v. Comm’r, 140 F.2d 636 (8th Cir. 1944). Possible distinctions that could be built into the trusts include: • Create the trusts at different times (separated by months, not 15 days as in Grace) • Fund the trusts with different assets and different values (observe that Grace holds that just having different assets is not sufficient to avoid the doctrine, but it applies only to the extent of mutual value, Estate of Cole v. Comm’r, 140 F.2d 636 (8th Cir. 1944)) • One trust allows distributions without any standard but the other trust imposes a HEMS standard • One trust might require considering the beneficiary-spouse’s outside resources and the other would not • One of the settlors would become a discretionary beneficiary only after the lapse of some specified time (say, 5 years) or on the occurrence of some event (for example, Letter Ruling 200426008 addresses trusts under which (i) husband would not become a beneficiary of wife’s trust until three years after wife’s death and then only if the husband’s net worth did not exceed a specified amount and his income from personal services was less than a specified amount, and (ii) wife had a “5 or 5” withdrawal power from husband’s trust after their son’s death) • One trust includes the “other settlor” as a discretionary beneficiary but the other trust would merely give an independent party (not exercisable as a fiduciary), perhaps after

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• • • •

• •

the passage of some specified time, the authority to add the “first settlor” as a discretionary beneficiary One trust allows conversion to a 5% unitrust but the other trust prohibits that Different termination dates and events Inter vivos power of appointment in one trust and not the other (like Levy) Different testamentary powers of appointment (maybe one trust has one and the other does not or perhaps there are different classes of permitted appointees or perhaps in one trust the power is exercisable only with the consent of a non-adverse party) Different trustees Different removal powers (one allows the grantor to remove and comply with Rev. Rul. 95-58 but the other puts removal powers in the hands of some third party).

There may be an advantage to making the primary beneficiary the Settlors’ grandchildren, and having the settlors include each other only as secondary beneficiaries. In any event the differences need to be “real.” Additionally, the structure of the trusts is only part of the equation, and probably not the most important part. How the trusts are administered after they are created may be the most critical factor. Clients may want to make gifts to the trusts and then immediately start flowing cash out of the trusts to each other the same as they did before the trusts were created. If that is done, the IRS would likely argue the existence of a pre-arranged plan that the income or other benefits would come right back to the grantor, even if only indirectly through the spouse. For a discussion of the reciprocal trust doctrine generally see M. Merric, The Doctrine of Reciprocal Trusts, LEIMBERG ASSET PROTECTION PLANNING NEWSLETTER (2008)(five- part article); P. Van Horn, Revisting the Reciprocal Trust Doctrine, 30 TAX MGMT. EST. GIFTS & TR. J. 224 (2005); G. Slade, The Evolution of the Reciprocal Trust Doctrine Since Grace and Its Current Application in Estate Planning, 17 TAX MGMT. EST. GIFTS & TR. J. 71 (1992). For an extended discussion of the reciprocal trust doctrine in the context of spouses creating lifetime QTIP trusts for each other, see M. Gans, J. Blattmachr & D. Zeydel, Supercharged Credit Shelter Trust, 21 PROB. & PROP. 52, 57-60 (July/August 2007). The Grace case involved reciprocal interests rather than powers. Subsequent cases have differed as to whether the reciprocal trust doctrine also applies to powers that would cause estate inclusion under section 2036(a)(2) or 2038. Estate of Bischoff v. Comm’r, 69 T.C. 32 (1977) (reciprocal trust doctrine applied to section 2036(a)(2) and 2038 powers); Exchange Bank & Trust Co. of Florida v. U.S., 694 F.2d 1261 (Fed. Cir. 1984); Ltr. Rul. 9235025 (where beneficiaries of two trusts can appoint property to each other, unrestricted by an ascertainable standard, the trusts would be uncrossed, and each beneficiary would be considered to have a general power of appointment over the trust of which he is a beneficiary, citing Matter of Spear, Jr., 553 N.Y.S.2d 985 (Sur. Ct. 1990), in which the court adopted the reciprocal trust theory to find that trust beneficiaries had general power of appointments to qualify for the “Gallo exemption” that was available for GST purposes prior to 1990); Ltr. Rul. 9451059 (the settlors’ two daughters had a power to appoint the trust property to any descendant of the settlor other than herself, including the other daughter; while noting the potential application of the reciprocal trust theory, the IRS concluded that the particular factual situation did not justify its application); Tech. Adv. Memo. 8019041 (applied doctrine to trusts created by two brothers naming each other as trustee with broad distribution powers); but see Estate of

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Green v. Comm’r, 68 F.3d 151 (6th Cir. 1995) (reciprocal trust doctrine did not apply to powers). b. Indirect Transfers. Various indirect transfers may be attributed to a grantor. For example, if A transfers cash to B, with the understanding that B will transfer property to a trust for A’s benefit, A is treated as the grantor of the trust even though he never owned the property that was transferred to the trust. Estate of Shafer v. Comm’r, 749 F.2d 1216 (6th Cir. 1984). See Brown v. U.S., 329 F.3d 664 (9th Cir. 2003)(husband made gift to wife; wife made gift to trust; husband died within three years; applied step transaction doctrine to determine that husband was the “real donor” so that §2035 applied to gift tax on transfer within three years of death). As another example, if a husband owes funds to his wife from a prior loan, but pays the funds into a trust for the wife instead of repaying her, the wife will be treated as the grantor of the trust. Estate of Marshall v. Comm’r, 51 T.C. 696 (1969), nonacq. 1969-2 C.B. xxvi. Cf. Treas. Reg. 25.2511-1(h)(2,3,9) (examples of indirect transfers for gift purposes). See also Estate of Kanter v. Comm’r, 337 F.3d 833 (7th Cir. 2003) (son was treated for income tax purposes as grantor of trusts purportedly established by his mother where son funded trusts). 2. Retained Beneficial Interest in Donor. a. Statutory Provision--Section 2036(a)(1). The gross estate includes the value of all property to the extent the decedent: •

Has made a transfer other than a bona fide sale for a full and adequate consideration;

•

Under which he has “retained” the possession or enjoyment of, or the right to the income from the property;

•

For his life or for any period not ascertainable without reference to his death (example: income quarterly for life but income in the quarter of his death will not be paid) or for any period which does not in fact end before his death (example: retain income for five years and donor dies within that five year period).

b. Only Donative Transfers Are Subject to Section 2036. Transfers for full and adequate consideration are not subject to Section 2036. If one donor creates a trust and another person sells assets to that trust for full and adequate consideration, the person who sold assets to the trust will not be subject to section 2036, regardless who serves as trustee of the trust. In Pierre v. Commissioner, T.C. Memo 2010-106, the court determined (1) that the step transaction doctrine applies to aggregate the gifts and sales made to each trust on the same day within moments of each other (50% combined interest transferred to each trust) for valuation purposes (although this determination had the negligible effect of merely reducing the lack of control discount from 10% to 8%). A possible risk of this type of reasoning is that the IRS might argue that the entire transaction of a gift to create a trust and a subs sequent sale to that trust should be collapsed into a single transaction for §2036 purposes. If so, the IRS might argue that the combined transfer is treated as a transfer for less than full and adequate consideration with a retained interest (i.e., the note payments), so that the sale portion of the transaction no longer qualifies for the “bona fide sale for full consideration” exceptions to §2035 and §2036. That is a huge step from what the court did in Pierre, and perhaps the IRS will never even make that argument let

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alone find a court receptive to it. Query whether the risk is reduced if the initial gift is not the same asset that is being sold; it may be harder to collapse those separate transactions involving separate assets (perhaps unless the gift asset is used as downpayment for the sale transaction). However, the downside risk is so great that it makes sense to take steps to avoid the argument, to the extent possible, by delaying the sale transaction for some “appropriate” period of time after the gift. c. Types of Retained Interests That Cause Estate Inclusion. (1) Right to Use of Property or Income. A direction that the donor has the right to actual use of trust property or trust income clearly comes within the meaning of the statute, regardless of who is serving as trustee. If there is a retained right to receive only a portion of the income, only that corresponding part of the trust is included in the estate. Treas. Reg. § 2036-1(a)(last paragraph). (a) Implied Understanding. The statute also applies if there is an implied understanding that the settlor will be allowed to use or receive income from the transferred property. The implied agreement may be “an understanding, express or implied, that the interest or right would later be conferred.” Treas. Reg. § 20.20361(c)(1). For example, section 2036 was applied on the basis of an implied agreement where the trustee merely had the discretion to make distributions to the settlor and others, but in fact distributed all of the income to the settlor for his lifetime. Estate of Skinner v. U.S., 316 F.2d 517 (3d Cir. 1973) See generally Estate of Paxton v. Comm’r, 86 T.C. 785 (1986) (donor transferred almost all assets to trust). The latest battleground for this IRS attack is with family limited partnerships, particularly where the donor continues to receive disproportionate distributions whenever the donor (or the donor’s estate) needs cash. E.g., Estate of Moore v. Comm’r, T.C. Memo. 2020-40 (implicit understanding existed that the decedent “would continue to use his assets as he desired and that his relationship with them changed formally, not practically”); Estate of Liljestrand v. Comm’r, T.C. Memo. 2011-259 (“The existence of an implied agreement is a question of fact that can be inferred from the circumstances surrounding a transfer of property and the subsequent use of the transferred property”); Estate of Strangi v. Comm’r, T.C. Memo. 2003-145 (“Circumstances that have been found probative of an implicitly retained interest under section 2036(a)(1) include transfer of the majority of the decedent’s assets, continued occupation of transferred property, commingling of personal and entity assets, disproportionate distributions, use of entity funds for personal expenses, and testamentary characteristics of the arrangement”), aff’d, 96 AFTR2d 2005-5230 (5th Cir. 2005); Kimbell v. U.S., 91 AFTR 2d 2003-585 (N.D. Tex. 2003) (“the circumstances surrounding the establishment of the partnerships show that, at the time of the transfer, there was an implied agreement or understanding that decedent would retain the enjoyment and economic benefit of the property he had transferred”), rev’d 371 F.3d 257 (5th Cir. 2004) (reversed based on full consideration exception to §2036; §2036(a)(1) not addressed directly); Estate of Thompson v. Comm’r, T.C. Memo. 2002-246 (“implied agreement or understanding that decedent would retain the enjoyment and economic benefit of the property he had transferred”), aff’d 382 F.3d 367 (3rd Cir. 2004). The IRS has made the implied understanding argument in a multitude of cases, with varying results. See generally Dodge, Transfers with Retained Interests and Powers, 50-

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5th T.M. at 160-169 (2002); Stephens, Maxfield, Lind & Calfree, Federal Estate And Gift Taxation, ¶4.08[4][c] (2001).

(b) Continued Use of Residence. Estate inclusion under Section 2036 has been argued in many cases involving continued use of a transferred residence by the donor. The cases have generally tended to require more than just continued possession of a residence in order to find that an agreement existed at the time of the transfer. See Stephens, Maxfield, Lind & Calfree, Federal Estate And Gift Taxation, ¶4.08[4][c] (2001). In fact, the IRS concedes that continued cooccupancy for interspousal transfers will not of itself support an inference or understanding as to retained possession or enjoyment by the donor. E.g., Estate of Gutchess v. Comm’r , 46 T.C. 554 (1966) (reviewed), acq. , 1967-1 C.B. 2; Rev. Rul. 78-409, 1978-2 C.B. 234; Rev. Rul. 70-155, 1970-1 C.B. 189; Ltr. Rul. 200240020; see Lischer, Retained Beneficial Interests (Sections 2036(a)(1) and 2037), 877-1st T.M. at D.3.(a)(1). However, the IRS is not as lenient where the residence is given to family members other than the spouse. See, e.g., Estate of Maxwell v. Comm’r, 3 F.3d 591 (2d Cir.1993); Estate of Trotter v. Comm’r, T.C. Memo. 2001-250; Estate of Adler v. Comm’r, T.C. Memo. 2011-28; Tech. Adv. Memo. 200532049. Where only a fractional interest in a property is transferred, the donor may retain proportionate use of the property consistent with the retained ownership. Estate of Wineman v. Comm’r, T.C. Memo. 2000-193 (2000). Co-tenants are each entitled to nonexclusive possession rights, so can the donor continue to live in the residence because of his or her retained undivided co-tenancy interest? Stewart v. Comm’r, 617 F.3d 148 (2d Cir. 2010) involved a situation where mother and son both co-occupied a residence. Mother made transfers of an undivided interest in the residence to the son and they both continued living there. The court (over a strong dissent) stated that “co-occupancy of residential premises by the related donor and donee is highly probative of the absence of an implied agreement.” The court suggested a test for residential premises, providing that if there is both “continued exclusive possession by the donor and the withholding of possession from the donee,” §2036(a)(1) will apply. The court suggested strongly that §2036(a)(1) would not apply if there is continued occupancy by both owners. In Estate of Tehan, T.C. Memo 2005-128, the IRS included the value of the decedent’s condominium ($275,000) in his gross estate under §2036 even though he had transferred the condo to his children in a series of three fractional gifts during three years prior to his death. The decedent had an agreement that as long as he owned any interest in the home, he would pay all of the expenses in return for the exclusive rights to use and occupy the property. However, that arrangement was continued for the two months after the decedent had transferred his entire interest up to his death. The IRS argued that the following facts proved the existence of a retained interest: The decedent retained possession of the condo, paid all expenses (even as the children’s percentage ownership increased to 35%, then 72%, then to 100%), did not pay any rent, and at trial it was established that the children would not have evicted him even if he had not paid expenses. (c) Payment of Rent by Donor. If the donor retains use of the transferred property under a lease agreement that provides for fair rent, it is not clear whether Section

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2036 applies. See generally Lischer, Retained Beneficial Interests (Sections 2036(a)(1) and 2037), 877-1st T.M. at D.3.(a)(2); Stephens, Maxfield, Lind & Calfree, Federal Estate And Gift Taxation, ¶4.08[6][c] (2001); John Bogdanski, Renting Mom Her House: Retained Interests and Estate of Riese, 38 EST. PL. 45 (2011). Applying the statute is problematic, because the statute only applies to transfers for less than full and adequate consideration, and the donor would be paying full consideration for the right to use the property. It is ironic that paying rental payments would even further deplete the donor’s estate. However, the trend of the cases is not to apply section 2036 where adequate rental is paid for the use of the property. E.g., Estate of Barlow v. Comm’r, 55 T.C. 666 (1971) (no inclusion under §2036 even though decedent stopped paying rent after two years because of medical problems); Estate of Giselman v. Comm’r, T.C. Memo 1988-391; Estate of Riese v. Comm’r, T.C. Memo. 2011-60 (following termination of qualified personal residence trust initial term the donor continued to live in the residence for six months until she died unexpectedly without paying rent or excuting a written lease, but court found that an agreement existed for the decedent to pay fair market rent; residence not included in estate) . The IRS has ruled privately in several different rulings that the donor of a qualified personal residence trust may retain the right in the initial transfer to lease the property for fair rental value at the end of the QPRT term without causing estate inclusion following the end of the QPRT term under Section 2036. E.g., Ltr. Rul. 199931028. However, the IRS does not concede that renting property for a fair rental value always avoids application of Section 2036. See Tech. Adv. Memo. 9146002 (Barlow distinguished). Most of the cases that have ruled in favor of the IRS have involved situations where the rental that was paid was not adequate. E.g., Estate of Maxwell v. Comm’r, 3 F.3d 591 (2d Cir.1993) (rent payment cancelled out interest payment on note when decedent sold residence to her son and his wife and estate did not pay rent following decedent’s death); Estate of Du Pont v. Comm’r, 63 T.C. 746 (1975). The Tax Court rejected the Barlow approach in a case where the decedent did not pay fair rental value. In Disbrow v. Comm’r, T.C. Memo 2006-34, the decedent transferred her residence to a partnership comprised of herself and family members for no consideration. (She subsequently gave her 28% interest in the partnership to the other partners.) There was an agreement that decedent would continue to live in the residence, and there was a formal lease agreement. However, the court determined that the decedent did not pay fair rental value to the partnership for the residence. While the presence of a lease may sometimes lead to a finding of a lack of retention for purposes of section 2036(a)(1), see, e.g., Estate of Barlow v. Commissioner, 55 T.C. 666 (1971) (possession and enjoyment of real property pursuant to a lease was not a retention of the possession or enjoyment of the property for purposes of section 2036(a) where the tenant paid FRV), such is not true where, as here, the tenant pays less than FRV as to the lease of the property. Decedent's rights under the lease agreements to the exclusive possession and enjoyment of the residence triggers the application of section 2036(a)(1) to the residence in that decedent did not pay FRV for that possession and enjoyment.

The court also concluded that the annual lease agreements were a subterfuge to disguise the testamentary nature of the transfer for various reasons. (1) The partnership was not a business but was a testamentary device whose goal was to

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remove the residence from the decedent’s estate. (2) The decedent’s relationship to the residence was not treated by either the decedent or the partnership as that of a tenant to leased property (payments were frequently late, the partnership never sent late notices or accelerated payments, rent was set at an amount under fair rental value that was considered necessary to maintain the residence). (3) The residence transfer occurred when decedent was almost 72 years old and in poor health, and after decedent’s death the partnership never sought to rent the residence but sold the residence to a family member for less than full market value. (4) The donees wanted decedent to continue to reside in the residence as long as she wanted. (5) Decedent transferred the residence to the partnership on advice of counsel to minimize estate taxes. The court rejected the estate’s contention that the rent was fair rental value because she shared the residence with others. The court reasoned that there was no credible evidence that anyone other than the decedent could use the residence without her consent. (2) Payment of Grantor’s Debts. The grantor is treated as having retained the “use, possession, right to income, or other enjoyment” of property to the extent that such interest is to directed to be applied toward the discharge of legal obligations of the decedent (regardless who is the trustee). Treas. Reg. § 2036-1(b)(2); Hooper v. Comm’r, 41 B.T.A. 114 (1940). (3) Support of Dependents. If the trust directs the trustee to make payments in support of the grantor’s dependents, Section 2036(a)(1) applies. Treas. Reg. § 2036-1(b)(2). However, if the trust merely directs the payment of income to a person whom the donor is obligated to support, Section 2036(a)(1) does not apply if the grantor’s support obligation would continue, because the income distribution in that situation would not benefit the grantor. See Colonial-American Nat’l Bank v. U.S., 243 F.2d 3112 (4th Cir. 1957). For example, the IRS has ruled that a trust requirement that required the trustee to consider the beneficiary’s other resources would avoid Section 2036(a)(1) if the other resources included the support obligation of the grantor. Ltr. Rul 8504011. Similarly, if a trust requires that all income be distributed to a grantor’s dependent, but states that the beneficiary “should” use the income for his maintenance and support, Section 2036(a)(1) is not triggered unless local law provides that receipt of the income by the beneficiary discharges the donor’s legal support obligation. Wishard r. U.S., 143 F.2d 704 (7th Cir. 1944). Even if a trust provides for distributions in support of the grantor’s dependent, once the grantor no longer has the obligation to support the trust beneficiary (such as when the dependent reaches the age of majority), Section 2036 would cease to apply. The retained right would not have continued for a period that does not in fact end before the grantor’s death. Estate of Pardee v. Comm’r, 49 T.C. 140 (1967). d. Settlor as Totally Discretionary Beneficiary. Two different phrases/words in the statute suggest that naming the grantor as a beneficiary in the trustee’s discretion might not trigger Section 2036. First, the statute refers to the grantor keeping a “right to” income. Second, the statute requires that the grantor “retain” the income interest. As to the first argument, the legislative history indicates that the substitution of the phrase “right to the income” in 1932 was meant to broaden, not restrict the reach of Section 2036(a)(1) and to extend it to cases where the grantor had the right to income but did not actually receive it. See Dodge, Transfers with Retained Interests and Powers, 50-5th T.M. at 56 (2002) (now superseded). The second argument does lend a credible argument that a totally

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discretionary interest might not be subject to Section 2036(a)(1). Professor Lischer lists four exceptions to the “general rule that a discretionary trust for the settlor’s benefit is not included under §2036(a))(1).” Lischer, Retained Beneficial Interests (Sections 2036(a)(1) and 2037), 877-1st T.M. at D.3.(b)(3)(b). Those four exceptions are: •

Where there was an agreement or understanding that the transferor would receive the income. Such an agreement may sometimes be inferred from the fact that the transferor in fact received (all of) the income. (See section II.B.2.c.(1)(a) of this outline, above.)

•

Where, under the law of creditor’s rights, the settlor’s creditors can reach the trust income to pay the transferor’s debt. (See Section II.B.2.d.(1) of this outline, immediately below.)

•

Where the settlor is herself trustee of such a discretionary trust. (See Section II.B.2.f. of this outline, below.)

•

Where the trustee’s discretion is limited by a standard that can be enforced by the settlor-beneficiary. See Blunt v. Kelly, 131 F.2d 632 (3d. Cir. 1941) (“support, care or benefit”); Estate of John J. Toeller, 165 F.2d 665 (7th Cir.1946) (“misfortune or sickness”); Estate of Boardman v. Comm’r, 20 T.C. 871 (1953), acq. 1954-1 C.B. 3 (trust provided distributions for grantor “as the trustee deems necessary for her comfort, support and/or happiness”; held that these standards—especially “happiness”—gave grantor an enforceable right to demand income distributions and caused inclusion under Section 2036).

(1) Includible if Settlor’s Creditors Can Reach Trust Assets. If the donor’s creditors can reach the trust assets, because of the potential discretion to distribute assets to the donor, Section 2036(a)(1) would apply. UNIF. TRUST CODE §505 (2000) (settlor’s creditors can reach whatever “can be distributed to or for the settlor’s benefit”); RESTATEMENT (THIRD) OF TRUSTS § 60, Comment f (if settlor is discretionary beneficiary, creditors can reach maximum amount the trustee, in the proper exercise of fiduciary discretion, could pay to or apply for the benefit of the settlor”); Rev. Rul. 77-378, 1977-2 C.B. 347 (gift complete, even though trust assets were distributable to settlor in trustee’s complete discretion, where donor’s creditors could not reach trust assets); Rev. Rul. 76-103, 1976-1 C.B. 293 (gift incomplete, where trust assets were distributable to settlor in trustee’s complete discretion and where donor’s creditor could reach trust assets; also trust assets included in donor’s estate under § 2038 because of donor’s control to terminate the trust by relegating the grantor’s creditors to the entire trust property); Estate of Uhl v. Comm’r, 241 F.2d 867 (7th Cir. 1957)(donor to receive $100 per month and also to receive additional payments in discretion of trustee; only trust assets needed to produce $100 per month included in estate under §2036(a)(1) and not excess because of creditors’ lack of rights over other trust assets under Indiana law); Outwin v. Comm’r, 76 T.C. 153 (1981) (trustee could make distributions to settlor in its absolute and uncontrolled discretion, but only with consent of settlor’s spouse; gift incomplete because settlor’s creditors could reach trust assets, and dictum that grantor’s ability to secure the economic benefit of the trust assets by borrowing and relegating creditors to those assets for repayment may well trigger inclusion of the property in the creditor’s gross estate under Sections 2036(a)(1) or 2038(a)(1)); Estate of German v. U.S., 7 Cl. Ct. 641 (1985) (denied

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IRS’s motion for summary judgment, apparently based on §2036(a)(1), because settlor’s creditors could not reach trust assets where trustee could distribute assets to grantor in trustee’s uncontrolled discretion, but only with the consent of the remainder beneficiary of the trust and a committee of nonbeneficiaries). (2) “DAPT Trusts”. Some states (Alaska was the first) have amended their trust and creditor laws to provide that creditors cannot reach trust assets merely because the trustee may, in its discretion, make distributions to the settlor, if certain procedural requirements are satisfied. At least nineteen states have adopted varying approaches regarding “self-settled spendthrift trusts” (the two newest states are Indiana and Connecticut): Alaska, Connecticut, Delaware, Hawaii, Indiana, Michigan, Mississippi, Missouri, Nevada, New Hampshire, Ohio, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia, West Virginia and Wyoming. Those 19 states cover over 20% of the United States population. These self-settled spendthrift trusts are sometimes referred to “domestic asset protection trusts” or “DAPT trusts.” For an excellent summary of the 19 DAPT statutes, see David Shaftel, Twelfth ACTEC Comparison of the Domestic Asset Protection Trust Statutes (updated through August 2019)(available at http://www.shaftellaw.com/dave.html). See section I.D of this outline. Self-settled trusts, with the grantor as a discretionary beneficiary, can be used to overcome the concern of some clients that they will run out of money. Establish the trust in one of the DAPT states so that creditors do not have access to the trust can help in avoiding §2036 (discussed below). It is not clear that a person living in another state, who creates a trust governed by the laws of one of those states, would necessarily be exempted from creditors claims in the state of domicile. The settlor’s state of domicile may refuse to recognize the asset protection features of the trust on public policy grounds. The state of the settlor’s residence may assert that public policy prevents using an asset protection trust in another state. See Huber v. Huber, 2013 WL 21454218 (Bkrtcy. W.D. Wash. May 17, 2013) (under §290 of the Restatement (Second) of Conflict of Laws (1971), the choice of law designated in the trust is upheld if it has a substantial relation to the trust considering factors such as the state of the settlor’s or trustee’s domicile, the location of the trust assets, and the location of the beneficiaries; held that Washington State has a strong public policy against self-settled asset protection trusts and that the trust instrument’s designation of Alaska law is disregarded under the principles of §270 of the Restatement); In re Herbert M. Zukerhorn, BAP No. NC-11-1506, U.S. Bankruptcy Appellate Panel of the Ninth Circuit (Dec. 19, 2012)(dictum). The position that the self-settled trust will not be included in the gross estate of the grantor may be the strongest for self-settled trusts created in Alaska and Nevada. In all of the other self-settled trusts states, some creditors can reach the trust assets (for example, for certain family obligations such as for alimony or child support), and that may jeopardize the “no inclusion” argument. See Rothschild, Blattmachr, Gans & Blattmachr, IRS Rules Self-Settled Alaska Trust Will Not Be In Grantor’s Estate, 37 EST. PL. 3, 11-12 (Jan. 2010). (3) Section 2036 Concerns. Creating the trust under the laws of a self-settled trust state can help alleviate concerns that §2036 may apply to the trust. Furthermore, the trust could be structured to include only the settlor’s spouse as beneficiary as long as the settlor is married — so that the settlor is not even a direct beneficiary as long as he or

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she is married. The potential §2036 concern could be further ameliorated by giving someone the power to remove the settlor as a beneficiary, and that power could be exercised when the settlor is near death. Whether a retained enjoyment exists under §2036 is tested at the moment of death, and §2035 should not apply because the settlor has nothing to do with removing himself or herself as beneficiary (as long as no prearrangement exists). See Tech. Adv. Memo. 199935003 (§2035 will apply if pre-planned arrangement). A §2036 concern may arise if the settlor ever needs distributions from the trust and distributions are made to the settlor. That might give rise to at least an argument by the IRS of a pre-arrangement or implied agreement that distributions would be made when requested. Of course, if the settlor gets to the point of needing distributions from the trust, estate tax concerns may be the least of the settlor’s worries. Another possible strategy is for the trust to specify that an independent trust protector could add the grantor as a beneficiary, but only if the grantor’s net worth became less than a specified amount. Private Letter Ruling 200944002 addressed an Alaska trust and recognized that the “trustee’s authority to distribute income and/or principal to Grantor, does not, by itself, cause the Trust corpus to be includible in Grantor’s gross estate under §2036” as long as state laws provide that including the grantor as a discretionary beneficiary does not cause the trust to be subject to claims of the grantor’s creditors. However, the ruling expressly declined to give an unqualified ruling and noted that the discretionary authority to make distributions to the grantor “combined with other facts (such as, but not limited to an understanding or pre-existing arrangement between Grantor and trustee regarding the exercise of this discretion) may cause inclusion of Trust’s assets in Grantor’s gross estate for federal estate tax purposes under §2036.” Although this is only a private letter ruling that cannot be relied on by other taxpayers, it is comforting that PLR 200944002 relied on a published ruling. Revenue Ruling 2004-64, 2004-2 C.B. 7 holds that a discretionary power of a trustee to reimburse a grantor for paying income taxes attributable to a grantor trust, whether or not exercised, would not cause inclusion in the gross estate under §2036. However, Revenue Ruling 2004-64 observes (in Situation 3 of that ruling) that giving the trustee the discretion to reimburse the grantor for income taxes attributable to the grantor trust may risk estate inclusion if an understanding or pre-existing arrangement existed between the trustee and the grantor regarding reimbursement, or if the grantor could remove the trustee and appoint himself as successor trustee, or if such discretion permitted the grantor’s creditors to reach the trust under applicable state law. For a general discussion of Letter Ruling 200944002, see Shaftel, IRS Letter Ruling Approves Estate Tax Planning Using Domestic Asset Protection Trusts, 112 J. TAX’N 213 (April 2010); Rothschild, Blattmachr, Gans & Blattmachr, IRS Rules Self-Settled Alaska Trust Will Not Be in Grantor’s Estate, 37 EST. PL. 3 (Jan. 2010). Beginning in late 2011, the IRS has told other parties requesting similar rulings that it is not willing to issue further similar rulings. According to counsel, the Service’s unwillingness to rule is not attributable to family exceptions or other differences under the laws of other states. Rather, the Service appears to be troubled by commentary about the Mortensen Alaska bankruptcy case. Battley v. Mortensen, Adv. D.Alaska, No. A0990036-DMD (2011) allowed the bankruptcy trustee to recover assets transferred to an Alaska “self-settled trust” under the 10-year “clawback” provisions of §548(e) of the Bankruptcy Act. The agents at the Service said that PLR 200944002 probably wouldn’t

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have been issued if they were looking at it currently and that the Service since has declined other Alaska ruling requests. Choosing the laws of a “self-settled trust state” as the governing law for the trust provides no absolute protection if the settlor does not reside in that state or unless the trust otherwise has significant contacts with that state. Letter Ruling 200944002 does not address the result if the grantor is not a resident of Alaska. Many commentators view the analysis as applying even if the grantor does not reside in the state in which the trust is created. See Letter Rulings 9332006 (U.S. grantors created self settled spendthrift trusts under the laws of a foreign country and IRS held no estate inclusion) & 8037116; Estate of German v. United States, 7 Ct. Cl. 341 (1985) (Maryland trust created by Florida grantor). However, several bankruptcy cases (discussed in Section II.B.2.d.(2) in this outline above) have denied a discharge to grantors of a foreign situs self-settled spendthrift trust apparently because the law of the grantor’s domicile did not permit such trusts. (4) Potential Incomplete Gift Issue. Some planners have expressed concern that the IRS might take the position that the gift is an incomplete gift, because of the possibility (perhaps, however remote) that creditors might be able to reach the assets. E.g., Outwin v. Comm’r, 76 T.C. 153, 162-65 (1981)(gift to trust incomplete if creditors can reach trust assets); Herzog v. Comm’r, 116 F.2d 591 (2d Cir. 1941)(gift to trust is completed gift if state law provides that settlor-beneficiary’s creditors could not reach the trust corpus or income). Private Letter Ruling 200944002 recognized that transfers to a trust (apparently under Alaska law) were completed gifts, even though the grantor was a discretionary beneficiary, because he could not re-vest beneficial title or change the beneficiaries. The Illinois Supreme Court recently held that a decedent’s creditors could reach assets that had been transferred to a Cook Islands trust. Rush University Medical Center v. Sessions, 2012 Ill. 112906 (2012). That case involved an egregious fact situation in which an individual transferred almost all of his assets to a Cook Islands trust of which the settlor was a discretionary beneficiary, knowing that he had made a large charitable pledge and that his remaining assets would not be sufficient for his estate to satisfy the pledge. The court did not address which jurisdiction’s law should apply under relevant conflict of laws principles, but held that the state’s passage of a fraudulent conveyance statute did not supersede Illinois common law principles allowing the creditors of a settlor to reach trust assets to the extent that the trust assets could be distributed to the settlor. In Rush University, the Cook Islands trust owned real estate in Illinois that had sufficient value to satisfy the judgment, so apparently there was no issue about having to enforce the judgment in the Cook Islands. That case has caused concern among some planners about whether transfers to domestic asset protection trusts might arguably be incomplete gifts if the settlor resides and has assets in another jurisdiction that does not have “self-settled trust” legislation. (5) Grantor Trust Under Section 674(a). Income tax effects of trustee selection are covered in a later section of this outline. However, be aware that if the grantor is a potential beneficiary, the trust will be a grantor trust, unless the consent of an adverse party is required before a distribution may be made to the grantor. I.R.C. §674(a). The mere possibility that income may distributed in satisfaction of the grantor’s legal obligation of support does not cause grantor trust treatment—the income is taxed to the grantor only to the extent that income is actually distributed in satisfaction of the grantor’s support obligation (other than to the grantor’s spouse.) I.R.C. § 674(b).

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e. Transfer to Spouse With a Potential of Having Spouse Appoint the Assets Back to Grantor. A popular way of using the increased gift exemption may be for a settlor to make gifts to a “lifetime credit shelter trust” for the benefit of the settlor’s spouse (and possibly children). This is often referred to as a “spousal lifetime access trust,” or “SLAT.” The trust could be designed to give as much control and flexibility as possible to the surviving spouse without creating tax or creditor concerns. The trust could still be used for the “marital unit” if the client has concerns that large gifts may unduly impoverish the settlor and his or her spouse, but the assets would not be included in the gross estates of the settlor or the settlor’s spouse. Such a trust would likely be a grantor trust as to the grantor under §677 (unless the consent of an adverse party were required for distributions to the spouse). For a general discussion of planning considerations in structuring the terms of a SLAT, see Item 78.a of Akers, ACTEC 2020 Annual Meeting Musings (March 2020) available at https://www.bessemertrust.com/insights/actec-2020annual-meeting-musings. If the grantor gives property in trust for his spouse (or anyone else), and gives the beneficiary of the trust an inter vivos or testamentary power of appointment to appoint the trust assets to anyone, including the grantor (but not to the beneficiary, his estate, his creditors, or the creditors of his estate), does the grantor have to include the assets in his estate under Section 2036(a)(1) because of the possibility of receiving the assets back from the trust? (The gift effects of this transfer will also be addressed in light of the unique nature of this type of transfer.) (1) Completed Gift for Gift Tax Purposes. Despite the fact that the property may eventually be returned to the donor, the transfer is a completed gift, because the donor has so parted with dominion and control as to leave him in no power to change its disposition whether for his own benefit or for the benefit of another. Reg. § 25.2511-2(b). Also, the donor has retained no power to revest beneficial title to the property in himself, which also makes a gift incomplete. Reg. § 25.2511-2(c). Letter Ruling 9141027 held that a transfer to an irrevocable trust for the donor’s spouse was a completed gift even though the spouse had a special testamentary power of appointment to appoint the assets to a trust for the benefit of the donor, and even though the IRS found that an implied agreement existed between the spouses that the donee spouse would in fact execute a codicil to her will appointing the trust assets to a trust for the benefit of the donor. However, to assure that the initial transfer is treated as a completed gift, there should be no express or implied agreement regarding the exercise of the power of appointment. Furthermore, if a creditor of the donor could reach the trust assets, the gift would be incomplete. Until the power of appointment is exercised appointing some interest in the property to the creditor, a creditor arguably would have no rights in the trust property. However, if the spouse holds an inter vivos power of appointment and if the donor’s creditor is also a creditor of the spouse, underlying state law may afford creditors rights to the property, since the spouse would have the current power to appoint the property in a manner that would satisfy the donor’s and spouse’s creditors. To avoid this argument, the spouse should not hold an inter vivos power of appointment, or at least should be restricted from the appointing the property in a manner that would have the effect of satisfying the spouse’s creditors.

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(2) Application of Section 2702. If the gift is complete, does §2702 apply in valuing the gift? Section 2702 should not apply, because the spouse will not have held an interest in the transferred property, both before and after the transfer. Ltr. Rul. 9141027. (3) Inclusion in Spouse’s Estate. Whether the trust is included in the spouse’s estate depends on whether, under traditional planning principles, the spouse has a power over the trust that is taxable under Section 2041. Two letter rulings in 1991 addressed situations in which the donee-spouse had a power of appointment to appoint the trust property back to the donor. In Letter Ruling 9140068, the transfer was to an inter vivos QTIP trust, and the trust assets were includible in the donee spouse’s estate under Section 2044. In Letter Ruling 9141027, the transfer was to a trust that was not included in the spouse’s estate. Letter Ruling 9128005 involved an outright transfer from husband to wife, where the wife, on the same day as the gift, executed a codicil leaving the property back to a trust for the husband if she predeceased him. The property was obviously included in her gross estate. (4) Inclusion in Donor’s Estate. The main issue is whether the trust assets are included in the donor’s gross estate, (1) if the donor predeceases the spouse, or (2) if the spouse predeceases and in fact appoints the trust property to a trust for the benefit of the donor. Section 2036(a)(1) includes in a decedent’s gross estate the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer by trust or otherwise, under which the decedent has retained for the decedent’s life or for any period which does not in fact end before the decedent’s death the possession or enjoyment of, or the right to the income from the property. Has the donor retained an interest in the trust, if the spouse must later exercise the power to leave the assets back to the donor? Regulation § 20.2036-1(c)(1) provides that an interest or a right is treated as being retained or reserved if at the time of the transfer there was an understanding, express or implied, that the interest or right would later be conferred. The regulations address such a contingency with respect to Sections 2038 and 2036(a)(2), dealing with powers that the donor could regain upon the occurrence of contingencies, but does not address the effect of such a contingency under Section 2036(a)(1), which is the relevant section. Reg. § 20.2038-1(a)(3) & 1(b), § 20.20361(b)(3). See Section II.B.2.e.(4) of this outline regarding those regulations. This issue is receiving increased attention by planners. The IRS might argue that §2036 could apply in the donor spouse’s estate if it could establish an implied agreement that the donee-spouse would leave the donated assets back into a trust for the benefit of the donor spouse. This is analogous to situations in which one spouse makes a gift to the other spouse, and the other spouse bequeaths the property back into a trust for the benefit of the original donor spouse. See Estate of Skifter v. Comm’r., 56 T.C. 1190, at 1200 n.5 (19172), aff’d 468 F.2d 699, 703 (2d Cir. 1972)(life insurance policy transferred to wife and bequeathed back to trust for husband with husband as trustee at wife’s death not includible in husband’s estate under §2042, reasoning that §§2036 and 2038 would not have applied if an asset other than a life insurance policy had been the subject of the transfer; Tax Court and circuit court both emphasized that if the transfer and bequest were part of a

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prearranged plan, estate inclusion would have resulted, noting that the bequest back to the husband was made “long after he had divested himself of all interest in the policies”); Estate of Sinclaire v. Comm’r, 13 T.C. 742 (1949)(predecessor to §2036 and 2038 applied where decedent gave assets to her father, who transferred the assets the following day to a trust providing decedent with a life interest and power to appoint the remainder interests); Rev. Rul. 84-179, 1984-2 C.B. 195 (§2036 did not apply because decedent’s transfer to the donee and the bequest back to the decedent in trust were unrelated and not part of a prearranged plan); Gen. Couns. Mem. 38,751 (June 12, 1981) (indication that step transaction doctrine will be applied if the decedent’s transfer and the donee’s bequest for the benefit of the decedent were part of a prearranged plan, and in particular that cases where the donee’s transfer occurs shortly after the decedent’s initial transfer would invoke the doctrine); see generally Gans, Blattmachr & Bramwell, Estate Tax Exemption Portability: What Should the IRS Do? And What Should Planners Do in the Interim?, 42 REAL PROP., PROB. & TR. J. 413, 432-33 (2007). To the extent possible, structure the transfer to remove the inferences of such an implied agreement (by allowing the passage of time, not transferring all assets, having the donee-spouse actually exercise a power of appointment rather than just allowing assets to pass back into trust for donor under trust default provisions, etc.). There is a specific exception in the QTIP regulations providing that the §2036/2038 issue does not apply for gifts to an inter vivos QTIP trust, where the assets are left back into a bypass trust for the benefit of the donor spouse. Reg. §§25.2523(f)1(d)(1) & 25.2523(f)-1(f) Exs. 10-11. However, those examples would not apply because the rationale in them is that there will be estate inclusion in the doneespouse’s estate under §2044. Summary of Potential Application of §2036. The issue is whether the entire transaction and appointment back was pursuant to an implied understanding that these series of transactions would occur. Prof. Jeffrey Pennell’s conclusion: “I think, frankly, it would be difficult for the government to make that case, but of course you could leave a trail of documents — a smoking gun — that could allow the government to say this was all part of a prearrangement, and that conceivably could get you into §2036.” However, the creditors right issue may raise potential inclusion issues under §2036. Various other possible restrictions would help bolster the argument that the spouse’s power of appointment would not cause an estate inclusion problem for the donor. The actual exercise of the power, or even more conservatively, the manner in which the power of appointment could be exercised in favor of the donor-spouse, could be limited in the following possible ways. The appointment for the donor could be limited to payments for the health, support and maintenance of the donor. (Observe, however, that there are no cases suggesting an ascertainable standard exception for Section 2036(a)(1) like there are for Sections 2036(a)(2) and 2038.) Additionally, the permissible trust could require that distributions could be made to the grantor only after other income and assets of the donor had been exhausted, so that A’s creditors could not reach the property. See Covey, Current Developments, 1992 UNIV. OF MIAMI PHILIP E. HECKERLING INST. ON EST. PL. ¶ 115.8. If case law subsequently becomes clear that the mere existence of the power causes estate inclusion problems for the original donor, the donee-spouse could release the

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power of appointment, but the release would have to occur more than 3 years before the donor’s death under section 2035. Summary of Potential Application of §2038. Section 2038 can apply to an ability to alter, amend, revoke, or terminate that exists in the trust at the death of the decedent — it did not have to be retained at the outset. So in exercising the non-general power of appointment, the donee spouse must be careful not to give the donor spouse anything that would rise to the level of a right to alter, amend, revoke, or terminate. For example, the donor could not have a testamentary power of appointment by reason of the exercise. In addition, if creditors can reach the assets in a trust to which assets have been appointed by the donee-spouse under the reasoning of the relation back doctrine (discussed below), that could create a §2038 problem, even if there was no implied agreement of how the donee-spouse would exercise the power of appointment at the time of the original transfer. Although various cases that have held that assets in a trust that can be reached by the donor’s creditors are in the donor’s gross estate under §2036 [e.g., Estate of Paxton v. Comm’r, 86 T.C. 785 (1986)], some cases have also suggested that inclusion may also result under §2038. E.g., Outwin v. Comm’r, 76 T.C. 153 (1981) (trustee could make distributions to grantor in its absolute and uncontrolled discretion, but only with consent of grantor’s spouse; gift incomplete because grantor’s creditors could reach trust assets, and dictum that grantor’s ability to secure the economic benefit of the trust assets by borrowing and relegating creditors to those assets for repayment may well trigger inclusion of the property in the grantor’s gross estate under §§2036(a)(1) or 2038(a)(1)). Creditor Rights Issue. A totally separate issue is that, despite the tax rules, for state law purposes the donor to the lifetime credit shelter trust may be treated as the donor of the continuing trust for his or her benefit after the death of the donee-spouse. Therefore, for state law purposes, there is some possibility that the trust may be treated as a “self-settled trust” and subject to claims of the donor’s creditors. This would seem to turn on what has been called the “relation back doctrine.” The creditor under the Relation Back Doctrine could argue: (i) the exercise of a special power of appointment constitutes a transfer “from the donor of the power, not from the donee,” Restatement (First) of Property §318 comment (b) (1940)); and (ii) the power of appointment is “conceived to be merely an authority to the power holder to do an act for the creator of the power,” American Law Institute, Donative Transfers vol. 2 §§ 11.1-24.4, in Restatement (Second) of Property 4 (1986)]. However, “none of the reported cases regarding the Relation Back Doctrine address its application to the donor of a QTIP or credit shelter trust who receives trust assets upon the death of the donee spouse through the exercise of a special power of appointment ….” Barry Nelson, Asset Protection & Estate Planning – Why Not Have Both?, at 15-11 2012 Univ. Miami Heckerling Inst. on Est. Planning ch. 17, ¶ 1701.2[B] (2012). After discussing the relation back doctrine in this context, one commentator concludes, “Thus, it is not clear that a court would actually hold that it was a transfer from the donor to a trust for his own benefit through a power holder’s discretionary exercise of a power of appointment, but it is a risk.” Alexander Bove, Using the Power of Appointment to Protect Assets – More Power Than You Ever Imagined, 36 ACTEC L.J. 333, 337 (2010). See also Watterson v. Edgerly, 40 Md. App. 230, 388 A.2d 934 (1978)(husband gave assets to wife and next day wife signed will leaving assets to

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trust for husband; held that the trust was protected from husband’s creditors under the trust spendthrift clause). Nineteen states are domestic asset protection trust (DAPT) states, (Alaska, Connecticut, Delaware, Hawaii, Indiana, Michigan, Mississippi, Missouri, Nevada, New Hampshire, Ohio, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia, West Virginia, and Wyoming). See section I.D of this outline above. The creditor issue is not a problem in those states because a settlor’s creditors cannot reach assets in a properly structured “self-settled” trust that may be distributed to the settlor under a discretionary standard. In addition, at least eighteen states have statutes that address this situation in the context of initial transfers to an inter vivos QTIP trust, as opposed to transfers to a lifetime credit shelter trust. Those states are Arizona, Delaware, Florida, Georgia, Kentucky, Maryland, Michigan, New Hampshire, North Carolina, Ohio, Oregon, South Carolina, Tennessee, Texas, Virginia, Wisconsin, and Wyoming. The Arizona, Maryland, Michigan, Ohio, and Texas statutes also address the issue for all inter vivos trusts initially created for the settlor’s spouse (including the lifetime credit shelter trust strategy discussed in this subparagraph) where the assets end up in a trust for the original settlor-spouse. E.g., ARIZ. REV. STAT. §14-10505(E-F); OHIO REV. CODE §5805.06(B)(3)(a); TEX. PROP. CODE §§112.035(d)(2) (settlor becomes beneficiary under exercise of power of appointment by a third party), 112.035(g)(1) (marital trust after death of settlor’s spouse), 112.035(g)(2) (any irrevocable trust after death of settlor’s spouse), 112.035(g)(3) (reciprocal trusts for spouses). For a discussion of this issue and citations to these statutes, see David Shaftel, Twelfth ACTEC Comparison of the Domestic Asset Protection Trust Statutes, (August 2019) )(available at http://www.shaftellaw.com/dave.html). See also Richard Franklin, Lifetime QTIPs – Why They Should be Ubiquitous in Estate Planning, 50TH ANN. HECKERLING INST. ON EST. PL., at ¶II.J (2017). Gross Estate Inclusion Because of Creditor Rights? If the donor’s creditors can reach the trust assets, that would cause inclusion in the donor’s estate for estate tax purposes under §2036 if the IRS could establish the existence of an implied agreement that the spouse would exercise the limited power of appointment to appoint the assets into a trust for the donor’s benefit, which creates the creditor’s rights problem. However, at least one case (Outwin v. Comm’r, 76 T.C. 153 (1981)) also states that §2038 could apply if the donor’s creditors can reach the trust assets, and §2038 does not require an implied agreement of a retained interest at the time the gift is originally made, but only looks to conditions that exist at the donor’s death. Accordingly, it may be important to exercise the limited power of appointment to establish a new trust in a “self-settled trust state” or a state that has passed a law similar to the Arizona, Maryland, Michigan, Ohio and Texas statutes discussed above. However, even using a “self-settled trust state” for the new trust provides no absolute protection; the donor’s state of domicile may refuse to recognize the asset protection features of the new trust on public policy grounds. The state of the donor’s residence may assert that public policy prevents using an asset protection trust in another state. See Huber v. Huber, 2013 WL 21454218 (Bkrtcy. W.D. Wash. May 17, 2013) (under §290 of the Restatement (Second) of Conflict of Laws (1971), the choice of law designated in the trust is upheld if it has a substantial relation to the trust considering factors such as the state of the settlor’s or trustee’s domicile, the location of the trust assets, and the location of the beneficiaries; held that Washington

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State has a strong public policy against self-settled asset protection trusts and that the trust instrument’s designation of Alaska law is disregarded under the principles of §270 of the Restatement); In re Herbert M. Zukerhorn, BAP No. NC-11-1506, U.S. Bankruptcy Appellate Panel of the Ninth Circuit (Dec. 19, 2012)(dictum). To avoid §2038 inclusion if the settlor’s creditors can reach the trust assets, having an ascertainable standard may satisfy the “definite external standard” exception that has been recognized by the IRS (Rev. Rul. 73-143, 1973-1 C.B. 407) and various courts for avoiding §2038. E.g., Jennings v. Smith, 161 F.2d 74 (2d Cir. 1947); Estate of Ford v. Commissioner, 53 T.C. 114 (1969), nonacq. 1978-2 C.B. 3, aff’d per curiam, 450 F.2d 878 (2d Cir. 1971); Estate of Wier v. Commissioner, 17 T.C. 409 (1951), acq. 1952-1 C.B. 4 (addressing predecessor of §2036(a)(2) and §2038; “the education, maintenance and support” and “in the manner appropriate to her station in life”). Another possible defense is that there are precious few cases applying this relation back doctrine in the creditor situation, so maybe the potential creditor issue is not a problem at all under the relation-back doctrine. A planning alternative to minimize the risk of estate inclusion for the donor spouse is for the original donee spouse to appoint the assets to a trust that merely gives a party the power to add the settlor as a discretionary beneficiary or perhaps that gives a third party a power to appoint assets to the settlor. The potential creditor issue will never arise if the settlor is never added as a discretionary beneficiary, and the settlor may never need to be a potential discretionary beneficiary of the trust assets. If the rainy day arises and there really is a need, it may well be that estate tax problems are the least of the settlor’s concerns at that point. (5) Summary. Giving the donee-spouse a testamentary power of appointment to appoint the assets back to the donor or to a trust for the benefit of the donor should not create inclusion problems for the donor as long as there is no express or implied agreement that the spouse would exercise the power of appointment for the donor. Do not have the spouse sign a new will exercising the power of appointment for some period of time. Make sure that the spouses understand that there really is no preconceived plan of whether the power of appointment will be exercised, but that it is just included to provide helpful flexibility. Other restrictions, discussed above, could be added would help bolster a non-inclusion argument. f.

Effect of Trustee Selection on Retained Right to Income. (1) Grantor as Trustee. If the grantor is the trustee with the power to make distributions of income to the grantor, to make payments in satisfaction of the grantor’s obligations, or in satisfaction of the grantor’s support obligations, Section 2036(a)(1) applies. That is the case even if there are no directions to make distributions for the “support” of the grantor’s dependents but merely the discretion to make distributions to dependents. See Helfrich Estate v. Comm’r, 143 F.2d 43 (7th Cir. 1944); Ltr. Rul 9122005. The same rule applies if the decedent reserved the power to name himself as the trustee. Estate of McTighe v. Comm’r, 36 T.C.M. 1655 (1977) (estate inclusion under Section 2036 where decedent reserved the power to substitute

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himself as trustee and the trustee retained the right to apply the trust income to satisfy his obligation to support the beneficiary). What if the grantor can name himself as trustee only if an event outside his control occurs (for example, when a vacancy occurs)? That would clearly still cause inclusion if the issue is a power to control enjoyment of the property under Section 2036(a)(2), but the answer is not totally clear if the issue is whether there is a retained beneficial interest under Section 2036(a)(1). There is a regulation to Section 2036(a)(2) making clear that the contingent power to become trustee is problematic (Treas. Reg. § 20.2036-1(b)(3)), but there is no similar statement in the regulation to Section 2036(a)(1). The primary issue is the retention issue—has the grantor retained the right when he has no control over whether it arises—and that issue should be the same for subsections (a)(1) and (a)(2) of Section 2036. See Estate of Farrell v. U.S., 553 F.2d 637 (Ct. Cl. 1977) (analysis of situation involving Section 2036(a)(2), but analysis repeatedly referred just to Section 2036(a), without making a distinction for (a)(1) and (a)(2)). (2) Third Party as Trustee—General Rule. As discussed above, if the trust directs that income be distributed to the grantor, be applied to discharge the grantor’s debts, or to provide for the support of the grantor’s dependents, Section 2036(a)(1) is triggered, regardless of who is serving as trustee. However, if the trust instrument gives the trustee discretion in making such distributions, Section 2036(a)(1) may be avoided if there is a third-party trustee. (3) Third Party as Trustee—Discretion to Make Payments for Support of Grantor’s Dependents. If the trust instrument directs distributions under standards (such as “comfort” or “welfare”) other than support or maintenance of the dependent, Section 2036(a)(1) is not triggered if there is a third party trustee. Rev. Rul 77-60, 1977-1 C.B. 282. For example, in Gokey v. Comm’r, 72 T.C. 721 (1979), a trust for the donor’s child’s “support, care, welfare, and education” was held to be included in the estate under Section 2036(a)(1), under the reasoning that under local law, the last three terms referred to the child’s accustomed standard of living, and merely restated the concept of support. Furthermore, if payments for support are left up to the trustee’s discretion, Section 2036(a)(1) should not apply, because no one can compel the distributions and the grantor has therefore not “retained” the right to the distributions. Commissioner v. Douglas, 143 F.2d 961 (3d Cir. 1944); Chrysler Estate v. Comm’r, 44 T.C. 55 (1965), acq. in result, 1970-2 C.B. xix, rev’d on other issues, 361 F.2d 508 (2d Cir. 1966). Even a close relative as trustee can have the discretion to make distributions for support of the grantor’s dependents without triggering Section 2036(a)(1). Mitchell Estate v. Comm’r, 55 T.C. 576 (1970), acq., 1971-1 C.B. 2. However, the trustee’s discretion must extend to whether distributions for support should be made at all, and not merely as to when or how much should be distributed. See Richards v. Comm’r, 375 F.2d 997 (10th Cir. 1967) (distributions for settlor’s wife’s support and maintenance “at such times as the trustee in its sole discretion shall determine”; assets includible under Section 2036); Ltr. Rul. 8504011. (4) Third Party as Trustee—Discretion to Make Income Distributions to Grantor. If there are enforceable standards, which the grantor could enforce to require income distributions, Section 2036 applies even if there is an independent trustee. Even if the trustee has total discretion to make distributions to the grantor, the trust assets

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will still be includible under Section 2036 if the grantor’s creditors can reach the trust assets under applicable state law. If the trust is established in a manner that the grantor’s creditors cannot reach the trust assets (i.e., it is created in one of the “DAPT states,” discussed in Section II.B.2.d.(2) of this outline above, AND if the state of the grantor’s domicile will recognize such spendthrift protection as to creditors’ claims arising in the state of domicile), Section 2036(a)(1) probably will not apply to the trust. See Section II.B.2.d.(2-3) of this outline. However, even in that case, the IRS may, in a last ditch effort, argue for estate inclusion in extreme cases where the third party is controlled by the grantor’s domination, or where there is an implied agreement or understanding. (5) Nature of Relationship of Third Party Trustee to Grantor. Merely having a close relationship with a third party does not necessarily cause estate inclusion. The courts have generally rejected the IRS’s “de facto control” argument, but the Wyly case may have resurrected de facto control concerns. See section II.B.3.f of this outline regarding powers held by third party trustees. See section II.B.2.c.(1)(a) of this outline regarding an implied agreement or understanding with a third party. g. Summary of Trustee Selection Issues With Respect to Retained Beneficial Interests in Donor. The grantor cannot serve as trustee if there is any possible retained beneficial interest in the donor, or else the trust will be included in the donor’s estate. Similarly, if the donor has any possible beneficial interest, the donor cannot have the power to name himself as successor trustee (even if he could become a successor trustee only if a contingency occurs that is outside his control.) As to support of dependents, if a third party trustee serves, the trust could authorize distributions to dependents of the donor as long as there is not a standard for distribution tied to support or maintenance of the donor’s dependents. (The more conservative approach is to always prohibit any distributions from a trust that would satisfy the donor’s legal obligation of support, regardless of who is the trustee.) If there is any possibility for distributing assets to the donor at some point in the future, there must be a third party trustee to have any hope of excluding the trust assets from the donor’s estate. Even then, the trust must give the trustee complete discretion in making distributions to the grantor, the trust must be established in a jurisdiction that allows “self-settled trusts,” and the jurisdiction of the donor’s domicile must recognize the spendthrift protection of the self-settled trust. A few older cases questioned whether a trustee who has a close relationship to the donor, and who always follows the donor’s directions, can avoid estate inclusion problems under Section 2036(a)(1). However, most cases have refused to apply a “de facto” control analysis. Regardless of who is the trustee, there must be no agreement or understanding with the trustee regarding how the trust assets will be distributed. 3. Retained Dispositive Powers in Donor. a. Statutory Provision--Section 2036(a)(2). The gross estate includes the value of all property to the extent the decedent:

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•

Has made a transfer other than a bona fide sale for a full and adequate consideration,

•

Under which he has “retained” the right either alone or in conjunction with any person

•

To designate the persons who shall possess or enjoy the property or the income from the property

•

For his life or for any period ascertainable without reference to his death or for any period which does not in fact end before his death.

b. Statutory Provision—Section 2038. The gross estate includes the value of all property to the extent the decedent: •

Has made a transfer other than a bona fide sale for a full and adequate consideration

•

Under which the decedent had at the date of his death (regardless of when or from what source the decedent acquired a power)

•

The power (in whatever capacity exercisable), either by the decedent alone or in conjunction with any person

•

To alter, amend, revoke, or terminate enjoyment of the property,

•

Or where such power is relinquished during the 3-year period ending on the date of his death.

c. Dispositive Powers that Trigger Application. (1) Sprinkling Power. The power to shift income or trust property among beneficiaries causes inclusion under either Section. Estate of McManus v. Comm’r, 172 F.2d 697 (6th Cir. 1949) (predecessor to Section 2036(a)(2)); Estate of Craft v. Comm’r, 608 F.2d 240 (5th Cir. 1980) (Section 2038 inclusion where decedent had power to change beneficiaries and change their respective shares). A power to add beneficiaries would cause inclusion. But see Rev. Rul. 80-255, 1980-2 C.B. 272 (decedent’s ability to have more children and add beneficiaries is not a power to change beneficial interests under Section 2038). A power exercisable to change the beneficiaries only in the decedent’s will causes inclusion. Adriance v. Higgins, 113 F.2d 1013 (2d Cir. 1940) (predecessor to Section 2038); Marshall v. U.S. 338 F. Supp 1321 (D. Md. 1971). (2) Power to Accumulate. The power to affect only the timing of distributions, and not the beneficiaries who receive distributions, clearly triggers inclusion under Section 2038. Lober v. U.S., 346 U.S. 335 (1953); Estate of Alexander v. Comm’r, 81 T.C. 767 (1983) (retained power to accumulate income for distribution every five years caused inclusion, even though all income eventually had to be distributed to the income beneficiary). The regulations under Section 2038 state explicitly that “Section 2038 is applicable to any power affecting the time or manner of enjoyment of property or its income, even though the identity of the beneficiary is not affected.” Treas. Reg. § 20.2038-1(a). The regulation illustrates this with an example where

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grantor has the power to accumulate income or distribute it to A and to distribute corpus to A, even though the remainder is vested in A or his estate. (In the example described in the regulation, it appears that only the value of the remainder interest would be includible under Section 2038, and not the value of the income interest. The grantor would not have the power to change when A receives the income. He would have to wait until the income is earned in any event before he could receive it. See Dodge, Transfers with Retained Interests and Powers, 50-5th T.M. at 100 (2002).) A power to accumulate or distribute income causes inclusion under Section 2036(a)(2) where the income beneficiary is different from the remainder beneficiary, because accumulating income may shift the recipient from the income beneficiary to the remainderman. U.S. v. O’Malley, 383 U.S. 627 (1966), rev’g 340 F.2d 930 (7th Cir. 1964). (The briefs in O’Malley indicate that the trust lasted for a term of years. At termination, the trust assets would pass to the income beneficiary if living but if not, to a third party. See R. Stephens, G. Maxfield, S. Lind, & Calfree, Federal Estate and Gift Taxation ¶ 4.08[5][c] n. 54 (6th ed. 1991). If the income beneficiary and the remaindermen are the same (if the assets pass to the income beneficiary’s estate or if the income beneficiary holds a general power of appointment), neither the statutory language of Section 2036(a)(2) nor the regulations address whether Section 2036(a)(2) applies. An argument can be made that Section 2036(a)(2) should not apply because a power “to designate the persons who shall possess or enjoy” connotes some ability to choose among multiple “persons.” The Tax Court has observed that “[w]hile this position is not without a certain superficial appeal, as well as some support from commentators, we conclude that the weight of logic and judicial precedent is to the contrary.” Estate of Alexander, 81 T.C. 757 (1983), aff’d in unpub. Op. (4th Cir. 1985). The case cited the following commentators as supporting the opposite result. R. Stephens, G. Maxfield, & S. Lind, Federal Estate and Gift Taxation, ¶4.08[5][c] (5th ed. 1983); C. Lowndes, R. Kramer & J. McCord, Federal Estate and Gift Taxes, § 9.20 (3d ed. 1974). Cases have held that Section 2036(a)(2) applies even in the single vested beneficiary situation. Struthers v. Kelm, 218 F.2d 810 (8th Cir. 1955) (sole income beneficiary was remainder beneficiary at trust termination; trust contained no provision as to disposition if beneficiary predeceased trust termination; court determined that under state law the beneficiary’s interest was vested and that the trust assets would pass to the beneficiary or to the beneficiary’s devisees; predecessor to §2036(a)(2) applied); Ritter v. U.S., 297 F. Supp. 1259 (S.D. W. Va. 1968) (single income beneficiary/remainderman; trust assets pass to beneficiary at age 21 or if die before age 21, “to persons appointed by the beneficiary in his will or if there was no will, to the legal representative of the estate of the beneficiary;” held that § 2036(a)(2) applies, relying primarily on O’Malley, which said that the power to deny beneficiaries the “privilege of immediate enjoyment and conditioning their eventual enjoyment upon termination of the trust” is sufficient to invoke § 2036(a)(2)); Estate of Alexander, 81 T.C. 757 (1983), aff’d in unpub. Op. (4th Cir. 1985)(§2036(a)(2) applied where grantor as trustee could accumulate income for sole beneficiary where the beneficiary or her estate was the sole remainder beneficiary); Estate of O’Connor v. Comm’r, 54 T.C. 969 (1970) (child was sole beneficiary and remainderman was child or child’s estate; §2036(a)(2) applied to power to accumulate funds). Cf. Joy v. U.S., 404 F.2d 419 (6th Cir. 1968) aff’g 272 F. Supp. 544 (E.D. Mich. 1967) (trust instrument includes contingent remainder if income beneficiary predeceases trust termination). Despite these cases, some commentators continue to believe that Section 2036(a)(2) should not apply to a mere power to accumulate without a power to shift benefits from one

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person to another. E.g., R. Stephens, G. Maxfield, S. Lind & Calfree, Federal Estate and Gift Taxation ¶4.08[5][c](6th ed. 1991). (3) Power to Invade Corpus. A power to invade corpus is a power to alter enjoyment under Section 2038. Estate of Yawkey v. Comm’r, 12 T.C. 1164 (1949). The power to terminate a trust by acceleration of the corpus distribution causes inclusion under Section 2038. Lober v. U.S., 346 U.S. 335 (1953); Estate of O’Connor v. Comm’r, 54 T.C. 969 (1970). Similarly, under Section 2036(a)(2), an unlimited power to invade corpus for the income beneficiary or other beneficiary is subject to Section 2036(a)(2). See Commissioner v. Holmes, 326 U.S. 480 (1946). (4) Power to Revoke. Unlike most states, Texas law provides that every trust is revocable unless it explicitly states that it is irrevocable. TEX. PROP. CODE §112.051. Accordingly, a trust established under Texas law must explicitly state that it is irrevocable, or else the trust assets will be included in the estate under Section 2038. Estate of Hill v. Comm’r, 64 T.C. 867 (1975), acq. 1976-2 C.B. 2; Tech Adv. Memo. 9032002. d. Similarities In Application of Sections 2036(a)(2) and 2038. (1) Triggering Powers. As discussed in the preceding section, the powers that trigger the two sections are very similar, with a great deal of overlap. (2) Joint Powers. Even though the decedent holds the power jointly with another person, inclusion results under both sections. Unlike the treatment of powers of beneficiaries under Section 2041, or the gift tax treatment of powers held by grantors, whether the person who holds the joint power has an adverse interest is irrelevant under Sections 2036(a)(2) and 2038. E.g., Treas Reg. §20.2036-1(b)(3) (“whether the power was exercisable alone or only in conjunction with another person or persons, whether or not having an adverse interest”). (3) Joint Power Holder Can Override Grantor’s Decision. Even if the joint power holders can override the grantor’s decision (such as where a majority vote controls), both Sections still apply. See Estate of Yawkey v. Comm’r, 12 T.C. 1164 (1949). (4) Veto Power. Whether the grantor can act with the consent of another, or whether another person can act with the consent of the grantor makes no difference. Even if the grantor is not the trustee, but merely holds a veto power over actions of the trustee, both Sections would apply if the veto power affects a decision that triggers the Sections. See Rev. Rul. 70-513, 1970-2 C.B. 194 (only the value of the remainder interest is includible in decedent's gross estate where the enjoyment of the son's life estate was not subject to change through exercise of decedent's reserved power to consent to or veto the trustees' power to terminate the trust ); Rev. Rul. 55683, 1955-2 C.B. 603 (predecessor to Section 2038 applied where grantor’s wife could modify or revoke the trust only with the consent of the grantor). The court in Estate of Carrie Grossman v. Commissioner, 27 T.C. 707 (1957), noted that “it is irrelevant whether the decedent's participation initiates the termination, or, as here, is in the nature of a consent after others have set the machinery in motion, it being sufficient under the statute merely that she act 'in conjunction' with the others * * *,” citing Thorp's Estate v. Commissioner, 164 F.2d 966 (1947), cert. denied 333 U.S. 843; and Du Charme's Estate v. Commissioner, 164 F.2d 959 (1947). The fact that

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the decedent does not take an active part in the trust management or administration does not matter. Biscoe v. U.S., 148 F. Supp. 224, 225 (D. Mass. 1957). The IRS agrees with the position that veto powers invoke Sections 2036 and 2038. E.g., Rev. Rul. 70-513, 1970-2 C.B. 194; Ltr. Rul. 8038014 (5) Disability of Grantor Disregarded. Under both sections, the inability of the grantor to exercise the problematic powers because of incompetency or other disability is disregarded. Tech. Adv. Memo. 8623004. This is similar to the rule under Section 2041 as to powers held by disabled beneficiaries. E.g., Pennsylvania Bank & Trust Co. v. U.S., 597 F.2d 382 (3d Cir. 1979); Fish v. U.S., 432 F.2d 1278 (9th Cir. 1970). (6) Capacity in Which Power Is Held Is Irrelevant. Under both sections, estate inclusion results whether the power is held in an individual or a fiduciary capacity. As an example, if the grantor makes a transfer to a private foundation, and has the ability to control disposition of the donated funds as a director of the foundation, estate inclusion results. Rifkind v. U.S., 84-2 U.S.T.C. 13,577, 5 Ct. Cl. 362 (1984) (inclusion under Section 2036(a)(2)); Rev. Rul. 72-552, 1972-2 C.B. 525 (value of inter vivos transfers to a charitable corporation is includible in the estate of the donor who, as president of the corporation, retained power over the disposition of its funds; the value is also includible in determining the marital deduction allowable and qualifies as a charitable deduction.) (7) Full Consideration Transaction Excluded. Both sections apply only to the extent that the grantor has made a transfer other than a “bona fide sale for an adequate and full consideration.” e. Differences Between Section 2036(a)(2) and 2038. See generally Lischer, Retained Powers (Sections 2036(a)(2) and 2038, 876-1st T.M. at IV-V. (1) Retention of Power Over Income Only; Amount of Inclusion. A retention of power over distributing or accumulating income alone is enough to cause inclusion of the entire trust property under Section 2036(a)(2). However, under Section 2038, only the actual property over which a power is held is included in the estate. Therefore, a power over only income would require inclusion of only the income interest under Section 2038. Similarly, a power over only the remainder interest would require inclusion of just the remainder interest and not the income interest under Section 2038. Rev. Rul. 70-513, 1970-2 C.B. 194. (2) Retained Power vs. Power Held At Death For Whatever Reason. Under Section 2036(a)(2), only powers “retained” by the decedent cause inclusion. Under Section 2038, it is sufficient that the decedent holds the power at death, regardless of “at what time or from what source the decedent acquired his power.” Treas. Reg. § 20.20381(a). For example, if a decedent did not retain the power to control distributions, but acquired the power only through appointment as trustee by another person, Section 2038 would apply, but Section 2036 would not. (3) Contingent Power. Under Section 2036(a)(2), “whether the exercise of the power was subject to a contingency beyond the decedent’s control which did not occur before his death (e.g., the death of another person during the decedent’s lifetime)” is irrelevant. Treas. Reg. § 20.2036-1(b)(3). In Revenue Ruling 73-21, the decedent reserved the power to name a successor trustee (which, under state law, included

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himself) upon the death, resignation or removal of the trustee. The Ruling concludes that Section 2036(a)(2) applied even though a vacancy had not occurred by the time of the decedent’s death. Rev. Rul. 73-21, 1973-1 C.B. 405. At least one case has disagreed with the government’s position, holding that a contingent power to determine who enjoys property or the income from property is not subject to Section 2036(a)(2), based on an interpretation of the predecessor statute in the 1939 Code. Estate of Kasch v. Comm’r, 30 T.C. 102 (1958). However, most cases have supported the IRS’s position regarding contingent powers under Section 2036(a)(2). E.g., Estate of Farrel v. U.S., 553 F.2d 637 (Ct. Cl. 1977). In contrast, under Section 2038, the power must actually be possessed at death. “Section 2038 is not applicable to a power the exercise of which was subject to a contingency beyond the decedent’s control which did not occur before his death (e.g., the death of another person during the decedent’s life).” Treas. Reg. §20.2038-1(b). The contingency rule under Section 2036(a)(2) creates a trap—estate inclusion can result if there is the possibility that the grantor might at some point be appointed as the successor trustee if a vacancy occurs, even if the grantor does not hold the power to fire a trustee and appoint himself. Estate of Gilchrist v. Comm’r, 630 F.2d 340 (5th Cir. 1980) (power of grantor to appoint himself as trustee if vacancy occurs). (4) Third Party Authority to Grant Limited Power of Appointment to Grantor. A very flexible alternative to cause estate inclusion for the trust settlor would be to give an independent party the authority to grant a power to the settlor that would cause estate inclusion, such as a testamentary limited power of appointment, which would cause estate inclusion under §2038 and result in a basis adjustment under §1014(b)(9). Does this work? Might the grantor be treated as having such a power even if never granted? The key issue is whether the decedent would be treated as having retained a §2036(a)(2) power to designate persons who could enjoy the property. No prearranged understanding should exist for the grant of such a power to defend against an argument that the decedent indirectly retained the power so that §2036(a)(2) could apply (because that section requires that the power be retained by the decedent at the time of the transfer). Reg. §20.2036-1(b)(3) provides that §2036 applies even if a power is merely exercisable in conjunction with other persons (whether or not adverse) and regardless of whether the exercise of the power was subject to a contingency beyond the decedent’s control which did not occur before his death. That arguably would apply to the permitted grant to the grantor of a limited power of appointment even if it was never actually granted. That same provision is not included in the regulations under §2038. See Reg. §20.2038-1(b) (“However, section 2038 is not applicable to a power the exercise of which was subject to a contingency beyond the decedent’s control which did not occur before his death… See, however, section 2036(a)(2) for the inclusion of property in the decedent’s gross estate on account of such a power.”) The court in Estate of Skifter v. Commissioner, 468 F.2d 699 (2d Cir. 1972), addressed a fact scenario in which the decedent had transferred a life insurance policy on his life to his wife who years later left the policy under her will to a trust for her daughter with the decedent as the trustee. The analysis analogized §2042 to §§2036 and 2038, and reasoned, in dictum, that §2036 would not apply because the power

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over the policy was not “retained by the grantor … when he transferred it to another” (without addressing the potential application of Reg. §20.2036-1(b)(3)). The court reasoned that §2038 would not apply to a power conferred on the decedent “by someone else long after he had divested himself of all interest in the property subject to the power,” but suggested that §2038 would apply if the power were actually granted to the decedent and if the grant was pursuant to authority “that the decedent created at the time of transfer in someone else and that later devolved upon him before his death.” If the grantor authorized a third party to grant a limited power of appointment to the grantor, and the third party actually granted that power to the grantor, then §2038 would apply under this analysis. Whether the grantor will be treated as having the power causing inclusion in the gross estate even if the limited power of appointment is never actually granted to the grantor by the third party is not clear. The regulation under §2036 is very broad and potentially applies to the situation, and the discussion in Skifter is dicta. (because the court addressed a §2042 issue and merely discussed §§2036 & 2038 by analogy and even that analysis did not mention the §2036 regulation). If the independent party merely has the power to grant to the settlor a testamentary limited power of appointment, however, estate inclusion should not result if the power is not actually granted. The problematic regulation under §2036 about powers subject to a contingency that did not occur before the settlor’s death would not apply because §2036 applies only to powers that can be exercised during the settlor’s life and not testamentary powers, and while §2038 can apply to testamentary powers, it does not apply to powers subject to a contingency beyond the decedent’s control that did not occur before death. f.

Exception for Powers Held By Third Party Trustee. Powers held by a third party rather than by the grantor generally will not cause estate inclusion. However, the grantor must be careful not to have an express agreement or understanding regarding the trustee’s decisions. Also, the reciprocal trust doctrine might apply to uncross powers held by trustees of “interrelated trusts.” See section II.B.1.a. of this outline. (1) Close Relationship of Grantor to Trustee. A variety of cases have recognized that a grantor did not retain a power held by a trustee, “just because the trustee is the settlor’s wife, young daughter, or golfing companion, or because the trustee tends to follow the settlor’s wishes in exercising discretion.” Dodge, Transfers with Retained Interests and Powers, 50-5th T.M. at 159 (2002). An example is Estate of Beckwith v. Comm’r, 55 T.C. 242 (1970). In that case, the IRS contended that a variety of factors enabled the grantor to control the flow of income from the trust, including “close business relationships between the settlor and the individual trustees.” The court rejected that position. 55 T.C. at 248-249. (2) De Facto Control. A few cases, in extreme circumstances, have suggested that a grantor is treated as holding powers of a third party trustee where the grantor actually controlled the trustee’s actions. See Estate of Klauber v. Comm’r, 34 T.C. 968 (1960) (reviewed)(dictum); see also Tech Adv. Memo. 9043074 (grantor controlled institutional trustee). However, courts have generally been reluctant to attribute powers of a trustee to the grantor. In an early case, the court refused to include assets in the settlor’s estate where the trustee in its discretion could make distributions to the settlor’s minor child, specifically rejecting notion that a court should presume that a trustee would do what the settlor asked of him:

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The Commissioner's argument that these trustees would be likely to do what he asked of them about assigning income for the support of a minor child departs from the 'practical' and 'realistic' approach we are asked, in the same argument, to take. We have no notion what the trustees would have done had such a request been made. It is apparent, from the terms of the instrument, that the settlor could not direct or control the matter, once the trust settlement had become effective. Comm’r v. Douglass Estate, 143 F.2d 961 (3rd Cir. 1944).

In Estate of Goodwyn v. Comm’r, T.C. Memo. 1973-153, the grantor at all times, with the acquiescence of two attorneys serving as trustees, made all decisions regarding the administration of the trust including distributions. Despite that fact scenario, the court concluded that the grantor did not retain the right to designate who could receive distributions to cause estate inclusion under §2036(a)(2). The court in Goodwyn based its reasoning largely on the U.S. Supreme Court case United States v. Byrum, 408 U.S. 125, 136-37 (1972), which held that the term “right” as used in §2036(a)(2) refers to “an ascertainable and legally enforceable power.” If the trust allows distributions in the total discretion of the trustee, it will be difficult to show a violation of the trustee’s fiduciary duties. See McCabe v. U.S., 475 F.2d 1142 (Ct. Cl. 1973) (no estate inclusion even though trustee ignored interests of beneficiaries other than settlor). “In sum, the de facto control issue may be essentially dead.” Dodge, Transfers with Retained Interests and Powers, 50-5th T.M. at 159 (2002). A recent federal district court has again resurrected the de facto trustee argument. SEC v. Wyly, 2014 WL 4792229 (S.D.N.Y. Sept. 25, 2014) was a securities law violation case in which the court determined that the amount of disgorgement would be based in part on the income taxes that the defendants avoided by an offshore trust structure. Trust protectors had the power to remove and replace independent trustees located in the Isle of Man. The court determined that the settlers controlled all decisions for the trust, by expressing their “recommendations” to trust protectors who relayed those recommendations to the trustee, who always did as instructed. The court determined that the independent trustee exception to the grantor trust rules under §674(c) did not apply because the settlors in fact controlled all decisions. The court acknowledged Estate of Goodwyn, T.C. Memo 238 (the same fact situation as in the prior Goodwyn case discussed above), which applied the independent trust exception to §674(c), even though the grantors in fact made all decisions, because §674(c) refers to “an ascertainable and legally enforceable right, not merely the persuasive control which [the grantor] may exercise over an independent trustee who is receptive to his wishes.” The court disagreed with that analysis, with strong language that conceivably could be extended broadly to other contexts: The Wylys, through the trust protectors who were all loyal Wyly agents, retained the ability to terminate and replace trustees. The Wylys expected that the trustees would execute their every order, and that is exactly what the trustees did. The evidence amply shows that the IOM trustees followed every Wyly recommendation, whether it pertained to transactions in the Issuer securities; making unsecured loans to Wyly enterprises, or purchases of real estate, artwork, collectibles, and other personal items for the Wylys and their children. The trustees made no meaningful decisions about the trust income or corpus other than at the behest of the Wylys. On certain occasions, such as the establishment of the Bessie Trusts [with their nominal foreign grantors], the IOM trustees actively participated in fraudulent activity

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along with the Wylys. The Wylys freely directed the distribution of trust assets for personal purchases and personal use. Because the Wylys and their family members were beneficiaries, the IOM trustees were thus “distributing” income for a beneficiary at the direction of the grantors—the Wylys.

Other more recent cases have raised similar concerns. E.g., United Food & Commercial Workers Unions v. Magruder Holdings, Inc., Case No. GJH-16-2903 (S.D. Md. March 27, 2019) (ERISA case in which court looked to whether §678 applied to beneficiary’s ability to withdraw assets as needed for health, education, support, and maintenance, but trustees never questioned whether withdrawn amounts were actually needed for those purposes; court reasoned that a “HEMS provision that exists only on paper cannot be said to restrict the power exercisable” by the beneficiary); Estate of Moore v. Comm’r, T.C. Memo. 2020-40 (retained interest in assets contributed to family limited partnership under §2036 in part because decedent’s relationship to his assets remained unchanged; two children were cotrustees of trust that was general partner of family limited partnership, but the “children typically did things because Moore asked them to, and giving them nominal ‘power’ was no different from Moore’s keeping that power,” and an implicit understanding existed that the decedent “would continue to use his assets as he desired and that his relationship with them changed formally, not practically.”). (3) Implied Agreement or Understanding. See section II.B.2.c.(1)(a) of this outline. g. Ascertainable Standard Exception. If the distribution powers held by the grantor are limited by a determinable external standard, enforceable in a court of equity, the grantor arguably does not have any power to alter the distributions from the terms of the trust, because the standard sufficiently limits the grantor’s discretion. However, there is no explicit ascertainable standard exception in the statutory provisions or regulations to Sections 2036 and 2038. (Regulations under various other sections give guidance on what standards would constitute an ascertainable standard or a definite external standard. Treas. Reg. §§ 20.2041-1(c)(2), 25.2511-1(g)(2), and 1.674(b)-1(b)(5)(i).) The seminal case establishing the ascertainable standard exception for a donor controlled power over disposition is Jennings v. Smith, 161 F.2d 74 (2d Cir. 1947). In that case, the grantor retained the power as trustee to make distributions to enable the beneficiary to keep himself and his family in comfort “in accordance with the station in life to which he belongs.” The court held that power would not cause inclusion under the predecessor to Section 2038. Since that time, many courts have ruled on whether particular standards are sufficient to avoid inclusion under Section 2036 and 2038. Standards relating to “health education, support and maintenance” are invariably held to avoid estate inclusion, by analogy to the standards exception in Section 2041. E.g., Estate of Weir v. Comm’r , 17 T.C. 409 (1951), acq. 1952-1 C.B. 4 (“the education, maintenance and support”' and “in the manner appropriate to her station in life”). The IRS has recognized that assets will not be included in a settlor’s estate under §2038 if the settlor was empowered to invade corpus only for the beneficiary’s support and education. Rev. Rul. 73-143, 1973-1 C.B. 407. The ruling reasoned as follows: Nondiscretionary powers to vary the beneficial interests of a trust held by a settlor-trustee do not render the value of the property subject to the trust includible in his gross estate under section 2038 of the Code. Nondiscretionary powers are those limited by an ascertainable

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standard. Estate of Walter E. Frew, 8 T.C. 1240 (1947), acquiescence, 1947-2 C.B. 2. A power to alter or amend, the exercise of which is not limited by definite external standards and which is, therefore, discretionary in nature renders the value of the property subject to the power includible in the decedent-settlor-trustee’s gross estate. Charlotte H. Hurd v. Commissioner, 160 F.2d 610 (1947). … The power to distribute corpus for support and education is an ascertainable standard which can be objectively applied.

The courts have been lenient in recognizing standards as being ascertainable for purposes of Section 2036 and 2038, as long as some definite standard (other than amorphous terms such as “pleasure,” “well-being,” or “happiness”) are used. Darin Digby, of San Antonio, Texas, has provided the following outstanding compilation of cases that have recognized standards as being ascertainable. Digby, Drafting Donor-Trustee Irrevocable Trusts Without Adverse Income, Gift or Estate Tax Consequences to the Donor and Drafting Defective Grantor Trusts, STATE BAR OF TEXAS 6th ANN. ADV. DRAFTING: ESTATE PL. & PROB. COURSE, at H-5 (1995). Blunt v. Kelly, 131 F.2d 632 (3d. Cir. 1941) (“support, care or benefit”); Estate of John J. Toeller, 165 F.2d 665 (7th Cir.1946) (“misfortune or sickness”); Industrial Trust Co v. Comm’r, 165 F.2d 142 (1st Cir 1947), aff’g in part and rev’g in part, 7 T.C. 756 (1946) (“in case of sickness or other emergency”); Jennings v. Smith, 161 F.2d 74 (2d Cir. 1947), rev’g, 63 F. Supp 834 (income—“benefit, support, maintenance or education”; corpus—“suffer prolonged illness or be overtaken by financial misfortune which trustees deemed extraordinary”); Estate of Wilson v. Comm’r, 187 F.2d 145 (3d Cir 1951), aff’g, 13 T.C. 869 (“in case of need for educational purposes or because of illness or for any other good reason”); State Street Trust Co. v. U.S., 263 F.2d 635 (1st Cir. 1959), aff’g, 160 F. Supp 877 (D.C. Mass.); (“comfortable maintenance and/or support”; United States v. Powell, 307 F.2d 821 (10th Cir. 1962) (“maintenance, welfare, comfort, education or happiness”); Estate of Ford v. Comm’r, 450 F.2d 878, aff’g, 53 T.C. 114 (1969) (“illness, infirmity … or support, maintenance, education, welfare and happiness”); Leopold v. U.S., 510 F.2d 617 (9th Cir. 1975) (“support, education, maintenance and general welfare”); Pardee v. Comm’r, 49 T.C. 140 (1967) (“education, maintenance, medical expenses, or other needs … occasioned by emergency”); Seasongood v. U.S., 331 F. Supp. 486 (S.D. Ohio 1971) (“as [beneficiary] may require”); Estate of Klafter v. Comm’r, 32 T.C.M. 1088 (1973) (income—“to maintain [beneficiary’s] standard of living in the style to which she has been accustomed;” corpus—“support, maintenance, health, education and comfortable living”); Estate of Gokey v. Comm’r, 72 T.C. 721 (1979) (children—“support, care, welfare and education;” spouse—“care, comfort, support or welfare”). The following, including a compilation of cases by Mr. Digby, summarizes cases where the stated standard was too broad, and where estate inclusion resulted under Section 2036 or 2038. Old Colony Trust Co. v. U.,S., 423 F.2d 601 (1st Cir. 1970) (“changed circumstances” standard was acceptable, but “for his best interests” standard” was not); Hurd v. Comm’r, 160 F.2d 610 (1st Cir. 1947) (“the circumstances so require”); Michigan Trust Co. v. Kavanagh, 284 F.2d 502 (6th Cir. 1960) (“a special emergency”); Estate of Yawkey v. Comm’r, 12 T.C. 1164 (1949) (“best interests”);Estate of O’Connor v. Comm’r, 54 T.C. 969 (1970) (“for the benefit of”); Estate of Bell v. Comm’r, 66 T.C. 729 (1976) (“for purposes of providing [‘beneficiary’] with funds for a home, business … or for any other purpose believed by the Trustee to be for [beneficiary’s] benefit …”); Estate of Carpenter v. U.S., 80-1 U.S.T.C. ¶13,339 (Wis.) (“trustees are authorized but not required” “in the sole discretion of the Trustees”). Cf. Merchants Nat’l Bank v.

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Comm’r, 320 U.S. 256, 64 S. Ct 108 (1943) (“happiness” not an ascertainable standard for purposes of allowing charitable deduction); Industrial Trust Co. v. Comm’r, 151 F.2d 592 (1st Cir. 1945), cert. denied, 327 U.S. 788 (“pleasure” not an ascertainable standard for purposes of charitable deduction). The analysis must extend beyond just looking to see if “magic” unacceptable words are used in the description of standards. An excellent discussion of this principle is provided by a Tax Court case that was affirmed by the Second Circuit Court of Appeals. Estate of Ford v. Comm’r, 53 T.C. 114 (1969), nonacq. 1978-2 C.B. 3, aff’d per curiam, 450 F.2d 878 (2d Cir. 1971). In that case, the instrument included the following clause regarding distributions: If any time or from time to time it shall appear to the satisfaction of the Trustee that the said [beneficiary] shall be in need of funds in excess of the income which may then be available for his benefit from the trust estate and from any other source or sources of which the Trustee has knowledge, for the purpose of defraying expenses occasioned by illness, infirmity or disability, either mental or physical, or for his support, maintenance, education, welfare and happiness, then the Trustee may relieve or contribute toward the relief of any such need by paying to him or using and applying for his benefit such sum or sums out of the principal of the trust estate as the Trustee deems to be reasonable and proper under the circumstances. The Trustee, in considering at any time whether or not to make any disbursements of principal under the terms hereof, shall consider primarily the welfare of the said [beneficiary], and shall not unduly conserve the principal for later distribution to him or to others having contingent remainder interests. 53 T.C. 114, at 120-21 (emphasis added).

The court acknowledged that “the word 'happiness' standing alone, or in conjunction with language exhorting the trustee to administer the trust liberally for the benefit of one beneficiary over another, does not provide an ascertainable standard enforceable in a court of equity.” 53 T.C. at 125. However, the court observed that the invasion provision contains a clause advising the trustee that he should “consider primarily the welfare” of the beneficiary. In addition, the invasion power is prefaced with the clause that it applies when the trustee is satisfied that the income beneficiary is “in need” of funds in excess of the income which may then be available, and that invasion is permitted to “relieve or contribute toward the relief of any such need.” The instrument placed a fiduciary responsibility on the trustee to determine “need” before he could invade principal for any of the prescribed reasons. In response to the IRS’s argument that the term “happiness” afforded unbridled discretion to the grantor-trustee, the court responded: To the contrary, we do not accord this single word such as talismanic effect. A word, such as 'happiness,' must be construed in the context in which it appears 'because its meaning may be affected by the words it accompanies.' Estate of Marvin L. Pardee, 49 T.C. 140, 144 (1967). Viewing the invasion provision in its entirety, we conclude that its emphasis on 'need' delimits 'happiness' as well as the other enumerated terms, and provides an external, objective standard enforceable against the grantor-trustee in a court of equity. United States v. Powell, 307 F.2d 821, 826-828 (C.A. 10, 1962). It is well settled that where the trust instrument contains such a standard, the grantor- trustee is not deemed to have retained sufficient dispositive discretion to activate the operative provisions of either section 2036 or section 2038. Jennings v. Smith, 161 F.2d 74, 77-78 (C.A. 2, 1947). Estate of C. Dudley Wilson, 13 T.C. 869, 872-873 (1949), affirmed per curiam 187 F.2d 145 (C.A. 3, 1951); and Delancey v. United States, 264 F.Supp. 904, 907 (W.D. Ark. 1967). Moreover, an examination of the applicable State law reveals

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that an aggrieved beneficiary could indeed enforce his rights against an imprudent or wrongdoing trustee. … … Thus, although we deem the question to be a close one, we conclude that the grantor-trustee herein did not have untrammeled discretion to invade corpus at his own whim or that of the income beneficiary. Consequently, the presence of the invasion power in the trust indenture does not in our view operate to trigger the provisions of sections 2036(a)(2) and/or 2038(a)(1). 53 T.C. at 126-27.

This extended discussion of the Ford decision is included to emphasize that the ascertainable standard issue will be resolved in the context of the overall provisions for distributions in the trust instrument. The cases cited above have not been overruled. However, be sensitive to the body of case law that has developed with respect to family limited partnerships suggesting that §§ 2036(a)(2) might apply to partnerships for which the owner has made gifts of limited partnership interests if the owner has “excessive” control as general partner (even if “in conjunction with” others). E.g., Estate of Powell v. Commissioner, 148 T.C. 392 (2017)(§2036(a)(2) applied even though decedent was only a limited partner because decedent, in conjunction with other partners, could dissolve the partnership; plurality opinion of 8 judges and a 7-judge concurring opinion also agreed that §2036(a)(2) applied; two other judges concurred in result only); Strangi v. Commissioner, T.C. Memo. 2003-145, aff’d, 417 F.3d 468 n.7 (5th Cir. 2005) (Fifth Circuit’s affirmance of “Strangi 3” did not address § 2036(a)(2), merely concluding that §2036(a)(1) applied); Kimbell v. Commissioner, 91 A.F.T.R.2d 2003-585 (N.D. Tex. 2003), rev’d, 371 F.3d 257 (5th Cir. 2004 (district court concluded that §2036(a)(1) and §2036(a)(2) applied; reversal based on full consideration exception to § 2036; no specific discussion of § 2036(a)(2) issue as to an FLP; as an LLC, the Fifth Circuit concluded “Mrs. Kimbell’s interest in the LLC was only a 50% interest, and her son had sole management powers over the LLC. Thus, Mrs. Kimbell did not retain the right to enjoy or designate who would enjoy the LLC property.”); Turner v. Commissioner, T.C. Memo 2011-209 (court pointed to several powers of the decedent as general partner, without indicating how important each was in its conclusion that §2036(a)(2) applied: (i) the sole and absolute discretion to make distributions of partnership income, (ii) the ability to make distributions in kind, and (iii) the ability to amend the partnership without the consent of limited partners). As a practical matter, the IRS does not always press hard on §2036(a)(2) claims. For example, in Mirowski v. Commissioner, T.C. Memo. 2008-74, the IRS did not even argue that the decedent’s serving as the sole manager of the LLC by itself triggered §2036(a)(2). These cases are discussed more fully in Section II.B.4.c of this outline. Reliance on the older cases should be appropriate, particularly in light of the IRS’s published ruling (Rev. Rul. 73-143), but the IRS’s approach in these few FLP cases suggests that the IRS could at some point take an opposing viewpoint. Whether a court would agree seems suspect, but the issue could arise. h. Summary of Planning for Ascertainable Standard Exception. To be conservative in the planning process, if the trust instrument reserves for the grantor any dispositive powers, the instrument should apply a strict “health, education, support and maintenance” standard. Using any other words is taking a risk that the IRS might

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question whether Sections 2036 or 2038 should apply. E.g., Rev. Rul. 73-143, 1973-1 C.B. 407 (power to make payments early “in case of need for education purposes or because of illness or for any other good reason” is not an ascertainable standard). Even though the courts have generally recognized other reasonable standards as being ascertainable, why place yourself in the position of having to argue with the IRS and possibly face an adverse court decision? i.

Effect of Adding That Trustee Makes Decision “In His Sole Discretion”. Various cases have held that adding that a trustee may decide in his sole or uncontrolled discretion whether the stated standards have been satisfied does not change the result. E.g., Jennings v. Smith, 161 F.2d 74 (2d Cir. 1947) (“in their absolute discretion”); State Street Trust Co. v. U.S., 160 F. Supp 877 (D. Mass 1958) (power to invade capital for the “comfortable maintenance and/or support” of each beneficiary, in the trustee's '”sole and uncontrolled discretion”), aff’d, 263 F.2d (1st Cir. 1959); Estate of Budd v. Comm’r, 49 T.C. 468 (1968) (“suitable support, education and maintenance of any such beneficiary, the Trustee may, in his uncontrolled discretion, apply …”). In Estate of Budd, the IRS argued that adding the modifier “in his uncontrolled discretion” rendered the standard as not being ascertainable. The Tax Court disagreed, under the reasoning that even though “a court of equity ordinarily will not substitute its discretion for that of the trustee, nevertheless, even where the power is granted in terms of the ‘sole’ or ‘uncontrolled’ discretion of the trustee, it will review his action to determine whether in light of the standards fixed by the trust instrument, such discretion has been honestly exercised.” Cf. Treas. Reg. § 25.2511-1(g)(2)(“the fact that the governing instrument is phrased in discretionary terms is not itself an indication that no such standard exists”). However, some commentators have pointed out that adding such a modifier, where the grantor has retained a power over distributions, is dangerous and generally should be avoided. See Kasner, Why One Should Never Rely on A Private Letter Ruling, TAX NOTES, 742 (August 5, 1996) (commenting on Letter Ruling 9625031 in which the IRS held that trusts were not included under Section 2036 and 2038 where the trustees—including the grantor—had the right to pay the beneficiary “in their discretions” for his health, support, maintenance, and education). Indeed, the IRS did raise the argument, albeit unsuccessfully, in Estate of Budd.

Summary of Trustee Selection Issues With Respect to Grantor Powers Over Dispositive Provisions. If the grantor has the power, either as trustee or otherwise, to add beneficiaries, change the disposition among beneficiaries, accumulate or distribute income, invade corpus, or revoke the trust, Sections 2036 and/or 2038 will apply. (Under Section 2038, it is not necessary that the grantor “retain” the power; Section 2038 applies if the grantor holds the power at his death, regardless of how the grantor acquired the power.) Estate inclusion also occurs if the grantor has the right to appoint himself as trustee, either currently or (under Section 2036, but not Section 2038) upon the occurrence of a future contingency even if the contingency is out of the grantor’s control (such as a vacancy in the office of trustee.) The Sections apply whether the grantor serves alone or as a co-trustee, or if the grantor just has a veto power, or may act only subject to another person’s veto power. The Sections apply if the grantor keeps the dispositive power in any capacity (for example, as director of a private foundation that receives a gift from the grantor), not just as trustee. Estate inclusion will not occur if the dispositive power is subject to a determinable standard (despite the absence of an ascertainable standard exception in the statues

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or regulations under Section 2036 and 2038.) A wide variety of standards have been approved by courts, but if the grantor holds (or may in the future hold) any dispositive powers, the conservative course of action would be to use a pure “health, education, support and maintenance” standard, without further embellishment. For example, to be conservative, if the grantor might possibly acquire dispositive powers, do not provide that the trustee may make dispositive decisions under the standard in the trustee’s sole or uncontrolled discretion. If a third party trustee has powers that would trigger estate inclusion if held by the grantor, the grantor should not have the unlimited power to remove and replace the trustee. (See Section III.B.5.g. & h. of this outline.) 4. Retained Administrative and Management Powers. a. Administrative Powers Can Affect Distributions. Certain administrative decisions may have the effect of shifting benefits from one beneficiary to another. For example, the power to allocate receipts and disbursements between income and principal can affect the amounts distributed to income beneficiaries and remaindermen. Similarly, a trustee’s investment powers to invest in high-growth non-income producing assets may shift benefits from the income beneficiary to the remaindermen. Courts have long recognized that “standard” administrative powers would not invoke the predecessors of Section 2036 and 2038. E.g., Reinecke v. Northern Trust Co., 278 U.S. 339 (1929). However, the IRS has argued (with some success in early cases) that various broad administrative powers would cause estate inclusion under Sections 2036 and 2038. E.g., State Street Co. v. U.S., 263 F.2d 635 (1st Cir. 1959) (court concluded, in a “very close” case, that broad management powers, including the power to exchange trust property for other property without regard to the values of the properties, as well as other broad powers, caused the predecessor to Section 2036 to apply). b. Key Issue: Is Exercise of Power Subject to Review By Court? As the courts have sifted through these types of cases, the emerging principle is that a grantor’s broad management powers will not invoke Section 2036 or 2038 as long as the grantor’s actions are subject to review by a court of equity (for example, if the exercise of the power is subject to fiduciary standards.) See Lischer, 876-1st T.M., Retained Powers (Sections 2036(a)(2) and 2038) at V.E.1. This is particularly true if the grantor’s actions are subject to a standard that, as a practical matter, can be enforced by a court as opposed to actions taken under a “sole discretion” standard. See Gans & Blattmachr, Strangi: A Critical Analysis and Planning Suggestions, TAX NOTES 1153, 1157 (Sept. 1, 2003). However, some courts have applied this principal regarding management powers even if the grantor has very broad discretion. The court that ruled in favor of the IRS in the State Street case changed its position in 1970, specifically overruling the result in State Street, and adopting a position under Massachusetts law that no amount of administrative discretion prevents judicial supervision of the trustee. Old Colony Trust Co. v. U.S., 423 F.2d 601, 603 (1st Cir. 1970). In Old Colony, a provision that the trustees could “do all things in relation to the Trust Fund which the Donor could do if living” did not cause Sections 2036 or 2038 to apply. See also United States v. Powell, 307 F.2d 821 (10th Cir. 1962) (trustee-grantor had power to invest assets as he deemed “most advisable for the benefit of the trust estate”; held that trustee’s acts were subject to review by court of equity and did not invoke the predecessor to Section 2038). Some courts have even held that a grantor’s non-trustee powers were reserved in a fiduciary capacity, thus invoking the general rule that administrative powers subject to court review do not trigger application of Section 2036 or 2038; Estate of Graves v. Commissioner, 92 T.C. 1294, 1302-03

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(1989) (“Even if the decedent had the power to direct the investment of the trust property, this power would not constitute a power to alter, amend or revoke because she would have effectively been a trustee. As a trustee, she would have had to act in good faith, in accordance with her fiduciary responsibility, and safeguard and conserve the trust principal.”); Estate of King v. Comm’r, 37 T.C. 973 (1962), nonacq. 1963-1 C.B. 5 (grantor had the right to direct the trustee regarding investment of trust assets, but the court reasoned that “the grantor had in effect made himself a fiduciary” and held that there was “no retained right or power in the decedent to divert any of the corpus to the income beneficiaries or to divert any income to the remaindermen”). The key under these cases is the existence of a fiduciary duty that a court can supervise and ensure that the fiduciary will act impartially. The absence of a fiduciary duty was the determining factor in finding that a grantor who retained controls over Illinois land trusts was subject to Sections 2036(a)(2) and 2038. Estate of Bowgren v. Comm’r, 105 F.3d 1156 (7th Cir. 1997) (decedent had no duty to seek agreement of other beneficiaries to deal with their interests and had no fiduciary duty to the donee who received an assignment of an interest in a land trust). c. Supreme Court’s Pronouncement in Byrum. The Supreme Court held that retained rights to vote the transferred stock of a closely held corporation does not constitute a Section 2036(a)(2) power over the property. U.S. v. Byrum, 408 U.S. 125 (1972). The Court reasoned, first, that management powers generally are not powers subject to Section 2036(a)(2). The very strong language of the Supreme Court is quoted at length: At the outset we observe that this Court has never held that trust property must be included in a settlor’s gross estate solely because the settlor retained the power to manage trust assets. On the contrary, since our decision in Reinecke v. Northern Trust Co., 278 U.S. 339, 73 L Ed 410, 49 S. Ct. 123, 66 ALR 397 (1929), it has been recognized that a settlor’s retention of broad powers of management does not necessarily subject an inter vivos trust to the federal estate tax. Although there was no statutory analogue to § 2036(a)(2) when Northern Trust was decided, several lower court decisions decided after the enactment of the predecessor of § 2036(a)(2) have upheld the settlor’s right to exercise managerial powers without incurring estate tax liability. In Estate of King v. Commissioner, 37 T.C. 973 (1962), a settlor reserved the power to direct the trustee in the management and investment of trust assets. The Government argued that the settlor was thereby empowered to cause investments to be made in such a manner as to control significantly the flow of income into the trust. The Tax Court rejected this argument, and held for the taxpayer. Although the court recognized that the settlor had reserved “wide latitude in the exercise of his discretion as to the types of investments to be made,” id. at 980, it did not find this control over the flow of income to be equivalent to the power to designate who shall enjoy the income from the transferred property. Essentially the power retained by Byrum is the same managerial power retained by the settlers in Northern Trust and in King. Although neither case controls this one – Northern Trust, because it was not decided under § 2036(a)(2) or a predecessor; and King, because it is a lower court opinion—the existence of such precedents carries weight. The holding of management without adverse estate tax consequences, may have been relied upon in the drafting of hundreds of inter vivos trusts. The modifications of this principle now sought by the Government could have a seriously adverse impact, especially upon settlors (and their estates) who happen to have been “controlling” stockholders of a closely held corporation. Courts properly have been reluctant to depart from an interpretation of tax law that has been generally accepted when the departure could have potentially far-reaching consequences.

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When a principle of taxation requires reexamination, Congress is better equipped than a court to define precisely the type of conduct that results in tax consequences. When courts readily undertake such tasks, taxpayers may not rely with assurance on what appear to be established rules lest they be subsequently overturned. Legislative enactments, on the other hand, although not always free from ambiguity, at least afford the taxpayers advance warning. 408 U.S. at 132-35.

Second, the Court held that Mr. Byrum did not have a retained “right” as described in Section 2036(a)(2), because of the fiduciary duty that Mr. Byrum owed to the corporation: It must be conceded that Byrum reserved no such “right” in the trust instrument or otherwise. The term “right,” certainly when used in a tax statute, must be given its normal and customary meaning. It connotes an ascertainable and legally enforceable power, such as that involved in O’Malley. Here, the right ascribed to Byrum was the power to use his majority position and influence over the corporate directors to “regulate the flow of dividends” to the trust. That “right” was neither ascertainable nor legally enforceable and hence was not a right in any normal sense of that term. A majority shareholder has a fiduciary duty not to misuse his power by promoting his personal interests at the expense of corporate interests. Moreover, the directors also have a fiduciary duty to promote the interests of the corporation. However great Byrum’s influence may have been with the corporate directors, their responsibilities were to all stockholders and were enforceable according to legal standards entirely unrelated to the needs of the trust or to Byrum’s desires with respect thereof. 408 U.S. at 136-138.

The IRS summarized its understanding of the Byrum holding and reasoning as follows: “The court concluded that because of the fiduciary constraints imposed on corporate directors and controlling shareholders, the decedent ‘did not have an unconstrained de facto power to regulate the flow of dividends, much less the right to designate who was to enjoy the income.’ ” Rev. Rul. 81-15, 1981-1 C.B. 457. This is despite the Supreme Court’s acknowledgement in footnote 25 that its conclusion was not based just on the premise that “the general fiduciary obligations of a director are sufficient to eliminate the power to designate with the meaning of §2036(a)(2).” An interesting position urged by the IRS in one private ruling is that the fiduciary duty doctrine of the Byrum case only applies if there are minority adverse interests who might question decisions made by the fiduciary. The IRS’s view was that “interests of family members, employees, agents or other related or non-adverse persons do not represent minority interests, since whatever legal rights they may be perceived to have under Byrum are apt not to be exercised. Conversely, the presence of a single truly adverse minority interest would make the Byrum rationale applicable.” Ltr. Rul. 8038014. This factor was also mentioned in Strangi (discussed below). Several cases involving controls by a decedent over a family limited partnership have provided further discussion of the impact of Byrum on retained powers. The IRS recognized in Technical Advice Memorandum 9131006 and in Letter Ruling 9415007 that a parent may make gifts of interests in a limited partnership, and retain investment and distribution authority over partnership assets as the general partner without causing the partnership assets to be included in his or her estate as a transfer with the retained power to control beneficial enjoyment. In those rulings, the IRS observed that the donorgeneral partner “occupied a fiduciary position with respect to the other partners and could

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not distribute or withhold distributions, or otherwise manage the partnership for purposes unrelated to the conduct of the partnership business.” See also Letter Rulings 9332006, 931039, 9026021, G.C.M. 38,984 (May 6, 1983), G.C.M 38,375 (May 12, 1980). The IRS subsequently retreated from that position in several cases involving a decedent with powers over a limited partnership in his capacity of having an interest as general partner of the partnership. In Kimbell v. U.S., 91 AFTR 2d 2003-585 (N.D. Tex. 2003), the court found that the decedent retained the rights to possession of the economic benefits of the property (§ 2036(a)(1)) and the right to designate who would benefit from the income of the property (§2036(a)(2)). There is no need in this case to search for an implied agreement, because the decedent had the right under the agreement to remove the general partner at any time and appoint herself as the general partner. As the general partner, she could then control distributions. The estate contended that even if the decedent were the general partner, she still would not have sufficient powers to require inclusion under section 2036 because her powers would be held in a fiduciary capacity. The Kimbell court reasoned that “Byrum … was expressly overruled by Congressional enactment of § 2036(b).” Furthermore, even if Byrum were applicable, the partnership agreement expressly provides that the general partner will not owe a fiduciary duty to the partnership or to any partner. This last factor makes the Kimbell case clearly distinguishable, and the court’s statement that the Byrum case is overruled by § 2036(b) is just wrong. The case was reversed by the Fifth Circuit based on the “bona fide sale for adequate and full consideration” exception in §2036. 371 F.3d 257 (5th Cir. 2004). The court very briefly addressed whether LLC assets should be includible under §2036(a)(1) and (a)(2). The court concluded: “Mrs. Kimbell’s interest in the LLC was only a 50% interest, and her son had sole management powers over the LLC. Thus, Mrs. Kimbell did not retain the right to enjoy or designate who would enjoy the LLC property.” In Strangi v. Comm’r, T.C. Memo 2003-145 (2003), the court had an extended analysis rejecting a broad fiduciary duty exception under Byrum. (The Fifth Circuit affirmed the decision based on §2036(a)(1). 96 AFTR2d 2005-5230 (5th Cir. 2005). Having decided the case under §2036(a)(1), the court expressly declined to address §2036(a)(2).) Judge Cohen’s Tax Court memorandum decision pointed to various distinguishing factual distinctions, in its case involving a family limited partnership in which an agent of the decedent held a 47% interest in a corporation that served as the general partner of the partnership and that gave the general partner the sole discretion to determine distributions. The court’s distinctions include the following. (1) Independent Trustee. In Byrum, the decedent retained the right to vote stock, which could be used to elect directors, who decided what distributions would be made from the corporation. However, the stock was given to a trust with an independent trustee who had the sole authority to pay or withhold income. In Strangi, distribution decisions were made by the corporation. The decedent owned 47% of the stock and was the largest shareholder. All decisions were ultimately made by decedent’s attorney-in-fact as the manager of the corporation and partnership. (2) Economic and Business Realities. The flow of funds in Byrum was dependent on economic and business realities of small operating enterprises that impact the earnings and dividends. “These complexities do not apply to [the partnership or corporation], which held only monetary or investment assets.”

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(3) Fiduciary Duties. Fiduciary duties in Byrum were distinguished because there were unrelated minority shareholders who could enforce these duties by suit. “The rights to designate traceable to decedent through [the corporation] cannot be characterized as limited in any meaningful way by duties owed essentially to himself. Nor do the obligations of [the corporation’s] directors to the corporation itself warrant any different conclusion. Decedent held 47 percent of [the corporation], and his own children held 52 of the remaining 53%. Intrafamily fiduciary duties within an investment vehicle simply are not equivalent in nature to the obligations created by the United States v. Byrum, supra, scenario.” The fact that there was a 1% shareholder of the corporation was “no more than window dressing.” “A charity given a gratuitous 1-percent interest would not realistically exercise any meaningful oversight.” (OBSERVATION: Holding that fiduciary duties provide a limit on the right to designate who enjoys or possesses transferred property only if there are unrelated persons who can enforce those duties seems inconsistent with cases that have held that very broad administrative powers retained by a donor as trustee do not invoke section 2036, primarily because of the restriction imposed by the fiduciary duties. Those cases involve trust transactions that do not involve any unrelated parties. E.g. Old Colony Trust Co. v. U.S., 423 F.2d 601, 603 (1st Cir. 1970)(broad trustee administrative powers that could “very substantially shift the economic benefits of the trust” did not invoke section 2036(a)(2) because such powers were exercisable by the donor-trustee in the best interests of the trust and beneficiaries, and were subject to court review). In addition, several earlier Tax Court cases relied on the fiduciary duty exception regarding powers that may affect distributions. Estate of Gilman, 65 T.C. 296 (1975), aff’d per cur. 547 F.2d 32 (2nd Cir. 1976)(no estate inclusion; decedent was co-trustee with power to vote stock; there was active conduct of a business and 40% of voting shares of corporation were held by sisters and there was family disharmony); Estate of Cohen, 79 T.C. 1015 (1982)(§2036(a)(2) did not apply to decedent as co-trustee of Massachusetts real estate trust; because courts hold business trustees to a “fair standard of conduct,” the decedent and his sons [as co-trustees] did not have the power to withhold dividends arbitrarily).) One commentator has observed that interpreting Byrum to apply only if there are unrelated parties involved means that “Byrum would not apply to the vast majority of closely held corporations owned entirely by related parties. It may be questioned whether the Supreme Court intended its decision in Byrum to be so limited in its precedential value.” Mulligan, Courts Err in Applying Section 2036(a) to Limited Partnerships, EST. PL. (Oct. 2003). E.g., Gans & Blattmachr, Strangi: A Critical Analysis and Planning Suggestions, Tax Notes 1153, 1157-58 (Sept. 1, 2003) (“It is true that, in Byrum, in the course of discussing the constraining nature of the fiduciary duty imposed on the grantor and the corporate directors he could select, the Court did allude to the fact that there were minority shareholders unrelated to the decedent. This raises the question whether the presence of these shareholders was critical to the Court’s holding. The structure of the decision, as well as the backdrop of a wellaccepted exception grounded in fiduciary duty principles, suggests it was not….This reading is consistent with Rev. Rul 73-143, which implicitly adopts the principle that a fiduciary duty owed to a family member can so circumscribe the grantor’s retained discretion so as to preclude it from being characterized as a right…. In Rev. 81-15, invoking Byrum’s fiduciary–duty analysis, the Service concluded that section 2036(a)(2) did not apply in the case of corporate stock where the decedent had retained voting rights even though the only shareholders were apparently the decedent and a family trust created by the decedent.”) See Hellwig, Estate Tax Exposure of Family Limited Partnerships Under Section 2036, 38 REAL PROP., PROB. & TR. J. 169 (Spring 2003)(view that Byrum does not create a broad fiduciary duty exception); but see Gans & Blattmachr, Strangi: A Critical Analysis and Planning Suggestions, TAX NOTES 1153

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(Sept. 1, 2003); Korpics, The Practical Implications of Strangi II for FLPs—A Detailed Look, 99 J. TAX’N 270 (Nov. 2003). Strangi’s interpretation of the Byrum case is far more restrictive than the IRS’s published interpretation of Byrum in Rev. Rul. 81-15, 1981-1 C.B. 457, which suggests a general fiduciary duty analysis as the rationale for the Supreme Court’s decision in Byrum. (Interestingly, the court cites the IRS’s unpublished rulings interpreting Byrum with respect to partnerships [PLRs 9415007, 9310039, & TAM 9131006] and discounts those rulings as having no precedential force, but does not cite the IRS’s published position interpreting the fiduciary duty analysis in Byrum. Under CC-2003-014, Chief Counsel attorneys cannot argue contrary to “final guidance.” Final guidance includes Revenue Rulings. Accordingly, Chief Counsel attorneys cannot argue contrary to positions in Revenue Rulings that have not been modified or withdrawn. The fact that subsequent cases have been more favorable to the government is irrelevant. The Tax Court generally followed Strangi’s analysis of the Byrum case in Estate of Powell v. Commissioner, 148 T.C. 392 (2017)(§2036(a)(2) applied even though decedent was only a limited partner because decedent, in conjunction with other partners, could dissolve the partnership; plurality opinion of 8 judges and a 7-judge concurring opinion also agreed that §2036(a)(2) applied; two other judges concurred in result only); Following Strangi, very few family limited partnership cases have addressed §§2036(a)(2) or 2038. Estate of Bongard v. Comm’r, 124 T.C. 95 (2005) applied § 2036(a)(1) under very dubious reasoning, based on the conclusion that the decedent had the ability to cause the FLP to acquire cash. This seems more closely aligned to a “right to designate who can enjoy” under § 2036(a)(2) than a retained right of enjoyment under § 2036(a)(1), particularly in light of the court’s acknowledgement that the decedent did not need any of the assets transferred to the FLP to maintain his lifestyle. Perhaps the reason that the court did not apply §2036(a)(2) is that there is no implied agreement concept in §2036(a)(2) like there is under §2036(a)(1). Instead, the decedent must have the legal right to designate who can enjoy the transferred assets (although that legal right may have to be exercised “in conjunction with” others.) In Estate of Kelley v. Comm’r, T.C. Memo 2005-235, the IRS dropped its §2036 and 2038 arguments about 20 days before trial without explanation. There was an LLC that was the 1% general partner. The Decedent owned 1/3 of the member interests of the LLC. The case seems fairly analogous to the Strangi case where the decedent owned 47% of the S corporation that was the 1% GP. Judge Cohen’s broad “in conjunction with” analysis would seem to apply as much to the Kelley facts as to the Strangi facts. Another FLP case to address §§2036(a)(2) and 2038 is Mirowski v. Comm’r, T.C. Memo. 2008-74. The decedent was the sole manager of the LLC, but the IRS did not even argue that being the sole manager caused §§2036(a)(2) and 2038 to apply as to interests in the LLC that the decedent gave to her daughters. Instead the IRS argued that the agreement allowed the members to determine the timing and amounts of distributions, and the decedent continued to hold a majority interest. The court responded that the agreement in various places contemplated pro rata distributions and observed that the decedent acted in a fiduciary capacity in her role as manager of the LLC. In Turner v. Comm’r, T.C. Memo. 2011-209, supplemental opinion in response to motion for reconsideration, 138 T.C. No. 14 (2012), the original opinion addressed §2036(a)(2).

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The court concluded that the decedent retained the right to designate which person or persons would enjoy the transferred property, which would cause estate inclusion under § 2036(a)(2). After acknowledging that a transferor's retention of the right to manage transferred assets does not necessarily require inclusion under § 2036(a)(2), the court then listed several reasons for its conclusion that § 2036(a)(2) applied in this case. (i) The decedent effectively was the sole general partner. (In footnote 28, the court acknowledged that the decedent’s wife was an equal co-general partner, but the court concluded that even if it were to treat her as a “coequal” general partner, it would reach the same conclusion because § 2036(a)(2) applies if the power is held “alone or in conjunction with any person.”) (ii) The partnership agreement gave the decedent as general partner “broad authority not only to manage partnership property, but also to amend the partnership agreement at any time without the consent of the limited partners.” (iii) As general partner, the decedent “had the sole and absolute discretion to make pro rata distributions of partnership income (in addition to distributions to pay Federal and State tax liabilities) and to make distributions in kind.” (iv) Even after the gifts of limited partnership interests, the decedent and his wife held more than 50% of the limited partnership interests and could make any decision requiring a majority vote of the limited partners. Interestingly, the court did not include in its list of reasons the fact that the partnership gave the general partner the right to terminate and dissolve the FLP without a vote of the limited partners. The Tax Court, in a plurality opinion, held that §2036(a)(2) applied to a decedent’s interest in a limited partnership even though she only ever held just a limited partnership interest. Estate of Powell v. Commissioner, 148 T.C. 392 (2017). The majority and concurring opinions both agreed that §2036(a)(2) applied (though the concurring opinion did not address the reasoning for applying §2036(a)(2)). The majority opinion reasoned (1) that the decedent, in conjunction with all the other partners, could dissolve the partnership, and (2) that the decedent, through her son as the GP and as her agent, could control the amount and timing of distributions. The opinion adopted the analysis in Strangi as to why the “fiduciary duty” analysis in Byrum did not apply to avoid inclusion under §2036(a)(2) under the facts of the case because any such fiduciary duty was “illusory.” Fifteen of seventeen Tax Court judges joined in this conclusion; eight judges in the majority opinion and 7 judges in a concurring opinion–two judges concurred in result only. The “in conjunction with others” rational was also adopted in a later case involving intergenerational split dollar life insurance, based on the decedent’s ability, in conjunction with an irrevocable life insurance trust, to terminate a split dollar arrangement. Estate of Cahill v. Commissioner, T.C. Memo. 2018-84 (2018). See also Estate of Morrissette v. Commissioner, T.C. Memo. 2021-60 (prior Order in the case dated February 19, 2019 denied taxpayer’s motions for summary judgment that §§2036(a)(2), 2038(a)(1), and 2703(a) do not apply, reasoning merely that Estate of Cahill “is directly on point” regarding §§2036(a)(2) and 2038(a)(1)). d. Broad Powers to Allocate Between Income and Principal. Even broad authority to allocate receipts and disbursements between income and principal will not trigger Sections 2036 or 2038. E.g., Old Colony Trust Co. v. U.S., 423 F.2d 601, 604 (1st. Cir. 1970); Estate of Budd v. Comm’r, 49 T.C. 468 (1968); cf. Treas. Reg. § 20.2056-5(f)(4) (“power to determine the allocation or apportionment of receipts and disbursements between income and corpus” will not disqualify spouse’s income interest from qualifying for marital deduction). In Estate of Ford v. Commissioner, the trust authorized trustee “to

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apportion between principal and income of the trust estate any loss or expenditure in connection with the trust estate, which in his opinion should be apportioned, and in such manner as he may deem advantageous and equitable.” Estate of Ford v. Comm’r, 53 T.C. 114, 120 (1969), nonacq. 1978-2 C.B. 3, aff’d per curiam, 450 F.2d 878 (2d Cir. 1971). The IRS argued that the administrative and management powers gave the fiduciary uncontrolled discretion. It stressed particularly the power to allocate receipts, losses, and expenditures of the trust between income and principal. The court dismissed this argument, observing that this provision is commonly included in trust instruments 'to give the trustee some discretion so that he would not be required to seek court guidance in making doubtful allocations.' … The trustee herein is directed to exercise this power in an 'advantageous and equitable' manner. Of course, should he abuse his discretion by classifying an obvious item of principal as income, he would be subject to equity court review. 53 T.C. at 128.

Nevertheless, if the trust instrument permitted an unrestrained power to allocate capital gains to either to principal or income without the possibility of court review, Sections 2036 and 2038 could apply. Stephens, Maxfield, Lind & Calfree, Federal Est. & Gift Tax’n, ¶ 4.10[4][c] (2001). e. Broad Investment Authority. Various cases recognize that authorizing the trustee to invest in investments that would not otherwise be permissible under state law or to sell or exchange trust assets does not invoke Sections 2036 or 2038. E.g., United States v. Powell, 307 F.2d 821 (10th Cir. 1962); Estate of Ford v. Comm’r, 53 T.C. 114 (1969), nonacq. 1978-2 C.B. 3, aff’d per curiam, 450 F.2d 878 (2d Cir. 1971) (“the power to invest in 'nonlegals' (i.e., investments not classified under a particular State law or ruling of the pertinent court as legal investments for trust funds) and the power to sell or exchange the trust property do not amount to a right to designate who shall enjoy the trust property or a right to alter, amend, or revoke the terms of the trust”); Estate of Budd v. Comm’r, 49 T.C. 468, 475 (1968) (authority to retain or invest in securities or property that may not be of a character permitted for trustees’ investment under applicable State law). f.

“All Powers As I Would Have If Trust Not Executed”. A rather common catch-all administrative power is to say that the trustee can exercise any powers that the settlor could have exercised over the property if it had not been transferred to the trust. This type of common catch-all provision has been found not to trigger application of Sections 2036 or 2038. Old Colony Trust C. v. U.S., 423 F.2d 601, 603 (1st Cir. 1970) (reasoning that such language does not protect trustees from accountability to the court for exercise of the power).

g. Substitution Powers. A power of the grantor to substitute assets of equivalent value does not cause Section 2036 or 2038 to apply where it is held in a fiduciary capacity. State Street Co. v. U.S., 263 F.2d 635 (1st Cir. 1959) (court concluded, in a “very close” case, that broad management powers, including the power to exchange trust property for other property without regard to the values of the properties, as well as other broad powers, caused the predecessor to Section 2036 to apply). Despite the State Street decision (where the court barely found the predecessor to Section 2036 to apply when the donor, albeit as a fiduciary, could exchange assets with the trust without regard to values), the IRS again argued that a substitution power for equal value held by the grantor-trustee constituted a power to alter amend or revoke the instrument in Estate of Jordahl v.

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Comm’r, 65 T.C. 92 (1975). The court disagreed, reasoning that any property substituted should be 'of equal value' to property replaced, so the grantor was thereby prohibited from depleting the trust corpus. The court viewed that as being no different than the case where a settlor retains the power to direct investments. The IRS subsequently acquiesced in the case. 1977-2 C.B. 1. What if the grantor retains a substitution power in a nonfiduciary capacity (to cause the trust to be a grantor trust under Section 675(4)(C))? In Jordahl, the grantor who held the substitution power was a trustee, and held the power in a fiduciary capacity. However, the court’s reasoning suggests that the same result would have been reached if the substitution power had been held in a nonfiduciary capacity: “Even if decedent were not a trustee, he would have been accountable to the succeeding income beneficiary and remaindermen, in equity, especially since the requirement of 'equal value' indicates that the power was held in trust.” 65 T.C. at 97. Revenue Ruling 2008-22, 2008-16 I.R.B. 796, provides very helpful guidance, indicating that a grantor nonfiduciary substitution generally will not trigger estate inclusion under §§ 2036 or 2038. The Ruling cites Jordahl, but says that it did not apply § 2038 because the decedent was bound by fiduciary standards. Even if the grantor is not bound by fiduciary standards, the ruling observes that the trustee has the duty to ensure that equivalent value is substituted. Indeed, it says that if the trustee thinks the assets being substituted have a lower value than the assets being reacquired, “the trustee has a fiduciary duty to prevent the exercise of the power.” The ruling reasons that (1) the trustee “has a fiduciary obligation to ensure that the assets exchanged are of equivalent value,” and (2) the trustee must prevent any shifting of benefits among beneficiaries that might otherwise result from the substitution in view of the trustee’s power to reinvest assets and the trustee’s duty of impartiality regarding the beneficiaries. See section II.C.3.e of this outline for further discussion of Rev. Rul. 2008-22. The rulings states that [a] substitution power cannot be exercised in a manner that can shift benefits if: (a) the trustee has both the power (under local law or the trust instrument) to reinvest the trust corpus and a duty of impartiality with respect to the trust beneficiaries [Observe, state law would generally impose both of these duties unless the trust instrument negates these duties]; or (b) the nature of the trust’s investments or the level of income produced by any or all of the trust’s investments does not impact the respective interests of the beneficiaries, such as when the trust is administered as a unitrust (under local law or the trust instrument) or when distributions from the trust are limited to discretionary distributions of principal and income.

Revenue Ruling 2011-28, 2011-49 I.R.B. 830 is a follow-up to Rev. Rul. 2008-22. It provides that a nonfiduciary substitution power generally will not trigger estate inclusion under §2042. For a more detailed discussion of substitution powers see section II.C.3.e. of this outline. h. Management Powers Over Partnership. The principles of Byrum v. U.S., 408 U.S. 125 (1972), should mean that the powers of a transferor-general partner of a limited partnership should not cause transfers of limited partnership interests to be included in the estate under Section 2036(a)(2). However, a few cases have applied § 2036(a)(2) to an individual’s who contributed assets to a partnership and held certain management powers over a partnership, See section II.B.4.c of this outline for an extended discussion of the Byrum case and the FLP cases where the person who made contributions to a

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partnership held direct management powers over the partnership. Would those cases apply with the same force if the individual held those same powers only as a trustee of a trust that owned an interest in the partnership? Section 2036(b), enacted in response to the Byrum case, applies only to stock of a controlled corporation. There are no rulings where the IRS has taken the position that Section 2036(b) applies to transfers of partnership interests—since the statute specifically references stock of corporations. i.

Effect of Exculpatory Clause Limiting Trustee’s Personal Liability. As discussed above, the fact that a court of equity has the power to review administrative and management decisions of the trustee is the overriding principle that removes administrative and management powers from the reach of Section 2036(a)(2) or 2038. Does the existence of a broad exculpatory clause in the instrument change that result? It should not, because under state law, it is not possible to give a trustee complete exculpation from liability for its decisions. RESTATEMENT (SECOND) OF TRUSTS § 222 (prohibits enforcement of an exculpatory clause that would relieve a trustee of liability for a breach of trust committed in bad faith, intentionally or with reckless indifference to the interest of the beneficiary); E.g., InterFirst Bank Dallas, N.A. v. Risser, 739 S.W.2d 882, 888 (Tex. App.—Texarkana 1987, no writ) (exculpatory clause does not protect a trustee who used the trustee position to obtain an advantage by action inconsistent with the trustee’s duties and detrimental to the trust, or who takes actions in bad faith or acts “intentionally adverse or with reckless indifference to the interest of the beneficiary”). Cases interpreting Sections 2036 and 2038 have agreed. E.g., Old Colony Trust Co. v. U.S., 423 F.2d 601, 602 (1st Cir. 1970) (IRS argued that exculpatory clause triggered Sections 2036 and 2038; court disagreed observing that exculpatory clause “has no bearing on the question in this case because it does not affect the meaning, extent or nature of the trustees’ duties and powers”).

Effect of Guarantees. (1) Guaranty By Trustee. If the trustee has the authority to guarantee a personal obligation of the settlor or other individual, could that administrative power cause Section 2036 or 2038 to apply? The general principle regarding administrative powers that are exercisable subject to fiduciary standards for the benefit of the trust should control this situation. Texas courts have emphasized the fiduciary duties of trustees in analyzing whether a trustee even has the authority to issue a guaranty. See Three Bears, Inc. v. Transamerican Leasing Co., 574 S.W.2d 193, 197 (Tex. Civ. App.—El Paso 1978), aff’d in part and rev’d in part on other gr, 586 S.W.2d 472 (Tex. 1979). (2) Guaranty by Donor. If an individual guaranties a trust indebtedness, the question that arises is whether that individual makes a gift to the trust. In Letter Ruling 9113009, the IRS suggested that a guaranty by an individual for the benefit of another is a transfer, but the IRS indicated that it was not taking a position as to how the gift should be valued. That ruling came under intense criticism, and was withdrawn by Letter Ruling 9409018. An analogous situation is that an S corporation shareholder receives no basis from the guarantee of a corporate loan since nothing is “paid” by merely giving the guaranty. Another analogy is that an insured’s loan to a trust to pay premiums does not create an incident of ownership, where the policy is not used as security for the loan. Ltr. Rul. 9809032. If the loan is not an incident of

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ownership, a guarantee of a loan should not be an incident of ownership either. There are no further rulings or cases that have addressed whether guarantees constitute gifts. k. Administrative Powers That CANNOT Be Retained by Grantor. The prior subsections have addressed various administrative powers that do not cause inclusion under Sections 2036 or 2038. There are two situations where administrative powers cannot be retained by the grantor. (In addition, certain controls over the appointment of trustees, such as removal powers, may have adverse consequences. They are addressed in section II.B.5. of this outline.) (1) Voting Powers. The IRS argued in the past that retaining voting powers over stock that is transferred to a trust constitutes a power causing inclusion under Section 2036(a)(2). The Supreme Court ultimately rejected this argument in U.S. v. Byrum, 408 U.S. 125 (1972). (The Byrum case is discussed in detail in section II.B.4.c. of this outline.) In response, the IRS (nine years later) withdrew an earlier ruling that stated that a power to control dividends by the right to vote nontransferred stock constituted a Section 2036(a)(2) power. Rev. Rul. 81-15, 1981-1 C.B. 457, rev’g, Rev. Rul. 67-54, 1967-1 C.B. 269. In 1976, Congress passed the “anti-Byrum” amendment, enacting the predecessor to Section 2036(b). That Section provides that a grantor’s retention of the power to vote shares in a “controlled corporation” is deemed to be the retention of the enjoyment of the property for purposes of Section 2036(a)(1). Interestingly, this legislative response to the issue leaves undisturbed the Byrum holding as to Section 2036(a)(2). Section 2036(b) imposes two requirements: (1) there must be a controlled corporation, and (2) the decedent must have retained voting rights. As to the first requirement, a corporation is a “controlled corporation” if at any time after the transfer of stock and during the three year period ending on the date of the decedent’s death, the decedent owned (taking into account the attribution rules of Section 318) or had the right (either alone or in conjunction with any person) to vote stock possessing at least 20% of the total combined voting power of all classes of stock. I.R.C. § 2036(b)(2). As to the second requirement, the grantor must retain the right to vote (directly or indirectly) the stock that is transferred. The right to vote nontransferred stock does not count, and the grantor may give non-voting stock and retain even all of the voting stock of the corporation. Prop. Reg. § 20.2036-2(a). Proposed regulations (that have been outstanding for years) take the position that the grantor retains the right to vote, for this purpose, if the power is merely exercisable in a fiduciary capacity as trustee or co-trustee, or where the grantor may appoint himself as trustee. Prop. Reg. § 20.2036-2(c). There is a right to vote “indirectly” if there is any agreement, either express or implied, as to how the shareholder will or will not vote the stock. Id. However, the mere fact that persons whose ownership of stock would be attributed to the grantor under Section 318 have the right to vote stock will not be treated as a retention of voting power by the grantor. Id. In addition, the IRS takes the position that if stock of a controlled corporation is transferred to a partnership of which the grantor is a general partner and has the right

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to vote the stock as general partner, Section 2036(b) applies. That is the case even if the voting rights are subject to the fiduciary duties of a general partner. Tech. Adv. Memo. 199938005, docketed in the Tax Court as Estate of Coulter v. Comm’r, Docket No. 17458-99. Some planners disagree with the conclusion, because under state law a partner has no direct or indirect rights with respect to the property of the partnership. Under this argument, the insured-transferor who is the general partner has no individual right to vote that stock. Only the partnership has the right to vote that stock. Observe that Section 2036(b) has its own three-year rule, rather than just using the three-year rule in Section 2035. The difference is that the Section 2036(b) provision applies if the grantor held the power to vote at any time within three years prior to death, whereas Section 2035 does not apply as long as the relinquishment of any problematic power occurs automatically under the agreement without any volition on the part of the grantor. Accordingly, any right that the grantor has as trustee (or otherwise) to vote stock in a controlled corporation must be relinquished at least three years before the grantor dies, or else estate inclusion will result under Section 2036(b). For example, if the grantor of a GRAT is the trustee during the initial term of the GRAT, the grantor would have to survive at least three years after relinquishing any voting power over controlled corporation stock. Therefore, if stock of a controlled corporation is being contributed to a GRAT, (1) the grantor either should not serve as trustee at all, (2) the grantor should resign as trustee or in some other manner give up the right to vote the stock at least three years before the GRAT terminates, or (3) there must be a co-trustee who would hold all of the voting power with respect to stock of any controlled corporation and the grantor must be precluded from ever holding any power to vote such stock. (2) Incidents of Ownership Over Life Insurance. Section 2042 provides that life insurance proceeds are included in the insured’s estate if (i) the proceeds are payable to or for the benefit of the insured’s estate, or (ii) if the insured, at his death, possessed any incidents of ownership in the policy, exercisable either alone or in conjunction with any other person. The term “incidents of ownership” has been interpreted very broadly, and includes just about any power over the policy, including the following powers: to change the beneficiary; to surrender or cancel the policy; to assign the policy; or to pledge the policy for a loan or obtain a loan on the policy from the insurer. Treas. Regs. § 20.2042-1(c)(2). In addition, incidents of ownership include the power to elect a settlement option, In Re Estate of Lumpkin, 474 F.2d 1092 (5th Cir. 1973), or to veto the owner’s right to assign the policy or designate policy beneficiaries, Rev. Rul. 75-70, 1975-1 C.B. 301. However, the insured’s merely making a loan to a trust to enable it to pay premiums is not an incident of ownership in the policy as long as it is not used as collateral for the loan. Ltr. Rul. 9809032. Any such powers held by the insured in a fiduciary capacity will be treated as if the insured held the incidents of ownership for purposes of Section 2042. Treas. Reg. § 20.2042-1(c)(4); Terriberry v. United States, 517 F.2d 286 (5th Cir. 1975), cert denied, 427 U.S. 977 (1976); Freuhauf v. Comm’r, 427 F.2d 80 (6th Cir. 1970); but see Bloch v. Comm’r, 78 T.C. 850 (1982). Under Revenue Ruling 84-179, an insured who holds powers over a policy in a fiduciary capacity will avoid Section 2042 only if all of the following are satisfied: (i) the powers are held only in a fiduciary capacity, (ii) the powers are not exercisable for the insured’s personal

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benefit, (iii) the insured did not transfer the policy to the trust and did not transfer to the trust from personal assets any of the consideration for purchasing or maintaining the policy by the trust, and (iv) the insured did not obtain his trustee powers through some prearranged plan in which the insured participated. 1984-2 C.B. 195. The last two requirements would not be satisfied where the insured transfers an insurance policy to a trust and serves as the trustee or became trustee through some prearranged plan. Even if the insured is not the initial trustee, if the insured can appoint himself as trustee, the insured will be treated as holding incidents of ownership in the policy. Furthermore, if the insured just has the power to remove and appoint a replacement trustee, the insured may be treated as holding any incidents of ownership held by the trustee. The general effects of trustee removal powers are addressed in section II.B.5.g. of this outline. The effects of removal powers for purposes of Section 2042 are discussed in section II.B.5.h. of this outline. l.

Summary of Trustee Selection Issues With Respect to Administrative Powers. Administrative or management powers of the trustee will generally not cause inclusion under Section 2036 or 2038, even if the grantor is the trustee or has the power to become trustee. The cases have reached this conclusion by relying on the authority of a court to review the trustee’s actions under its fiduciary duty; therefore the trustee does not have unfettered control. Accordingly, if the grantor is or may become the trustee, be wary of including language giving extremely broad management powers that are purportedly to be exercised solely in the trustee’s discretion without any court control. (That type of language is probably not enforceable anyway, but why push the envelope?) Similarly, be wary of using extremely broad exculpatory provisions if the grantor is or may become the trustee. Two powers that the grantor cannot have without adverse tax consequences are (1) the right to vote stock of a “controlled corporation” that the grantor contributes to the trust, and (2) any incidents of ownership over life insurance policies on the grantor’s life. As an example, if the grantor of a GRAT serves as trustee during the initial term, he should not have the power to vote stock if “controlled corporation” stock is conveyed to the GRAT—because the grantor would have to survive at least three years after ceasing to serve as trustee (with the power to vote) before the assets would be excluded from the grantor’s estate for estate tax purposes.

5. Trustee Removal and Appointment Powers. a. Power to Appoint Self at Any Time. The grantor will be treated as holding any dispositive or management powers held by the trustee if the grantor can appoint himself as the trustee at any time. Treas. Reg. § 20.2036-1(b)(3) (power to remove trustee and appoint himself); Estate of McTighe v. Comm’r, 36 T.C.M. 1655 (1977) (power to substitute self as trustee and power of trustee to make distributions in satisfaction of grantor’s support obligations). b. Contingent Power to Appoint Self as Successor Trustee. If the grantor has a contingent power to appoint himself as trustee upon the occurrence of an event that is out of his control (such as a prior trustee ceasing to serve due to his death or resignation), Section 2038 does not apply, but Section 2036(a) does apply. Estate of Farrel v. U.S., 553 F.2d 637 (Ct. Cl. 1977) (trustees, under provisions of irrevocable trust, had right to designate

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persons who would possess trust property and income; settlor could designate herself as trustee if vacancy occurred in office of trustee during her life, and settlor had opportunity to appoint two successor trustees before her death; held, right of trustee to designate beneficiaries would be attributed to settlor); Estate of Alexander v. Comm’r, 81 T.C. 757 (1983); Rev. Rul. 73-21, 1973-1 C.B. 405; See Treas. Reg. § 20.2036-1(b)((3). (At least one case has disagreed with this position, but most have agreed with it. See section II.B.3.e.(3) of this outline.) c. Power to Appoint Self as Co-Trustee. Sections 2036 and 2038 apply to powers held jointly with someone else. Therefore, the ability to add one’s self as a co-trustee would be just as damaging as being able to become sole trustee—unless the trust instrument reserved the problematic power just for the co-trustee other than the grantor. See section II.B.3.d.(2) of this outline. d. Veto Power. A corollary to the co-trustee rule is that a power reserved by the grantor to veto actions of the trustee will cause the grantor to be treated as holding the powers of the trustee over which the veto power may be exercised. See section II.B.3.d.(4) of this outline. e. Power to Appoint a Series of Successor Trustees. Is the power to appoint a series of trustees in effect a power to “amend” the trust that would be subject to Section 2038? No case has directly addressed that argument, although that type of power has been present in a variety of reported cases that have addressed Section 2036 and 2038. E.g,, Estate of Budd v. Comm’r, 49 T.C. 468 (1968) (“power to appoint a successor trustee or trustees by instrument in writing lodged with said successor trustee or trustees, and specifying the date or event upon which the appointment of such successor trustee or trustees shall take effect”). f.

Power to Add Co-Trustees (Not Including Self). If the grantor merely has the power to add co-trustees, the grantor generally should not be treated as holding the powers of the trustees, as long as he cannot appoint himself. Durst v. U.S., 559 F.2d 910 (3d Cir. 1977) (corporate trustee had a power to control disposition, and grantor reserved right to name an individual trustee as co-trustee; court concluded that grantor could not name himself, and there was no estate inclusion). Nevertheless, there is concern that if the grantor can keep adding co-trustees indefinitely, the grantor could control the trustees’ decision by just appointing trustees who would agree with his position. Even in that situation, there would still be the argument that the grantor has no real power at all, because anyone he appoints is subject to fiduciary standards and control of the courts, unless an express or implied agreement could be shown. See Estate of Vak v. Comm’r, 973 F.2d 1409 (8th Cir. 1992) (transfer constituted completed gift; court rejected IRS’s argument that donor “had the power to replace trustees with individuals who would do his bidding”); Estate of Wall v. Comm’r, 101 T.C. 300, 312 (1993) (“a trustee would violate its fiduciary duty if it acquiesced in the wishes of the settlor by taking action that the trustee would not otherwise take”) (See section II.B.2.c.(1)(a) of this outline regarding the implied agreement principle.)

g. Power to Remove and Replace Trustee—Sections 2036 and 2038. If the grantor could remove the trustee and appoint himself, it has long been clear that the grantor is treated as holding the powers of the trustee for purposes of Sections 2036 and 2038. See section II.B.5.a of this outline, above. There is a long history of disagreement as the tax effect of the grantor’s power to remove the trustee and appoint someone other than the grantor as

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successor trustee. Since 1995, there is now a very clear objective safe harbor, but a brief review of the history of this issue may help provide perspective (and help to analyze situations where the safe harbor is not met.) In a 1977 revenue ruling, the IRS ruled on a situation in which the decedent held the power to appoint a successor corporate trustee if the original trustee resigned or was removed by judicial process. The IRS ruled that Section 2036 did not apply because “the decedent’s power to appoint a successor corporate trustee in the event of resignation or removal of the original trustee did not amount to a power to remove the original trustee that, in effect, would have endowed the decedent with the trustee’s discretionary control over trust income.” Rev. Rul. 77-182, 1977-1 C.B. 273. The IRS followed that with the now infamous Revenue Ruling 79-353, 1979-2 C.B. 325, which takes the position that the right to remove a corporate trustee without cause and appoint a successor corporate trustee caused estate inclusion under Sections 2036 and 2038. The IRS posited that this removal and appointment power was an “extremely potent power,” even though the decedent was forced to appoint a successor corporate trustee. After receiving considerable criticism of the ruling, the IRS relented somewhat in 1981, and agreed that Revenue Ruling 79-353 would apply only to transfers after the date of the 1979 ruling. Rev. Rul. 81-151, 1981-1 C.B. 458. The first court case to address the IRS’s position in Revenue Ruling 79-353 was Estate of Vak, which held that the grantor’s unlimited power to remove the trustee and appoint a successor independent trustee (who was not a related or subordinate party under Section 672(c)) did not prevent the grantor from making a completed gift when the transfer to the trust was made. The case summarily rejected the IRS’s position that "Mr. Vak had the power to replace the trustees with individuals who would do his bidding." Estate of Vak v. Comm’r, 973 F.2d 1409 (8th Cir. 1992). The IRS next urged its position under Sections 2036 and 2038 regarding removal powers in Estate of Wall. That case presented facts very similar to the facts of Revenue Ruling 79-353. Estate of Wall v. Comm’r, 101 T.C. 300 (1993). The IRS’s position was “that even a corporate trustee will be compelled to follow the bidding of a settlor who has the power to remove the trustee; otherwise the settlor will be able to find another corporate trustee which will act as the settlor wishes. In other words, says respondent, under these circumstances the settlor has the de facto power to exercise the powers vested in the trustee.” 101 T.C. at 311. The Tax Court rejected this argument, relying primarily on the fiduciary duty of any trustee that might be appointed by the grantor: [U]nder established principles of the law governing trusts, a trustee would violate its fiduciary duty if it acquiesced in the wishes of the settlor by taking action that the trustee would not otherwise take regarding the beneficial enjoyment of any interest in the trust, or agreed with the settlor, prior to appointment, as to how fiduciary powers should be exercised over the distribution of income and principal. The trustee has a duty to administer the trust in the sole interest of the beneficiary, to act impartially if there are multiple beneficiaries, and to exercise powers exclusively for the benefit of the beneficiaries. … In the absence of some compelling reason to do so, which respondent has not shown, we are not inclined to infer any kind of fraudulent side agreement between Mrs. Wall and First Wisconsin as to how the administration of these trusts would be manipulated by Mrs. Wall. Instead, since

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the language of the trust indentures provides maximum flexibility as to distributions of income and principal, the trustee would be expected to look to the circumstances of the beneficiaries to whom sole allegiance is owed, and not to Mrs. Wall, in order to determine the timing and amount of discretionary distributions. 101 T.C. at 312-313.

The court concluded by relying on the Supreme Court’s analysis of Section 2036 in U.S. v. Byrum, 408 U.S. 125 (1972), to concluded that the grantor did not retain an ascertainable and enforceable power to affect the beneficial enjoyment of the trust property. 101 T.C. at 313. Following its losses in Estate of Vak and Estate of Wall, the IRS changed its position in Revenue Ruling 95-58, 1995-2 C.B. 1. The ruling revokes Revenue Ruling 79-353 and Revenue Ruling 81-51. In addition, it modified Revenue Ruling 77-182 “to hold that even if the decedent had possessed the power to remove the trustee and appoint an individual or corporate successor trustee that was not related or subordinate to the decedent (within the meaning of § 672(c)), the decedent would not have retained a trustee's discretionary control over trust income.” In effect, the ruling allows a safe harbor based on the facts of the Vak case. The safe harbor is that Sections 2036 and 2038 will not apply to a grantor who could remove a trustee, but who had to appoint as a successor trustee someone who was “not related or subordinate to the decedent” within the meaning of Section 672(c). (Interestingly, this position is consistent with the removal provisions in the income tax regulations for grantor trusts. Treas. Reg. § 1.674(d)-2.) Thus, the grantor can retain an unlimited right to remove the trustee, and there is no requirement that a successor corporate trustee be appointed. However, the IRS does add the requirement that, to come within the safe harbor, the successor trustees must not be a “related or subordinate party.” In many situations, the grantor will want to have a removal power and have the power to appoint someone other than the grantor, but the grantor may want to keep the ability to name relatives or others who would not come within the safe harbor. The grantor will need to weigh the desire for the retained flexibility vs. the comfort of coming within the safe harbor of Revenue Ruling 95-58. If the grantor decides to keep the more expansive ability to appoint relatives as successor trustees, the grantor would rely on the broad language in Estate of Wall relying primarily on the fiduciary duty of any trustee who might be appointed. h. Power to Remove and Replace Trustee—Section 2042. Revenue Ruling 79-353, 1979-2 C.B. 325 held that retaining the ability to remove a trustee gave the grantor all of the powers of the trustee for purposes of Sections 2036 and 2038, but did not address Section 2042. Technical Advice Memo 8922003 held, in reliance on Revenue Ruling 79-353, 1979-2 C.B. 325, that the ability of the insured to remove the trustee without cause and appoint someone other than the insured as successor trustee resulted in the insured holding incidents of ownership. Revenue Ruling 95-58, 1995-2 C.B. 1, revoked Revenue Ruling 79-353 (which addressed Sections 2036 and 2038) and provided that those Sections would not apply to a grantor who could remove a trustee, but who had to appoint as a successor trustee someone who was “not related or subordinate to the decedent” within the meaning of Section 672(c).

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The revocation of Revenue Ruling 79-353 seems to imply that the extension of its rationale to Section 2042 in TAM 8922003 is no longer valid. Furthermore, Letter Ruling 9832039 cited Revenue Ruling 95-58’s revocation of Revenue Ruling 79-353 to support its conclusion that the power to remove a trustee for cause did not trigger Section 2042. (However, the citation to Revenue Ruling 95-58 was not necessary because the power to remove a trustee for cause was probably not an incident of ownership even prior to Revenue Ruling 95-58.) See Janson, Life Insurance Potpourri—Recent Developments and Private Split Dollar Plans, 34TH ANNUAL UNIV. OF MIAMI PHILIP E. HECKERLING INST. ON EST. PL. ¶ 401.5.C. (2000). The IRS has not addressed the effect of a removal power without cause for purposes of Section 2042, but it would probably be treated the same as for Sections 2036 and 2038 under Revenue Ruling 95-58. See Ltr. Rul. 200314009 (if trustee ceased to serve or was removed, insured could appoint successor trustee who was not related or subordinate to insured; held that section 2042 did not apply; ruling did not clarify whether insured held a removal power, but the reasoning of the ruling seems to apply Rev. Rul 95-58 for §2042 purposes); Covey, Recent Developments in Transfer Taxes and Income Taxation of Trusts and Estates, 35TH ANNUAL UNIV. OF MIAMI PHILIP E. HECKERLING INST. ON EST. PL. ¶ 120 (2001) (suggesting that the IRS likely will not take a harsher position under Section 2042 than under Sections 2036 and 2038, observing that the IRS has taken same position in PLR 9746007 regarding the effect of removal powers on a beneficiary under Section 2041). i.

Disability of Grantor. The disability of the grantor will have no impact on powers that may be held by the grantor with respect to any of the prior subsections regarding trustee appointment powers. See section II.B.3.d.(5) of this outline.

Summary of Selection of Trustee Issues Regarding Trustee Removal and Appointment Powers. If the trustee holds powers that would cause estate inclusion if the grantor held the powers directly, the following restrictions apply regarding appointment procedures to avoid estate inclusion by reason of the appointment powers. The grantor cannot have the power to appoint himself--even a power contingent upon the occurrence of future conditions outside his control. Also, the grantor cannot serve as a co-trustee or have a power to veto actions by the trustee. The grantor can, however, keep the power to appoint a successor or series of successor trustees in the future (apparently) or to add co-trustees. The grantor can keep the power to remove and replace the trustee (with someone other than the grantor) as long as the successor is someone who is not related or subordinate to the grantor. If the grantor wants to have the ability to remove and appoint a successor (other than himself) is who a related party, the parties would have to rely on the reasoning of Vak and Wall that any successor trustee would be subject to fiduciary duties, but that procedure would not be within the safe harbor that is clearly recognized by the IRS.

6. Special Trusts. a. Minor’s Trusts Under Section 2503(c). If the grantor serves as trustee of a minor’s trust created under Section 2503(c) (to qualify for the gift tax annual exclusion), the trust assets will be included in the grantor’s estate for under Sections 2036 and 2038 if he dies while serving before the termination of the trust. See Alexander v. Comm’r, 81 T.C. 757

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(1983); Estate of O’Connor v. Comm’r, 54 T.C. 969 (1970). Under Section 2503(c), there can be no “substantial restrictions” on the trustee’s exercise of the discretionary power to make distributions for the minor beneficiary. Treas. Reg. § 25.2503-4(b)(1). A discretionary power to make distributions for “support, education, care, comfort and welfare” will qualify under Section 2503(c). Rev. Rul. 67-70, 1967-2 C.B. 349. Even that standard, however, is probably too expansive to satisfy the ascertainable standard exception under Section 2036 and 2038 (as discussed in Section II.B.3.g. of this outline). (In addition, estate inclusion would result if the grantor resigns as trustee within three years of his death. I.R.C. § 2035(a).) Accordingly, the grantor should not serve as trustee or co-trustee (or have the power to appoint himself as trustee or co-trustee) of a Section 2503(c) trust. In addition, the grantor’s spouse generally should not be the trustee either. If the spouse dies before the trust terminates, the assets may be included in the spouse’s estate, because she would have the power to make distributions in satisfaction of her legal obligation of support. Treas. Reg. § 20.2041-1(c)(1). Furthermore, when the child becomes of majority age, so that the spouse no longer owes a legal obligation of support, the IRS may argue that a lapse of the spouse’s general power of appointment occurs, thus resulting in a gift from the spouse to the trust. See generally Zaritsky, Tax Planning for Family Wealth Transactions, ¶ 4.05[1][a]. The trustee’s discretionary power over distributions in a Section 2503(c) trust is not a grantor trust power. See I.R.C. § 674(b)(7). b. Special Needs Trust. A “special needs trust,” designed to provide benefits for a disabled beneficiary that would not disallow governmental benefits, must provide complete discretion to the trustee in making distributions. Obviously, the grantor cannot be the trustee or co-trustee (or have the power to appoint himself as trustee or co-trustee.) c. Qualified Domestic Trust. Bequests of other transfers at the death of a spouse to a surviving spouse who is not a citizen of the United States will qualify for the estate tax marital deduction only if the transfer is made to a qualified domestic trust. I.R.C. 2056A. One of the statutory requirements is that the trust instrument require that one trustee of the trust be an individual citizen of the United States of a domestic corporation. I.R.C. § 2056A(a)(1)(A). In the addition, the regulations add various requirements that must be satisfied depending on the size of the trust. If the trust is over $20 million in value, the trust must meet one of three additional requirements. Treas. Reg. § 20.2056A-2(d)(1)(i). The easiest of those three requirements is to have at least one co-trustee that is a domestic bank or the United States branch of a foreign bank (in which event there must be another co-trustee (individual or a domestic corporation) that is a United States citizen. Treas. Reg. § 20.2056A-2(d)(1)(i)(A). (An additional option is available if the QDOT has assets under $2.0 million, namely that the trust instrument provide that no more than 35% of the fair market value of the trust assets, determined annually, may be invested in real property that is located outside the United States, Treas. Reg. § 20.2056A-2(d)(1)(ii).) d. S Corporation. Only certain types of trusts can qualify as shareholders of an S corporation. These include (1) a grantor trust, (2) a “Section 678” trust requiring that all income be taxable to a trust beneficiary, (3) a Qualified Subchapter S Trust, (“QSST”) or (4) an electing small business trust. (“ESBT”). I.R.C. § 1361(c)(2)(A). If a trust is not a grantor trust (as to the grantor under Section 671-677 or as to the beneficiary under Section 678), it is often preferable for the trust to qualify as a QSST, due to the

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complexity of administering ESBTs and the requirement that all S corporation income attributable to an ESBT will automatically be taxed at the trust’s highest marginal rates. I.R.C. § 641(c). One of the requirements of a QSST is that there be only one current income beneficiary, and that corpus distributions may only be made to the current income beneficiary. I.R.C. §1361(d)(3)(A)(i-ii). Another requirement is that all of the income must be distributed currently to the income beneficiary. I.R.C. § 1361(d)(3)(B). If a trust instrument allows distributions to more than one beneficiary, and if the grantor anticipates that the trust may at some point own or acquire stock in an S corporation, the trust instrument may include a provision permitting the trustee to divide the trust into separate trusts for the beneficiaries, so that there is a separate single-beneficiary trust for each beneficiary; the S corporation stock would be distributed to those separate trusts. Furthermore, the special S corporation authority will typically provide that if such separate trusts are created for each income beneficiary, there will be a mandatory income requirement with respect to those separate trusts (so that the trust will not be at risk for losing S corporation status for all of the shareholders of the S corporation by inadvertently failing to distribute all of the trust’s accounting income during the year). If that type of provision is included, and if the grantor is the trustee or co-trustee (or may become the trustee or a co-trustee), the authority to acquire stock of an S corporation and to divide a sprinkle trust into separate trusts and to convert a discretionary income provision into a mandatory income provision may cause estate inclusion for the grantor under Sections 2036 and 2038. e. Charitable Remainder Trust. Subject to several limitations, a grantor may serve as the trustee of a charitable remainder trust. See e.g., Ltr. Rul. 7730015; but see Ltr. Rul 9442017. However, difficulties arise if difficult-to-value assets are held in a charitable remainder unitrust (“CRUT”). A CRUT’s assets must be valued annually. I.R.C. § 554(a)(2)(A). Regulations adopted in 1998 provide that “unmarketable assets” (defined as assets that are not cash, cash equivalents or assets that can be readily sold for cash or cash equivalents, Treas. Reg. § 1.664-1(a)(7)) must be valued either (1) by an “independent trustee”, or (2) by a qualified appraiser. Treas. Reg. § 1.664-1(a)(7). For this purpose, an independent trustee is a person who is not the grantor, a noncharitable beneficiary, or a related or subordinate party to the grantor, the grantor’s spouse, or a noncharitable beneficiary (within the meaning of Section 672(c)). Accordingly, if there are any difficult-to-value assets in a CRUT, an independent trustee (as defined above) must be used if the grantor does not want to have to incur the expense of obtaining a formal qualified appraisal of the trust assets each year. f.

Grantor Retained Annuity Trust (GRAT). The grantor typically serves as the trustee of the GRAT during the term of the annuity payments. (The assets will be included in the grantor’s estate in any event if the grantor dies before the annuity payments end.) Generally, there is no requirement that the grantor live at least three years after ceasing to serve as trustee (because Section 2035(a)(1) provides that the three year rule applies if a Section 2036 or 2038 power is “relinquished;” the grantor does not “relinquish” anything at the end of the GRAT term, instead the instrument mandates that the annuity ends.) If the grantor continues to serve as trustee following the end of the annuity term, the other requirements discussed in this outline in order to avoid estate inclusion under Sections 2036 and 2038 with respect to retained powers must be satisfied.

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There is a special three-year problem if the GRAT owns stock in a “controlled corporation” and if the grantor has the right as a trustee (or co-trustee) to vote such stock. The grantor would have to cease serving as trustee or otherwise relinquish any voting rights at least three years before his death in order to avoid estate inclusion under Section 2036(b). See section II.B.4.k.(1) of this outline. If the grantor serves as trustee of a GRAT that may hold stock of a “controlled corporation,” as defined in Section 2036(b), the trust instrument should specify that the grantor will not have the right to vote such stock, and there should be a co-trustee who has the right to vote such stock. g. Sales to Grantor Trusts. A popular estate planning strategy is to have a donor create a grantor trust (i.e., a trust that the grantor is deemed to own for income tax purposes but not for estate and gift tax purposes). The donor would give some assets to the trust, then would sell other assets to the trust in return for a fixed interest note. Hopefully, the income and appreciation of the asset that is sold to the trust will be larger than the interest on the note, so that net accumulation will occur in the trust. One of the risks of the sale to grantor trust strategy is that under extreme circumstances, it is possible that the IRS may take the position that the note is treated as a retained equity interest in the trust rather than as a mere note from the trust. If so, this would raise potential questions of whether some of the trust assets should be included in the grantor’s estate under §2036 and §2702. It would seem that §2036 (which generally causes estate inclusion where the grantor has made a gift of an asset and retained the right to the income from that asset) should not apply to the extent that the grantor has sold (rather than given) the asset for full market value. See Letter Rulings 9436006 (stock contributed to grantor trust and other stock sold to trust for 25-year note; ruling holds §2702 does not apply); 9535026 (property sold to grantor trust for note, interest-only AFR rate for 20 years with a balloon payment at end of 20 years; held that the note is treated as debt and “debt instrument is not a retained interest” for purposes of §2702; specifically refrained from ruling on § 2036 issue). One letter ruling concluded that Section 2036 did apply to property sold to a grantor trust in return for a note, based on the facts in that situation. Letter Ruling 9251004 (transfer of $5.0 million of stock to trust in return for $1.5 million note in “sale/gift” transaction; ruling held that §2036 applies to retained right to payments under note, reasoning that note payments would constitute a major share, if not all, of the trust income, thus causing inclusion of trust property in estate). For a listing of cases that have addressed the application of section 2036 in the context of private annuity transactions where are the grantor is retaining the right to receive substantial payments from a trust, see Hesch & Manning, Beyond the Basic Freeze: Further Uses of Deferred Payment Sales, 34 UNIV. MIAMI INST. EST. PL. ¶ 1601.1 n. 55 (2000). One commentator has suggested that there is a significant risk of section 2036(a)(1) being argued by the IRS if “the annual trust income does not exceed the accrued annual interest on the note.” Covey, Practical Drafting 4365-4370, at 4367. Much of the risk of estate inclusion seems tied to the failure to have sufficient “seeding” of equity in the trust prior to the sale. One commentator summarizes the possible risks of thin capitalization as follows-a. includibility of the gross estate under section 2036, b. a gift upon the cessation of section 2036 exposure, c. applicability of section 2702 to such a gift,

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d. the creation of a second class of equity in the underlying property with possible consequences under section 2701, e. possible loss of eligibility of the trust to be an S Corporation, f. treatment of the trust as an association taxable as a corporation, g. continued estate tax exposure under section 2035(a) for three years after cessation of section 2036 exposure, and h. inability to allocate GST exemption during the ensuing ETIP. The section 2036 problem may go away as the principal on the note is paid down, or as the value the purchased property (the equity) appreciates, but the ETIP problem would remain. Aucutt, Installment Sales to Grantor Trusts, ALI-CLE PLANNING TECHNIQUES FOR LARGE ESTATES 613, 669 (April 2013). Various cases have addressed when promissory notes will be respected for general tax purposes. Estate of Deal v. Comm’r, 29 T.C. 730 (1958) (intent to forgive notes at time they were received cause gift treatment at outset); Estate of Holland v. Comm’r, T.C. Memo 1997-302 (loan owed by estate not treated as valid loan qualifying for estate tax debt deduction; “The determination of whether a transfer was made with a real expectation of repayment and an intention to enforce the debt depends on all the facts and circumstances including whether: (1) There was a promissory note or other evidence of indebtedness, (2) interest was charged, (3) there was security or collateral, (4) there was a fixed maturity date, (5) a demand for repayment was made, (6) any actual repayment was made, (7) the transferee had the ability to repay, (8) any records maintained by the transferor and/or the transferee reflected the transaction as a loan, and (9) the manner in which the transaction was reported for Federal tax is consistent with a loan.”); FSA 1999-837 (if intent to forgive loan as part of prearranged plan, loan will not be treated as consideration and donor makes gift to the full extent of the loan). The same nine objective factors listed in Estate of Holland were also described in Miller v. Commissioner, T.C. Memo 1996-3, aff’d, 113 F.3d 1241 (9th Cir. 1997). See also Santa Monica Pictures, LLC v. Commissioner, T.C. Memo. 2005-104. If the note that is received from the trust is treated as debt rather than equity, the trust assets should not be included in the grantor/seller’s gross estate under §2036. The Rosen case reiterated some of these same factors in determining that advances from an family limited partnership should be treated as equity distributions rather than being recognized as advances in return for a note. Estate of Rosen v. Comm’r, T.C. Memo 2006-115 (decedent never intended to repay the advances, demand note with no fixed maturity date, no written repayment schedule, no provision requiring periodic payments of principal or interest, no stated collateral, no repayments by decedent during lifetime, no demand for repayment, only one note was prepared during lifetime even though numerous “advances” were made, decedent had no ability to honor a demand for repayment, no interest payments on the note, repayment of the note depended solely on the FLP’s success, transfers were made to meet the decedent’s daily needs, adequacy of interest on the note was questioned). For an excellent discussion of the impact of the Rosen case on potential estate inclusion, see Blattmachr & Zeydel, Comparing GRATs and Installment Sales, 41ST ANNUAL HECKERLING INSTITUTE ON ESTATE PLANNING ¶202.3[C][2](2007). John Porter reports that he has had several cases in which the IRS took the position that notes given by grantor trusts in exchange for partnership interests should be ignored, based on the assertion that the “economic realities of the arrangement … do not support a

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part sale,” and that the full value of the partnership interest was a gift not reduced by any portion of the notes. (This position conflicts with Treas. Reg. § 25.2512-a, which provides that transfers are treated as gifts “to the extent that the value of the property transferred by the donor exceeds the value in money or money’s worth of the consideration given therefore.”) If the note term is longer than the seller’s life expectancy, the IRS may have a stronger argument that §2036 applies. The IRS has questioned the validity of a sale of limited partnership interests to a grantor trust in the Karmazin case, which was settled in a manner that recognized the sale. T.C. Docket No. 2127-03, filed Feb. 10, 2003. That case was ultimately settled (favorably to the taxpayer), but the wide ranging tax effects of having the note treated as equity rather than debt were highlighted. The IRS attacked a sale to grantor trust transaction in two companion cases that were filed December 26, 2013 in the Tax Court. Estate of Donald Woelbing v. Commissioner, Docket No. 30261-13; Estate of Marion Woelbing v. Commissioner, Docket No. 3026013. (These are pronounced “WELL-bing.”) In 2006, Mr. Woelbing sold that number of shares of non-voting stock in Carma Laboratories (a closely-held company located in Wisconsin) having a value of $59 million to his grantor trust in return for a $59 million note. The IRS questioned the value of the assets and the value of the note for gift tax purposes. It also argued that the stock was includable in the estate under §§2036 and 2038. A stipulated decision was entered in the cases in March, 2016 resulting in no additional gift tax for Donald or Marian Woelbing’s estate and no additional estate tax for Mr. Woelbing’s estate. Attorneys involved in the case report that the IRS recognized the “Wandry-like” provision in the sales agreement (selling that number of shares equal to $59 million), and that §§2702, 2036, and 2038 did not apply because 10% equity existed in the grantor trust that purchased the shares. The result apparently is that more shares were retained by Donald, and passed from his estate to Marian (qualifying for the marital deduction at Donald’s death). The settlement likely included an agreement of the additional shares that were included in Marion’s estate, and the date of death valuation of those shares–even though the pending Tax Court cases does not address her estate tax. The IRS made a similar §2036 attack on a sale of limited partnership interests to grantor trusts in Estate of Beyer. The Tax Court held that the FLP assets were included in estate the without specifically addressing the sale transaction. Estate of Beyer v. Commissioner, T.C. Memo. 2016-183. Practical Planning Pointers: One respected commentator summarizes planning structures to minimize the estate tax risk. The reasoning in Fidelity-Philadelphia Trust suggests that the estate tax case is strongest when the following features are carefully observed: a. The note should be payable from the entire corpus of the trust, not just the sold property, and the entire trust corpus should be at risk. b. The note yield and payments should not be tied to the performance of the sold asset.

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c. The grantor should retain no control over the trust. d. The grantor should enforce all available rights as a creditor. Aucutt, “Grantor Retained Annuity Trusts (GRATs) and Installment Sales to Grantor Trusts,” ALI-CLE PLANNING TECHNIQUES FOR LARGE ESTATES 395, 476 (April 2016). Avoid the §2036 issue by having the grantor’s spouse or another grantor trust loan funds to the trust that will purchase the assets from the grantor, so that note payments will not thereafter be made to the grantor/seller. See Jonathan Blattmachr, Protecting an Estate Tax Plan from Turner, Trombetta, Davidson, Woelbing, Etc., ANNUAL NOTRE DAME ESTATE PLANNING INST. (2014). C. Federal Income Tax Issues. 1. Foreign Trust Status and Effects. a. Tax Concerns With Being Foreign Trust. Various tax complexities arise for foreign trusts. A few of them are described. (1) Reporting Requirements. U.S. beneficiaries (including a grantor) who receive, directly or indirectly, any distribution from a foreign trust must report information to the IRS on Form 3520. (Additional required information is described in Notice 9734.) In addition, a U.S. person who makes a gift to a foreign trust must file a notice of the gift on Form 3520, with penalties of up to 35% of the amount transferred if the report is not made. In addition, the foreign trust must file an annual return, and if it does not, the U.S. person (if any) who is treated as the owner of the trust may be liable for a 5% penalty of the value of the trust assets that are treated as owned by that person. I.R.C. § 6677(b). If a U.S. trust becomes a foreign trust during the lifetime of a U.S. grantor, the U.S. grantor must report the transfer. I.R.C. § 679(a)(5). (2) Foreign Grantor Trust. If a U.S. grantor establishes a foreign trust for the benefit of U.S. beneficiaries, it is treated as a grantor trust. I.R.C. § 679. Upon termination of grantor trust status (i.e., at the death of the grantor or if there are no longer any U.S. beneficiaries), Section 684 imposes a tax on the unrealized appreciation. However, if that occurs because of the death of the grantor, the step-up in basis under Section 1014 should avoid having any gain to which Section 684 would apply. (3) Foreign Nongrantor Trust. If a foreign trust is not treated as a grantor trust (which, for example, could occur despite Section 679 if it is created in a testamentary transfer at the death of the U.S. grantor, or it is created by a non-U.S. grantor, or if it is created during the lifetime of a U.S. grantor and does not have any U.S. beneficiaries) special income tax rules apply. It is subject to U.S. income tax only on certain types of income (primarily income effectively connected with a U.S. trade or business, I.R.C. § 871(b), U.S. source fixed or determinable annual or periodic income [such as interest, dividends, and rents], I.R.C. § 871(a)(1)(A), U.S. source gains, I.R.C. § 871(a)(1)(B & D), or income on the disposition of U.S. realty, I.R.C. §871(a)(1)(A)).

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U.S. beneficiaries of foreign nongrantor trusts are subject to several special rules. DNI of a foreign nongrantor trust is determined under special rules, a primary distinction of which is that capital gains are included in DNI. I.R.C. § 643(a). The ticking time bomb for foreign nongrantor trusts is that if all of the DNI is not distributed each year, accumulation distributions (again determined under very special rules in Section 665(b)) are subject to the imposition of a tax under the throwback rule, I.R.C. § 665(d). Furthermore, the tax under the throwback rule is increased by an interest charge. I.R.C. §§ 667(a)(3) & 668. The interest rate is the floating interest rate under Section 6621 that applies to underpayments of tax generally. (4) Cannot Be S Corporation Shareholder. A foreign trust is not an eligible S corporation shareholder. I.R.C. § 1361(c)(2) (last sentence). (5) Bottom Line—Substantial Complexity and Possible Increased Tax Costs. The extremely brief preceding summary of some of the tax effects of foreign trusts demonstrates that the tax rules become substantially more complex, with huge penalties for failure to file required information to the I.R.S., and with potentially increased taxes (with interest charges). b. Selection of Trustee Can Cause Foreign Trust Treatment. A trust is a foreign trust unless both of the following tests are satisfied: (1) courts in the U.S. must be able to exercise primary supervision over the trust; and (2) one of more U.S. persons have the authority to control all substantial decisions of the trust. I.R.C. §§ 7701(a)(30)(E) & (31)(B). A foreign person is someone who is not (among other things) a U.S. citizen or resident, or a U.S. domestic corporation. If a foreign person has control over only one “substantial decision,” foreign trust status results. ”Substantial decisions” are defined in the regulations to mean “all decisions other than ministerial decisions.” Treas. Reg. § 301.7701-7(d)(1)(ii). Examples are included that are very expansive, including not only the power to determine the timing, amount and selection of beneficiaries, but other administrative actions such as making income/principal allocations, investment decisions, and compromising claims. The definition even includes the power to appoint a successor trustee (unless it is restricted so that it cannot change the trust’s residency) and the power to remove, add, or replace a trustee. Id. c. Summary of Selection of Trustee Issues Regarding Foreign Trusts. Do not appoint a foreign person (anyone other than a U.S. citizen or resident or a U.S. domestic corporation) as a trustee with the power to control any substantial decision—unless the planner (who really knows what he or she is doing with foreign trusts) purposefully wants the trust to be a foreign trust. (This generally means that any non-U.S. person or persons must be less than half of the trustees, and no decisions are left specifically to their control even though non-U.S. persons are a minority vote.) 2. Grantor Trust Rules—Effects of Grantor Trust Status. a. Grantor Report Income For Income Tax Purposes. If the trust is a grantor trust, the grantor would report on his or her income tax return all income, deductions, and credits attributable to the trust property. The grantor should understand that the grantor trust rules could impose substantial liability on the grantor to pay income taxes on the trust’s income.

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Having trust income taxed in the grantor’s income tax bracket may be advantageous if the grantor is not in the highest tax bracket (in 2021, applicable for married individuals having taxable income exceeding $622,051). Undistributed income of a trust is subject to the top brackets at $13,050 of income (in 2021). Furthermore, the 3.8% Medicare tax may not apply if the grantor materially participates in a business that is owned by the trust if the grantor trust rules apply; the tax does not apply to non-passive trade or business income (but that may change under proposed legislation). The law is more unclear as to how a trust can materially participate in a business and therefore qualify for that exception as to undistributed trust income. b. Gift Tax Effects of Grantor’s Payment of Income Taxes on Trust’s Income. Payment by the grantor of income taxes with respect to the trust’s income permits the trust to grow at a faster rate (because it does not have to pay income taxes). At one time, the IRS took the position in a private ruling (Letter Ruling 9444033, later revised to delete the relevant sentence) that the grantor’s payment of income taxes with respect to a grantor trust was a taxable gift. The IRS has now changed its position. Revenue Ruling 2004-64, 2004-2 C.B. 7 held that the grantor’s payment of income taxes attributable to a grantor trust is not treated as a gift to the trust beneficiaries. (Situation 1) Furthermore, the Ruling provides that a mandatory tax reimbursement clause would not have any gift consequences, but would cause “the full value of the Trust’s assets” at the grantor’s death to be included in the grantor’s gross estate under section 2036(a)(1) because the grantor would have retained the right to have the trust assets be used to discharge the grantor’s legal obligation. (Situation 2). c. Income Tax Reimbursement Provision. The IRS at one time required that the grantor be reimbursed for income taxes borne by the grantor with respect to income in excess of the annuity amount in order to get a private ruling approving a GRAT. In PLR 9444033, the IRS stated in dicta that the failure to reimburse the grantor for income taxes would be considered a gift by the grantor to the remaindermen. The IRS subsequently reissued the ruling without the dicta in PLR 9543049 and has yet to challenge taxpayers on this issue. Rulings have approved various types of reimbursement provisions. PLRs 9415012, 9416009, 9353004, and 9353007. In light of this position, some planners have drafted GRAT instruments to require the trustee to reimburse the grantor for income taxes, but only to the extent necessary for the trust to create a "qualified annuity interest" under section 7520. (However, that approach would no longer be advisable following the issuance of Revenue Ruling 2004-64, as discussed below.) The IRS’s position created a dichotomy, because including an income tax reimbursement provision would seem to create some risk that the trust would be included in the grantor's estate under section 2036 (by providing for payment of legal obligations of the grantor.) See Treas. Reg. § 20.2036-1(b)(2). Various IRS private rulings previously held that there would be no inclusion under Section 2036(a). See Ltr. Ruls. 200120021; 199922062; 199919039; 9710006; 9709001; 9413045. However, the IRS changed its position in Revenue Ruling 2004-64, 2004-2 C.B. 7. Revenue Ruling 2004-64 held that the grantor’s payment of income taxes attributable to a grantor trust is not treated as a gift to the trust beneficiaries. (Situation 1) Furthermore, the Ruling provides that a mandatory tax reimbursement clause would not have any gift

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consequences, but would cause “the full value of the Trust’s assets” at the grantor’s death to be included in the grantor’s gross estate under section 2036(a)(1) because the grantor would have retained the right to have the trust assets be used to discharge the grantor’s legal obligation. (Situation 2) (The statement that the “full value of the trust assets” would be includible may overstate the issue. Courts might limit the amount includible in the estate to the maximum amount that might possibly be used for the grantor’s benefit at his or her death.) In addition, giving the trustee the discretion to reimburse the grantor for income taxes attributable to the grantor trust may risk estate inclusion if there were an understanding or pre-existing arrangement between the trustee and the grantor regarding reimbursement, or if the grantor could remove the trustee and appoint himself as successor trustee, or if such discretion permitted the grantor’s creditors to reach the trust under applicable state law. (Situation 3) The Ruling provides that the IRS will not apply the estate tax holding in Situation 2 adversely to a grantor’s estate with respect to any trust created before October 4, 2004. Some planners suggest allowing a third person to authorize the trustee to reimburse. A number of states have amended their laws to provide that the mere existence of a discretionary power by the trustee to reimburse the grantor for income taxes attributable to the trust will not give creditors access to the trust. E.g., TEX. PROP. CODE §112.035(d)(1). d. S Corporation Shareholder. The trust will be a permissible shareholder of S corporation stock if the trust is a grantor trust as to income and corpus. I.R.C. §1361(c)(2)(A)(i). E.g., Ltr. Rul. 200001015. e. Sales Between Trust and Grantor. No capital gain or loss should be recognized on sales between the trust and the grantor. Rev. Rul. 85-13, 1985-1 C.B. 184 (to the extent grantor is treated as owner of trust, the trust will not be recognized as separate taxpayer capable of entering into a sales transaction with the grantor). In that ruling, the I.R.S. indicated that it would not follow Rothstein U.S., 735 F.2d 704 (2d Cir. 1984) to the extent it would require a different result. See Rev. Rul. 2007-13, 2007-11, I.R.B. 684 (Situation 1, of ruling reasons that the sale of a policy from one "wholly-owned" grantor trust to another "wholly-owned" grantor trust is not a transfer at all for income tax purposes because the grantor is treated as the owner of the assets of both trusts); Rev. Rul. 92-84, 1992-2 C.B. 216 (gain or loss on sale of asset by QSST, which is grantor trust, is treated as gain or loss of the grantor or other person treated as owner under the grantor trust rules and not of the trust, even if the gain or loss is allocable to corpus rather than to income). f.

Exclusion of Gain From Sale of Personal Residence. The $250,000 ($500,000 for joint returns) capital gains exclusion under Section 121 for the sale of a principal residence by an individual is available if the residence is owned by a grantor trust. See Rev. Rul. 8545, 1985-1 C.B. 783; Ltr. Rul. 9118017 (prior section 121 provision excluding gain on sale of residence by individual over age 55).

3. Grantor Trust—Trust Provisions that Cause Grantor Trust Status. a. Power of Disposition by Related or Subordinate Parties Not Governed by Reasonably Definite External Standard. (1) Overview. A power in trustees, more than half of whom are related or subordinate parties, to sprinkle or accumulate income or corpus of the trusts without a “reasonably

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definite standard” will not qualify for any of the exceptions from grantor trust treatment under Section 674(c)-(d). Furthermore, the trust can be planned to avoid the exceptions in Section 674(b)—generally by giving the trustee “spray” powers without having separate shares for the beneficiaries. Therefore, the trust would be a grantor trust under the general rule of Section 674(a). (2) Section 674(a) General Rule. Section 674(a) triggers grantor trust treatment if the grantor or a non-adverse party holds a power of disposition over trust assets. As long as the participation of the grantor or a non-adverse party is required (for example, if one of two co-trustees is non-adverse, thus requiring consent of the non-adverse party), Section 674(a) is triggered. A non-adverse party is generally someone who is not a beneficiary and does not have a legal obligation to support a beneficiary. Various exceptions in Sections 674(b), 674(c), and 674(d) can negate grantor trust treatment. Therefore, to rely on a trustee’s general power of disposition to trigger grantor trust status requires very careful navigating of all of those exceptions. (3) Section 674(b)(5) Exception for Corpus. Section 674(b)(5) is an exception from grantor trust treatment as to corpus if there is a reasonably definite standard (§674(b)(5)(A)) or if separate shares are created for the respective beneficiaries (§674(b)(5)(B)). Therefore, to avoid this exception, there should be no “reasonably definite standard” for the distributions, and the trustee should have a spray power and not have to charge any distributions of corpus against the beneficiary’s proportionate share of corpus. (4) Section 674(b)(6) Exception for Income. Section 674(b)(6) is an exception from grantor trust treatment as to income if any of the following apply: (a) Income accumulated for a beneficiary must ultimately be payable to that beneficiary, to his estate, or to his appointees including anyone other than his estate, his creditors, or the creditors of his estate, §674(b)(6)(A), (b) Income accumulated for a beneficiary must ultimately be payable on termination of the trust or in conjunction with a distribution of corpus that includes accumulated income to the current income beneficiaries in shares which have been irrevocably specified in the trust instrument, §674(b)(6)(B), or (c) Income accumulated for a beneficiary is payable to the beneficiary’s appointees or to one or more designated alternate takers (other than the grantor or grantor’s estate) if the beneficiary dies before a distribution date that could reasonably be expected to occur within the beneficiary’s lifetime, §674(b)(6)(second paragraph). The regulations provide that these rules generally mean that the exception from grantor trust treatment will not apply “if the power is in substance one to shift ordinary income from one beneficiary to another.” Treas. Reg. §1.674(b)-1(b)(6)(i)(c). An exception from this general summary of the income exception applies if the grantor or a nonadverse party has the power to shift income from one beneficiary to another by accumulating income with a provision that at a later distribution date the accumulated income will be distributed to current income beneficiaries in shares that are irrevocably specified. For example, an instrument might provide for payment of income in equal shares to two daughters but permit withholding the distribution from either daughter. When the youngest daughter reaches age 30, the remaining trust would be distributed equally between the two. If income is withheld from a daughter, this has the effect of ultimately

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shifting one-half of the accumulated income from one daughter to the other. However, this shift would not negate the exception from grantor trust treatment. Treas. Reg. §1.674(b)-1(b)(6)(ii)(Ex. 1). Accordingly, provisions that would flunk this exception include the following. Permit totally discretionary distributions of current and accumulated income to be sprayed among beneficiaries. See Treas. Reg. §1.674(b)-1(b)(6)(ii)(Ex. 2). Alternatively, if the grantor wishes to provide for “separate shares” for each beneficiary to accumulated income, provide that the trust will last for the lifetime of the beneficiary and does not distribute accumulated income to the beneficiary’s estate or give the beneficiary a testamentary power of appointment. (5) Section 674(c), Independent Trustees. Section 674(c) provides that the general rule triggering grantor trust treatment under Section 674(a) will not apply if no more than half of the trustees are related or subordinate parties and they have the power to distribute or accumulate income or corpus for a class of beneficiaries. To avoid this exception, more than half of the trustees would have to be “related or subordinate parties who are subservient to the wishes of the grantor.” The term “related or subordinate party” is defined in Section 672(c), and includes the grantor’s spouse (if living with the grantor), father, mother, issue, brother, sister, as well as an employee of the grantor, a corporation or any employee of a corporation in which the stock holdings of the grantor and the trust are significant form the viewpoint of voting control, and a subordinate employee of a corporation in which the grantor is an executive. (6) Section 674(c), “Subservient to the Wishes of the Grantor.” The Section 674(c) exception from grantor trust treatment provides that no more than half of the trustees can be related or subordinate parties “who are subservient to the wishes of the grantor”. Section 672(c) creates a presumption that a related or subordinate party is subservient to the grantor. This presumption is difficult to overcome, and would require a finding that the trustee is not acting in “accordance with the grantor’s wishes.” S. Rep. No. 1622, 83d Cong. 2d Sess. 87 (1954). A federal district court concluded (in a securities law case, not a tax case) that the independent trustee exception in §674(c) did not apply in a fact scenario in which the grantors actually made all trust decisions over a long period of time. SEC v. Wyly, 2014 WL 4792229 (S.D.N.Y. Sept. 25, 2014) (discussed in Section II.B.2.f of this outline). That case rejected the approach of the Tax Court to apply the §674(c) independent trustee exception even in a case in which the grantor made all decisions regarding the trust administration, including distribution decisions, with the acquiescence of the trustee. Estate of Goodwyn v. Commissioner, T.C. Memo. 1976-T.C. Memo. 238. The requirement that the trustee be “subservient to the wishes of the grantor” to cause grantor trust treatment raises an interesting estate tax question. If the person who holds the power to make distributions without a standard is in fact subservient to the wishes of the grantor, does a potential estate inclusion issue arise under Sections 2036 and 2038? See Estate of Goodwyn v. Comm’r, 1973 T.C. Memo. 153 (de facto control of trustee was insufficient to cause inclusion in grantor’s estate under §2036). (7) Section 674(d), Reasonably Definite External Standard. Section 674(d) provides that the general rule triggering grantor trust treatment under Section 674(a) will not apply if the trustees (other than the grantor or grantor’s spouse) have the power to make or withhold

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distributions of income or corpus, if the power is limited by a reasonably definite external standard. Observe that this is not the same as an “ascertainable standard” under §2041. For example, an “emergency” standard appears to be a reasonably definite external standard, but may not be an ascertainable standard under §2041. (8) Spousal Unity Rule. The grantor is treated as holding any power or interest held by (a) any individual who was the spouse of the grantor at the time of the creation of such power of interest (i.e., even if there is a subsequent divorce), or (b) any individual who subsequently became the spouse of the grantor, but only as to periods after such person became the grantor’s spouse. §674(e). This rule may come into play with a number of the other grantor trust rules. (9) Summary of Trust Provisions to Trigger Grantor Trust Status Under Section 674. Navigating all of the exceptions based on a dispositive power of the trustee requires very careful planning. A non-adverse party must serve as trustee with a power of disposition over trust assets (Section 674(a)). The instrument must not have reasonably definite external standards for distributions (to avoid Section 674(d)), and more than half of the trustees must be related or subordinate parties (to avoid Section 674(c)). In addition, the trustee should have a spray power over corpus distributions and not have to charge any distributions of corpus against the beneficiary’s proportionate share of corpus (to avoid Section 674(b)(5)). Also, the trust should permit totally discretionary distributions of current and accumulated income to be sprayed among beneficiaries (to avoid Section 674(b)(6)). (Alternatively, to avoid Section 674(b)(6), if the grantor wishes to provide for “separate shares” for each beneficiary to accumulated income, provide that the trust will last for the lifetime of the beneficiary and do not distribute accumulated income to the beneficiary’s estate or give the beneficiary a testamentary power of appointment.) (10)Does Not Have the Appearance of Just Being a “Grantor Trust” Provision. An advantage of qualifying for grantor trust treatment under this approach is that it does not have the appearance of merely being a provision added to confer grantor trust status. The provision has real-life economic consequences that are of major importance to trustors-the decision of who has the power to control distributions. (11)Giving Grantor’s Spouse Power to Control Distributions Without a Reasonably Definite Standard. One possible method of using this approach to cause grantor trust status would be to give the grantor’s spouse the power to distribute income or corpus to third parties without including a “reasonably definite external standard”. As long as the spouse did not make any contributions to the trust, this power should not result in estate inclusion for the spouse (as long as the spouse cannot distribute to himself or herself or in satisfaction of his or her legal obligations). Observe that this would result in grantor trust treatment even following a divorce if the prior spouse continued to serve as trustee (although the grantor may not want that person to continue to serve as trustee for other reasons). The trust instrument should carefully plan who the successor trustees would be in the event the spouse ceases to serve, to assure that more than half of the trustees would be related or subordinate parties. To guard against the possibility of a divorce, the trust might give the grantor the power to remove and replace a divorced spouse in a manner that complies with Rev. Rul. 95-58.

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b. Power of a Non-Adverse Person to Distribute to or Accumulate Income for the Grantor or the Grantor’s Spouse, §677(a)(1) or (2). (1) May Result in Grantor Trust Treatment Only as to Income. The literal language of Section 677(a) would suggest that income and corpus of the trust would be treated as a grantor trust. I.R.C. Section 677(a) (“the owner of any portion of a trust…whose income…is, or…maybe” distributed or accumulated for distribution to the grantor or the grantor’s spouse). However, an example in the Regulations very specifically indicates that the Section 677 power only results in the grantor being treated as the owner of the income portion of the trust and not the corpus. Treas. Reg. §1.677(a)-1(g), Ex. 1. Despite the very clear example in the regulations, the IRS has issued several private letter rulings holding that both the income and corpus portion of a GRAT would be treated as owned by the grantor under the grantor trust rules because the annuity amount would be payable from principal to the extent that income was insufficient. Letter Rulings 9504021, 9451056, 9449012, 9444033, and 9415012. See also Ltr. Rul. 9501004 (CRUT treated as grantor trust as to income and corpus under §677(a) because of the possibility that income allocable to principal could be used to satisfy the unitrust payment). However, the IRS is currently taking the position that a retained annuity alone no longer confers grantor trust status as to both the income and corpus portion of a GRAT. Letter Ruling 9625021. (2) Grantor or Grantor’s Spouse as Discretionary Beneficiary Plus Power of Appointment May Cause Grantor Trust Status As to Income and Corpus. Various rulings have indicated that a combination of Sections 677 and 674(b)(3) can be used to confer grantor trust status as to income and corpus for a GRAT. The authority to make distributions of the annuity payments would result in grantor trust treatment as to the income under Section 677. If the grantor retains a testamentary power of appointment to appoint the trust assets (for example, in the event the grantor dies before the stated termination of the GRAT), this power will result in grantor trust treatment as to the corpus under Sections 674(a) and 674(b)(3). See Treas. Reg. §1.674(b)-1(b)(3) (“if a trust instrument provides that the income is payable to another person for his life, but the grantor has a testamentary power of appointment over the remainder, and under the trust instrument and local law capital gains are added to corpus, the grantor is treated as the owner of a portion of the trust and capital gains and losses are included in that portion"); Letter Rulings 200001013 & 200001015 (grantor trust treatment as to income because trustee had discretion to pay all of GRAT’s income—if any is remaining after payment of the annuity payments—to the grantor; grantor trust treatment as to corpus under section 674(a) because capital gains are accumulated and added to corpus and grantor held general testamentary power of appointment over the accumulated amounts); 9707005 (GRAT is a grantor trust as to income and corpus under §674(a) and §677(a) because grantor will either receive all the trust income or be able to appoint it by will, and qualifies as an S corporation shareholder); 9625021. The IRS has reiterated this position, even for trusts requiring mandatory income distributions to the grantor, if capital gains are not allocated to income. Ltr. Rul. 201326011. In that ruling (which involved a trust other than a GRAT), all income was payable to the grantor at least quarterly, and the grantor had a testamentary power of appointment over trust income and corpus. The trust provided that receipts from the sale of trust property shall be allocated to principal. The ruling held that the trust is a grantor trust as to income under §677(a)(1). Also, the trust is a grantor trust as to corpus under

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§674(a) because the grantor’s testamentary power of appointment did not come within the exception in §674(b)(3). Section 674(b)(3) provides that §674(a) does not apply to a power exercisable only by will, other than a power in the grantor to appoint by will the income of the trust where the income is accumulated for disposition by the grantor or may be accumulated in the discretion of the grantor or a nonadverse party, or both, without the approval or consent of any adverse party. The “exception to the exception” in §674(b)(3) might seem not to apply because there is a mandatory income distribution requirement and income is not accumulated. (Similarly, see the discussion of this testamentary power of appointment exception in Reg. §1.674(b)-1(b)(3).) However, in the ruling, capital gains were allocated to corpus and therefore were not subject to the mandatory distribution requirement. The ruling reasoned: Because Grantor has a testamentary power of appointment over the corpus of Trust (and any accumulated income allocable to corpus) and, pursuant to the document, capital gains are added to corpus, Grantor will be treated as the owner of the corpus of Trust during the trust term under §674(a).

(3) Grantor Trust Status May be Unintended. Additional economic flexibility can be created for the parents engaged in transfer planning if one of the parents transfers his or her separate property into a trust that would include the spouse as a discretionary beneficiary. The trust should specifically restrict the use of trust income to discharge the grantor’s obligation of support. Treas. Reg. §20.2036-1(b)(2). (Each spouse cannot name the other as beneficiary or the reciprocal trust doctrine may apply.) By including the spouse as a discretionary beneficiary, the trustee would be able to access the trust for the benefit of the spouse in the unlikely event that the spouse ever needed distributions from the trust. However, the parties should be aware that including this provision will cause the trust to be a grantor trust as to the income under Section 677. (4) Difficult to Relinquish Grantor Trust Status if Spouse is Discretionary Beneficiary. If the spouse is included as a potential beneficiary, shedding grantor trust status may be difficult. If the spouse relinquishes his or her rights as a discretionary beneficiary, a taxable gift from the spouse may result (unless the relinquishment is a qualified disclaimer within nine months of the creation of the interest.) One possible planning strategy would be to give an independent party the power to remove the spouse as a discretionary beneficiary. (5) Grantor Status Would Be Terminated at Spouse’s Death. If Section 677 is being utilized to confer grantor trust status by including the grantor’s spouse as a potential beneficiary, the death of the spouse would result in the trust no longer being a grantor trust (unless one of the other grantor trust provisions applies.) (6) No Estate Tax Inclusion For Spouse Even if Split Gift Election is Made. As long as the spouse does not make any contribution to the trust, merely including the spouse as a potential discretionary beneficiary will not cause inclusion in the spouse’s estate for estate tax purposes (as long as the spouse does not have a general power of appointment under §2041). For purposes of applying §§2036 and 2038, the spouse is not a grantor to the trust, so those sections would not apply. This is true even if the split gift election is made, because the split gift election applies just for gift tax and GST exemption allocation purposes. I.R.C. §2513(a)(1) & 2652(a)(2); there is no analogous estate tax provision. E.g., Rev. Rul. 74-556, 1974-2 C.B. 300 (no §2038 inclusion). Observe that the split gift election is not available if the spouse’s interest in the trust cannot be

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quantified. See generally Zeydel, Gift Splitting—A Boondoggle or a Bad Idea? A Comprehensive Look at the Rules, 106 J. TAX’N 334 (June 2007). (7) Estate Tax Inclusion Risk if Grantor is Discretionary Beneficiary. If the grantor, rather than the grantor’s spouse, is a discretionary beneficiary, there is a likelihood that the trust assets would be included in the grantor’s estate under §2036 unless the trust is formed in a state which has adopted a Domestic Asset Protection Trust statute (where a settlor can be a discretionary without subjecting the trust assets to the settlor’s creditors.) Even in such a “self-settled trust” state, however, if the trustee actually makes distributions to the grantor, a concern may arise under §2036 as to whether there was an implied agreement about distributions to the grantor, which could trigger §2036 inclusion even apart from creditors rights. (Some attorneys respond to that concern by noting that the donor would only receive trust distributions if he has lost all of his other assets, in which case he may not care about estate taxes.) Some attorneys suggest providing that if the grantor is included as a discretionary beneficiary (in a self-settled trust state), give a third party the power to eliminate the grantor as a potential beneficiary; the 3-year rule under §2035 should not apply if the removal is exercised, even shortly before the grantor’s death, because there is no transfer (or relinquishment) by the grantor. The §2036 and creditors rights issue is discussed at length in Section II.B.2.d. of this outline. c. Power of Non-Adverse Person to Use Income to Pay Life Insurance Premiums on Life of Grantor or Grantor’s Spouse, §677(a)(3). (1) Statutory Provision. The grantor is treated as the owner of any portion of the trust whose income may be applied to the payment of premiums of policies of insurance on the life of the grantor or the grantor’s spouse. I.R.C. §677(a)(3). This statutory provision appears to be very broad. Literally, giving a trustee the power to pay life insurance premiums on income of a trust would conceivably cause all of the income and corpus of the trust to be a grantor trust. See generally, Katzenberg, Unlocking the Trapdoor of IRC Section 677(a)(3), TRUSTS & ESTATES (April 2016). The only binding guidance from the IRS is Rev. Rul. 66-313, 1966-2 C.B. 245. The ruling addressed the effect of a two irrevocable trusts created by the same grantor, Trusts A and B, and Trust B held only life insurance policies on the grantor’s life. The beneficiaries of Trust A consented to the income of Trust A being used to pay the life insurance premiums for Trust B. Even though the policies were owned by another trust created by the same grantor, the ruling stated that “the grantor will be considered the owner under section 677(a) of the Internal Revenue Code of 1954 on the amount of the trust income which is used to pay the premiums on these policies of insurance on her life.” This language suggests that the grantor is taxed only on an amount of trust income equal to the premiums actually paid. A Field Attorney Advice (20062701F) takes the position that the mere power to purchase life insurance on the grantor’s life causes grantor trust treatment. The complete analysis about §677(a)(3) in that ruling is as follows: “Article II of B Trust Agreement authorizes the trustee to purchase life insurance on taxpayer. There does not appear to be any limit on the amount the trustee may apply to the payment of premiums. Therefore, pursuant to section 677(a)(3), taxpayer is treated as the owner of B.” (However, that was a ruling involving a complicated foreign trust situation where it was in the IRS’s interest that the trust be a grantor trust.). Cases have been more restrictive.

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(2) Grantor Trust Treatment May Apply Only as to Actual Payment of Life Insurance Premiums. The grantor clearly is taxed on any trust income actually used to pay premiums on policies on the life of the grantor or the grantor’s spouse. Treas. Reg. §1.677(a)-1(b)(2). However, cases have imposed restrictions on grantor trust status merely because of the power to pay life insurance premiums. For example, if the trust does not actually own a life insurance policy on the grantor’s life, one case concluded that the mere power to purchase an insurance policy and to pay premiums from income would not be sufficient to cause grantor trust status. Corning v. Comm’r, 104 F.2d 329 (6th Cir. 1939) (trust owned no policy on grantor’s life). Even if the trust owns policies on the grantor’s life, some cases (that predated the 1954 and 1969 changes to §677 and the current “portion” regulations under §671) have concluded that the grantor will merely be treated as the owner of so much of the income as is actually used to pay premiums. Weil v. Comm’r, 3 T.C. 579 (1944), acq. 1944 C.B. 29: Iversen v. Comm’r, 3 T.C. 756 (1944); Rand v. Comm’r, 40 B.T.A. 233 (1939), acq. 1939-2 C.B. 30, aff’d., 116 F.2d 929 (8th Cir. 1940), cert. denied, 313 U.S. 594 (1941); Moore v. Comm’r, 39 B.T.A. 808, 812 (1939), acq., 1939-2 C.B. 25. Various informal rulings from the IRS fail to provide a consistent guide of the extent to which §677(a)(3) results in the grantor being treated as owner of a particular portion of the trust. One commentator summarizes that the rulings as falling into three categories: (1) A ruling that views “the grantor as the owner of only that portion of the trust that is actually used to pay premiums (PLR 6406221750A)”; (2) Rulings involving facts “in which the entire income was actually used to pay premiums, rendering uncertain how the IRS would have addressed a situation in which the trust had income not applied to the payment of insurance premiums (PLR 8007080, PLR 8014078, and PLR 8839008)”; and (3) Rulings “that appear to view the grantor as the owner of the entire trust because of the trustee’s ability to pay premiums (PLR 8103074, PLR 8118051, and PLR 8126047; FAA 20062701F)” (FAA 20062701F is summarized above; a similar ruling is PLR 8852003, which ruled that a trust that authorized the trustee to use income or corpus to purchase life insurance policies on the grantor’s life caused the trust to be treated as owned entirely by the grantor under §677(a)(3), without indicating whether the trust actually purchased any policies, and the trust therefore qualified as an S corporation shareholder under §1361(c)(2)(A).” Robert T. Danforth & Howard M. Zaritsky, T.M. 819-2nd, Grantor Trusts (Sections 671-679), at E.(4).f. Letter Ruling 8839008 interestingly involved a trust that prohibited the trustee from using trust income to pay life insurance premiums for policies on the grantor’s life. The trustee some years later purchased policies on the grantor’s life, paying the premium with a single payment that exceeded the trust income for that year. The premium was deemed to be paid from the trust income. The ruling reasoned that even though the trustee may have used principal for trust accounting purposes to pay the premiums, for tax purposes they were still using trust income. One commentator views the ruling as “quite problematic” and wonders “whether the IRS would have reached the same result if the trust instrument had expressly directed that trust’s accounting income be currently distributed to other beneficiaries.” Zaritsky, Lane & Danforth, Federal Income Taxation of Estates and Trusts (WG&L) ¶10.05[2]. See generally Zaritsky, Drafting and Planning Life Insurance Trust for Policies Both Traditional and Unusual, UNIV. OF MIAMI PHILIP E. HECKERLING INST. ON EST. PL. ¶403.2.D.2.a. (1994).

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A troubling concept is that the IRS might extend this reasoning to more of the grantor trust triggers. This would suggest the wisdom of using a power of disposition in a nonadverse party as described in Item II.C.3.a. above. An advantage of having a grantor trust involved with life insurance ownership is that a policy can be transferred between the grantor and trust or between grantor trusts without being treated as a transfer for value for purposes of §101(a)(2). Rev. Rul. 2007-13, 20071 C.B. 684; see e.g., Letter Rulings 200514001, 200514002, 200518061, and 200606027. (3) Not Useful to Assure Grantor Trust Status. Due to the case law limitations discussed above, the power is not useful as a tool to assure that a trust will be treated as a grantor trust. However, if the draftsman wishes to use this as one of multiple grantor trust triggers, provide in the trust agreement that the trustee may pay insurance premiums from income or principal, to build the best possible argument that the trust is a grantor trust as to both income and principal. d. Actual Borrowing of Trust Funds by Grantor or Grantor’s Spouse Without Adequate Interest Or Security, §675(3). (1) Actual Borrowing Required. Under §675(3), if the grantor has (directly or indirectly) actually borrowed corpus or income from the trust and has not completely repaid the loan with interest before the beginning of the taxable year, the trust will be treated a grantor trust. Grantor trust treatment will not result if the loan provides for adequate interest or security and if the loan is made by a trustee other than a related or subordinate party. Under the statute, actual borrowing is required; the mere power to borrow is not sufficient to cause grantor trust status. (2) Grantor Trust Status if Loan Outstanding Any Time During the Year. The statutory language suggests that grantor trust status depends upon whether a loan is outstanding at the beginning of a taxable year. Under that interpretation, if borrowing occurs during year one, but is repaid before year two, grantor trust status would not exist in either year one or year two. However, the IRS interprets §675(3) as imposing grantor trust status if the loan to the grantor has been outstanding any time during the year. Rev. Rul. 86-82, 19861 C. B. 253, following Mau v. United States, 355 F. Supp. 109 (D. Hawaii 1973). For example, if a loan is outstanding on 12/31/07 and repaid on 1/2/08, the grantor would be treated as owning the trust for all of 2007 and 2008 under Revenue Ruling 86-82. There is the intriguing possibility of just making a loan on December 30 of a year to make the trust a grantor trust for the entire year. That may be used in year-end planning, (but there is the possibility that the IRS might take the position at some point that this is an abusive strategy, despite the outstanding Revenue Ruling and case support.) Repurchase of Asset For a Note. Most attorneys overlook that Revenue 85-13 (which concluded that transactions between grantor and grantor trusts do not result in gain recognition) says that a non-grantor trust can be converted into a grantor trust by having the grantor just buy back the trust asset for a note, and the grantor trust treatment is effective even as to that sale. Rev. Rul 85-13 stands for more than just no gain recognition. It is unresolved whether the amount of the borrowing impacts the portion of the trust that is treated as a grantor trust. (See the following paragraph.)) However, the Second Circuit held that such a purchase of trust assets for a note caused the trust to be a

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grantor trust as to future transactions, but the purchase transaction itself resulted in gain recognition. Rothstein v. U.S., 735 F.2d 704 (2nd Cir. 1984). (3) Unclear as To Portion of Trust Treated as Grantor Trust. It is not clear whether grantor trust status relates only to amounts actually borrowed and not repaid before the end of the taxable year, or whether it applies to all income or corpus which could have been borrowed if some borrowing occurs. Compare Bennett v. Comm’r, 79 T.C. 470 (1982) (grantor borrowed less than all of the income; held that grantor was taxable on portion of current year’s income which the principal of the loan at the beginning of the year bears to the total trust income from the trust inception) with Benson v. Comm’r, 76 T.C. 1040 (1981) (grantor borrowed all income of trust owning real estate; held that grantor should be taxed on all trust income). Unless the grantor borrows the entire corpus, there can be no assurance that the grantor will be treated as the owner of the entire income and corpus of the trust for income tax purposes. (4) Permits Toggling, But Close Supervision Required. Because grantor trust status is predicated on actual borrowing, it would be possible to toggle grantor trust status on and off. If the grantor wanted to achieve grantor trust status in any particular year, the grantor could borrow all of the trust funds for some period of time during the year (if the trustee is not a related or subordinate party, the borrowing should not provide for adequate interest or security. However, if the trustee is a related or subordinate party, the borrowing could provide for adequate interest and security and still result in grantor trust status.) The grantor would need to repay the entire amount of the loan before the end of the taxable year, so that the grantor could make an independent decision in the following year whether the grantor trust status was desired in the following year. e. Power Exercisable in a Nonfiduciary Capacity to Reacquire Assets By Substituting Assets of Equivalent Value, §675(4)(C). (1) Statutory Provision. Section 675 provides that the existence of various administrative powers will cause a trust to be a grantor trust for income tax purposes. Section 675(4) lists several general powers of administration, which if exercisable in a nonfiduciary capacity by any person without the approval or consent of any person in a fiduciary capacity, will cause grantor trust treatment. One of those powers, listed in § 675(4)(C), is “a power to reacquire the trust corpus by substituting other property of an equivalent value.” (2) Grantor Trust as to Both Corpus and Income. Even though §675(4)C) refers to a power to reacquire “trust corpus,” this power causes the grantor to be treated as the owner of trust corpus and income (including ordinary income not allocable to corpus). Treas. Reg. § 1.671-3(b)(3). (3) Nonfiduciary Capacity Determination. The regulations provide that “the determination of whether the power [of substitution] is exercisable in a fiduciary or nonfiduciary capacity depends on all the terms of the trust and the circumstances surrounding its creation and administration.” Treas. Reg. §1.675-1(b)(4). The IRS has taken the position in several rulings that whether the grantor holds the power in a nonfiduciary capacity for purposes of section 675 is a question of fact to be determined by the district director after returns have been filed. Ltr. Ruls. 199942017, 9645013, 9525032, 9407014, 9352007, 9352004, 9337011, 9335028, 9248016, 9253010. Other letter rulings have not applied the facts and circumstances requirement, but have held that the substitution power caused

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the trust to be a grantor trust. Ltr. Ruls. 9451056, 9352017, 9351005, 9345035, 9248016. Some rulings have applied a compromise approach, stating that the grantor trust determination depends on the facts and circumstances but that, assuming exercise of a Section 675(4)(c) power in a nonfiduciary capacity, the trust would be treated as a grantor trust. E.g., Letter Ruling 9810019 (charitable lead trust). (4) Trustee Should Not Hold Power. Because grantor trust status depends upon the power being held in a “non fiduciary” capacity, the power of substitution should not be held by the trustee. Similarly, a trustee’s approval or consent should not be required. Regulation §1.675-1(b)(4) provides that if a power is exercisable by a person “as trustee,” there is a rebuttable presumption that the power is exercisable in a fiduciary capacity primarily in the interests of the beneficiaries. Similarly, a trustee’s approval or consent should not be required (or else the requirement in the initial sentence of §675(4) will not be satisfied.) The power should not be held by an adverse party. Even though several clauses of § 675 require that a power be exercisable by a nonadverse party (§675(1) & (2)), §675(4), which deals with general powers of administration, merely refers to powers held “by any person” without requiring that the power be held by a nonadverse party. However, Regulation §1.675-1(b)(4) refers to powers of administration held in a nonfiduciary capacity “by any nonadverse party.” Despite the clear contradiction of the statute, it is possible that the regulation might be upheld under the broad deference standard announced in Chevron U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984). Accordingly, the substitution power should not be held by a trust beneficiary. (5) Retention of Power by Grantor. Can the grantor retain a nonfiduciary power to substitute assets of equivalent value without causing inclusion in the grantor’s estate for estate tax purposes? (If you’re not interested in the gory historical details, jump to paragraph 6 for a discussion of the current state of the law in light of Revenue Ruling 2008-22.) (a) Historical Perspective. A power of the grantor to substitute assets of equivalent value does not cause Section 2036 or 2038 to apply where it is held in a fiduciary capacity. State Street Co. v. U.S., 263 F.2d 635 (1st Cir. 1959) (court concluded, in a “very close” case, that broad management powers, including the power to exchange trust property for other property without regard to the values of the properties, as well as other broad powers, caused the predecessor to Section 2036 to apply). Despite the State Street decision (where the court barely found the predecessor to Section 2036 to apply when the donor, albeit as a fiduciary, could exchange assets with the trust without regard to values), the IRS again argued that a substitution power for equal value held by the grantor-trustee constituted a power to alter amend or revoke the instrument in Estate of Jordahl v. Comm’r, 65 T.C. 92 (1975). The court disagreed, reasoning that any property substituted should be 'of equal value' to property replaced, so the grantor was thereby prohibited from depleting the trust corpus. The court viewed that as being no different than the case where a settlor retains the power to direct investments. The IRS subsequently acquiesced in the case. 1977-2 C.B. 1. What if the grantor retains a substitution power in a nonfiduciary capacity (to cause the trust to be a grantor trust under Section 675(4)(C))? In Jordahl, the grantor who held the substitution power was a trustee, and held the power in a fiduciary capacity. However, the court’s reasoning suggests that the same result would have been reached if the substitution power had been held in a nonfiduciary capacity:

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Even if decedent were not a trustee, he would have been accountable to the succeeding income beneficiary and remaindermen, in equity, especially since the requirement of 'equal value' indicates that the power was held in trust...We do not believe that decedent could have used his power to shift benefits in [a manner to deprived the remainder of benefits or to deprive an income beneficiary of property.] Substitutions resulting in shifted benefits would not be substitutions of property “of equal value.”

Commentators have generally concurred that the Jordahl result should apply even where the substitution power is held in a nonfiduciary capacity. See Practical Drafting 3753-3757 (R. Covey ed. 1994). In addition, several private letter rulings have ruled that a substitution power held in a nonfiduciary capacity would not cause estate inclusion. Ltr. Ruls. 200001015 & 200001013 (ruled that if grantor survives term of GRAT, the value of property in the trust will not be includible in the grantor’s gross estate under section 2036(a); did not specifically address grantor’s nonfiduciary substitution power in the analysis), 199922007 (charitable lead trust contained substitution clause, and IRS held trust assets not includible in estate, but no specific discussion of effect of substitution clause on estate inclusion issue), 9642039 (substitution clause in charitable lead trust, which causes charitable lead trust to be a grantor trust for income tax purposes, does not cause estate inclusion under §§2033, 2035-38, or 2041), 9548013 (grantor trust holding S corporation stock), 9413045 (no estate inclusion under sections 2036, 2038, or 2042, with discussion of Jordahl): 9227013, and 9037011. But see Ltr. Rul. 9318019 (declined to rule on whether amending GST grandfathered trust to give grantor power to exchange assets of equal value would cause loss of GST grandfathered status or whether it would create estate tax exposure to the grantor). PLR 200603040 addresses a trust with a substitution power where “the instrument provides that Grantor’s power to acquire Trust property under this section may only be exercised in a fiduciary capacity.” The PLR concluded that the substitution power would not cause estate inclusion under §§2033, 2036(a), 2036(b), 2038 or 2039. The PLR focused on the fact that the instrument said that the substitution power could only be exercised in a fiduciary capacity. In Jordahl, the decedent was a co-trustee so one might infer that all powers held by the grantor in that case were held in a fiduciary capacity. However, the PLR interpreted Jordahl as follows: “Rather, the court concluded that the requirement that the substituted property be equal in value to the assets replaced indicated that the substitution power was held in trust and, thus, was exercisable only in good faith and subject to fiduciary standards. Accordingly, the decedent could not exercise the power to deplete the trust or to shift trust benefits among the beneficiaries.” Under this reasoning, would any substitution power be exercisable only in a fiduciary capacity? That reasoning might suggest why the IRS refuses to rule in PLRs whether a substitution power is held in a nonfiduciary capacity (to be a grantor trust trigger under §675(4)) even though the instrument specifically says the power is not held in a fiduciary capacity. Similarly, PLR 200606006 said that §2036 would not apply in a situation where the substitution power was held in a fiduciary capacity. Without changing the trust under state law so that the trustee would hold the substitution power in a fiduciary capacity, the IRS would not give a favorable ruling on §2036. (In the facts of that ruling, there were other grantor trust triggers, so the trust was a grantor trust even without a nonfiduciary substitution power. The substitution

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power was important to the grantor in that ruling, because the grantor planned to transfer closely held business interests to the trusts, and the grantor wanted a substitution power to be able to substitute cash for those interests.) Despite the existence of dozens of previous private letter rulings saying that §2036 does not apply to a substitution power even if it is held in a nonfiduciary capacity, the IRS is no longer willing to grant favorable §2036 rulings to nonfiduciary substitution powers. Jordahl is often quoted to say that a substitution power does not trigger §2036, but under the facts of Jordahl, the grantor held the power in fiduciary capacity. However, the regulations and other authority under §§2036 and 2038 say that it makes no difference how the power is held. Treas. Reg. §§20.2036-1(b)(3) (“it is immaterial … in what capacity the power was exercisable by the decedent or by another person or persons in conjunction with the decedent”) & 20.2038-1(a) (“immaterial in what capacity the power was exercisable by the decedent or by another person or persons in conjunction with the decedent”). If there is a bad power, it does not help that it is held in a fiduciary capacity. So if the substitution power was bad in Jordahl, holding it in a fiduciary capacity would not have helped. Stated differently, if holding a power in a fiduciary capacity does not help to cure a §2036/2038 problem, then holding a power in a nonfiduciary capacity should not hurt in causing a §2036/2038 problem. Therefore, Jordahl does seem to provide protection from §2036 inclusion. (b) Revenue Ruling 2008-22. Revenue Ruling 2008-22, 2008-16 IRB 796, provides very helpful guidance, indicating that a grantor non-fiduciary substitution generally will not trigger estate inclusion under §2036 or 2038. The Ruling cites Jordahl, but says that it did not apply §2038 because the decedent was bound by fiduciary standards. Even if the grantor is not bound by fiduciary standards, the ruling observes that the trustee has the duty to ensure that equivalent value is substituted. Indeed, it says that if the trustee thinks the assets being substituted have a lower value than the assets being reacquired, “the trustee has a fiduciary duty to prevent the exercise of the power.” The ruling reasons that (1) the trustee “has a fiduciary obligation to ensure that the assets exchanged are of equivalent value,” and (2) the trustee must prevent any shifting of benefits among beneficiaries that might otherwise result from the substitution in view of the trustee’s power to reinvest assets and the trustee’s duty of impartiality regarding the beneficiaries. The precise holding of the ruling states (the indentions and words in ALL CAPS are added for clarity): A grantor’s retained power, exercisable in a nonfiduciary capacity, to acquire property held in trust by substituting property of equivalent value will not, by itself, cause the value of the trust corpus to be includible in the grantors gross estate under §2036 or 2038, provided the trustee has a fiduciary obligation (under local law or the trust instrument) to ensure the grantor’s compliance with the terms of this power by satisfying itself that the properties acquired and substituted by the grantor are in fact of equivalent value, AND further provided that the substitution power cannot be exercised in a manner that can shift benefits among the trust beneficiaries. [The Ruling does not suggest how that might

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occur, but it does provide some safe harbors against the possible shifting of benefits in the next sentence.] A substitution power cannot be exercised in a manner that can shift benefits if: (a) the trustee has both the power (under local law or the trust instrument) to reinvest the trust corpus AND a duty of impartiality with respect to the trust beneficiaries [Observe, state law would generally impose both of these duties unless the trust instrument negates these duties]; OR (b) the nature of the trust’s investments or the level of income produced by any or all of the trust’s investments does not impact the respective interests of the beneficiaries, such as when the trust is administered as a unitrust (under local law or the trust instrument) or when distributions from the trust are limited to discretionary distributions of principal and income.

Attorneys have differed as to drafting approaches to assure that the trustee must satisfy itself that assets of equivalent value are substituted and that the substitution power cannot be exercised in a manner that can shift benefits among trust beneficiaries. Some attorneys recommend relying on state law and general fiduciary principles. Other attorneys have suggested drafting those requirements into the trust instrument. In an initial reaction to the ruling, Jonathan Blattmachr and Michael Graham suggest the following: Without reducing or eliminating the fiduciary duties imposed upon the Trustee acting hereunder under the terms of this instrument or applicable law, the Trustee shall ensure the Substitutor’s compliance with the terms of this power by being satisfied that the properties acquired and substituted by the Substitutor are in fact of equivalent value within the meaning of Rev. Rul. 2008-22; further, this power to substitute property shall not be exercised in a manner that may shift benefits among the trust beneficiaries within the meaning of Rev. Rul. 2008-22; without limiting the foregoing prohibition upon shifting benefits among trust beneficiates, the Trustee shall have the power to reinvest the trust corpus and a duty of impartiality with respect to the trust beneficiaries at all times while this power of substitution is in effect, within the meaning of Rev. Rul. 2008-22.

A somewhat more detailed example form clause is provided by Diana Zeydel, Miami, Florida, and Jonathan Blattamchr, New York, New York: During the settlor’s lifetime, the settlor shall have the power, exercisable at any time in a nonfiduciary capacity (within the meaning of section 675(4) of the Internal Revenue Code), without the approval or consent of any person in a fiduciary capacity, to acquire or reacquire the trust estate (other than any direct or indirect interest in stock described in section 2036(b) of the Internal Revenue Code or any policy insuring the life of the settlor) by substituting other property of an equivalent value, determined as of the date of such substitution. This power to substitute property is not assignable, and any attempted assignment will render this power void. Without reducing or eliminating the fiduciary duties imposed on the trustees under this agreement or applicable law, the settlor shall exercise this power to substitute property by certifying in writing that the substituted property and the trust property for which it is substituted are of equivalent value and the trustees shall have a fiduciary obligation to ensure the settlor’s compliance with the terms of this power to substitute property buy being satisfied in advance of completing the substitution that the properties acquired and substituted are in fact or equivalent value, within the meaning of Revenue Ruling 2008-22.

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This power to substitute property shall not be exercised in a manner that can shift benefits among the trust beneficiaries within the meaning of Revenue Ruling 2008-22. Without limiting the foregoing prohibition upon shifting benefits among trust beneficiaries, the trustees shall have the power to reinvest the principal of the trust and, except in the case of an Marital Trust, the duty of impartiality with respect to trust beneficiaries at all times while this power of substitution is in effect, unless the trustees shall have absolute discretion in making distributions of principal and income among the trust beneficiaries so that the power to reinvest the principal of the trust and the duty of impartiality are not required in order to avoid this power of substitution potentially causing a shift of benefits among trust beneficiaries, all with the meaning of Revenue Ruling 2008-22.

Attorneys have also differed as to whether the trust instrument should give the trustee the power to prevent the substitution if the trustee thinks the value is not equivalent, or if the trustee can merely sue after-the-fact if the substituted assets have a lower value than the assets being reacquired. The rationale for the position that the trustee cannot prevent the sale if the value is too low is that §675 refers to a “power of administration … exercisable in a nonfiduciary capacity by any person without the approval or consent of any person in a fiduciary capacity.” On the other hand, Rev. Rul. 2008-22 specifically says that if a trustee believes that the substituted assets have a lower value, “the trustee has a fiduciary duty to prevent the exercise of the power.” One attorney’s approach is to provide that if the trustee believes the property sought to be substituted is not in fact property of equivalent value, the Trustee shall seek a determination by a court of competent jurisdiction to assure that the equivalent value requirement of the substitution provision is satisfied. Treasury and IRS officials expressed their personal views at the American Bar Association Section of Real Property Trust & Estate Law Section 2008 Spring Meeting that the trustee would exercise its fiduciary duty to question the value issue before the transfer if the trustee believes that the value being substituted was not equivalent, and that is different than requiring “approval or consent” of the trustee. Revenue Ruling 2011-28, 2011-49 I.R.B. 830 (December 1, 2011) is a follow-up to Revenue Ruling 2008-22. It says that a nonfiduciary substitution power generally will not trigger estate inclusion under §2042. (See sub-paragraph (6) below.) Both Rev. Rul. 2011-28 and 2008-22 condition the conclusion that assets are not included in the estate under §§2036, 2038 or 2042 on the fiduciary “satisfying itself that the properties acquired and substituted by the grantor were, in fact, of equivalent value.” Interestingly, under §675(4), in order for a nonfiduciary substitution power to cause a trust to be a grantor trust, the power must be exercisable “without the approval or consent of any person in a fiduciary capacity.” Apparently, satisfying that the substituted property is of equivalent value is different than giving “approval or consent.” (6) Substitution Power Held By Third Party. Giving a third party a substitution power could be very desirable because it might be sufficient to cause grantor trust treatment for income tax purposes (as to the grantor, not the third party who holds the substitution power) but clearly does not give the donor any power that would risk estate inclusion for estate tax purposes. E.g., Ltr. Rul. 199908002 (grantor’s brother held substitution power over CLAT and CLUT; no inclusion of trust assets in gross estate). In addition, allowing a third party to hold the substitution power could create additional flexibility to “turn off” or to “toggle” grantor trust status (as discussed below).

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The statute and regulations would both literally suggest that the power of substitution can be held by a third party. I.R.C. §675(4) (power “exercisable in a nonfiduciary capacity by any person”); Treas. Reg. §1.675-1(b)(4) (referring to existence of powers of administration exercisable in a nonfiduciary capacity by “any non adverse party”). However, the statute refers to the power to “reacquire” trust corpus by substituting other property of equivalent value. A very literal reading might suggest that only the grantor (or a third party who at one time owned the property in the trust) could hold the power to reacquire the property. Letter Rulings 199908002, 9810019, and 9713017 ruled that a power to substitute assets given to a third party in a nonfiduciary capacity for a charitable lead trust was sufficient to cause grantor trust treatment for income tax purposes. (If the grantor of a charitable lead trust held the power of substitution, any exercise of that power would be a prohibited transaction under §4941(d).) Letter Ruling 9037011 gave one of the trustees a power to “acquire any property that held in trust by substituting property…”. The IRS similarly held that power caused grantor trust status. Those rulings did not address the statutory requirement of a power to “reacquire” trust assets. Observe that the “reacquire” possible IRS argument does not exist if the grantor’s spouse holds the substitution power, because any power or interest held by the grantor’s spouse is deemed to be held by the grantor for purposes of the grantor trust rules. I.R.C. §672(e). The IRS issued Rev. Proc. 2007-45 (inter vivos trusts) and 2007-46 (testamentary trusts) describing sample forms for charitable lead annuity trusts. Rev. Proc. 2007-45 provides a form for a grantor trust CLAT, and it uses a third party substitution power to cause grantor trust status. Similarly, Rev. Proc 2008-45 uses the same approach for the sample inter vivos CLUT grantor trust form. Observe that several private letter rulings have held (apparently incorrectly and inadvertently) that a trust with a third party substitution power was a grantor trust as to the holder of the substitution power. E.g.¸PLRs 201216034, 9311021. (7) Substitution Power Held by Grantor’s Spouse. If someone other than the grantor can hold the substitution power (as discussed above), the grantor’s spouse could be given the substitution power. For example, a spousal substitution power might be used for voting stock of a controlled corporation. The grantor’s spouse could be given the substitution power without risk that the “reacquire” language would cause §675(4)(C) not to apply, because §672(e) treats that grantor as holding any powers or interests that are held by the grantor’s spouse. However, the spouse should not be given the power to both relinquish and reacquire the substitution power, or the grantor would be treated as having the substitution power continuously under Section 672(e). (8) Power of Substitution Held by Insured Not an Incident of Ownership. Revenue Ruling 2011-28, 2011-49 I.R.B. 830 (December 1, 2011) is a follow-up to Revenue Ruling 200822. It says that a nonfiduciary substitution power generally will not trigger estate inclusion under §2042. A 1979 Revenue Ruling, however, provides that the IRS position is that a power to purchase a policy does create an incident of ownership. Revenue Ruling 79-46, 1979-1 C.B. 303, takes the position that an employee has an incident of ownership if the

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insured’s employment contract gives the insured the right the buy the policy at any time for its cash surrender value. The ruling reasons that the right to buy the policy amounted to a power to veto the policy’s cancellation, and that constituted an incident of ownership. The IRS lost that argument in Estate of Smith v. Commissioner, 73 T.C. 307 (1979), acq. in result, 1981-1 C.B. 2, but the acquiescence in result only disagrees with the Tax Court’s reasoning of what constitutes an incident of ownership, and Rev. Rul. 79-46 has never been withdrawn. Interestingly, Rev. Rul. 2011-28 does not retract the prior seemingly inconsistent ruling, and does not even mention the Estate of Smith case, which directly supports the conclusion of Rev. Rul. 2011-28. The valuation issue of determining an “equivalent value” could be particularly difficult for life insurance policies, which by their nature can be very difficult to value. However, as a practical matter, the substitution power over a life insurance policy typically would never be exercised. The important planning point is that the mere existence of the substitution power causes the trust to be a grantor trust, and that power can now safely be used for life insurance policies as well as other assets. Caution should be exercised if the powerholder ever wishes to actually exercise the power. (9) Potential Application of Section 2036(b) Indirect Power to Control Voting of Stock of Controlled Corporation. Similarly, some planners suggest providing that the power could not be exercised to acquire to any voting stock of a “controlled corporation” for purposes of §2036(b). A “controlled corporation” is, generally speaking, a corporation in which the decedent held, at any time after a transfer of stock and within three years of the decedent’s death, the right to vote stock possessing at least 20% of the combined voting power of all classes of stock, after applying the attribution rules of §318 and including a right to vote held in conjunction with another person. §2036(b)(2). For this purpose, any relinquishment or cessation of voting rights within three years of the date of death triggers a special §2035 rule. §2036(b)(3). A substitution power might conceivably be treated indirectly as the power to control the voting of the stock under §2036(b). The issue under §2036(b) is whether the power to reacquire stock is a “retention of the right to vote (directly or indirectly) shares of stock of a controlled corporation” within the meaning of §2036(b). Cf. Letter Ruling 200514002 (involving a trust agreement providing that the grantor’s substitution power did not extend to stock of a controlled corporation).] However, the explicit holding of the Revenue Ruling is that a grantor nonfiduciary substitution power by itself will not cause inclusion under §2036 or §2038 (which obviously includes §2036(b)), even though the ruling does not specifically address the reasoning of the potential application of §2036(b). Extending the concept of an indirect power to vote stock to the power to repurchase stock by paying full value for the stock seems a huge stretch. In any event, there should be no necessity of excepting out partnerships from substitution powers (in light of the fact that §2036(b) only applies to corporations and not partnerships). The Tax Court decided in Jordahl that the right to buy an asset for its fair market value is not a retained right or interest for purposes of §2036 or §2042, and the IRS acquiesced in the result of the case. Some planners point out that if a right to purchase assets constitutes a retained right under §2036, questions could be raised about the application of §2036 to a buy-sell agreement that gives a donor of stock a right of first refusal if the donee elects to sell the stock or a right to buy back the stock if the donee predeceases the donor. Also, questions would be raised regarding the impact under the charitable split-interest rules of

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a contribution of voting stock (or other asset) to a charity that is subject to such buy-sell provisions, exercisable either by the donor or by other persons. (10)Valuation If Substitution Power is Exercised. If the grantor or a third party exercises the substitution power, if marketable securities are included, should values at the close of the day be used, or should the mean between the high and low on the day of substitution be used (for valuing both the assets acquired from the trust as well as the substitution assets? Because the “mean between the high and the low” is the general valuation approach for estate and gift tax purposes, most planners use that method (which may required a small adjustment on the following day if the exact high and low prices are not known on the day of the substitution). (11)Practical Implications of Implementing Swap Powers. For an interesting discussion of practical problems that arise in implementing and exercising swap powers, see Martin Shenkman & Bruce Steiner, Swap Powers-Consider Some Often Overlooked Practical and Technical Aspects¸ TRUSTS & ESTATES 45 (DEC. 2015). Two state courts have reached opposite results as to whether the attempted exercise of a substitution power was effective when the grantor sought to substitute a note for trust assets. Benson v. Rosenthal, 2016 WL 2855456 (E.D. La. 2016) (slip copy), mot. for partial summary judgment denied, 2016 WL 6649199 (E.D. La. 2016) (refused to grant summary judgement treating proffer of note as ineffective; court observed that (1) the trust agreements did not explicitly exclude a promissory note from being used to exercise the substitution power, (2) the notes are assets having value, and (3) the real estate and loan forgiveness that the grantor offered as part of the substitution are further proof that a loan was not intended); In re The Mark Vance Condiotti Irrevocable GST Trust, No. 14CA0969 (unpublished opinion Col. App. 2015) (attempt to exercise substitution power by offering unsecured note for trust asset held ineffective, reasoning that the proposed transaction was an attempt to borrow from the trust, not to substitute assets, so that the trustees could properly reject it). f.

Power of Non-Adverse Trustee to Make Loans to the Grantor and/or Grantor’s Spouse Without Adequate Security, §675(2). (1) Mere Existence of Power Sufficient. The mere existence of the power exercisable by the grantor or a non adverse party that enables the grantor to borrow corpus or income, directly or indirectly, without adequate interest or without adequate security except where a trustee (other than the grantor) is authorized under a general lending power to make loans to any person without regard to interest or security, will confer grantor trust status. I.R.C. §675(2). The mere existence of the power is sufficient to cause grantor trust status regardless whether the power is actually exercised. (Contrast this provision with Section 675(3), discussed below, which requires an actual borrowing of trust funds by the grantor to confer grantor trust status.) (2) Grantor Treated as Owner of Entire Trust. As long as the power extends to borrowing corpus or income from the trust, grantor trust status will result as to the entire trust. (Some of the other grantor trust powers will result only in partial grantor trust treatment.) (3) Power to Borrow Without Adequate Security is Sufficient. If the grantor has the power to borrow funds either without adequate security or without adequate interest, the trust will be treated as a grantor trust. Grantor trust status can be achieved if the trustee has the power to lend unsecured, even if the loan provides for adequate interest. Letter Rulings

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199942017 (grantor has authority to borrow all or any of the corpus or income “without adequate security”), 9645013, and 9525032. To avoid an argument that the grantor has retained a discretionary beneficial interest in the trust that would cause estate tax inclusion, the lending power should be limited to the authority to make loans without security, and should not include the authority to make loans to the grantor without adequate interest. Furthermore, in order to assure that the “adequate” requirement is satisfied, the power is typically drafted in a manner that would explicitly permit making loans without any security to the grantor. See Ltr. Ruls. 9645013 (non-adverse party authorized to lend to the grantor without security) and 9525032 (grantor’s power to borrow without security causes GRAT to be grantor trust). However, in Letter Ruling 199942017, the IRS issued a ruling that the trust would be a grantor trust where the grantor retained the power to borrow all or any portion of the corpus or income of the trust “without adequate security”. (Presumably, the result would be the same if the trustee merely had the power to lend without adequate security as opposed to the grantor having the power to borrow without adequate security.) Interestingly, in that ruling, the S corporation and the grantor who were seeking the grantor trust ruling represented that their intention was “that this section allows Settlor to exercise this power unconditionally, without the approval of the trustees, or any other party”. (4) Non Adverse Party Other Than Grantor Should Hold the Power. A provision giving the grantor the power to make loans to himself or herself without adequate security would cause grantor trust treatment under Section 675(2), but could risk estate inclusion for estate purposes if the IRS were to determine that the power gave the grantor the authority to receive trust assets for less than full and adequate consideration. To minimize this estate inclusion risk, the power should be held by a non-adverse party other than the grantor. The safest course would be to use someone who is not a “related or subordinate party” to the grantor, by analogy to Revenue Ruling 95-58, 1995-2 C.B. 191, which permits a grantor to remove a trustee without risking estate inclusion under Sections 2036 or 2038 as long as the replacement trustee must be someone who is not a related or subordinate party within the meaning of Section 672(c). g. Power of Non-Adverse Party to Add Beneficiaries, §674(b), §674(c), 674(d). (1) Statutory Provisions. Section 674(a) states the general rule that a grantor is treated as the owner of the trust the beneficial enjoyment of which is subject to a power of disposition. Exceptions are provided in Sections 674(b), 674(c), and 674(d). The provisions for many of those exceptions provide that the exceptions will not apply if “any person has a power to add to the beneficiary or beneficiaries or to a class of beneficiaries designated to receive the income or corpus except where such action is to provide for after-born or after-adopted children”. If such a power to add beneficiaries exists, the exceptions provided in Section 674(b), (c), and (d) will not apply, so the general rule in Section 674(a) provided for grantor trust treatment would apply. Who Should Hold the Power? The exception to the exceptions in Sections 674(b), (c), and (d) applies if “any person” holds the power to add beneficiaries. Therefore, there is no limitation on who can hold the power as far as whether the power will result in grantor trust status. The general rule of Section 674(a), which triggers grantor trust treatment where there is a power of disposition over trust property, applies only if the power of disposition is exercisable “by the grantor or a nonadverse party, or both, without the approval or consent of any adverse party.” However, as long as a non-adverse party holds a power over dispositions, there is no requirement that the person who holds the power to

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add beneficiaries be a non-adverse party. However, a beneficiary should not hold the power to add non-charitable beneficiaries, or else gift consequences might result from its exercise. Practical Planning Strategies. Document that the person who holds the power is aware of its existence, to show that the power is not “illusory.” Consider actually exercising the power at some point, to show that it is not “illusory” such as by adding the spouse of a particular beneficiary as a potential discretionary beneficiary. Typically, the power to add beneficiaries is discontinued following the grantor’s death. A possible planning strategy might be to provide that the person who has the power to add beneficiaries also has the power to remove any beneficiary that was added as a potential beneficiary by that same person. Another possibility if there is a desire to keep as much flexibility as possible would be to give someone the power to add a beneficiary for that particular calendar year. (a) Grantor. The grantor should not hold the power to add beneficiaries because that retained power would cause the transfer to result in an incomplete gift. Treas. Reg. 25.2511-2(c)(f). In addition, the assets may be included in the grantor’s estate under Sections 2036(a)(2) or 2038. (b) Grantor’s Spouse. The power could be held by the grantor’s spouse without risking estate inclusion as long as no property is contributed to the trust by the spouse and as long as the spouse is not controlled by the grantor. (However, a successor holder of the power should be provided or else the death of the spouse could cause a termination of grantor trust status.) (c) Beneficiary. The power to add beneficiaries should not be held by a beneficiary. An exercise of the power by a beneficiary might result in a deemed gift. Perhaps a gift would not result if the beneficiary merely has the power to add to the class of permissible beneficiaries but another trustee holds the power to make discretionary distributions to the added beneficiary. (d) Trustee. The power to add beneficiaries is sometimes granted to the trustee of the trust. See Letter Rulings 199936031 (trustee who was a non-adverse party held power to add one or more charitable organizations to the class of beneficiaries eligible to receive distributions from a CLAT upon the termination date), 9709001 & 9010065 (independent trustee holds power to add charities as beneficiaries). Query whether fiduciary principles would place any constraint on the ability of the trustee to add a beneficiary. One commentator summarizes this fiduciary problem: One must face the dilemma that a trustee ordinarily would have no reason consistent with fiduciary duty to voluntarily relinquish powers that might be exercised in the future in the best interests of the trust beneficiaries. This is particularly true when an obvious result of such relinquishment would be to subject the trust or its beneficiaries to an income tax that they otherwise would avoid. Broad discretion in the trust instrument might not be sufficient to authorize the trustee to relinquish a power when there is no reason to do so. Mere accommodation of the grantor does not appear to ever by a proper reason. Recent family limited partnership cases under section 2036(a) should give us pause. Aucutt, Installment Sales to Grantor Trusts, ALI-ABA PLANNING TECHNIQUES FOR LARGE ESTATES 1539, 1555 (April 2007).

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(Ron Aucutt suggests that one possible solution to this dilemma is to provide that the trustee acquires a desirable power by relinquishing the power that makes the trust a grantor trust. For example, the Trustee might acquire the power to vary the shares of family members or to broaden the standard for distributions by relinquishing the power to add charitable beneficiaries. Id.) If the client would really like the prospect of adding charitable beneficiaries of the trust in certain circumstances, perhaps the instrument could give guidance to the trustee regarding the situations in which the trustee should particularly consider adding charitable beneficiaries. However, the instrument should not add objective standards that may likely never be satisfied before a charitable beneficiary could be added. A court might determine in that situation that no real ability to add charitable beneficiaries existed. (2) Classes of Beneficiaries That May Be Added. The statute provides that the power to add beneficiaries “to provide for after-born or after-adopted children” would not cause grantor trust status. There appears to be no other limitations on the permissible class of added beneficiaries. (a) Charities. Various cases and rulings have recognized grantor trust status where there is a power to add charities as beneficiaries. Eg. See Madorin v. Comm’r, 84 T.C. 667 (1985) (power of trustee to add charitable organizations causes grantor trust treatment); Ltr. Rulings 199936031 and 9709001. Another permissible way of limiting the types of charities that could be added would be to permit only the addition of charitable remainder trusts or charitable lead trusts with the grantor’s issue as the noncharitable beneficiaries. (b) Specified Classes of Individuals. The power could be granted so broadly as to permit adding any person as a permissible additional beneficiary. However, most grantors would be uncomfortable granting that broad of discretion to any individual. The permissible classes of additional beneficiaries could be limited in any manner desired by the grantor. For example, the power could be given to add members of a specific group, such as nieces and nephews, spouses of children, or more remote relatives. However, it is not clear that a power to “add” persons who are already contingent remote beneficiaries would be treated as a power to “add” beneficiaries that would trigger grantor trust treatment. “Adding” beneficiaries in that situation arguably just elevates their beneficiary status, but really does not “add” them as beneficiaries. (3) Special Power of Appointment. A special power of appointment granted to an individual to appoint trust assets to non-beneficiaries should constitute a power to add beneficiaries that would confer grantor trust status. See Letter Ruling 9643013 (trustee for one trust and grantor’s spouse for another trust held special power of appointment currently exercisable in favor of spouses and former spouses of the grantor’s descendants; held that the power of appointment was the equivalent of the power to add beneficiaries, which meant that the §674(c) exception did not apply). (4) Checks and Balances. Because of the very broad power granted to an individual to add beneficiaries, the grantor may feel more comfortable with a “checks and balances” system to assure that various individuals concur with the addition. (However, the consent of beneficiaries should not be required (because the actual grant of consent by beneficiaries may be a deemed gift)).

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An approach used by some planners to provide “checks and balances” is to give someone other than the trustee the power to add beneficiaries, but to provide that the trustee would make the decision of when to make distributions to the new beneficiaries, the same as for all trust beneficiaries. However, one commentator has suggested that under section 674(a), the same person who has the power to add beneficiaries must “also have the power, without the approval or consent of an adverse party, to direct a distribution to such added beneficiaries.” Aucutt, Installment Sales to Grantor Trusts, ALI-CLE PLANNING TECHNIQUES FOR LARGE ESTATES 615, 631 (April 2013) (recognizing that “some estate planners … do not share this concern and regard this precaution as unnecessarily conservative”). Even if the person who has the power to add beneficiaries does not have the power to cause distributions, there would still be a non-adverse party who has a power of disposition over trust assets, thus triggering §674(a), and none of the exceptions in §674 would seem to apply. h. Inter Vivos Power of Appointment. Carlyn McCaffrey suggests giving a third party (who is not a trustee and is not a beneficiary) a presently exercisable power of appointment, at least during the grantor’s lifetime. The third party must be a nonadverse party (so a beneficiary cannot hold the power). Because the person is not a trustee, the exception in §674(c) would not apply. [Consider using a related or subordinate party if there is any concern that the power may be deemed to be held in a fiduciary capacity; in that event, § 674(c) still would not apply.] Because there is no standard, the exception in §674(d) would not apply. The testamentary power of appointment exception in §674(b)(3) would not apply (because the power of appointment is presently exercisable). None of the other exceptions in Section 674 would apply, so the general rule of §674(a) would treat the trust as a grantor trust because the third party who is not an adverse party would have a power of disposition over the asset. Provide a succession of power holders during the grantor’s lifetime—so that the trust will continue as a grantor trust if the initial power holder dies before the grantor. i.

Foreign Grantor Trust. If a U.S. grantor establishes a foreign trust for the benefit of U.S. beneficiaries, it is treated as a grantor trust. I.R.C. § 679. Upon termination of grantor trust status (i.e., at the death of the grantor or if there are no longer any U.S. beneficiaries), Section 684 imposes a tax on the unrealized appreciation. However, if that occurs because of the death of the grantor, the step-up in basis under Section 1014 should avoid having any gain to which Section 684 would apply.

Foreign Grantor. Section 672(f) provides that the grantor trust rules will not apply if they would cause someone other than a U.S. citizen or resident or domestic corporation to be treated as the owner of the income. Therefore, if a foreign person is the grantor of a trust, the grantor trust rules will not apply as to that person. For example, a foreign person could create a trust for a U.S. beneficiary, who might be the trustee of the trust, and who might also be treated as the owner of the income of the trust under section 678 if the beneficiary has a Crummey withdrawal power over all contributions to the trust. Broad dispositive powers could be granted without fear of causing the foreign person to be treated as the owner of the trust under the grantor trust rules.

k. Converting Non-Grantor Trust to Grantor Trust. Possible ways of converting a nongrantor trust to a grantor trust include the following:

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• If the trust allows distributions without an ascertainable standard, change trustees so that more than half of the trustees are related or subordinate parties (§674(c)). (This strategy can also be used to toggle between grantor trust and non-grantor trust status.) • Turn the trust into a foreign trust (§679) [but many other complexities arise with being a foreign trust]. • Actual borrowing of assets from the trust by the grantor without giving adequate security (§675(3)). (See Section V.I.4 of this Part for a more detailed discussion of this alternative.) Grantor Trust Trust Conversion During a Year. If a non grantor trust is converted into a grantor trust, as of what date does it become a grantor trust? Generally, the trust does not become a grantor trust for the entire year, but only for a fraction of the year. However, for some triggers (such as borrowing from the trust), the trust would become a grantor trust for the entire year. l.

Summary of Selection of Trustee Issues With Respect to Grantor Trust Rules. The trust will be a grantor trust if the trust may make distributions to the grantor or grantor’s spouse (probably only as to trust income) or if premium payments may be made on life insurance on the life of the grantor or grantor’s spouse (probably only as to the amount of premiums actually paid during the year.) If the planner wants to avoid grantor trust status, use one of the following exceptions. (1) Use an independent trustee (no more than half of whom are related or subordinate parties) and give them the authority to distribute assets among a designated class of beneficiaries. (2) Use a trustee other than the grantor or grantor’s spouse, whose distribution powers are limited by a reasonably definite external standard. (3) With no limitation on who is the trustee—as to corpus use a reasonably definite distribution standard (or have separate shares for the beneficiaries), and as to income, either have (i) a vested trust for a single beneficiary, (ii) provide that the income must ultimately pass to current income beneficiaries in irrevocably specified shares, or (iii) provide that on termination the assets may be appointed to appointees (other than the grantor or grantor’s estate) if the trust is reasonably expected to terminate during the current beneficiary’s lifetime. (4) Use an adverse party as trustee. Even if one of those exceptions is satisfied, also make sure the trust is not a foreign trust and that none of the proscribed administrative powers in Section 675 are present. If the planner wants to trigger grantor trust status, use one (or more to be safe) of the following. (1) Select trustees and dispositive powers to flunk all of the exceptions in Section 674—generally, more than one-half of the trustees are related or subordinate parties and there is no reasonably definite external standard for distributions. (2) Give a non-adverse party the power to add beneficiaries. (3) Give a non-adverse trustee the power to make a loan to the grantor and not have to require adequate security for the loan. (4) Give the grantor a substitution power in a nonfiduciary capacity (realizing that the IRS takes the position that whether it is exercisable in a nonfiduciary capacity is a fact question, to be determined in every case.)

m. Non Grantor Trusts With Grantor as Discretionary Beneficiary. “Delaware Incomplete NonGrantor” Trusts are trusts used to avoid state income tax by having the trust sitused in a jurisdiction that will not tax the accumulated and capital gains income in a non-grantor trust.

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(Income of a grantor trust would presumably be subject to tax in the state of the grantor’s residence.) The trust is merely designed to avoid state income tax. For example, if a New York resident creates a Delaware trust with the settlor as a discretionary beneficiary, any undistributed income that is not Delaware source income would not be subject to income tax in either New York (because there is no New York trustee or administration in New York or New York source income) or Delaware (because the trust is not deemed to be a Delaware resident trust that is subject to Delaware income taxes). Because the goal is merely to avoid state income tax, the donor most certainly does not want to risk having to pay federal gift taxes (at a 40% rate) to have an argument of avoiding state income taxes at a much lower rate. The “DING trust” (these are also sometimes referred to as “NING trusts” when Nevada law applies) typically allows a distribution committee to make distributions to the beneficiaries, including the grantor. The distribution committee typically consists of several beneficiaries other than the grantor. The trust avoids grantor trust treatment under §674 by requiring the consent of an adverse party to all distributions during the grantor’s lifetime. The grantor retains a testamentary limited power of appointment. Various rulings have ruled that the transfer to the trust is an incomplete gift for gift tax purposes, and some (the rulings in 2006 and 2006) have also ruled that the distribution committee members do not have gift tax consequences. The general fact scenarios of the rulings prior to 2013 have generally involved distribution committees comprised of two individuals, each of which are also discretionary beneficiaries under the trust agreement. Distributions can be made (1) by approval of both distribution committee members, or (2) action of one distribution committee member and consent by the grantor. There, a distribution to any beneficiary (including the grantor) will be made only with the consent of some adverse party as to that individual. Some of the early rulings were PLRs 200148028, 200247013, 200502014, 200612002, 200637025, 200647001, & 200715005. 2013 Rulings. No DING Trust rulings had been issued for five years prior to the issuance of PLRs 201310002-201310006 (described below). The status of DING Trust rulings had been in doubt for several reasons. These are the major issues that were addressed in the 2013 rulings and in subsequent rulings. (i) Gift tax consequences for distribution committee members. IR-2007-127 (July 9, 2007) announced that the IRS was reconsidering its position in these rulings with respect to the gift tax consequences of trust committee members. The IRS expressed concern that the prior letter rulings may be inconsistent with Revenue Ruling 76-503 and Revenue Ruling 77-158. The IRS announcement says that those Revenue Rulings indicate that “because the committee members are replaced if they resign or die, they would be treated as possessing general powers of appointment over the trust corpus.” The ABA Real Property Trust and Estate Law Section submitted comments to the IRS on September 26, 2007. The letter was prepared by prominent members of the estate planning bar, including Jonathan Blattmachr, Prof. Mitchell Gans, Carlyn McCaffrey, Diana Zeydel, and others. The letter concludes that the DING PLRs are not inconsistent with Rev. Ruls. 76-503 and 77-158 (or 79-63). The letter points out various distinctions, and that the copowerholders in the DING rulings situations have considerably more adversity to each other than the co-powerholders in the revenue rulings. It also points out that the regulation at issue does not necessarily require succession to a power on the powerholder’s death to create adversity; it merely gives that as an additional way that a co-holder of a power can be deemed to be adverse if his only interest in the trust is as a

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co-holder of a power. In addition, it reasons that no one can have a general power of appointment over property the transfer of which is incomplete (addressing a revenue ruling, a case and several PLRs that might arguably be inconsistent with that proposition). As a corollary to this argument, the letter states that if the original donor has not made a gift to a beneficiary, the beneficiary should not be able to make a gift back to the donor by agreeing to a distribution to the grantor. (ii) Incomplete gift treatment for grantor. CCA 201208026 concluded that retained testamentary powers of appointment over a trust under which the grantors were not beneficiaries cause the remainder interest to be an incomplete gift, but concluded that the testamentary powers of appointment relate only to the remainder interest. During the grantors’ lifetimes, they had no ability to keep the trustee from making distributions among the potential trust beneficiaries — which might potentially include all of the trust assets. Therefore, the CCA reasoned that the gift was complete as to the “beneficial term interest” that existed before the grantors’ deaths — but was an incomplete gift as to the remainder interest. (Reg. §25.2511-2(b) states that if the donor is the discretionary income beneficiary, a retained testamentary power of appointment causes the transfer to the trust to be an incomplete gift.) The issue then became to determine the relative values of the term interest (a completed gift) and the remainder interest (an incomplete gift). The CCA reasoned that §2702 applied, and because the retained interest (i.e., the interest passing to “applicable family members”) was not a qualified interest, it had to be valued at zero under §2702. Therefore, the completed gift of the term interest was the full value transferred to the trust. CCA 201208026 raised concerns that merely reserving a testamentary limited power of appointment in the grantor may be insufficient by itself to cause the transfer to a DING trust to be an incomplete gift by the grantor. PLRs 201310002-201310006. PLRs 201310002-201310006, issued March 8, 2013, addressed the grantor trust and gift tax issues for DING trusts. Subsequent rulings have followed the general reasoning of these 2013 rulings. The trusts are believed to be Nevada DING trusts (though the rulings do not state explicitly that they are Nevada trusts) Based on local law limitations, it is clear that this cannot be a Delaware trust. The rulings all involve identical fact situations, and the rulings were identical (except that PLR 201310003 inadvertently [apparently] deleted a phrase in the paragraph about Grantor’s Consent Power in the discussion of Rulings 2 and 3). Basic Facts. Grantor created an irrevocable trust of which Grantor and his issue were discretionary beneficiaries. There was a corporate trustee, who was required to distribute income or principal at the direction of a distribution committee or principal upon direction from Grantor. The distribution committee consists of Grantor and each of his four sons. Three alternative methods are provided for distribution directions: (1) Grantor consent power-distribute income or principal upon direction of a majority of the distribution committee members with the written consent of Grantor; (2) Unanimous member power-distribute income or principal upon direction by all distribution committee members other than Grantor; and (3) Grantor’s sole power-distribute principal to any of Grantor’s issue (not to Grantor, and not income) upon direction from Grantor as Grantor deems advisable in a nonfiduciary capacity to provide for the health, maintenance, support and education of his issue. Distributions can be directed in an unequal manner among potential beneficiaries.

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There must always be two “eligible Individuals” (defined) serving as distribution committee members. “A vacancy on the Distribution Committee” must be filled by the eldest of Grantor’s adult issue other than then serving members of the committee (with alternate successors if there are no such surviving adult issue). (The rulings do not clarify whether this is interpreted to mean that a vacancy occurs when any member ceases to serve or only when there are less than two members serving. Some commentators say that a distribution committee member is not replaced unless there is only one remaining committee member, and that this provision may be important in resolving the IRS’s concern that prior DING rulings may be inconsistent with Rev. Ruls. 76-503 and 77-158. Under this reasoning, it is not clear whether the distribution committee members would have a general power of appointment once the committee has been reduced to only two individuals. See Bill Lipkind on PLR 201310002: DING Redux, LEIMBERG EST. PL. EMAIL NEWSLETTER #2076 (March 12, 2013).) The distribution committee ceases to exist upon Grantor’s death. There is a decanting power, authorizing the distribution committee to distribute assets to qualified trusts. Grantor has a testamentary power of appointment to appoint the assets to any persons or entities other than Grantor’s estate, creditors, or creditors of the estate. In default of exercise of the power appointment, the assets will pass to the issue of Grantor’s deceased father. Rulings. The IRS gave four important rulings in the 2013 rulings. (1) Non-Grantor Trust. The trust is not a grantor trust. Without any explanatory analysis, the ruling merely concludes that §§673, 674, 676, and 677 do not apply. Whether §675 applies is a question of fact to be determined when federal income tax returns of the parties are filed. Section 678 does not apply because no beneficiary can unilaterally vest trust income or corpus in himself. Section 674(a) provides that a grantor is treated as the owner of any portion of a trust for which the beneficial enjoyment of corpus or income is subject to a power of disposition, exercisable by the grantor or a non-adverse party, or both, without the approval or consent of any adverse party. Similarly, §§676(a) and 677(a) provides that a grantor is treated as the owner of a trust subject to certain other powers that can be exercised without the approval of an adverse party. Section 672(a) provides that for purposes of the grantor trust rules, the term “adverse party” means any person having a substantial beneficial interest in the trust which would be adversely affected by the exercise or nonexercise of the power which he possesses respecting the trust. With respect to the grantor consent power and unanimous member power, distributions can be made only with the consent of an adverse party. (The rulings do not specifically reason that the distribution committee members are adverse to the grantor for this income tax purpose, but that must be the basis of the rulings’ conclusion. Observe that the rulings conclude that the distribution committee members are NOT adverse to Grantor for gift tax purposes, as discussed in the discussion below regarding the impact of Grantor’s consent power on the issue of whether the transfer to the trusts is an incomplete gift by Grantor.) With respect to the “Grantor’s sole power” alternative, the grantor has the power to distribute principal (not income) in a nonfiduciary capacity (the nonfiduciary capacity element is important as a basis for finding that the transfer to the trust is not a

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completed gift by Grantor, as explained below), §674(b)(5)(A) has an exception for the power to distribute corpus that is limited by reasonably definite standard. (2) Incomplete Gift by Grantor. The rulings give four reasons that Grantor does not make a completed gift upon creation of the trust. •

Grantor’s consent power. Under Reg. §25.2511-2(b) a gift is complete if the donor “has so part with dominion and control as to leave him in no power to change its disposition.” Grantor’s consent power is deemed to be such a power over disposition (which makes the gift incomplete), because a donor is considered as having a power exercisable in conjunction with someone else as long as the other person does not have a substantial adverse interest in the disposition of the transferred property. Reg. § 25.2511-2(e). The rulings conclude that the other distribution committee members do not have interests adverse to Grantor for this purpose. Reg. §25.2511-2(e) does not define “substantial adverse interest,” but Reg. §25.2514-3(b)(2) states that a “taker in default of appointment under a power has an interest which is adverse to an exercise of the power.” The ruling gives no explanation as to why the four sons are not deemed to be “takers in default” if a distribution is not made. (Perhaps it is because of Grantor’s retained testamentary limited power of appointment, so that none of the four sons could be assured of receiving any undistributed trust assets, but the rulings do not discuss that reasoning.) The next two sentences of Reg. §25.2514-3(b)(2) state: A coholder of the power has no adverse interest merely because of his joint possession of the power nor merely because he is a permissible appointee under a power. However, a coholder of a power is considered as having an adverse interest where he may possess the power after the possessor’s death and may exercise it at that time in favor of himself, his estate, his creditors, or the creditors of his estate.

Rather than treating this as merely a possible method of showing adversity, the rulings reason that continued holding of the power after the possessor’s death is a prerequisite to showing adversity by the coholder of a power: Under §25.2514-3(b)(2), a coholder of a power is only considered as having an adverse interest where he may possess the power after the possessor’s death and may exercise it at that time in favor of himself, his estate, his creditors, or the creditors of his estate. In this case, the Distribution Committee ceases to exist upon Grantor’s death. Accordingly, the Distribution Committee members do not have interests adverse to Grantor under §25.2514-3(b)(2) and for purposes of §25.2511-2(e). (Emphasis added).

The comments submitted to the IRS by the ABA Real Property Trust and Estate Law Section on September 26, 2007 take the position that the regulation does not necessarily require succession to a power on the power holder’s death to create adversity, but merely gives that as an additional way that a coholder of the power can be deemed to be adverse if his only interest in the trust is as a coholder of the power. In any event, the rulings conclude that Grantor’s consent power (i.e., the ability to join with the other distribution committee members in making distributions by consenting to distributions that a majority of the distribution committee members

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want to make) “causes the transfer of property to Trust to be wholly incomplete for federal gift tax purposes.” •

Grantor’s sole power over principal. Grantor’s sole power to make distributions (for health, maintenance, support or education) causes the transfer of property to the trust to be “wholly incomplete” for federal gift tax purposes. The rulings do not specifically discuss how this provision causes the transfer to be “wholly incomplete” even though it is only a power over principal and not income. The rulings do not discuss regulations providing that a transfer will not be incomplete for gift tax purposes if the donor has a power to change beneficial interest but the power is held in a fiduciary capacity and is subject to a “fixed and ascertainable standard.” Reg. §§25.2511-2(c) & 25.2511-2(g). In this situation, however, Grantor’s authority to direct distributions was held in a nonfiduciary capacity. Interestingly, the IRS treats whether a grantor holds a substitution power in a nonfiduciary capacity for purposes of §675(4)(C) as a question of fact to be determined in each year for income tax purposes. The IRS gave no analysis of whether Grantor actually held the power in a nonfiduciary capacity as a factual matter. Grantor’s sole power over principal in effect gives Grantor a lifetime power of appointment. CCA 201208026, discussed immediately below, held that a mere testamentary power of appointment caused the trust to be incomplete only as to the remainder interest. A lifetime power of appointment in effect would cause the transfer to be incomplete as to the term interest as well prior to the termination of the trust. However, if including this provision is essential to cause incomplete gift treatment, the plan could not be used in any states that do not permit the grantor to retain a lifetime power of appointment in order for a self-settled trust to be protected from claims of the grantor’s creditors (and if the grantor’s creditors can reach the trust, it would be a grantor trust). Delaware used to have that restriction, but the statute was revised in 2014 to permit the grantor of a selfsettled trust to have a lifetime or testamentary limited power of appointment). See 12 Del. C. § 3570(11)b.2.

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Grantor’s testamentary limited power of appointment. The rulings reiterate the limitation under CCA 201208026 on incompleteness by merely retaining a testamentary limited power of appointment. The rulings state that the testamentary power of appointment causes “a retention of dominion and control over the remainder,” and concludes that the retention of the testamentary power causes the transfer of property to the trust to be incomplete “with respect to the remainder” for federal gift tax purposes. Accordingly, retaining a testamentary limited power of appointment would not, under the reasoning of these rulings or CCA 201208026, cause a transfer to be incomplete as to the term interest prior to the termination of the trust.

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Unanimous member power does not remove Grantor’s dominion and control. Grantor retains dominion and control over the income and principal until the distribution committee members exercise their unanimous member power. Therefore the existence of the unanimous member power does not remove Grantor’s ability to shift beneficial interests under the other two alternatives for giving distribution directions to the trustee (thereby causing the gift upon transfer property to the trust to be incomplete).

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(3) No Completed Gift by Distribution Committee Members Upon Making Distribution to Grantor. The rulings reason very simply that “[a]ny distribution from Trust to Grantor is merely a return of Grantor’s property. Therefore, we conclude that any distribution of property by the Distribution Committee from Trust to Grantor will not be a completed gift subject to federal gift tax, by any member of the Distribution Committee.” (This adopts the reasoning of the comments from the ABA Real Property Trusts and Estate Law Section submitted on September 26, 2007.) (4) No Completed Gift by Distribution Committee Members Upon Making Distribution to Another Person Other Than Grantor. The issue is whether distribution committee members have general powers of appointment; if so, the exercise or release of a general power of appointment is treated as a transfer by the individual possessing the power under §2514(b). The rulings conclude that the distribution committee members do not have general powers of appointment. Distribution committee members can participate in distribution decisions under the (1) Grantor’s consent power, or (2) Unanimous member power. •

With respect to the Grantor’s consent power, §2514(c)(3)(A) provides that if the power is exercisable only in conjunction with the creator of the power, it is not deemed a general power of appointment.

•

With respect to the unanimous member powers, §2514(c)(3)(B) provides that a power is not a general power of appointment if it can be exercised only “in conjunction with a person having a substantial interest in the property subject to the power, which is adverse to exercise of the power in favor of the possessor.” The rulings rely on the statement in the regulations quoted above about the coholder of a power having an adverse interest if the coholder may exercise the power after the possessor’s death in favor of himself, his estate, his creditors, or the creditors of his estate. Reg. §25.2514-3(b)(2). That regulation goes on to provide an example: Thus, for example, if X, Y, and Z held a power jointly to appoint among a group of persons which includes themselves and if on the death of X the power will pass to Y and Z jointly, then Y and Z are considered to have interests adverse to the exercise of the power in favor of X. Similarly, if on Y’s death the power will pass to Z, Z is considered to have an interest adverse to the exercise of the power in favor of Y.

For example, under the facts of the rulings, if the distribution committee directs a distribution to Son 1, the sons are considered adverse to each other as to that decision, so the power to make a distribution, held jointly with the other sons, is not a general power of appointment. If a distribution committee member ceases to serve, the remaining distribution committee members continue to serve. Contrast the reasoning as to this issue with the reasoning regarding the issue of whether the “Grantor consent power” results in an incomplete gift by Grantor. For purposes of that issue, the sons were not considered to have an interest adverse to Grantor because their jointly held powers do not continue after Grantor’s death. However, as to the interests of the sons among themselves, a son’s jointly held power to make distributions does not cease to exist at the death of any of the other sons.

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The IRS had expressed concern in IR-2007-127 that the prior favorable DING Trust letter rulings may be inconsistent with Revenue Ruling 76-503 and Revenue Ruling 77-158 because those rulings suggest that because distribution committee members are replaced if they resign or die, they would be treated as possessing general powers of appointment over the trust corpus. PLRs 201310002-201310006 do not give any indication whatsoever how the IRS resolved that issue, or whether particular attributes of the trusts involved in the rulings were central to the IRS’s favorable ruling as to this power of appointment issue. No-Ruling Revenue Procedures and Subsequent Rulings. The no-ruling revenue procedure for 2020 includes, as one of the items for which rulings or determination letters will not be issued, certain trusts that are typically structured to be non-grantor trusts as an alternative for saving state income taxes (these types of trusts are often referred to as DINGs or NINGs – Delaware incomplete non-grantor trusts or Nevada incomplete non-grantor trusts). Rev. Proc. 2020-3, §3.01(93). The ruling says that rulings regarding the taxation of the trust under §671 (i.e., whether or not it is a grantor trust) will not be issued for such trusts that are structured to authorize distributions – (A) at the direction of a committee if (1) a majority or unanimous agreement of the committee over trust distributions is not required, (2) the committee consists of fewer than two persons other than a grantor and a grantor's spouse, or (3) all of the committee members are not beneficiaries (or guardians of beneficiaries) to whom all or a portion of the income and principal can be distributed at the direction of the committee, or (B) at the direction of, or with the consent of, an adverse party or parties, whether named or unnamed under the trust document (unless distributions are at the direction of a committee that is not described in paragraph (A)). Accordingly, DING and NING transactions would presumably be structured in the future to avoid the “bad facts” listed. See William Lipkind & Tammy Meyer, Revenue Procedure 2020-3 – IRS Will Not Rule on Certain Provisions of Non-Grantor Trusts, LEIMBERG INC. TAX PL. NEWSLETTERS #190 (Feb. 4, 2020). The 2021 revenue procedure deleted that provision regarding taxation under §671 in the “no rulings” section, but added various other provisions in the “areas under study in which rulings will not be issued” section making clear that ING rulings will not be issued regarding the effects under §§671, 678, 2041 and 2514 (powers of appointment), or 2511 (incomplete gift). Rev. Proc. 2021-3, §5.01(9), (10), (15), & (17). Various IRS rulings subsequent to the seminal 2013 rulings have approved ING trusts. E.g., Letter Rulings 202006002-006 (community property in ING trust remains community property at first spouse’s death for basis adjustment purposes; no ruling whether trust is grantor trust under §675 because that involves fact issues at death), 201925005-201925010, 201908002-201908008, 201852014, 201852009, 201850001201850006, 201848009, 201848002, 201832005-201832009, 201744006-008, 201742006, 201718012, 201718005-201718006, 201653001-201653009, 201650005, 201642019, 201636029, 201614006-201614008, 201613007, 201550005-201550012,

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201510001-201510008, 201436010-201436011, 201430003-201430007, 201404008, 201426014, and 201410001-201410010. The rulings make various miscellaneous observations in addition to the primary rulings described above. (a) The fair market value of the trust assets is includible in Grantor’s gross estate for federal estate tax purposes. (b) Any distribution to any beneficiary other than Grantor will be a gift by Grantor for federal gift tax purposes. (c) The rulings specifically decline to express an opinion about the effect of the decanting authority to make distributions to other trusts. For a detailed analysis of the various tax effects of ING trusts and the shifting positions of the IRS in private letter rulings regarding varying structures of INGs, see Grayson M.P. McCouch, Adversity, Inconsistency, and the Incomplete Nongrantor Trust, 39 VA. TAX REV. 419 (2020). For excellent discussions of the prior rulings, see William Lipkind, Tax Planning With Self-Settled Non-Grantor Trusts, Trusts & Estates 22 (June 2016); Kevin Ghassomian, Eliminate State Tax on Trust Income: A Comprehensive Update on Planning With Incomplete Gift Non-Grantor Trusts, 39 ACTEC L.J. 317 (Winter 2013). The effectiveness of ING trusts to avoid state income taxes has been removed by legislation in New York and a proposal is pending in California to do the same. See Eric R. Bardell, California Admits Incomplete Gift Non-Grantor Trusts Work … For Now, BLOOMBERG LAW NEWS (December 4, 2020). 4. Grantor Trust—Toggle Provisions. a. Desirability of Flexibility. A grantor may be concerned with being liable for what could potentially be huge amounts of income and capital gains taxes on trust income indefinitely into the future. Being able to “turn off” the grantor trust status when the grantor no longer wishes to pay income taxes on the trust income can be an important factor in the grantor being willing to create a trust that would initially be treated as a grantor trust. Furthermore, planning flexibility could be increased if the power to “toggle” grantor trust status could be achieved. b. General Guidelines to Maximize Flexibility. (1) Use Different Persons to Trigger Power Verses Right to Relinquish or Reacquire Power. If the grantor has the right to relinquish a power that causes grantor trust status but has the right to reacquire that power, the relinquishment would not be given effect. The regulations provide specifically that if the grantor has a power broad enough to permit an amendment causing the grantor to be treated as the owner of the portion of the trust under Section 675, he will be treated as the owner of the portion from the trust’s inception. Treas. Reg. §1.675-1(a). Therefore, at a minimum, if the grantor has the authority to relinquish the power that causes grantor trust status, only a third party should be given the authority to reinstitute that power (to toggle back “on” the grantor trust status.) Furthermore, the grantor’s retention of the right to toggle grantor trust status might arguably constitute a Section 2036(a)(2) estate inclusion power or arguably result in an incomplete gift. (2) Adverse or Non-Adverse Party Could Hold Power to Relinquish and Reinstate The Grantor Trust Power. Many of the grantor trust powers must be exercisable by a non adverse party in order to result in grantor trust status. However, the power to relinquish

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or reinstate a grantor trust power could be held by either an adverse party or a nonadverse party. (Non-adverse party status is only important for the person who holds the grantor trust power, and has no relevance to a person who has the authority to relinquish or reinstate that power.) An example of this is Letter Ruling 9010065, where the grantor’s descendants (who were beneficiaries of the trust and, therefore, adverse parties) held the power to terminate the trustee’s grantor trust power. (3) Spouse Holding Power to Relinquish or Reacquire Grantor Trust Powers. The grantor’s spouse could have the power to exercise the grantor trust power directly, or could be authorized to relinquish the grantor trust power. (This may be helpful in some circumstances, because powers that could not be held by the grantor without risking estate inclusion could generally be held by the grantor’s spouse.) However, beware of Section 672(e), which indicates that any powers held by the spouse will be deemed to be held by the grantor for income tax purposes. Accordingly, if the grantor’s spouse is given the power to relinquish and to reacquire the grantor trust power, the grantor would be treated as holding the power to reacquire the grantor trust power and grantor trust status arguably would not be cut off by relinquishment of the power causing grantor trust status. (4) Using Different Persons May Provide Helpful Checks and Balances. The powers used to result in grantor trust status may be very “powerful” powers. Giving different persons the authority to exercise those powers, to relinquish them, or to reacquire them, may provide useful checks and balances of the ability to misuse those powers. Letter Ruling 9010065 illustrates an intricate checks and balances system. An unrelated trustee could add a qualified charity (which would cause grantor trust status). However, the designation of a charity as an additional beneficiary could not be made without the approval of the taxpayer’s spouse (but if the spouse were not living, with the approval of the taxpayer’s brother). Other parties (a majority of the taxpayer’s adult descendants) were given the power to cut off grantor trust status by terminating the trustee’s authority to designate additional beneficiaries. (5) Relinquishment Should Address Whether it Binds Successors; Only Permit Reinstatement in Subsequent Year. The relinquishment of a grantor trust power should specifically indicate whether it is binding on successor trustees or successor persons holding the relinquishment power. Maximum flexibility could be retained by not having the relinquishment binding on all successors, so that a third party could reinstate the power. In that case, perhaps provide that the reinstatement power could only be exercised in a subsequent taxable year, to help clarify that the trust is not a grantor trust in the year in which the relevant power is relinquished. (6) Consideration From Grantor for Terminating Grantor Trust Status? If the grantor trust status of the trust is terminated, the grantor is benefited by being relieved of the substantial income tax liability. Could the grantor pay consideration to the trust in return for the termination of the grantor trust status by the trust or other third person on behalf of the trust, without being treated as having made an additional taxable gift to the trust? If so, this could help relieve fiduciary concerns for the trustee to take steps to terminate the grantor trust treatment if that were desirable for some reasons (for example, if having a grantor trust subjects the trust to state income that otherwise could be avoided), even though doing so would subject the trust to federal income taxation.

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(7) Notice 2007-73 Identifies Certain “Toggling” Grantor Trusts as Transactions of Interest. Notice 2007-73 identifies two rather complicated series of transactions involving grantor trusts. In each, a grantor trust would be formed that creates unitrust interest and a noncontingent remainder interest for the grantor. The noncontingent remainder interest would cause grantor trust status. A substitution power would arise at a stated date in the future. The grantor would give the unitrust interest, and after certain transactions, would sell the retained remainder interest (which allegedly would remove grantor trust status). The institution of the substitution power at the later date would allegedly reinstate grantor trust status for the trust. Later, the grantor would purchase the unitrust interest. The goal of the scenarios is either to generate a tax loss to the grantor that is not a real economic loss or to avoid the recognition of gain. The Notice states that “transactions that are the same as, or substantially similar to, the transactions described in this notice are identified as transactions of interest” that require disclosure. Therefore, the Notice addresses the complicated transactions described in the two scenarios, and does not appear to apply to “garden variety” grantor trusts (even thought grantor trust status has been toggled). The Notice states explicitly that merely terminating grantor trust status does not invoke the Notice: The transactions in this notice, as described above, do not include the situation where a trust’s grantor trust status is terminated, unless there is also a subsequent toggling back to the trust’s original status for income tax purposes.

c. Examples of Toggle Arrangements. (1) Removal and Replacement Power of Trustees Where Power to Make Discretionary Distributions by Trustee Who is Not “Related or Subordinate” is Used to Cause Grantor Trust Status. The power of a trustee, more than half of whom are related or subordinate parties, to make discretionary distributions not covered by a reasonably external standard will result in grantor trust treatment as to the entire corpus and income of the trust. See section II.C.3.a. of this outline. A third party could be given the power to remove and replace the trustees. This power could be exercised in a manner that would cause more than half of the co-trustees to be related or subordinate parties (if grantor trust status was desired) or that would cause no more than one-half of the trustees as being related or subordinate parties (if grantor trust status was not desired.) The grantor should not hold the power to remove and replace successor trustees unless any such successor must be someone who is not a related or subordinate party in order to meet the “safe harbor” provided in Revenue Ruling 95-58, 1995-2 C.B. 191. Using this mechanism may be mechanically cumbersome unless the grantor is willing to give the party who has the removal power (or perhaps another party) a power to replace the removed trustee. If the grantor wishes to include a list of specified successor trustees in the event that a trustee fails to serve, it would be difficult to determine whether the next successor should be a related or subordinate party or not at the time that the trust agreement was prepared. The person being given the authority to remove and replace trustees should be protected by broad exculpatory provisions so that decisions regarding the grantor trust tax status of the trust will not be challenged by the grantor or by the beneficiaries.

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(2) Third Party Having Authority to Cancel and Reinstate Substitution Power. Grantor trust status could be toggled by giving someone other than the grantor the right to cancel and reinstate a power of substitution under Section 675(4)(C). (3) Power to Loan to Grantor Without Adequate Security. Either the trustee or the grantor could be given the authority to relinquish the trustee’s power to make loans to the grantor without requiring adequate security. Someone other than the grantor could be given the power to reinstate the power to loan without adequate security. To provide additional checks and balances, different persons could be given the authority to terminate and reinstitute the power to lend without adequate security. However, if desired, a single person, who is not related or subordinate to the grantor (to put the grantor in the best position to argue that the power to lend without adequate security does not cause estate inclusion) could be given the power to both terminate and reinstate the lending power. (4) Power to Add Beneficiaries. The person who is given the authority to add beneficiaries could also be given the authority to relinquish the right to add beneficiaries. If a potential toggle is desired, another party should be given the authority to reinstitute the power to add beneficiaries. (If the original party has the power to reinstitute the authority to add beneficiaries, he or she would be treated as never having relinquished the authority to add beneficiaries.) Even if different persons are used, some commentators are concerned that the IRS may view the two persons together as still holding the power. Aucutt, Installment Sales to Grantor Trusts, ALI-ABA PLANNING TECHNIQUES FOR LARGE ESTATES 1359 (April 2007) (“The ability to reacquire the power may be viewed as tantamount to having the power itself. Even if the power is held by someone other than the trustee (such as a ‘protector’), that probably only means that the trustee and the protector together still have the power.”). d. Income Tax Effects of Toggling Off Grantor Trust Status. A change in the grantor trust status of a trust may cause unexpected income tax consequences. For an excellent review of potential income tax effects, see Peebles, “Mysteries of the Blinking Trust,” 147 Tr. & Est. 16 (Sept. 2008) (addressing issues involving pass-through entities, estimated payments, suspended losses and deductions, basis, and carryovers). A Chief Counsel Advice suggests that toggling will not necessarily trigger income recognition. CCA 200923024. That CCA is discussed in Section II.C.8 of this outline. 5. Grantor Trust Issues With Life Insurance Trusts. a. Transfer to Grantor Trust Does Not Violate Transfer for Value Rule; Rev. Rul 2007-13. The IRS has ruled privately in various rulings that transfers of a life insurance policy among grantor trusts do not trigger the transfer for value rule. PLRs 200514001, 200514002, 200518061 and 200606027 all held that an exchange of a policy between grantor trusts was not a taxable event and did not trigger the transfer for value rule because the grantor was the treated as the owner of both trusts for income tax purposes. Some of the rulings have also relied on the “same basis” exception in the transfer for value rule [§101(a)(2)(A)]. Life insurance proceeds are generally excludable from income under §101(a)(1), but if the policy has been transferred for consideration, the death proceeds are taxable income to the extent the proceeds exceed the consideration paid for the policy and premiums or other amounts later paid by the purchaser of the policy. §101(a)(2). There is an

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exception to the transfer for value rule if the policy is transferred to the insured, a partner of the insured, a partnership of which the insured is a partner, or a corporation in which the insured is a shareholder or officer. §101(a)(2)(B). Rev. Rul. 2007-13 addresses a transfer of a policy between grantor trusts and from a non grantor trust to a grantor trust. Rev. Rul. 2007-13 covers two situations. In Situation 1, the Ruling reasons that the sale of a policy from one "wholly-owned" grantor trust to another "wholly-owned" grantor trust is not a transfer at all for income tax purposes because the grantor is treated as the owner of the assets of both trusts. The "whollyowned" term apparently means that the trust is a grantor trust as to both income and principal of the trust, and that the grantor is the only grantor of the trust. Cf. Swanson v. Commissioner, 518 F.2d 59 (8th Cir. 1975) (transfer of policy to a grantor trust did not constitute a transfer for value, but only to the extent of the grantor’s 91% of contributions to the trust). In Situation 2, the Ruling reasons that the sale of the policy from a non-grantor trust to a grantor trust is a “transfer” for income tax purposes. [Accordingly, the sale could generate taxable gain if the consideration paid exceeds the owner's basis in the policy. While the Ruling does not specifically address the gain issue, other private letter rulings have addressed that transfers between two grantor trusts do not result in gain recognition. E.g. Pvt. Ltr. Rul. 200606027.] However, the Ruling concludes that the transaction is treated as a transfer to the grantor, so the "transferred to the insured" exception to the transfer for value rule applies if the policy insures the grantor's life. We’ve been waiting since Swanson for the IRS to rule that “grantor trust equals the insured” for transfer for value purposes. This was particularly important in Situation 2, because the ruling could not rely on the “same basis” exception to §101, but had to conclude that the transfer was treated as a transfer to the insured-grantor. b. Reconfirming Position That Grantor Is Treated as Owner of Trust Assets For Income Tax Purposes. The IRS officially restates its often cited 20-year-old position in Rev. Rul 8513, 1985-1 C.B. 184, which treats the grantor as the owner of the trust assets of a grantor trust for income tax purposes. (Some commentators have suggested that the grantor trust rules are now being used proactively by taxpayers and that the IRS may seek to retreat from that position at some point. This ruling reiterates that the IRS is not changing its position anytime soon.) Therefore, transfers between grantors and grantor trusts do not trigger gain for income tax purposes. c. Advantages of Transferring Policies Between Trusts. Transfers of policies to or between grantor trusts are very helpful for two reasons. First, sales of policies may help avoid the three-year rule of §2035 that generally applies if an insured gives a life insurance policy on his life within three years of his subsequent death (and the ruling makes clear that a sale can be made to a grantor trust without violating the transfer for value rule.) There is an exception from the three-year rule under §2035(a)(2) if the transfer is for full consideration. (This may be more than the gift tax value, and should take into consideration the value of the policy in the secondary market for insurance policies.) Furthermore, the IRS might argue, based on the old Allen case, that the full consideration exception to §2035 only applies if the amount of the consideration is the amount that would otherwise have been included in the grantor's gross estate. United States v. Allen, 293 F.2d 916 (10th Cir. 1961). However, the IRS has ruled privately that sales of policies for their gift value would not require inclusion in the gross estate under §2035 if the insured died within three years of the sales. E.g., Pvt. Ltr. Rul.9413045 (sale of policies

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for interpolated terminal reserve value plus the value of any unexpired premiums). Interestingly, the ruling did not cite Allen. A difference with Allen is that a transfer of a life insurance policy requires future investment to bring it to fruition. Even if Allen does not apply, what is the value of the policy for purposes of the full consideration rule in §2035? The interpolated terminal reserve value was developed when the only cash value life insurance was whole life. However, for a universal policy, it is not clear that additional premiums will be paid. So, it is safest if the policy is issued directly to the trust; but if that is not done, a sale may avoid the three-year rule and a sale is permitted without violating the transfer for value rule if the transfer is to a grantor trust. Second, a transfer to a new grantor trust may provide helpful flexibility if the insured decides that he or she becomes unhappy with the terms of the original irrevocable trust (and may be unwilling to contribute additional gifts for paying future premiums.) The existing trust might sell the policy to a new grantor trust having acceptable trust terms. (The trustee of the selling trust would have to exercise diligence to assure that the trust is receiving full value for the policy.) The transfer to the new wholly-owned grantor trust would not trigger the transfer for value rule. d. Planning Concerns With Transfers Between Trusts. There are several reasons to be cautious with these kinds of transfers between trusts. 1) The sale should be at fair market values, and the life settlement industry might suggest higher prices than just the cash surrender value. (The regulations under §2042 refer to the cost of a comparable policy.) 2) If a beneficiary thinks the trust sold the policy for too low a price, there are fiduciary liability possibilities. 3) Make sure that the trusts are grantor trusts or else the transfer for value rule may cause the proceeds to become taxable. 4) A typical plan is to move a policy from an old “bad” trust to a new “good” trust. If the “good” trust is better because it cuts out certain beneficiaries or restricts the rights of beneficiaries, there may be fiduciary liability concerns that individual trustees often totally overlook. e. Using Partnership to Assure Transfer for Value Rule Not Violated. Some attorneys like to have a partnership in which the trust and grantor are partners. In case it is not a grantor trust for some reason, the transfer is still protected from transfer for value rule under the partnership exception in §101(a)(2)(B). There have been several private rulings where the partnership was formed moments before the transfer for that purpose—and IRS still held it worked. (But reliance on that position would not seem appropriate in the planning stage.) A simpler solution would be for the grantor trust and the insured to buy units of a master limited partnership. However, that may not work. The legislative history to §101 suggests that §101 refers to a true partnership of partners joining together and not an investment vehicle. f.

Transfer to Insured (or Grantor Trust) Cleanses Prior Transfer for Value Problems. The regulations under §101 say that if a policy is transferred to the insured, that cleanses all prior transfers for value. Treas. Reg. §§1.101-1(b)(3)(ii) & 1.101-1(b)(5)(Ex. 7). So if there has been a transfer for value “hiccup’ somewhere in the history of the policy, the problem can be cleansed by a transfer to a grantor trust.

g. Achieving Grantor Trust Status for Life Insurance Trusts. If the trust does not prohibit paying premiums on life insurance policies on the life of the grantor, is that sufficient to

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make the trust a grantor trust? (One attorney has reported having an agent take the position that trust is a grantor trust if it does not expressly prohibit paying life insurance premiums of the life of the insured, because the trustee would have the authority to purchase a policy.) For a detailed discussion of the power to pay life insurance premiums as a grantor trust trigger, see Section II.C.3.c of this outline. For a discussion of the effects of a Crummey clause on the grantor trust status of a trust, see Section III.E.1.g of this outline. 6. Grantor Trusts With Split Purchase Transactions. A transaction may be structured as split purchase transactions where the “retained income interest” that is purchased by the parent is in the form of a qualified interest under section 2702 (either a qualified interest in a residence or a qualified annuity interest). An old ruling said that the parties would be treated as an association rather than a trust if there are successive interests. To avoid any possible such income tax consequences, some planners structure split purchase transactions so that the grantor or a grantor trust are on all sides of the transaction. 7. Structure to Give Beneficiary Power of Withdrawal Rather Than Having Stated Termination Date During Grantor’s Lifetime. Letter Ruling 200840025 concluded that the power of the nonadverse trustee to make loans to the grantor, with or without security, caused the trust to be a grantor trust under § 675(2) so long as the grantor is alive and the nonadverse trustee has not released the power with respect to a particular trust. Under the trust instrument, a beneficiary could withdraw assets upon reaching a specified age. The ruling concluded that the grantor would continue to be treated as the sole owner of the trust, even after the beneficiaries reach those specified ages, so long as the grantor is alive and the nonadverse trustee has not released the lending power. The ruling acknowledged that the withdrawal powers held by the beneficiaries would otherwise cause them to be treated as the owners of the trust under §678 after they reach the age for making withdrawals. Practical Planning Pointer: Instead of requiring terminating distributions as the beneficiary reaches specified ages, instead give the beneficiary a power of withdrawal. This gives the beneficiary the flexibility to keep the assets in trust to maintain the grantor trust treatment. 8. Conversion From Nongrantor to Grantor Trust Status Not a Taxable Event; CCA 200923024. In Chief Counsel Advice 200923024, the Chief Counsel’s office addressed what seems to be an abusive transaction. The basic (way oversimplified) facts are that a nongrantor trust sold appreciated property for a private annuity, so that the gain would be recognized ratably over the duration of the annuity. The purchaser sold the asset, recognizing no gain because the sale proceeds did not exceed its cost basis (i.e., the value of the annuity). [Actually, the purchaser was a partnership with a § 754 election in effect and the partnership sold the assets for a price about equal to its inside basis as a result of the § 754 election.] The nongrantor trust later converted to grantor trust status (by a change in the trustee to someone who was a “related or subordinate person”), with the result that the grantor would not realize gain on any subsequent annuity payments received from his grantor trust. An IRS agent argued that the conversion from nongrantor to grantor trust status was a taxable event, and that the transferee grantor trust would recognize gain. The CCA disagreed. It recognized that the transaction appears to be abusive, and observed that it was not addressing the possible applicability of the step transaction, economic substance or other judicial doctrines. However, it observed that treating the conversion as a taxable transaction would have an impact on non-abusive transactions, noting that nongrantor trusts may be converted to grantor trusts by various ways, including a change of trustees, borrowing of the trust corpus, or payment of the grantor’s

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legal obligation. It noted that Rev. Rul. 85-13, which held that the conversion of a nongrantor trust to a grantor trust (by reason of the trust’s purchase of assets from the grantor for a note, which constituted an indirect borrowing by the grantor) did not result in taxable income to the grantor. An interesting statement in the CCA is relevant to the commonly asked question of whether there is gain recognition on remaining note payments at the death of the grantor if the grantor has sold assets to a grantor trust for a note. In addressing the relevance of “Example 5” (Reg. § §1.1001-2(c) Ex. 5), Madorin, and Rev. Rul. 77-402, the CCA observed: We would also note that the rule set forth in these authorities is narrow, insofar as it only affects inter vivos lapses of grantor trust status, not that caused by the death of the owner which is generally not treated as an income tax event. (emphasis added)

III. BENEFICIARY TAX ISSUES A. Gift Tax Issues. 1. Exercise of General Power of Appointment. Gift tax consequences for the beneficiary can arise if the beneficiary has a general power of appointment over the trust assets (meaning that the beneficiary has a power over the assets exercisable in favor of the beneficiary, his estate, his creditors, or the creditors of his estate.) I.R.C. § 2514 (c). In that case, if the beneficiary exercises the power, or releases the power, the beneficiary makes a taxable gift. I.R.C. § 2514(b). Accordingly, if a beneficiary ever has a general power of appointment over trust assets (perhaps through inadvertent inclusion of expansive discretionary distribution powers in a situation where the beneficiary at some point becomes the trustee), the beneficiary will have not be able to divest himself of that power without being treated as making a transfer (if the power lapses during the beneficiary’s lifetime, I.R.C. § 2514(b)) or as being included in the beneficiary’s estate (if the beneficiary never releases the power, and dies holding the general power of appointment, I.R.C. § 2041(a)(2).) While a release of the general power of appointment is treated as a transfer, whether it is a completed gift depends on whether the beneficiary still retains the power to shift benefits among a group of individuals. For example, assume the beneficiary is trustee and can make a discretionary distribution (with no standards) to a group of persons, including himself, and assume that he relinquishes the power to make a distribution to himself but can still make distributions among the remaining class of beneficiaries. No taxable gift has occurred, because “the possessor of the power has retained the right to designate the ultimate beneficiaries of the property over which he holds the power and since it is only the termination of such control which completes a gift.” Treas. Reg. § 25.2514-3(c). See section II.A.3.a of this outline. If the power holder retains a power that causes the gift to be incomplete, that retained power would cause estate inclusion under Section 2036 or 2038 if the power holder were the grantor. In that situation, Section 2041 includes the assets subject to that power at the decedent’s death in the power holder’s estate, the same as if the power holder still had the power to distribute the property to himself. I.R.C. § 2041(a)(2). Despite the seemingly permanent taint if a beneficiary ever acquires a general power of appointment, as discussed above, options to avoid taxation may be available. In Letter Ruling 201132017, a provision in a bypass trust for a surviving wife required that the trust assets be used to pay the debts, taxes and expenses of the wife’s estate. Therefore the wife would have

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a general power of appointment causing inclusion of the trust assets in her estate under § 2041. A state court reformed the trust to remove the offensive provision based on various provisions in the trust document itself suggesting that the cross reference to the bypass trust as the trust to pay the debts, taxes and expenses was a scrivener’s error and based on affidavits from the attorney and surviving spouse that the intent was to save taxes and to avoid taxation of the bypass trust at the surviving spouse’s death. The IRS ruled that the wife would no longer hold a general power of appointment over the trust, would not be deemed to have released the power during her life for gift tax purposes, and was not deemed to have made a gift. The ruling reasoned that documentation “strongly indicates that Decedent and Surviving Spouse did not intend to have any control over the assets held in the By-Pass Trust, and that the provision … was the result of a scrivener’s error.” 2. Exercise Limited Power of Appointment. A limited power of appointment is the power to appoint property to a class of persons, which can be as broad as anyone other than the power holder, his estate, his creditors, or the creditors of his estate. If the person who holds the limited power of appointment over trust property is also a beneficiary of that trust, an exercise of the limited power of appointment to another individual reduces the pool of assets that might eventually be distributed to the beneficiary. In that circumstance, is the exercise of the limited power of appointment a gift? This is an important issue, because persons who hold limited powers of appointment over trust assets often are also beneficiaries. a. Mandatory Income Interest. If the power holder also has a mandatory income interest in the trust, the Tax Court and the IRS maintain that a taxable gift occurs if the beneficiary/power holder exercises the limited power of appointment over a portion (or all) of the trust corpus. Estate of Regester v. Comm’r, 83 T.C. 1 (1984); Rev. Rul. 79-327, 1979-2 C.B. 342; Treas. Reg. § 25.2514-1(b)(2); Letter Ruling 200427018. The Court of Claims, in a 1956 case, concluded that no gift results in that situation. Self v. United States, 142 F. Supp. 939 (Ct. Cl. 1956). However, the IRS amended its regulations after the Self case to make its position clearer, and the regulations carry a presumption of correctness. See National Muffler Dealers Ass’n v. U.S., 440 U.S. 472, 477 (1979). See generally Horn, Whom Do You Trust: Planning, Drafting and Administering Self and Beneficiary-Trusteed Trusts, 20TH UNIV. OF MIAMI PHILIP E. HECKERLING INST. ON EST. PL.¶ 502.3 (1986). b. Discretionary Beneficial Interest. If the power holder is merely a potential discretionary, and does not have a mandatory income interest, it is not clear at all that a gift should result from a lifetime exercise of the limited power of appointment to appoint some of the trust assets to others. Particularly if there are still some assets in the trust, the beneficiary/power holder may be able to receive as many distributions as a beneficiary that he would have received had the pool of assets not been depleted by the exercise of the power of appointment. If the beneficiary/power holder is entitled to receive distributions under a HEMS standard, and if he exercises a limited power of appointment to appoint trust assets to his children, an example in the regulations says that there would be no taxable gift under Section 2514 (because the power to distribute to himself under the HEMS standard falls within the ascertainable standard exception, so a lapse of that right is not a gift under Section 2514.). Treas. Reg. § 25.2514-3(e) Ex. 2. However, the regulation does not address whether the power holder has made a gift of the value of his right to distributions under the ascertainable standard under the general gift principles of Section 2511. See Henkel, Estate Planning and Wealth Preservation, ¶3.04[2] (2001).

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The IRS has taken the position in private letter rulings that taxable gifts can result where the power holder who exercises a limited power of appointment is merely a discretionary beneficiary under the trust. Ltr. Ruls. 8535020 (IRS did not say how to value the gift); 9419007 (two daughters were beneficiaries of separate trusts and had power with a co-trustee to make distributions to herself with a HEMS standard; each daughter planned to appoint the trust assets to the other daughter; ruled that each daughter would make a gift of her right to receive HEMS distributions); 200745015 (daughter entitled to receive discretionary distributions of income for her support, maintenance and medical expenses as well as for other purposes; daughter can request $a annually from the trust and the trust has the discretion to distributed principal in excess of that; daughter’s relinquishment of beneficial interest is a gift that would be valued in accordance with the general valuation principles contained in Reg. § 25.2512-1, and the interest “has more than a nominal value” [citing Rev. Rul. 67-370]). Observe that this issue may not directly impact the selection of trustee issue—because the beneficiary/holder of the power of appointment may have the same potential gift tax consequences whether or not he or she is the trustee. c. Summary. If the instrument grants an inter vivos limited power of appointment to a trust beneficiary, the planner must recognize that the beneficiary will face this gift issue if he or she ever decides to appoint some or all of the trust assets during his lifetime. The gift tax issue could be avoided by giving the inter vivos power of appointment to someone other than the beneficiary. For example, the power of appointment might be granted to the beneficiary’s spouse. 3. Gift By Beneficiary If Fail to Exercise Rights. If a beneficiary has ascertainable interests under the trust instrument, and if the beneficiary fails to enforce those rights, a taxable gift may result. See Dickman v. Comm’r, 465 U.S. 330 (1984) (failure to charge adequate interest on demand loan constituted continuing gift each year the loan remained outstanding); Snyder v. Comm’r, 93 T.C. 529, 546-47 (1989) (holder of preferred stock, which held a 7% noncumulative dividend had right to convert to another class of preferred that had a 7% cumulative dividend; held that annual failures to convert constituted continuing gifts to common shareholders of the preferred dividends that could have been paid by the corporation). But see Rev. Rul. 74-492, 1974-2 C.B. 298 (amount of elective share that could have been acquired if the election had been made during the statutory period is not includable under §2041; “which the widow is considered to acquire only if she exercises her right to take it. The widow must accept the benefits of the state law through exercise of the personal right of election or else the inchoate right is, in effect, renounced by operation of law.”). 4. Gift if Beneficiary/Trustee Makes Distribution to Another Under Discretionary Standard. A regulation indicates that a trustee with a beneficial interest in trust property does not make a gift if he distributes trust property to another beneficiary under a fiduciary power that is limited by a “reasonably fixed or ascertainable standard” (and the regulation goes on to give examples of standards that would qualify). Treas. Reg. § 25.2511-1(g)(2). The implication is that if a beneficiary is also the trustee and makes a distribution to another beneficiary under a standard that is not an ascertainable standard, a gift would result. For example, assume that Tom is trustee of a trust, and can makes distributions to himself for “health, support and maintenance.” In addition, he can make distributions to his siblings for their “health, support, maintenance, or happiness.” Under the regulations, distributions from Tom to his siblings appear to be a gift. The regulation applies to any trustee that has “a beneficial interest

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in trust property.” (Indeed, that language would suggest that the same gift result might occur if the trustee is not a current potential beneficiary but only has a contingent remainder interest.) Another unresolved issue is whether a power to make distributions in the discretion of the trustee, but not exceeding amounts needed for health, education, support and maintenance would be treated as a “reasonably fixed or ascertainable standard” for purposes of this regulation. There have been no cases or rulings interpreting that regulation in this context. However, commentators have advised planners of the potential issue. E.g., Horn, Whom Do You Trust: Planning, Drafting and Administering Self and Beneficiary-Trusteed Trusts, 20TH UNIV. OF MIAMI PHILIP E. HECKERLING INST. ON EST. PL. ¶ 503.2 (1986). That commentator suggests including a “savings clause” provision in instruments providing “that no trustee shall have any discretionary power, other than a power described in Regulations Section 25.2511-1(g)(2), to pay to other than himself any trust property in which he personally has a beneficial interest.” Id. at. ¶ 506, p. 5-70 (1986). Planners often focus on limiting the trustee’s ability to make distributions to himself to only ascertainable standards, so that the trustee does not hold a general power of appointment. However, this regulation, if it is upheld, means that planners also need to limit the ability of trustees to make distributions for other beneficiaries to an ascertainable standard also if the trustee has any beneficial interest in the trust. Several recent letter rulings, while not addressing regulation § 25.2511-1(g)(2), would seem to cast doubt on the implications suggested above. The rulings would seem to avoid the gift tax consequences upon a beneficiary-trustee making a distribution to another person if there are multiple beneficiary-trustees who must join in that decision in making a distribution to someone other than the beneficiary-trustees making that distribution. The rulings involved trusts that allowed discretionary distributions to the grantors but were specifically designed not to be grantor trusts (by requiring adverse parties [i.e., other beneficiaries] to consent to distributions to the grantors). The rulings concluded that the distribution committee members who consent to the distributions do not make taxable gifts if they consent to distributions to the grantor even though they are also discretionary beneficiaries. The rulings reason that the distribution committee members do not hold general powers of appointment, because of the exception for joint powers held by an adverse party in the definition of a general power of appointment. Letter Rulings 200502014, 200612002, 201310002-201310006. (There is a detailed discussion of the reasoning of the IRS in PLRs 201310002-201320006 in Section II.C.3.m above.) 5. Gift if Beneficiary/Trustee Makes Distribution to Another Where Trustee’s Determination “Is Conclusive”. Trust instruments sometimes attempt to protect a trustee against demands (and lawsuits) by beneficiaries to distributions by providing that “the determination of the trustee shall be conclusive with respect to the exercise or nonexercise of a power” (or words to that effect.). The regulation addressed above specifically says that type of language means the distribution power is “not limited by a reasonably definite standard.” Treas. Reg. § 25.2511-1(g)(2). Therefore, the possibility exists, under the regulation, that a distribution under that type of clause to a person other than the beneficiary-trustee would be treated as a gift. 6. Gift if Beneficiary/Trustee Fails To Makes a Distribution to Himself. What if a beneficiarytrustee has the discretion to make distributions to himself within stated standards, and the trustee does not make any distributions to himself? Can the IRS argue that the trustee has a made a gift to the other beneficiaries? There are no cases where this issue has been raised. However, the possibility of the argument has been noted by commentators. See Pennell, Avoiding Tax Problems For Settlors and Trustees When An Individual Trustee is Chosen, EST. PL. 264, 271 (September 1982).

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7. Summary of Application of Selection of Trustee to Gift Tax Issues. Once a beneficiary becomes trustee or otherwise acquires a power that constitute a general power of appointment, there is a permanent taint that is difficult to shed. If the beneficiary realizes that there is a problem while he is still alive, getting rid of the problematic power generally will cause the beneficiary to make a completed gift for gift tax purposes (unless he still has the power to shift benefits among other beneficiaries.) In granting ascertainable distribution rights to beneficiaries, (including a trustee who is a beneficiary) realize that the IRS might conceivably argue for a gift if the beneficiary does not enforce his legal rights. If a trustee has any beneficial interest in the trust, the regulations imply that the trustee makes a gift if he makes a distribution to other beneficiaries under a discretionary power to make distributions that is not limited by an ascertainable standard. To be safe, provide that any trustee who also has a beneficial interest in the trust is limited to a HEMS standard in making distributions to other beneficiaries as well as to himself and do not provide that the trustee’s determination in that regard is “conclusive” (or other words to that same effect). B. Estate Tax Issues—Dispositive Powers. 1. Section 2041—General Rules. a. General Rule. If a decedent has at his death a “general power of appointment” over property , or if the decedent released or exercised the general power of appointment over property while retaining powers over the property that would cause the property to be included in his estate under Sections 2306-2038 if he were the grantor of such property, the decedent will have to include the trust property in his estate. I.R.C. § 2041(a)(2). (There are substantially different rules under Section 2041 for powers created on or before October 21, 1942 compared to powers created after that date. This outline only addresses powers created after October 21, 1942.) Section 2041 applies to powers over property that do not cause estate inclusion under Sections 2036 to 2038. Treas. Reg. § 20.2041-1(b)(2). Therefore, powers of a grantor are analyzed under those Sections. Powers of individuals other than the grantor are analyzed under Section 2041. b. General Power of Appointment. An individual has a “general power of appointment” if he has the power to determine who (including himself) may become the owner of the property. Under Section 2041, a decedent has a general power of appointment if he has a power that is exercisable in favor of the decedent, his estate, his creditors, or the creditors of his estate; unless the power satisfies one of several important exceptions, discussed in the following subsections c-f below. Sometimes the planner specifically wants to create a general power of appointment in a beneficiary (for example, to cause the trust assets to be included in the beneficiary’s estate for estate tax purposes rather than being subject to the generation-skipping transfer tax.) Even though the general power of appointment is needed for some tax purpose, the settlor may wish to limit, as much as possible, the beneficiary’s ability to divert the assets away from the settlor’s family. The IRS has acknowledged that merely allowing exercise in favor of the

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creditors of the beneficiary’s estate is sufficient to create a general power of appointment. E.g., Ltr. Rul. 8836023. c. Ascertainable Standard Exception. If the power to consume, invade or appropriate property for the decedent is limited by an ascertainable standard relating to his health, education, support, or maintenance, the power is not a general power of appointment. I.R.C. § 2041(b)(1)(A). This exception is addressed in detail in section III.B.4. of this outline below. d. Joint Power—Exercisable With Grantor. If the power is exercisable only in conjunction with the creator of the power, it is not a general power of appointment. I.R.C. § 2041(b)(1)(B). (The policy behind this exception is that the creator of the power will likely have to include the property in his estate under Sections 2036 or 2038 if the grantor holds this power jointly with the power holder. See section II.B.3.d.(2-4) of this outline.) e. Joint Power—Exercisable With Person With Adverse Interest. If the power is exercisable only in conjunction with a person who has a “substantial interest” in the property which is adverse to the exercise of the power in favor of the decedent, the power is not a general power of appointment. I.R.C. § 2041(b)(1)(C)(ii). As to the “substantial” requirement, the regulations merely say that an interest is substantial if its value in relation to the total value of the property subject to the power is “not insignificant.” Treas. Reg. § 20.2041-3(c)(2). The IRS has ruled privately that the actuarial value of the interest of the other party must be at least five percent of the trust’s value to be “substantial.” Ltr. Rul. 8911028. The regulations provide several examples of “adverse” interests. A taker in default of exercise of the power is an adverse party. Treas. Reg. § 20.2041-3(c)(2). In addition, a coholder has an adverse interest if the coholder may possess the power to appoint the property to himself after the decedent’s death. I.R.C. § 2041(b)(1)(C)(2); Treas. Reg. § 20.2041-3(c)(2). A person is not adverse merely because he is a coholder of the power or because he is a potential appointee under the decedent’s power. Id.; Miller v. U.S., 387 F.2d 866 (3rd Cir. 1968); Estate of Towle v. Commissioner, 54 T.C. 368 (1970). A person is not adverse just because he is a trustee of the trust. Miller v. U.S., 387 F.2d 866, 869-70 (3rd Cir. 1968); Rev. Rul. 82-156, 1982-2 C.B. 216. Furthermore, naming the spouse of a person who would have an adverse interest does not satisfy the adverse party requirement—because the spouse has no chance for direct personal benefit from the property. Stephens, Maxfield, Lind & Calfree, Federal Est. & Gift Tax’n ¶4.13[4][c] (2001). f.

Joint Power-Exercisable With Person Who is Potential Appointee. A coholder of a power of appointment who is a potential appointee under the decedent’s power of appointment does not have an adverse interest, for purposes of the prior exception. However, a further exception applies in that situation. In that situation, each of the coholders could, in conjunction with the other, appoint the property to himself. Accordingly, each coholder of the power is deemed to have a general power of appointment as to a fractional part of the property. The fractional part is based on the number of persons (including the decedent) in whose favor the power is exercisable. I.R.C. §2041((b)(1)(C)(iii). This rule is based on a self-interest concept. Conceivably, each person would give consent to the other person’s exercise of the power only if the power is exercised in favor of all such persons equally.

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Thus, if three persons must join in the exercise only one-third of the value of the property would be included in the first decedent’s estate. g. Other Joint Powers. Powers of appointment which must be exercised in conjunction with any other person (not described in the prior three subsections) do not fall within an exception, and the decedent will be treated as having a general power of appointment even though the decedent cannot control the exercise of the power. Section 2041 uses very similar language as Sections 2036 and 2038 in referring to powers exercised “in conjunction with another person.” Accordingly, the conclusions reached by cases addressing the effects of joint powers by those Sections should apply to Section 2041. For example, it is sufficient that the other person must merely consent to exercise of the power; it is not required that the other person be able to initiate an exercise of the power (assuming both coholders agree). However, in that situation, the person who must merely consent to the exercise of the power by someone else is not elevated to the position of a coholder of the general power of appointment, so the fractional inclusion rule does not apply. Rev. Rul. 79-63, 79-1 C.B. 302 (at any time during the decedent's lifetime the decedent, with the consent of one of the decedent's children, could direct the trustees to distribute all or any part of the trust property to anyone, including the decedent). h. Contingent General Powers of Appointment and Impact on Formula General Powers of Appointment. Contingent or formula powers of appointment might be helpful for making use of a trust beneficiary’s excess GST exemption amount or for causing estate inclusion for a beneficiary with excess estate tax exclusion amount in order to achieve a basis adjustment under §1014. However, the planner will want the general power of appointment to be treated as being existence for tax purposes only to the extent that it is actually granted. If the existence of the power is by its terms contingent upon an event that did not occur before the decedent’s death, it is not a power “which the decedent has at the time of his death”—which is a requirement for estate inclusion under Section 2041. The regulations address powers of appointment subject to a contingency: However, a power which by its terms is exercisable only upon the occurrence during the decedent's lifetime of an event or a contingency which did not in fact take place or occur during such time is not a power in existence on the date of the decedent's death. For example, if a decedent was given a general power of appointment exercisable only after he reached a certain age, only if he survived another person, or only if he died without descendants, the power would not be in existence on the date of the decedent's death if the condition precedent to its exercise had not occurred. Treas. Reg. § 20.2041-3(b).

The courts have interpreted this regulation to conclude that the decedent could have some control over the contingency and still not have a general power of appointment, but the contingency must not be “illusory” and must have independent significant non-tax consequences. The primary case regarding powers of appointment subject to contingencies is Kurz v. Commissioner, 101 T.C. 44 (1993), aff’d, 68 F.3d 1027 (7th Cir. 1995). In Kurz, the decedent was a beneficiary of both a marital trust and a family trust. The decedent was entitled to all income and the right to withdraw principal of the marital trust. She could request distributions from the family trust subject to two conditions: (1) the principal of the marital trust must have been exhausted; and (2) she could withdraw no more than 5% per

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year from the family trust. In fact, the decedent did not withdraw all of the principal from the martial trust, so could not withdraw any principal from the family trust at her death. However, the IRS argued that she had a general power of appointment over 5% of the family trust because the contingency to be able to exercise that power was within the decedent’s control (i.e., she could have withdrawn all of the principal from the marital trust so that contingency would have been satisfied). The estate argued that the decedent’s access to the principal of the family trust was subject to a contingency that did not occur, so she did not have a general power of appointment under Reg. §20.2041-3(b) (“However, a power which by its terms is exercisable only upon the occurrence during the decedent's lifetime of an event or a contingency which did not in fact take place or occur during such time is not a power in existence on the date of the decedent's death. For example, if a decedent was given a general power of appointment exercisable only after he reached a certain age, only if he survived another person, or only if he died without descendants, the power would not be in existence on the date of the decedent's death if the condition precedent to its exercise had not occurred.”). The Tax Court interpreted this regulation to conclude that the decedent could have some control over the contingency and still not have a general power of appointment, but the contingency must not be “illusory” and must have independent significant non-tax consequences: …the event or contingency must not be illusory and must have some significant non-tax consequence independent of the decedent’s ability to exercise the power.… We think any illusory or sham restriction placed on a power of appointment should be ignored. An event or condition that has no significant non-tax consequence independent of a decedent's power to appoint the property for his own benefit is illusory.

The Tax Court analogized to the contingency provisions under §2038, and gave two examples of situations involving independent consequences: For example, for purposes of section 2038, a power is disregarded if it becomes operational as a mere by-product of an event, the non-tax consequences of which greatly overshadow its significance for tax purposes. See Bittker & Lokken, Federal Taxation of Income, Estates and Gifts, par. 126.5.4, at 126-64 (2d ed. 1984). If the power involves acts of "independent significance", whose effect on the trust is "incidental and collateral", such acts are also deemed to be beyond the decedent's control. See Rev. Rul. 80-255, 1980-2 C.B. 272 (power to bear or adopt children involves act of "independent significance", whose effect on a trust that included after-born and after-adopted children was "incidental and collateral"); see also Estate of Tully v. United States, 208 Ct. Cl. 596, 528 F.2d 1401, 1406 [ AFTR2d 76-1529] (1976) ("In reality, a man might divorce his wife, but to assume that he would fight through an entire divorce process merely to alter employee death benefits approaches the absurd."). Thus, if a power is contingent upon an event of substantial independent consequence that the decedent could, but did not, bring about, the event is deemed to be beyond the decedent's control for purposes of section 2038.

The Seventh Circuit affirmed, agreeing with the reasoning of the Tax Court that merely stacking or ordering withdrawal powers does not exclude the powers that come later in the list. By contrast, the sequence in which a beneficiary withdraws the principal of a series of trusts barely comes within the common understanding of “event or...contingency”. No one could say of a single account: “You cannot withdraw the second dollar from this account until you have withdrawn the first.” The existence of this sequence is tautological, but a check for $2 removes that sum without satisfying a contingency in ordinary, or legal, parlance…

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No matter how the second sentence of sec. 20.2041-3(b) should be applied to a contingency like losing 20 pounds or achieving a chess rating of 1600, the regulation does not permit the beneficiary of multiple trusts to exclude all but the first from the estate by the expedient of arranging the trusts in a sequence. No matter how long the sequence, the beneficiary exercises economic dominion over all funds that can be withdrawn at any given moment. The estate tax is a wealth tax, and dominion over property is wealth. Until her death, Ethel Kurz could have withdrawn all of the Marital Trust and 5 percent of the Family Trust by notifying the Trustee of her wish to do so.

Kurz makes clear that contingencies that would have independent significant non-tax consequences are to be ignored. Those contingencies prevent the decedent from having realistic unfettered control to access the trust assets. Indeed, the contingency in Kurz was as non-independent as could be imagined. It involved a mere sequencing of withdrawal powers. The assets of trust 2 could not be withdrawn before the assets of trust 1 were withdrawn. The decedent still had clear authority to withdraw all of the assets from both trusts. The Tax Court questioned whether this was even a contingency at all. As an example of how this doctrine might apply is the granting of formula general powers of appointment for basis optimization purposes. For example, if the formula refers assets valued at greater than the decedent’s remaining exemption amount, the decedent’s power during his lifetime to make gifts using up his exemption amount might be deemed to give the decedent a general power of appointment over all of the trust (whether or not the gifts are made). Similarly, the power to make marital or charitable bequests is within the decedent’s control, and if the formula refers to the maximum amount that could pass without estate tax at the decedent’s death, the formula could be interpreted to assume that the decedent would leave all of his estate to a surviving spouse or charity and therefore give the decedent a general power of appointment over all of the trust (up to the decedent’s exemption amount) even if the decedent in fact did not leave his estate to a surviving spouse or charity. The contingency to have a general power of appointment over the trust up to the maximum amount is within the decedent’s control. Under Kurz, contingencies that would have independent significant non-tax consequences are to be ignored. The decision to make large lifetime gifts or to leave a bequest to a spouse or charity has much greater independent non-tax consequences than the mere ordering of withdrawal powers among trusts in Kurz. In any event, Kurz raises uncertainties about such formulas. As to the possibility of a marital or charitable bequest increasing the amount of the general power of appointment under such a formula, such bequests would seem to be acts of independent significance. However, to avoid that argument, the formula could refer to the largest portion of the assets of the Bypass Trust which would not increase any federal estate tax payable by the estate of the Surviving Trustor without taking into consideration any charitable or marital gift by the Surviving Trustor that would be deductible by the estate of the Surviving Trustor pursuant to Section 2055 or Section 2056 of the Internal Revenue Code. See Al Golden, Back to the Future – The Marital Deduction from Before ERTA to After ATRA, STATE BAR OF TEXAS ADVANCED ESTATE PLANNING COURSE at p.17 (2013)(excerpt from formula general power of appointment form suggest by Mr. Golden).

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Other commentators have made the same observation regarding the impact of possible marital or charitable bequests on the operation of formula general powers of appointment. Making charitable or spousal bequests should logically be deemed to be acts of independent significance, such that they would not be deemed to control the grant of a general power of appointment, but it is not certain that a court would so hold, and it is very possible that the IRS would assert this position and the taxpayer would need to litigate. One could minimize this risk by drafting the formula clause granting a general power of appointment based on the surviving spouse’s taxable estate, determined without regard to marital or charitable deductible transfers. This approach significantly reduces the likelihood that a court would conclude that the surviving spouse holds a general power of appointment over a greater share of the trust assets than his or her available applicable exclusion amount. If it is known that the surviving spouse will make certain charitable bequests, these can be expressly excluded from the calculation, with the same result. Howard Zaritsky, PRACTICAL ESTATE PLANNING IN 2011 AND 2012.

For various form suggestions for formula general powers of appointments, see Ed Morrow, The Optimal Basis Increase and Income Tax Efficiency Trust (2014)(available from author); Leonard & Schingler, Using a “Formula General Power of Apportionment [sic] to Resolve Income Tax Basis “Step-Up” Issues in the Age of Portability and a Request for Clarification Regarding Revenue Procedure 2001-38, CALIF. TAX LAWYER, at 24-32 (Fall 2014);Al Golden, Back to the Future – The Marital Deduction from Before ERTA to After ATRA, STATE BAR OF TEXAS ADVANCED ESTATE PLANNING COURSE at p.17 (2013); Howard Zaritsky, PRACTICAL ESTATE PLANNING IN 2011 AND 2012 (various forms and excellent analysis); James Blase, Drafting Tips That Minimize the Income Tax on Trusts—Part 2, ESTATE PLANNING (Aug. 2013). For a much more detailed discussion of the validity of such formula general powers of appointments, with references to various articles discussing them in detail with sample forms, and for examples of formula general powers of appointment see Item 7.e and Exhibits A and B of the Hot Topics and Current Developments Summary (December 2014) available at http://www.bessemer.com/portal/binary/com.epicentric.contentmanagement.servlet.ContentD eliveryServlet/Advisor/Presentation/Print%20PDFs/2014%20Hot%20Topics%20and%20Cur rent%20Developments_FINAL.pdf. An alternative to a formula general power of appointment is granting a third party the authority to grant a general power of appointment to the beneficiary (that possibly could be exercisable only with the consent of some other non-adverse party (but not the grantor). If that approach is use, consider using broad exculpatory language for the person who can grant the power of appointment and consider providing that the powerholder has no duty to monitor whether a general power should be granted or possibly provide that the powerholder has no authority to grant a general power until requested by a family member to consider exercising his or her discretion to grant a general power. Section 2041(b)(1)(C) provides that a power exercisable “in conjunction with” another person will be a general power unless the other person is the creator of the power or is an adverse party (for example, another beneficiary). Some planners have raised the question of whether there is a real difference between a power that is conferred by a third party vs. a power exercisable in conjunction with a third party. See Ronald Aucutt, When is a Trust a Trust?, at 17, printed as part of It Slices, It Dices, It Makes Julienne Fries: Cutting Edge Estate Planning Tools, STATE BAR OF TX. 20TH ANN. ADV. ESTATE PLANNING STRATEGIES COURSE (2014). This raises the possible IRS argument that the beneficiary may be deemed to hold a general power of appointment even if it is never formally granted by the

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third party. A possible counterargument is the provision in Reg. §20.2041-3(b) that if a power is exercisable only on the occurrence of an event or contingency that did not in fact take place, it is not a general power of appointment. If the independent party never grants the general power of appointment, arguably that is a contingency that never took place within the meaning of that regulation. A Uniform Act cannot change tax consequences but attempts to “nudge the law;” a Comment to the Uniform Power of Appointment Act supports the view that the ability to create a general power of appointment ought not to be viewed as the equivalent of the ability to exercise the power with another. The Comment to §102 notes that if a person can change a general power into a nongeneral power or vice versa, the power is either general or nongeneral depending on the scope of the power at any particular time. For state law purposes, the power is what it is at the time it is being looked at, not what it has been or could be. i.

Existence of General Power of Appointment Prior to Acceptance of Office as Trustee. Under the principles regarding contingent powers of appointment discussed above, the IRS has taken the position that the mere fact that a testamentary trust was not funded and the decedent had not accepted office as trustee, under which he would have the power to make distributions for his “reasonable comfort” or “best interests,” did not preclude the decedent from being deemed to have a general power of appointment at his death. Tech. Adv. Memo. 9125002. The IRS reasoned that under local law, an interest in property established by a will takes effect at the time of death unless the will provides otherwise. See Estate of Bagley v. United States, 443 F.2d 1266 (5th Cir. 1971) (husband and wife were killed in automobile accident; husband’s will said wife would be deemed to survive in a common accident and gave wife a general power of appointment over property to qualify for marital deduction; wife’s estate argued it did not have a general power of appointment because will had not been probated at time of her death; held, that power of appointment existed in the theoretical instant in which wife survived husband); Treas. Reg. § 20.2041-1(e) (“power of appointment created by will is, in general, considered as created on the date of the testator’s death”). The effect of these rules regarding contingencies is that once conditions have occurred such that a beneficiary is qualified to accept office as trustee (with overly broad distribution powers), the beneficiary has a general power of appointment. The beneficiary cannot avoid the general power of appointment taint by merely declining to accept office as trustee. However, a power holder may “disclaim” a power, and not be considered as having released the power, if the requirements of Section 2518 are met. Treas. Reg. § 20.2041-3(d)(6)(i), referencing Reg. § 25.2518-2(c)(3); see Ltr. Rul. 9521032. An attempt to disclaim a general power of appointment by limiting it to a limited power to appoint to others, or by limiting it to an ascertainable standard may not be recognized. Ltr. Rul. 8149009; Goudy v. United States, 86-2 USTC ¶ 13,690 (D. Ore. 1986), revd. in unpub. opinion (9th Cir. 1988); Treas. Reg. § 20.2041-3(d)(6). Under Section 2518, the power holder generally must disclaim the power within nine months after the transfer creating the power. Treas. Reg. § 25.25182(c)(3).

Effect of Incompetency of Power Holder. The incompetency of the power holder at the time of death does not nullify the power of appointment for purposes of Section 2041. E.g., Estate of Gilchrist v. Comm’r, 630 F.2d 1213 (5th Cir. 1980, cert. denied 446 U.S. 918; Williams v. U.S.. 634 F.2d 894 (5th Cir. 1981); Estate of Rosenblatt v. Comm’r, 633 F.2d 176 (10th Cir. 1980); Estate of Alperstein v. Comm’r, 613 F.2d 1213 (2d Cir. 1979), cert. denied 446 U.S. 918 (1980). The fact that the decedent was incompetent from the time that the power arose until his subsequent death has not mattered in various cases. E.g., Estate of Alperstein v.

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Comm’r, 613 F.2d 1213 (2d Cir. 1979), cert. denied 446 U.S. 918 (1980). Estate of Bagley v. United States, 443 F.2d 1266 (5th Cir. 1971); Pennsylvania Bank & Trust Co. v. United States, 451 F.Supp. 1296 (W.D. Pa. 1978). k. Reciprocal Powers. The IRS applied an analogy of the reciprocal trust doctrine to general powers of appointment in Letter Ruling 9235025. By analogy to that doctrine, where beneficiaries of two trusts can appoint property to each other, unrestricted by an ascertainable standard, the IRS stated that the trusts would be uncrossed, and each beneficiary would be considered to have a general power of appointment over the trust of which he is a beneficiary. In that ruling, the IRS cited Matter of Spear, Jr., 553 N.Y.S.2d 985 (Sur. Ct. 1990), in which the court adopted the reciprocal trust theory to find that trust beneficiaries had general power of appointments to qualify for the “Gallo exemption” that was available for GST purposes prior to 1990. The IRS again observed that the possible application of the reciprocal trust theory to powers of appointment in private letter ruling 9451059. In that ruling, the settlors’ two daughters had a power to appoint the trust property to any descendant of the settlor other than herself, including the other daughter. While noting the potential application of the theory, the IRS concluded that the particular factual situation did not justify its application. Each of PLRs 201345004, 201345026, 201345027, and 201345028, involving the same fact pattern, permitted the modification of irrevocable pre-1985 trusts to add a “distribution trustee” who could make distributions in addition to an independent trustee to the beneficiary under a non-ascertainable standard. The facts of the PLRs stipulated that the distribution trustee could not be a related or subordinate party, and “a cousin cannot serve as a Distribution Trustee for a trust if the beneficiary is serving as the Distribution Trustee for the cousin’s trust.” The rulings concluded that the beneficiaries would not have §2041 general powers of appointment and the GST grandfathered status of the trust was preserved. There is no way of knowing whether the IRS required the limitation of not having reciprocal cousins as trustees of each other’s trust as a condition of granting a favorable ruling. One ruling that might be the basis of an argument that the reciprocal trust doctrine does not apply in the context of §2041 is PLR 200748016, which stated that the reciprocal trust doctrine is only applicable under §§2036 and 2038. The reciprocal trust doctrine was not relevant to the §2041 issue under the facts of that ruling. Reciprocal grantor powers are discussed in Section II.B.1.(a) of this outline. One planning strategy might be to have somewhat differing trust terms for the two trusts, by analogy to the Levy case and Letter Ruling 200426008, as discussed in Section II.B.1.a of this outline. l.

Creditor Impact on Holder of General Powers of Appointment. The mere existence of the authority of someone to create a general power of appointment does not of itself create creditor concerns for the person who might be granted a general power of appointment. If a beneficiary is actually granted a general power of appointment (either by a third party or by formula at the beneficiary’s death), the traditional rule has been that would not by itself allow creditors to reach the assets. However, the beneficiary’s creditors could reach the assets if the beneficiary actually exercised the general power of appointment (although a 1935 Kentucky case said that creditors could not reach the assets even if the power was exercised as long as it was not exercised in favor of creditors). That traditional rule (dating back to a 1879 Massachusetts case) was the position of the Restatement (Second) of Property (Donative

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Transfers) (§§13.2, 13.4, 13.5). The Restatement (Third) of Property, however, takes the position that property subject to an unexercised general power of appointment can be reached by the power holder’s creditors if his or her property or estate cannot satisfy all of the powerholder’s creditors. Restatement (Third) of Property (Donative Transfers) §22.3 (2011). Some states (such as California, Michigan, and New York) have specific statutory measures adopting the position of the Third Restatement. The Uniform Trust Code applies the Restatement (Third) position to inter vivos general powers of withdrawal in §505(b)(1) (presumably that would also apply to inter vivos general powers of appointment); it does not address property subject to a testamentary general power of appointment, but refers to the Restatement Second position—suggesting that creditors could not reach property subject to an unexercised testamentary general power of appointment. Section 502 of the Uniform Power of Appointment Act provides that creditors of the holder of a general power may reach the assets subject to the power to the extent the powerholder’s property (if the power is presently exercisable) or the powerholder’s estate is insufficient. (This wording [and the Comment to §502] suggests that the creditors of a person who holds a testamentary general power of appointment would not be able to reach the trust assets until after the powerholder dies.) The Comment to §502 clarifies that the rationale of this position is that a presently exercisable general power of appointment is equivalent to ownership. Whether the powerholder has or has not exercised the power is not relevant to this issue. This is the biggest change from traditional law principles under the Act, and this is the provision that states are most likely to consider changing. As discussed above, traditionally the creditors of a powerholder with a testamentary general power could not reach the property unless the powerholder exercised the power, but the uniform act changes that result to allow the creditors of the powerholder to reach the assets and some states may want to change that result. There is an exception in the Act for property subject to Crummey withdrawal rights in §503; upon the lapse, release, or waiver of a withdrawal power, it is treated as a presently exercisable general power only to the extent that it exceeds the annual exclusion amount. Creditors of a powerholder of a nongeneral power of appointment generally cannot reach the assets subject to the power. §504 of the Uniform Power of Appointment Act. A possible solution to keep from making assets subject to a general power of appointment available to the powerholder’s creditors is to require the consent of a third person (who would need to be a nonadverse party in order for the power of appointment to cause estate inclusion under §2041). See Bove, Using the Power of Appointment to Protect Assets—More Power Than You Ever Imagined, 36 ACTEC L.J. 333, 337-38 (Fall 2010). Greg Gadarian (Tucson, Arizona) suggests a very interesting planning strategy that exists for lapsed withdrawal powers in two states (Arizona and Michigan) that treat the lapsed powerholder as not being the settlor of the trust for creditor purposes. See Ariz. Rev. Stat. §1410505(B). A number of states have similar provisions that limit creditors’ access to assets over which a power of withdrawal has lapsed to amounts described in §§2041(b)(2), 2514(e), or 2503(b), but Arizona and Michigan apply this protection to the entire amount of the lapsed withdrawal. For example, the trust might give a Trust Protector the authority to grant a withdrawal power over the entire trust assets to a beneficiary; the withdrawal power would lapse 30 days after it is granted. The assets would be included in the powerholder’s gross estate (to the extent the lapsed power exceeds the “5 or 5” amount in §2041(b)(2)), and the powerholder would (according to various IRS letter rulings) be treated as the owner of the trust for income tax purposes under §678, but the entire trust would continue to have spendthrift protection. This could be used to cause estate inclusion for a surviving spouse to allow a basis adjustment at his or her death and to cause the trust to be a grantor trust as to the surviving

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spouse, all without subjecting the trust assets to the spouse’s creditors following the lapse of the withdrawal power. The possibility that creditors of the powerholder of a general power of appointment can reach the appointment assets (in light of the uncertainty of the development of state law regarding this issue) is an important factor that planners should consider before creating general powers of appointment. Even if an individual has no creditor concerns, the individual is just one auto accident away from a financial disaster. 2. Independent Trustee With Complete Discretion. a. General Rule—No General Power of Appointment. If a trustee is someone other than a beneficiary, Section 2041 generally will not apply to the beneficiary, even if the trustee has very broad discretion in making distributions to the beneficiary. For example, in Estate of Cox, 59 T.C. 825 (1973), acq., 1973-2 C.B. 1, the court held that, under Texas law, the income beneficiary did not hold a power of invasion or appointment with respect to a testamentary trust that provided the trustee (the testator's son) was to have the “sole and exclusive right of management” of the trust property, and that if the income was insufficient to comfortably and adequately supply the beneficiary with all comfort and necessities, then the beneficiary's comfort and necessities were to be provided for by the trustee selling trust assets. In reaching its decision that the trustee and not the beneficiary had the power of appointment or invasion, the court determined that neither the words of the will nor the extrinsic evidence indicated an intent by the testator to grant such a power to the income beneficiary. It thus decided that to attribute to the beneficiary an implied power of invasion would be inconsistent with the testator's intent and with the will provision expressly granting the trustee 'sole and exclusive' management powers. The IRS addressed this issue in detail in Revenue Ruling 76-368, 1976-2 C.B. 271, and concluded that an invasion power that is not limited by an ascertainable standard that is held by independent trustee, cannot be imputed to the decedent so as to render the power taxable in the decedent's gross estate under Section 2041. In the facts of that ruling, the trustee, an independent bank, was authorized to invade the trust corpus and pay portions thereof to or for the use and benefit of the decedent in such manner as the trustee, in its sole and unfettered discretion, deemed advisable should the decedent be in need of funds in excess of the trust income for 'health, comfort, maintenance, welfare, or for any other purpose or purposes.' The trustee was directed to liberally exercise its discretionary power of invasion. Prior to the decedent's death in 1976, numerous requests had been made to the trustee for additional funds and all such requests of the decedent had been honored by the trustee. The ruling pointed to various cases holding that an independent trustee’s powers should not be imputed to a beneficiary. Even with an independent trustee, a concern may be raised if the trustee always complies with beneficiary requests with little consideration of the exercise of its discretion. For example, SEC v. Wyly, 2014 WL 4792229 (S.D.N.Y. Sept. 25, 2014) was a securities law violation case in which the court determined that the amount of disgorgement would be based in part on the income taxes that the defendants avoided by an offshore trust structure. The court reasoned in part that the independent trustee exception to the grantor trust rules under §674(c) did not apply because the independent trustee always did as instructed with respect to “recommendations” from the settlor that were communicated through a trust protector. See Section I.G.3 of this outline for further discussion of the Wyly opinion.

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b. Power to Bring Judicial Action to Compel Trustee to Make Distributions. The fact that a beneficiary might be able to go to court and force a trustee to make distributions within a broad standard does not mean that the beneficiary has a general power of appointment. The IRS made that very argument in Security-Peoples Trust Co. v. U.S., 238 F. Supp. 40, 46 (W.D. Pa. 1965). The IRS in that case argued that under Pennsylvania law, the beneficiary could compel the trustee to distribute principal under the “health, comfort, maintenance or welfare” standard, and thus could control the disposition of the trust property. The court rejected the IRS’s argument, and pointed out that the trustee alone held the power to distribute and that this power could not be imputed to the beneficiary. The IRS agreed that it would not pursue making this argument in the future in Revenue Ruling 76-368, 1976-2 C.B. 271. The IRS specifically pointed to the Security-Peoples decision in support of its conclusion that the power of an independent trustee could not be imputed to the beneficiary. In that ruling, the IRS acknowledged directly that a beneficiary could bring a lawsuit had the trustee, in the judgment of the decedent, failed to exercise liberally its discretionary power of invasion on the decedent's behalf. However, the IRS concluded that this kind of power does not transfer a power of invasion granted an independent trustee to the beneficiary of the trust. That is to be distinguished, however, from a situation in which a beneficiary has a power under the terms of the trust instrument to direct the trustee to make distributions to the beneficiary. See Tech. Adv. Memo. 8606002. c. Giving Trustee Extremely Broad Discretion. A settlor with spendthrift children may wish to utilize extremely broad standards, or even no standards at all, but instead leave the trustee with extremely broad discretion to determine when to make (and not make) distributions. If beneficiaries are not trustees, using a broader standard than a HEMS standard may provide helpful flexibility. For example, the trust agreement may authorize distributions for the “best interests” of the beneficiaries. Actions taken under a broad distribution standard are subject to judicial review but generally merely to correct for an abuse of discretion considering the trust terms and settlor intent. See section I.F. of this outline. Giving the trustee extremely broad discretion does not endanger Section 2041 inclusion. The IRS specifically addressed that issue in Revenue Ruling 76-368, 1976-2 C.B. 271. Under the facts of that ruling, the bank-trustee was authorized to invade the trust corpus for the use and benefit of the decedent in such manner as the trustee, in its sole and unfettered discretion, deemed advisable should the decedent be in need of funds in excess of the trust income for 'health, comfort, maintenance, welfare, or for any other purpose or purposes.' The Ruling’s reasoning saw no problem with giving such broad discretion to the trustee. In fact, that extremely broad discretion helps thwart any possible argument that the beneficiary has control to force distributions to himself by bringing a court action to force distributions. Even if the trust instrument purports to give the trustee “sole and uncontrolled discretion” and provides that the trustee’s decisions will be “final and conclusive,” there are cases indicating that the trustee’s discretion is still not absolute. Lucas v. Lucas, 365 S.W.2d 372, 376 (Tex. Civ. App.—Beaumont 1962, no writ). Courts may intervene if the trustee acts “outside the bounds of a reasonable judgment.” To determine that, the test is whether the trustee acts “in that state of mind in which the settlor contemplated that it should act.” First National Bank of Beaumont v. Howard, 229 S.W.2d 781, 784-85 (Tex. 1950). Restatement (Second) of Trusts § 187, cmt. j (1959) (“trustee will not be permitted to act dishonestly, or from some motive

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other than the accomplishment of the purposes of the trust, or ordinarily to act arbitrarily without an exercise of his judgment”). Absolute discretion does not mean absolute discretion — the trustee still owes fiduciary duties, even if the instrument says the trustee has the same discretion as if the trustee owned the assets individually. Courts will generally uphold the trustee’s decisions under an absolute discretion standard. The trustee is entitled to a presumption of good faith. Possible court intervention may occur if there is bad faith on the trustee’s part or disregard of the trust purposes. 3. Beneficiary as Co-Trustee. Naming the beneficiary as a co-trustee (with someone who does not have a substantial adverse interest) does not help at all in avoiding Section 2041 if the co-trustees have the authority to make distributions to the beneficiary that are not subject to an ascertainable standard. See section III.B.1.g. of this outline. Naming a co-trustee to serve with the beneficiary, however, can be very helpful if the trust instrument restricts the beneficiary/co-trustee from participating in any decision to make distributions to himself beyond an ascertainable HEMS standard. As long as the beneficiary has no right to succeed to the powers held by that co-trustee, the broad distribution powers of the cotrustee will not be imputed to the beneficiary. Indeed, it is wise to use a “savings clause” that automatically restricts the beneficiary from taking any actions that might possible be construed as a personal benefit, unless those actions are limited by a HEMS standard, and to provide that any such actions would be taken only by the co- trustee. If no co-trustee is acting, the beneficiary/trustee could take steps to have the next successor trustee appointed as a co-trustee for the sole purpose of making that decision. See Section IV of this outline. 4. Beneficiary as Trustee—Distributions to Self as Beneficiary. The practical difficulty of applying Section 2041 in practice comes in the very common situation where the settlor wishes to name a beneficiary as trustee and give the beneficiary the authority to make distributions to himself. a. Ascertainable Standard Exception. As discussed above, there is an exception in the statutory language of Section 2041 for “a power to consume, invade, or appropriate property for the benefit of the decedent which is limited by an ascertainable standard relating to the health, education, support, or maintenance of the decedent.” I.R.C. § 2041(b)(1)(A). (This is unlike Sections 2036 and 2038, which contain no ascertainable standard exception in the statute. But that has not deterred the courts in fashioning an ascertainable standard exception for those sections also.) b. Regulations. The regulations give a variety of detailed examples of language that constitutes an ascertainable standard: A power is limited by such a standard if the extent of the holder’s duty to exercise and not to exercise the power is reasonably measurable in terms of his needs for health, education, or support (or any combination of them). As used in this subparagraph, the words “support” and “maintenance” are synonymous and their meaning is not limited to the bare necessities of life. … Examples of powers which are limited by the requisite standard are powers which are limited by the requisite standard are powers exercisable for the holder’s “support,” “support in reasonable comfort,” “maintenance in health and reasonable comfort,” “support in his accustomed manner of living,” “education, including college and professional education,”

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“health,” and “medical , dental, hospital and nursing expenses and expenses of invalidism.” Treas. Reg. § 20.2041-1(c)(2).

The regulation also gives the following examples of standards that do not constitute an ascertainable standard: A power to use property for the comfort, welfare, or happiness of the holder of the power is not limited by the requisite standard. Id.

See generally Christian Kelso, But What’s an Ascertainable Standard? Clarifying HEMS Distributions Standards and Other Fiduciary Considerations for Trustees, 10 EST. PLAN. & COMMUNITY PROP. L.J. 1 (Fall 2017). c. Slight Difference in Language Can Be Critical. A very slight difference in language may produce a different result. For example, in Estate of Vissering v. Comm’r, the trustee authorized distributions “required for the continued comfort” of the beneficiary, as well as other standards. 990 F.2d 578 (10th Cir. 1994), rev’g, 96 T.C. 749 (1991). The Tenth Circuit acknowledged that the use of the word “comfort,” without further qualifying language, creates a general power of appointment. However, the trust language puts a limit on this word, saying it permits distributions only as “required”, not as “determined” or “desired.” Furthermore, the court observed that the invasion must be for the beneficiary’s “continued” comfort, implying amounts reasonably necessary to maintain the accustomed standard of living. The Court concluded that such words did not constitute a general power of appointment. When the stated standards differ from the safe harbor standards described in the regulation, it is often impossible to rationalize results that have been reached in varying cases. For example, in Whelan v. U.S., the court held that an invasion power “for the reasonable support, care and comfort of such beneficiary” constituted an ascertainable standard. 81-1 USTC ¶ 13,393 (S.D. Cal. 1981). Seven years earlier, the very same court held that a standard permitting invasion of corpus for “reasonable care, comfort and support” was not an ascertainable standard. Tucker v. U.S., 74-2 USTC ¶ 13,026 (S.D. Cal. 1974). Another example of the impossibility of rationally categorizing the cases based on the language in the instrument is Brantingham v. U.S., 631 F.2d 542 (7th Cir. 1980). The decedent’s will contained a provision stating that “my wife shall have and is hereby given the uncontrolled right, power and authority to use and devote such of the corpus thereof from time to time as in their judgment is necessary for her maintenance, comfort and happiness.” Those words are typically held not to constitute an ascertainable standard. However, the court analyzed Massachusetts law, and concluded that this language constituted an ascertainable standard. The IRS has indicated that it will not follow the Brantingham case. Rev. Rul. 82-63, 1982-1 C.B. 135. The Vissering case and the combination of the Whelan and Tucker cases illustrate the extreme danger in modifying, even slightly, the standards given as safe harbor language in the regulations. The Brantingham case illustrates that using some of the magic “bad” words may nevertheless be sanctioned by a court, but one certainly cannot rely on such a result. d. Two-Fold Analysis Approach; Combination of Clauses and Total Context of Standards Control, Not Presence of Single Words. The courts have reviewed trust instruments in their entirety rather than just focusing on “magic” words that are or are not present. One

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commentator has suggested applying a two-level analysis. First, are the powers of invasion of trust assets limited to ascertainable standards related to the beneficiaries’ health, education, support or maintenance, thus bringing the trust assets within the safe harbor language of Section 2041(b)(1)(A)? Second, are the standards expanded (or restricted) elsewhere in the trust documents? See Corbett, Judicially Determined Standards Formulated Under §§2036, 2038, and 2041, 15 TAX MANGT ESTATES, GIFTS & TR. J. 198, 201 (Nov. 8, 1990). e. Summary of Standards that Typically Are Not Ascertainable. While there is no uniform consistency in the cases, courts have typically found certain words not to be ascertainable: For example, the federal courts have repeated concluded that the presence of any of the condemned, operative words—‘welfare and ‘happiness’—prevents a standard from being ascertainable. Other synonymous words and phrases not limited to an ascertainable standard include: “well-being,” “benefit,” “use and benefit of,” “enjoyment,” “pleasure,” “as she may require,” “as she may see fit,” “business purpose,” and “any purpose whatsoever.” Randall & Schmidt, The Comforts of the Ascertainable Standard Exception, 59 TAXES 242, 244 (1981).

Example Cases and Rulings Finding Ascertainable Standard Exists. A detailed compilation of cases that have addressed the ascertainable standard exception under Section 2041 are contained in several differing articles. See Randall & Schmidt, The Comforts of the Ascertainable Standard Exception, 59 TAXES 242, 247-49 (1981) (chart compilation of cases and rulings); Corbett, Judicially Determined Standards Formulated Under §§2036, 2038, and 2041, 15 TAX MANGT. ESTATES, GIFTS & TR. J. 198, 201 (Nov. 8, 1990) (chart summarizing cases under Sections 2036 and 2038 and separate chart summarizing cases under Section 2041). The following is a sampling of some of the cases and rulings that have found that an ascertainable standard exists. Tucker v. U.S., 74-2 USTC ¶ 13,026 (S.D. Cal. 1974) (“reasonable care, comfort, and support”); Estate of Vissering v. Comm’r, 990 F.2d 578 (10th Cir. 1994) (“required for the continued comfort”); Martin v. U.S., 780 F.2d 1147, 1150 (4th Cir. 1986) ("[i]n the event of the illness of Theo N. Martin or other emergency"; court said clear that IRS argument “was a loser”, and if argument was not “frivolous” before, it became so after Sowell decision of Tenth Circuit was issued); Finlay v. U.S., 752 F.2d 246 (6th Cir. 1985) (“right to encroach if she desires”); De Oliveira, Jr. v. U.S., 767 F.2d 1344 (9th Cir. 1985) (“for the benefit of”); Sowell v. Comm’r, 708 F.2d 1564 (10th Cir. 1983) (“in case of emergency or illness”); Pittsfield Nat’l Bank v. U.S., 181 F. Supp. 851 (D.C. Mass 1960) (“as he may from time to time request, he to be the sole judge of his needs”); Estate of Anderson v. U.S., 96-1 USTC ¶ 60,223 (D. Neb. 1995) (“reasonably necessary for … comfort, support and maintenance”) Hunter v. U.S., 597 F. Supp. 1293 (W.D. Pa. 1984) (“should any emergency arise”); Estate of Strauss v. Comm’r, 69 TCM 2825 (1995) (“care and comfort, considering his standard of living as of the date of … death”); Estate of Duvall v. Comm’r, 66 T.C.M. 164 (1993) (“to do as she pleases”); Whelan v. U.S., 81-1 USTC ¶ 13,393 (S.D. Cal. 1981)(“reasonable support, care and comfort”); Estate of Chancellor v. Comm’r, T.C. Memo. 2011-172 (“necessary maintenance, education, health care, sustenance, welfare or other appropriate expenditures … taking into consideration the [beneficiary’s] standard of living…”; court substituted what it believed Mississippi courts would determine and concluded that the provisions beyond the strict ascertainable standard were merely a “rounding out” of the standard); Rev. Rul. 78-398 (“maintenance and medical care”). The IRS has been surprising lenient in a number of private letter rulings in interpreting standards to come within the ascertainable standard requirement. E.g., Ltr. Ruls. 200028008 (construing reference to “other emergency” following an ascertainable standard as limited to the type of emergency covered by that standard); 200013012 (“actual living expenses only”);

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9728023 (“comfortable” modified “support and maintenance”); 9713008 (treats “care” equivalent to “support”); 9516051 (such distributions as the trustee deemed requisite or desirable under the circumstances if the trust income were insufficient to met the beneficiary’s reasonable needs); 9203047 (“maintenance, support and comfort, in order to defray expenses incurred by reason of sickness, accidents, and disability;” reference to “comfort” is qualified by other language limiting payment to medical costs); 9012053 (“to relieve emergencies affecting” beneficiaries; power to invade for emergencies is generally not ascertainable, but ruled that this standard was ascertainable in light of Martin v. U.S. decision). g. Example Cases and Rulings Finding That Ascertainable Standard Does Not Exist. Miller v. U.S. 387 F.2d 866 (3rd Cir. 1968) (“proper maintenance, support, medical care, hospitalization, or other expenses incidental to her comfort and well-being”); Strite v. McGinnes, 330 F.2d 234 (3rd Cir. 1964) (“reasonable needs and proper expenses or the benefit or comfort” of beneficiaries); Independence Bank Waukesha (N.A.) v. U.S., 761 F.2d 442, 443 (7th Cir. 1985) (one paragraph of the will authorized distributions “for her own proper maintenance;” that paragraph was nullified by more expansive powers in the next paragraph to use the assets “for whatever purpose she desires”); First Virginia Bank v. U.S., 490 F.2d 532 (4th Cir. 1974) (“right to dispose, sell, trade, or use (the stock) during her lifetime for her comfort and care as she may see fit”); Doyle v. U.S., 358 F. Supp. 300 (E.D. Pa. 1973) (“comfort, maintenance and support”); Estate of Jones v. Comm’r, 56 T.C. 35 (1971) (“”in cases of emergency, or in situations affecting her care, maintenance, health, welfare and well-being;” court says that words “comfort” and “well-being” and “comfort, welfare or happiness” are not ascertainable); Lehman v. U.S., 448 F.2d 1318 (5th Cir. 1971) (holder of life estate could "consume, invade, or appropriate" the corpus for her "support, maintenance, comfort and welfare,"); Hyde v. U.S., 950 F. Supp. 418 (D. NH 1996) (“as in her sole discretion shall be necessary and desirable”; court rejected taxpayer’s argument that the power was limited to emergencies); Estate of Schlotterer v. U.S., 421 F. Supp. 85 (W.D. Pa. 1976) (“comfort and pleasure”; court focused on “pleasure” saying it is synonymous with gratification, enjoyment and pursuit of happiness); Forsee v. U.S., 2001-1 USTC ¶ 60,393 (D. Kan. 1999) (“happiness, health, support and maintenance”); Renfro v. U.S., 78-1 USTC ¶ 13,241 (E.D. Tx. 1978) (holder of life estate could “sell, mortgage or otherwise dispose of such property at such times and on such terms as to her may seem proper”); Franz v. U.S., 77-1 USTC ¶ 13,182 (E.D. Ky. 1977) (“care, maintenance and welfare”, stating “one cannot escape the import of the word ‘welfare’ as being ‘very broad’ and indicating ‘the extent of the discretion given to the trustee’”); Stafford v. U.S., 236 F. Supp. 132 (E.D. Wis. 1964) (“use and enjoy the principal … for his care, comfort, and enjoyment”); Estate of Little v. Comm’r, 87 T.C. 599 (1986) (“proper support, maintenance, welfare, health and general happiness in the manner to which he [was] accustomed at the time of the death of [his wife];” court reasoned that standard did not relate just to HEMS, giving example of travel as an unrelated item to HEMS that might have been permissible under the standard in the agreement); Estate of Penner, 67 T.C. 864 (1977) (“business purpose”); Estate of Lanigan v. Comm’r, 45 T.C. 247 (1965) (“use and benefit”); Estate of Beyer v. Comm’r, T.C. Memo 1974-24 (“sole discretion … for any purpose whatsoever”); Rev. Rul. 82-63, 1982-1 C.B. 135 (“maintenance, comfort, and happiness”); Rev. Rul. 77-194, 1077-1 C.B. 283 (“proper comfort and welfare”); Rev. Rul. 77-60, 1077-1 C.B. 282 (“as desired to continue an accustomed standard of living”); Rev. Rul. 76-547 (“health, care, maintenance, and enjoyment”); Ltr. Rul. 9344004 (“comfort,” “happiness,” and “welfare”); Ltr. Rul. 9318002 ((“comfort,” “happiness,” and “welfare”; ruling subsequently revoked without explanation by Letter Ruling 9510001); Tech. Adv. Memo. 9344004 (“health, maintenance, support, comfort, and welfare at the standard of living to which he had become accustomed”, applying

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Texas law); Ltr. Rul. 9125002 (“reasonable comfort, best interest, and welfare”); Ltr. Rul. 9113026 (“care, support, maintenance, and welfare”); Ltr. Rul. 9030032 (“”if that spouse’s income from other sources is not sufficient for the surviving souse’s ‘support and comfort in the manner in which she was accustomed’”, reasoning that “support in reasonable comfort” is an ascertainable standard while “comfort” standing alone is not); Tech. Adv. Memo. 8606002 (provision for distributions for ascertainable standard, coupled with power to distribute for “emergency needs”); Tech. Adv. Memo. 8304009 (“any great emergencies which may arise in the lives and affairs … such as extra needed medical services or hospitalization”); Ltr. Rul. 7841006 (“emergency”); Ltr. Rul 7812060 (“as may be necessary for the well-being of my son”). h. Rulings Related to Standard of Living. The Regulations provide that “support in his accustomed manner of living” is an ascertainable standard. Treas. Reg. § 20.2041-1(c)(2). The following cases and rulings have held that references to a standard of living constituted an ascertainable standard. Estate of Vissering v. Comm’r, 990 F.2d. 578 (10th Cir. 1994) (“continued comfort” implies amounts reasonable necessary to maintain the accustomed standard of living); Estate of Klafter v. Comm’r, 32 T.C.M. 1088 (1973) (discretion to distribute income “to maintain [beneficiary’s] standard of living in the style to which she has been accustomed” is an ascertainable standard under Section 2036); Ltr. Ruls. 9036048 (“determines to be advisable, considering resources otherwise available to them . . . to provide for their health, education, support and maintenance in the manner of living to which they have become accustomed”); 7836008 (“reasonable health, education, support and maintenance needs consistent with a high standard and quality of living”); 7914036 (“to maintain the standard of living to which he or she was accustomed during the lifetime of the first of us to die, at and immediately prior to the time of the death of the first of us to die”; ruling reasoned that “accustomed standard of living” alone is not sufficient, but here, the word “maintain” tied the standard to one of the four HEMS standards). The following rulings have held that references to a standard of living did not constitute an ascertainable standard. Rev. Rul. 77-60, 1977-1 C.B. 282 (“continue an accustomed standard of living” without further restriction is not ascertainable); Ltr. Rul. 8339004 (“to provide comfortably for his wants according to the style of living which we have enjoyed”). i.

Rulings Related to “Emergency” Standard. For gift tax purposes, Regulation § 25.25111(g)(2) refers to a “reasonably fixed or ascertainable standard.” In an example, that Regulation states that “a power to distribute corpus for the education, support, maintenance, or health of the beneficiary; for his reasonable support and comfort; to enable him to maintain his accustomed standard of living; or to meet an emergency, would be such a standard.” Based on this language in the gift tax regulations, one would assume that an “emergency” standard would be treated as an ascertainable standard for purposes of Section 2041. Nevertheless, the IRS maintains (and has been successful in persuading some courts) that a distribution standard based on “emergency” relates to the “timeliness” of a distribution, not to need in terms of health, education, support, maintenance, or other ascertainable standards, and thus does not qualify as an ascertainable standard for purposes of Sections 2041 and 2514. E.g., Tech. Adv. Memo. 8606002 (provision for distributions for ascertainable standard, coupled with power to distribute for “emergency needs”); Tech. Adv. Memo. 8304009 (“any great emergencies which may arise in the lives and affairs … such as extra needed medical services or hospitalization”); Ltr. Rul. 7841006 (“emergency”).

Possibility of Reformation. If a “bad” word is included in the standard, there may be a possibility of reforming the instrument based on mistake. E.g., Ltr. Ruls. 200144018

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(inclusion of reference to “welfare” was mistake; reformation to delete that word did not result in release of general power of appointment); 200024015; 199936029. k. Effect of Providing that Trustee Must/May Consider Outside Resources. A provision that the trustee either should or should not or may consider the beneficiary’s outside resources in determining whether to make distributions under a standard that comes within the ascertainable standard should not have any effect on whether an ascertainable standard exists under §2041. See Treas. Reg. §§20.2041-1(c)(2)(“immaterial whether the beneficiary is required to exhaust his other income before the power can be exercised”) &25.2514-1(c)(2); Ltr. Rul. 9036048 (“determines to be advisable, considering resources otherwise available to them . . . to provide for their health, education, support and maintenance in the manner of living to which they have become accustomed”). It is very important that beneficiaries understand that requiring the trustee to consider outside resources has real economic consequences and may limit the ability to make distributions. If the instrument directs that distributions should be made for the beneficiary’s support without considering other resources, if trust assets are not used first for the beneficiary’s support, the beneficiary may be deemed to have made an indirect contribution to the trust. If a beneficiary of a trust with a HEMS distribution standard exercises an inter vivos limited power of appointment, the “considering other available resources” phrase may impact the amount of the gift that is made by the appointing beneficiary. If the instrument provides that the trustee may consider outside resources, what is the trustee’s responsibility to exercise due diligence to ascertain what outside resources are available? Under the literal language of the instrument, the trustee is not required to do so. Arguably, a duty of impartiality may in some situations indicate that the trustee should inquire about outside resources if the trust instrument gives the trustee the clear authority to do so. However, the panelists generally believe that the trustee does not have a duty to investigate outside resources if the trustee merely has the authority but not the direction to consider outside resources. If the trustee seeks information about outside resources and the beneficiary refuses to provide information, the trustee would be justified in not making distributions to that beneficiary if the instrument or state law gives the trustee the authority to consider outside resources. Requiring the trustee to consider outside available resources may result in a frozen trust for a long period of time. For example, if a bypass trust permits distributions only to the surviving spouse during the balance of his or her lifetime and requires the trustee to consider outside resources, the trustee may not be able to make any distributions during the spouse’s lifetime (if the spouse has plenty of outside resources). If the trust is silent about considering outside resources, state law may vary as to the result. For example, in Illinois, the trustee would not have to consider outside resources but probably would have to consider outside resources in California. As other examples, if the trust instrument is silent, the trustee is forbidden from considering outside resources in Georgia but the trustee may consider other resources in Virginia. Texas cases have been inconsistent on the issue. Compare First National Bank of Beaumont v. Howard, 229 S.W. 2d 781, 786 (Tex. 1950) (should consider all income available to the

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beneficiaries from any sources in determining whether to make distributions from principal) with Penix v. First National Bank of Paris, 260 S.W. 2d 63, 67 (Tex. Civ. App.—Texarkana 1953, writ ref’d) (trustee required to consider need for distribution “without regard to the financial ability of [the beneficiary’s] parents”). The Restatement (Second) of Trusts seems to suggest that the trustee should not consider outside resources available to a beneficiary if the trust instrument authorizes distributions for support but is silent on the issue of whether to consider outside resources. Restatement (Second) of Trusts §128, cmt. e (1992) (“It is a question of interpretation whether the beneficiary is entitled to support out of the trust fund even though he has other resources. The inference is that he is so entitled.”). However, the Restatement (Third) of Trusts suggests the opposite. Under the Restatement (Third) of Trusts, §50, Comment e, “the presumption is that the trustee will take the beneficiary’s other resources into account in determining whether and in what amounts distributions are to be made, except insofar as, in the trustee’s discretionary judgment, the settlor’s intended treatment of the beneficiary or the purposes of the trust will in some respect be better accomplished by not doing so.” Restatement (Third) of Trusts, §50, cmt. e (2003). The trustee generally may rely on the beneficiary’s representations and on readily available, minimally intrusive information requested of the beneficiary, unless the trustee has reason to suspect that the information thus supplied is inaccurate or incomplete. Id. at cmt. e(1). The Comments and Reporter’s Notes to Section 50 of the Restatement (Third) of Trusts summarizes the diversity of state law regarding the consideration of outside resources if the trust instrument is silent on the issue. If the beneficiary’s other resources are to be considered, does that mean just the beneficiary’s sources of income or all of the beneficiary’s assets? The general rule seems to be to limited the consideration to sources of income and not the beneficiary’s assets in general. Restatement (Third) of Trusts, §50, cmt. e (2003). State law regarding this issue can have an effect on decanting decisions. Decanting a trust from an Illinois trust to a California trust may mean that the trustee can no longer make discretionary distributions to the surviving spouse. Decanting the trust to California in that circumstance may subject the trustee to potential liability for breaching the duty of impartiality. l.

Small Trust Termination Provision. A provision giving the trustee the authority to terminate the trust and distribute to the current income beneficiaries (which could include the trustee individually) may create a general power of appointment. Such clauses are sometimes restricted so that they can only be exercised if the trust reaches an objective small amount. If that is the case, the general power of appointment probably would not arise until the trust diminishes to that size limit, at which time the power could be exercised. See section III.B.1.h of this outline. The IRS has ruled that the power of a trustee-beneficiary to terminate under very limited circumstances would not create a general power of appointment. Tech. Adv. Memo. 8606002. If an objective formula is not used, the trustee-beneficiary is at risk as to whether, in the exercise of its fiduciary capacity, it would actually have the power in existence at the time of his death. See generally Pennell, Avoiding Tax Problems For Settlors and Trustees When An Individual Trustee is Chosen, EST. PL. 264, 271-72 (September 1982) (“Accordingly, when a beneficiary is acting as trustee, the provision ought to be set to a clearly specified dollar amount. In the alternative, the determination of when termination may occur should be given to some other party.”).

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m. State Laws Limiting Discretionary Distributions for Self to an Ascertainable Standard. Various states have enacted laws that automatically restrict standards for distributions from trustees to themselves individually. New York historically has imposed an absolute prohibition against a trustee exercising a discretionary distribution power in favor of itself, except for a trust that is revocable by the beneficiary during his or her lifetime. The statute was amended, effective September 30, 2003, to allow distributions to the beneficiary-trustee within an ascertainable standard, or if the trust instrument expressly references the statute and overrides the prohibition on distributions to a trustee-beneficiary. N.Y. CLS EPTL § 10-10.1 (“for such person’s health, education, maintenance, or support within the meaning of sections 2041 and 2514 of the Internal Revenue Code, or any other ascertainable standard”). Like the current New York rule, some states apply the prohibition only if the distribution power in the instrument is not limited by an ascertainable standard relating to the health, education, maintenance or support of the power holder. ALASKA STAT. § 13.36.153; CONN. GEN. STAT.. § 45a-487(b); FLA. STAT. § 737.402(4)(a); MINN. STAT. § 501B.14; UTAH CODE § 75-7-41-(1);W. VA. CODE § 44-5-13. The Florida statute gives the trustees and beneficiaries of existing trusts the right to opt out of the statute, for fear that the prohibition in the statute would cause a lapse of a general power of appointment by trustee-beneficiaries who formerly had unlimited discretion to make distributions to themselves. However, the IRS subsequently ruled that the Florida statute would not be treated as causing the lapse of a power of appointment. Rev. Proc. 94-44, 1994-2 C.B. 683. Several states have statutory provisions permitting trustees to exercise discretionary distribution powers in favor of themselves, but the statutes cut back the power to one that may be exercised only to make distributions for the power holders’ health, education, support or maintenance. D.C. CODE § 21-1722; MD. CODE § 14-109; N.J. STAT. § 3B:11-4.1; PA. CONS. STAT. § 7504; TEX. PROP. CODE §113.029(b)(1). Some of the statutes also address other issues than just restricting distributions to the trusteebeneficiary. An example is the Utah Code provision. It also (1) restricts discretionary allocations of receipts and disbursement between income and principal, unless the trustee acts in a fiduciary capacity where he has no power to enlarge or shift a beneficial interest except as an incidental consequence of the discharge or his fiduciary duties; (2) restricts making or obtaining discretionary distributions to satisfy his legal obligations; and (3) restricts any powers that indirectly permits control over those other issues, including the right to remove and replace the trustee. The Utah statute makes clear that it does not apply to (1) revocable trusts, (2) a settlor’s spouse as beneficiary of a marital trust, (3) distributions within an HEMS standard, or (4) powers “clearly intended” to be general powers. Also, it provides that if any restricted power is held by two or more trustees, it may be exercised by the trustee who is not disqualified. If there is no acting co-trustee, the restricted power may be exercised by a trustee appointed under the appointment provisions of the trust instrument or by a court. Cases have recognized the effectiveness of such state laws in preventing a beneficiary from acquiring a general power of appointment. E.g., Sheedy v. U.S., 691 F. Supp. 1187 (E.D. Wis. 1988). n. Planning Issues Regarding Distribution Standards.

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(1) Different Standards for Different Trustees. Distribution powers may be bifurcated. For example, beneficiary-trustees will be limited by a health, education, maintenance and support (or “HEMS”) standard, but other trustees may have broader distribution standards. The client may be unwilling, however, to give a corporate trustee an absolute discretion standard. (2) May vs. Shall. Planners generally believe that a HEMS standard comes within the exception of §2041 whether the instrument directs that the trustee “may” or “shall” make distributions for HEMS purposes. See Estate Planning and Administration Group of Schiff Hardin LLP, What Language Should Be Used to Avoid a General Power of Appointment Over a Trust?, 36 EST. PL. 40 (April 2009). (3) “As May Be Needed.” An instrument may direct that distributions be made “as may be needed” for various purposes. The beneficiary may then come to the trustee with reasons that a distribution is needed and argue that the instrument requires that the distribution be made. This language gives room to the litigator to pressure the trustee to make distributions. However, “needed” is in the eye of the beholder and the trustee must still make a determination of whether the distribution is actually “needed.” (4) Accustomed Standard of Living. If a trust authorizes distributions to maintain the beneficiary’s “accustomed standard of living,” various uncertainties arise. For example, what if the beneficiary is eight years old when the trust is created and has a restricted standard of living at that time? (5) “Station in Life.” Trust agreements sometimes authorize distributions to beneficiaries in accordance with their “station in life.” The meaning of that phrase is quite uncertain. For example, if a beneficiary is at the poverty level, does the trustee determine that his station in life is that he is destitute and broke, and therefore not make any distributions? (6) Trustee Guidance; Example of Factors That the Trustee May Consider. Giving guidance to the trustee about specific factors to consider will be helpful for the trustee to know the settlor’s intentions as particular fact scenarios arise. Examples of factors that the trustee may consider include a beneficiary’s desire to begin a profession or to buy a home. The trustee may also consider whether distributions will provide a disincentive to the beneficiary to become productive. Defending a trustee’s actions is easier if the trustee has more specific guidance on which the trustee’s decisions are based. A possible concern is that listing a variety of specific factors may give rise to an implication that other factors should not justify distributions. For various sample clauses providing guidance to trustees regarding distribution intentions, see Benjamin H. Pruett, Tales from the Dark Side: Drafting Issues from the Fiduciary Perspective (2013) (available from the author, Pruett@bessemer.com). (7) Budgeting Issues. A beneficiary may request a higher level of distributions than can be justified. For example, a surviving spouse may tell the trustee that the deceased spouse had previously paid for a variety of things. However, the trustee may explain that if the prior level of expenditures is continued the trust run out of money during the beneficiary’s lifetime. A good trustee will discuss budgeting with the beneficiaries and address a level of distributions that will allow the trust to continue on a long-term basis. One panelist cautions that if the trustee sets a budget, it should be followed.

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One panelist said that he uses a “Mercedes and Chevrolet” analogy. Even though the decedent had paid for a Mercedes in the past, that may not be affordable in the future. A primary concern is that remainder beneficiaries may allege that the trustee violated the duty of impartiality by making excessive distributions to the current beneficiary. There is also concern that even the current beneficiary may complain after the trust has run out of money. (8) Concern of Individual Trustees Ignoring Stated Standards. Individual trustees often forget that there is a document that places limits on distributions. They think they know better than anybody else what the beneficiaries need regardless what the document says. If there are individual trustees, a large part of the professional’s role is educating them about their responsibility in the execution of trust. (9) Tax Minimization. The higher income tax brackets that apply to trust income above a very low threshold and the 3.8% Medicare tax may impact distribution decisions. Is tax minimization factor that may be considered by the trustee? What if the stated distribution standard is simply a HEMS standard? That depends upon the purpose of the trust. If the purpose is to minimize taxes, there may be broader authority to consider income tax effects in making distribution decisions. o. Creative Planning Strategy to Allow Beneficiary to Decide Whether to Retain Unfettered Control Over Trust or be Subject to Ascertainable Standard. Steve Gorin, (an attorney in St. Louis) suggests the following creative strategy if a client wants to make an outright bequest that might be sizable enough to justify a trust and does not want trustee discretion to impede the beneficiary’s access. Consider using a lifetime trust with ascertainable standards for income and principal, as well as an unlimited withdrawal right at a specified age. (By including an age restriction, this provision could be used for children who might currently be over that age as well as for grandchildren who may be under that age.) The child then has the choice of accepting the bequest in trust with that broad withdrawal right or doing a timely disclaimer of the withdrawal right. Because the unlimited withdrawal right is a general power of appointment, it is a separate interest that can be disclaimed, with the beneficiary still receiving distributions under ascertainable standards. See Reg. §25.2518-3(a)(1)(iii). 5. Beneficiary as Trustee—Effect of Authority to Satisfy Trustee’s Support Obligations; The Upjohn Issue. a. Regulations—Power to Discharge Decedent’s Obligation is Power Exercisable in Favor of Decedent. The regulations provide that a power to satisfy the decedent’s obligation is treated as a power exercisable in favor of the decedent: A power of appointment exercisable for the purpose of discharging a legal obligation of the decedent … is considered a power of appointment exercisable in favor of the decedent or his creditors. Treas. Reg. § 20.2041-1(c)(1).

See also Treas. Reg. § 25-2514-1(c)(1). Therefore, if a trustee has the power to make a distribution that satisfies any of his obligations, the trustee is deemed by the regulations to have a power to distribute to himself. Thus, although the trustee is not a beneficiary at all under the trust, power of appointment problems for the trustee can still arise if any person that the trustee owes legal obligations to is a beneficiary.

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b. The Illogical Disconnect. A trustee may have the power to distribute property to himself for his support and he does not have a general power of appointment. But the trustee may not possess the very same power to make distributions to his minor children for their support. The reason is that the power to satisfy the trustee’s obligations is treated as a power to distribute to the trustee. Therefore, that power is a general power of appointment, unless it meets the ascertainable standard exception. The ascertainable standard exception, however, requires that the power be related to the power holder’s “… support.” Because the power is related to the child’s support and not the support of the trustee, it is not limited by an ascertainable standard. The IRS concurs with this analysis. See Rev. Rul. 79-154, 1979-1 C.B. 301; Ltr. Ruls. 8924011, 8921022 c. Upjohn. This issue has become known by the name of a case that does not address this precise Section 2041 issue at all. Upjohn v. U.S., 72-2 USTC ¶12,888 (W.D. Mich. 1972). That case involved a Section 2503(c) trust which provided that the trustee should not make any distributions that would satisfy the settlor’s legal obligation of support. The issue was whether that constituted a “substantial restriction” on the right to make distributions to the beneficiary, so that it did not qualify under Section 2503(c), in which event gifts to the trust would not qualify for the annual exclusion. The court rejected the IRS’s argument, that this restriction constituted a substantial restriction, on the theory that it was no restriction at all to say that the trustee should not make a distribution to satisfy a need of the minor that someone else would provide anyway (i.e., the parent, because of the support obligation). In this regard, the provision really enlarged the rights of the minor child under the instrument, because it assured that the trust funds would be used to provide additional benefits that were not already provided for by the support obligation. The Section 2041 problem exists if the surviving spouse serves as trustee of a Section 2503(c) trust. Unless the taxpayer can convince the court to rule like Upjohn that a limitation on making distributions in satisfaction of the trustee’s legal obligations is not a substantial restriction, the spouse cannot serve as trustee of a Section 2503(c) trust. Either the trust would restrict the trustee from making distributions to satisfy his legal obligation of support (in which event it is not a valid Section 2503(c) trust if a court cannot be persuaded to follow Upjohn), or else the spouse would have a general power of appointment. Hence, clauses to solve this problem have come to be known as “Upjohn clauses.” Interestingly, no case has addressed what seems to be the real issue. If a trustee makes a distribution to a minor, and the parent uses that to provide what should be the parent’s legal obligation, has the parent violated his duty to his children, in effect converting the child’s assets for his own use? Does the parent still owe the amount of such support payment to the child? If so, a distribution from a trust to a minor does not satisfy the parent’s legal obligation of support. See section II.B.2.c.(3) of this outline. Stated differently, a distribution that satisfies the power holder’s legal obligation is in reality a distribution to the power holder. If the instrument says that no distribution may be made to the power holder other than for the power holder’s health, education, support or maintenance, the distribution would not be authorized (because it is not for the power holder’s “ … support”—but for the payment of a claim against the power holder.) See Horn, Whom Do You Trust: Planning, Drafting and Administering Self and Beneficiary-Trusteed Trusts, 20TH UNIV. OF MIAMI PHILIP E. HECKERLING INST. ON EST. PL. ¶ 502.2 (1986). d. The Fix. To cure any possible argument, planners insert what has become known as the Upjohn clause: A clause prohibiting the trustee from making any distribution that would have the effect of discharging that trustee’s legal obligations. For an excellent discussion

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of the tax effects if a trust does not absolutely prohibit satisfying legal obligations of the donor or of a trustee, see Pennell & Fleming, Avoiding the Discharge of Obligation Theory, PROBATE & PROPERTY 49 (Sept./Oct. 1998). One ruling approved a clause requiring that if the trustee (a surviving spouse) had the obligation to support any other trust beneficiary, the trustee was required to appoint a special trustee of her choosing at that time to make distributions for that beneficiary. Ltr. Rul. 9036048. See Section III.D.5. of this outline. Some of the state law statutory “savings clauses” address this issue. For example, TEX. PROP. CODE § 113.029(b)(2) provides that unless the trust provides otherwise, “a trustee may not exercise a power to make discretionary distributions to satisfy a legal obligation of support that the trustee personally owes another person.” 6. Special Issues With Settlor’s Spouse as Trustee. A very common estate plan is to name the surviving spouse as the trustee of any trusts created in the decedent’s will. A variety of tax and legal issues may arise that the planner should carefully consider. a. Restrict Power to Distribute to Self to Ascertainable Standard. The trust should restrict the spouse-trustee from making any distributions to himself that are not related to health, education, maintenance and support. b. Restrict Incidents of Ownership. In case the trust owns any life insurance on the spouse’s life, the trust should restrict the spouse, as trustee, from having the power to exercise any incidents of ownership over such policy. c. Restrict Power to Distribute to Minor Children or Otherwise in Satisfaction of Spouse’s Legal Obligations. In order to avoid the “Upjohn issue,” the spouse should be restricted from exercising any power to make a distribution in satisfaction of any of his legal obligations. See section III.B.5. of this outline. d. Spouse and Children as Discretionary Beneficiaries—Use Ascertainable Standard for Distributions to Children Also. One possible implication of Treas. Reg. § 25.25111(g)(2) is that the spouse is treated as making a gift if (1) the spouse has a “beneficial interest” in the trust, and (2) the spouse makes a distribution to someone else under a standard that is not an ascertainable standard. See section III.A.4. of this outline. Accordingly, if the spouse is the trustee, it is likely that the spouse has some kind of beneficial interest in the trust. If so, to be conservative in light of the possible implication of the regulation, the trust instrument should restrict the authority of the spouse-trustee to making distributions to any other beneficiaries only under an ascertainable standard. e. Use Tax Savings Clause. The author strongly urges using a tax savings clause designed to cure all of those prior problems in every trust—especially where the spouse is serving as trustee. See section IV of this outline. f.

Fiduciary Obligations. In some situations, spouses as trustees may face tremendous emotional pressures in responding to requests/demands from children for distributions. The spouse may face fiduciary issues in light of the conflict of having both the spouse and children as beneficiaries. The spouse may face fiduciary issues in connection with decisions that may be made innocently for independent tax reasons. (An example would be a spouse-trustee who makes distributions to himself under a HEMS standard to carry

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out all DNI to the spouse (and tax the income at lower rates) when the spouse had sufficient outside resources and could not justify a need for those distributions.) g. Income Tax. As discussed in Section III.E. below, the spouse may potentially be treated as the owner of the trust under Section 678 if the spouse is the sole trustee and has the authority to make distributions to himself. h. QTIP Trusts. The spouse may wish to make gifts of assets in a QTIP trust to take advantage of the lower effective gift tax as compared to the estate tax. To keep from including the trust directly in the spouse’s estate, the QTIP trust will probably not give the spouse unlimited discretion to make distributions from the QTIP (which would permit large distributions to the spouse so that he could make gifts.) For that situation, having a third party as trustee could be helpful. See generally Tiernan, Creating an Amicable Estate Plan for the Decedent’s Children and the Second Spouse, 94 J.TAX’N (Feb. 2001). i.

Clayton Trusts. A QTIP trust may specify that the trust passes differently depending on whether or not the QTIP election is made. If the trust provides that the trust assets will pass outright to the surviving spouse if the QTIP is not made, to be conservative, the spouse should not serve as the executor with the authority to make that election. See Sloan, Planning and Drafting for Maximum Flexibility in Credit Shelter/Marital Deduction Planning, 38th Annual Heckerling Inst. On Est. Pl. ¶ 800 (2004). If the spouse has the authority, through making a tax election, to receive the trust property not subject to an ascertainable standard, the spouse would have a general power of appointment. If the QTIP trust assets will pass to a standard bypass trust (which would be restricted so that the spouse would not have a general power of appointment), the spouse should not have a general power of appointment if the spouse serves as the executor, but questions could arise as to whether the spouse makes a gift by not making the QTIP election if the new trust terms do not give the spouse a mandatory income right.

Section 2503(c) Trusts. As discussed in section II.B.6.a., neither the settlor nor the settlor’s spouse should serve as trustee of a Section 2503(c) trust. (If the spouse serves as trustee, there is a clear Upjohn problem. Either the trust might not qualify for Section 2503(c) treatment because it does not satisfy the substantial restriction requirement, or else the spouse would have a general power of appointment. See Section III.B.5. of this outline.)

7. Summary of Selection of Trustee Issues Regarding Dispositive Powers Held by a Beneficiary. The beneficiary should not have the power as trustee to make distributions to himself that are not limited by an ascertainable standard relating to his HEMS. If the beneficiary is a co-trustee (or holds a veto power), the beneficiary will be deemed to hold distributive powers of the trustee unless he is a co-trustee with the grantor (but then there would adverse tax consequences to the grantor) or an adverse party. If the beneficiary has a contingent power to become trustee in the future upon the occurrence of events outside his control, the beneficiary will not be deemed to hold the powers of the trustee until the triggering event actually occurs. Once the events have occurred entitling the beneficiary to become trustee, he will be deemed to hold any problematic powers (even before he accepts as trustee) unless he formally disclaimed the right to be trustee (generally within nine months of when the original transfer in trust was made.) Reciprocal powers (in reciprocal trusts) may be uncrossed.

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If there is a third party trustee: A third party trustee can have complete discretion over distributions. However, if there are mandated distributions, the beneficiary will be deemed to have a general power of appointment over any undistributed but “accrued” amounts (but this does not apply if the trustee just has the discretion, even within a standard, to make distributions.) A third party trustee may be used as a co-trustee with a beneficiary, and the instrument could direct that any problematic powers (to make distributions beyond a HEMS standard to the beneficiary or to any other beneficiary or to make distributions that satisfy the beneficiary’s obligation of support) would be held solely by the third party trustee. Even if there is a third party trustee, to be safe, the instrument should prohibit any distributions in satisfaction of legal obligations of the trustee. If the beneficiary is trustee: Use an ascertainable standard. Do not get fancy and stray from the pure HEMS standard. Even slight word deviations could potentially have disastrous effects—or at least give rise to a lawsuit. Adding “in the accustomed standard of living” is satisfactory as long as those words modify the stated standard. (In addition, as discussed in Section III.A.4., the instrument should not allow the beneficiary-trustee to make distributions to another beneficiary unless the distribution is within an ascertainable standard as to that other beneficiary.) C. Estate Tax—Management/Administrative Powers. 1. The Issue. Overly broad administrative powers might potentially create (1) estate tax inclusion problems under Section 2041 if the powers enable the power holder to favor himself, and (2) gift tax concerns under Section 2514 if the power holder could exercise the power to favor himself, but instead exercises the power in a manner that favors others. 2. Regulations. The regulations to Sections 2041 and 2514 indicate that “mere … management {and} investment” powers will not cause the holder of the power to have a general power of appointment: The mere power of management, investment, custody of assets, or the power to allocate receipts and disbursements as between income and principal, exercisable in a fiduciary capacity, whereby the holder has no power to enlarge or shift any of the beneficial interests therein except as an incidental consequence of the discharge of such fiduciary duties in not a power of appointment. Treas. Reg. § 20.2041-1(b)(1); 25.2514-1(b)(1).

3. Lack of Cases; Analogy to Section 2036-2038 Cases. There have been very few cases addressing the effects of administrative and management powers under Section 2041. Estate of Rolin v. Comm’r, 68 T.C. 919 (1977), aff’d, 588 F.2d 368 (2nd Cir. 1978) (investment power not general power of appointment because required to be exercised in fiduciary capacity). However, the cases regarding the effects of administrative and management powers under Sections 2036 and 2038 should provide guidance by analogy. The underlying principles would seem to be the same. In particular, the Supreme Court’s discussion in Byrum of the effects of management powers (in particular, in that case, the power to vote stock) in relation to the power to designate the persons who may possess or enjoy property or the income therefrom. As discussed above, the planner should be careful to make clear that any administrative owners of a beneficiary-trustee must be exercised in a fiduciary capacity. See generally section II.B.4. of this outline.

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The lack of very many cases under Section 2041 regarding administrative powers, however, does raise potential concerns. Some planners may want to draft around potential arguments by the IRS in sensitive situations. 4. Potentially Troublesome Powers. One commentator has given an excellent summary of potentially troublesome powers that might possibly be interpreted to give the trustee the power indirectly to favor himself: The mere existence of [an administrative] power arguably can be a power (even a general power of appointment or a power exercisable solely by the power holder to vest income or corpus in himself). The exercise or lapse of the power in favor of other than the power holder arguably can be a taxable gift. Potentially troublesome are powers: (1) to retain, dispose and invest property when particular types of income are allocated to particular beneficiaries; (2) to retain or invest in unproductive or underproductive property (especially if the governing instrument waives the application of state law that otherwise would require an adjustment in favor if income); (3) to allocate receipts and expenses between income and principal; (4) to lend without adequate security or interest; (5) to exchange property with the trustee; (6) to release a trustee or accept the trustee’s account; (7) to distribute in non-pro rata shares without regard to unrealized gain for tax purposes; and (8) to pay (or cause payment of) death costs (i.e., debts, costs of administration and taxes) from one fund rather than another. Horn, Whom Do You Trust: Planning, Drafting and Administering Self and Beneficiary-Trusteed Trusts, 20TH UNIV. OF MIAMI PHILIP E. HECKERLING INST. ON EST. PL. ¶ 503.36 (1986).

Mr. Horn’s article has a very thoughtful discussion of drafting steps that the planner might take to avoid potential problems in sensitive situations. 5. Income and Principal Allocations. If the amount that is or may be distributed to the trustee depends on income/principal allocations (such as would occur if the surviving spouse or another beneficiary is the trustee of a QTIP trust), the regulation suggests that giving the trustee the power make such allocations would not raise problems, as long as the power is “exercisable in a fiduciary capacity.” However, this is a particularly sensitive power. The potential problems of many other powers can be avoided by using a tax savings clause to limit any discretionary distributions to the trustee within an ascertainable standard. For many other issues, it may not matter how an administrative power is exercised, as long as ultimately any discretionary distributions to the spouse must meet an ascertainable standard. However, the exercise of the income/principal power will directly cause (or prevent) the distribution of assets if there is a mandatory income interest in the trust. Regulations under Section 2041 make clear that the power to allocate receipts and disbursements between income and principal in a fiduciary capacity is not a power of appointment. Treas. Reg. § 20.2041-1(b)(1); 25.2514-1(b)(1). Regulations under Section

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2056 regarding the mandatory income interest requirement in marital trusts may also give guidance by analogy: If it is evident from the nature of the trust assets and the rules provided for management of the trust that the allocation to income of such receipts as rents, ordinary cash dividends, and interest will give to the spouse the substantial enjoyment during life required by the statute, provisions that such receipts as stock dividends and proceeds from the conversion of trust assets shall be treated as corpus will not disqualify the interest passing in trust. Similarly, provision for a depletion charge against income in the case of trust assets which are subject to depletion will not disqualify the interest passing in trust, unless the effect is to deprive the spouse of the requisite beneficial enjoyment. The same principle is applicable in the case of depreciation, trustees’ commissions, and other charges. Treas. Reg. § 20.2056(b)-5(f)(3). Among the powers which if subject to reasonable limitations will not disqualify the interest passing in trust are the power to determine the allocation or apportionment of receipts and disbursements between income and corpus, the power to apply the income or corpus for the benefit of the spouse, and the power to retain the assets passing to the trust. … Nor will such a power [i.e., to retain unproductive property] disqualify the interest if the applicable rules for administration of the trust require the trustee to use the degree of judgment and care in the exercise of the power which a prudent man would use if he were owner of the trust assets. Treas. Reg. § 20.2056(b)-5(f)(4) (emphasis added).

A very standard clause for QTIP trusts is to provide that the income/principal allocation power may not be exercised in a manner that would endanger the availability of the marital deduction. Similarly, in any trust where there is a mandatory income interest (or where distributions may only be made from income or principal, but not both) the planner should consider whether to be conservative and provide that whenever a beneficiary is serving as trustee, the income/principal allocations shall be made in accordance with applicable rules of law (or similar language). See Heisler & Butler, Trust Administration § 5.33 Illinois Inst. For Continuing Legal Ed. (1999). That might impose a rather sever administrative burden, however, by forcing the trustee to get legal opinions on a variety of issues as to how the income/principal allocation should be made under the technicalities (and uncertainties) of the appropriate state trust laws. An alternative would be to give a non-beneficiary co-trustee broad discretion in making income/principal allocations. Typically, in that situation, there is just a requirement that any such fiduciary power be exercised in a reasonable manner. 6. Valuations; Non Pro Rata Distributions. Some commentators have suggested that the drafter “should also avoid authorizing the trustee-beneficiary to divide or distribute trust property ‘at such valuations as the trustee considers fair’ or make ‘non pro rata distributions’ of trust property items.” Id. The concern is that these powers might be argued to permit the trustee to shift benefits to himself. However, most planners do not impose these restrictions on trustee-beneficiaries. The Jordahl case, which held that a settlor-fiduciary who had the power to substitute assets of equivalent value with a trust did not have Section 2038 or 2042 powers over the trust, because the settlor would be required to exercise the power fairly in a manner that would not deplete the corpus of the trust. (That case even suggested that holding such a power in a nonfiduciary capacity would be permissible for purposes of Section 2038 and 2042.) Estate of Jordahl v. Comm’r, 65 T.C. 92 (1975). See section II.B.4.g of this outline. 7. Tax Elections. Certain tax elections can directly benefit the trustee in an individual capacity. For example, a decision to take administration expenses as income tax deductions rather than estate tax deductions will benefit income beneficiaries over remaindermen. However, most commentators believe that the exercise (or non-exercise) of such tax elections, which have an

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incidental effect of benefiting certain beneficiaries, should not raise Section 2041 concerns. See Adams, Questions & Answers, TR. & ESTS, 53 (Sept. 1985). However, the spouse should not have the power to make a QTIP election, where the assets will pass outright to the surviving spouse if the QTIP election is not made. See Section III.B.6.i of this outline. 8. Power to Adjust Under Section 104. Section 104 of the new Uniform Principal and Income Act, was approved by the National Conference of Commissioners on Uniform State Laws in July 1997. It has been passed or is being considered in many states (including Texas in 2003). If a trust provides for the mandatory distribution of all income, and if a trustee makes the decision under section 104 to allocate some or all capital gains to income for a particular year, the decision directly impacts the amount to be distributed to the income beneficiary. Accordingly, section 104 of the Uniform Act and most of the states adopting the provision stipulate that the discretion may only be exercised by an independent trustee. See Section I.E of this outline. Query, what would be the tax effect if the trustee-beneficiary were authorized to make an adjustment under Section 104 only with court approval? 9. Incidents of Ownership Over Life Insurance. If the trust holds any life insurance on the trustee’s life, the trustee should be restricted from having any discretion regarding exercising any incidents of ownership over the policy. See section II.B.4.k.(2) of this outline. 10. Beneficiary Consent to Trustee’s Administrative Actions. The regulations make clear that “the right in a beneficiary of a trust to assent to a periodic accounting, thereby relieving the trustee from further accountability, is not a power of appointment if the right of assent does not consist of any power or right to enlarge or shift the beneficial interest of any beneficiary therein.” Treas. Reg. § 20.2041-1(c)(1). Thus, unless the IRS could establish that a beneficiary is relinquishing clear legal rights (so as to constitute a gift—see Section III.A.3 of this outline), the ability of beneficiaries to consent to administrative actions should not case gift problems. 11. Beneficiary Power to Veto Stock Sales. The IRS has ruled privately that a power in the beneficiary to veto proposed sales of stock by the trustee does not constitute a general power of appointment. Ltr. Rul. 9042048. 12. Power to Borrow, Pledge Trust Property, Dispose or Property and Contract With Trust. The IRS has ruled privately that a testamentary beneficiary-trustee’s power to borrow money, to pledge trust property as security, to renew indebtedness, to dispose of trust property, and to enter into any transaction with the executor of the decedent’s estate without the consent or approval of any interested person or court is not a general power of appointment. In that situation, the wife had a mandatory income interest in the trust, was a discretionary beneficiary of corpus within a HEMS standard, and served as co-trustee with her daughter. Ltr. Rul. 8942094. 13. Summary of Selection of Trustee Issues Regarding Administrative Powers. Make explicitly clear that all of the trustee powers are held in a fiduciary capacity. If any beneficiary has a mandatory income interest, require that income/principal allocations be made in a reasonable manner, and to be conservative, say that such allocations should be made by a co-trustee who is not a beneficiary or remainderman. If the trustee will be able to make a Section 104 discretionary power to allocate corpus to income, there must be a non-beneficiary trustee (or co-trustee) exercising that power. The beneficiary should not hold any incidents of ownership over life insurance on the

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beneficiary’s life. For the paranoid (in particularly sensitive situations), see Section III.C.4. for a listing of potentially troublesome administrative powers. D. Trustee Removal and Appointment Powers. 1. Overview; Analogy to Grantor Powers. If the power of the trustee to make distributions to a beneficiary is limited to a HEMS standard, and if the trustee is precluded from making distributions in satisfaction of his or own obligation to support a beneficiary, there is no estate inclusion problem for the beneficiary regardless who serves as trustee (ignoring restrictions that may be present under Section 2042 if the trust owns an insurance policy on the trustee’s life.) In those circumstances, it does not matter how much control the beneficiary keeps over other trustees. However, if the distribution authority of the trustee is not so prescribed, the ability of a beneficiary to remove and replace trustees could give the beneficiary a general power of appointment. Many of the appointment/removal issues that affect grantors also affect beneficiaries. There is a detailed discussion of this issue regarding removal and appointment powers retained by grantors in section II.B.5. of this outline, and much (but not all) of that discussion is relevant for trustee appointment powers held by beneficiaries. 2. If Beneficiary-Trustee Declines to Accept Office as Trustee. If a beneficiary is named as trustee, and if the beneficiary would have a general power of appointment because of dispositive powers of the trustee, the beneficiary will have a general power of appointment if he is the trustee, and as discussed in section III.A.1.a. of this outline, once the general power of appointment taint is cast, it is very difficult to ever get rid of that taint without gift or estate tax consequences. What if the beneficiary declines to serve as trustee before accepting office as trustee? That procedure apparently will not prevent the creation of a general power of appointment. However, the power holder may formally disclaim the power and not be treated as having released the general power of appointment, if the requirements of Section 2518 are satisfied. See section III.B.1.h. of this outline. The IRS ruled privately in Technical Advice Memorandum 9125002 that the mere fact that the named beneficiary-trustee died before the trust was funded and before accepting office as trustee did not prevent the beneficiary from having a general power of appointment. But cf. Rev. Rul. 74-492 (amount of elective

share that could have been acquired if the election had been made during the statutory period is not includable under §2014; “which the widow is considered to acquire only if she exercises her right to take it. The widow must accept the benefits of the state law through exercise of the personal right of election or else the inchoate right is, in effect, renounced by operation of law.”).

3. Power to Appoint Self as Trustee. If a beneficiary has the power at any time to appoint himself or herself as trustee or co-trustee (unless the other co-trustee has a substantial interest in the trust that is adverse), the beneficiary will be treated as holding the powers of the trustee. The regulations provide directly that a donee’s power to remove a trustee and appoint himself may be a power of appointment. Treas. Reg. § 20.2041-1(b)(1). 4. Power to Appoint Self as Trustee Under Limited Conditions That Have Not Yet Occurred. “[T]he decedent is not considered to have a power of appointment if he only had the power to appoint a successor, including himself, under limited conditions which did not exist at the time of his death, without an accompanying unrestricted power of removal.” Treas. Reg. § 20.2041-1(b)(1).

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5. Power to Appoint Co-Trustee to Exercise Tax Sensitive Powers. Trusts often include a savings clause, to provide that the beneficiary-trustee cannot exercise various dispositive powers that would cause tax problems, but to provide that the beneficiary-trustee can appoint a co-trustee to exercise that discretion. The IRS has approved a similar arrangement in private letter ruling 9036048. In that ruling, the decedent’s will named the surviving spouse as trustee of a bypass trust for the benefit of the spouse and descendants. The trust requires the surviving spouse to choose a special trustee in the event that the surviving spouse has a legal obligation to support any beneficiary under the bypass trust. The special trustee will have the exclusive power to make all decisions involving any discretionary distribution or allocation to such a beneficiary. The surviving spouse will not have the power to remove a special trustee. The ruling acknowledged the problem that would arise if the trustee could make distributions that would satisfy her legal obligations. (See section III.B.5. of this outline.) However, the IRS ruled that the procedure requiring the spouse to appoint a Special Trustee (of her choosing at that time) served to eliminate the problem. Cf. Matter of Shurley, 115 F.3d 333 (5th Cir. 1997) (power of beneficiary to appoint special trustees who could terminate the trust did not invalidate the spendthrift protection of the trust). 6. Power to Appoint Successor Trustee Other Than Self. A non-grantor beneficiary may name a successor trustee other than himself. The beneficiary, in that case, “never moves into a position of possessing the powers of the trustee and never has a voice in the determination of whether the power in the trustee will be exercised.” 3A Casner, ESTATE PLANNING § 12.0, at 84 (5th ed. 1986). 7. Power to Veto Appointment of Independent Trustee. The IRS has ruled privately that the power to veto the appointment of an independent trustee and the subsequent legal right to petition the court to select an independent replacement who is not a related or subordinate to any of the beneficiaries is not a general power of appointment. Ltr. Rul. 9741009. (The facts of that ruling are rather vague, and the beneficiary served as a co-trustee, so it is not clear why any power over the appointment of a successor to another co-trustee raises any Section 2041 issues. If there are any Section 2041 issues, they presumably still exist because the beneficiary serves directly as a co-trustee.) 8. Power to Remove and Appoint Successor Other than Self. If a trustee holds powers that would be treated as a general power of appointment if held by a beneficiary, will a beneficiary’s power to remove and replace the trustee with someone other than himself cause the beneficiary to have a general power of appointment? a. Power to Remove For Cause. If a beneficiary has the power to remove a trustee for cause and replace the trustee, the beneficiary does not have a general power of appointment. A power to remove a trustee only for cause is a power that is subject to a contingency that is beyond the control of the power holder. Therefore, such a power can be given to a beneficiary without concern that it will result in the trustee’s powers being imputed to the beneficiary. See Treas. Reg. § 20.2041-3(b), discussed in section III.B.1.h. of this outline. Cf. Ltr. Rul 9832039 (right to remove and replace trustee for cause did not trigger Section 2042). (However, if a grantor holds the power to remove and replace a trustee for cause, there may be at least theoretical concerns, because even contingent powers can still be taxable powers under Section 2036. Treas. Reg. § 20.2036-1(b)(3); see generally Moore & Powell, Millennium Schmimium: Is Your Tax Drafting Y2K Compliant? 34 ANNUAL UNIV OF MIAMI PHILIP E. HECKERLING INST. ON EST. PL. Fundamentals Program Materials (2000).)

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b. Power to Remove Without Cause. If the beneficiary holds the power to remove and replace the trustee without cause, there may be situations when the beneficiary would be power holder would be deemed to hold the powers of the trustee. If so, this would give the beneficiary a general power of appointment if the trustee can make distributions to the beneficiary that are not limited to HEMS or if the trustee can make distributions to a beneficiary who the trustee is obligated to support. Following the issuance of Rev. Rul. 79-353, 1979-2 C.B. 325, the IRS extended that analysis to removal powers held by beneficiaries. Ltr. Rul. 8916032. In Rev. Rul. 95-58, 1995-2 C.B. 191, the IRS ruled that Sections 2036 and 2038 are not triggered if a grantor holds a removal and appointment power as long as the grantor must appoint someone other than the grantor who is not related or subordinate to the grantor under Section 672(c). The IRS, in private rulings, has extended the same principle to Section 2041 with respect to powers of removal held by beneficiaries. E.g., Ltr. Ruls. 201432005, 200551020, 200213013, 200031019, 9735025, 9735023 & 9746007. The IRS granted a ruling in 2000 that is more liberal than Rev. 95-58, in that a beneficiary could remove and appoint a successor (including individuals who are beneficiaries). Ltr. Rul. 200024007. The ruling relied on a restriction in the trust agreement that prohibited any trustee from participating in any decision to pay or apply trust assets to himself or his issue, and provided that any such decision would be made by the other then acting trustees. In effect, the beneficiary could appoint anyone else, who could make distributions back to the beneficiary. One wonders if the IRS realized the impact of its ruling. Reliance on the ruling at the planning stage would seem unwarranted. c. Power to Remove and Replace Trustee—Section 2042. The principles of Rev. Rul. 9558 would appear to extend to the power of an insured to remove and replace a trustee who holds incidents of ownership over a policy on the insured’s life. See a detailed discussion of this issue in section II.B.5.h. of this outline. 9. Summary of Selection of Trustee Issues Regarding Removal and Appointment Powers. The beneficiary will have the powers of the trustee if the conditions have occurred giving the beneficiary the power to accept office as trustee or to appoint himself as cotrustee (unless the beneficiary formally disclaimed the right to become trustee within the required time.) If the conditions allowing appointment of the beneficiary as trustee have not yet occurred, he does not yet hold a general power of appointment. A beneficiary-trustee can have the power to appoint a co-trustee who would exercise tax sensitive powers. (To be very cautious, the instrument could stipulate that any such cotrustee would have to be an “independent trustee"—with some definition of that term. However, that should not be required—unless there is an extreme case of a beneficiary having an explicit prearrangement with whomever he appoints directing how the cotrustee’s powers will be exercised, and even there, the taxpayer could make arguments that the fiduciary responsibility of the appointed co-trustee should override any such informal “agreements.”) If a beneficiary has the right to remove the trustee and appoint himself, that beneficiary will be deemed to hold the powers of the trustee. If a beneficiary has the power to remove and appoint someone else—the IRS appears to recognize a safe harbor if the beneficiary must appoint someone who is not a related or subordinate party. If the power is retained to appoint a replacement who is a related or subordinate party, the taxpayer would argue, based on the Vak and Wall cases (see Section II.B.5.g. of this outline) that the fiduciary responsibility of any such successor would preclude the

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beneficiary from being deemed to hold any powers such appointee would have as trustee. E. Income Tax Issues. 1. Section 678—Income Taxed to Beneficiary As Owner Under Grantor Trust Rule. a. Issue. If a beneficiary of a trust serves as the sole trustee and has the authority to make distributions to himself, there is the possibility (perhaps remote if the distribution power is limited by an ascertainable standard) that the income of the trust will be taxed to the beneficiary under a grantor trust rule, regardless of whether distributions are actually made to that beneficiary. Whether there is an ascertainable standard exception is not clear. If the beneficiary serves as co-trustee and does not make discretionary distribution decisions by himself, Section 678 clearly does not apply. b. Statute. Section 678(a)(1) provides that an individual shall be treated as the owner of any portion of a trust with respect to which the individual has a power, exercisable solely by himself, to vest the corpus or income from the trust in himself. See Ltr. Rul. 8211057 (trustee-beneficiary with mandatory income/discretionary principal interest with $100,000 annual distribution cap taxable on income to that extent). c. Ascertainable Standard Exception Is Uncertain. There is no ascertainable standard in the statutory language of Section 678. Many planners, however, take the position that the trustee will not be taxed on trust income under Section 678 if the trustee’s discretion is subject to an ascertainable standard. The theory is that the statutory language requires that the trustee be able to vest the corpus or income in himself “solely by himself,” and the trustee is not making a determination “solely by himself” if he is making a distribution decision based on whether ascertainable standards are satisfied. The legislative history states that Section 678 would treat a person as an owner of the trust “if he has an unrestricted power to take the trust principal or income.” S. Rep. No.1622, 83d Cong., 2d Sess. 87 (1954) (emphasis added). The reference to an unrestricted power is consistent with case law under a predecessor provision to Section 678. See Funk v. Comm’r, 185 F.2d 127 (3d Cir. 1950) (trustee’s power to distribute income to herself for her “needs” did not cause trust income to be taxed to trustee as owner); Smither v. U.S., 108 F. Supp 772 (S.D. Tex 1952), aff’d, 205 F.2d 518 (5th Cir. 1953) (power to distribute income for support, maintenance, comfort and enjoyment; trustee not taxed on trust income as owner). In addition, there is one reported case that has addressed this issue after the adoption of Section 678, and it adopts an ascertainable exception approach. U.S. v. DeBonchamps, 278 F.2d 127, 130 (9th Cir. 1960) (held that grantor trust rules applied to determine tax effects of holder of life estate; life tenant did not have unrestricted power under state law to distribute corpus to self, but only for “needs, maintenance and comfort”; held that undistributed capital gains not taxed to life tenant). Private rulings from the IRS have been inconsistent. Compare Ltr. Rul. 8211057 (trustee-beneficiary with discretionary principal interest for “support, welfare and maintenance” taxable on income under Section 678) with Ltr. Rul. 9227037 (trusteebeneficiary with discretionary principal interest for “health, support and maintenance” held not taxable under Section 678). See also Ltr. Rul. 8939012 (trustee-beneficiary not

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taxable as owner of trust under Section 678; however exact distribution standard not clearly set forth in ruling). d. Effect if Beneficiary-Sole Trustee Appoints Co-Trustee. If a beneficiary initially serves as sole trustee and appoints a co-trustee, the beneficiary who was initially the sole trustee will still likely be taxed on the trust income under Section 678(a)(2). e. Distributions to Satisfy Trustee’s Support Obligation. The authority of a sole trustee to make distributions that would satisfy such person’s legal obligation of support will be taxed as income to the person only to the extent that such distributions are actually made. I.R.C. § 678(c). See Ltr. Rul. 8939012 (sole trustee not taxable under Section 678 where beneficiaries were trustee’s adult children and descendants to whom he owed no legal obligation of support). (If any such support distributions are actually made, the power holder is taxed under Sections 661-662—based on an allocation of DNI—rather than being treated as the owner of a portion of the trust. I.R.C. § 678(c).) f.

Effect of Disclaimer. Section 678 does not apply if the power holder renounces or disclaims the power within a reasonable time after the holder first became aware of its existence. I.R.C. § 678(d). See section III.B.1.h. of this outline for a discussion of the Section 2041 effects of a disclaimer.

g. Treating Crummey Beneficiary as “Owner” of Trust Under §678. In order to avoid gain recognition on a sale to a grantor trust, the grantor must be treated as wholly owning the assets of the trust. Theoretically, this may be endangered if the trust contains a Crummey withdrawal clause. However, recent private letter rulings reconfirm the IRS’s position that using a Crummey clause does not endanger the grantor trust status as to the original grantor. The Potential Problem. The IRS generally treats the holder of a Crummey power as the owner of the portion of the trust represented by the withdrawal power under Section 678(a)(1) while the power exists and under Section 678(a)(2) after the power lapses if the power holder is also a beneficiary of the trust. See Ltr. Ruls. 200011058, 200011054056, 199942037 & 199935046. The IRS’s position under Section 678(a)(2) as to lapsed powers may be questioned because that section confers grantor trust status following the “release or modification” of a withdrawal power. This arguably is not the same as the mere lapse of a withdrawal power. A “release” requires an affirmative act whereas a “lapse” is a result of a passive nonexercise of a power. Furthermore, the gift and estate tax statutes make a distinction between lapses and releases. (Sections 2041b)(2) and the 2514(e) provide that “the lapse of a power … shall be considered a release of a power.”) Despite this argument, the IRS clearly treats the beneficiary as an owner of the trust with respect to lapsed withdrawal rights. Observe that treating Crummey powerholders as owners under §678 can cause a complex reporting nightmare. There may be 20 Crummey powerholders, each of whom is treated as owning a portion of the trust. (There are no reported cases where the IRS has pursued Crummey powerholders for not reporting trust income.) h. IRS Has Reconfirmed Informal Rulings That Using Crummey Trust Does Not Invalidate “Wholly Owned” Status of Grantor. Section 678(b) generally provides that if grantor

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trust status is conferred on the grantor under Section’s 673-677 and on a beneficiary under Section 678, the grantor trust status on the original grantor will prevail. However, Section 678(b) literally applies only as to “a power over income” and a withdrawal power is typically a power to withdraw corpus. However, the 1954 Committee Reports make apparent that the language of section 678(b) contains a drafting error and that it was intended to apply to a power over income and corpus, similar to Section 678(a)(1). The committee reports relating to Sections 671 through 678 include the following statement: A person other than the grantor may be treated as a substantial owner of a trust if he has an unrestricted power to take the trust principal or income ... unless the grantor himself is deemed taxable because of such a power. H.R. Rep. No. 1337, 83d Cong., 2d Sess. 63 (1954); S. Rep. No. 1622, 83d Cong., 2d Sess. 87 (1954).

Despite arguments from the literal statutory language (the exception in section 678(b) refers to a power over income, but a Crummey withdrawal power is a power over corpus), various rulings have indicated that the grantor trust provisions will “trump” a section 678 power attributable to a person holding a Crummey withdrawal right that lapses. E.g., PLRs 200011054; 9309023; 9321050. (See also PLR 9141027, but in that ruling the spouse also had an inter vivos power of appointment of principal.) This issue was raised in a PLR request that was discussed by Jonathan Blattmachr at the 2005 Heckerling Institute and the IRS said (during discussions in 2004) that this issue was “in a state of flux.” A recent PLR held that where a Crummey withdrawal power was held by the grantor’s spouse, the trust was still a grantor trust as to the grantor “notwithstanding the powers of withdrawal held by Spouse that would otherwise make her an owner under §678.” PLR 200603040 & 200606006. Jonathan Blattmachr indicates that the IRS has informally confirmed that this issue is no longer “in a state of flux” with the IRS. This has been confirmed by a number of recently issued private letter rulings, which all concluded that the original grantor continued to be treated as the “owner” of the all of the trust under the grantor trust rules despite the existence of a Crummey clause in the trust. Ltr. Ruls. 200729005, 200729007, 200729008, 200729009, 200729010, 200729011, 200729013, 200729014, 200729015, 200729016, 200730011. In any event, the IRS can change its position from that taken in prior PLRs. If grantor trust treatment for the entire trust is really important, at least consider this issue in determining whether to use a Crummey withdrawal power. A message dated February 17, 2007 has been published that was sent from David Handler to Catherine Hughes (U.S. Department of Treasury) describing the problem of using a Crummey provision in a grantor trust and concluding that the issuance of private letter rulings does not solve the problem: However, we cannot rely on private letter rulings, as you know. This uncertainty has caused great headaches or inconvenience for many practitioners and their clients. Guidance confirming what the letter rulings have concluded would be most helpful.

Unfortunately, the IRS and Treasury Department has not acted on that request. The 2007-2008 IRS Priority Guidance Plan does not list this issue as one of the projects for the upcoming year.

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Even if the trust does continue as a grantor trust as to the original grantor, it is not clear what happens at the grantor’s death. Does the trust then become a grantor trust as to the Crummey beneficiaries under §678(a)? Just reading the statute says the lapsed powers come roaring back to life — and the trust is treated as owned by the Crummey power holders. There have been only two private rulings (and they arose out of one ruling: 9321050, revoking 9026036 on the §678 issue). The IRS initially ruled that the beneficiary would be treated as the owner. Several years later, the IRS revoked that position and said the beneficiary would not be treated as the owner-with no further discussion.) Perhaps the IRS was saying that no one could figure this out. Practically, the IRS apparently does not want to treat all of the Crummey powerholders as the owners, but cannot justify that position under its general interpretation of the statute. i.

“Beneficiary Controlled Trust” (Sometimes Referred to as “BDIT”). If the trust does not contain any provisions that would cause the original grantor to be treated as the owner of the trust for income tax purposes under the grantor trust rules, a beneficiary who has a withdrawal power over the trust may be treated as the owner of the trust for income tax purposes under §678. As discussed above, the IRS generally treats the holder of a Crummey power as the owner of the portion of the trust represented by the withdrawal power under Section 678(a)(1) while the power exists and under Section 678(a)(2) after the power lapses if the power holder has interests or powers that would cause §§671-677 to apply if such person were the grantor of the trust (and that is typically satisfied by the reference to §677 if the power holder is also a beneficiary of the trust). See Ltr. Ruls. 201216034, 200949012, 200011058, 200011054 through 200011056, 199942037, & 199935046. An advantage of the “beneficiary controlled trust” approach is that after the trust has been funded, the beneficiary might sell additional assets to the trust in return for a note. If the beneficiary is treated as the owner of all of the trust under §678 for income tax purposes, there would be no gain recognition on the sale. The trust would not be included in the beneficiary’s estate and future appreciation in the assets sold to the trust in excess of the low interest charge on the note would be removed from the beneficiary’s estate. The decision to transfer value to the trust would be an easy decision because the beneficiary is a discretionary beneficiary of the trust (and could hold a power of appointment with respect to the trust.) For example, a client’s parents might create a trust for the client, and contribute $5,000 to the trust, with a Crummey power that would lapse after 30 days (before any growth occurred). The beneficiary would be treated as the owner of the entire trust for income tax purposes under §678. Because the beneficiary never contributes anything to the trust, the trust assets would not be included in the beneficiary’s estate, the beneficiary could serve as the trustee of the trust, and the trust should not be subject to the beneficiary’s creditors if it contains a spendthrift clause. Furthermore, the trust could give the client a broad limited testamentary power of appointment. In many ways, this is a perfect estate planning vehicle for the client. If the client can build the value of the trust through special investment opportunities, for example, the client can build a source of funds that is available to the client (as a beneficiary) but that is not in the client’s estate for estate tax purposes and cannot be reached by the client’s creditors. Such leveraging might occur through sales to the trust after the lapse of the Crummey power. In order to provide a 10% (or more) “seeding” of the trust to support the note given by the trust, persons other than the grantor (such as the grantor’s spouse or

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a beneficiary) might give guarantees, paid for by the trust. (An advantage of having the grantor’s spouse give the guarantees is that if there is any gift element in the guarantee, that would not prevent having a fully grantor trust during the life of both spouses.) Sales to the trust may be able to take advantage of valuation discounts, and can accomplish an estate freeze by limiting the build-up in the client’s estate (that otherwise result from the assets that were sold to the trust) to interest on the note. Furthermore, if the trust gives the client a testamentary power of appointment, any gifts to the trust as a result of the IRS asserting that the sale price is insufficient would result in an incomplete gift, not subject to immediate gift taxes. (The trustee could then divide the trust into “exempt” and “nonexempt” portions if the trust has a typical provision authorizing the trustee to divide the trust into identical separate trusts; the incomplete gift portion would be included in the client’s estate at his or her subsequent death, but lifetime distributions to the client could first be made out of the non-exempt portion to minimize the estate tax liability.) The trust can deplete the client’s other estate assets to the extent that the client pays income taxes on the trust income out of other assets. The depletion aspect is not as dangerous as other grantor trusts where the grantor may be subject to paying larger income taxes than anticipated; in this situation, the client is also a beneficiary of the trust, so distributions may be made to the client to assist in making the income tax payments after the client has “burned” as much of his or her other assets as desired through the income tax payments. Richard Oshins, of Las Vegas, Nevada, refers to this as incorporating “a freeze, a squeeze, and a burn.” The freeze is the obvious freeze of future appreciation on assets acquired by the trust, the squeeze is taking advantage of valuation discounts, and the burn is depleting the client’s other assets in making the income tax payments. In order to make a substantial sale to the trust that has been funded with a relatively small amount by the client’s parents or other relatives, the planner may decide to use guarantees to support a large sale to the trust for a note and to have the trust pay fair value for the guarantees. For an excellent discussion of planning considerations, see Richard A. Oshins, The Beneficiary Defective Inheritor’s Trust (“BDIT”): Finessing the Pipe Dream, CCH Practical Strategies (Nov. 2008); Jonathan Blattmachr, Mitchell Gans & Alvina Lo, A Beneficiary as Trust Owner: Decoding Section 678, 35 ACTEC L.J. 106 (Fall 2009). (1) 2012 Letter Ruling. A 2012 private letter ruling was consistent with the prior rulings that have ruled that the trust is treated as owned by the Crummey power holder/beneficiary under §678. Ltr. Rul. 201216034. In that ruling the beneficiary had a non-fiduciary substitution power, and the ruling reasoned that the existence of the non-fiduciary substitution power constituted the requisite retained interest or power that would cause §675 to apply if the power were held by the grantor. That ruling, like many of the other rulings issued by the IRS acknowledging that §678 applies to the trust, involved a trust that held S corporation stock, and the ruling held that the trust was a qualified shareholder of the S corporation, because it is a grantor trust. The ruling appears to be wrong — because the existence of the beneficiary’s nonfiduciary substitution power causes the trust to be a grantor trust as to the original grantor (and §678(b) makes clear that the trust is not treated as owned by the power holder under §678(a) if the original grantor is treated as the owner). The IRS has made clear that third-party substitution powers (held by someone other than the grantor) cause the grantor trust rules to apply as to the grantor. Rev. Proc. 2007-45. (Letter Ruling 9311021 similarly concluded (apparently inadvertently and

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incorrectly) that a trust with a third party substitution power was a grantor trust as to the holder of the substitution power.) (2) IRS No-Ruling Position. There have been informal indications from the IRS that the IRS is likely to continue to give favorable §678 rulings for a trust that receives or purchases S corporation stock. The IRS will no longer issue §678 “comfort” rulings in other situations to trusts about to engage in leveraged transactions. The IRS formally announced in Rev. Proc. 2013-3 that it will no longer issue private rulings that the trust assets in this type of situation will be excluded from the beneficiary’s estate under §§2035, 2036, 2037, 2038 or 2042, that the sale will not be treated as a taxable gift under §2501, or that §2702 will not apply. This no-ruling position applies in situations in which the beneficiary meets the requirements of §678 to be treated as the owner of the trust and sells property to the trust for a note, and “the value of the assets with which the trust was funded by the grantor is nominal compared to the value of the property that is purchased.” Rev. Proc. 2013-3, §§4.01(48)-(52), (55), 2013-1 IRB 113 (Jan. 2, 2013). That no-ruling position has been continued in subsequent years. E.g., Rev. Proc. 2021-3, §§4.01(42), (49), (53), 2021-1 IRB 140. (3) Summary of Tax Risks. (i) There is a risk of estate tax inclusion under §§2036 and 2038 if the sale is not deemed to be a “bona fide sale for an adequate and full consideration.” Reporting the sale on a gift tax return that meets the adequate disclosure requirements may assist in providing cover as to this issue. (ii) If the seed gift is insufficient to support the note, having another trust guarantee the note in exchange for fees may be necessary. (iii) If such guarantees are unreasonably high compared to the net value of the trust, courts may view that as an indication that the sale is not a “bona fide” transaction for purposes of §§2038 and 2038. (iv) If the beneficiary is deemed to be the “transferor” of the property that is sold to the trust, the beneficiary’s creditors may be able to reach the trust assets. Therefore, creating the trust in a self-settled trust state may be advisable. (4) Selected Technical Issues. The IRS’s position under §678(a)(2) as to lapsed powers may be questioned because that section confers grantor trust status following the “release or modification” of a withdrawal power. This arguably is not the same as the mere lapse of a withdrawal power. A “release” requires an affirmative act whereas a “lapse” is a result of a passive nonexercise of a power. Furthermore, the gift and estate tax statutes make a distinction between lapses and releases. [Sections 2041b)(2) and 2514(e) provide that “the lapse of a power … shall be considered a release of a power.”] Despite this argument, the IRS clearly treats the beneficiary as an owner of the trust with respect to lapsed withdrawal rights. A further complication is that under §678(a), grantor trust treatment applies to “any portion” of a trust as to which the power of withdrawal exists and has been released while reserving control that would cause §§671-677 to apply if such person were the grantor of the trust. The regulations discuss the “portion” issue in Treas. Reg. §1.6712(e)(6) Ex. 4. In that example, the beneficiary holds an unrestricted power to withdraw “certain amounts contributed to the trust.” The example concludes that the beneficiary is treated as an owner of “the portion of [the trust] that is subject to the withdrawal power.” Some planners believe that the “portion” refers to a fractional interest rather than an amount, so that if all gifts are subject to withdrawal power by the beneficiary, the entire trust would be treated as owned by the beneficiary under

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§678. However, the term “portion” might refer to the amount that can be withdrawn by the beneficiary, which would exclude growth in the trust from the time of the contribution to the time of the release of the withdrawal right. Under that view, if the initial contribution of $20,000 is covered by a withdrawal power, but the trust is worth $100,000 at the beginning of year 2, only 20,000/100,000, or 20% of the trust would be treated as owned by the beneficiary in year 2. [Observe that under this approach, in all of the private letter rulings that have been issued treating the Crummey power holder as the owner of a trust owning S stock, there would no longer be a wholly grantor trust if there were any growth in the assets before the withdrawal power lapsed, which would cause the trust no longer to be a qualified S shareholder under the grantor trust exception. None of the S stock/Crummey trust PLRs have even hinted at that limitation. Furthermore, this approach would require revaluing Crummey trusts each year in order to determine the portion of the trust hat is attributable to the power holder and the portion that is attributable to the trust. It presents an administratively unworkable reporting requirement.] j.

Beneficiary Deemed Owner Trust (BDOT). The BDIT approach (described immediately above) uses withdrawal powers over the entire contribution to the trust and relies primarily on §678(a)(2) following lapses of the withdrawal powers. Under this approach, relatively small gift transfers (typically $5,000) are made to the trust so that the lapse of the withdrawal power does not result in the beneficiary being treated as having made a transfer to the trust, which would cause partial estate inclusion in the beneficiary’s estate. The practical problem with the BDIT is how to leverage a small $5,000 gift to a trust into a significant size through later transactions with the trust. (See paragraph m below for a further discussion of BDITs and potential planning concerns with BDITs.) Ed Morrow suggests another approach, in which the beneficiary has the right to withdraw an amount equal to all of the trust’s taxable income in any given year (from all of the trust assets) but does not have the right to withdraw the entire contribution to the trust. The approach relies primarily on §678(a)(1) because the beneficiary holds a withdrawal over taxable income each year. This approach does not have the limitation of allowing only small gifts to the trust; gifts of any size could be made to the trust because there is no concern of keeping the entire contribution within the “5 or 5” power amount. Mr. Morrow calls this a “beneficiary deemed owner trust (“BDOT”). For an outstanding summary and analysis of this approach, see Ed Morrow, IRC 678(a)(1) and the “Beneficiary Deemed Owner Trust” (BDOT), LEIMBERG ESTATE PLANNING NEWSLETTER #2516 (Sept. 5, 2017). Observe the highlighted words below in §678(a)(1): “A person other than the grantor shall be treated as the owner of any portion of a trust with respect to which: (1) such person has a power exercisable solely by himself to vest the corpus or the income therefrom in himself…” The BDOT approach is based primarily on the “OR income” phrase in §678(a)(1). The regulations governing the grantor trust rules (§§671-679) clearly provide that the reference to “income “unless specifically limited, refers to income determined for tax purposes and not to income for trust accounting purposes. Treas. Reg. §1.671-2(b). (In contrast, for purposes of the non-grantor trust provisions of Subchapter J (Parts A-D, F), a reference to income generally means trust accounting income. Treas. Reg. §1.643(b)-1.)

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In order for the beneficiary to be treated as the owner of the entire trust for income tax purposes under §678(a)(1), the withdrawal power must apply to all net taxable income during the year, including capital gains. If a trust agreement merely provides that the beneficiary may withdraw “income,” under state law principles that would generally refer to income determined for trust accounting purposes which would not typically include extraordinary dividends or capital gains. To cause the taxable income attributable to the corpus portion of the trust also to be treated as owned by the beneficiary, the withdrawal power must apply with respect to an amount equal to all of the net taxable income. Having the corpus portion of the trust being treated as owned by the beneficiary for income tax purposes is extremely important if the beneficiary wishes to sell assets to the trust and have the transfer treated as a non-recognition event under the reasoning of Rev. Rul. 83-12. Case law supports the conclusion that a power to withdraw taxable income attributable to trust principal, without the power to withdraw the principal itself, causes the powerholder to be taxable on the taxable income attributable to trust principal. Campbell v. Commissioner, T.C. Memo 1979-495 (beneficiaries had the power to cause the trustee to distribute capital gains; beneficiaries did not request and the trustee did not distribute the capital gains income to the beneficiaries, but they “were deemed to be the owners of the capital gains income” under §678(a)(1)). Private letter ruling 201633021 also supports this conclusion. In that ruling, trust #1 had the power to withdraw from trust #2 “any dividends, interest, fees and other amounts characterized as income under §643(b) of the Code” and the net short term capital gains and the net long term capital gains. Trust #1 did not have the power to withdraw principal of trust #2 beyond the taxable income. The ruling concluded that all of the taxable income of trust #2, including the net capital gains, were taxed to trust #1 under §678(a)(1). PLR 202022002 addressed the sale from a trust (Trust 1) to an irrevocable grantor trust (Trust 2) that is a grantor trust as to A. In the ruling, Trust 1 prohibits a distribution of “Shares,” but allows for a distribution of the proceeds from the sale of the Shares, and because the beneficiary had reached age 40, the beneficiary could withdraw the proceeds of the sale. A Subtrust of Trust 1 agreed to sell an LLC that held the Shares (the only asset of the Trust 1 Subtrust) to Trust 2 in return for cash and a promissory note. The IRS reasoned that the Trust 1 Subtrust was treated as owned by A under §678 for purposes of the sale even though A could only withdraw the proceeds of the sale and not the Shares or LLC prior to the sale. (This was somewhat similar to the situation in Rev. Rul. 85-13, in which a trust was treated as a grantor trust with respect to a sale to the grantor for an unsecured promissory note, which was treated as a borrowing by the grantor that triggered §675(3).) No ruling or case has previously addressed whether non-recognition treatment under the reasoning of Rev. Rul. 85-13 would be applied to transactions between a §678 trust and the beneficiary-deemed owner of the §678 trust. This ruling does not directly address that issue, but analogously ruled that “the transfer of the LLC interests to Trust 2 is not recognized as a sale for federal income tax purposes because Trust 2 and Subtrust are both wholly owned by A.” The ruling’s reasoning for applying Rev. Rul. 85-13’s non-recognition treatment to this §678 situation is as follows: Rev. Rul. 85-13 states that although A did not engage in a direct borrowing of the Corporation Z shares, A’s acquisition of the T corpus in exchange for the unsecured note was, in substance, the economic equivalent of borrowing trust corpus. Accordingly, under § 675(3), A

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was treated as owner of the portion of T represented by A’s promissory note. Further, because the promissory note was T’s only asset, A was treated as owner of the entire trust. Moreover, because A was considered owner of the promissory note held by the trust, the transfer of the Corporation Z shares by T to A was not recognized as a sale for federal income tax purposes because A was both the maker and owner of the promissory note. Citing Dobson v. Commissioner, 1 B.T.A. 1082 (1925), the ruling states that a transaction cannot be recognized as a sale for federal income tax purposes if the same person is treated as owning the purported consideration both before and after the transaction.

This reasoning does not necessarily extend to BDOTs, in which another party has the right to withdraw all income (including capital gains) from a trust, rather than having the ability to withdraw all trust assets (as was the case under the facts of Letter Ruling 202022002). In that situation, the party would not necessarily be treated as the owner of the entire trust, and the IRS might take the position that Rev. Rul. 85-13 applies only if the deemed owner is treated as the deemed owner of the entire trust. For a further discussion of structuring issues and risks for BDOTs and possible planning applications, see Item 16 of the Hot Topics and Current Developments Summary (December 2018) available at https://www.bessemertrust.com/insights/estate-planningcurrent-developments-and-hot-topics-final-for-2018. k. Sale of S Corporation Stock by Beneficiary to QSST. If a beneficiary consents to a qualified subchapter S trust (QSST) election, the beneficiary “is treated as the owner, for purposes of section 678(a), of that portion of the trust that consists of the stock of the S corporation for which the QSST election is made.” Reg. §1.1361-1(j)(8), referring to §1361(d)(1). Accordingly, the beneficiary is taxed on the K-1 income of the trust from the S corporation. Could the beneficiary also sell additional S stock in that same corporation to the trust and avoid having the sale treated as a taxable transaction? Presumably that is allowed because the beneficiary is treated as the owner of the portion of the trust holding the S stock — both before the sale and after the sale of additional S stock to the trust. (Rev. Rul. 85-13 said that a sale by the grantor to a trust that was not a grantor trust in return for a note without adequate security caused the trust to become a grantor trust and shielded that very sale from being a taxable sale. This seems to be an easier situation because the trust indeed is a grantor trust as to the S stock both before and after the sale.) However, note that the QSST regulations do not explicitly address whether a sale to the trust of additional S stock in the same company by the consenting beneficiary will be taxed as a sale by the beneficiary to the beneficiary’s grantor trust — and therefore non-taxable. The strategy has advantages over the sale to §678 trust described above because there is no $5,000 limit that might otherwise apply to contributions to “seed” the trust, there are no technical issues regarding the “lapse” or “partial release” of a power of withdrawal. Being able to have considerably more value in the trust prior to the sale assists in defending against potential §§2036/2038 arguments about the bona fides of the sale. If the beneficiary sells S corporation stock to the QSST in return for a note, it is imperative that the stock serve as collateral for the note. A QSST must distribute all net accounting income as determined under state law to the beneficiary, §1361(d)(3)(B), referring to §643(b). A sale of S stock to a QSST raises the question of whether distributions from the S corporation to the trust must be entirely distributed to the beneficiary or whether some portion could be used to make principal and interest payments on the note. The interest payments should be fine — because they reduce net

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accounting income that must be distributed to the beneficiary. Some portion of the payment may also be used to make principal payments, as summarized by Stacy Eastland at the 2013 Heckerling Institute on Estate Planning: The distributions on the purchased Subchapter S stock can also be used by the trustee of the QSST to retire the principal on the note, if the distributions are security for a note on which the QSST is the obligor. Compare the interaction of Secs. 502(b) and 504(b) of the Uniform Principal and Income Act. There may need to be an equitable adjustment between the principal and income of the trust when the distributions from purchased Subchapter S stock are used by the trustee of the QSST to retire principal of the debt used for that purchase, depending upon the interaction of Secs. 502(b) and 504(b)(4) of the Uniform Principal and Income Act. The fact that Subchapter S distributions are part of the security for the debt, and are used to retire the principal of the debt, does not disqualify the trust from being a QSST [citing Ltr. Ruls. 914005 and 200140046].

2. State Income Tax Issues. State income tax considerations are important in the selection of trustee analysis, because a determination of what state has jurisdiction to impose its state income tax on the trust will, in some states, depend on the residency of the trustee or where the administration of the trust occurs. The one thing that is consistent across the board regarding the state income taxation of trusts is inconsistency. There is a complex labyrinth of separate rules throughout the 50 states and the District of Columbia. Only nine states do not tax the income of trusts (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming). The remaining 42 states (including the District of Columbia) base the taxation of trusts on a variety of factors. See generally Richard W. Nenno, Reprise The State Taxation of Trust Income Give Years Later, 51ST UNIV. OF MIAMI PHILIP E. HECKERLING INST. ON EST. PL. ch. 15 (2017); ACTEC Study 6, State Taxation on Income of Trusts With Multi-State Contacts (2001); Gutierrez, The State Income Taxation of Multi-Jurisdictional Trusts – The New Playing Field, 36TH ANNUAL UNIV OF MIAMI PHILIP E. HECKERLING INST. ON EST. PL , ch 13 (2002). a. Brief Overview of State Taxation Approach. Grantor trusts are typically taxed to the grantor in his state of domicile. For non-grantor trusts, most states allow a deduction for distributions, and the distributed amounts are taxed to beneficiaries in their states of domicile. The undistributed income of trusts is taxed under the complex scheme of varying rules. Almost all states with a state income tax will impose their taxes on undistributed income of trusts that is from real estate or businesses located in the state (sometimes referred to as “source income”). (That can be a difficult determination for businesses which produce income in a variety of states.) Therefore, no matter whether a trust is a “resident trust” or a “nonresident trust,” undistributed trust income from real estate and businesses in the state will be taxed by that state. The remaining income is generally taxed based on where the trust is deemed to be a resident—and a wide pattern of residency rules have developed over the years in determining whether a trust is a resident trust or nonresident trust as to a particular state. After going through the steps described above, if two different states impose income tax on the same trust, most states allow some form of credit to the extent that other states impose an income tax on the same trust income (but the form of the credit varies dramatically).

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This issue is arising more frequently as (1) states are strapped for revenue and are getting more aggressive, and (2) beneficiaries and individual trustees are more mobile, which may have the effect of changing the tax situs. Beware of naming family members as trustee without considering whether the appointment could cause the trust to be subject to income tax in the state of the trustee’s residence. These issues are exacerbated by the trend of splitting up trustee functions among co-trustees, increasing the possible likelihood of having at least one co-trustee in a state that uses the trustee’s residence as a basis for taxing trusts. b. Resident vs. Nonresident Trusts. All of the 42 states including the District of Columbia that impose an income tax on trusts tax the undistributed income of a non-grantor trust as a “resident trust” based on one or more of the following five criteria: (1) if the trust was created by a resident testator (for a testamentary trust), (2) if the trust was created by a resident trustor (for an inter vivos trust), (3) if the trust is administered in the state, (4) if the trust has a resident fiduciary, and (5) if the trust has a resident beneficiary. Observe that the governing law of the trust is not one of those criteria (except in Louisiana; also in Idaho and North Dakota that is a factor considered along with other factors). A trust included in one of the first two categories is referred to as a “founder state trust” (i.e., the trust is a resident trust if the founder of the trust was a resident of the state). Based on the trend of recent cases (summarized below), most commentators believe that taxing a nonresident trust solely because the testator or settlor was a resident is probably unconstitutional. However, if that state’s court system is utilized, for example, because of a probate proceeding in that state, chances are better that the state does have the authority to tax the trust. For a very complete survey of the nexus rules in the various states, see the Bloomberg BNA Special Multistate Tax Report, 2017 Trust Nexus Survey, available at http://src.bna.com/tBG (published October 2017). For an outstanding analysis of the state trust taxing systems and the constitutional implications, see Richard W. Nenno, Reprise The State Taxation of Trust Income Give Years Later, 51ST UNIV. OF MIAMI PHILIP E. HECKERLING INST. ON EST. PL. ch. 15 (2017). (1) Residency of Decedent Creating Testamentary Trust. Sixteen states tax a trust solely because the testator lived in the state at death. (Therefore, if a decedent dies in one of those states, any testamentary trusts created by that decedent are forever taxed by that state.) Other states include the residence of the testator as a factor, in connection with other factors. For example, in New York a testamentary trust created by a New York decedent is a “resident trust” but an exemption treats some resident trusts as “exempt resident trusts” that are not subject to taxation in New York. (2) Residence of Settlor of Inter Vivos Trust. Twelve states tax trusts solely because the settlor lived in the state when the trust was created. Some other states consider the residence of the settlor in connection with other factors. Courts in various states have reached varying results as to the constitutionality of these statutes. States that base taxation solely on the residence of the settlor when the trust was created are

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particularly suspect on constitutional grounds (see Item Error! Reference source not found.). For residents of the states that base their taxation of trusts solely on the residency of the grantor, state income taxation is still an important issue in the selection of trustee process. If the instrument appoints a trustee from a state that taxes on the basis of administration or trustee residency, issues of dual taxation and multi-state credits arise. (a) New York Example. New York has a grantor/testator-resident statute for taxing trusts, treating as a “Resident Trust” any trust of which the testator was a New York resident on the date of death or was a New York resident on the date the inter vivos trust became irrevocable (or when the revocable trust was created if the trust is still revocable). N.Y. Tax Law §605(b)(3)(B)-(C). Even so, following the Mercantile-Safe Deposit and Taylor v. State Tax Commissioner cases, the New York Tax Commissioner issued regulations making clear that New York will not tax a trust that has no New York trustees, no New York sitused assets, and no New York source income. N.Y. Comp. Codes R. & Regs. Tit. 20 § 105.23(c). This exemption was subsequently codified. N.Y. Tax Law § 605(b)(3)(D)(i). A Resident Trust that is exempt from taxation under these exceptions is referred to as an Exempt Resident Trust. Accordingly, the selection of trustee for a trust created by a New York resident is a critical factor for determining if the New York income tax will apply to undistributed income from the trust. For example, if a Delaware bank is named as trustee and trust assets are located in Delaware, the undistributed trust income would not be taxed in New York or Delaware. (If the grantor wants a New York resident to control investments, consider creating a partnership and naming the New York resident as the general partner of the partnership and contribute the partnership interest to the trust with the Delaware trustee, but query whether New York might try to tax the trust on the theory that the general partner, who is a New York, resident is acting as a fiduciary?) This New York approach is mentioned because this approach is also relevant in almost half the states. The 2014-2015 New York budget bill made two substantive changes to how New York taxes income. First, New York residents must pay an accumulations distribution tax (which does not include capital gains) when an Exempt Resident Trust later makes distributions to New York residents, and imposes reporting requirements on the trustees of Exempt Resident Trusts. Second, the bill classifies incomplete nongrantor trusts as grantor trusts for New York and New York City income tax purposes (b) Throwback Rule for Trust Distributions. Even though undistributed income from an Exempt New York Resident Trust in New York is not subject to income tax in the year the income is received by the trust, distributions from the trust to a New York resident beneficiary after 2014 are subject to New York income taxes with respect to certain accumulations of trust income. This “throwback” tax will not apply to income that was accumulated in the trust either (i) before 2014, or (ii) before the beneficiary first became a New York resident. There is no interest charge on the throwback tax. Capital gains are not typically considered income for these purposes (if the capital gains are not included in distributable net income).

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California imposes a similar throwback tax. The New York State Bar Association Tax Section had requested that the throwback tax be delayed because of technical problems with the proposal and difficulties of incorporating the federal rules by reference. See Throwback Tax in New York Budget Plan Raise Concerns, NYSBA Tax Section Says, BLOOMBERG DAILY TAX REPORT (March 11, 2014).

(3) Administration in the State. Twelve states impose tax on the basis of administration in the state. Six other states apply this factor in combination with other factors. Accordingly, appointing a trustee who would be conducting a significant part of the administration in one of those states would subject the trust to income taxation in that state. Of the states that impose tax on this basis, only Oregon offers guidance as to what constitutes administration within the state. The other states offer no such guidance. What if the trust has co-trustees and only one co-trustee is in the state? (4) Residency of Trustee. Four states impose tax on the basis of the domicile of the trustee (or any co-trustee). Additional states impose tax on this basis when combined with other factors. If co-trustees are located in multiple states, the income may be pro-rated. For example, this is the approach in California. Cal. Rev. & Tax Code § 17743. Obviously, this is a very important fact to consider before appointing a trustee who is a resident of one of these states. (5) Residency of Beneficiary. Only four states impose tax on this basis (California, Georgia, North Carolina, and Tennessee). Two other states use this factor when combined with other connections. An example of a state that taxes on this basis is California. For example, if no trustee is a resident of California, the trust is taxed on California source income and that portion of non-source income that is to be distributed to resident noncontingent beneficiaries. Cal. Rev. & Tax Code § 17744. Various other states have similar provisions. While not typically done by fiduciaries, trustees might inquire annually specifically about the residence of all beneficiaries, in case a beneficiary moves to a state that uses this factor, causing the trust to owe income tax in that state. c. Constitutional Issues. (1) Pre-Quill (1992) History. Three older U.S. Supreme Court cases (all before 1947) have addressed constitutional issues of state taxation. Safe Deposit and Trust Company v. Virginia held that the Due Process Clause prohibits state taxation of a trust based on the residence of beneficiaries. Guaranty Trust Co. v. Virginia held that Virginia could tax resident beneficiaries on distributions they received from a nonresident trust. Greenough v. Tax Assessors of Newport held that the Due Process Clause did not prevent the city of Newport from imposing a personal property tax on a resident trustee of an otherwise nonresident trust. Eight state cases addressed the state taxation of trusts in the intervening years before the U.S. Supreme Court again spoke on the issue in 1992.

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(2) Quill (1992). The U.S. Supreme Court next spoke on the general issue in 1992, Quill Corporation v. North Dakota. Quill had nothing to do with the income taxation of trusts. It involved North Dakota’s attempt to collect use tax on catalog sales to North Dakota residents. The case held that the Due Process Clause minimum contacts test no longer required that a business have a physical presence in the state whereas the Commerce Clause substantial nexus test continued to require such a presence. Prior to Quill, the cases had focused on the Due Process Clause. Following Quill, cases also focus on the Commerce Clause. Quill has influenced state income tax cases that have been decided since 1992. (3) State Cases (1992-2019). State cases in 1997 (District of Columbia v. Chase Manhattan Bank) and 1999 (Chase Manhattan Bank v. Gavin) upheld state trust taxation against constitutional attacks under the Due Process and Commerce Clauses. Commentators have roundly criticized those District of Columbia and Connecticut cases. Nevertheless, they are the law in those two jurisdictions. A variety of state cases beginning in 2013 have suggested a shifting trend when state courts address the constitutional issue. Three state cases in 2013 found that Illinois (Linn v. Dep’t of Revenue), New Jersey (Kassner v. Division of Taxation), and Pennsylvania (McNeil v. Commonwealth of Pennsylvania) could not tax trusts merely because the settlor was a resident of those states when the trust was created. Also in 2013, a North Carolina opinion (Kaestner, discussed below) regarding this issue allowed the case to continue by rejecting the state’s motion for summary judgment. Several of these cases were affirmed by appellate courts in 2015. Minnesota found unconstitutional a statute providing that an inter vivos trust is treated as a resident trust if the grantor was a Minnesota resident when the trust became irrevocable (and the U.S. Supreme Court declined certiorari in 2019). William Fielding, Trustee of the Reid and Ann MacDonald Irrevocable GST Trust for Maria V. MacDonald, et al., v. Commissioner of Revenue. (4) Supreme Court-Credits for State and County Taxes From Other States. In Comptroller of the Treasury of Maryland v. Wynne, 575 U.S. 542 (2015), Maryland residents had taxable income from an S corporation that was sourced in several other states. They paid taxes to those states and sought a credit for the taxes paid against their Maryland state and county income taxes. They received a credit against their state income tax, but not the county level tax. This Supreme Court affirmed the Maryland Court of Appeals finding that the failure to provide the credit at the county level unconstitutionally discriminated against interstate commerce. The failure to provide the credit violates the dormant Commerce Clause by burdening out-of-state business with double taxation. (5) U.S. Supreme Court Weighs In, North Carolina Department of Revenue v. Kimberley Rice Kaestner 1992 Family Trust. In a 9-0 decision, the U.S. Supreme Court upheld lower court findings that the taxation of undistributed income from a trust by North Carolina solely on the basis of the beneficiaries’ residence in North Carolina violated the Due Process Clause, but the Court emphasized that its ruling was based on the specific facts of the case for the specific tax years in question. The first paragraph of the opinion is an excellent synopsis of the case and the Court’s holding.

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This case is about the limits of a State’s power to tax a trust. North Carolina imposes a tax on any trust income that “is for the benefit of” a North Carolina resident. N. C. Gen. Stat. Ann. §105–160.2 (2017). The North Carolina courts interpret this law to mean that a trust owes income tax to North Carolina whenever the trust’s beneficiaries live in the State, even if—as is the case here—those beneficiaries received no income from the trust in the relevant tax year, had no right to demand income from the trust in that year, and could not count on ever receiving income from the trust. The North Carolina courts held the tax to be unconstitutional when assessed in such a case because the State lacks the minimum connection with the object of its tax that the Constitution requires. We agree and affirm. As applied in these circumstances, the State’s tax violates the Due Process Clause of the Fourteenth Amendment.

North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust, 588 U.S. __ (2019)(Justice Sotomayor), concurring opinion (Justice Alito, joined by Chief Justice Roberts and Justice Gorsuch), aff’g Kaestner 1992 Family Trust v. North Carolina Department of Revenue, 814 S.E.2d 43 (N.C. June 8, 2018), aff’g 789 S.E.2d 645 (N.C. App. 2016), aff’g, 12 CVS 8740 (N.C. 2015). The Supreme Court concluded that the Kaestner Trust beneficiaries did not have the requisite relationship with the trust property to justify the state’s tax, but footnote 7 made clear that the Court did “not decide what degree of possession, control, or enjoyment would be sufficient to support taxation.” The Court pointed to various reasons that the mere residence of the beneficiaries in North Carolina does not supply the required “minimum connection” necessary to support state taxation of the trust. First, the beneficiaries did not actually receive any income during the years in question. Second, “the beneficiaries had no right to demand trust income or otherwise control, possess, or enjoy the trust assets in the tax years at issue.” The trustee had “absolute discretion” in deciding when, whether, and to whom distributions would be made. The Court emphasized that “Critically, this meant that the trustee had exclusive control over the allocation and timing of trust distributions.” Distributions could be made to one beneficiary to the exclusion of others, “with the effect of cutting one or more beneficiaries out of the Trust.” The trustee and not beneficiaries made investment decisions. A spendthrift clause prevented beneficiaries from assigning their interests in trust property to anyone. (Footnote 9 makes clear that the Court does not address whether the absence of a spendthrift clause would mean that the minimum contacts requirements for due process is satisfied.) While the trust agreement directed the trustee to be liberal in exercising its distribution discretion and the trustee could not act in bad faith or some improper motive, the beneficiaries still could not demand distributions or direct that Trust assets be used for their benefit. Third, the beneficiaries “could not count on necessarily receiving a specific amount of income from the Trust in the future.” While the trust was scheduled to terminate in 2009, the New York decanting statute allowed the trust to distribute to a new trust with a longer termination date, which the trustee in fact did. As a result of these facts, one might view the interests of the beneficiaries as “contingent” on the exercise of the trustee’s discretion. The Court in footnote 10 said that it specifically was not

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addressing “whether a different result would follow if the beneficiaries were certain to receive funds in the future.” In light of these three reasons, Kimberly and her children “had no right to ‘control or posses[s]’ the trust assets ‘or to receive income therefrom.’” “Given these features of the Trust, the beneficiaries’ residence cannot, consistent with due process, serve as the sole basis for North Carolina’s tax on trust income.” The decision is narrow in the sense that North Carolina may be unique in looking solely to the residency of a beneficiary, including a beneficiary whose interest is “contingent,” but the opinion does respect the fundamental character of trusts and recognizes the distinct interests and functions of the settlor, trustee, and beneficiaries. In addition the opinion implies that the Court’s recent opinion in South Dakota v. Wayfair, Inc. 585 U.S. __ (2018), will not have a major impact on the analysis of the constitutionality of state taxation of trusts. While the trend of cases over the last four years has been to find state taxation of trusts on various grounds to be unconstitutional (with most of those cases addressing systems that are based on the residency of the settlor of the trust), the Court goes out of its way to make clear that it is not addressing any of the other regimes for state taxation of trusts. The opinion provides minimal guidance as to the constitutionality of those various systems (or the North Carolina beneficiary-based system under other facts), but reiterates and applies traditional concepts that due process concerns the “fundamental fairness” of government activity and requires “minimum contacts” under a flexible inquiry focusing on the reasonableness of the government’s action. The opinion leaves open the possibility that states may be able to tax undistributed trust income based on a trust beneficiary’s residence in the state in certain situations (for example, possibly if the beneficiary received some income during the year in question, had the right to demand income from the trust during that year, or had a vested interest in ultimately receiving that trust income). The opinion points out in footnote 12 that the North Carolina beneficiary-based regime may be unique, leaving open the question of the constitutionality not only of the North Carolina regime in other fact situations but also the constitutionality of the other (possibly different) beneficiary-based state trust taxing systems. For example, one of the factors mentioned in Kaestner is that the resident-beneficiary was not assured of ultimately receiving the trust income. The Court in footnote 10 said that it specifically was not addressing “whether a different result would follow if the beneficiaries were certain to receive funds in the future.” For example, one of the factors that California uses in taxing the undistributed income of trusts is whether any “non-contingent” beneficiaries reside in California. Page 6 of the opinion addresses three taxing regimes that do pass the Due Process Clause’s “minimum contacts” requirement: (1) taxation of actual trust distributions to a state resident, Maguire v. Trefry, 253 U.S. 12, 16-17 (1920); (2) taxation based on the residence of the trustee, Greenough v. Tax Assessors of Newport, 331 U.S. 486 (1947); and (3) possibly taxation based on the place of administration (cases suggesting that is constitutional are Hanson v. Denckla, 357 U.S. 235, 251 (1958) (involving personal jurisdiction, not trust taxation, issues), and Curry v. McCanless, 307 U.S. 357, 370 (1939)). In addition, cases are clear that states can tax income that comes from sources within the state (sometime referred to as “source income”).

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(6) Summary of Constitutional Issues. To uphold state trust income taxation against a constitutional attack under the Due Process Clause, the taxing state must prove: •

The trustee has some definite link, some minimum connection, with the taxing state and income attributed to the state must be rationally related to values connected with the taxing state;

•

Physical presence in the taxing state is not required; and

•

Whether nonstatutory connections must be considered is unsettled.

To uphold state trust income taxation against a constitutional attack under the Dormant Commerce Clause, the taxing state must prove: •

The trustee has a substantial nexus with the taxing state (physical presence is not required);

•

The tax must be fairly apportioned, being internally and externally consistent;

•

The tax must be fairly related to services provided by the taxing state; and

•

The tax must not discriminate against interstate commerce.

(7) Approach While Awaiting Determination of Constitutionality. If a founder state attempts to tax the accumulated income of a trust just based on the founder’s residence when the trust was created or a beneficiary’s residence, what should the trust do? The most conservative approach is to pay the tax and request a refund based on the unconstitutionality of the tax. IV. SAVINGS CLAUSES TO AVOID ADVERSE TAX EFFECTS FOR GRANTORS, BENEFICIARIES AND TRUSTEES A. Significance of Savings Clauses Regarding Tax Effects For Grantors, Beneficiaries and Trustees. To avoid inadvertent adverse tax effects, consider using a “savings clause” to limit automatically any retained powers of the grantor, or of the beneficiary. While a primary dispositive provision may come within accepted ascertainable standard language, other provisions of the will may inadvertently change the result. For example, in Independence Bank Waukesha (N.A.) v. U.S., 761 F.2d 442, 443 (7th Cir. 1985), one paragraph of the will authorized distributions “for her own proper maintenance,” which would have been an ascertainable standard. However, it was nullified by more expansive powers in the next paragraph to use the assets “for whatever purpose she desires.” 761 F.2d at 442, 443, and 444. An excellent discussion of the various provisions that could be included in savings clauses to avoid adverse tax consequences with respect to powers that trustees may have is in Horn, Whom Do You Trust: Planning, Drafting and Administering Self and Beneficiary-Trusteed Trusts, 20TH UNIV. OF MIAMI PHILIP E. HECKERLING INST. ON EST. PL. ¶ 506 at p. 5-70 (1986). A number of states have statutes that automatically restrict standards for distributions from trustees to themselves as beneficiaries to a “health, education, support and maintenance” standard, so that the power if not a general power of appointment. E.g., TEX. PROP. CODE § 113.029 (2009). See Section III.B.4.m of this outline. Such laws have been recognized as effective to prevent a beneficiary from acquiring a general power of appointment. E.g., Sheedy v. U.S., 691 F. Supp. 1187 (E.D. Wis.

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1988). The court in a case involving whether §2036(a)(1) applied to a private annuity transaction appeared to conclude that the California statute limiting a trustee’s authority to distribute to herself to a health, education, maintenance and support standard was not relevant in the context of §2036(a)(1). Estate of Trombetta v. Commissioner, T.C. Memo. 2013-234 (“Petitioner failed to cite, and we have not found, any case in which a court has held that a State statute that limited the decedent’s authority to distribute income attributable to transferred property rendered that authority irrelevant in considering whether the decedent had retained a right to the income of the transferred property.”) B. IRS Recognizes Savings Clauses For Section 2041 Purposes. The IRS has recognized the effectiveness of savings clauses to avoid adverse tax results for grantors and beneficiaries. For example, one letter ruling concluded that the beneficiary-trustee did not have a general power of appointment because of this clause in the instrument: Restriction on exercise of power for fiduciary’s benefit. (a) Except as provided in subsection (b), a power conferred upon a person in his capacity as a fiduciary to make discretionary distributions of principal or income to himself or to make discretionary allocations in his own favor or receipts or expenses as between income and principal cannot be exercised by him. If the power is conferred on two or more fiduciaries, it may be exercised by the fiduciaries who are not so disqualified. If there is no fiduciary qualified to exercise the power, it may be exercised by a special fiduciary appointed by the court. Ltr. Rul. 7935015. Limits on using savings clauses to correct mistakes to exist, however. Belk v. Commissioner, 774 F.3d 221 (4th Cir. 2014) was not an estate or gift tax case but involved a violation of one of the substantive requirements to obtain a conservation easement. The taxpayer argued that a “savings clause” in the contribution agreement prohibiting any agreements that would cause the property to fail to satisfy §170(h) should make the taxpayer eligible for the charitable deduction. The court disagreed: Indeed, we note that were we to apply the savings clause as the Belks suggest, we would be providing an opinion sanctioning the very same “trifling with the judicial process” we condemned in Procter. 142 F.2d at 827. Moreover, providing such an opinion would dramatically hamper the Commissioner’s enforcement power. If every taxpayer could rely on a savings clause to void, after the fact, a disqualifying deduction (or credit), enforcement of the Internal Revenue Code would grind to a halt.

Belk suggests that savings clauses intended to protect against inadvertent or incidental violations will be respected, but not “save” transactions involving violations that go to the core of the transaction. See also TOT Property Holdings, LLC v. Commissioner, 127 AFTR 2d 2021-2420 (11th Cir. 2021). C. Miscellaneous Examples of Savings Clauses and Other Clauses Important to Achieve Tax Effects of Irrevocable Trusts. 1. Irrevocability. Any Trust created hereunder shall be irrevocable and shall not be altered, amended or revoked by the Settlor or by any other person. Any Trust created hereunder shall only be terminated in accordance with the provisions of this Agreement. 2. Fiduciary Powers Only.

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All powers given to the Trustee by this Agreement are exercisable by the Trustee only in a fiduciary capacity and no power given to the Trustee hereunder shall be construed to enable the Settlor or the Trustee or any person to purchase, exchange, or otherwise deal with or dispose of the principal or income therefrom for less than an adequate and full consideration in money or money's worth. 3. Settlor Prohibited From Serving as Trustee. At no time shall the Settlor be appointed Trustee (Co-Trustee or otherwise) of any Trust created under this agreement. Observe: Using this clause is not necessary if the trust has been carefully planned to avoid adverse tax consequences, as discussed in Section II of this outline. 4. Prohibit Distributions Satisfying Support Obligations of Settlor Or Trustee. Notwithstanding any other provision of this Agreement, no person serving as Trustee shall have the power or authority to distribute income or principal of a Trust in a manner that would (i) discharge such person's legal obligation to support a beneficiary of the Trust, or (ii) discharge the Settlor’s (or the Settlor’s spouse’s) contractual, support or other legal obligation. 5. Limitations on Beneficiary-Trustee as to Distributions, Termination, Estimated Taxes, and Life Insurance. Beneficiary Serving As Trustee and Independent Trustee. If an individual serving as Trustee of any trust created under this Agreement is a beneficiary of such trust, such individual shall be authorized to make distributions to himself or herself pursuant to the terms of such trust, but such individual shall not possess or exercise any powers with respect to, nor authorize or participate in any decision as to: (i) any discretionary distribution or any loan to or for the benefit of himself or herself or any other beneficiary, except to the extent that such distributions are limited to amounts necessary for the person’s health, maintenance, support and education; (ii) any discretionary distribution to any other beneficiary, if such distribution would discharge any of his or her legal obligations; (iii) the termination of such trust because of its small size, if such termination would result in a distribution to himself or herself or if the distribution would discharge any of his or her legal obligations; (iv) the treatment of any estimated income tax payment as a payment by such individual except to the extent that the payment is limited to an amount necessary for his or her health, maintenance, support and education; or (v) any action to be taken regarding an insurance policy held in such trust insuring the life of such individual unless such action is expressly authorized by other provisions of this Agreement. These decisions shall be made solely by the other then serving Trustee or Trustees of such trust (“Independent Trustee”). If such individual serving as Trustee desires to engage in any such prohibited action but no Independent Trustee is then serving for such trust, the currently acting Trustee may appoint the individual or entity next designated to act as Trustee as an Independent Co-Trustee of such trust; otherwise, upon written request of the currently acting Trustee, an Independent Co-Trustee of the trust shall be appointed by the Trustee Appointer. However, if an Independent Co-Trustee is appointed under these circumstances, the sole power and responsibility

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of the Independent Co-Trustee shall be to make decisions reserved to the Independent Co-Trustee. Insurance On Life Of Beneficiary Serving As Trustee. This Section shall apply whenever any trust created under this Agreement owns any interest in an insurance policy on the life of an individual serving as sole Trustee of such trust. Such Trustee must: (i) designate the Trustee of such trust as the beneficiary of the policy to the extent of such trust’s interest in the policy; (ii) continue to pay the premiums on such policy without using policy loans; and (iii) allow any policy dividends to reduce premiums. Upon termination of such trust, such Trustee must distribute the policy to the beneficiaries of such trust. Such Trustee shall not possess or exercise any other powers with respect to, or authorize or participate in any other decision as to, such policy. All other actions with respect to the policy shall be made solely by the other then serving Trustee or Trustees of the trust (“Insurance Trustee”). If such an individual serving as Trustee desires to engage in any such prohibited action but no Independent Trustee is then serving, then the currently acting Trustee may appoint the individual or entity next designated to act as Insurance Co-Trustee; but if no successor Trustee is designated, upon written request of the currently acting Trustee, an Insurance Trustee shall be appointed by the Trustee Appointer. If an Insurance Trustee is appointed, the only authority of the Insurance Trustee shall be to exercise the exclusive authority to make discretionary decisions as to the policy, including decisions to surrender or cancel the policy, borrow against the policy, and distribute the policy during the term of such trust. The intent of Settlor is that no Trustee will have any “incidents of ownership” over an insurance policy on the Trustee’s life within the meaning of Section 2042 of the Code. Observations regarding the Beneficiary Serving As Trustee and Independent Trustee clause: Clause (i) restricts distributions to the trustee except for HEMS to avoid inadvertent violations of Section 2041 generally and restricts any distributions to any other beneficiary of the trust except for HEMS to avoid Regulation § 25.2511-1(g)(2), as discussed in section III.A.4 of this outline. Clause (ii) restricts making any distributions that satisfies the trustee’s legal obligations to avoid the Upjohn issue, as discussed in Section III.B.5 of this outline. Clauses (iii) (small trust terminations) and (iv) (estimated tax payments) are included to avoid Section 2041—in case those powers might be held to constitute Section 2041 powers. Clause (v) is included to avoid having incidents of ownership in a policy on the trustee’s life, as discussed in section II.B.4.k.(2) of this outline. Observations regarding the Insurance On Life Of Beneficiary Serving As Trustee clause: This clause is also intended to avoid having incidents of ownership in a policy on the trustee’s life. It mandates certain actions with respect to the policy (such as naming the trust as the beneficiary and paying premiums), so that the trustee could take extremely routine actions with respect to the policy without having to appoint another co-trustee to take those actions. With respect to discretionary decisions, a co-trustee must be appointed to take those actions. 6. Jerry Horn’s “Short-Form” Savings Clause.

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(1) No particular Trustee shall possess, or participate in the exercise of, any power given the Trustee by this instrument or by law to make any determination with respect to (a) any payment or application which would discharge any legal obligation of such particular Trustee personally, or (b) any payment to, or expenditure for the benefit of, such particular Trustee personally (neither the preceding portion of this paragraph (1) nor any otherwise-applicable rule of law shall limit such particular Trustee’s possession or participation in the exercise of any power (or severable portion thereof) granted in this instrument to such Trustee to consume, invade or appropriate property for the benefit of such Trustee personally which is limited by an ascertainable standard relating to the health, education, support or maintenance of such Trustee personally.) Horn, Whom Do You Trust: Planning, Drafting and Administering Self and Beneficiary-Trusteed Trusts, 20TH UNIV. OF MIAMI PHILIP E. HECKERLING INST. ON EST. PL. ¶ 502.2 at p. 5-14 (1986). 7. Broad Comprehensive Catch-All Savings Clauses for Settlor and Beneficiary to Avoid Estate Inclusion and Grantor Trust Treatment. For a broad extremely comprehensive set of savings clauses to avoid estate inclusion and grantor trust treatment for grantors and to avoid estate inclusion for beneficiaries, see Appendix A for form clauses developed by Don Malouf and Alex Nakos, of Malouf Lynch Jackson Swinson, in Dallas, Texas. V. CREDITOR ISSUES A. Self-Settled Trusts. Self-settled trusts for the benefit of the settlor generally may be reached by the settlor’s creditors. For example, under the Texas spendthrift statute for self-settled trusts, the settlor’s creditors may reach “his interest in the trust estate.” TEX. PROP. CODE 112.035(d); Matter of Shurley, 115 F.3d 337 (5th Cir. 1997). A few jurisdictions have changed their statutes to allow creditor protection for the settlor if certain requirements are met. Under those statues, the settlor must merely be a discretionary beneficiary of the trust, and the trustee must be someone other than the settlor. In addition, to come within the protection of those statues, there must be a resident trustee from that state. B. Spendthrift Protection for Trust Beneficiaries. Texas and many other states recognize that an individual may establish a trust for a beneficiary that prevents the beneficiary from voluntarily or involuntarily assigning his interest. TEX. PROP. CODE § 112.035(a); First Bank & Trust v. Gross, 533 S.W.2d 93 (Tex. Civ. App.—Houston [1st Dist.] 1976, no writ). While there is a strong policy recognizing spendthrift trusts, there are limitations. The assets can still be reached by claims for federal taxes (U.S. v. Dallas Nat’l Bank, 152 F.2d 582 (5th Cir. 1945)), and by claims for reimbursement for expenses incurred for the legal support and maintenance of a beneficiary’s dependents, (TEX. FAM. CODE § 154.005, Lucas v. Lucas, 365 S.W.2d 372 (Tex. Civ. App.—Beaumont 1962, no writ), Kolpack v. Torres, 829 S.W.2d 913 (Tex. App.—Corpus Christi 1992, writ denied)). Some courts allow creditors of a beneficiary to reach trust assets that are distributable to the beneficiary for “necessities.” Erickson v. Bank of California, N.A., 643 P.2d 670 (Wash. 1982) (bankruptcy trustee could reach assets of spendthrift trust for bankrupt beneficiary’s necessities). The effectiveness of spendthrift trusts against claims of a beneficiary’s creditors may depend on various structural provisions for the trust.

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A trust that is recognized as a valid spendthrift trust under state law will also be recognized in bankruptcy. 11 U.S.C. § 541(c)(2). 1. Discretionary Trust. The strongest protection can be obtained by giving the trustee total discretion in making distributions to the beneficiary. Courts have held that spendthrift trusts which require distributions to be made for the support of the beneficiary may be reached by creditors for support-related debts, but creditors generally cannot seize assets of a spendthrift trust that allows the trustee to distribute property based solely on the trustee’s discretion. See Hildebrand, Asset Protection For Estate Planners, STATE BAR OF TEX. ADV. EST. PL & PROB COURSE (1995). The beneficiary of a discretionary trust cannot compel the trustee to pay him or to apply for his use any part of the trust property, nor can a creditor of the beneficiary reach any part of the trust property until it is distributed to the beneficiary. G. Bogert, The Law of Trusts and Trustees § 228 (2d ed. 1979). See e.g., Kolpack v. Torres, 829 S.W.2d 913, 915 (Tex. App.—Corpus Christi 1992, writ denied) (statute authorized court to award trust assets to pay beneficiary’s obligation to pay child support from spendthrift trust, but court could not direct such payment until legal obligation of beneficiary had been established). An IRS Internal Memorandum addresses how the federal tax lien applies to a trust that authorizes distributions to the taxpayers in the discretion of the trustee under ascertainable standards. ILM 200036045. The memorandum takes the position that a federal tax lien should attach to the right to receive payments necessary for the taxpayer’s proper health, maintenance, support and education, as determined by the trustee, and that an appropriate collection device would be a suit to foreclose the federal tax lien. A hybrid between a mandatory and discretionary trust is one that gives the trustee discretion, but provides that the trustee “shall consider that the primary purpose of the trust is to provide for the health, support, care, and maintenance of the beneficiary.” Id. A broad discretionary trust cannot be used, however, if the beneficiary is the trustee. The beneficiary-trustee would hold a general power of appointment under Section 2041 (if there is a broad discretionary standard not including detailed standards such as health, education, support and maintenance.) Furthermore, the creditor may be in a position to argue that the beneficiary has control over the trust and that the creditor should be able to reach it. Despite the traditional spendthrift protection that has been afforded to beneficiaries under a discretionary trust with an independent trustee, some commentators believe that there may be a trend in the law limiting the spendthrift protection to beneficiaries of even discretionary trusts: The best way to protect a beneficial interest is to give an independent trustee the ability to make discretionary distributions to the beneficiary. The Second Restatement takes the position that a beneficial interest cannot be attached by a creditor if the beneficial interest is discretionary [citing Restatement (Second) of Trusts § 155(1) (1959)]. Nor can the interest of a discretionary beneficiary be reached by a spouse or child for alimony or support by a creditor who provides necessary supplies or services to the beneficiary or by a governmental unit that may have a claim against the beneficiary [Id. § 157]. The nature of the interest provides the protection; a creditor cannot compel payment because the beneficiary cannot compel payment [Id. § 155 Comment b]. However, what is gained in creditor protection is lost in beneficiary control. The draft of the Third Restatement takes a dramatically different position with respect to the creditor protection available to a beneficiary of a discretionary trust. The Third Restatement

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provides that regardless of how the discretionary trust is worded, if the settlor's purpose is to provide for the beneficiary's needs, and if it is acceptable social policy that the beneficiary not be left without support, then the trustee would be subject to a general standard of reasonableness in determining whether a distribution should be made to a beneficiary [citing Restatement (Third) of Trusts § 60 Comment a (Tentative Draft No. 2, 1999)]. A beneficiary's need for support usually includes the needs of those who might be dependent on the beneficiary [Id.]. Thus, children, spouses and ex-spouses would be able to compel the trustee to make distributions to them in such an amount as would be considered equitable under the circumstances [Id.]. It is evident that a loss of creditor protection would occur in a discretionary trust if a dynasty jurisdiction adopts the new position of the Third Restatement. It is also important to note the Uniform Trust Code, as passed by the National Conference of Commissioners on Uniform State Laws on August 3, 2000, takes the same position as the Third Restatement regarding discretionary trusts. In fact, the Uniform Trust Code adopts nearly every position taken in the Third Restatement with respect to the manner in which trust assets can be protected from claims brought by a creditor against the beneficiary of a trust [citing Uniform Trust Code §§ 502-503 (2000), and observing that section 505(b) of the Uniform Trust Code differs from the position taken in the Third Restatement with respect to the creditor effects of withdrawal rights of beneficiaries]. Greer, The Alaska Dynasty Trust, 18 ALASKA L. REV. 253, 263-264 (2001).

2. Sprinkling Trust May Afford More Protection. “Ideally, the trust should give the trustee the power to ‘sprinkle’ trust property among more than one beneficiary (perhaps, the beneficiary and the beneficiary’s descendants), rather than limiting the trustee’s discretion to a single beneficiary.” Rothschild, Protecting the Estate from In-laws and Other Predators, 35TH ANNUAL UNIV OF MIAMI PHILIP E. HECKERLING INST. ON EST PL. ¶ 1707.3 (2001). 3. Allow Trustee to Change Beneficiary or “Hold-Back” Distributions to Maximize Protection. To be as conservative as possible where the settlor knows that a beneficiary has potential creditor’s claim that may be pursued against the trust, the trust may authorize an independent trustee or Trust Protector to change the beneficiaries of the trust at the trustee’s discretion. Alternatively, if the settlor wants to provide for mandatory distributions but also afford creditor protection to the beneficiary, the trust might use a “hold-back” provision, authorizing an independent trustee to withhold otherwise mandatory distributions if the trustee, in the exercise of its sole and absolute discretion should deem the distribution to be adverse to the beneficiary’s interest. Rothschild, Protecting the Estate from In-laws and Other Predators, 35TH ANNUAL UNIV OF MIAMI PHILIP E. HECKERLING INST. ON EST PL. ¶ 1707.16 (2001). In either of those situations, a third party trustee would be required. 4. Beneficiary as Trustee. a. Same Person as Sole Trustee and Sole Beneficiary. A restraint on alienation generally is ineffective where the same person is given both the entire legal and beneficial interest (i.e., sole trustee and sole beneficiary) under the doctrine of merger of the legal and equitable title. See 2A SCOTT & FRATCHER, THE LAW OF TRUSTS § 99. Therefore, if the sole trustee is also the sole beneficiary, the beneficiary’s creditors may be able to reach the property. However, some state merger statutes specifically address that this rule will not invalidate a spendthrift trust. Under the Texas statute, if the sole trustee-sole beneficiary is not the settlor and if the trust is a spendthrift trust, the trust shall continue to be valid and the court shall appoint a new trustee or co-trustee. TEX. PROP. CODE § 112.034(c).

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Typically, the merger doctrine does not apply, because there are remainder beneficiaries in most trusts that are different from the current beneficiary. In the unusual situation where a trust is created for one beneficiary that will pass to that beneficiary or his estate, the trust must not appoint the beneficiary as the sole trustee. b. A Beneficiary is Also Trustee. “Black-letter” trust law would suggest that the beneficiary-trustee’s creditors cannot reach the trust assets where the trustee is not the sole beneficiary. “If A holds upon a spendthrift trust for A and B, A’s interest, being an interest under the trust and not a legal interest merely, cannot be assigned by him or reached by his creditors.” 2A SCOTT & FRATHCHER, THE LAW OF TRUSTS § 99.3. The Restatement 2d of the Law of Trusts clearly takes the position that a beneficiary’s creditors cannot reach trusts with an ascertainable standard for “education and support” of the beneficiary. Restatement of the Law of Trusts, 2d §154. (However, that section does not specifically deal with a support trust of which the beneficiary is the trustee.) Some states have adopted the position, by statute or by case law, that creditors of beneficiary-trustees cannot reach trust assets that are subject to an ascertainable standard. See., e.g., N.C. GEN. STAT. §36A-115(b)(1); TEX. PROP. CODE §112.035(f)(1)(A)(ii); Athorne v. Athorne, 128 A.2d 910 (N.H. 1957). One commentator, citing those authorities, has concluded that “[t]he present law of most states, whether statutory or judicially created, does not allow a creditor of a beneficiary who is also a trustee to force a distribution which would then be attachable by the creditor.” Oshins & Riser, Scheffel v. Krueger: The Effectiveness of Statutory Spendthrift Trust Protection, TRUSTS & ESTATES (Oct. 2001). Despite the existing “black-letter law,” there is little in the way of strong authority saying that a trust beneficiary may also serve as trustee, and still be assured absolutely of relying on strong spendthrift protection. The Restatement (Third) of the Law of Trusts, takes the position in §60, Comment g that a creditor of a trustee-beneficiary can reach as much as the trustee-beneficiary could properly distribute to himself under the terms of the trust instrument. The Restatement gives the following illustrations: “9. S’s will leaves his residuary estate to his daughter D, as trustee, “to pay income or principal to or for the benefit of anyone or more of D, her children, and their issue in such amounts, if any, as the trustee deems appropriate and desirable for the particular beneficiary’s support, education, and care, taking account of the beneficiary’s other resources if and to whatever extent the trustee deems appropriate.” D’s creditors may reach the maximum amount of trust funds that she may, without abuse of her discretion, distribute to herself for the authorized purposes (see generally § 50), without reduction for other resources available to her for those purposes, but subject to a possible reservation the court may make for D’s actual support needs. 10. The facts are the same as in Illustration 9, except that T serves as co-trustee with D, and they together hold the discretionary power to determine trust distributions. The special rule of this Comment does not apply. The creditors may still attach D’s interest, absent a spendthrift restraint, but under the general rule of this Section.” Restatement (Third) of the Law of Trusts, §60, Comment g (2003).

Some of the cases that are sometimes cited as support for the position in the Restatement (Third) of Trusts have actually been decided based on the principle that a beneficiary’s creditors can reach assets of a trust that the beneficiary has complete control to withdraw. Despite the existence of distribution standards, courts in those cases have determined,

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under local law, that the beneficiary had the unfettered right to withdraw assets from the trust. For example, in Estate of Marcia Flood, N.Y. Law Journal (March 11, 1998). the decedent’s husband was co-trustee with decedent’s two children of a By-Pass Trust and Residuary Trusts created under Marcia Flood’s will. The will directed the trustees to make payments to the husband from the By-Pass Trust of “so much of the principal of such trust as he shall request for his support and maintenance and the education of our children.” The will also directed the trustees to make payments from the Residuary Trust to the husband of all the net income “together with so much or all of the principal as my husband may deem necessary for his health, support and welfare.” The court determined that under state law, a beneficiary’s right to invade corpus as he deems necessary for support and maintenance is absolute if the extent of the invasion is to be determined solely in the beneficiary’s own judgment. Also, a gift for support and maintenance at the beneficiary’s request or for health, support and welfare as the beneficiary deems necessary likewise confers on the beneficiary the right to demand distribution of the entire corpus. The court concluded: The spouse is entitled to distribution of the principal on demand and the creditors can reach his interest [Restatement of Trusts [Second], sec 161, illustration [2]). The will confers upon the spouse a general power of appointment which subjects the property to the claims of creditors. Id.

In Florida, the courts have stated that a creditor can reach the debtor’s interest in a spendthrift trust (even where the trust is created by a third party) if the debtor-beneficiary can exercise dominion over the trust property. See In re May, 83 B.R. 812, 814 (Bankr. M.D. Fla. 1988) (“A trust fails, under Florida law, where the beneficiary exercises absolute dominion over trust property. … Similarly, where the beneficiary has the right to require the trustee to convey trust property to him or her, the beneficiary has dominion and control over the trust res and the trust will fail as a spendthrift trust.”). Some bankruptcy cases have allowed creditors to reach a spendthrift trust because the beneficiary had control to obtain the trust assets. In re George McCoy, 274 B.R. 751 (N.D. Ill. 2002). In that case, the surviving husband was the trustee and primary beneficiary of a testamentary trust created under his wife’s will. The trust authorized the trustee, in its discretion, to pay so much of the assets as the trustee determines “to be required or desirable for his health, maintenance and support. The trustee need not consider the interests of any other beneficiary in making distributions to my spouse.” The court cited the Restatement (Second) of Trusts, for the proposition that “if the beneficiary can call for the principal or can take it as needed, the restraint on alienation is invalid.” The court reasoned that the use of the term “desirable” and the fact that the trustee did not have to consider the interests of other beneficiaries meant that the husband-trustee did not have “a sufficient restraint to prevent the beneficiary to receive the corpus.” The court interpreted the settlor’s intent as giving the surviving spouse complete dominion and control. (Interestingly, the court said it would have recognized spendthrift protection if the trust had omitted the word “desirable” in the standard for distribution.) Another case arose under Arizona law. In re Pugh, 274 B.R. 883 (2002). In that case, a mother created two separate trusts, one for the benefit of each of her son and daughter. Each child was named as sole trustee of his or her trust, but before any distributions could be made, the child had to appoint a co-trustee, and could not participate in any distribution decisions. The son appointed the daughter as the co-trustee of his trust, but

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the evidence showed that the trust bank account was exclusively controlled by the son (who became the debtor in the bankruptcy case.) The court determined that the daughter did not, in fact, act as trustee. The Arizona spendthrift statute provides that a spendthrift trust is invalid if the sole beneficiary is also the trustee, and the court allowed the son’s creditors to reach the trust assets. The Restatement position is raising significant concern among planners as to whether beneficiary-sole trustee trusts can be afforded protection from claims of the beneficiarytrustee’s creditors. Harris & Klooster, TRUSTS & ESTATES 37 (Dec. 2006). Despite the fact that some of the cases supporting the position of the Restatement (Third) of Trusts have actually been decided based on factors other than a beneficiary’s right as trustee to make distributions under an ascertainable standard, some commentators have raised questions about the result when a beneficiary-debtor is also the trustee. See Crowell, Asset Protection vs. Asset Collection, STATE BAR OF TEXAS ADV. EST. PL & PROB COURSE ¶ I.C.2 (1993) (“Query: what happens to a creditor’s claim when the debtor is both the beneficiary and the trustee?”). In reviewing the Pugh case (discussed above), Mr. Gideon Rothschild, of New York, draws the conclusion: “Always appoint a co-trustee who participates in discretionary decisions!” Steve Leimberg’s Asset Protection Planning Newsletter (May 1, 2002). Some commentators maintain that the beneficiary definitely should not serve as trustee if asset protection is important. Practitioners should generally avoid making the individual subject of asset protection planning a trustee of a trust, regardless of whether the individual created the trust or whether the trust was created for such individual by another party. Notwithstanding the fact that the trustee must govern himself or herself in accordance with fiduciary obligations, this situation raises the appearance of impropriety and may hinder the ability of a court to impartially consider the facts. Nelson, Asset Protection & Estate Planning Why Not Have Both? POWER OF ASSET PROTECTION ANNUAL WEALTH PROTECTION. CONF. (2002). It is still advisable to provide for the appointment of an independent trustee in an effort to foreclose any suggestion by the trustee/beneficiary’s creditors that the law should be otherwise or that the trust is, in fact, somehow a “sham.” Rothschild, Protecting the Estate from In-laws and Other Predators, 35TH ANNUAL UNIV OF MIAMI PHILIP E. HECKERLING INST. ON EST PL. ¶ 1707.4 (2001).

Mr. Rothschild suggests that a bank or trust company should be used as trustee in particularly sensitive situations: “Even where the trust is not self-settled, where maximum asset protection is needed, a bank or trust company can be named as trustee in lieu of an individual.” Id. The potential creditor concerns with having a beneficiary serve as trustee are particularly troublesome in a jurisdiction that has adopted the position taken in the Third Restatement of Trusts: At the other end of the continuum regarding beneficiary control, the beneficiary could serve as his own trustee, and he could be entitled to discretionary distributions limited to an ascertainable standard relating to the beneficiary's health, education, maintenance and support. This type of trust is sometimes referred to as a "beneficiary-controlled" dynasty trust. Care must be taken that the limitation (that distributions can be made only for the

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beneficiary's health, education, maintenance and support in the beneficiary's accustomed manner of living) is not interpreted as setting forth a standard that requires the trustee to make distributions to the beneficiary. In other words, the limitation should set forth only a ceiling, and not a floor, in which the range of discretion may be employed. The Second Restatement does not give the creditor more rights if a beneficiary has been named as the sole trustee of his trust [citing Restatement (Second) of Trusts § 152 Comment m (1959)], presumably because he would be subject to the same fiduciary standards (particularly those that might be owed to remaindermen) as would be applicable to an independent trustee. As previously mentioned, under the Second Restatement, only special claimants such as children, spouses and exspouses, providers of necessaries and governmental units would have a right to reach the interest of the beneficiary in satisfaction of their claims. The position taken in the Third Restatement differs markedly with regard to the rights of creditors against a beneficiary who is a trustee of his own trust. The Third Restatement's position is that spendthrift provisions are disregarded when the beneficiary is also the trustee. The result is that not only do the special claimants referred to above have a right to reach the beneficial interest, but any claimant can reach the maximum amount that the beneficiary could distribute to himself without the distribution being considered an abuse of discretion. The Third Restatement states any fiduciary position that the beneficiary occupies can be disregarded, and it describes the beneficiary's fiduciary rights as a limited form of ownership analogous to certain general powers. These rather harsh results do not apply if an independent co-trustee is appointed [citing Restatement (Third) of Trusts § 60 Comment g (Tentative Draft No. 2 1999)]. In jurisdictions where a current beneficiary cannot serve as sole trustee without leaving the trust vulnerable to creditor claims, it would be desirable to name an independent co-trustee who would be solely responsible for distributions. Greer, The Alaska Dynasty Trust, 18 ALASKA L. REV. 253, 272 (2001).

A strategy suggested by various commentators would be to name two trustees—the primary beneficiary as the investment trustee, and another person (perhaps a friend of the beneficiary) as a distribution trustee. The primary beneficiary might even be given the power to remove and replace the distribution trustee. Oshins & Riser, Scheffel v. Krueger: The Effectiveness of Statutory Spendthrift Trust Protection, TRUSTS & ESTATES (Oct. 2001). Mr. Greer indicates that “[t]he right to remove and replace the independent trustee could continue to be given to the beneficiary, provided the beneficial interest is not wholly discretionary but is limited to an ascertainable standard. However, it is preferable for both tax and creditor protection purposes to give the beneficiary the power to remove the independent trustee only ‘for reasonable cause,’ as defined in the trust document.” Greer, The Alaska Dynasty Trust, 18 ALASKA L. REV. 253, 274 (2001). The Uniform Trust Code originally did not address this issue. Section 504 was revised to provide that if the trustee’s discretion to make distributions for the trustee’s own benefit is limited by an ascertainable standard, a creditor may not reach or compel distribution of the beneficial interest except to the extent the interest would be subject to the creditor’s claim were the beneficiary not acting as trustee. The Comment to the revised section 504 observes that trusts are commonly drafted to give the trustee the power to make discretionary distributions of income and or principal to the trustee, limited by an ascertainable standard to prevent estate tax inclusion. The drafting committee’s position was that “adoption of the Restatement rule would unduly disrupt standard estate planning and should be limited.” See generally Kenneth Kingma, A Beneficiary Serving as Trustee May Affect Asset Protection, 38 EST. PL. 22 (April 2011) (discussion and chart of states’ treatment of UTC §504(e)).

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Some states are amending their spendthrift trust laws, in light of concerns raised by Comment g to §60 of the Restatement Third of Trusts to provide that a beneficiary is not considered a settlor for spendthrift trust purposes merely because the beneficiary has the right to distribute trust assets to himself under an ascertainable standard. E.g., TEX. PROP. CODE §112.035(f); Illinois 735 ILCS 5/2-1403. A variety of states have adopted their own versions of revised section 504 of the Uniform Trust Code. E.g., FL. TRUST CODE § 736.504(2). Some states are adopting statutes that negate the ability of a creditor to attach trust assets due to a discretionary income tax reimbursement clause. E.g., NY EPTL 7-3.1(d). C. Summary of Selection of Trustee Issues With Respect to Creditors Rights. If the settlor wishes to create a self-settled spendthrift trust, he will need to create the trust under the laws of one of the few states that have statutes recognizing spendthrift protection for self– settled trusts. Those statutes require using a trustee who resides in that state. (Even then, is not clear that courts in the settlor’s state of residence will recognize the spendthrift protection of the other state with respect to claims brought in the courts of the state of residence.) To create spendthrift protection for beneficiaries other than the settlor, the law is unclear as to whether the beneficiary can be assured of spendthrift protection if he serves as the trustee with the ability to control distributions to himself. A creditor would be able to force the trustee to make distributions that the beneficiary, in his individual capacity, could compel. Whether creditors could compel distributions where the trustee is authorized to make distributions under an ascertainable standard is not clear. If creditor protection is important, to be conservative, a trustee other than the beneficiary should control distribution decisions to the beneficiary. However, it is certainly possible that a court would recognize spendthrift protection where the beneficiary is the trustee with an ascertainable distribution standard. In situations where creditor protection is not an immediate concern, the planner may, in weighing the issues, decide to name a beneficiary as trustee or cotrustee, but impress upon the beneficiary that he or she should resign as trustee as soon as possible when the beneficiary realizes that there may potentially be creditor issues in the future. (The beneficiary cannot wait too long in resigning, or else the creditor may raise arguments that the act of resigning is effectively a transfer in fraud of creditors rights under the Fraudulent Transfer Act, and that the creditor should still be able to reach the trust assets.) An alternate approach, to be conservative, would be to provide for the beneficiary to serve as the “investment co-trustee” and to name a third party as the “distribution co-trustee” (and perhaps even give the beneficiary the power to remove and replace the “distribution co-trustee,” which some commentators would include only if distributions were subject to an ascertainable standard.)

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APPENDIX A Broad Comprehensive Catch-All Savings Clauses for Settlor and Beneficiary to Avoid Estate Inclusion and Grantor Trust Treatment The author expresses appreciation to Don Malouf and Alex Nakos, of Malouf Lynch Jackson Swinson, in Dallas, Texas for permission to include these comprehensive savings clauses: Restrictions on Trustees. Notwithstanding any other provision of this Agreement (including, but without limitation, any power specifically conferred upon a Trustee hereunder), no Trustee shall ever participate as a Trustee of any Trust hereunder in (i) the exercise, or decision not to exercise, any discretion over payments, distributions, applications, uses or accumulations of income or principal to or for the benefit of a beneficiary or for such Trustee personally (including, but not limited to a payment, distribution, application or use of Trust property in discharge of such Trustee’s legal obligations), unless the exercise or nonexercise of such discretion is limited by an ascertainable standard relating to the beneficiary or Trustee’s health, education, support, or maintenance, (ii) the exercise or decision not to exercise any power conferred on the Trustees under Section ____ (dealing with merger of trusts), and Section ___ (dealing with change of situs) or (iii) the exercise of any general power of appointment described in Section 2041 of the Code. If any Trustee (in his individual capacity) is under a duty to support a beneficiary or is acting as a guardian, conservator or committee of any individual who is a beneficiary, such Trustee shall not participate in the exercise, or the decision not to exercise, any discretion over payments, distributions, applications or uses of Trust property to or for the benefit of a beneficiary in discharge of any obligation of support of such Trustee (in his individual capacity). The preceding sentence shall not restrict the Trustee from being able to make distributions to himself as a beneficiary for his health, education, support or maintenance. No Trustee shall participate in the exercise of any discretion (including, but without limitation, any discretion which would constitute an “incident of ownership” within the meaning of Section 2042(2) of the Code) with respect to any insurance policy on his or her life held hereunder. In each case, the determination of the remaining Trustees or Trustee shall be final and binding upon the beneficiaries of such trust. No individual shall serve as Trustee of any Trust which holds property with respect to which such individual has made a qualified disclaimer within the meaning of Section 2518 of the Code. In addition, notwithstanding any other provision of this Agreement (including, but without limitation, any power specifically conferred upon a Trustee hereunder), no Trustee shall possess any power that would cause the Grantor to be treated as owner of any portion of the Trust under Sections 671-677 of the Code or that would cause any portion of the Trust assets to be includible in the gross estate, for federal estate or state death tax purposes, of the Grantor or the Primary Beneficiary, or of any Trustee. No powers of any Trustee enumerated in this Agreement, or now or hereafter conferred upon Trustees generally, shall be construed to enable the Grantor or any other Person to purchase, exchange, or otherwise deal with or dispose of all or any part of the principal or income of any Trust for less than an adequate consideration in money or money’s worth, or to enable the Grantor to borrow all of any part of the principal or income of any Trust, directly or indirectly, without adequate interest or without adequate security, or to allow any Person to exercise a power of administration (as described in Section 675(4) of the Code) over

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this Trust in a nonfiduciary capacity without the approval or consent of any Person in a fiduciary capacity. Powers of Independent Trustee. Except to the extent specifically provided otherwise in this Agreement, the Independent Trustee shall have (i) the powers enumerated in this Section ___and (ii) any power not expressly granted to one or more Trustees and/or an Investment Manager in this Agreement to the extent such power is substantially similar to the types of powers expressly enumerated in this Section ___. (1) Apportionment of Income and Expenses. Where not otherwise clearly provided by law or otherwise set forth herein, the Independent Trustee shall have the power to determine with finality, as to each sum of money or other thing of value held or received by any Trustee, whether and to what extent the same shall be deemed to be principal or to be income, and as to each charge or expense paid by any Trustee, whether and to what extent the same shall be charged against principal or against income, including, without hereby limiting the generality of the foregoing language, power to apportion any receipt or disbursement between principal and income and to determine what part, if any, of income is available for distribution according to the terms hereof, and what part, if any, of the actual income received upon a wasting investment, or upon any security purchased or acquired at a premium, shall be returned and added to principal to prevent a diminution of principal upon exhaustion or maturity thereof; and to set up such reserves out of principal or income as the Independent Trustee shall think fit. (2) Management of or Division into Shares or Separate Trusts. To hold, manage, invest, and account for the several shares or separate Trusts which may be held in trust, either as separate funds or as a single fund, as the Independent Trustee shall think fit; if as a single fund, to make division thereof only upon the books of account, to allocate to each share or Trust its proportionate part of the principal and income of the single fund, and to charge against each share or Trust its proportionate part of the common expenses. In addition, the Independent Trustee shall have the power to divide any Trust established by this Agreement into separate identical shares or Trusts if the Independent Trustee determines that doing so may be advantageous for tax or other reasons. (3) Method of Distribution or Division. In dividing the Trust estate into separate shares or trusts, or in distributing the same, to divide or distribute in cash, in kind, or partly in cash and partly in kind, using different properties according to their fair market values or undivided interests in the same property, as the Independent Trustee shall think fit for any purpose. The reasonable and good faith determination of the fair market value of the Trust estate or any part thereof shall be conclusive and binding on all parties. (4) Use or Occupancy of Trust Property. To allow any of the following Persons to use or occupy any Trust property without payment of rent or other remuneration: (a) Any beneficiary; (b) With regard to any residential property occupied by a beneficiary, the spouse or significant other of the beneficiary and any descendants of the beneficiary;

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(c) With regard to any residential property occupied by a beneficiary, any individual appointed by a court of competent jurisdiction and qualified to serve as the guardian of the person of such beneficiary; and (d) With regard to any residential property occupied by a beneficiary, the spouse or significant other of the individual appointed by a court of competent jurisdiction and qualified to serve as guardian of the person of such beneficiary. (5) Termination of Small Trust. Notwithstanding any provision of this Agreement, to terminate any separate Trust established by this Agreement whenever in the Independent Trustee’s opinion such Trust is so small in value that the administration thereof is no longer economically advisable. In making this determination, the Independent Trustee is requested to take into consideration the financial and special advantages to the beneficiary or beneficiaries of continuing the Trust estate. In the event of a termination, the Independent Trustee shall distribute the remaining Trust assets to the then income beneficiary or beneficiaries, per stirpes. The Independent Trustee’s judgment shall be final and binding upon all interested parties, and distribution of Trust assets in any manner provided in this Agreement shall relieve the Trustee of any further responsibility with respect to such assets. (6) Generation-Skipping Transfer Taxes and Payment. If the Independent Trustee considers any distribution or termination of any interest hereunder as a distribution or termination subject to a generation-skipping transfer tax, the Independent Trustee is authorized: (a) To augment any taxable distribution by an amount which the Independent Trustee estimates to be sufficient to pay that tax and to charge the same to the particular Trust or share to which the tax relates without adjustment of the relative interests of the beneficiaries; (b) In the case of a taxable termination, to pay the tax from the particular Trust or share to which the tax relates, without adjustment of the relative interests of the beneficiaries. If the tax is imposed in part by reason of the Trust property hereunder and in part by reason of other property, the Independent Trustee shall pay only the portion of the tax which the Independent Trustee determines in good faith to be attributable to the taxable termination hereunder, taking into consideration deductions, exemptions, credits and other factors which the Trustee deems advisable; and (c) Subject to the limitations of the rule against perpetuities to postpone final termination of any particular Trust and to withhold all or any portion of the Trust property until the Independent Trustee is satisfied the Trustee and the Trust no longer have any liability to pay any generation-skipping transfer tax with reference to the Trust or its termination. (7) Assistance to Certain Estates. The Independent Trustee may, in its sole discretion, utilize the principal of any Trust as set forth in this paragraph, and

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any payment made in the bona fide belief that it is pursuant to this paragraph shall be binding upon all beneficiaries: (a) Investments. To purchase and to retain as investments any property, real or personal, belonging to the estate of the Primary Beneficiary. (b) Loans. To make loans to the Executor of the Primary Beneficiary’s estate on such terms as the Trustee deems advisable. Renouncement of Interest by Grantor. Notwithstanding any other provision in this Agreement, no part of the principal or income of any Trust established herein shall ever revert to or be used for the satisfaction of legal obligations of the Grantor, and no income of any Trust established herein shall be applied to the payment of premiums of insurance on the life of the Grantor (or the Grantor’s spouse, if any) without the prior written approval of all of the then income beneficiaries of such Trust. The Grantor renounces for himself and his estate any interest, either vested or contingent, including any reversionary right or possibility of reverter, in the principal and income of the Trusts, and any power to determine or control, by alteration, amendment, revocation, termination, or otherwise, the beneficial enjoyment of the principal or income of the Trusts. Independent Trustee. Any original or successor Independent Trustee appointed pursuant to this Section __ shall be either (i) any Person other than (x) the Grantor, (y) any beneficiary, or (z) any Person who is “related or subordinate” (within the meaning of Section 672(c) of the Code) to either the Grantor or any beneficiary or (ii) any corporate fiduciary.

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APPENDIX B Twenty Things You Have to Know About Selecting Trustees and Structuring the Powers of Trustees Steve R. Akers Bessemer Trust Copyright © 2021 by Bessemer Trust Company, N.A. All rights reserved. PROBING NON-TAX ISSUES 1. Probe the appropriate selection of trustee for non-tax factors in our role as counselor. DONOR ISSUES GIFT TAX 2. Plan whether or not the transfer to the trust should be a completed gift. ESTATE TAX 3. If the goal is to keep the asset out of the donor’s estate, do not allow the donor to be a beneficiary, unless the trust is in a “self-settled trust” jurisdiction. 4. Be careful with having the donor serve as trustee if the donor has powers over distributions. 5. If the trustee’s powers over distributions are not limited by a fixed determinable standard, prohibit any possibility of the donor becoming trustee or co-trustee. 6. The donor can serve as trustee if there is a determinable external standard on distributions. 7. The donor can have administrative powers as trustee as long as the powers are subject to court control and fiduciary duties. 8. Do not give the donor-trustee either of two prohibited powers. 9. The donor can have broad trustee appointment and removal powers. INCOME TAX 10. Avoid having foreign persons as ½ or more of the trustees. 11. Avoid or trigger the grantor trust rules, as desired. BENEFICIARY ISSUES GIFT TAX

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12. If the beneficiary is trustee, use an ascertainable standard on distributions to OTHER beneficiaries. ESTATE TAX 13. Limit the beneficiary from serving as trustee if distributions to the beneficiary are not limited by an ascertainable standard. 14. The beneficiary can be given the authority as trustee to make distributions to himself or herself if there is an ascertainable standard on distributions. 15. Restrict the trustee from making distributions that would satisfy the trustee’s legal support obligations. 16. The beneficiary may have broad powers to appoint and remove trustees (like the donor). INCOME TAX 17. Having a beneficiary as sole trustee MAY result in grantor trust treatment as to the beneficiary. 18. Determine if the appointment of a trustee in another state will avoid or cause state income taxation on undistributed trust income and gains. MISCELLANEOUS ISSUES 19. Use a Savings Clause 20. Be wary of having a beneficiary as trustee with the authority to make distributions if there are any creditor concerns for the beneficiary.

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section 06

Estate Planning Current Developments October 2021

Steve R. Akers

Ronald D. Aucutt

Kerri G. Nipp

Senior Fiduciary Counsel Bessemer Trust 300 Crescent Court Suite 800 Dallas, TX 75201 214-981-9407 akers@bessemer.com www.bessemer.com

Senior Fiduciary Counsel Bessemer Trust 703-408-3996 aucutt@bessemer.com

Fiduciary Counsel Bessemer Trust 300 Crescent Court Suite 800 Dallas, TX 75201 214-245-1423 nipp@bessemer.com 323

Table of Contents Introduction ....................................................................................................................................................... 1 1. Summary of Top Developments in 2020 .................................................................................................... 1 2. Legislative Developments .......................................................................................................................... 1 3. Corporate Transparency Act Overview ..................................................................................................... 29 4. Planning for IRA and Retirement Plan Distributions Under the SECURE Act ............................................. 30 5. Administrative Guidance Regarding 2017 Tax Act Changes ...................................................................... 35 6. Treasury-IRS Priority Guidance Plan and Miscellaneous Guidance From IRS............................................. 37 7. Estate Planning for Moderately Wealthy Clients ....................................................................................... 44 8. Transfer Planning for Clients Who Want to Make Use of the Increased Exclusion Amounts But Do Not Want to Make Large Gifts (or At Least Don’t Want to Lose Access); Flexibility to “Undo” Transfers ....... 45 9. Using Trust Protectors for Flexibility Considering Legislative Uncertainty ................................................. 51 Items 10-18 Discuss Transfer Planning Alternatives to Minimize Risk of Gift Taxes Due to Retroactive Gift Tax Legislation. ...................................................................................................................................... 54 10. Formula Gifts Up to the Exclusion Amount ............................................................................................... 54 11. Transfer to Inter Vivos QTIPable Trust ...................................................................................................... 56 12. Transfer to Trust With Disclaimer Provision Causing Reversion to Donor ................................................. 63 13. Combinations of Alternatives.................................................................................................................... 67 14. Sale for Note, Leaving Ability Later to Forgive Part of Note ...................................................................... 67 15. Rescission of Part of Gift After Gift Exclusion Amount is Decreased Retroactively ................................... 68 16. Defined Value Clause ............................................................................................................................... 72 17. Conditional Gifts ....................................................................................................................................... 72 18. Example Form for Formula Gift Combined With Disclaimer Provision ....................................................... 72 19. Fixing Mistakes; Retroactive Revisions and Reversals .............................................................................. 73 20. Tax Effects of Settlements and Modifications; Early Termination of Trust; Commutation of Spouse’s Interest in QTIP Trust ............................................................................................................................... 78 21. GST Tax Planning Issues—Queries and Conundrums ............................................................................... 88 22. Maintaining Client Confidentiality and Other Ethical Challenges While Working Remotely........................ 92 23. Consideration of Beneficiary’s Other Resources in Making Discretionary Distribution Decisions .............. 96 24. Planning for Non-U.S. Citizen Spouses ..................................................................................................... 97 25. “Descendants”—Issues Arising from DNA Testing; Inheritance; Adoption ............................................ 100 26. Planning Developments With Deemed Owner Trusts Under Section 678 .............................................. 102 27. Electronic Wills and Uniform Electronic Wills Act ................................................................................... 104 28. Family Limited Partnership and LLC Planning Developments; Planning in Light of Estate of Powell v. Commissioner and Estate of Cahill v. Commissioner .............................................................................. 104 29. FLP Assets Included Under §2036(a)(1); Application of §2043 Consideration Offset; Formula Transfer to Charitable Lead Trust Not Respected; Loans Not Respected; No Deduction for Attorney’s Fee, Estate of Howard V. Moore v. Commissioner, T.C. Memo. 2020-40...................................................................... 114 30. Treatment of Advances to Son as Legitimate Loans vs. Gifts, Estate of Bolles v. Commissioner, T.C. Memo. 2020-71...................................................................................................................................... 119 31. Gift and Sale of Partnership Interests Expressed as Dollar Amounts Based on Subsequent Appraisals, Lack of Control and Lack of Marketability Discounts, Multi-Tiered Discounts, Nelson v. Commissioner, T.C. Memo. 2020-81...................................................................................................................................... 123 32. Charitable Gift Followed by Redemption Not Treated as Anticipatory Assignment of Income, Dickinson v. Commissioner, T.C. Memo. 2020-128 .................................................................................................... 127 www.bessemertrust.com/for-professional-partners/advisor-insights

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33. Decanting That Violates Duty of Impartiality, Hodges v. Johnson ........................................................... 128 34. Titling of Casualty Insurance Policy, Jones v. Phillips .............................................................................. 129 35. John Doe Summons Upheld to Determine Identity of Law Firm’s Clients Seeking Advice Regarding Particular Issues, Taylor Lohmeyer Law Firm P.L.L.C. v. United States .................................................. 129 36. Valuation of Majority Interests in LLCs Owning Real Estate; Estate Tax Charitable Deduction Based on Values Passing to Each Separate Charity, Estate of Warne v. Commissioner, T.C. Memo. 2021-17 ....... 130 37. Sale Decisions by Sponsors of Donor Advised Funds Contrary to Expectations of Donors, Fairbairn, et al. v. Fidelity Investments Charitable Gift Fund, Pinkert v. Schwab Charitable Fund .................................... 137 38. Valuation of Publicity Rights, Undervaluation Penalties, Estate of Michael Jackson v. Commissioner, T.C. Memo. 2021-48...................................................................................................................................... 138 39. Intergenerational Split Dollar Life Insurance, Estate Tax Treatment of Repayment Right, Estate of Morrissette v. Commissioner, T.C. Memo. 2021-60 ............................................................................... 143 40. Savings Clause Rejected in Conservation Easement Cases, TOT Property Holdings, LLC v. Commissioner (And Others)........................................................................................................................................... 146

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Introduction This summary reflects estate planning developments in 2020 - 2021 (including various legislative developments and legislative proposals). It includes observations from presentations at the 54th Annual Heckerling Institute on Estate Planning, which was held virtually May 3-6, 2021. 1.

Summary of Top Developments in 2020 Ron Aucutt (Lakewood Ranch, Florida) lists the following as his top ten developments in 2020 in his report, “Top Ten” Estate Planning and Estate Tax Developments of 2020 (January 2021) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights: (1) Social disruption and refocus: Health and racial justice; (2) The 2020 election; (3) Increasing confirmation of solutions to defined value clause dilemmas; (4) Valuation of interests in entities (Grieve, Nelson)(see Item 31 below); (5) Deductibility of estate and trust administration expenses (Reg. §§1.67-4, 1.642(h)-(2)) (see Item 5.b.–c below); (6) Crunch time for syndicated conservation easements (see Item 40 below); (7) Section 2703 substantial modification rules applied (PLR 202014006); (8) Revenue Ruling 85-13 applied to transfers between trusts (PLR 202022002) (see Item 26.d below); (9) Assignment of income avoided on charitable donation of stock (Dickinson) (see Item 32 below); and (10) Hazards of death-bed planning and of post-opinion analysis (Moore) (see Item 29 below).

Legislative Developments a.

CARES Act. The Coronavirus Aid, Relief and Economic Security (CARES) Act (P.L. 116-136, 3/27/2020) provided for direct stimulus payments for taxpayers with adjusted gross income up to $99,000 ($198,000 for joint return taxpayers) and also included a number of tax-related provisions for 2020, including: •

Extension of the deadline in 2020 for making contributions to a traditional or Roth IRA to July 15, 2020;

•

Waiver of required minimum distributions (RMDs) for all retirement accounts except defined benefit accounts in 2020 (this included IRAs, even inherited IRAs) and for deferred 2019 RMDs due April 1, 2020;

•

Qualified taxpayers could take a “coronavirus-related distribution” of up to $100,000 in 2020 and avoid the 10% penalty for early distributions;

•

Relaxed borrowing provisions from 401(k) or retirement plans (but not IRAs);

•

$300 Above-The-Line charitable deduction (the staff of the Joint Committee on Taxation interpreted this provision as being $300 for both individuals and joint return filers); Increased limit for deducting cash contributions to public charities in 2020 from 60% to 100% of the individual’s “contribution base” (but not applicable to contributions to donor advised funds, supporting organizations, or private foundations other than operating foundations or “flowthrough” foundations); and

•

Increased corporate charitable deduction limit from 10% to 25% of taxable income for 2020.

For a discussion of these provisions, see Item 2.l. of Estate Planning Current Developments and Hot Topics (May 2021) found here and available at www.bessemertrust.com/for-professionalpartners/advisor-insights. www.bessemertrust.com/for-professional-partners/advisor-insights

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Consolidated Appropriations Act, 2021. The Consolidated Appropriations Act, 2021 was enacted on December 27, 2020. It includes the COVID-related Tax Relief Act of 2020, which (among many other things) clarifies the tax treatment of PPP loans, and the Taxpayer Certainty and Disaster Tax Relief Act of 2020 that extends or makes permanent numerous tax provisions. At 5,593 pages, it is the longest legislation ever passed by Congress. Tax provisions include: (i) an extension (and expansion) of the $300 non-itemizer charitable deduction ($600 for joint returns) for 2021; Professor Sam Donaldson says this is an additional itemized deduction in addition to the standard deduction rather than an adjustment in arriving at adjusted gross income (as it was in 2020); (ii) an extension of the 100% of AGI limit for cash contributions to public charities (but not donor advised funds, supporting organizations, or private non-operating foundations) for 2021 (for both 2020 and 2021, an individual must make an affirmative election on Form 1040, Schedule A, Line 11 by entering the amount of qualified contributions on the dotted line next to the Line 11 entry space) (in computing the charitable deduction, apply the AGI limits first to current year charitable contributions that do not qualify for the 100% of AGI and then to carryover contributions within each category); (iii) an extension of the increase of the corporate charitable deduction to 25% of taxable income for 2021; (iv) a permanent increase of the §6662 penalty for overstating qualified charitable contributions from 20% to 50%; (v) a permanent extension of the reduction of the medical expense deduction floor from 10% to 7.5%; and (vi) the addition of a 100% deduction for business meals, including delivery and carryout meals, provided by a restaurant for amounts paid or incurred in 2021 or 2022. For further discussion of the Consolidated Appropriations Act of 2021, see Item 2.m. of Estate Planning Current Developments and Hot Topics (May 2021) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights.

American Rescue Plan. The American Rescue Plan is a $1.9 trillion coronavirus rescue package passed under the reconciliation legislative process, signed by the President on March 11, 2021. The legislation includes a wide variety of relief measures, including stimulus checks, vaccinations and testing funding, state and local aid, unemployment insurance, minimum wage, and paid leave provisions. It also includes expanding the child tax credit (for 2021 only, a refundable credit of $3,000 for each child ages 6 – 17 and $3,600 for each child under age 6 for couples who make $150,000 or less and single parents who make $112,500 or less) and the earned income tax credit (some provisions apply for 2021 only but other modifications of the EITC are permanent). See Rev. Proc. 2021-23 adjusted tables for those credits and the premium tax credit.

Democratic Sweep. The sweep of the White House, Senate and House of Representative by Democrats in the 2020 elections (and the Georgia Senate run-off elections) has changed the calculus of anticipated tax legislation, including legislation relating to the transfer tax. Tax legislation including some of the tax proposals from the Biden campaign appears much more likely than if Republicans controlled the House or Senate, but significant tax increases will likely have to be enacted through the reconciliation process so that only a majority of the Senate is required (see Item 2.n below). Sweeping changes will likely still be difficult, even using reconciliation, considering the 50-50 division of the Senate and the practical requirement that every (or perhaps almost every) Democratic senator agree to the change (see Item 2.p(2)-(3) below).

The American Jobs Plan and The Made in America Tax Plan Proposal. The centerpiece of an expansive infrastructure proposal is The American Jobs Plan, released March 31, 2021. Alongside the infrastructure plan is The Made in America Tax Plan with proposed changes to the corporate tax code. Among other things, the corporate tax plan would increase the corporate tax rate from 21% to 28% (still less than the 35% rate that applied before the 2017 Tax Act), adopt various provisions to

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discourage shifting jobs and profits offshore, and enact a minimum tax on large corporations’ book income (anticipated to apply to 45 very large publicly traded companies). Detailed descriptions of these proposals are included in the Biden Administration’s “General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals” (popularly called the “Greenbook”). The infrastructure component of the American Jobs Plan is reflected in the Infrastructure Investment and Jobs Act (H.R. 3684), a $550 billion infrastructure package that passed the House on July 1, 2021, was amended in the Senate on August 10, 2021, and is now pending in the House for approval of the changes. The Act includes some revenue provisions but does not include the major revenue provisions in The Made in America Tax Plan. f.

The American Families Plan Proposal. Alongside The American Jobs Plan’s proposed investment in infrastructure, The American Families Plan is proposed as an investment in the nation’s children and families. It includes various education investments, various measures to support for families (such as child care, family and medical leave program, and nutrition assistance), and tax relief measures for families, including extending key tax cuts in the American Rescue Plan benefitting lower- and middle-income families (such as the child tax credit, the earned income tax credit, the child and dependent care tax credit, and health insurance tax credits). The American Families Plan also includes various tax increases (many of which reverse the tax decreases in the 2017 Tax Act). The FY 2022 Greenbook includes detailed descriptions of the tax proposals in The American Families Plan. Those proposal include: •

Raising the top income rate from 37% to 39.6%;

•

Taxing capital gains and qualified dividends as ordinary income (top rate of 39.6% plus the 3.8% “Medicare” tax) for taxpayers having adjusted gross income over $1 million, but only to the extent the taxpayer’s income exceeds $1 million ($500,000 for married filing separately), indexed for inflation after 2022, effective “for gains required to be recognized after the date of announcement” (presumably the date the White House released the Fact Sheet about The American Families Plan); the combined federal and state rate in high-tax states could exceed 50%, for example, as high as 52.22% in New York and 56.7% in California); see Laura Davison & Allyson Versprille, Biden Aims at Top 0.3% With Bid to Tax Capital Gains Like Wages, BLOOMBERG DAILY TAX REPT. (April 23, 2021);

•

Providing for deemed realization of gains at the time of gifts and at death for capital gains exceeding $1 million (increased from $100,000 during the Presidential campaign); the Fact Sheet for The American Families Plan referred to “ending the practice of ‘stepping-up’ the basis for gains in excess of $1 million … and making sure the gains are taxed if the property is not donated to charity,” but the FY 2022 Greenbook allows for “stepping-up” the basis of assets passing from a decedent, even for the amount of gains covered by the deemed realization exclusion; the deemed realization proposal for gifts and at death is discussed in more detail in Item 2.j below;

•

Taxing “carried interests” as ordinary income;

•

Eliminating real estate like-kind exchanges for gains in excess of $500,000, or $1 million for married individuals filing a joint return (the like-kind exchange provision was enacted 100 years ago in 1921 and has been relied on since; repeal could be a huge change for real estate owners, who often have invested using repeated like-kind exchanges and planning on a stepped up basis at death, see Martin Sullivan, Can Biden Upset the Swap, Swap, and Drop Approach to Commercial Real Estate?, TAX NOTES (Jan. 19, 2021));

•

Permanently extending the current limitation that restricts large excess business losses;

•

Applying the 3.8% tax to business income from pass through entities for taxpayers with adjusted gross income over $400,000 who materially participate in the business; and

•

Adding $80 billion to the IRS with the goal of raising an additional $700 billion of revenue over ten years. (The Congressional Budget Office, however, estimates that increasing IRS funding

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by $80 billion over a decade would raise $200 billion in total revenue. Biden Tax Plan Suffers $116B Blow as IRS Revenue Forecast Drops, BLOOMBERG DAILY TAX REPORT (Sept. 2, 2021).) Transfer taxes are not included in the tax measures that are in The American Families Plan or in the FY 2022 Greenbook, but the plan will be the subject of intense negotiations – some commentators have noted that the Joint Committee on Taxation in scoring tax proposals often refuses to credit much anticipated revenue to increased compliance efforts that are not tied to specific policy changes, and the Administration may end up needing more revenue generators to offset the costs of the infrastructure provisions in the plan, see Jonathan Curry, Biden’s Next Plan Targets Like-Kind Exchanges and Stepped-Up Basis, TAX NOTES (May 3, 2021). Typically, bold proposals like those in The American Families Plan would be expected to be included in budget reconciliation provisions, and those proposals could emerge under the $3.5 trillion budget resolution that has been approved in the Senate and House. g.

President Biden’s Other General Tax Proposals. The Administration has repeatedly said that it will not increase income taxes on families with income less than $400,000, but a White House official has reported that the threshold is actually higher than that in keeping with the tax brackets before the 2017 Tax Cuts and Jobs Act; the taxable income threshold in 2022 is anticipated to be $452,700 (individuals)/$509,300 (married filing jointly). See Jonathan Curry, Biden’s NII Tax Fix Destined to Be the Bane of Practitioners, TAX NOTES (May 3, 2021). Some of the other income tax proposals by President Biden that are not included in the FY 2022 Greenbook include the following, many of which are to roll back the 2017 Trump tax cuts:

•

Applying the payroll tax to earnings over $400,000;

•

Limiting reduction in tax liability from itemized deductions to no more than 28% of deductions;

•

Restoring the Pease limitation on itemized deductions for taxable incomes above $400,000;

•

Phasing out the §199A deduction for qualified business income above $400,000; and

•

Eliminating fossil fuel subsidies.

Transfer Taxes. As mentioned above, transfer taxes are not addressed in The American Families Plan. President Biden’s position on transfer tax rates and exclusions was unclear through much of the Presidential campaign. The Obama Administration’s budget “Greenbook” proposals, beginning in 2013, had included returning to the 2009 estate, gift, GST, and gift tax parameters (45% rate, $3.5 million exclusion for estate and GST taxes, and $1 million exclusion for gift taxes). The exclusion amounts were not indexed. A rather obtuse reference on the Biden campaign website suggested that Presidential candidate Biden supported a return to the 2009 parameters ($3.5 million/$1 million exclusions, not indexed, and 45% rate). The Biden campaign website (https://joebiden.com/plans-to-support-womenduringcovid19/), under the topic of “Highlights of Joe Biden’s Plans to Support Women During the COVID-19 Crisis,” stated: Permanently provide family, medical, and safe leave as well as sick and safe days. As President, Biden will work to provide the type of comprehensive 12 weeks of paid family and medical leave envisioned in the FAMILY Act sponsored by Senator Kristen Gillibrand and Representative Rosa DeLauro. Biden will pay for this proposal by returning the estate tax to 2009 levels.

Dr. Janet Yellen’s written responses to questions in her Senate confirmation process also pointed to a $3.5 million exemption level. Her testimony suggested that tax reform is not the Administration’s initial highest priority, but she was more positive in affirming the proposal to reduce the estate tax exemption to $3.5 million and increase the estate tax rate to 45%. When Senator Grassley stated that the proposal would “disproportionately affect farmers and small business owners in Iowa and across the nation through wasteful compliance costs and increased taxes,” Dr. Yellen responded: If confirmed, I look forward to working with you to advance a range of policies that the President has proposed to strengthen rural America and small businesses. www.bessemertrust.com/for-professional-partners/advisor-insights

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On the President’s estate tax proposal in particular, it may be helpful to note that only about the wealthiest six out of every thousand estates would face any tax – less than 1% -- and every couple with assets under $7 million would be fully exempt from the estate tax. Id.

As indicated by Dr. Yellen, a $3.5 million estate exclusion amount would mean that about 0.6% of estates would be subject to estate tax. The Biden Administration may also support various transfer tax reforms, for example, regarding GRATs, valuation discounts, and family limited partnerships. A paper previously written by current key Biden Administration officials (David Kamin, current deputy director of the National Economic Council, and Professor Lily Batchelder, nominated as Assistant Secretary of the Treasury for Tax Policy) makes clear their disdain for these planning alternatives. Lily Batchelder & David Kamin, Taxing the Rich: Issues and Options, at 23 (Sept. 11, 2019) available at https://ssrn.com/abstract=3452274. For further discussion of their views about these transfer tax items and other measures for taxing the wealthy, see Items 2.c.(.2) and 2.c.(4) of Estate Planning Current Developments and Hot Topics (May 2021) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. i.

Controversial Proposals for Deemed Realization on Making Gifts or at Death; Deemed Realization Legislation Seems Unlikely. The Biden administration proposes a deemed realization of gain on making gifts or at death. For a discussion of the realization at death proposals by the Obama Administration in 2015 and 2016, see Aucutt, Estate Tax Changes Past, Present, and Future, §17.i. (June 2021) found here and available at www.bessemertrust.com/for-professionalpartners/advisor-insights). The Biden Administration proposal, House and Senate legislative proposals, and current planning implications of these proposals are discussed in Items 2.j, 2.k, 2.l below. For an interesting discussion of various collateral tax effects and open questions regarding the deemed realization proposals, see Monte Jackel, No Escape: Proposals for Taxing Gains at Death, TAX NOTES (July 5, 2021). The deemed realization proposals are bold new taxing approaches in the U.S. that are quite controversial. In an unusual move, all 50 Republican senators signed a letter to President Biden on July 21, 2021 urging the President to drop the realization at death proposal. The letter includes that … many businesses would be forced to pay tax on appreciated gains, including simple inflation, from prior generations of family owners—despite not receiving a penny of actual gain. These taxes would be added to any existing estate tax liability, creating a new backdoor death tax on Americans. These changes are a significant tax increase that would hit family-owned businesses, farms, and ranches hard, particularly in rural communities. These businesses consist largely of illiquid assets that will in many cases need to be sold or leveraged in order to pay the new tax burden. Making these changes could force business operators to sell property, lay off employees, or close their doors just to cover these new tax obligations. The complexity and administrative difficulty of tracking basis over multiple generations and of valuing assets that are not up for sale will lead to colossal implementation problems and could also lead to huge tax bills that do not accurately reflect any gains that might have accumulated over time. As you will recall, a proposal to reach a similar outcome by requiring an heir to “carry-over” the decedent’s tax basis was tried before in 1976—and failed so spectacularly it never came into effect. It was postponed in 1978 and repealed in 1980.

Senator Grassley (R-Iowa) wrote a scathing criticism of carryover basis and the deemed realization proposal in an opinion published in the Wall Street Journal. Families faced the unthinkable: Uncle Sam could snatch away a lifetime of effort at the hour of death. The estate tax was bad enough. But now, if a family had to sell part of the farm to pay it, additional taxes were triggered based on decades of paper gains in the value of the land. The 1976 experiment shows how adding a new tax on top of the estate tax created excessive paperwork, compliance costs and uncertainty. Family farms and businesses operate on tight margins. They can’t afford to divert resources to pay accountants and tax attorneys to untangle decades of appreciation and depreciation on livestock, crops, machinery and farmland. … … Among other issues, it would require complex reconstruction of the decedent’s assets, give rise to extended audits, and trigger litigation for next of kin. Eliminating step-up in basis is another post-death tax grab, adding punitive taxes on thrift, savings and investments. www.bessemertrust.com/for-professional-partners/advisor-insights

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… Democrats propose to go beyond even what Congress did in 1976 by generally treating a transfer of property at death as a taxable event, not only once it’s sold. The administration claims it would protect family businesses by making an exception for them. However, it merely defers the tax—the liability still exists. So, family operations would be in the same boat as 1976, potentially contending with both the estate tax and taxes on paper gains on the appreciation of any property that’s sold. What’s more, a tax lien could loom over the operations inhibiting family owners from obtaining a business loan or other financing. Mr. President, watch where you step. Your new death tax would suffocate economic growth, job creation and capital formation needed to improve productivity and reduce inflation. And it would dismantle the family farm. Chuck Grassley, A ‘Death Knell’ Tax Threatens Family Farms and Businesses, WALL STREET J. (Aug. 12, 2021).

The deemed realization proposals are controversial, and adoption of a deemed realization approach seems unlikely. All 50 Democratic senators would likely have to vote for such measures in order to pass them in a reconciliation act, and some Democratic Congressmen have already expressed skepticism. For example, House Agriculture Committee Chairman David Scott has sent a letter to President Biden expressing “serious concerns” about how the proposed tax increases could affect farmers, ranchers and other small businesses and stating that even with exemptions in the proposals, “the provisions could still result in significant tax burdens on many family farming operations.” House Ways and Means Committee Chair Richard E. Neal (D-Mass.) “is believed to have doubts about the taxation at death proposal even though he supports the administration in public.” Lee Sheppard, Woke Wealth Taxation, TAX NOTES (July 19, 2021). About a third of the Democrats on the House Ways and Means Committee “are advocating for a lower rate on investments, potentially around 28%”(rather than 39.6%), and “[s]ome Democrats on the panel are also balking at Biden’s plan to end a tax preference, known as ‘step-up-in-basis” and are concerned that the deemed realization at death proposal “would hurt family farms and small businesses.” Kaustuv Basu, Capital-Gains Tax Hike Exposes Divisions Among House Democrats, BLOOMBERG DAILY TAX REPORT (Sept. 1, 2021). Well respected moderate former Democratic Senators Max Baucus and Heidi Heitkamp have criticized the proposal to end basis step-up at death, and thirteen House Democrats representing rural districts have expressed concern about the deemed realization at death proposal. See Jonathan Curry, Baucus Lends Name to Stepped-Up Basis Fight, TAX NOTES (Sept. 6, 2021). Senator Jon Tester (D-MT) has also expressed concern about ending stepped-up basis and the impact of the deemed realization approach on farmers and ranchers. The capital gains rate and deemed realization proposals are facing “pushback” within the Democratic caucus: Other changes, including increases to capital gains rates and rule changes that would tax assets at the time they are passed on to heirs – rather than when they are sold – have faced pushback within the caucus. Laura Davison, Biggest Tax Hike on Wealthy Since ’93 is Bogged Down in Congress. BLOOMBERG DAILY TAX REPORT (Aug. 20, 2021).

Jorge Castro of Miller & Chevalier Chtd. has noted that the Democrats will have a far more difficult challenge to wrangle total unanimity among their members in the Senate than the Republicans faced in enacting the $2 trillion of tax cuts in 2017 (also using reconciliation) because “it’s much easier to dole out tax benefits and tax cuts than tax hikes.” Jonathan Curry, Baucus Lends Name to SteppedUp Basis Fight, TAX NOTES (Sept. 6, 2021). “Lobbyists already expect [the deemed realization at death] changes to wash out in the lobbying deluge.” Jonathan Weisman, Alan Parreport & Jim Tankersley, Democrats and Lobbyists Gird for Battle Over Far-Reaching Tax Increases, NEW YORK TIMES (Sept. 7, 2021). Some commentators have also questioned whether the deemed realization proposal would present constitutional concerns if the deemed realization is treated as a “direct tax” that must be apportioned among the states by population. See Erik Jensen, Wealth Taxes Can’t Satisfy Constitutional Requirements, BLOOMBERG DAILY TAX REPORT (July 27, 2021); Benjamin Willis, Realizing Deemed Income From “Holey” New Taxes, TAX NOTES (Aug. 23, 2021) (“Provisions for realization upon death or gifts, expansive mark-to-market regimes on publicly traded assets, and a wealth tax could push the boundaries of the constitutional power to tax”). That concern might be particularly relevant for the deemed realization of appreciation in trusts every 90 years under the Greenbook proposal (or 30 www.bessemertrust.com/for-professional-partners/advisor-insights

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years under H.R. 2286 or 21 years under the STEP Act proposal in the Senate), because the tax would be imposed even when there is no realization “event,” such as a transfer. j.

Deemed Realization Proposals in Treasury’s Explanation of Fiscal Year 2022 Budget Proposals (“Greenbook”). Whether The American Families Plan calls for a deemed realization at death system was unclear based on the Fact Sheet that the White House released on April 28, 2021, but the FY 2022 Greenbook provides a detailed description of the deemed realization taxing regime. The Treasury Department released its “General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals” (popularly called the “Greenbook”) on May 28, 2021, available at https://home.treasury.gov/system/files/131/General-Explanations-FY2022.pdf. It proposes no changes to the estate and gift taxes. Following up proposals announced in the Administration’s “American Families Plan” on April 28, 2021, and citing the need to “reduce economic disparities among Americans,” the Greenbook (at pages 60-62) includes proposals to increase the top marginal individual income tax rate to 39.6 percent (as it was before the 2017 Tax Act), effective January 1, 2022, and to tax capital gains at the same rate as ordinary income for taxpayers with adjusted gross income greater than $1 million, effective “for gains required to be recognized after the date of announcement” (presumably April 28, 2021). The Greenbook (at pages 62-64) also provides details focusing and clarifying the proposal for the “deemed realization” of capital gains foreshadowed by the Obama Administration’s Greenbooks for Fiscal Years 2016 (Feb. 2, 2015, pages 156-57) and 2017 (Feb. 9, 2016, pages 155-56), by President Biden’s campaign, and by Representative Bill Pascrell’s H.R. 2286 and Senator Van Hollen’s “discussion draft” of the Sensible Taxation and Equity Promotion (“STEP”) Act of 2021 discussed in Item 2.k below. That Greenbook proposal is summarized as follows: (1) Effective Date. The proposal would take effect on January 1, 2022, like H.R. 2286. But it would apply to pre-2022 appreciation; there would be no “fresh start” as, for example, in the 1976 carryover basis legislation. (2) Realization Events. Gain would be explicitly recognized on transfers by gift or at death, equal to the excess of an asset’s fair market value on the date of the gift or death over the donor’s or decedent’s basis in that asset. Losses obviously would also be recognized if basis exceeds fair market value because the Greenbook refers to “the use of capital losses … from transfers at death” as an offset. The Greenbook does not mention holding periods or distinguish short-term and long-term gain. The Greenbook also does not specifically incorporate the alternate valuation date for transfers at death, although it does state generally that a transfer “would be valued using the methodologies used for gift or estate tax purposes.” (3) Taxpayer, Return, and Deductibility. The Greenbook states that the gain would be reported “on the Federal gift or estate tax return or on a separate capital gains return.” Reassuringly, however, the Greenbook confirms that the gain “would be taxable income to the decedent” and, consistently with that characterization, explicitly adds that “the tax imposed on gains deemed realized at death would be deductible on the estate tax return of the decedent’s estate (if any).” This means that the combined income and estate tax on the appreciation would be 39.6% (income tax) + (40% x [1 - .396]) (estate tax) = 63.76%. (4) Exclusion for Tangible Personal Property. “[T]angible personal property such as household furnishings and personal effects (excluding collectibles, such as art)” would be exempt. There is no mention of explicit application to property held for investment as in H.R. 2286 or property related to the production of income as in the STEP Act. (5) Exclusion for Transfers to Spouses. The Greenbook would exempt “[t]ransfers by a decedent to a U.S. spouse,” without explicitly exempting lifetime gifts to a spouse as both H.R. 2286 and the STEP Act do. There is no elaboration of the term “U.S. spouse” (for example, citizen or resident), and there are no special provisions targeted to spousal trusts. Typically the effect of

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exempting transfers to spouses will be simply to defer the application of the deemed realization rules until the spouse’s disposition of the asset or the spouse’s death. (6) Exclusion for Transfers to Charity. The Greenbook would exempt transfers to charity. But it adds that “[t]he transfer of appreciated assets to a split-interest trust would generate a taxable capital gain, with an exclusion allowed for the charity’s share of the gain based on the charity’s share of the value transferred as determined for gift or estate tax purposes.” This will require further elaboration. In addition, the Greenbook does not clarify the effect of applying the ordinary income rate to capital gains on §170(e)(1), which reduces the amount of any charitable contribution by, among other things, the amount of gain that would not have been long-term capital gain if the property had been sold at its fair market value. The green book is unclear about the effect of taxing capital gains by high-income individuals at ordinary rates on the amount of the deduction to which an individual would be entitled if the property were contributed to a charity. The proposal may simply raise the tax rate on gain from property that would otherwise have been subject to the preferential rate on long-term capital gain, without changing the character of property. On the other hand, consistent with the purpose of section 170(e)(1), the proposal could be read to limit the amount of the deduction to the basis of property in the hands of the donor. Lawrence M. Axelrod, The Dying Art of Donating Appreciated Property, TAX NOTES (Aug. 30, 2021).

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(9) Valuation. As noted above, the Greenbook contemplates that a transfer generally “would be valued using the methodologies used for gift or estate tax purposes.” But the Greenbook adds that “a transferred partial interest would be its proportional share of the fair market value of the entire property.” In other words, no discounts. The Greenbook does not indicate whether “partial interest” is meant to be limited to undivided interests such as in tenancies-in-common, or whether it might include nonmarketable interests in entities like partnerships, limited liability companies, and corporations. Surely it would not include, for example, publicly traded stock, but attention in drafting might be required to confirm that. The AICPA on August 24, 2021 sent a letter to Congressional leaders criticizing various aspects of the deemed realization proposal, and in particular criticizing this proportional-share-of-full-value valuation provision because it is inconsistent with well-established valuation principles, and a partial owner often does not have “adequate insights or access to information that would allow for a determination of FMV of the entire property” and could not provide “any reasonable and supportable value of the partial interest.” (10) Special Rules for Trusts and Entities. Generally mirroring H.R. 2286 and the STEP Act, the Greenbook provides that transfers into, and distributions in kind from, a trust would be recognition events, unless the trust is a grantor trust deemed wholly owned and revocable by what the Greenbook calls “the donor.” There is no mention of “grandfathering” irrevocable trusts in existence on the date of enactment, and therefore this Greenbook feature would apparently apply to distributions of appreciated assets to both current and successive or remainder beneficiaries of preexisting trusts, including, for example, both the grantor and the remainder beneficiaries of a pre-2022 GRAT. With regard to revocable trusts, the deemed owner would recognize gain on the unrealized appreciation in any asset distributed (unless in discharge of the deemed owner’s obligation) to anyone other than the deemed owner or the deemed owner’s “U.S. spouse” (again undefined), and on the unrealized appreciation in all the assets in the trust when the deemed owner dies or the trust otherwise becomes irrevocable. But the Greenbook goes a lot farther. The rules about transfers into and distributions in kind from a trust also apply to a “partnership” or “other non-corporate entity.” This looks like a far reach, but the Greenbook does not explain further. The Greenbook also states: Gain on unrealized appreciation also would be recognized by a trust, partnership, or other noncorporate entity that is the owner of property if that property has not been the subject of a recognition event within the prior 90 years, with such testing period beginning on January 1, 1940. The first possible recognition event for any taxpayer under this provision would thus be December 31, 2030.

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of family ownership results from the family’s sale of the business, that postponed realization approach would be the same as current law in subjecting any sale like that to tax, except apparently for the loss of a stepped-up basis at intervening deaths. The enactment of this proposal or any close variation of it in a tightly divided Congress is by no means certain, and the long-term durability of such a provision enacted in such a political climate would not be guaranteed. That could create special challenges in cases where a tax on the succession of the family businesses is nominally imposed, but is suspended for many years, decades, or even generations. And of course the statutory language implementing this Greenbook proposal should be expected to include definitions of a “business,” “family-owned,” and “family-operated,” as well as rules for the identification of assets that should be excluded from the deferral because they are not used in the business, and such rules might also create or aggravate challenges over a long-term suspension. In addition, like the STEP Act and the Obama Administration Greenbooks (and broader than H.R. 2286), the Greenbook proposal would allow “a 15-year fixed-rate payment plan for the tax on appreciated assets transferred at death, other than liquid assets such as publicly traded financial assets and other than businesses for which the deferral election is made.” Details about start dates and interest rates are not provided, but the proposal might resemble the STEP Act’s proposed section 6168, which in turn resembles section 6166 without the 35-percent-of-grossestate requirement to qualify, with an interest rate equal to 45 percent of the normal annual rate as in section 6601(j)(1)(B), but without the “2-percent portion” as in section 6601(j)(1)(A). As in H.R. 2286 and the STEP Act, the IRS would be authorized to require reasonable security at any time from any person and in any form acceptable to the IRS. (12) Administrative Provisions. Following the Obama Administration Greenbooks, with a few additions, the Greenbook envisions (but without details) a number of other legislation features, covering topics such as a deduction for the full cost of related appraisals, the imposition of liens, the waiver of penalties for underpayment of estimated tax attributable to deemed realization of gains at death (which, of course, could not have been foreseeable), a right of recovery of the tax on unrealized gains, rules to determine who selects the return to be filed, consistency in valuation for transfer and income tax purposes, and coordination of the changes to reflect that the recipient would have a basis in the property equal to the value on which the capital gains tax is computed. (13) Regulations. Treasury would be granted authority to issue any regulations necessary or appropriate to implement the proposal, including reporting requirements that could permit reporting on the decedent’s final income tax return, which would be especially useful if an estate tax return is not otherwise required to be filed. In a tacit acknowledgment of the harshness of proceeding with such a proposal without a “fresh start” for basis as in 1976, the Greenbook explicitly contemplates that the regulations will include “rules and safe harbors for determining the basis of assets in cases where complete records are unavailable.” (14) Revenue Estimate. Taxing capital gains at the same rate as ordinary income for taxpayers with adjusted gross income greater than $1 million and the proposed “deemed realization” of capital gains together are estimated to raise $322.485 billion over the next 10 fiscal years. This includes $1.241 billion estimated for Fiscal Year 2021, which ends September 30, 2021. That presumably results from the proposed retroactive effective date for taxing capital gains at the same rates as ordinary income, but evidently also contemplates increased estimated income tax payments by September 30. (This is the only proposal in the Greenbook that is estimated to have an effect on revenues in Fiscal Year 2021.) Overall, the tax increases proposed by the Greenbook are estimated to raise revenue over the next 10 fiscal years by about $3.6 trillion. k.

House and Senate Deemed Realization Proposals Under Consideration.

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(1) Legislation Introduced and Under Discussion. On March 29, 2021, Ways and Means Committee Member Bill Pascrell, Jr. (D-New Jersey) introduced H.R. 2286, described as a bill “to amend the Internal Revenue Code of 1986 to treat property transferred by gift or at death as sold for fair market value, and for other purposes.” On the same day, Senator Chris Van Hollen (DMaryland), joined by Senators Cory Booker (D-New Jersey), Bernie Sanders (I-Vermont), Sheldon Whitehouse (D-Rhode Island), and Elizabeth Warren (D-Massachusetts), issued a statement calling “the Stepped-Up Basis Loophole” “one of the biggest loopholes in the U.S. tax code, which subsidizes America’s wealthiest heirs,” citing a Joint Committee on Taxation estimate that it will cause a loss of $41.9 billion of tax revenue in 2021 alone. The statement was accompanied by 32 pages of statutory language titled the “Sensible Taxation and Equity Promotion (“STEP”) Act of 2021,” with the acronym of “STEP” evidently designed to recall the “step-up” in basis that it attacks. (2) Effective Dates. A conspicuous and significant difference between Congressman Pascrell’s H.R. 2286 and Senator Van Hollen’s “discussion draft” of the “STEP Act” is their effective dates. H.R. 2286 would apply to gifts and transfers made, including transfers from decedents dying, after December 31, 2021. Consistent with the exclusion amount and rate changes in Senator Sanders’ “For the 99.5 Percent Act” discussed in Item 2.n below that is the typical effective date for broad changes in the taxation of transfers by gift and at death, although other provisions of the Sanders bill itself show how the date of enactment can be a typical effective date for changes to the tax treatment of particular transactions or structures. For the Senate discussion draft, the corresponding date would be December 31, 2020. In other words, it would be uncharacteristically retroactive to the beginning of 2021. This could be a portent of less deference to conventional effective-date norms in the political climate of the current Congress. Or it could mean only that Congressman Pascrell, as a member of the Ways and Means Committee, has received more technical assistance from staff members who understand the historical and practical preferences for avoiding retroactivity. Or it could mean that a “discussion draft” is only that. Both proposals would tax past appreciation, not just appreciation following enactment. This contrasts with the 1969 proposed “Taxation of Appreciation of Assets Transferred at Death or by Gift,” which stated that “[o]nly appreciation occurring after the date of enactment would be subject to tax.” “Tax Reform Studies and Proposals, U.S. Treasury Department,” Joint Publication of the House Committee on Ways and Means and Senate Committee on Finance, at 335 (91st Cong., 1st Sess., Feb. 5, 1969). It also contrasts with the 1976 enactment (which proved to be temporary) of carryover basis, which provided a “fresh start” valuation on December 31, 1976, and a proration of appreciation over the entire holding period of nonmarketable assets acquired before that date. Section 1023(h), added by section 2005(a)(2) of the Tax Reform Act of 1976, Public Law 94-455 (94th Cong., 2d Sess., Oct. 4, 1976). Interestingly, it does not contrast as sharply with the “aggregate basis increase” and “spousal property basis increase” provided by the second (also temporary) enactment of carryover basis in 2001, taking effect in 2010, which was not as clearly tailored to sheltering pre-enactment appreciation. Section 1022(b) and (c), added by section 542(a) of the Economic Growth and Tax Relief Reconciliation Act of 2001, Public Law 107-16 (107th Cong., 1st Sess., June 7, 2001). (3) Deemed Sale Rule of New Section 1261. The proposals would add a new section 1261 to the Code, generally treating any property transferred by gift or at death as sold for its fair market value on the date of the gift or death. Both proposals appear to contemplate that the gain on deemed sales at death would be reported on the decedent’s final income tax return (Form 1040), or a supplement to it, but they do not say that. (4) Exception for Tangible Personal Property. The deemed sale rules would not apply to transfers of tangible personal property other than collectibles (including coins and bullion) and property held in connection with a trade or business. H.R. 2286 adds property held for investment, and the STEP Act adds property related to the production of income under section 212, to the coverage of the deemed sale rules. www.bessemertrust.com/for-professional-partners/advisor-insights

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(5) Exception for Transfers to Spouses. A transfer to the spouse of a transferor or surviving spouse of a decedent would be exempt from this deemed sale treatment if the spouse is a U.S. citizen (or long-term resident under the STEP Act), essentially deferring sale treatment until the spouse disposes of the asset. Under H.R. 2286, this exemption is extended to a “qualifying spousal trust,” which is defined as a qualified domestic trust (“QDOT”) of which the transferor’s spouse or surviving spouse is the sole current income beneficiary and has the power to appoint the entire trust. Under the STEP Act, this exemption is extended to a QTIP trust. Awkwardly, the STEP Act describes a QTIP trust as “qualified terminal [sic, not “terminable”] interest property.” Also awkwardly, H.R. 2286 incorporates the QDOT definition of section 2056A, even though the spouse must be a U.S. citizen to qualify for the deemed sale exception in H.R. 2286 in the first place. That could conceivably even require any ordinary QTIP trust for a U.S. citizen spouse to mandate the withholding under section 2056A(a)(1)(B) of estate tax payable with respect to distributions, for example (or, channeling it into the deemed sale context, withholding the income tax on unrealized appreciation avoided by the transfer to the trust), although there is no indication that such an odd result is intended or would serve any purpose of this proposed legislation. And a strict application of the “qualifying spousal trust” rules in H.R. 2286 would also require the transferor or the spouse to have the power to appoint the entire trust, which is not normal in an ordinary QTIP trust. Property transferred in such an exempt transfer to an eligible trust for the benefit of the transferor’s spouse or surviving spouse would be subject to the deemed sale rules (1) upon a distribution from the trust to someone other than the spouse, (2) upon the cessation of the trust’s status as an eligible trust, or (3) upon the spouse’s death. (6) Exception for Transfers to Charity. A transfer to a charity or another organization described in section 170(c) would not be a deemed sale. The STEP Act adds explicit exemptions for (1) a trust in which property is set aside for such an organization (subject to annuity, unitrust, and other valuation rules of section 2702), (2) a qualified disability trust defined in section 642(b)(2)(C)(ii), and (3) a cemetery perpetual care fund described in section 642(i). (7) Other Estate-Includible Grantor Trusts. In the case of a transfer to a trust is that is both deemed owned by the transferor under subpart E of part 1 of subchapter J (commonly called generically the “grantor trust rules”) and includible in the transferor’s gross estate, the deemed sale would occur, not when the property is transferred to the trust, but when: (a) a distribution is made to a person other than the deemed owner, (a) the transferor ceases to be the deemed owner of the trust (including, apparently, upon the transferor’s death), or (b) the trust ceases to be includible in the gross estate of the transferor (oddly, in H.R. 2286, explicitly including upon the transferor’s death). (8) Other, Non-Includible, Grantor Trusts. Under the STEP Act, in the case of other deemedowned trusts (except the spousal, charitable, disability, and cemetery care trusts discussed above) – that is, a deemed-owned trust that is not includible in the transferor’s gross estate – the deemed sale would apparently occur: (a) when a transfer is made to the trust, (c) when a distribution is made to a person other than the deemed owner, (d) when the transferor ceases to be the deemed owner of the trust, or (e) upon the death of the transferor. This type of trust is commonly called a “defective grantor trust.” The treatment of a transfer to the trust, a distribution from the trust, the termination of grantor trust status, and the death of the

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transferor as deemed realization events, in effect overturning Rev. Rul. 85-13, 1985-1 C.B. 184, would likely be viewed as quite harsh. Under H.R. 2286, for grantor trusts not in the gross estate (as well as nongrantor trusts), a deemed sale would occur when a distribution is made from the trust but would not occur at the grantor’s death if no distribution occurs at that time. However, for grantor trusts includible in the gross estate, a deemed sale would occur at the grantor’s death, even if the assets remain in the trust. (9) Non-Grantor Trusts. In the case of other trusts – that is, a trust that is not deemed owned by the transferor for income tax purposes – transfers to the trust and distributions from the trust (under the STEP Act, perhaps only if the transfer is to another trust) would be treated as a sale, and property held in a long-term trust would be deemed sold at specified intervals. In H.R. 2286, property that has been held in trust for 30 years without being subject to section 1261 would be deemed sold, or, if it has been continuously held in trust for more than 30 years on the effective date (January 1, 2022), it is treated as sold on that date. In the STEP Act, all property held by such a trust would be treated as sold every 21 years, with property in a trust created before January 1, 2006, first treated as sold on December 31, 2026. Thus, H.R. 2286 would apparently require tracking the holding period of each individual asset, while the STEP Act would apparently subject all trust assets to tax every 21 years regardless of the asset’s holding period. In addition, H.R. 2286 would treat a modification of the direct or indirect beneficiaries of a trust (or the beneficiaries’ rights to trust assets) or the transfer or distribution of trust assets (including to another trust) as a deemed sale, unless Treasury and the IRS determine “that any such transfer or modification is of a type which does not have the potential for tax avoidance.” This apparently is intended to include some decantings. (10) Other Exclusions. H.R. 2286 would exclude annual exclusion gifts and up to $1 million of net capital gain at death. The $1 million amount would be indexed for inflation after 2022. Thus, lifetime exclusions would be measured by the total value transferred (and the number of donees), while the exclusion at death would be measured by the net gain. Among other complications, the exclusion of gifts to the extent of the dollar amount of the annual exclusion would present the challenge of allocating that exclusion when gifts to any individual of assets with different bases exceed the annual exclusion amount in any year, as well as the challenge of applying that allocation in the case of gift-splitting by spouses. The STEP Act would provide what amounts to a “lifetime exclusion” of $100,000 of gain, expressed as “the excess of … $100,000, over … the aggregate amount excluded under this subsection for all preceding taxable years.” For transfers at death, the exclusion would be $1 million, less the amount of the $100,000 exclusion applied to lifetime gifts. Both the $100,000 and $1 million amounts would be indexed for inflation. The proposals would not change the exclusion for sales of a principal residence. (11) Netting of Gains and Losses. In the case of deemed sales occurring upon death, the proposals would exempt the sales from the disallowance of related-party losses under section 267, which would allow losses on deemed sales to offset gains. (12) Coordination with Basis Rules. The basis rules for property acquired from a decedent (section 1014) or upon gift or transfer to a trust (section 1015) would be amended to more or less coordinate with the new deemed sale rules, generally providing a stepped-up (or stepped-down) basis if there is a deemed sale. Apparently, under H.R. 2286, that would mean that even annual exclusion gifts excluded from deemed sale treatment would receive a new basis equal to the fair market value at the time of the gift. Spouses and surviving spouses would receive a carryover basis in all cases. (13) Extension of Time for Payment of Tax. The proposals would add a new section 6168, providing an election to pay the income tax on deemed sales in installments, similar to the rules in section 6166 for estate taxes. Like section 6166, section 6168 would apply only with respect to transfers www.bessemertrust.com/for-professional-partners/advisor-insights

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at death, not during life. In contrast to section 6166, however, section 6168 would apply not only to closely held business interests that exceed 35 percent of the gross estate, but to all assets other than “actively traded” personal property (such as securities traded on an exchange). The STEP Act would mirror section 6166 by allowing payment of the additional income tax in up to 10 equal annual installments beginning no later than five years after the prescribed due date. H.R. 2286 would allow up to seven equal annual installments, with no deferral of the first installment. Both proposals would provide for payment of interest (at 45 percent of the normal rate as in section 6601(j)(1)(B) for estate tax extended under section 6166, but with no “2-percent portion” as in section 6601(j)(1)(A)), and the STEP Act would make that interest nondeductible for estate tax purposes. Both proposals, like section 6166, would also include provisions for a special lien (which the STEP Act would allow to be partially replaced by a bond), extensions of the period of limitations on assessment, and proration of deficiencies to installments. The STEP Act, but apparently not H.R. 2286, would provide for acceleration of the payment of deferred tax if the subject property is disposed of or is used in whole or in part to secure nonrecourse indebtedness. (14) Information Reporting. H.R. 2286 would add a new section 6050Z requiring that, except in the case of securities transactions reported by brokers under section 6045(g), the donor or executor must report to the IRS the name and taxpayer identification number of the recipient of each transfer and information describing the property and stating its fair market value and basis. The donor or executor must also report that fair market value and basis to the recipient of the property. These requirements are similar to the rules currently in section 6035 regarding the consistent basis of property transferred at death, except that section 6050Z would require this information reported to the IRS to be shared only with “the person to whom such transfer was made” (not, for example, to all beneficiaries who might receive an asset, as with Schedule A of Form 8971) and only “at such time and in such form and manner as the Secretary shall by regulations prescribe.” The STEP Act omits such a reporting requirement, but, seeming to step off-topic somewhat, it would add a new section 6048A requiring any trust (not already reporting under section 6034(b) or 6048(b)) with assets of more than $1 million or gross income for the year of more than $20,000 to report annually to the IRS “(1) a full and complete accounting of all trust activities and operations for the year, (2) the name, address, and TIN of the trustee, (3) the name, address, and TIN of the grantor, (4) the name, address, and TIN of each beneficiary of the trust, and (5) such other information as the Secretary may prescribe.” (15) Miscellaneous Matters. In addition, the STEP Act would provide that the costs of appraising property deemed sold under new section 1261 would be deductible for income tax purposes and would not be a “miscellaneous itemized deduction” subject to section 67. The STEP Act also would waive penalties for underpayment of estimated tax related to income tax on deemed realized gains at death (which, of course, would not have been foreseeable). l.

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If a transfer triggering a deemed sale of a trust asset under §1261(a) has not occurred within 30 years, a deemed realization event would occur for specific assets in the trust every 30 years (or on January 1, 2022 if the asset has been held continuously in trust for more than 30 years on that date). Apparently, this provision applies for each individual trust asset, thus requiring tracking of the holding periods of all trust assets. (b) Grantor Trusts Includible in Gross Estate. For assets in a grantor trust that is includible in the grantor’s gross estate, there would be a deemed realization event at the grantor’s death, even if the assets remain in the same trust. Proposed §1261(c)(1)(B). It seems ironic that assets in a grantor trust includible in the estate would have a deemed realization at the grantor’s death, but assets in a grantor trust not includible in the gross estate would not necessarily have a deemed realization event at the grantor’s death. (2) Senate Proposal, STEP Act. Under the STEP Act draft, there would be a deemed realization of assets in a grantor trust (whether or not includible in the grantor’s gross estate) at the grantor’s death. Proposed §1261(b)(1)(B). For nongrantor trusts, there would not be deemed realization at the death of the grantor, but a deemed realization event might occur if the asset is “transferred … in trust” to another trust at the grantor’s death. See Proposed §1261(a). In any event, a deemed realization event would occur every 21 years (with property in a trust created before January 1, 2006 being first treated as sold on December 31, 2026). (3) Greenbook Proposal. Under the Greenbook description, grantor trusts and nongrantor trusts are treated the same (except for revocable grantor trusts). There is no automatic deemed realization at the grantor’s death, but there would be a deemed realization if a trust asset is “distributed.” So, if the assets remain in the same trust for the grantor’s descendants (i.e., a pot trust for multiple beneficiaries), there would be no deemed realization, but if the assets pass to new separate trusts for the grantor’s descendants, there would be a deemed realization. A deemed sale of assets in a trust would occur every 90 years if there has been no deemed sale of those particular assets within the prior 90 years (the testing period begins on January 1, 1940 and the first such “90-year deemed sale” would be December 31, 2030). This apparently applies on an asset-by-asset basis. (4) Increased Use of Pot Trusts or Separate Trusts for Grandchildren. The various proposals have varying rules for when the death of the settlor will result in a deemed sale of trust assets in different trust situations. For those situations in which a deemed sale does not occur unless assets are transferred from the trust (including to a new trust), using “pot trusts” for multiple generations may avoid having trusts terminate at the death of the settlor or for a trust beneficiary to avoid a deemed sale. An alternative approach for a client with grandchildren who is creating a new trust is to use a separate trust for each grandchild (of which the grandchild’s parent and the grandchild would be discretionary beneficiaries) so that at the death of the client or of the client’s child who is the parent of the client’s grandchildren there would be no distribution to a new trust, but the assets could simply remain in each separate grandchild’s trust for each respective grandchild. (That would be a very unusual plan structured to anticipate provisions that we don’t know will ever be enacted. Complications would arise in providing equitable treatment for any grandchildren born after the grandchildren’s trusts are created.) m.

Impact of Deemed Realization Proposals on Traditional Trust Planning. The deemed realization proposals are controversial, and adoption of a deemed realization approach seems unlikely considering the ultra-thin Democratic voting margin in the Senate. See Item 2.i above. Even so, planners are considering whether current trust planning should be adjusted to address the rather substantial income tax impact that the proposals could have on trusts being planned currently. For example, as discussed in Item 2.j above, under the FY 2022 Greenbook proposal, transfers to or distributions in kind from trusts (including grantor trusts other than “revocable” grantor trusts) would be deemed realization events. The income tax ramifications of the proposal may gut many of the traditional transfer planning techniques planners have used – even though the Administration’s

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proposal does not directly address estate and gift taxes. The following are examples of issues that planners are considering currently in light of these proposals. •

•

The right of recovery raises the possibility of an additional gift if the donor does not demand the reimbursement.

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Separate Trusts for Grandchildren. Another approach may be to create separate trusts for each grandchild, as described in Item 2.l(4) above, to avoid having a deemed sale at the death of the settlor or of the child of the settlor who is the parent of the grandchild.

•

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passing from the trust in the sale or substitution transaction. (Under the Greenbook proposal and the Senate proposal, a deemed sale occurs upon “distributions” from the trust, and a purchase by the trust would not seem to be the same as a trust distribution. In contrast, under the House proposal, a deemed sale occurs upon a “transfer” from the trust.)

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Decanting. Decantings to new trusts may be realization events.

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Flexibility. Building in as much flexibility as possible into irrevocable trusts may be more important than ever (for example, using trust protectors with very broad amendment powers). See Item 9 below regarding planning considerations for using trust protectors.

Adding a statutory anti-clawback provision for both estate and gift taxes (included in the 2019 proposal, removed from the 2021 proposal);

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Extending basis consistency provisions (and accompanying reporting requirements) to gifts (included in the 2019 proposal, removed from the 2021 proposal);

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•

Major changes for grantor trusts (under new §2901) –

•

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§2901(a)(1), Estate inclusion in grantor’s gross estate;

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§2901(a)(2), Distributions are treated as gifts from the grantor;

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§2901(a)(3), Gift of entire trust if it ceases to be a grantor trust during the grantor’s life;

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The initial gift to the trust is also a gift, but a reduction will apply in the amount of gifts or estate inclusion deemed to occur (under the first three rules) by the amount of the initial gift;

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Any estate tax imposed by new §2901 would be a liability of the trust (but the bill has no details about how the amount of estate tax attributable to §2901 would be determined);

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The 2021 proposal eliminates an exception for trusts that do not have as a significant purpose the avoidance of transfer taxes, as determined by regulations or other guidance from the Treasury;

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Observe that this may result in estate inclusion of ILITs (unless the trust is structured as a non-grantor trust) created after the date of enactment, or the portion of an ILIT attributable to post-date-of-enactment contributions to the trust (for example, to make premium payments). See Michael Geeraerts & Jim Magner, Alternative Life Insurance Ownership Structures if Congress Takes a Swing at ILITs Using New Code Section 2901, LEIMBERG ESTATE PLANNING NEWSLETTER #2865 (Feb. 22, 2021).

Regardless of GST exemption allocated to a trust, a trust will have a GST inclusion ratio of 1 (i.e., fully subject to the GST tax) unless “the date of termination of such trust is not greater

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than 50 years after the date on which such trust is created”; this provision applies to postdate-of-enactment trusts, and prior trusts would have the inclusion ratio reset to one 50 years after the date of enactment; the provision is more aggressive than the Obama Administration proposal which had a limit of 90 rather than 50 years, and which merely reset the inclusion ratio to one after the 90-year term rather than applying an inclusion ratio of one from the outset if the trust did not have to terminate within the maximum allowed time; and •

Budget Reconciliation Legislative Process for Passage in Senate With Mere Majority Vote. The 50-50 split in the Senate makes passing far-reaching legislation (including tax legislation) difficult with the general 60-vote requirement in the Senate. While the budget reconciliation process offers the opportunity of passing certain types of legislation with only a majority vote in the Senate, it has various limitations and can be quite cumbersome. (1) Generally. For a general summary of the reconciliation process including the statutory authority, the two-step process of a budget resolution and reconciliation act, examples of the use of reconciliation, and the Byrd rule (which limits reconciliations measures that would produce additional deficits outside the “budget window” set in the budget resolution), see Item 2.d. of Estate Planning Current Developments and Hot Topics (May 2021) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. (2) Two Reconciliation Acts Possible in 2021. Reconciliation can be used only once for each fiscal budget cycle, but reconciliation could be used in 2021 for both the fiscal 2021 and 2022 years. (Republicans used two reconciliation acts in 2017, one of which was the 2017 tax reform measure.) Democrats used reconciliation for passage of the American Rescue Plan Act of 2021 for the 2021 fiscal budget cycle (i.e., the October 1, 2020 – September 30, 2021 budget year), but a subsequent reconciliation act could be used later in 2021 for the fiscal 2022 budget. The act for the 2022 fiscal year generally would not be effective until October 1, 2021 or later, the beginning of the 2022 fiscal year, but there is precedent for rate changes effective as of an earlier date. The Omnibus Budget Reconciliation Act of 1993, pursuant to the concurrent resolution on the budget for fiscal year 1994, was enacted August 10, 1993 (Vice President Al Gore cast the deciding 51st vote in the Senate on the Conference Report); OBRA 1993 included individual and business income tax rate changes retroactive to January 1, 1993. (3) Additional Reconciliation Measure Available by Amending Current Budget Resolution. Furthermore, the Senate parliamentarian on April 5, 2021 construed §304 of the Congressional

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Budget Act to mean that a revised budget resolution with reconciliation instructions could be adopted, which in effect would allow an additional reconciliation measure to be added to the reconciliation act that was passed in March 2021. Effectively, this would permit three or more reconciliation measures to be passed in a single calendar year. However, she later clarified that revising the earlier 2021 budget resolution must go through committee and floor amendment votes, and a legitimate reason – such as a new economic downturn – would be required for a revision. Therefore, Democrats are more likely to attempt a fresh fiscal 2022 budget resolution and reconciliation approach if reconciliation is needed for some of the infrastructure measures, but the budgeting process requires debate and votes on the relevant Congressional panels, which “could allow Republicans to bottle up the budget in committee by denying a quorum.” Erik Wasson, Schumer’s Infrastructure Path May Get Trickier After Ruling, BLOOMBERG DAILY TAX REPORT (June 2, 2021). Under the parliamentarian’s clarification, using the fiscal year 2022 budget for a reconciliation act dealing with infrastructure plans would preclude using it later for other purposes, such as Obamacare expansion or cutting drug prices. Id. p.

2021 Priorities and Likelihood and Timing of Tax Legislation. (1) Administration’s General Priorities. Top priorities of the Administration at this point appear to be COVID, infrastructure, immigration reform, voting rights, and social justice issues. These stated priorities of the Administration suggest that tax legislation (other than tax measures directly related to paying for those measures) will be a low priority at least during the beginning of the Administration, and that the likelihood of allocating significant political capital to “tax reform” in 2021 would seem low until late in the year (or even into 2022). (2) Evenly Divided Congress. The Congress is very evenly divided, with a 220-211 split in the House and 50-50 split in the Senate (with Vice-President Harris breaking a tie vote). The close margins may require more deliberation and negotiation and would seem to result in more moderate results. Moderation may be required, even using the reconciliation process, because a single Democratic defection may preclude passage. With narrow majorities, Democrats don’t necessarily get to do everything they say they want … Even though offsets are required, it looks bad to moderates if the net spending number is too big. There are moderates, like Democratic Sens. Joe Manchin III from West Virginia, Krysten Sinema of Arizona, and Jon Tester of Montana. Even new Democratic Sen. Raphael Warnock of Georgia may suddenly become a moderate because he is up for reelection in 2022. Lee A. Sheppard, Will There Be a Tax Bill?, TAX NOTES (Jan. 19, 2021).

The bolder tax proposals would seem unlikely to be successful in such an evenly divided Congress. Indeed, Senator Manchin has made clear that he will not support a $3.5 trillion reconciliation package that is expected to include some of the Administration’s tax proposals. Instead of rushing to spend trillions on new government programs and additional stimulus funding, Congress should hit a strategic pause on the budget-reconciliation legislation. A pause is warranted because it will provide more clarity on the trajectory of the pandemic, and it will allow us to determine whether inflation is transitory or not. While some have suggested this reconciliation legislation must be passed now, I believe that making budgetary decisions under artificial political deadlines never leads to good policy or sound decisions. I have always said if I can’t explain it, I can’t vote for it, and I can’t explain why my Democratic colleagues are rushing to spend $3.5 trillion. Joe Manchin, Why I Won’t Support Spending Another $3.5 Trillion, WALL STREET J. (Sept. 3, 2021).

(3) 2022 Midterms. While tax reform may not be among the highest priorities, Democrats in Congress may feel that they are facing time pressures. Midterms are historically tough on the president’s party. Losing just one net Senate seat to Republicans would result in loss of control of the Senate for Democrats. Therefore, while the split Congress may make sweeping changes harder to achieve, the possibility of a shift of control in the House or Senate in the 2022 midterms adds urgency for Democrats to do what they can now regarding tax legislation. But Democrats may sense even more urgency to pass measures that Americans feel directly rather than haggling over tax negotiations. In all this, Democrats face a ticking clock. Midterms are typically rough on the president’s party, and losing even one Senate seat would end Democrats’ control of Congress and thus their ability to govern. That gives www.bessemertrust.com/for-professional-partners/advisor-insights

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Democrats much less room for error than they had in 2009 [with the upcoming 2010 midterms in the first term of the Obama Administration]. Then, their congressional majorities reached 60 in the Senate and 257 in the House. They will start this session with 50 senators and 222 House members. If they are to avoid a midterm wipeout -- and a possible rehabilitation of the Trump brand -- they need to govern well, and they need Americans to feel the benefits of their governance fast. Ezra Klein, Opinion Today, NEW YORK TIMES (Jan. 21, 2021).

On the other hand, Democrats may feel more comfortable about holding the Senate in 2022, despite the history of traditional midterm losses by the president’s party, “as Republicans will be defending 20 of the 34 open seats, including two seats in states (Pennsylvania and Wisconsin) won by President Biden, while Democrats will not be defending any seat in a state won by President Trump. All of this makes confident predictions very difficult.” Ronald D. Aucutt, The Top Ten Estate Planning and Estate Tax Developments of 2020 (January 2021) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights). Securing votes for politically sensitive transfer tax provisions may be especially difficult (as discussed further immediately below). Three Democratic senators up for re-election in 2022 won their last race by less than 6% (Senators Hassan [NH], Mastro [NV], and Bennett [CO]), and three more Democratic senators up for re-election in 2024 are from states won by President Trump in 2020 (Senators Manchin [WV], Tester [MT], and Brown [OH]). Also Senators Warnock and Ossof in Georgia won their 2020 races by less than 1% of the vote. Securing votes for estate tax increases from any of these eight Democratic senators seemingly would be very difficult (but anything can happen as packaging of proposals and legislative negotiations proceed). See Bruce Givner, The Federal Estate Tax Will Not Increase in 2021, LEIMBERG ESTATE PL. NEWSLETTER #2882 (April 27, 2021). (4) Predictions of Scope and Timing of Tax Reform and Transfer Tax Measures. Various commentators have been predicting that passing sweeping tax reform measures will be difficult and likely not to be front-burner priorities; however, several of the bold tax reform measures are included in The American Families Plan and in the FY 2022 Greenbook. Lee A. Sheppard, a frequent commentator with Tax Notes, predicts that many of the Biden tax proposals will not be enacted, but she thinks that “[t]he reduction of the transfer tax exemption could well happen.” It’s a political football, and estate planners were scrambling to have clients make gifts last year. It’s a quick and dirty way for Democrats to take progressive action without getting blue-state constituents riled up about income taxes. And it would raise nearly $300 billion over 10 years.” Lee A. Sheppard, Will There Be a Tax Bill?, TAX NOTES (Jan. 19, 2021).

Ron Aucutt, though, concludes as to future transfer tax increases – “not much and not soon.” The legislative process in 2021 will be affected by the close margins in Congress. It will also be affected by some obvious priorities – COVID relief and prevention, social justice, environmental concerns, and infrastructure. But another priority is raising revenue, particularly after the 2020 surge of spending in response to the COVID pandemic on an emergency basis that postponed the issue of paying for it (appropriately so in an emergency). Even in 2021, raising revenue to make up for 2020’s spending will probably proceed with caution, to avoid undoing some of the 2020 relief or jeopardizing the recipients of that relief. But sooner or later both Democrats and Republicans will have a keen interest in raising revenue again, although very likely with different reasons and different ideas how to do it and how to allocate the burden. … In any event, there may be less interest and urgency for estate tax changes (compared to income tax changes with wider and more immediate effect), less likelihood of making income tax changes (other than changes offering COVID relief) effective January 1, 2021, and even less likelihood of a January 1, 2021, effective date for transfer tax changes, for which the calendar year is less relevant. … And perhaps dominating all of this is the recollection of Vice President Biden’s role in negotiating, for example, the estate tax provisions of the 2012 Tax Act with a Republican House and Democratic Senate. …

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Bottom Line. So – bottom line prediction – not much and not soon? But it is never possible to be sure. Ronald D. Aucutt, The Top Ten Estate Planning and Estate Tax Developments of 2020 (January 2021) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights).

Possibility of Retroactive Tax Changes. (1) Democratic Sweep; Transfer Tax Changes? The sweep of the White House, Senate and House of Representative by Democrats in the 2020 elections (and the Georgia Senate run-off elections) has changed the calculus of anticipated tax legislation, including legislation relating to the transfer tax. A variety of transfer tax proposals have been submitted, ranging from repealing the estate tax or substantially reducing the rate to accelerating the sunset of the doubling of the $5 million (indexed) basic exclusion amount or even reducing the exclusion amount to $3.5 million (and possibly reducing the gift exclusion amount to $1 million). At a minimum, the possibility of accelerating the sunset of the gift, estate and GST exclusion amount to $5 million (indexed) before 2026 has been heightened. (2) Significance of Possibility of Retroactive Gift Tax Changes. Throughout 2020, some planners were concerned that clients should make transfers in 2020 in case legislation in 2021 reducing exclusions or increasing rates would be made retroactive to January 1, 2021. In 2021, there is concern that legislation might reduce the gift exclusion amount (the ”For the 99.5 Percent Act” proposal would reduce it to $1.0 million, not indexed) and increasing the maximum gift tax rate from 40% to 65% (the Biden Administration has suggested increasing the rate to 45%). If the effective date should be some date before the date of enactment (for example, January 1, 2021, the date of introduction of the bill, or the date the bill is approved by the House Ways & Means Committee), clients might have made gifts of $11.7 million (the existing gift exclusion amount) thinking that no gift taxes would be due, only to find out that the excess $10.7 million times 45% equals a resulting gift tax of $4,815,000. If a married couple each made $11.7 million gifts and the gift exclusion amount were reduced to $1 million retroactively, the couple would owe almost $10 million of gift tax!! This would be a rude (to put it mildly) surprise. More to the point, it would be outrageously unfair. The operation of the unified credit for federal gift tax purposes creates the possibility of an inadvertent retroactive gift tax change. Section 2505 describes the unified credit for gift tax purposes, and §2505(a)(1) says the gift tax unified credit is the unified credit under §2010(c) (the estate tax unified credit) “which would apply if the donor died as of the end of the calendar year” [with another adjustment not relevant]. Therefore, if a donor made an $11 million gift on April 1, and the Congress reduces the exclusion amount to $5 million (indexed) effective December 31, the exclusion amount for gift tax purposes for the April 1 gift would be only $5 million (indexed). That is a scary possibility—but transfer tax changes are typically made effective on January 1 of the year following the date of enactment; therefore, the exclusion amount would not be changed as of the date of the gift. Indeed, changes to the exclusion amount in §2010 and §2505 over the last four decades have generally followed the approach of having the revision apply “after December 31” (in 2017, 2013, 2010, 2001, 1997, 1981, and 1976). The possibility of retroactive legislation has two countering effects. One is a push toward making gifts as soon as possible, to beat what may end up being the retroactive effective date. The other is a fear of making any gifts over $1.0 million for fear of missing the effective date (and getting the “rude surprise”). In the very evenly divided Congress (discussed in Item (2)-(3) above), the likelihood of a retroactive reduction of the gift exclusion amount is extremely low in light of the extreme unfairness of such a change, In addition, the Administration has never hinted at retroactive transfer tax changes. The specter of retroactive tax legislation has appeared most recently with the release of a Discussion Draft of the “Sensible Taxation and Equity Promotion (“STEP”) Act of 2021,” which would impose a new deemed realization on transfers by gift or at death with a proposed effective date of January 1, 2021. See Item 2.k above. (3) Retroactive Tax Legislation Generally and Constitutionality. A long history exists of examples of retroactive legislation. Indeed, the Supreme Court has gone so far as to state that

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Congress “almost without exception” has given general revenue statutes effective dates prior to the dates of actual enactment. United States v. Darusmont, 449 U.S. 292, 296 (1981). For various examples, see Item 2.b.(3) of Estate Planning Current Developments and Hot Topics (May 2021) found here and available at www.bessemertrust.com/for-professional-partners/advisorinsights). (a) General Constitutionality of Retroactive Tax Legislation. Retroactive tax legislation is not absolutely barred by the U.S. Constitution, and is almost always upheld by the Supreme Court. See, e.g., United States v. Carlton, 512 U.S. 26 (1994); United States v. Hemme, 476 U.S. 558 (1986); United States v. Darusmont, 449 U.S. 292 (1981); Welch v. Henry, 305 U.S. 134 (1938); United States v. Hudson, 299 U.S. 498 (1937); Milliken v. United States, 283 U.S. 15 (1931). It has been viewed by the Supreme Court as “customary congressional practice” that is “generally confined to short and limited periods required by the practicalities of producing national legislation.” Carlton (quoting Darusmont). Indeed, there are few examples of retroactive tax legislation being declared unconstitutional, but it is not out of the question that retroactive legislation could go too far and violate the Constitution (for example if it has an extended period of retroactivity or targets certain taxpayers or penalizes past conduct). See Erika Lunder, Robert Meltz, & Kenneth Thomas, Constitutionality of Retroactive Tax Legislation, CONGRESSIONAL RESEARCH SERVICE REPORT (Oct. 25, 2012) (includes a detailed analysis of possible constitutional attacks, including Fifth Amendment Due Process, takings for purposes of the Fifth Amendment, unconstitutional ex post facto legislation [but that just applies for criminal laws], unconstitutional bill of attainder, or Fifth Amendment equal protection guarantees). One example of retroactive tax legislation that went “too far” was the retroactive introduction of the federal gift tax. Untermyer v. Anderson, 276 U.S. 440 (1928). (b) United States v. Carlton – Retroactive “Corrective” Estate Tax Legislation Upheld. Carlton upheld an amendment enacted in December 1987 that retroactively limited the availability of a 50% deduction under §2057 that had been enacted in October 1986 for stock that is sold by the estate to an ESOP, so that the deduction would apply only to stock owned immediately prior to death, as if the amendment were incorporated in the 1986 law. The Carlton estate on December 10, 1986 purchased stock after the decedent’s death, sold the stock two days later to an ESOP for $10,575,000 (which was $631,000 less than the purchase price), and claimed an estate tax deduction equal to 50% of the sale price that reduced the estate tax by $2,501,161. The estate argued that the retroactive law change violated the Due Process Clause of the Fifth Amendment. The Court disagreed, primarily because the amendment “is rationally related to a legitimate legislative purpose,” giving several specific reasons. (1) The amendment was curative to prevent the deduction from applying to what some called “essentially sham transactions,” and the retroactive application was supported by a legitimate purpose furthered by rational means. The change, which prevented an anticipated revenue loss of up to $7 billion by denying the deduction to those who made purely tax-motivated stock transfers, was not unreasonable. (2) The change involved “only a modest period of retroactivity” having been proposed by the IRS in January 1987 and Congress in February 1987 within a few months of the deduction’s original enactment. (3) The estate’s detrimental reliance was insufficient to establish a constitutional violation because “[t]ax legislation is not a promise, and a taxpayer has no vested right in the Internal Revenue Code.” (4) The estate’s lack of notice of the change before engaging in the purchase transaction is not dispositive because prior cases (Welch v. Henry and Milliken) had upheld retroactive taxes despite the absence of advance notice. Concurring opinions in Carlton observed that some limits should apply. Justice O’Connor reasoned that Congress does not have “unlimited power to ‘readjust rights and burdens … and upset otherwise settled expectations;’” for example “a ‘wholly new tax’ cannot be imposed retroactively.” She observed that the retroactive change in this case applied “for only a short period prior to enactment,” and that “a period of retroactivity longer than the year preceding the legislative session in which the law was enacted would raise, in my view, www.bessemertrust.com/for-professional-partners/advisor-insights

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serious constitutional questions.” Justice Scalia (in a concurring opinion joined by Justice Thomas) believed that the “rationally related to a legitimate legislative purpose” standard announced by the Court was very broad because “[r]evenue raising is certainly a legitimate legislative purpose …, and any law that retroactively adds a tax, removes a deduction, or increases a rate rationally furthers that goal.” In Justice Scalia’s hyperbolic manner, he observed that “the reasoning the Court applies to uphold the statute guarantees that all retroactive tax laws will henceforth be valid” (emphasis in original). He welcomed the Court’s effective recognition (in his view of the Court’s standard) that the Due Process Clause does not prevent retroactive taxes, “since I believe that the Due Process Clause guarantees no substantive rights, but only (as it says) process.” However, he did state his belief that the refusal to reimburse the estate’s economic loss for acting in reliance on a tax-incentive provision was harsher and more oppressive than merely imposing a new tax on past actions. Query whether the Supreme Court would have reacted similarly for a retroactive change in the gift tax, particularly a substantial decrease in the gift exclusion amount? (c) Untermyer v. Anderson – Retroactive Introduction of Gift Tax Not Upheld. The initial 1924 introduction of the federal gift tax on a retroactive basis for gifts made at any time during the calendar year was not upheld. Untermyer v. Anderson, 276 U.S. 440 (1928). The Court ruled that the application of the new gift tax to bona fide gifts not made in anticipation of death that were fully consummated prior to June 24, 1924 (the date of enactment) was arbitrary and invalid under the Due Process Clause of the Fifth Amendment. This case from nearly a century ago has never been overruled by the U.S. Supreme Court, but it has been distinguished in situations that did not involve the introduction of a new tax regime. (4) Retroactive Transfer Tax Legislation Seems Unlikely. While tax legislation is sometimes retroactive to a date prior to the date of enactment (though that is more likely to happen with the income tax than the transfer tax), retroactive changes in the transfer tax are extremely unlikely in this Congress, due to the evenly divided nature of the Congress (see Item (2)-(3) and Item 2.q(2) above and the extreme unlikelihood that all 50 Democratic senators would go along, especially with a retroactive reduction in the gift exclusion amount that would be so particularly egregious. Commentators have predicted that retroactive tax hikes in 2021 are unlikely. Jonathan Curry, Retroactive Tax Hikes Seen as Unlikely Under Biden Administration, TAX NOTES (Nov. 16, 2020). The Administration so far has not even hinted at any retroactive tax proposals. (5) Planning in Light of Possible Retroactive Legislation. The possibility of retroactive legislation in some ways encourages current transfers but in other ways raises concerns about making current transfers. In late 2020, before it was known whether the Democrats would have a Senate majority in 2021, some clients made transfers in late 2020 for fear that legislation in 2021 rolling back transfer tax exclusions or enacting other transfer tax reforms conceivably might be made retroactive to sometime in early 2021. Similarly, in 2021, planners may want to act sooner rather than later in taking advantage of the large $11.7 million gift exclusion amount in case the exclusion amount is reduced retroactively to a time earlier than date of enactment of legislation. (But realistically -- how likely is it that Congress would pass a retroactive decrease in the gift exclusion amount, catching prior gifts?) In other ways though, the possibility of retroactive legislation raises risks of triggering unexpected gift taxes. Considering the possibility of retroactive changes, some planners have examined ways of making gifts that could be limited not to trigger gift tax or that could be “undone” in the event of subsequent legislation making the gift inadvisable. Alternatives include (1) formula gifts up to the available exclusion amount, (2) gifts to QTIPable trusts, (3) gifts to QTIPable trusts with a disclaimer provision that would pass assets to a trust for descendants (or possibly a SLAT although that is not clearly allowed) if the spouse disclaimed, (4) gifts to trusts providing that disclaimed assets would revert to the donor, (5) combinations of the above, (6) selling assets to delay the decision to make a gift by forgiving the note but shifting future appreciation beginning immediately, and (7) attempting to rescind the gift later based on changed

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circumstances. See Items 10-18 below for a more detailed discussion of these alternative approaches. r.

Wealth Tax and Mark-to-Market Proposals. The proposed Ultra-Millionaire Tax Act, co-sponsored by Senators Sanders, Warren, and various others, provides a 2% annual tax on the net worth of households and trusts ranging from $50 million to $1 billion and an additional 1% annual tax (for a 3% total tax) on assets above $1 billion. Estimates are that about 100,000 Americans (or fewer than 1 in 1,000 families) would be subject to the wealth tax in 2023, and that it would raise about $3 trillion over a decade, according to an analysis by University of California Berkeley Economics Professors Emmanuel Saez and Gabriel Zucman. Treasury Secretary Janet Yellen has confirmed that President Biden does not favor a wealth tax, and that a wealth tax would have significant implementation problems. See Yellen Favors Higher Company Tax, Capital Gains Worth a Look, BLOOMBERG DAILY TAX REPORT (Feb. 22, 2021). For a more detailed discussion of the wealth tax concept, including constitutionality issues and administrative complexities, see Item 2.d. of Estate Planning Current Developments and Hot Topics (December 2020) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. Senator Wyden (Chair of the Senate Finance Committee) proposes taxing long-term capital gains at applicable ordinary income rates and applying an annual mark-to-market regime. For a summary of the Wyden mark-to-market proposal see Item 2.j. of Estate Planning Current Development and Hot Topics (May 2021) found here and available at www.bessemertrust.com/for-professionalpartners/advisor-insights.

Accelerating Charitable Efforts (ACE) Act Proposal. Sen. Angus King (I-ME) and Sen Chuck Grassley (R-IA) on June 9, 2021, introduced bipartisan legislation, the Accelerating Charitable Efforts (ACE) Act, to cause philanthropic funds to be made available to working charities within a reasonable time period by tightening restrictions on donor advised funds (DAFs) and private foundations. These changes are introduced in response to coalitions of philanthropic and nonprofit leaders and academics urging reforms to unlock hundreds of billions of dollars in DAFs and foundation endowments. A statement from Senator King’s office observes that DAFs currently have more than $140 billion set aside for future charitable gifts with no requirement to ever distribute these resources to working charities. However, the proposal is strongly opposed by the Council of Foundations and others in the charitable sector. If the proposal advances to a committee or Senate floor vote, Council on Foundations president and chief executive officer Kathleen Enright has said “we expect a big, pitched battle over it.” Philanthropy Divided Over Legislation to Accelerate DAF Grants, Philanthropy News Digest website (posted June 11, 2021). (1) Additional Restrictions on DAFs. Four restrictions would apply to contributions to “nonqualified” DAFs in order to receive an income tax charitable deduction: (i) no deduction would be allowed for non-cash contributions unless the fund sells the asset for cash; (ii) no deduction would be allowed until the fund makes a qualifying distribution of the contribution (or the sale proceeds of the contribution); (iii) the deduction would be limited to the qualifying distribution amount; and (iv) contribution must be distributed within 50 years to avoid the imposition of a 50% excise tax on the undistributed portion of the contribution and attributable earnings. For contributions to a “qualified” DAF, no income tax charitable deduction would be allowed for the contribution of a “non-publicly traded” asset until the year the asset is sold, and the deduction would not exceed the gross proceeds received from the sale and credited to the fund. A “qualified” DAF is one that requires the donor’s advisory privilege to end before the last day of the 14th taxable year beginning the year after the year in which the contribution is made, and in which the donor identifies at the time of contribution a preferred charitable organization to receive any assets that remain in the fund at the end of the time limit. That limitation does not apply, however, to a “qualified community foundation donor advised fund,” meaning that (i) no individual with advisory privileges has advisory privileges with respect to more than $1,000,000 (indexed) in DAFs with that sponsoring organization, (ii) the DAF must make qualifying distributions of at least 5% of the fund value each year, and (iii) the community foundation must

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serve the needs of a particular geographic community that is no larger than four states and that holds at least 25% of the organization’s total assets outside of DAFs. The new rules would apply to contributions after the date of enactment. (2) Changes to Private Foundation Minimum Distribution Requirements. The following would not count toward the 5% minimum distribution requirement for private foundations: (i) administrative expenses paid to substantial contributors or family members and (ii) distributions to a DAF. These two new rules would apply, respectively, to (i) taxable years beginning after December 31, 2021, and (ii) returns required to be filed after December 31, 2021. (3) Exemptions From Investment Income Excise Tax. The investment income excise tax would not apply to private foundations meeting either of two requirements: (i) the foundation makes qualifying distributions in excess of 7% of the foundation’s asset value (other than direct use assets); or (ii) the foundation has a specified duration of not more than 25 years and does not make distributions to other private foundations having a common disqualified person. These provisions would apply to taxable years beginning after the date of enactment. (4) Public Support Test Changes. To determine whether a charity meets the public support test to be classified as a public charity rather than a private foundation, contributions from a DAF to the charity will be treated as coming from the original donor, or if the original donor is not identified, all contributions from DAFs for which the donor is not identified will be treated as coming from a single donor. This provision would apply to contributions made after the date of enactment. t.

Proposal to Cap the Section 199A Benefit and to Extend the Section 199A Deduction to Additional Professions. Senator Ron Wyden (D-Ore.), chairman of the Senate Finance Committee, has introduced the Small Business Tax Fairness Act (which he hopes to include in the larger $3.5 trillion reconciliation bill being planned by congressional Democrats) to cap the eligibility for the 20 percent passthrough deduction under §199A to taxpayers with taxable income of $500,000 or less (the deduction is phased out for taxpayers with taxable income between $400,000 and $500,000). Under current law, certain professions (including the legal and accounting professions) are not eligible for the deduction, but the proposal would extend the eligibility for the deduction to “any trade or business other than the trade or business of performing services as an employee.” Senator Wyden estimates that the proposal would raise $147 billion of revenue (but that has not been verified by any official estimates). The Biden campaign had proposed phasing out the deduction for qualified business income above $400,000, but that proposal was not included in the Biden Administration’s FY 2022 budget proposal. See generally Senator’s Pass-Through Plan Could Raise $147B to Offset Spending, BLOOMBERG DAILY TAX REPORT (July 20, 2021); Frederic Lee, Wyden Passthrough Bill Pitched as Remedy to GOP Tax ‘Giveaways,’ TAX NOTES (July 21, 2021); Michael Geeraerts & Jim Magner, Senator Ron Wyden Introduces Bill to Limit 199A Deduction, LEIMBERG BUSINESS ENTITIES EMAIL NEWSLETTER #235 (July 28, 2021).

Fiscal Year 2022 Budget Reconciliation. The fiscal year 2022 Budget reconciliation process and the House Ways and Means Committee package of tax changes is summarized by Ronald L. Aucutt. (1) Budget Resolution. On August 24, 2021, the House of Representatives agreed to the Senateapproved Concurrent Resolution on the Budget for Fiscal Year 2022 (S. Con. Res. 14), establishing in principle spending priorities of about $3.5 trillion for the fiscal year beginning October 1, 2021, and ending September 30, 2022. The votes were strictly partisan. In the Senate on August 11 the vote was 50-49, with all Democrats in favor and all Republicans opposed except Senator Mike Rounds (R-SD), who did not vote. In the House on August 24 the vote was 220-212, with all Democrats in favor and all Republicans opposed. The resolution left the House Ways and Means Committee and the Senate Finance Committee with flexibility to develop tax changes to pay for the contemplated expenditures. (2) Ways and Means Committee Action. On September 15, 2021, the House Ways and Means Committee approved the “Build Back Better Act” (H.R. 5376), a package of tax changes pursuant to the budget resolution. Only one Democratic member of the Committee, Rep. Stephanie Murphy (D-FL), joined all the Republicans in voting against it. The bill now is on the

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House floor, while we wait for a corresponding consideration of revenue proposals by the Senate Finance Committee. The Ways and Means Committee’s bill includes the following: (a) No Deemed Realization. The Ways and Means Committee has omitted any deemed realization proposals like those made in the current Congress and in the Administration’s Fiscal Year 2022 Greenbook (see Item 2.j above). (b) Early Sunset for Doubled Basic Exclusion Amount. The sunset of the 2017 Tax Act’s doubling of the $5 million basic exclusion amount (indexed for inflation since 2012) would be accelerated from January 1, 2026, to January 1, 2022. Thus, the basic exclusion amount would return to $5 million, indexed for inflation since 2012, which the Joint Committee on Taxation (JCT) staff projects would be $6,020,000 for 2022. This is estimated to raise $54 billion over ten years. (c) Closer Alignment of Grantor Trust and Transfer Tax Rules. The bill approved by the Ways and Means Committee would create a new chapter 16, consisting solely of a new section 2901, effectively linking the grantor trust rules and the transfer tax rules so that a trust designed as a grantor trust would continue to be exposed to gift or estate tax with respect to the grantor. Thus the bill picks up, with some significant changes, the proposals in section 8 of Senator Sanders’ “For the 99.5 Percent Act” (discussed in Part Error! Reference source not found.), which in turn track the Obama Administration Greenbooks. With respect to a trust or portion of a trust that is not otherwise includable in the grantor’s gross estate and is funded on or after the date of enactment (either upon initial formation or by a contribution to an existing trust), section 2901 would i.

include the value of the assets of such portion in the grantor’s gross estate for estate tax purposes,

ii. subject to gift tax any distribution from such portion to one or more beneficiaries during the grantor’s life, other than distributions to the grantor or the grantor’s spouse or in discharge of an obligation of the grantor, and iii. treat as a gift by the grantor, subject to gift tax, all assets of such portion at any time during the grantor’s life if the grantor ceases to be treated as the owner of such portion for income tax purposes. Unlike the “For the 99.5 Percent Act,” this proposal would apply only to “any portion of a trust with respect to which the grantor is the deemed owner.” It omits the additional explicit application in the “For the 99.5 Percent Act” to the extent a deemed owner engages in a leveraged “sale, exchange, or comparable transaction with the trust” that appears to have been aimed at the technique known as a “Beneficiary Defective Inheritor’s Trust” (“BDIT”). (Compare Part Error! Reference source not found..) The creation of, or addition to, such a grantor trust would not escape gift tax, but, in determining future gift or estate taxes upon one of the events described in paragraphs (a), (b), and (c) above, “amounts treated previously as taxable gifts” would be “account[ed] for” with a “proper adjustment.” (d) Certain Sales Between Deemed Owned Trust and Deemed Owner. Going a step beyond the “For the 99.5 Percent Act,” the bill would add a new section 1062 providing: In the case of any transfer of property between a trust and a person who is the deemed owner of the trust (or portion thereof), such treatment of the person as the owner of the trust shall be disregarded in determining whether the transfer is a sale or exchange for purposes of this chapter.

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The bill would also amend section 267 to disallow losses between “[a] grantor trust and the person treated as the owner.” Like the closer alignment of grantor trust and transfer tax rules in section 2901, this rule, as written, would apparently apply only to a trust created, and any portion of an existing trust attributable to a contribution made, on or after the date of enactment. The Ways and Means Committee report states that it “is intended to be effective for sales and other dispositions after the date of enactment” – that is, regardless of when the trust was created or funded – but it adds in a footnote that “[a] technical correction may be necessary to reflect this intent.” This provision and section 2901 together are estimated to raise $8 billion over ten years. (e) Valuation of Certain Nonbusiness Assets in Entities. In a proposal traceable at least to the Reagan and Clinton Administrations and virtually identical to section 6 of Senator Sanders’ “For the 99.5 Percent Act” (see Part Error! Reference source not found.), the Ways and Means Committee bill would in effect require the valuation of nonbusiness assets in an entity by a look-through method. The proposal would add a new section 2031(d)(1) to the Code, applicable to transfers (by gift or upon death) after the date of enactment, to read as follows: (d) VALUATION RULES FOR CERTAIN TRANSFERS OF NONBUSINESS ASSETS—For purposes of this chapter [estate tax] and chapter 12 [gift tax]— (1) IN GENERAL—In the case of the transfer of any interest in an entity other than an interest which is actively traded (within the meaning of section 1092) [see, e.g., Reg. §1.1092(d)-1(a) & (b)]— (A) the value of any nonbusiness assets held by the entity with respect to such interest shall be determined as if the transferor had transferred such assets directly to the transferee (and no valuation discount shall be allowed with respect to such nonbusiness assets), and (B) such nonbusiness assets shall not be taken into account in determining the value of the interest in the entity.

Like the “For the 99.5 Percent Act,” the proposal includes detailed rules about “passive assets” that might be used in a business and “look-thru rules” for entities that are at least 10 percent owned by another entity. The proposal also adds a broad grant of regulatory authority, specifically including the issues of whether a passive asset is used in the active conduct of a trade or business or is held as part of the reasonably required working capital needs of a trade or business. This proposal is estimated to raise $20 billion over ten years. Unlike the “For the 99.5 Percent Act,” however, the proposal does not also include a general prohibition on “minority discounts” in family owned or controlled entities, a prohibition that in the “For the 99.5 Percent Act” (see Part Error! Reference source not found.) is not limited to “nonbusiness” entities or assets and thus would arguably have a much broader and harsher impact on family businesses. (f) Increased Benefit of Special Use Valuation. In contrast to the preceding provisions that would make the estate and gift tax more burdensome, the Ways and Means Committee bill, effective January 1, 2022, would increase the cap on the “special use” reduction in the estate tax value under section 2032A of real property used in family farms and other family businesses, which currently is $750,000 indexed for inflation since 1998 ($1,190,000 in 2021). Such an increase has often been offered by lawmakers opposed to across-the-board repeal or reduction of the estate tax as a way to target relief to the family farms and businesses that are often cited as justifications for such repeal or reduction. But, unlike section 3 of Senator Sanders’ “For the 99.5 Percent Act” (see Part Error! Reference source not found.), which would increase the limitation to only $3 million, indexed for inflation going forward, the Ways and Means Committee proposal would raise the limitation to $11.7 million (which happens to be the current basic exclusion amount), indexed going forward. This is estimated to decrease revenues by $317 million over ten years. (g) Other Income Tax Proposals. www.bessemertrust.com/for-professional-partners/advisor-insights

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Individual Income Tax Rates. Beginning January 1, 2022, the 39.6 percent top individual income tax rate, suspended for eight years by the 2017 Tax Act, would be reinstated for taxable incomes over $400,000 ($450,000 for joint returns and surviving spouses) and $12,500 indexed (projected by the JCT staff to be $13,450 in 2022) for trusts and estates. In addition, a 3 percent surtax would be applied to “modified adjusted gross income” over $5 million for individuals and $100,000 for trusts and estates.

ii. Capital Gain Tax Rates. The rate of income tax on capital gains would be increased from 20 percent to 25 percent to the extent the taxpayer is subject to the reinstated 39.6 percent top rate – that is, for taxable incomes over $400,000 ($450,000 for joint returns and surviving spouses and $12,500 indexed for trusts and estates). Notably, this provision is designed to take effect on September 14, 2021, with an exception for gains recognized in 2021 pursuant to written binding contracts entered into before September 14, 2021. iii. Corporate Income Tax Rates. Beginning January 1, 2022, the 21 percent corporate income tax rate would be retained for taxable income from $400,000 to $5 million, but it would be lowered to 18 percent on the first $400,000 of taxable income and raised to 26.5 percent on the amount of taxable income in excess of $5 million. iv. Expansion of Tax on Net Investment Income. Beginning January 1, 2022, the 3.8 percent tax on net investment income would be expanded by effectively eliminating the “trade or business” exception in section 1411(c)(1)(A) for individuals with modified adjusted gross income over $400,000 ($500,000 for joint returns and surviving spouses) and for trusts and estates with adjusted gross income in excess of the threshold for the highest income tax bracket for trusts and estates (projected by the JCT staff to be $13,450 in 2022). v. Limitation of Qualified Business Income Deduction. Beginning January 1, 2022, the qualified business income deduction of section 199A (added by the 2017 Tax Act) would be capped at $400,000 for individuals ($500,000 for joint returns and surviving spouses) and $10,000 for trusts and estates. 3.

Corporate Transparency Act Overview a.

Brief Summary. The Corporate Transparency Act (CTA) was enacted on January 1, 2021 as part of the National Defense Authorization Act. It effectively will create a national beneficial ownership registry. This is an outgrowth of the efforts of the international community, through the Financial Action Task Force (FATF), to combat the use of anonymous entities for money laundering, tax evasion, and the financing of terrorism. Regulations in the U.S., adopted in 2016 and 2018 (the “CDD Regulations”), require financial institutions to obtain identifying information when opening bank accounts for entities and require title insurance companies to provide beneficial ownership information for legal entities used to make high-end cash and wire purchases of real estate in various metropolitan areas. Still, the U.S. has been viewed internationally as being vulnerable to money laundering and tax evasion because of a perceived lack of corporate transparency and reporting of beneficial ownership. The CTA requires that certain entities must disclose to the Financial Crimes Enforcement Network (“FinCEN”) identifying information about individual owners and those who control the entity (“Beneficial Owners”) and “Applicants” applying to form an entity. A national registry of entities and their applicants and owners will be created. At this point, private trusts apparently are not included among the entities that must report, and charitable organizations, including private foundations, are specifically exempt from the reporting requirements. See generally Kevin L. Shepherd and Edward M. Manigault, Beneficial Ownership Disclosure and the Corporate Transparency Act: Overdue or Overwrought?, 35 PROB. & PROP. No. 4 (July/Aug. 2021);

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Brooke Tansill, The Corporate Transparency Act: What Practitioners Need to Know, ABA REAL PROP. TRUST & ESTATE LAW SECTION EREPORT (Summer 2021). b.

Reporting Companies. Companies that must report are corporations, LLCs, and other “similar entities” that are created by filing a document with a secretary of state or similar office or foreign entities registered to do business in the U.S. Trusts would seem not to be included as a Reporting Company because they are not created by filing a document with a secretary of state, but some question exists as to whether they might be considered a “similar entity.” Future study of partnerships, trusts, and other legal entities is called for under the CTA, so these rules may evolve in time. Companies that are exempt from reporting include (1) certain specified companies already under close federal regulation (e.g., banks, bank holding companies, SEC registered entities, insurance companies, charitable organizations exempt from tax under §501(c)(3), 501(a), 527(a) or 4947(a), etc.), (2) companies with a physical presence in the U.S. that employ more than 20 people and that have gross receipts exceeding $5 million, and (3) certain entities with no active trade or business (a number of requirements apply to this dormant company exception).

Beneficial Owner. A “Beneficial Owner” (who must be reported) is any individual who directly or indirectly (i) exercises substantial control over a Reporting Company or (ii) owns or controls at least 25% of the Reporting Company. Certain individuals are excluded as Beneficial Owners: (i) minors (provided the parent or guardian’s information is reported); (ii) nominees or agents; (iii) an employee whose control or economic benefits from the Reporting Company come solely from employment; (iv) an owner solely through a right of inheritance; and (v) a creditor of a Reporting Company (who is not otherwise a Beneficial Owner directly). For a trust that is a Beneficial Owner of 25% or more of an entity, regulations may adopt an approach, like the approach of the CDD Regulations, that the trustee is the deemed beneficial owner (and not the individual beneficiaries). See John A. Terrill & Michael Breslow, Congress Passes Corporate Transparency Act to Require Disclosure of Beneficial Owners of Entities and the Creation of a National Registry of Entities, LEIMBERG BUSINESS ENTITIES NEWSLETTER #218 (Jan. 21, 2021).

Regulations and Effective Date. The Treasury Secretary has broad regulatory authority and must promulgate regulations by January 1, 2022. The CDD Regulations must be conformed with the CTA to eliminate duplicative burdens. The regulations will “use risk-based principles for requiring reports of beneficial ownership information.” The reporting requirements take effect on the effective date of the regulations.

Filing Due Dates. Existing companies when the regulations become effective must file the required information within two years of the effective date of the regulations. Any company formed subsequently must file the report on the formation of the entity. Every Reporting Company must also file a report within one year of certain specified changes of Beneficial Ownership (including any Beneficial Owner exceeding or falling below 25%).

Penalties. Failure to file a timely required report with FinCEN will result in civil and criminal fines (penalties of $500/day the report is outstanding, up to $10,000) and up to two years imprisonment. Any person who willfully provides false ownership information is subject to similar penalties. Penalties will also be imposed on anyone who makes an unauthorized disclosure of information about Applicants or Beneficial Owners.

Planning for IRA and Retirement Plan Distributions Under the SECURE Act a.

Overview. The SECURE Act made various changes regarding retirement benefits including (i) changing the required beginning date for minimum distributions (April 1 of the following year) from age 70½ to 72, (ii) eliminating the prohibition on contributions to an IRA after age 70½ (but if an individual both contributes to an IRA and takes a qualified charitable deduction (QCD) between ages 70½ and 72, the IRA contribution will reduce the portion of the QCD that would otherwise be treated as tax-free), and (most important) (iii) substantially limiting “stretch” planning for distributions from

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defined contribution plans and IRAs over a “designated beneficiary’s”(DB’s) lifetime (with several exceptions). The SECURE Act mandates that distributions to a designated beneficiary be made within 10 years following the death of the participant, with exceptions for five categories of “eligible designated beneficiaries” (EDBs). b.

Eligible Designated Beneficiaries. The five categories of EDBs are (i) the surviving spouse, (ii) a participant’s child who “has not reached majority,” (iii) a disabled individual, (iv) a chronically ill individual, and (v) an individual not described above who is not more than 10 years younger than the participant. These beneficiaries qualify for a modified life expectancy payout. Status as an EDB is determined at the participant’s death. A DB who later satisfies one of the five categories of EDBs does not become an EDB for purposes of being able to use an adjusted lifetime payout rather than being subject to the 10-year rule. (A special rule applies for minors – if the minor is disabled upon reaching majority, the minor exception continues through the period of disability.)

Trust Beneficiaries. A big change for planners comes into play if the owner wants to use a trust as a beneficiary of a qualified plan or IRA. (1) Conduit Trusts Generally No Longer Desirable. A “conduit trust” is a trust that must immediately pay any distribution from a qualified plan or IRA to the trust beneficiary. They were often used because they do not have many complexities that apply to “accumulation trusts” (that permit plan or IRA distributions to be “accumulated” in the trust). They worked fine when plan or IRA distributions were made were distributed over the beneficiary’s lifetime, because the distribution each year was relatively small. But when the entire plan must be distributed within 10 years, when the bulk of the plan benefits are distributed to the trust, they would have to be distributed to the beneficiary, and therefore would not serve the purposes for which the owner wanted to use a trust in the first place. Natalie Choate summarizes, “Almost invariably, conduit trusts will not work the way the client anticipated or wants.” (2) Conduit Trusts Still Appropriate for Surviving Spouse (and Perhaps for Minors). A distribution to a trust for a surviving spouse probably has to be made to a conduit trust, rather than an accumulation trust, to qualify as an EDB. For example, a standard QTIP trust does not qualify as an EDB and the 10-year rule would apply after the participant’s death. A QTIP trust that also requires such distributions to the spouse of all plan distributions would constitute a conduit trust that is an EDB and would qualify for the spousal special treatment. Conduit trusts can be helpful if they result in EDB treatment for the beneficiary with a payout over the beneficiary’s life expectancy until the EDB status ends. But the owner must understand that the trust protection will end within 10 years after EDB status ends for a beneficiary if a conduit trust is used. A trust for a minor would probably have to be a conduit trust in order to qualify for the minor child exception. Some people might choose to use a conduit trust for a minor child, to be able to make very slow distributions (life expectancy distributions, which would be very small each year for a minor child) until the child reaches the “age of majority” (defined as having completed a specified course of education, but no later than age 25), but when the child reaches the age of majority, all of the plan or IRA would have to be distributed within the next 10 years, and if it is paid to a conduit trust, the distribution would immediately be paid out from the trust to the beneficiary, thus avoiding any further protections afforded by the trust. (3) Accumulation Trusts Generally Used. Other than for surviving spouses, accumulation trusts will probably be used if the owner wants a trust to receive plan distributions. Accumulation trusts for disabled or chronically ill individuals will qualify for the lifetime payout exception.

New Life Expectancy Tables for Retirement Plan Required Minimum Distributions. The Single Life and Uniform Life tables for calculating required minimum distributions are in Reg. §1.401(a)(9)9(b)-(c). (The Uniform Life table, which is based on the life expectancy of an individual and someone 10 years younger, may be used only while the account owner is living or for a spousal rollover IRA. Otherwise the Single Life (or Joint Lives) Table must be used. The Uniform Life table allows taking

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withdrawals at a substantially slower rate. For example, the life expectancy of a 72-year old person under the Single Life table is 17.2 years, and under the Uniform Life table is 27.4 years.) Proposed regulations containing revised tables were issued in November 2019, and the revised tables would have applied to distribution calendar years beginning on or after January 1, 2021. The preamble to the proposed regulations stated that the “life expectancy tables and applicable distribution period tables in the proposed regulations reflect longer life expectancies than the tables in the existing regulations that are generally between one and two years longer than under the existing regulations.” Professor Chris Hoyt (Kansas City, Missouri) concludes that “[m]ost individuals will experience reduced RMD amounts of between 0.3% and 0.5% of what they would have had to receive under the prior tables.” Christopher Hoyt, Reduced RMDs From Retirement Accounts, TRUSTS & ESTATES at 46 (June 2021). Final regulations were issued November 4, 2020 (T.D. 9930, published in the Federal Register on November 12, 2020), and the effective date was moved back to plan years beginning on or after January 1, 2022. e.

ACTEC Comments; Waiting on IRS Guidance; Preview from 2021 IRS Publication 590-B. These provisions of the SECURE Act create many uncertainties. ACTEC filed comments with the IRS on July 14, 2020 and July 29, 2020 identifying various uncertainties and making various recommendations for IRS guidance. American College of Trust & Estate Counsel, Letters to Department of Treasury and IRS titled “Request for Guidance from Treasury on Section 401 of the SECURE Act, Part 1 (July 14, 2020) and Part 2 (July 29, 2020).” These extremely detailed comments include recommendations regarding various issues about the 10-year rule and the effective date in Part 1, and regarding trusts for DBs other than EDBs, trusts for spouses, EDB issues generally, minor child beneficiary and age of majority, disabled and chronically ill EDBs, applicable multi-beneficiary trusts, and the “not more than 10 years younger” EDB category in Part 2. The comments are available from the “Legislative and Regulatory Comments by ACTEC” webpage of the ACTEC website, found here. ACTEC more recently requested the IRS to issue proposed regulations regarding the various uncertainties in light of the September 30, 2021 deadline for determining designated beneficiaries for retirement account holders who died in 2020 and for the beneficiaries to create inherited IRA accounts and take their first distribution by December 31, 2021. If proposed regulations cannot be issued “in sufficient time for beneficiaries of 2020 decedents to comply with the SECURE Act requirements, ACTEC further recommends that some grace period be given to beneficiaries to permit them to satisfy all requirements on a timely basis.” American College of Trust & Estate Counsel, Letter to Department of Treasury and IRS titled “Request for Guidance Regarding Section 401 of the SECURE Act to Issue Soon, (July 23, 2021).” The IRS is expected to provide guidance on many issues regarding the SECURE Act. Stephen Tackney, of the IRS Office of Associate Chief Counsel (Employee Benefits, Exempt Organizations, and Employment Taxes) has confirmed that regulations addressing required minimum distributions under the SECURE Act “will come out in a lengthy but complete package” but the timing is not imminent. “I always say it’s in the ‘soon’ category; that means later than imminent but before eventually.” The regulations will address not only issues arising under the SECURE Act but will also address “long-standing questions about trusts named as beneficiaries of IRAs.” He noted that “[t]he trust and estate bar has asked for lots of flexibility, and the IRS and Treasury hope to accommodate those requests., [but] … flexibility brings with it very complex rules.” See Nathan Richman, Proposed SECURE Act Regs Far Along but Not Imminent, TAX NOTES (June 1, 2021). Hopefully, the IRS will address many of the uncertainties raised in the ACTEC comment letters. For example, the IRS may relax restrictions that no longer serve a purpose for accumulation trusts. A preview of some positions that the IRS might take in proposed regulations can be gleaned from this year’s annual edition of IRS Publication 590-B, Distribution from Individual Retirement Arrangements (IRAs) (March 25, 2021). An example on page 12 in the initial 2021 publication suggests that payments would have to be made each year (based on a life expectancy payout) during the general 10-year period for making distributions from qualified plans and IRAs following the participant’s death, but the example was simply a mistake; the only requirement is that the entire account must be distributed by December 31 of the tenth year. See Natalie Choate, IRS Publication 590-B Offers Preview of Treasury Guidance on Post-SECURE RMD Rules … and Some Bloopers,

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LEIMBERG EMPLOYEE BENEFITS AND RETIREMENT PLANNING NEWSLETTER #757 (April 26, 2021). The IRS issued a statement revising that example on May 13, 2021; a revised version of Publication 590-B dated May 13, 2021 is available for download. f.

Roth IRAs. The 10-year rule anti-stretch provisions in the SECURE Act apply to Roth IRAs. The accelerated payments from the Roth IRA following the owner’s death would not bear a 37% immediate tax, but the opportunity for future tax-free buildup over a long period of time would be lost. Roth conversions may still make sense for taxpayers who are in considerably lower income tax brackets (because of lower income, NOLs, loss carryovers, etc.) than the beneficiaries. (If an accumulation trust is the beneficiary, the trust reaches the maximum 37% bracket at a mere $13,050 of taxable income in 2021, so the participant might be in a significantly lower bracket. However, the time period for the tax-free growth would generally be limited to 10 years following the person’s death because of the 10-year rule.) For a discussion of considerations for making Roth conversions in 2020, see Bernard Kent, Roth IRA Conversions in 2020, LEIMBERG EMPLOYEE BENEFITS AND RETIREMENT PLANNING NEWSLETTER #737 (June 9, 2020).

IRA Charitable Rollover. The SECURE Act does not eliminate the IRA charitable rollover, but the $100,000 limit on qualified charitable distributions from an IRA that can be excluded from income will be correspondingly reduced by any contributions to IRAs after a person has reached age 72. Changing the age for required minimum distributions from 70½ to 72 will not change the age at which qualified charitable distributions from IRAs will be permitted. Particularly for nonitemizers, donors over age 70½ should consider making their charitable donations with IRA charitable rollovers at least up to the amount of the minimum required distribution and up to a maximum of $100,000 per year. Even though the nonitemizer donor does not get an income tax deduction, the donor will avoid recognizing income on the distributions. Especially if the donor has reached the RBD (April 1 of the year after reaching age 72 if the person had not reached age 70½ in 2019), the donor will avoid recognizing income on the required distributions from the IRA. (1) Reporting. Box 1 of Form 1099-R from the IRA custodian will show the total amount of distributions from the IRA. The Form 1099-R does not reflect which of the distributions are “qualified charitable distributions.” The taxpayer reports the full distribution amount on line 4a of Form 1040, and reports the taxable distributions (for example, the amount that is not a qualified charitable distribution) on line 4b of Form 1040 and should enter “QCD” next to line 4b. The qualified charitable distribution amount cannot be deducted and will not be entered on Lines 11 or 12, Schedule A of Form 1040. (2) Cannot Use Donor Advised Fund. An IRA qualified charitable distribution cannot be made to a donor advised fund (or to a supporting organization or private foundation).

Charitable Planning. A charity is a good beneficiary of a retirement plan, because the plan benefits are taxed as ordinary income on receipt by an individual, but a charitable beneficiary is tax-exempt and pays no income tax. (1) Mechanics of Naming Charity as Beneficiary. The preferable way to name a charity as beneficiary of a retirement plan or IRA is to name a donor advised fund of an institutional provider. If a charity is named directly, some IRA providers require massive amounts of information regarding the charity and all its directors to comply with the “Know Your Customer” (KYC) rules under the Patriot Act. Community foundations and other institutions sponsoring DAFs are familiar with complying with those rules. (2) Charitable Remainder Trust or Charitable Gift Annuity. A charitable remainder trust (CRT) makes annual annuity or unitrust payments to an individual for the individual’s life expectancy or for a term of years (up to a maximum of 20 years). The trust must be structured so that the value of the charitable remainder interest is worth at least 10% of the value contributed to the trust. The IRS has published a sample CRT form. Natalie Choate strongly suggests using the IRS sample form, with a

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few tweaks suggested in LEIMBERG CHARITABLE PLANNING NEWSLETTERS #80 (by Larry Katzenstein) and #88 (by Richard Fox) in 2006. The plan benefits could be paid to the CRT immediately following the participant’s death, thus satisfying the RMD requirements for the plan. The CRT is a tax-exempt entity and does not pay income tax on receipt of the plan benefits. Plan benefits generally must be paid out within 10 years, but if the plan benefits are paid to a CRT, the distributions from the CRT could be made over the lifetime of the individual beneficiary of the trust, thus assuring distributions over the lifetime of the individual and deferring the time that income tax must be paid on the distributions to the beneficiary. If a CRT is used, the best approach will generally be to use a charitable remainder unitrust (CRUT) payable over the lifetime of the beneficiary (not a term-of-years CRT, which must be no more than 20 years—which is only 10 years longer than the payout allowed under the SECURE Act if benefits are paid directly to the beneficiary). Can the deferral advantage mean that the family member receives more with a CRT than if the plan benefit is left outright to family member? Generally, not. The use of the CRT is not primarily a way to beat the SECURE Act and save income taxes. Reasons that that family members generally do not receive more benefits with a CRT than having payment made directly to the beneficiary include the following. •

The payout to the individual must be set so that the present value of the charitable remainder when the CRT is created is at least 10% of the amount contributed to the trust.

•

When distributions are made to the individual beneficiary, a “four-tier system” applies to carry out the income tax attributes of the CRT’s assets to the individual beneficiary – ordinary income is deemed distributed first. As payments are made over the life of the beneficiary, all or almost all the amounts paid to the individual likely will represent the plan benefits and will be taxed as ordinary income. (After the aggregate CRT distributions have carried out all the plan benefits, the distributions will next represent capital gains of the trust. The CRT should not invest in tax-exempt bonds; as a practical matter the distributions to the beneficiary will never be the tax-exempt income.)

•

Do not use a CRT if the decedent is paying federal estate taxes. The §691(c)(1)(A) deduction of the estate tax attributable to the IRD (i.e., the plan benefit paid to the trust) is netted from the first tier ordinary income but is not directly made available to the income beneficiary. PLR 199901023. In effect, the §691(c) deduction amount becomes “tier four” corpus (distributions of which would not be taxable income to the beneficiary).The income beneficiary benefits from the §691(c) deduction only after the trust shrinks to an amount less than the original plan benefits paid to the trust minus the §691(c) deduction.

The ”sweet spot” when the CRT may result in a better financial result for the beneficiary than an outright distribution to the beneficiary is (i) if the decedent does not pay federal estate tax, (ii) if the plan benefits will be taxed at a high income tax rate (i.e., the beneficiary is in a high tax bracket), and (iii) a lifetime CRUT is used and the beneficiary lives for at least 30 years after the CRT is created (outcomes vary with investment returns and tax rates). Otherwise, a CRT should be used to receive plan benefits only if the client has significant philanthropic goals. For a discussion of other resources about using CRTs to receive plan benefits or of leaving an IRA to charity for a gift annuity, see Item 3.j. of Estate Planning Current Development and Hot Topics (December 2020) found here and available at www.bessemertrust.com/for-professionalpartners/advisor-insights. i.

Trusteed IRAs. The SECURE Act applies to trusteed IRAs the same as custodial IRAs. The only difference is that the plan provider is a fiduciary who has responsibility for investment and distribution decisions rather than just serving as custodian of the IRA. A distinction is that trusteed IRAs are often marketed as a way of getting stretch payouts without the client’s having to prepare a separate complicated trust agreement. The nontax advantages of the trusteed IRA arrangement still exist, but not the stretch purpose (except for EDBs).

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More Detailed Discussion. For a much more detailed discussion of planning issues in light of the SECURE Act, see Item 3 of Estate Planning Current Developments and Hot Topics (December 2020) found here and available at www.bessemertrust.com/for-professional-partners/advisorinsights.

Administrative Guidance Regarding 2017 Tax Act Changes a.

Anti-Clawback Regulation. The anti-clawback regulation was issued in November 2019 in response to §2001(g)(2) added by the 2017 Tax Act. The regulation allows the estate to compute its estate tax credit using the higher of the basic exclusion amount (BEA) applicable to gifts made during life or the BEA applicable on the date of death. Notable planning aspects of the anti-clawback regulation include the following. •

Clients have a “window of opportunity” to make use of the large $10 million (indexed) gift exclusion amount, before the exclusion amount is reduced to $5 million (indexed) in 2026 (or perhaps by earlier legislation). “[T]he increased BEA is a ‘use or lose’ benefit that is available to a decedent who survives the increased BEA period only to the extent the decedent ‘used it’ by making gifts during the increased BEA period.” Preamble to Final Regulation at 4.

•

Donors cannot use the “bonus” exclusion amount (the excess of the large current exclusion amount over a later reduced exclusion amount) before first using the “base” exclusion amount. Preamble to Final Regulation at 8.

•

Think twice about gift-splitting. In order to make use of the bonus exclusion amount before it disappears, a gift by one spouse of $11 million is better than $5.5 million gifts by both spouses. If the parties anticipate that the split gift election will be made, consider having the donor’s spouse contractually agree to consent to the election at the time the gift is made (in case a divorce occurs before the gift tax return is filed in which event the donor’s spouse might express reluctance to consent to gift splitting).

•

DSUE amount elected during the increased BEA period will not be reduced as a result of the sunset of the increased BEA. Reg. §20.2010-1(c)(2)(iii), Exs. 3-4.

•

DSUE available to a donor must be utilized before using the bonus exclusion amount. Reg. §20.2010-1(c)(2)(iv), Ex. 4.

•

The IRS hinted that the current increased GST exemption amount can be allocated to gifts made before 2018.

•

The IRS is still considering an anti-abuse rule that would not apply the anti-clawback rule to gifts that are included in the gross estate, such gifts as with retained life estates or with retained powers or interests or certain gifts valued at a higher amount under §2701 or §2702, or a gift of a legally enforceable note. See Item 8.f below.

For further discussion of each of these issues, see Item 4 of Estate Planning Current Developments and Hot Topics (May 2021) found here and available at www.bessemertrust.com/for-professionalpartners/advisor-insights and Item 4 of Estate Planning Current Developments and Hot Topics (December 2019) found here and available at www.bessemertrust.com/for-professionalpartners/advisor-insights. b.

Executor or Trustee Fees and Other Miscellaneous Estate or Trust Expenses. An amendment to regulation §1.67-4(a) (finalized in October 2020) clarifies that the following deductions allowed to an estate or non-grantor trust (including the S portion of an electing small business trust) are not miscellaneous itemized deductions (which are suspended under §67(g) through 2025): •

Costs paid or incurred in connection with the administration of an estate or non-grantor trust that would not have been incurred if the property were not held in the estate or trust;

•

The personal exemption of an estate or non-grantor trust; and

•

The distribution deduction for trusts distributing current income or accumulating income.

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Excess Deductions or Losses at Termination of Estate or Trust. Regulation §1.642(h)-2 and §1.642(h)-5 (published in connection with the proposed and final regulation §1.67-4) clarifies the treatment of certain deductions on the termination of an estate or trust, which are available as deductions to the beneficiaries succeeding to the property under §642(h). The regulation stipulates that each deduction comprising the section 642(h)(2) excess deduction retains its separate character in one of three categories reported separately to beneficiaries: (1) an amount allowed in arriving at adjusted gross income (i.e., expenses that that were incurred solely because the property was in an estate or trust, §67(e)); (2) a non-miscellaneous itemized deduction; or (3) a miscellaneous itemized deduction. Furthermore, Example 2 of Reg. §1.642(h)-5 was revised in the final regulation to make it clear that the executor can choose which deductions to allocate against income and which to carry out as excess deductions. Any §67(e) deductions that are carried out to beneficiaries will not be treated as miscellaneous itemized deductions (for which a deduction is suspended until 2026). In mid-July, 2020, the IRS posted guidance regarding reporting of excess deductions, referencing codes and adjustments to be entered on specific lines of Schedule 1 of Form 1040. Internal Revenue Service, Reporting Excess Deductions on Termination of an Estate or Trust on Forms 1040, 1040-SR, and 1040-NR for Tax Year 2018 and Tax Year 2019. The 2020 “Instructions for Schedule K-1 (Form 1041) for a Beneficiary Filing Form 1040 or 1040-SR” (released Oct. 21, 2020), citing the final regulations, clarify and elaborate previous versions in explanations titled “Box 11, Code A—Excess Deductions on Termination - Section 67(e) Expenses” and “Box 11, Code B—Excess Deductions on Termination - Non-Miscellaneous Itemized Deductions.” If §67(e) applies to certain expenses of an estate or trust, and if the estate or trust terminates and passes to another trust, can those expenses be deducted by the recipient trust under §67(e)? The regulations do not address that issue specifically, but treating expenses as having the same “character” under §67(e) for beneficiaries as for the original estate or trust would presumably apply for trusts as beneficiaries as well as for individual beneficiaries.

State and Local Taxes Deduction. The $10,000 limit on state and local tax (SALT) deductions has led some states to consider implementing laws providing relief from state income tax to the extent of contributions to a specified charitable fund, in hopes that the taxpayer could deduct the full charitable contribution without any $10,000 limitation. The IRS issued final regulations, published in the Federal Register on June 13, 2019, blocking these types of arrangements by disallowing a federal charitable deduction when the donor expects to receive an offsetting credit against state and local taxes. The IRS recognizes special rules for C corporations and specified pass through entities in light of the fact that the $10,000 SALT limitation was never meant to apply to state and local taxes imposed on businesses and business income. Rev. Proc. 2019-12, 2019-4 I.R.B. 401, issued on December 28, 2018, recognized the effectiveness of a charitable contribution offset for C corporations and specified pass-through entities. Some states went beyond allowing a charitable deduction offset for state and local taxes of the business and enacted laws allowing businesses to pay state and local taxes directly at the entity level. The IRS accepted this approach in Notice 2020-75, issued on November 9, 2020, and acknowledged that such payments would reduce the partner’s or shareholder’s distributive or pro-rata share of income, and that the $10,000 SALT deduction limitation on deductions by the individual owners would not be applicable to such payments. In order for partners or S corporation shareholders to utilize this approach to avoid the $10,000 limitation for taxes incurred by the entity, the state would have to enact a mandatory or elective entity-level income tax on the entity. More than a dozen states have such an elective entity-level tax, including Alabama, Illinois, Louisiana, Maryland, New Jersey, New York, Oklahoma, Rhode Island, and Wisconsin. In addition, Connecticut has a non-elective entity-level tax. Similar proposals are being considered in Colorado, Ohio, and Pennsylvania. See McQuillan, SALT Workarounds Spread to More States as Democrats See Repeal, BLOOMBERG DAILY TAX REPORT (April 27, 2021).

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Life Insurance-Basis of Life Insurance and Annuity Contracts Not Reduced by Mortality Charges, Rev. Rul. 2020-5. The 2017 Tax Act amended §1016(a) to provide that the basis of life insurance and annuity contracts would not be reduced by mortality expenses, or other reasonable charges under the contracts. This is important for determining the amount of income recognized upon the sale of such contracts. This change is contrary to the announced IRS position in Rev. Rul. 2009-13 (Situations 2 & 3) and Rev. Rul. 2009-14 (Situation 2). Rev. Rul. 2020-5, 2020-9 I.R.B. 454 (Feb. 24, 2020), amends those prior revenue rulings to be consistent with the amendment to §1012(a), and to clarify that the basis is not reduced by the “cost of insurance charges,” regardless of why the contract was purchased.

Carried Interest Final Regulations. Section 1061, enacted as part of the 2017 Tax Act, requires certain investment funds (referred to as “applicable partnership interests” (APIs)) to hold assets for more than three years, rather than just for one year, for managers to receive long-term capital gain treatment. In addition, §1061(d) accelerates capital gain recognition in connection with the “direct or indirect” transfer of an API to a “related person” (defined by reference to §318(a)(1)) and in that situation recharacterizes certain long-term gains as short-term gains. Final regulations were released on January 7, 2021 and are effective January 13, 2021. T.D. 9945 (Jan. 13, 2021). The final regulations (i) confirm that gifts to non-grantor trusts would not invoke the acceleration provisions, (ii) adopt the suggestion that only transfers to related persons that would be a sale or exchange would trigger acceleration of gain, and (iii) eliminate certain definitions that had been used for the family office exclusion, which the IRS continues to study. The preamble to the final regulations clarifies that the §1061(d) acceleration applies only to transfers that would be a sale or exchange. For a summary of the ACTEC comments and the final regulations reaction to those comments see Kevin Matz, IRS Issues Final Regulations on Carried Interests, posted on WealthManagement.com (Jan. 22, 2021).

Miscellaneous Other 2019 Guidance. For a discussion of other guidance issued in 2019 regarding (i) reportable policy sales and transfer of value issues, (ii) the deduction under §199A for qualified business income, and (iii) qualified opportunity funds, see Item 5.d.-f. of Estate Planning Current Developments and Hot Topics (December 2020) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights.

More Detailed Discussion. For a more detailed discussion of the issues discussed in Items 5.b.-f. above, see Item 5 of Estate Planning Current Developments and Hot Topics (May 2021) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights.

Treasury-IRS Priority Guidance Plan and Miscellaneous Guidance From IRS a.

2021-2022 IRS Priority Guidance Plan. The 2021-2022 IRS Priority Guidance Plan released on September 9, 2021 contains various changes from the 2020-2021 Plan regarding estate planning related issues. For a general discussion of and commentary about the 2020-2021 Priority Guidance Plan, see Ronald D. Aucutt, 2020-2021 Treasury-IRS Priority Guidance Plan, ACTEC CAPITAL LETTER NO. 50 (Nov. 25, 2020) found here and available at www.bessemertrust.com/for-professionalpartners/advisor-insights. (1) No Deadline. The Plan sets the priority for guidance projects during the Plan year (from July 1, 2021 to June 30, 2022). Several years ago, the IRS said that the Priority Guidance Plan had been pared so that only projects anticipated to be completed during the Plan year were included. That statement no longer appears; instead, it states “the plan does not provide any deadline for completing the projects.” (2) Omission from 2020-2021 Plan – Basis of Assets in Grantor Trust at Death. The 2021-2022 omits this item from the 2020-2021 Plan: “Guidance on basis of grant trust assets at death under § 1014.” IRS representatives informally indicated in 2017 that the intent of this project was to address broadly when grantor trust assets get a step up in basis in a wide variety of situations including under exercises of substitution powers, sales to grantor trusts, sales to grantor trusts for self-cancelling installment notes, and elective community property for residents in other

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states. For further discussion of this project, see Item 6.c of Estate Planning Current Developments and Hot Topics (December 2019) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. (3) Continuations from 2020-2021 Plan. Items in the 2020-2021 Plan that carry over into the 20212022 Plan include: 1. Final regulations establishing a user fee for estate tax closing letters. Proposed regulations were published on December 31, 2020. 2.Final regulations under §§1014(f) and 6035 regarding basis consistency between estate and person acquiring property from decedent. Proposed and temporary regulations were published on March 4, 2016. … 4. Regulations under §2032(a) regarding imposition of restrictions on estate assets during the six-month alternate valuation period. Proposed regulations were published on November 18, 2011. 5. Regulations under §2053 regarding personal guarantees and the application of present value concepts in determining the deductible amount of expenses and claims against the estate. … 7. Final regulations under §2642(g) describing the circumstances and procedures under which an extension of time will be granted to allocate GST exemption. … 9. Regulations under §7520 regarding the use of actuarial tables in valuing annuities, interests for life or terms of years, and remainder or reversionary interests.

(a) Items 2 (Basis Consistency), 4 (Alternate Valuation Date), 5 (§2053), and 7 (§2642(g)). Numbers 2 and 7 in that list, the basis consistency provision and the §2642(g) GST exemption allocation extension provision, were in “Part 3. Burden Reduction” of the 20202021 Plan and have been moved to the “Gifts and Estates and Trusts” section of the 20212022 Plan. For further details about the (i) basis consistency, (ii) alternate valuation date, and (iii) §2053 personal guarantees and present value concepts, see Item 6.c.- e. of Estate Planning Current Developments and Hot Topics (December 2019) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. When the basis consistency regulations are finalized, among other things planners hope that the requirement of filing reports for subsequent transfers will be relaxed. Interestingly, the Form 8971 does not specifically address the reporting of subsequent transfers. (b) Number 1, Estate Tax Closing Letter User Fee. On December 28, 2020 the IRS released a proposed regulation (published in the Federal Register on December 31, 2020) that would impose a new $67 user fee to request an estate tax closing letter (IRS Letter 627). Prop. Reg. §300.13. The regulation was finalized on September 27, 2021, effectoive October 28, 2021. Reg. §300.13 (T.D. 9957). At one time, the IRS routinely issued estate closing letters after estate tax examinations had been completed, but for returns filed on or after June 1, 2015, the IRS announced that closing letters would be issued only on request. After receiving many complaints from taxpayers’ advisors about long delays in obtaining closing letters, the IRS suggested that estates could obtain an estate tax account “transcript” and that a transcript with code “421” would serve “as the functional equivalent of an estate tax closing letter.” That approach was not sufficient, however, because purchasers from estates often wanted the more formal estate tax closing letter for comfort that no estate tax lien was outstanding, and advisors often recommend that executors delay distributing estate assets until a closing letter could be obtained in light of the potential personal liability of executors if assets are distributed before estate taxes are paid. The preamble to the proposed regulation observes, in a classic understatement, that “the IRS received feedback from taxpayers and practitioners that the procedure for requesting an estate tax closing letter can be inconvenient and burdensome,” and summarizes the rationale for the new fee and the process that will ultimately be used. www.bessemertrust.com/for-professional-partners/advisor-insights

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In view of the resource constraints and purpose of issuing estate tax closing letters as a convenience to authorized persons, the IRS has identified the provision of estate tax closing letters as an appropriate service for which to establish a user fee to recover the costs that the government incurs in providing such letters. Accordingly, the Treasury Department and the IRS propose establishing a user fee for estate tax closing letter requests …. As currently determined, the user fee is $67…. Guidance on the procedure for requesting an estate tax closing letter and paying the associated user fee is not provided in these proposed regulations. The Treasury Department and the IRS expect to implement a procedure that will improve convenience and reduce burden for authorized persons requesting estate tax closing letters by initiating a one-step, web-based procedure to accomplish the request of the estate tax closing letter as well as the payment of the user fee. As presently contemplated, a Federal payment website, such as http://www.pay.gov, will be used and multiple requests will not be necessary. The Treasury Department and the IRS believe implementing such a onestep procedure will reduce the current administrative burden on authorized persons in requesting estate tax closing letters and will limit the burden associated with the establishment of a user fee for providing such service.

In rationalizing the reasonableness of charging a user fee for issuing closing letters, the preamble to the proposed regulation reasoned that the issuance of closing letters “is fundamentally a customer service convenience offered to authorized persons in view of the unique nature of estate tax return filings.” The preamble to the final regulation reiterates that a user fee is approrpaite because the closing letter is “the provision of a service that confers special benefits, beyond those accruing to the general public,” without mentioning that the general public does not face the liens, liabilities, priority over other creditors, and burdens peculiar to the estate tax. Planners have expressed relief regarding the new system as compared to the existing system characterized by some planners as “horrendous” because “hours are spent on the phone trying to contact IRS on this at substantial expense to the client” (the IRS replaced the telephone method with a fax method during the pandemic). Estate planners might not be thrilled about a newly proposed $67 user fee for estate tax closing letter requests, but they’re content to say goodbye to a process that has drawn their ire for years. … For Ronald D. Aucutt, Bessemer Trust, the proposed user fee is a means to a better process. The $67 amount “may be a token, but it enables this drama to come to an end,” he said. Proposed Estate Tax Closing Letter Fee Earns Sigh of Relief, TAX NOTES (Jan. 4, 2021).

Other planners have also been critical of the proposed user fee. While the fee amount is not outrageously high, it is always irksome when the government charges members of the public before that government will discharge its duty. In this case, that is particularly so since it is the liability that the government imposes on fiduciaries (both in their fiduciary capacity and their individual capacity) that necessitates a closing letter. A secondary concern is fee creep. We have all seen modest government fees increase over time to unreasonable amounts. Look no further than the fees charged for private letter rulings – these at one time had no fee, then a small fee, and now bear fees in the many thousands of dollars. As of now, the fee is only proposed. Chuck Rubin, IRS Is Proposing a User Fee for Estate Tax Closing Letter, LEIMBERG ESTATE PLANNING NEWSLETTER #2853 (Jan. 14, 2021).

The regulation does not explain how to request an estate tax closing letter and pay the user fee, but the preamble to the final regulation states that “[i]nformation about who will receive an estate tax closing letter in resonse to a request, together with specific instructions for requesting the estate tax closing letter and paying the user fee, will be available on https://www.pay.gov (and on the IRS website at https://www.irs.gov” on or before October 28, 2021. (c) Number 9, New Actuarial Tables. The actuarial tables project, added in the 2019-2020 Plan, is to update the §7520 actuarial tables based on updated mortality information, which must be done every ten years and was last done effective May 1, 2009. The tables were not updated by May 1, 2019, as was required by §7520, and IRS officials have informally www.bessemertrust.com/for-professional-partners/advisor-insights

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indicated that the IRS has been waiting on data from another agency. That data now appears to be available. On August 7, 2020, the National Center for Health Statistics at the Centers for Disease Control and Prevention issued the decennial life table for 2009-2011, which apparently is the underlying data for the IRS actuarial tables. The new Lx table lists the number of individuals, out of a total of 100,000, who will be alive at each of ages 0-110, based on data from the 2010 census (which obviously is already 10 years old). The new data reflects a somewhat remarkable increase in life expectancies compared to the existing Lx table (based on 2000 census data). For example, at age 84 the number of individuals, out of the 100,000 starting pool, expected to be surviving has increased from 37,837 to 44,809, an 18.4% increase in just 10 years. Larry Katzenstein summarizes: The improvements in longevity at older ages is truly remarkable. For example, the probability of survival from age 60 to age 90 went from 21.088% to 26.6021% in just ten years. No wonder the Today show stopped years ago highlighting viewers who attained age 100. There were just too many of them. Larry Katzenstein, New Actuarial Tables Are Coming, LEIMBERG CHARITABLE PLANNING NEWSLETTER #303 (Nov. 30, 2020) (includes the new Lx table, compared to the existing Lx table).

The rather dramatic increase in life expectancy from the 2010 census data compared with the 2000 census data interestingly is contrasted with a CDC report in February 2021 that life expectancy declined about one year from 2019 to the first six months of 2020 (and declined 2.7 years for non-Hispanic Black people and 1.9 years for Hispanic individuals). National Center for Health Statistics Vital Statistics Rapid Release, Rept. No. 10 (February 2021). The new tables will result in a larger charitable deduction for CLATs for the life of an individual, but a lower deduction for a CRAT (and more difficulty in satisfying the 10% remainder test and 5% exhaustion test for a CRAT) and for the remainder in a personal residence after a retained life estate. Presumably, proposed regulations with the new tables will be coming soon. Larry Katzenstein points out the following questions that remain. Questions remain. Will we be allowed to elect to use the new rates for any transaction after April 30, 2019, the date on which the new tables were mandated by section 7520 to be effective? Will there be an effective date transition period? Will the IRS at some point allow use of exact computer- generated factors rather than the almost-exact published factors—almost exact because of rounding and related issues required to make published tables workable? Will the IRS make minor tweaks to the Lx table …? Larry Katzenstein, New Actuarial Tables Are Coming, LEIMBERG CHARITABLE PLANNING NEWSLETTER #303 (Nov. 30, 2020).

Because the mortality tables have not been late before, there is no model for such transitional relief. But even the timely promulgation of the 2009 mortality tables provided what the preamble described as “certain transitional rules intended to alleviate any adverse consequences resulting from the proposed regulatory change.” T.D. 9448, 74 Fed. Reg. 21438, 21439 (May 7, 2009). The preamble went on to elaborate: For gift tax purposes, if the date of a transfer is on or after May 1, 2009, but before July 1, 2009, the donor may choose to determine the value of the gift (and/or any applicable charitable deduction) under tables based on either [the 1990 or 2000 census data]. Similarly, for estate tax purposes, if the decedent dies on or after May 1, 2009, but before July 1, 2009, the value of any interest (and/or any applicable charitable deduction) may be determined in the discretion of the decedent’s executor under tables based on either [the 1990 or 2000 census data]. However, the section 7520 interest rate to be utilized is the appropriate rate for the month in which the valuation date occurs, subject to the … special rule [in section 7520(a)] for certain charitable transfers.

In other words, transitional relief may be provided with respect to the actuarial components of calculations based on mortality (life expectancy) tables, but not with respect to merely financial components such as applicable federal rates and the section 7520 rate, which have been published monthly as usual without interruption. For example, such transitional relief would apply to the calculations since May 1, 2019, of the values of an interest for life, an interest for joint lives, an interest for life or a term whichever is shorter or longer, or a remainder following such an interest. But no transitional relief would be necessary for www.bessemertrust.com/for-professional-partners/advisor-insights

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calculations related to promissory notes or GRATs that involve only fixed terms without mortality components, which the new mortality tables would not affect. (4) Additions to 2021-2022 Plan. The 2021-2022 Plan includes the following new items: 3. Regulations under §2010 addressing whether gifts that are includible in the gross estate should be excepted from the special rule of § 20.2010-1(c). … 6. Regulations under §2632 providing guidance governing the allocation of generation-skipping transfer (GST) exemption in the event the IRS grants relief under §2642(g), as well as addressing the definition of a GST trust under §2632(c), and providing ordering rules when GST exemption is allocated in excess of the transferor’s remaining exemption. … 8. Final regulations under §2801 regarding the tax imposed on U.S. citizens and residents who receive gifts or bequests from certain expatriates. Proposed regulations were published on September 10, 2015.

(a) Number 3, Clawback Regulation Exception. Number 3 addresses the anti-abuse exception to the clawback regulation (discussed in Item 8.f(6) below). Inclusion of this project in the 2021-2022 Plan suggests that the IRS plans to address this issue affirmatively rather than just avoiding the issue and knowing that the chill of the possibility of such an exception keeps clients from employing planning alternatives that might be caught by such an exception. (b) Number 8, §2801 Gifts From Expatriates. This item first appeared in the 2008-2009 Plan, and proposed regulations were issued in 2015. The item was dropped from the 2017-2018 Plan and has not been in the Plan since then. For a discussion of this issue, see Item 27.g(5) of Ronald Aucutt, Estate Tax Changes Past, Present, and Future (June 2021) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. (5) Other Notable Omissions. Among new items added to the Treasury-IRS Priority Guidance Plan for the 12 months beginning July 1, 2015 were the following. “3. Guidance on basis of grantor trust assets at death under §1014. … 5. Guidance on the valuation of promissory notes for transfer tax purposes under §§2031, 2033, 2512, and 7872. … 8. Guidance on the gift tax effect of defined value formula clauses under §§2512 and 2511.”

These all address issues that are central to often-used transfer planning alternatives involving gifts and sales to grantor trusts. Number 3 remained in the Plan until this year. It is discussed in Item 6.a(2) above. Number 5, addressing the valuation of promissory notes, first appeared in the 2015-2016 Plan and was dropped from the 2019-2020 Plan. (It was moved to the “Financial Institutions and Products” section in 2017-2018 and 2018-2019 Plans). Number 8, regarding defined value formula clauses, was added in 2015 and was dropped in the 2017-2018 Plan and has not been in the Plan since then. For a detailed discussion of these important items that previously appeared in Plans, see Item 27.g(2)-(3) of Ronald Aucutt, Estate Tax Changes Past, Present, and Future (June 2021) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. b.

Inflation Adjustments. Inflation adjustments for 2020 and for 2021were announced in Rev. Proc. 2019-44 and Rev. Proc. 2020-45, respectively. Some of the adjusted amounts are as follows: •

Basic exclusion amount and GST exemption-$11,700,000 in 2021, from $11,580,000 in 2020 and $11,400,000 for 2019;

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•

Estates and trusts taxable income for top (37%) income tax bracket-$13,050 in 2021, from $12,950 in 2020 and $12,750 in 2019;

•

Taxable income threshold for §199A qualified business income-$329,800/$164,925 (married filing jointly/single) in 2021, from $326,600/$163,300 in 2020 and $321,400/$160,700 in 2019;

•

Standard deduction-$25,100/$12,550 (married filing jointly/single) in 2021, from $24,800/$12,400 in 2020 and $24,400/$12,200 in 2019;

•

Non-citizen spouse annual gift tax exclusion-$159,000 in 2021, from $157,000 in 2020 and $155,000 in 2019;

•

Section 6166 “two percent amount”-$1,590,000 in 2021, from $1,570,000 in 2020 and $1,550,000 in 2019; and

•

Special use valuation reduction limitation-$1,190,000 in 2021, from $1,180,000 in 2020 and $1,160,000 in 2019.

No-Rule List, ING Trusts. The no-ruling revenue procedure for 2020 includes, as one of the items for which rulings or determination letters will not be issued, certain trusts that are typically structured to be non-grantor trusts as an alternative for saving state income taxes (these types of trusts are often referred to as DINGs or NINGs – Delaware incomplete non-grantor trusts or Nevada incomplete non-grantor trusts. Rev. Proc. 2020-3, §3.01(93). The ruling says that rulings regarding the taxation of the trust under §671 (i.e., whether it is a grantor trust) will not be issued for such trusts that are structured to authorize distributions – (A) at the direction of a committee if (1) a majority or unanimous agreement of the committee over trust distributions is not required, (2) the committee consists of fewer than two persons other than a grantor and a grantor's spouse, or (3) all of the committee members are not beneficiaries (or guardians of beneficiaries) to whom all or a portion of the income and principal can be distributed at the direction of the committee, or (B) at the direction of, or with the consent of, an adverse party or parties, whether named or unnamed under the trust document (unless distributions are at the direction of a committee that is not described in paragraph (A)). Accordingly, DING and NING transactions would presumably be structured in the future to avoid the “bad facts” listed. See William Lipkind & Tammy Meyer, Revenue Procedure 2020-3 – IRS Will Not Rule on Certain Provisions of Non-Grantor Trusts, LEIMBERG INC. TAX PL. NEWSLETTERS #190 (Feb. 4, 2020). The 2021 revenue procedure deleted that provision regarding taxation under §671 in the “no rulings” section, but added various other provisions in the “areas under study in which rulings will not be issued” section making clear that ING rulings will not be issued regarding the effects under §§671, 678, 2041 and 2514 (powers of appointment), or 2511 (incomplete gift). Rev. Proc. 2021-3, §5.01(9), (10), (15), & (17). Various IRS rulings over the last several years have approved ING trusts. E.g., Letter Rulings 202006002-006 (community property in ING trust remains community property at first spouse’s death for basis adjustment purposes; no ruling whether trust is grantor trust under §675 because that involves fact issues at death), 201925005-010, 201908002-008, 201852014, 201852009, 201850001-006, 201848009, 201848002, 201832005-009, 201744006-008. For a detailed analysis of the various tax effects of ING trusts and the shifting positions of the IRS in private letter rulings regarding varying structures of INGs, see Grayson M.P. McCouch, Adversity, Inconsistency, and the Incomplete Nongrantor Trust, 39 VA. TAX REV. 419 (2020). The effectiveness of ING trusts to avoid state income taxes has been removed by legislation in New York and a proposal is pending in California to do the same. See Eric R. Bardell, California Admits Incomplete Gift Non-Grantor Trusts Work … For Now, BLOOMBERG LAW NEWS (Dec. 4, 2020).

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Administration’s Budget Proposals. The Administration releases a budget proposal each year (historically in a report titled “General Explanations of the Administration’s Fiscal Year ____ Revenue Proposals” that is often referred to as the “Greenbook”), and during the Obama years, a number of estate and gift tax proposals were included. The budget proposals from the Trump Administration did not include specific tax legislation proposals. The FY 2021 budget, titled “A Budget for America’s Future,” was published February 10, 2020; it was the Trump Administration final budget proposal. The “adjusted baseline projection” used in the budget assumed permanent extension of the individual income tax provisions in the 2017 Tax Act set to expire on December 31, 2025 and the estate and gift tax parameters and provisions in effect for calendar year 2025. The Biden Administration published its fiscal year 2022 Greenbook on May 28, 2021. The revenue proposals in the FY 2022 Greenbook provide details about tax proposals in the American Jobs Plan and The American Families Plan, as discussed in Item 20.e-f above but has no provisions about the transfer tax.

Using Electronic Signatures on Tax Forms. On August 28, 2020, the IRS announced that it would temporarily accept the use of digital signatures on certain forms that cannot be filed electronically. Additional forms were added to that list on September 10, including Forms 706, 706-NA, 709, 3520, and 3520-A. IR-2020-206. An IRS memorandum dated December 28, 2020 (Control Number: NHQ10-1220-006) allows using electronic or digital signatures for those forms (and other listed forms) that are signed and postmarked from January 1, 2021 through June 30, 2021, and a memorandum dated April 15, 2021 (Control Number NGQ-10-0421-0002) extends that permission through December 31, 2021. The memorandum observes in a footnote: Electronic and digital signatures appear in many forms when printed and may be created by many different technologies. No specific technology is required for this purpose during this temporary deviation.

The forms covered by those notices do not include Form 2848 (which taxpayers use to authorize a professional to represent them before the IRS) or Form 8821 (authorizing others to view tax return information), which are oft-used forms that practitioners would especially like to see covered. Steve Gorin (St. Louis, Missouri) reports that a digital signature with these forms can be used beginning in 2021. Sometime in January, instead of having to get wet signatures from clients, you’ll be able to get a PDF of their signed Form 2848 and use that. You will also be able to upload the 2848 through an electronic portal. A recording of a 12/10/2020 webinar on it is at Uploading Forms 2848/8821 with Electronic Signatures (webcaster4.com). To be able to do this, you need an e-Services account, which involves significant processing time once submitted to the IRS: e-Services | Internal Revenue Service (irs.gov). So you might consider doing this …, if you don’t already have one. IRS said that using the portal speeds delivery to IRS but does not necessarily speed processing once delivered.

Private Letter Ruling Fee Increase. Revenue Procedure 2021-1, 2021-1 I.R.B. 1 (Jan. 4, 2021) covers the procedures for obtaining private letter rulings, including in Appendix A the fee schedule for letter rulings. The fee varies for various types of letter rulings, but the fee for ruling requests not otherwise listed with other specific fees has increased from $30,000 (for requests received prior to February 4, 2021) to $38,000 (for requests received after February 3, 2021), representing a 26.7% increase. The fee for extension requests under §301.9100-3 for those same periods has increased from $10,900 to $12,600. (The user fee is significantly less for taxpayers with gross income under $250,000 [$3,000 after February 3, 2021], and for taxpayers with gross income from $250,000 to $1 million [$8,500 after February 3, 2021].)

Re-Emergence of Section 2704 Proposed Regulations Addressing Valuation? Proposed regulations released August 2, 2016 changed the valuation for transfer tax purposes of interests in a family-controlled entity that are subject to restrictions on redemption or liquidation. If the owner was restricted from being able to compel liquidation or redemption within six months for what the regulations called “minimum value” (the pro rata share of the net fair market value of the assets of

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the entity) the restriction was to be disregarded. Furthermore, a default federal or state law restriction would be disregarded unless it was absolutely mandatory and unavoidable under federal or state law. Prop. Reg. §25.2704-2(b)(4)(ii) & -3(b)(5)(iii). Other changes were proposed limiting a broad exception in the existing regulations for the lapse of a voting or liquidation right under §2704(a). Prop. Reg. §25.2704-1(c)(1). The proposed regulations were highly controversial, resulting in various bills being introduced in Congress to block the regulations. The Trump Administration issued Executive Order 13789 on April 21, 2017, directing the identification of tax regulations issued on or after January 2016 that impose an undue financial burden on taxpayers or add undue complexity to tax laws. The Treasury identified the proposed §2704 regulations as meeting at least one of those criteria in Notice 2017-38 (dated June 22, 2017) and stated that it would withdrew the proposed regulations in a report dated October 2, 2017 (https://www.treasury.gov/press-center/pressreleases/Documents/2018-03004_Tax_EO_report.pdf). The Treasury and the IRS acknowledged that the proposed regulations were unworkable. After reviewing these comments, Treasury and the IRS now believe that the proposed regulations’ approach to the problem of artificial valuation discounts is unworkable. In particular, Treasury and the IRS currently agree with commenters that taxpayers, their advisors, the IRS, and the courts would not, as a practical matter, be able to determine the value of an entity interest based on the fanciful assumption of a world where no legal authority exists. Given that uncertainty, it is unclear whether the valuation rules of the proposed regulations would have even succeeded in curtailing artificial valuation discounts. Moreover, merely to reach the conclusion that an entity interest should be valued as if restrictions did not exist, the proposed regulations would have compelled taxpayers to master lengthy and difficult rules on family control and the rights of interest holders. The burden of compliance with the proposed regulations would have been excessive, given the uncertainty of any policy gains. Finally, the proposed regulations could have affected valuation discounts even where discount factors, such as lack of control or lack of a market, were not created artificially as a value-depressing device.

The proposed regulations were formally withdrawn, 14½ months after their issuance, on October 20, 2017. For a detailed discussion of the history of the proposed regulations, see Item 18 of Ronald Aucutt, Estate Tax Changes Past, Present, and Future (June 2021) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. For a summary of the proposed regulations and concerns raised by them, see Item 5 of Estate Planning Current Developments and Hot Topics (December 2016) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. Will the IRS re-open the §2704 regulation project in an effort to restrict valuation discounts under the Biden Administration? The October 2017 report recognized that the regulations’ “approach to the problem of artificial valuation discounts is unworkable,” but left open the door to a re-working of regulations that might in some way address valuation discounts. See Jonathan Curry, A Look Ahead: Estate Planners Fear Return of ‘Ghastly’ Dead Regs, TAX NOTES (Jan. 4, 2021). A regulatory approach that focuses on valuation discounts for passive assets in an entity as opposed to operating businesses would likely draw fewer attacks from the business community. In addition, valuation discounts might be addressed in legislation. The “For the 99.5 Percent Act” sponsored by Senator Sanders includes such a provision (as discussed in Item 2.n above). The 2021-2022 IRS Priority Guidance Plan (discussed in Item 6.a above) does not add a project dealing with §2704 regulations. 7.

Estate Planning for Moderately Wealthy Clients a.

Small Percentage of Population Subject to Transfer Taxes; Paradigm Shift for Planners. About 4,100 estate tax returns are expected to be filed for persons who died in 2020, of which only about 1,900 will be taxable, representing less than 0.1 percent of the 2.8 million people who were expected to die in 2020. Tax Policy Center’s Briefing Book, Key Elements of the U.S. Tax System (May 2020). The $10 million (indexed) gift tax exclusion amount also means that many individuals have no concern with lifetime gifts ever resulting in the payment of federal gift taxes. For non-resident alien individuals, however, the exclusion amount has not been increased and remains at only $60,000.

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Concepts that have been central to the thought processes of estate planning professionals for their entire careers are no longer relevant for most clients – even for “moderately wealthy” clients (with assets of over several million dollars). b.

Important Planning Issues •

Do not ignore the GST tax. Without proper allocation (either automatically or manually) of the GST exemption (also $10 million indexed), trusts created by clients generally will be subject to the GST tax (currently 40%) at the death of the beneficiary unless the trust assets are included in the beneficiary’s gross estate. Consider allocating the increased GST exemption to previously created non-exempt trusts.

•

Review formula clauses.

•

Many moderately wealthy clients will want to rely on portability and leave assets at the first spouse’s death either outright to the surviving spouse (and rely on disclaimers if a trust is desirable) or to a QTIP trust with a Clayton provision (which allows the most flexibility). However, a credit shelter trust approach may be appropriate for some moderately wealthy clients.

•

Basis adjustment planning will be appropriate for many clients. They and their family members may not have estate tax concerns in light of the higher exclusion amounts even if trust assets are included in their estates so that the assets may qualify for a stepped-up basis at the person’s death under §1014 (assuming that §1014 is not repealed).

•

Including provisions to provide flexibility to accommodate changing circumstances or changing tax laws can be very helpful.

•

For planning in states with state estate taxes (about a third of the states), using multiple QTIP trusts may be helpful if the state recognizes QTIP trusts that are effective for state purposes only.

Further Discussion. For further discussion of these issues, see Item 7 of Estate Planning Current Development and Hot Topics (May 2021) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights.

Transfer Planning for Clients Who Want to Make Use of the Increased Exclusion Amounts But Do Not Want to Make Large Gifts (or At Least Don’t Want to Lose Access); Flexibility to “Undo” Transfers a.

Window of Opportunity; Anti-Clawback Regulation. The $10 million (indexed) gift tax exclusion amount will sunset back to $5 million (inflation adjusted, say about $6.8 million) in 2026 (unless changed by Congress prior to 2026), so gifts making use of the doubled gift tax exclusion amount are available only through 2025. Future legislation may decrease the large exclusion amount even before 2026. The anti-clawback regulation clarifies that the donor can benefit from using the increased gift exclusion amount even if the donor should die after the estate tax exclusion amount has been reduced. The anti-clawback regulation provides a special rule that allows the estate to compute its estate tax credit using the higher of the BEA [basic exclusion amount] applicable to gifts made during life or the BEA applicable on the date of death. Reg. §20.2010-1(c)(1). For a discussion of various issues regarding the anti-clawback regulation, see Item 5.a above.

Cushion Effect. Perhaps the most important advantage of the increased gift tax exclusion amount for many individuals will be the “cushion” effect – the ability to make gifts in excess of $5 million, but considerably less than $11 million, with a high degree of comfort that a gift tax audit will not cause gift tax to be imposed (perhaps even for assets whose values are very uncertain).

Defined Value Transfers. Because of the substantial cushion effect of the very large gift tax exclusion amount, clients making transfers significantly less than the full exclusion amount will have much less incentive to add the complexity of defined value transfers to gift transactions. However,

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clients wanting to use most of the $10 million (indexed) exclusion amount are more likely will plan to consider a defined value transfer to minimize the risk of having to pay gift tax. One possible defined value alternative is a “two-tiered Wandry arrangement.” The client would make a traditional Wandry transfer of that number of units that is anticipated to be worth the desired transfer amount (which could either be a gift or a sale), but with a provision that if those units are finally determined for federal gift tax purposes to be worth a higher value, a note would be given for the excess amount. That approach was used in True v. Commissioner (Tax Court Docket Nos. 2189616 & No. 21897-16), which cases were settled on a basis that, as reported in Tax Court filings, appears favorable for the taxpayer. For a more detailed discussion of defined value clauses, see Item 14 of the Current Developments and Hot Topics Summary (October 2017) found here and Item 8.c. of Grantor Retained Annuity Trusts (GRATs) and Installment Sales to Grantor Trusts (July 2020) found here, both available at www.bessemertrust.com/for-professional-partners/advisor-insights. d.

Transfers with Possible Continued Benefit for Grantor or Grantor’s Spouse; Sales to Grantor Trusts. Couples making gifts of a large portion of their $10 million (indexed) applicable exclusion amount may want some kind of potential access to or potential cash flow from the transferred funds. Various planning alternatives for providing some potential benefit or continued payments to the grantor and/or the grantor’s spouse are discussed in more detail in Items 14-25 of the Current Developments and Hot Topics Summary (December 2013) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. Also, a preferred partnership freeze strategy is discussed in Item 3.q. of the Estate Planning Current Developments Summary (December 2018) found here and available at www.bessemertrust.com/forprofessional-partners/advisor-insights.

SLATs. One spouse funds an irrevocable discretionary “spousal lifetime access trust” (SLAT) for the other spouse and perhaps descendants. Assets in the trust avoid estate inclusion in the donor’s estate if the donor’s estate is large enough to have estate tax concerns. Both spouses may create “non-reciprocal” trusts that have sufficient differences to avoid the reciprocal trust doctrine. Assets are available for the settlor-client’s spouse (and possibly even for the settlor-client if the spouse predeceases the client) in a manner that is excluded from the estate for federal and state estate tax purposes. For a detailed discussion of SLATs and “non-reciprocal” SLATs, including a discussion of the §§2036 and 2038 issues and creditor issues, see Items 78 and 80 of the ACTEC 2020 Annual Meeting Musings (March 2020) found here, Item 10.i. of Estate Planning Current Developments and Hot Topics (December 2019) found here, and Item 16 of the Current Developments and Hot Topics Summary (December 2013) found here, all available at www.bessemertrust.com/for-professionalpartners/advisor-insights. (1) Potential Conflict of Interest Between Spouses. An often-neglected issue with SLAT planning is the potential for conflicts of interest between the spouses. Should the spouses be represented by independent counsel? What if the donee-spouse sues for divorce soon after the mega-SLAT is funded? For discussions of planning considerations for the donor-spouse raised by the repeal of §682, see Item 25 of Estate Planning Current Developments and Hot Topics (December 2019) found here and available at www.bessemertrust.com/for-professional-partners/advisorinsights. Aside from those tax issues, the client may be very unhappy with the planner if the planner has not discussed the potential for such an event following the creation of the SLAT. (2) Creditor Issues. One of the toughest issues that arises with SLAT planning is the potential creditor issue under the relation-back doctrine. If the donee spouse were to predecease the donor spouse, the donee spouse could have the ability to appoint the assets into a trust of which the original donor spouse is a discretionary beneficiary. Under the traditional “relation-back doctrine,” when a power of appointment is exercised it is deemed to be exercised on behalf of the settlor, so the settlor is treated as the settlor of the recipient trust for state property law purposes. For state law purposes, the donor spouse made

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the original contribution to the trust. The assets are now in a trust of which donor spouse is a discretionary beneficiary. The classic rule, unless the laws of a domestic asset protection trust state apply, would be that creditors of the donor could reach the trust assets. The client may not be overly concerned with actual creditor issues, but that could raise tax issues at that point. If there is an implied agreement that the original donee spouse will exercise the power of appointment in this way, that could raise a §2036(a)(1) concern. The implied agreement issue can likely be avoided by allowing some time to elapse before the power of appointment is exercised. But a §2038 issue may also apply, and keep in mind that §2038 does not require retention at the time of the original gift. The issue under §2038 is whether, at death, the donor has the power to “alter, amend, revoke, or terminate” the trust. As to the §2038 issue, Outwin v. Commissioner, 76 T.C. 153 (1981), said that §2038 potentially could apply if the settlor’s creditor can reach the trust assets. To avoid §2038 inclusion if the settlor’s creditors can reach the trust assets, having an ascertainable standard may satisfy the “definite external standard” exception that has been recognized by the IRS (Rev. Rul. 73-143, 1973-1 C.B. 407) and various courts for avoiding §2038. E.g., Jennings v. Smith, 161 F.2d 74 (2d Cir. 1947); Estate of Ford v. Commissioner, 53 T.C. 114 (1969), nonacq. 1978-2 C.B. 3, aff’d per curiam, 450 F.2d 878 (2d Cir. 1971); Estate of Wier v. Commissioner, 17 T.C. 409 (1951), acq. 1952-1 C.B. 4 (addressing predecessor of §2036(a)(2) and §2038; “the education, maintenance and support” and “in the manner appropriate to her station in life”). How much of a problem is this? Nineteen states are domestic asset protection trust (DAPT) states, (Alaska, Connecticut, Delaware, Hawaii, Indiana, Michigan, Mississippi, Missouri, Nevada, New Hampshire, Ohio, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia, West Virginia, and Wyoming). The creditor issue is not a problem in those states because a settlor’s creditors cannot reach assets in a properly structured “self-settled” trust that may be distributed to the settlor under a discretionary standard. There are at least five states that do not allow the settlor’s creditors to reach the assets in a trust that is the recipient of the exercise of a power of appointment by the original donee spouse of a SLAT under the relation-back doctrine. Those states are Arizona, Maryland, Michigan, Ohio, and Texas (three of those are not DAPT states). Another possible defense is that there are precious few cases applying this relation back doctrine in the creditor situation, so maybe the potential creditor issue is not a problem at all under the relation-back doctrine. A planning alternative to minimize the risk of estate inclusion for the donor spouse is for the original donee spouse to appoint the assets to a trust that merely gives a party the power to add the settlor as a discretionary beneficiary or perhaps that gives a third party a power to appoint assets to the settlor. The potential creditor issue will never arise if the settlor is never added as a discretionary beneficiary, and the settlor may never need to be a potential discretionary beneficiary of the trust assets. If the rainy day arises and there really is a need, it may well be that estate tax problems are the least of the settlor’s concerns at that point. f.

Gifts to “Lock In” Use of Increased Gift Exclusion. Exercise caution before using any of the alternatives described in subparagraphs (1)-(6) below. The IRS is considering whether to adopt an anti-abuse exception to the anti-clawback regulation that would remove the effectiveness of these planning alternatives, as discussed in subparagraph (6) below (and that project has been added to the 2021-2022 Priority Guidance Plan). (1) Enhanced Grantor Retained Income Trust. For the client that is reluctant to relinquish substantial value, but wants to make a large gift to “lock in” use of the increased gift exclusion to take advantage of the window of opportunity, consider making a gift of an asset while retaining the income from or use of the asset (in a manner that does not satisfy §2702). The asset will be included at its date of death value in the gross estate under §2036(a)(1), but the date of gift value will not also be included in the estate tax calculation as an adjusted taxable gift. §2001(b) (last sentence). The effect is that the asset has been given to someone else, the date of death asset

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value is included in the gross estate, but at least the date of gift value is offset by the estate tax unified credit, which is increased by the amount of exclusion applied against lifetime gifts under the anti-clawback regulation if that amount exceeds the exclusion amount available at death (for example, because of a decrease in the basic exclusion amount in 2026). The post-gift appreciation in the asset is all that is effectively subject to estate tax. For a detailed discussion of this approach, see R. Eric Viehman, Using an Enhanced Grantor Retained Income Trust (E-GRIT) to Preserve the Basic Exclusion Amount, STATE BAR OF TEXAS 25TH ANNUAL ADVANCED ESTATE PLANNING STRATEGIES COURSE, ch. 4.7 (April 2019). (2) Promise to Make Gift; Gift of Legally Enforceable Note. Revenue Ruling 84-25 says that a gratuitous transfer of a legally binding promissory note is a completed gift. If the donor dies when the note is still outstanding, the estate is not entitled to a §2053 debt deduction for the note, because it was not contracted for full consideration. But the IRS reasoned in Rev. Rul. 84-25 that the assets that would be used to pay the note are still in the donor’s gross estate, so the gift of the note would not be an adjusted taxable gift to be added back into the estate tax calculation. §2001(b) (last sentence). The anti-clawback regulation would mean that the BEA at death would be large enough to cover prior gifts made after 1976, including the note. Therefore, the effect is that the donor would have taken advantage of the window of opportunity if the gifted note is a substantial part of the approximately $11 million gift exclusion amount. The mere gift of a promissory note typically is not legally binding, but the recipient could in principle give some form of consideration (such as agreeing to visit on Mother’s Day), which might cause the note to be enforceable. If the IRS were to pass a regulatory anti-abuse rule under the anti-clawback regulation for gifts that are included in the gross estate, the gift by promise would likely not get the benefit of the anti-clawback rule because the assets that will be needed to pay the liability are still in the gross estate. A planning alternative, if that were to occur, would be for the donor to pay the promised gift amount before death. See Katie Lynagh, Potential Anti-Abuse Rules May Limit Use of the Temporarily Increased Gift Tax Exclusion, BNA ESTATES, GIFTS & TRUSTS J. (May 14, 2020). (3) Transaction That Does Not Satisfy §2701. Another approach is making a transfer that intentionally fails to satisfy §2701. A donor would make a gift of a common interest in a partnership/LLC while retaining a preferred interest that does not meet the requirements of §2701. The effect under §2701 is that the preferred interest is treated as having a zero value (for example, because it is noncumulative). The donor would be treated under §2701 as making a gift equal to the donor’s entire interest in the entity. (The donor would need to have remaining gift exemption equal to the value of the interest in the entity to avoid having to pay gift tax.) At the donor’s death, the mitigation rule in Reg. §25.2701-5(a)(3) will reduce the donor’s estate value by the same amount by which the gift value was increased because of the zero value rule. (4) Section 2519 Deemed Transfer. Another planning possibility is to make a §2519 deemed transfer (if a large QTIP exists for the client’s benefit), which is discussed in Item 3.j.(8) of the Estate Planning Current Developments Summary (December 2018) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. See Item 20.e below for a discussion of §2519 in connection with the commutation of QTIP trusts. (5) Retained Income Trust. A retained income trust alternative (different than the alternative discussed in Item 8.f.(1) above) is discussed in Item 25 of the Current Developments and Hot Topics Summary (December 2013) found here and available at www.bessemertrust.com/forprofessional-partners/advisor-insights. (6) Possible Anti-Abuse Exception to Anti-Clawback Regulation; New York State Bar Association Tax Section Recommendation to IRS. Planners should be cautious in using the planning approaches described in subparagraphs (1)-(5) above as a way of making use of the increased gift exclusion amount until we know whether the IRS adopts the recommendation not to extend the anti-clawback adjustment to gifts that are included in the gross estate or to

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situations in which assets have been valued under Chapter 14 (reserved in the November 2019 final regulation). The preamble to the anti-clawback final regulation notes that a commenter recommended that the anti-clawback rule be revised so that it would not apply to gifts that are included in the gross estate, such as gifts with retained life estates or with retained powers or interests or certain gifts “within the purview of chapter 14” (not identified in the preamble as gifts valued at a higher amount under §§2701 or 2702). The preamble concludes that although “such a provision is within the scope of the regulatory authority granted in section 2001(g)(2), such an anti-abuse provision would benefit from prior notice and comment. Accordingly, this issue will be reserved to allow further consideration of this comment.” The commenter referred to in the preamble was not identified in the preamble but was the New York State Bar Tax Section (cited below). For example, the enhanced grantor income trust would result in making use of the large current BEA even though the grantor would be able to receive all the trust income; this is clearly the result under the existing anti-clawback regulations. The preamble to the proposed regulations made clear that the increased BEA was applied for prior gifts “whether or not included in the gross estate.” (That approach has some support in the statutory language of §2001(b)(2) which, in the estate tax calculation process, provides for a subtraction of the hypothetical gift tax on all “gifts made by the decedent after December 31, 1976” not just on “adjusted taxable gifts,” which would exclude gifts that are includible in the gross estate (§2001 last sentence).) Will that change? Another approach, which would end up with gifts in the gross estate while still taking advantage of the window of opportunity, is making a gift by a legally enforceable note (described in subparagraph (2) above). If the donor dies before the note is paid, the assets that will be needed to pay the liability are still in the gross estate, and the same estate tax calculation applies so that the client would have taken advantage of the window of opportunity. A similar approach is making gifts valued under chapter 14 at different than fair market value (discussed in subparagraph (3) above). The New York State Bar Association Tax Section’s comments to the IRS regarding the anticlawback regulation “brings to the attention” of the IRS that the approach of increasing the estate tax unified credit amount by exclusions applied against gifts that are later included in the gross estate (if those exclusions exceed the BEA available at death) “permit individuals to make relatively painless taxable gifts that lock in the increased exclusion amount, even though they retain beneficial access to the transferred property.” The comments point out that the same benefit may result from making a gift that is subject to treating a retained interest as being worth zero for gift tax purposes under §2702. The comments recommend that the estate tax unified credit amount not be increased by exclusions applied against gifts that are included in the gross estate. We recommend that Treasury and the Service consider proposing rules that would create exceptions to the favorable rule of the Proposed Regulations in the case of gifts that are included in the gross estate. Under this approach, if a decedent made a gift of property before 2026 and the gift is included in the gross estate, any increased basic exclusion amount used by the gift is not preserved at death. As the gift would be purged from the estate tax computation base under Section 2001(b), there is no concern about claw back of tax. Further, the property would be subject to the estate tax lien and the decedent’s executor would normally have a right to recover the share of estate taxes attributable to the property.

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The 2021-2022 IRS Priority Guidance Plan adds the following project: “Regulations under §2010 addressing whether gifts that are includible in the gross estate should be excepted from the special rule of § 20.2010-1(c).” The addition of the project indicates that the IRS is actively considering the adoption of an anti-abuse rule (and suggests that it likely will adopt some kind of exception). Planners should be cautious in using these approaches as a way of making use of the increased gift exclusion amount until the IRS issues further guidance (or a proposed regulation). For an excellent discussion of planning alternatives that might be impacted by the anti-abuse rule, and planning considerations in light of the possibility of a future anti-abuse proposed regulation, see Katie Lynagh, Potential Anti-Abuse Rules May Limit Use of the Temporarily Increased Gift Tax Exclusion, BNA ESTATES, GIFTS & TRUSTS J. (May 14, 2020). For example, to guard against the possible issuance of such an anti-abuse rule, a possible planning alternative with a retained §2036 interest is to give a protector the ability to remove the grantor’s retained income interest (which arguably would not be subject to the three-year rule of §2035 because the donor would not be voluntarily releasing the retained interest, see PLRs 9032002 & 9109033, although a regulatory anti-abuse rule could conceivably address deathbed planning). (7) Locking in Use of GST Exemption. Clients might also lock in use of the “bonus GST exemption” before the GST exemption sunsets to $5 million (indexed) by making a transfer to a grantor retained income trust. The estate tax inclusion period (ETIP) during the period of the retained interest prevents the inclusion ratio from being determined during the ETIP, but does not appear to prevent GST exemption from being allocated. The GST tax regulations address the effect of allocating GST exemption prior to the end of the ETIP. Reg. §26.2632-1(c)(5) Exs. (1)-(2); §26.2642-1(b)(2)(i). However, the regulations do not specifically address the effect of a decline of the GST exemption during the ETIP. Also, if an anti-abuse rule is adopted regarding clawback of the estate and gift exclusion amount, will it also address similar alternatives making use of the GST exemption? g.

Transfer Planning During a Period of Legislative Uncertainty and in Low-Interest Rate Environment; Adding Flexibility. A great deal of uncertainty exists regarding whether gift/estate exclusion amounts will be reduced, whether rates will be increased, or whether other transfer tax reforms might be implemented (for example, attacking valuation discounts, GRATs, and future transfers to grantor trusts). For a terrific resource addressing a wide variety of planning alternatives during times of such uncertainty, see Carlyn McCaffrey & Jonathan Blattmachr, The Estate Planning Tsunami of 2020, ESTATE PLANNING (Nov. 2020). Adding flexibility to irrevocable trusts can be very helpful considering the existing substantial legislative uncertainty. Some of the ways of adding considerable flexibility are: •

using nontaxable powers of appointment;

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providing broad standards for distributions by independent trustees;

•

granting substitution powers to the settlor;

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authorizing trust decanting (which may be available under state statutes); and

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providing special modification powers to trust protectors (see the discussion in Item 9 below regarding trust protectors).

Transfers With Flexibility to “Undo” the Transfer. While the likelihood of retroactively reducing the gift exclusion amount in 2021 is very unlikely (see Items 2.p and 2.q(2) above), the possibility of retroactive legislation exists and some planners have examined ways of making gifts that could be limited not to trigger gift tax or that could be “undone” in the event of subsequent legislation making the gift inadvisable. Alternatives are discussed in Items 10-18 below.

Lifetime Gifts of Low Basis Assets; “Appreciation Hurdle.” The estate tax savings of gifts are offset by the loss of a basis step-up if the client dies no longer owning the donated property (unless §1014 should be repealed by future legislation). Be wary of making gifts of low-basis assets,

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particularly if the donor is in old age or near death. For a discussion of David Handler’s “appreciation hurdle” chart, see Item 10.k. of Estate Planning Current Developments and Hot Topics (December 2019) found here and available at www.bessemertrust.com/for-professional-partners/advisorinsights.

Report Transactions on Gift Tax Returns with Adequate Disclosure. Many planners encourage clients to file gift tax returns to report gift or non-gift transactions to start the statute of limitations. Otherwise, the possibility of owing gift tax on an old transaction is always present. In order to start the statute of limitations, the return must meet the adequate disclosure requirements of Reg. §301.6501(c)-1(f).

Further Discussion. For further discussion of each of these alternatives, see Item 8 of Estate Planning Current Developments and Hot Topics (May 2021) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights.

Using Trust Protectors for Flexibility Considering Legislative Uncertainty a.

General Description; Provides Flexibility. Offshore trusts have historically used trust protectors, leading to growing use in the United States. A “trust protector” may be given “grantor-like” powers that can be very limited or very broad to make changes regarding the trust. The trust protector is a third party (not the settlor, trustee, or a beneficiary) who is given powers in the trust instrument designed to assist in carrying out the settlor’s intent. A wide variety of powers is possible—but the powers must be specifically described and granted in the trust instrument. A trust protector can provide flexibility to address unforeseen circumstances. One of those unforeseen circumstances might be the impact of tax law changes on the trust. For example, the Biden Greenbook proposal would treat distributions in kind from a trust as deemed realization events. If that were to be enacted, terminating distributions from a trust might be subject to huge capital gains taxes. A trust protector with broad authority to amend the trust (or with authority to amend the trust for tax-savings purposes) might amend the trust to provide that it would not terminate into separate trusts for the primary beneficiary’s descendants but would continue as a single “pot trust” for all of the descendants in order to delay the capital gains tax until distributions to beneficiaries were made of in kind assets.

Trust Protector Statutory Authority. Section 808 of the Uniform Trust Code was largely superseded by the Uniform Directed Trust Act in 2017, but the former §808 had been entitled “Powers to Direct.” Section 808(d) provided that “a person, other than a beneficiary, who holds a power to direct is presumptively a fiduciary who, as such, is required to act in good faith with regard to the purposes of the trust and the interest of the beneficiaries.” The Comment to §808 stated that the section ratified the “use of trust protectors and advisers.” It explained that “Advisers” have been used for certain trustee functions and distinguishes trust protectors: “Trust protector,” a term largely associated with offshore trust practice, is more recent and usually connotes the grant of greater powers, sometimes including the power to amend or terminate the trust. Subsection (c) ratifies the recent trend to grant third persons such broader powers.

The Uniform Trust Code has been adopted in a majority of states; some of them adopted §808 verbatim and others made slight changes. Some states also have separate statutes governing trust advisors and trust protectors, or sometimes just trust protectors. The authority and specific powers held by a trust protector are as described in the trust instrument, but statutes developed in various states in recent years provide clarity regarding the role or actions of trust protectors. A variety of the state directed trust statutes have language broad enough to apply to trust protectors as well. Some states have enacted statutes addressing the powers of trust protectors specifically (including, among various others, Alaska, Delaware, Idaho, Illinois, Nevada, New Hampshire, South Dakota, Tennessee, and Wyoming) that list sample powers that trust protectors could hold.

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Almost all the state statutes are default statutes—providing a list of possible powers but stating specifically it is not an exclusive list. Most of the statutes make clear that trust protectors only have powers that are specifically granted in the trust instrument. c.

Common Powers of a Trust Protector. Trust protector powers related to the trustee may include the power to remove and replace trustees, to appoint additional trustees, to act as a tiebreaker, to provide advice or direction regarding discretionary distributions or regarding management actions, or to veto trustee decisions. Powers unrelated to the trustee include the power to change the trust situs or governing law, to terminate the trust under specified conditions, to amend the trust for any valid purpose such as to respond to changes in tax laws, or to alter the beneficial interests such as adding or removing beneficiaries.

Should the Trust Protector be a Fiduciary? Statutes sometime address whether a trust protector acts in a fiduciary capacity. Most of the statutes addressing trust protectors provide that they are considered to act as a fiduciary unless the trust instrument provides otherwise (Delaware is an example of that approach). Taking the opposite approach, the South Dakota and Alaska statutes provide that the trust protector is not a fiduciary unless the trust instrument provides otherwise. The Wyoming statute provides that trust protectors “are fiduciaries” to the extent of the powers, duties, and discretions granted to them in the trust instrument. Considering the variety in state law regarding whether protectors act as fiduciaries, the trust instrument should specify explicitly whether the protector acts in a fiduciary capacity. If the trust protector has the power to direct the trustee to take specified actions, the protector should act in a fiduciary capacity as to such powers. (1) Impact on Potential Liability of the Protector. A protector acting as a fiduciary will be held to a higher standard than a nonfiduciary. Indeed, a third person may be less willing to agree to act as trust protector if the person acts as a fiduciary. The planner might consider the settlor’s intent as to potential liability of the protector in determining whether to specify that the protector acts as a fiduciary. Settlors will typically want to minimize the risk for trust protectors. Even if the protector acts as a fiduciary, a very broad exculpatory provision could be included (to the extent allowed under state law). But whether the exculpatory clause will actually result in protecting the fiduciary will always be subject to some degree of uncertainty. Planners have varying views about this issue. Some would generally provide that trust protectors are not fiduciaries in order to reduce the risk to them. Others would generally provide that protectors are fiduciaries and rely on exoneration in a trust instrument to exonerate the protector from liability except in the case of willful misconduct. Some planners believe that a protector should be particularly careful with holding a fiduciary power to direct the trustee regarding investments and investment concentrations, even with broad exoneration in the trust instrument. (2) Standard for Protector Liability. In any event, the trust protector’s standard of liability should be clearly stated in the trust agreement to avoid uncertainty. (3) Power of Appointment Alternative. As an alternative to naming a trust protector to add flexibility for revising beneficial interests, the settlor could give an individual a limited power to appoint assets to a trust with differing beneficial interests or different beneficiaries because a limited power of appointment is a personal power, not a fiduciary power.

Potential Tax Attacks If Facts Reflect That Settlor Retains Tax-Sensitive Powers Indirectly Through Actions of a Trust Protector. Long ago, the IRS tried to make a “de facto trustee” argument, treating a settlor as holding the powers of the trustee if the settlor exercised persuasive control over the trustee. Courts (including a U.S. Supreme Court case) rejected that “de facto trustee” argument. However, SEC v. Wyly raises concerns for estate planning advisors by treating settlors as the de facto trustee of a trust (albeit in an extreme fact situation in which the trustees always followed the settlors’ directions for over a decade).

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SEC v. Wyly, 2014 WL 4792229 (S.D.N.Y. Sept. 25, 2014) (Judge Scheindlin), is the determination of the “disgorgement” remedy in a securities law violation case by the billionaire Wyly brothers. The court based the amount of disgorgement largely on the amount of federal income taxes that the defendants avoided from the use of offshore trusts, after finding that the trusts were grantor trusts and that the defendants should have paid federal income taxes on all the income from those trusts. The court determined in particular that the “independent trustee” exception in §674(c) did not apply even though the trustees were various Isle of Man professional management companies. Three close associates of the Wylys (the family attorney, the family office CFO, and the CFO of one of the Wyly entities) were trust protectors who had the power to replace the trustees. Throughout the trust administration, the Wylys expressed their requests to the trust protectors, who relayed them to the trustees, who always complied. There is a growing trend toward naming trust protectors with very broad powers, including the broad ability to amend trusts, change beneficial interests, veto or direct distributions, modify powers of appointment, change trustees, or terminate the trust—all in the name of providing flexibility to address changing circumstances, particularly for long-term trusts. The Wyly case points out how that could backfire if a pattern of “string-pulling” by the settlor occurs in practice with respect to the exercise of those very broad powers. Planners will not stop using trust protectors in the future because of Wyly but should be aware of potential tax risks that can arise if the broad trust protector powers are abused by overbearing settlors. f.

Structuring and Drafting Considerations. (1) Use a trust protector only if necessary or desirable for particular purposes. (2) Never rely on state law but spell out in detail what powers are included. Do not just adopt a list of powers that may be included in a state statute because some of those powers are likely not appropriate for a particular situation. (3) Make clear in the trust instrument whether the trust protector acts in a fiduciary capacity. (4) Clearly and specifically describe the powers, duties, and compensation of the protector. •

•

If the protector has a duty to monitor, provide that the protector has the right to receive information from the trustee that is appropriate to the monitoring function.

•

Provide for compensation appropriate to the protector’s functions.

•

Provide for appropriate exoneration of the trustee, the protector, or both with respect to actions taken or not taken by the protector.

•

Provide that the protector has standing to enforce its powers in a court action.

(5) Do not mandate that the protector exercise its power (unless that is the settlor’s intent) but provide that the protector may exercise its powers in its sole and absolute discretion and that its decisions will be binding on all persons. (6) Specify the duty and liability of the protectors—for example that there is no liability absent bad faith or willful misconduct. In providing for the protection of the protector, specify who will pay the protector’s attorney fees if the protector is sued. (7) Clarify whether the protector has the right to receive information from the trustee and what information is intended. www.bessemertrust.com/for-professional-partners/advisor-insights

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(8) Make clear that the term “protector” is just the name given to the person and that the protector does not have the function of “protecting” the trust generally. g.

Further Resources. See Item 3.h.(8)-(11) of the Current Developments and Hot Topics Summary (November 2017) found here, Item 3.j.(13) of the Estate Planning Current Developments Summary (December 2018) found here, and Items 34-47 of ACTEC 2021 Annual Meeting Musings (May 2021) found here, all available at www.bessemertrust.com/for-professional-partners/advisor-insights for a more detailed discussion of powers and limitations that can be added for trust protectors to provide flexibility.

Items 10-18 Discuss Transfer Planning Alternatives to Minimize Risk of Gift Taxes Due to Retroactive Gift Tax Legislation. The likelihood of legislation being enacted in 2021 with a retroactive reduction of the gift tax exclusion amount appears extremely low (if nonexistent). Nevetherless, some of the topics discussed below may present planning opportunities in light of the current legislative uncertainty. Furthermore, if the tax changes are not passed in 2021, these issues will again be present for planning in 2022 (with an even greater likelihood of a retroactive reduction of the exclusion amount in light of the notice to taxpayers that the decrease in the exclusion amount is being actively considered in Congress). 10. Formula Gifts Up to the Exclusion Amount a.

Description. The donor might make a gift that does not exceed the applicable gift exclusion amount similar to standard “A/B formula” testamentary bequests. The assignment might be a transfer of an amount (or a fractional share of an asset) equal to the remaining gift exclusion amount, taking into consideration any subsequent legislation that might reduce the exclusion amount effective as of the date of the gift, but not legislation increasing the exclusion amount as of that date. This would operate somewhat like a Wandry clause, transferring only the amount equal to the available exclusion, but the uncertainty about how much is being transferred currently is based on the vagaries of Congress might do, not based on a subsequent gift tax audit or gift tax court decision as with a Wandry clause. The clause would not have the effect of “undoing” the effect of any distant gift tax audit or court decision but would be based very objectively merely on what Congress does in the relatively short term. To be even more analogous to a standard testamentary marital deduction bequest, the clause could merely be a formula allocation of a block of assets, partly to a taxable gift portion (such as a trust for descendants or for descendants and the donor’s spouse) and partly to a nontaxable portion (such as to charity, a spouse, a QTIPable trust, a general power of appointment marital deduction trust, an estate marital trust, an “almost zeroed out” GRAT, or an incomplete gift trust).

Possible Procter Attack. The IRS might conceivably argue that the assignment with a condition subsequent would not be recognized under the reasoning of Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944), cert. denied, 323 U.S. 756 (1944), which rejected the claim that the following “savings clause” avoided a court determination that a $10,566.07 gift tax applied to a transfer: Eleventh: The settlor is advised by counsel and satisfied that the present transfer is not subject to Federal gift tax. However, in the event it should be determined by final judgment or order of a competent federal court of last resort that any part of the transfer in trust hereunder is subject to gift tax, it is agreed by all the parties hereto that in that event the excess property hereby transferred which is decreed by such court to be subject to gift tax, shall automatically be deemed not to be included in the conveyance in trust hereunder and shall remain the sole property of Frederic W. Procter free from the trust hereby created. (Emphasis added.)

The literal language of the transfer document in Procter contemplated that there was a present transfer that counsel believed was not subject to gift tax, and that any property “hereby transferred” that would be subject to gift tax was “deemed” not to be included in the conveyance. This is different from the contemplated formula assignment that purports only to transfer a specified amount and nothing else. The full Fourth Circuit Court of Appeals concluded that the provision imposed a condition subsequent to the transfer, and that the condition subsequent violated public policy for three reasons: (1) the www.bessemertrust.com/for-professional-partners/advisor-insights

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provision discouraged the collection of gift tax because any attempt to collect the tax would defeat the gift; (2) the condition obstructed the administration of justice by requiring a court to pass on a moot case; and (3) the provision would reduce a Federal court’s final judgment to a declaratory judgment. Observe that none of those three reasons applies to a formula assignment that merely takes into account retroactive gift tax law changes. Much of the attention in Procter about the effect of this clause was about a procedural defect—that the clause would change what had previously been transferred automatically based on what the court decreed and that the clause would automatically undo whatever the court decided. The court’s holding speaks to a procedural defect with the provision, namely, that the clause created a condition subsequent that could not become operative until a final judgment had been rendered, but once a judgment had been rendered it could not become operative because the matter involved had already been concluded by such final judgment…. “[T]he court in Procter [held] that because the adjustment was intended to take effect subsequent to the court’s judgment, it cannot avoid the imposition of gift tax, because the tax is imposed on the judgment, and is then final.” Diana S.C. Zeydel and Norman J. Benford, A Walk Through the Authorities on Formula Clauses, ESTATE PLANNING, December 2010, at 4. Tiffany Carmona and Tye Klooster, Wandry v. Commissioner-The ‘Secret Sauce’ Estate Planners Have Been Waiting For? 26 PROB. & PROP. 10, 11 (Nov./Dec. 2012).

The focus in Procter regarding the effectiveness of the formula clause was that the formula was designed to counteract any determination by the IRS or a court that would otherwise result in additional gift tax. The court was unwilling to accept the “Catch-22” effect that its own determination that a gift tax applied caused the gift tax not to apply. That is not the case with an assignment of the gift exclusion amount that could be decreased because of a retroactive law that the Congress might pass. The three reasons given by the Fourth Circuit that the clause violated public policy are not applicable to a formula that merely considered retroactive gift tax law changes. While Procter is often considered as presenting concerns for actions subject to a “condition subsequent,” that term was only used once in the opinion in the following sentence: “This is clearly a condition subsequent and void because contrary to public policy.” The court then discusses in some detail the three reasons that the clause violates public policy (all related to the issue that enforcement attempts by the IRS or courts to find the existence of additional gifts would automatically defeat the additional gifts). There was no discussion in Procter that “conditions subsequent” per se are not respected. Indeed, tax policy does not generally reject all “conditions subsequent.” For example, the marital deduction regulations specifically recognize the validity of a formula QTIP election “even though the executor’s determinations to claim administration expenses as estate or income tax deductions and the final estate tax values will affect the size of the fractional share.” Reg. §20.2056(b)-7(h), Ex. 7. As another example, a transfer of a specified dollar value of units of an LLC, to be determined by a specific appraiser within several months of the transfer, is a transfer subject to a condition subsequent (the appraised value) but is not viewed as abusive or contrary to public policy. Cf. Nelson v. Commissioner, T.C. Memo. 2020-81 (IRS raised no policy objections to the assignment). The Procter court reasoned that the condition subsequent violated public policy because of its effect of automatically undoing a determination by the court, not merely because it depended on some future events. Conservation easement cases that have rejected various types of “savings clauses” on the basis of Procter have also pointed out that the subsequent event is a finding that a problematic clause is “conditioned on a subsequent IRS or court determination.“ TOT Property Holdings, LLC v. Commissioner, 127 AFTR 2d 2021-2420 (11th Cir. June 23, 2021). Similarly, Belk v. Commissioner, 774 F.3d 221, 230 (4th Cir. 2014), emphasized that a savings clause purported to alter contract rights triggered by “a determination that [could] only be made by either the IRS or a court.” For a discussion of TOT Property Holdings and other similar conservation easement cases, see Item 40 below. The formula allocation approach rather than a formula transfer, with the excess amount attributable to the retroactive decrease in the gift exclusion amount passing to a nontaxable portion, seems to be less susceptible to a Procter attack, which has sometimes been referred to by the IRS as rejecting a formula that “retransfers” assets to a donor. For example, in Technical Advice Memorandum www.bessemertrust.com/for-professional-partners/advisor-insights

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200337012 the IRS rejected a formula transfer of “that fraction of Assignor’s Limited Partnership Interest in Partnership which has a fair market value on the date hereof of $A” because “a certain percentage of the Partnership interest held by Trust would be retransferred to Taxpayer. This is the type of clause that the courts in Procter and Ward conclude are void as contrary to public policy.” c.

Possible “Current Value Completed Gift” Argument. An assignment of an amount equal to the exclusion amount, taking into consideration retroactive legislation, is a completed gift because any adjustments in the amount being assigned is out of the donor’s control. The assignment document no doubt would control for state law purposes and a retroactive reduction in the gift exclusion amount would reduce the amount transferred, but whether such amount would be subtracted from the taxable gift is uncertain. The IRS might take the position that the assignment must be valued at the time of the gift because that is when the gift is complete. The value of the assignment would take into consideration the likelihood of the gift exclusion amount being reduced and by what amounts. (That likelihood would be difficult to value; perhaps the likelihood is so remote that the IRS would take the position that it should be ignored altogether in valuing the gift as of the time of the assignment.) An analogy might be the assignment of a derivative based on the performance of some particular asset (such as the value of a specified number of shares of Apple stock after 12 months). The gift would be valued based on the current value of that contractual right, not the actual amount transferred 12 months later based on the value of Apple stock at that time. See David Handler, Naked Derivatives and Other Exotic Wealth Transfers, 50th HECKERLING INST. ON EST. PL. ch. 8 (2016).

Drafting Issues. •

The assignment could include a “purpose” provision making clear that the purpose is to assign as large amount as possible without generating federal gift tax based on federal gift tax law as it is finally determined to exist as to the assignment by the time the federal gift tax return is filed and to eliminate any possible unintended gift tax due to retroactive tax law changes between the date of the assignment and the date the gift tax return is filed reporting the gift (or perhaps to the due date of such gift tax return).

•

The assignment might state the amount initially allocated to the assignment but make clear that the donor still owns any excess amount represented by any subsequent retroactive decreases in the gift exclusion amount and that titles will be adjusted accordingly to implement the formula transfer.

•

If a formula allocation approach is used, with the excess passing to a nontaxable portion, the clause might provide that the taxable portion amount will be placed in escrow until the federal gift tax return reporting the gift is filed, and if a retroactive tax law change reduces the exclusion amount, the excess amount initially allocated to the taxable gift portion will be moved to the nontaxable portion, including all income and appreciation attributable to that portion of the escrowed funds.

•

The formula might include an ordering provision, specifying what particular assets would first be used as adjustments are made under the formula.

11. Transfer to Inter Vivos QTIPable Trust a.

General Description. A donor might make a transfer to a QTIPable trust if the donor is comfortable with the spouse being the sole beneficiary of the trust. The donor can defer the decision of whether the transfer is a taxable gift until the donor decides whether to make the QTIP election on the gift tax return reporting the transfer. Making a QTIP election would mean that the gift to the trust would be covered by the gift tax marital deduction thus avoiding any taxable gift. If the gift exclusion amount is not decreased retroactively, the QTIP election would not be made. The decision of whether the donor would make the election on the Form 709 could be delayed until October 15 of the following calendar year if the gift tax return is extended.

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For outstanding resources discussing a wide variety of planning considerations for inter vivos QTIP trusts, see Richard S. Franklin, Lifetime QTIPs—Why They Should Be Ubiquitous in Estate Planning, 50th HECKERLING INST. ON EST. PL. ch. 16 (2016); Richard S. Franklin & George Karibjanian, The Lifetime QTIP Trust – the Perfect (Best) Approach to Using Your Spouse’s New Applicable Exclusion Amount and GST Exemption, 44 BLOOMBERG TAX MGMT. ESTATES, GIFTS & TR. J. 1 (March 14, 2019). b.

Features and Special Tax Considerations. (1) SLAT-Like Advantages. The QTIPable trust approach works well for the married donor who wants to take advantage of the “window of opportunity” to utilize the large gift exclusion amount but wants to keep some ability for the couple to have access to the gift assets if needed for lifestyle reasons. The QTIPable trust is a type of a spousal lifetime access trust (SLAT) that includes the donor’s spouse as a beneficiary. (2) Donor in Control of Decision to “Undo” the Taxable Gift. The donor is in control of the decision of whether to cause the transfer not to be a taxable gift (by making the QTIP election on the donor’s gift tax return). (3) Mandatory Income Interest. While all trust income must be paid to the spouse at least annually, the trust is not automatically disqualified merely because the trust permits non-income producing assets to be retained or because the trust invests in non-income producing assets, as long as the spouse has the power to require the trust to produce a reasonable amount of income. See Reg. §25.2523(f)-1(f), Ex. 2. (4) No Power of Appointment During Spouse’s Lifetime. No person (including the spouse) may have a lifetime power to appoint any of the trust assets to any person other than the spouse. §§2056(b)(7)(B)(ii)(II), 2523(f)(3). The spouse can be given a testamentary limited power of appointment. (5) Principal Distributions. The trust cannot allow any distributions to anyone other than the spouse during the spouse’s lifetime. The trust can prohibit principal distributions to the spouse or may allow principal distributions according to a standard or (if the spouse is not the trustee) within the discretion of the trustee or under other broad non-ascertainable standards (such as a “best interests” standard). (6) Make QTIP Election on Timely Filed Form 709. The QTIP election must be made on a timely filed gift tax return (§2523(f)(4)(A)), and there is no possibility of getting 9100 relief to make a late election (e.g., PLR 200314012). If the donor spouse dies before the end of the year of the gift, the gift tax return must be filed by the estate tax filing date, if sooner. §6075(b)(3). (7) Formula QTIP Election Permitted. The QTIP election may be made by a formula, for example based on the donor’s gift exclusion amount. See Item 11.c below. (8) Clayton Provision Probably Not Available. A “Clayton” provision, to allow beneficiaries other than just the spouse if the QTIP election is not made, likely cannot be used for inter vivos QTIP trusts. See Item 11.d below. (9) “Clayton Flexibility” Available to Some Extent With Disclaimer Provision. Although a Clayton provision cannot safely be used to add other beneficiaries if the QTIP election is not made, the flexibility to add other trust beneficiaries could be available by using a disclaimer provision, specifying where assets will pass if the donee spouse disclaims his or her interest in the trust. See Item 11.e below. (10) Remainder Alternatives. The trust must last for the spouse’s lifetime. As mentioned above, the spouse (or anyone else) could have a testamentary limited power of appointment following the spouse’s death. In default of exercise of any such power of appointment, the trust could continue as a trust for the benefit of the original donor spouse. The continuing trust could be a QTIPable trust or could be a “bypass trust” that would not be includable in the donor-spouse’s gross estate (see Item 11.f below). The assets could be divided by a formula between a QTIPable trust

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and a bypass trust for the original donor spouse. Reg. §§20.2056(b)-7(b)(2)(i) & 20.2056(b)-7(h), Exs. (7-8). (11) Deferral of Decision to Apply Donor’s or Donee’s GST Exemption; “Reverse QTIP Election.” The donor’s decision of whether to make the QTIP election can be deferred until the filing date of the gift tax return reporting the transfer (October 15 of the year following the gift if the original April 15 gift tax return due date is extended). Assume a husband makes a gift to a QTIPable trust for his wife. Upon filing the gift tax return reporting the transfer, if the QTIP election is not made, the donor can allocate his GST exemption if desired. If the QTIP election is made, the donee wife is generally treated as the transferor to the trust (and she could allocate her GST exemption to the transfer), but §2652(a)(3) allows the donor to elect for the donor to be treated as the transferor for GST tax purposes only, meaning that the donor could allocate his GST exemption to the QTIP trust if desired. The ETIP rule does not apply to a QTIP trust if the “reverse” QTIP election has been made. Reg. §26.2632-1(c)(2)(ii)(C). (12) Divorce Provisions. A special consideration in creating any inter vivos QTIP trust is that it must provide an income interest to the donee spouse for life, even in the event of divorce. The donor spouse must be comfortable with that possibility. If a divorce were to occur, the trust could provide that any right to receive discretionary principal distributions or a testamentary limited power of appointment for the spouse would terminate. Troublesome income tax issues with respect to the QTIP trust would also arise following a divorce. See Item 11.g below. (13) Grantor Trust. The trust is a grantor trust (with the donor spouse as the deemed owner) as to income because of the spouse’s mandatory income interest and it would also be a grantor trust as to principal if the trust authorizes discretionary principal distributions to the spouse. The trust can also be designed so that it would continue as a grantor trust as to the original donor even following the donee spouse’s death and even if the trust effectively continues as a “bypass trust” for the benefit of the original donor spouse. Reg. §1.671-2(e)(5) (if a trust transfers to another trust, the grantor of the original trust is also treated as grantor of the transferee trust unless a person with a general power of appointment over the original trust exercises that power in favor of another trust). See generally Gans, Blattmachr & Zeydel, Supercharged Credit Shelter Trust, 21 PROB. & PROP. 52, at 56 (July/August 2007). (14) Gifts by Donee Spouse; Release. The donee spouse can have the flexibility, in effect, to make a gift of the trust assets. If the trust does not have a spendthrift clause, the donee spouse could assign her interest in the trust, which would cause the spouse to be treated as having made a gift of the entire trust, of the income interest under §2511 and of the remainder interest under §2519. Even if the trust has a spendthrift clause, the trust might provide that a “release” by the donee spouse of her interest would not be treated as a prohibited alienation. See RESTATEMENT (THIRD) OF TRUSTS, §58 cmt. c; Richard S. Franklin, Lifetime QTIPs—Why They Should Be Ubiquitous in Estate Planning, 50th HECKERLING INST. ON EST. PL. ¶1602.4 (2016). (15) Disclaimer Flexibility. The donee spouse could trigger a taxable gift by disclaiming the gift within the 9-month disclaimer period if the spouse had not received any distributions from the trust. The disclaimer could be made by a formula. See Item 11.e below. (16) Minority Interests. Even if the QTIP election is made for the trust, assets in the trust are not subject to being aggregated to determine voting control with interests owned by either the donor or donee spouse. See Estate of Mellinger v. Commissioner, 112 T.C. 26 (1999), acq. 1999-35 I.R.B. 314, as corrected by Ann. 99-116, 1999-52 I.R.B. 763. (17) Must be U.S. Citizen. No marital deduction is allowed for a gift to a non-citizen spouse made on or after July 14, 1988. A modified annual exclusion is allowed for the first $100,000 (indexed from 1997) of annual gifts, but a gift to a lifetime QTIP does not qualify for that modified annual exclusion. Reg. §25.2523(i)-1(d), Ex. 4.

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Formula QTIP Election. Furthermore, this strategy may allow limiting the amount of the taxable gift if the donor wishes to put a cap on the amount of gift tax owed as a result of the transfer. Various examples in the regulations reiterate that formula QTIP elections may be used. See Reg. §§20.2056(b)-7(b)(2)(i) & 20.2056(b)-7(h), Exs. (7-8). For a discussion of the mechanics of making a formula election, see Tech. Adv. Memo. 9116003 (discussing validity of QTIP election of “an amount from the assets ... equal to the minimum amount necessary to reduce the federal estate tax payable as a result of my death to the least amount possible …”). By using a formula QTIP election, the planner can provide that the QTIP election is made over a sufficient portion of the transferred property so that no gift tax or only a maximum set amount of gift tax is payable on the transfer. In this manner, making a formula QTIP election operates much like using a defined value clause — except that the formula QTIP election approach is clearly sanctioned in the regulations and existing rulings. For example, a spouse may transfer to an inter vivos QTIP trust an amount equal to the unused gift exclusion amount and make a formula QTIP election sufficient to reduce the federal gift tax to zero, taking into consideration the available gift exclusion amount at the time of the election and considering finally determined gift tax values (which would cause the formula election to operate like a defined value clause) . The regulations provide that a taxpayer may make the gift tax QTIP election by means of a formula that relates to a fraction or percentage of the QTIP trust. Reg. §25.2523(f)1(b)(3). The estate tax QTIP regulations contemplate formula elections, §20.2056(b)-7(b)(2)(i) and have an example of such a formula partial election. Reg. §20.2056(b)-7(h), Exs. 7-8; see Tech. Adv. Memo. 9116003 (discussing validity of QTIP election of “an amount from the assets ... equal to the minimum amount necessary to reduce the federal estate tax payable as a result of my death to the least amount possible …”). Richard Franklin suggests the following formula election as an example: I elect to treat as qualified terminable interest property that portion of the gift, up to 100%, necessary to reduce the Federal gift tax to zero after taking into account the available gift tax exclusion amount and final gift tax values. Richard S. Franklin, Lifetime QTIPs—Why They Should Be Ubiquitous in Estate Planning, 50th HECKERLING INST. ON EST. PL. ¶1601.4[B] (2016).

(This tracks the language in the example in the regulation cited above.) d.

Clayton Uncertainty. The non-elected portion of an inter vivos QTIP should continue to give the spouse a mandatory income interest and permit distributions to no one other than the spouse during his or her lifetime. The Clayton regulation (based on the result in Estate of Clayton v. Commissioner, 976 F.2d 1486 (5th Cir. 1992)) provides that the portion of the assets for which the QTIP election is not made may pass to a trust having different terms than the required terms for a QTIP trust — including a trust that would be similar to a standard “bypass trust” for the spouse that would not be in the spouse’s estate for estate tax purposes. Reg. §20.2056(b)-7(d)(3). However, that provision, is only in an estate tax regulation and is not in the similar gift tax regulation, Reg. §25.2523(f)-1(b). The gift tax regulation is not a model of clarity, and there would seem to be some uncertainty about this result. Section 25.2523(f)-1(a)(1) of the gift tax regulations states as follows: (c) Qualifying income interest for life — (1) In general. For purposes of this section, the term qualifying income interest for life is defined as provided in section 2056(b)(7)(B)(ii) and § 20.2056(b)-7(d)(1).

On the one hand, this statement would seem to incorporate the “Clayton regulation,” because this statement provides that for gift tax purposes, the term “qualifying income interest for life” is defined as provided in §2056(b)(7)B)(ii). The Clayton regulation is in the section of the regulations describing a “qualifying income interest for life.” Therefore, the interpretation of that estate tax statutory term, as including an income interest that is contingent on the existence of a QTIP election, would seem to control for gift tax purposes also. More importantly, the gift tax QTIP statute itself provides that “rules similar to the rules of clauses (ii)… of section 2056(b)(7)(B) shall apply.” Section 2056(b)(7)(B)(ii) defines the term “qualifying income interest for life.” If the gift tax statute simply makes reference to the statutory definition of “qualifying income interest for life,” an interpretation of that statute to include an income interest that is contingent on the existence of a QTIP election would seem to be controlling for gift tax purposes also.

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On the other hand, the general statement in the gift tax regulation, quoted above, refers not only to §2056(b)(7)(B)(ii) of the statute, it also refers specifically to Reg. §20.2056(b)-7(d)(1). However, the “Clayton regulation” is in §20.2056(b)-7(d)(3). Furthermore, the gift tax regulation specifically restates (as a very similar mirror provision) what is in §20.2056(b)-7(d)(2), (4), (5), and (6), thus suggesting that the omission of 7(d)(3) has particular significance, raising the question of whether an income interest that is contingent on whether a QTIP election is made would qualify for the gift tax marital deduction. If a Clayton provision added other beneficiaries if the QTIP election is not made, it would seem that the gift would not be complete in the year of the original transfer — because the donor would retain the power to shift benefits among beneficiaries until the gift tax return filing date has passed. (Conceivably the gift would never become complete during the donor’s lifetime because the return making the election would always be due the following year, thus extending the completion of the gift to the following year, extending the due date of the return to the year after that, etc.) Even if a Clayton provision could be used for inter vivos QTIP trusts, including the provision could be problematic because until the period for making the election had passed, the donor might have retained a §2036(a)(2) power because of the donor’s ability to make or not make the election on the Form 709, which could trigger gross estate inclusion for an additional three years under §2035. e.

Disclaimer Provision to Add “Clayton Flexibility.” Although a Clayton provision cannot safely be used to provide for other beneficiaries if the QTIP election is not made, the trust could include a disclaimer provision specifying where assets that are disclaimed by the donee spouse will pass. The trust might provide that disclaimed assets would pass to a trust for descendants if the donee spouse disclaimed, as discussed in Richard Franklin, Lifetime QTIPs – Why They Should be Ubiquitous in Estate Planning, 50th ANN. HECKERLING INST. ON EST. PL. ¶1601.4[C] (2016)(including a form for a formula disclaimer provision). (1) No Acceptance of Benefits. The donee spouse could not receive benefits from the trust before making a disclaimer. (A QTIP trust includes a mandatory income interest for the donee spouse. The donee spouse would need to disclaim before accepting any income distributions from the trust.) (2) No Power of Appointment. The disclaimant-spouse could not have a power of appointment over disclaimed assets. (3) Nine-Month Limit for Disclaimer Allows Consideration of Any Retroactive Decrease in Exclusion Amount. The disclaimer would have to be made within 9 months of the original transfer rather than by October 15 of the following year, but that is probably long enough to have a good sense of whether a retroactive decrease in the gift exclusion amount is being considered by Congress. If not, the donee spouse may be comfortable disclaiming and allowing the trust to include other beneficiaries. If the gift exclusion amount has been reduced retroactively by Congress, the amount of such reduction would not be disclaimed by the donee spouse, so that the QTIP election could be made for that portion of the trust to avoid gift taxes with respect to the decrease of the exclusion amount. But the balance of the trust might be disclaimed so that the donee spouse would no longer have a mandatory income interest and so that the disclaimed assets could pass to a trust solely for descendants. (4) Formula Disclaimer Permitted. The donee spouse could disclaim by a formula, which could be of the largest amount that could pass free of federal gift tax taking into consideration the donor spouse’s remaining gift tax exclusion amount and the values of assets as finally determined for federal gift tax purposes. (In this manner, the formula disclaimer could act as a defined value provision, using a formula approach that is sanctioned by regulations. Such a formula disclaimer approach was specifically approved in Estate of Christiansen v. Commissioner, 586 F.3d 1061 (8th Cir. 2009).) (5) Questionable Whether Disclaimed Assets Could Pass to SLAT With Donee Spouse as Discretionary Beneficiary. Whether the disclaimed assets from an inter vivos QTIP could pass to a SLAT with the donee spouse as a discretionary beneficiary is not clear. One of the requirements of a valid disclaimer under §2518 is that the interest passes either “(A) to the

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spouse of the decedent, or (B) to a person other than the person making the disclaimer.” §2518(b)(4). In a testamentary context, it is clear that the disclaimed assets could pass to a trust of which the disclaimant spouse is a potential beneficiary. However, it is not clear that applies if the donor spouse has not yet died. Literally, §2518(b)(4)(A) refers to the “spouse of the decedent” and Reg. §25.2518-2(e)(2) has references to “decedent” and “surviving spouse,” Richard Franklin, Lifetime QTIPs – Why They Should be Ubiquitous in Estate Planning, 50th ANN. HECKERLING INST. ON EST. PL. ¶1601.4[C][1] (2016). Despite the literal wording of the statute and regulation, one planner reports having been through a tax audit with the situation in which the disclaiming spouse of a lifetime QTIP was a continuing beneficiary, and the arrangement presented no problems. One commentator has concluded that the spouse of a still-living donor should be able to disclaim and remain a beneficiary of the disclaimed assets, reasoning that “presumably § 2518(b)(4)(A) will be read to apply to the ‘spouse of the transferor.’” Christopher P Cline, Disclaimers—Federal Estate, Gift and Generation-Skipping Tax Considerations, 848-3rd TAX MGMT. (BNA) ESTATES, GIFTS AND TRUSTS, at III.A., n.102 (“Section 2518(b)(4)(A) [and Reg. §25.2518-2(e)(2)] refers to a spouse who disclaims as the ‘spouse of the decedent’; however, … in the unusual situation of a donee spouse who disclaims an inter vivos gift from the donor spouse that then passes, without direction on the donee spouse's part, to a trust for the benefit of the donee spouse … presumably §2518(b)(4)(A) will be read to apply to the ‘spouse of the transferor.’”). f.

Remainder to Bypass Trust for Donor Spouse. If assets remain in trust for the benefit of the original donor spouse after the death of the donee spouse, the regulations make clear that the assets will not be includable in the donor spouse’s gross estate under §2036 or §2038 because the donee spouse is treated as the transferor of the continuing trust. §2044(c); Reg. §25.2523(f)-1(f), Exs. 10 & 11; Treasury Decision 8522, 59 FED. REG. 9642 (Mar. 1, 1994) (explaining the regulation examples). That is not the end of the analysis, however. A totally separate issue is that, despite the tax rules, for state law purposes the donor of the QTIP trust may be treated as the donor of the continuing trust for his or her benefit after the death of the donee spouse. Can a creditor argue that the assets originally came from the original donor, and that when they end up in a trust for her benefit, she should be treated as having created that trust, so that it is a self-settled trust reachable by her creditors? Indeed, that result is a possibility if the assets pass to the trust for the original donor spouse. Under the traditional “relation-back” doctrine, the original donor spouse is still treated as the transferor of the trust for state law purposes. Therefore, for state law purposes, the trust may be treated as a “self-settled trust” and subject to claims of the donor’s creditors unless the donor resides in a state with a domestic asset protection trust (DAPT) statute. See generally Gans, Blattmachr & Zeydel, Supercharged Credit Shelter Trust, 21 PROB. & PROP. 52, at 56 (July/August 2007). If the client does not live in a self-settled trust state with a DAPT statute, an attempt to incorporate the laws of a self-settled trust state may not be effective for creditor purposes. The comments to the Uniform Voidable Transactions Act (formerly the Uniform Fraudulent Transfer Act) take the position that if the law of the state of the settlor’s principal residence does not recognize self-settled trusts, transferring assets to a trust under the laws of another self-settled trust state would be a voidable transfer. UNIF. VOIDABLE TRANSACTIONS ACT §4, Comment 8, (last paragraph) (July 2014). The ability of a grantor’s creditors to reach trust assets generally will trigger inclusion in the gross estate under §2036. See, e.g., Outwin v. Commissioner, 76 T.C. 153 (1981), acq. 1981-2 C.B. 1; Rev. Rul. 77-378, 1977-1 C.B. 348. But, as described above, Reg. §25.2523(f)-1(f) indicates that the trust will not be includible in the donor’s gross estate under §2036. Could the ability of a grantor’s creditors to reach trust assets trigger estate inclusion under §2041 as well? Section 2041 should not apply if trust distributions to the original donor spouse are subject to an ascertainable standard. See generally Gans, Blattmachr & Bramwell, Estate Tax Exemption Portability: What Should the IRS Do? And What Should Planners Do in the Interim?, 42 REAL PROP. PROB. & TR. J. 413, 436-437 (2007). Using ascertainable distribution standards avoids the §2041 issue, at least under the laws of most states providing that creditors cannot reach more than the trustee could distribute under a maximum exercise of discretion. See RESTATEMENT (THIRD) OF TRUSTS

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§60 cmt. f; Tech. Adv. Mem. 199917001 (ascertainable standard could limit creditor access under state law and therefore limit IRS’s ability to include trust in grantor’s estate under §2036). The creditor issue likely will be avoided if the laws of a DAPT state are applicable and the donor spouse is merely a discretionary beneficiary, or if the applicable state law includes a statute that protects lifetime QTIP trusts in this circumstance after the donee spouse’s death. (At least 18 states have statutes that address this situation in the context of initial transfers to an inter vivos QTIP trust. Those states are Arizona, Arkansas, Delaware, Florida, Georgia, Kentucky, Maryland, Michigan, New Hampshire, North Carolina, Ohio, Oregon, South Carolina, Tennessee, Texas, Virginia, Wisconsin, and Wyoming.) As discussed above, if the client does not live in a self-settled trust state, an attempt to incorporate the laws of a self-settled trust state may not be effective for creditor purposes. UNIF. VOIDABLE TRANSACTIONS ACT §4, Comment 8 (last paragraph) (July 2014). Whether the original donor spouse can retain a special power of appointment as part of the backend interest in a lifetime QTIP trust is not clear. Some private letter rulings appear to sanction it, but the regulations suggest that it is not permissible [see Reg. §25.2523(f)-1(a)(1); Jeffrey N. Pennell, Estate Tax Marital Deduction, 843-3rd TAX MGMT. (BNA) ESTATES, GIFTS, AND TRUSTS, at VI.F.6, note 518] and cautious planners may want to avoid the concern. A suggested alternative to allow needed flexibility is to grant an independent trustee broad authority to make distributions to the original donor spouse. If circumstances change, the independent trustee could make outright discretionary distributions to the donor spouse, who could then make adjustments in the ultimate distribution of the property. The continuing trust for the benefit of the donor spouse continues as a grantor trust as to the original donor. See Reg. §1.671-2(e)(5), discussed at Item 11.b.(13) above. g.

Special Tax Concerns Following Divorce. The trust would continue as a grantor trust, at least as to trust income, because of the donee spouse’s right to receive the trust income (unless an adverse party must approve the distribution to the spouse). §677(a). Section 672(e) treats a grantor as holding any power or interest held by an individual who was the spouse of the grantor at the time of the creation of such power or interest, so the ex-spouse’s interest as a beneficiary probably is sufficient to trigger grantor trust status under §677(a) even following the divorce (but see ACTEC comments filed with the IRS on July 2, 2018 suggesting the possibility of a contrary result). Previously, §682 provided that the income of the trust (which must be distributed to the donee spouse) will be taxable to the donee spouse even though the trust would continue as a grantor trust as to the donor spouse as to trust income. Section 682 has been repealed, though, for divorces occurring after 2018. The donor spouse will likely be unhappy having to pay income tax on income that is distributed to his or her ex-spouse from the trust. The donor spouse would want to negotiate in a marital agreement or in the divorce decree that the donee spouse will be responsible for any income tax attributable to trust income even if the trust is a grantor trust as to the donor spouse. Even prior to the repeal of §682, a similar concern existed as to capital gain income. If the donee spouse is a discretionary beneficiary of principal, §682 may not have applied as to capital gains allocated to principal because it applied to “income of any trust which such wife is entitled to receive,” and the donee arguably was not “entitled” to receive any principal under a discretionary distribution standard. The problem is that capital gain income would be taxed to the trust, or perhaps to the original donor spouse if the trust continues as a grantor trust as to the trust corpus. For planning considerations, see Nelson & Franklin, Inter Vivos QTIP Trusts Could Have Unanticipated Income Tax Results to Donor Post-Divorce, LEIMBERG ESTATE PLANNING NEWSLETTER #2244 (Sept. 15, 2014). For further discussion of the impact of the repeal of §682 following a divorce, see Item 7 of ACTEC 2020 Fall Meeting Musings found here and available at www.bessemertrust.com/forprofessional-partners/advisor-insights.

Approaches for Addressing Reciprocal Trusts Issue. If both spouses want to make gifts and want to take steps to minimize gift tax in the unlikely event of retroactive gift tax legislation, and if each spouse creates a QTIPable trust for the other spouse, the IRS might argue that the trusts are includable in each spouse’s gross estate under the reciprocal trust doctrine.

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An alternate approach might be for Spouse A to create a QTIPable trust for Spouse B and for Spouse B to make a gift outright to Spouse A with a provision that if Spouse A disclaims the gift, any disclaimed assets would pass to a trust for descendants. (Whether Spouse A could disclaim and have the assets pass to a trust for the benefit of Spouse A and descendants is not clear because of the reference in §2518(b)(4)(A) to “spouse of the DECEDENT,” as discussed in Item 11.e.(5) above) That approach would seem to avoid the §2036 reciprocal trust doctrine, but could the IRS argue that the disclaimer would not be a qualified disclaimer under §2518 under the theory that each spouse’s gifts were in consideration of the other’s gift? See Reg. §25.2518-2(d)(1) (“acceptance of any consideration in return for making the disclaimer is an acceptance of the benefits of the entire interest disclaimed”). But in the described transaction, Spouse A would not be receiving any consideration for making the disclaimer. This approach is not perfect; it does not satisfy the desire to have the combined gifts pass to trusts of which one of spouses is a potential beneficiary, but at least it allows nine months to make the decision of whether Spouse A would disclaim and have the assets pass to a trust of which neither spouse is a potential beneficiary. The other approach would be for each spouse to create QTIPable trusts for the other spouse, but make the trust terms as different as possible – different trustees, different trustee removal powers, different principal distribution standards, different remainder beneficiaries, different testamentary powers of appointment, different administrative provisions, etc. For a discussion of possible distinctions to avoid the reciprocal trust doctrine, see Item 25.c. of Transfer Planning in 2021, Including Transfers in Anticipation of Possible Retroactive Transfer Tax Legislation (April 2021) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. 12. Transfer to Trust With Disclaimer Provision Causing Reversion to Donor a.

General Description. The donor could make a transfer to a trust with a disclaimer provision specifying that if a particular beneficiary or the trustee disclaims, the disclaimed assets would be returned (i.e., “revert”) to the donor, which means that the donor would be treated as not having made a gift of the amount that reverts to the donor. This approach leaves nine months after the gift for “wait and see” planning, but in the meantime, beneficiaries could not accept any benefits in order for the disclaimer to be a qualified disclaimer under §2518. Planners commenting on this approach suggest that the disclaimer could be made by (1) a designated primary beneficiary of the trust on behalf of all beneficiaries (which would be particularly helpful if there are various minor or potentially unborn beneficiaries) or (2) the trustee. If the property reverts to the donor, the original transfer is not a completed gift. For an outstanding discussion of a wide variety of tax issues with this type of planning, see Ed Morrow, How Donees Can Hit the Undo Button on Taxable Gifts, LEIMBERG ESTATE PLANNING NEWSLETTER #2831 (Oct. 19, 2020).

Assets Do Not Remain in Trust If Gift is “Undone” By a Disclaimer. If some or all of the transfer is not treated as a taxable gift as a result of a disclaimer, those assets don’t remain in trust but are returned to the donor. Some donors would prefer that they keep assets that are not treated as taxable gifts. In contrast, the QTIPable trust approach results in the assets being maintained in the trust for the balance of the spouse’s life.

Donor Must Rely on Disclaimant Rather Than Having Control Over the Decision to “Undo” a Taxable Gift. An important disadvantage to this approach for some donors is that the donor is not in control of the decision to “undo” a taxable gift (for example if subsequent retroactive gift tax legislation occurs), but the donor must rely on a third party (the beneficiary or perhaps the trustee) to disclaim if making a taxable gift becomes undesirable.

Does Disclaimed Property from an Inter Vivos Gift Revert to the Donor? Property disclaimed from an inter vivos gift passes by state law, typically according to the terms of the dispositive instrument. UNIFORM DISCLAIMER OF PROPERTY INTERESTS ACT §6(b)(2) (UDPIA); e.g., TEX. PROP. CODE §240.051(d). If the instrument is silent, the property generally passes as if the donee had

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predeceased the gift. UNIFORM DISCLAIMER OF PROPERTY INTERESTS ACT §6(b)(3)(A). Under many state anti-lapse statutes, the assets would pass to the disclaimant’s surviving descendants. Id. at §6 Comments. Nothing in UDPIA (or most state laws) prevents the instrument from specifying a different disposition of the assets upon a disclaimer than upon the death of the disclaimant. The disclaimer regulations similarly recognize that the disposition of disclaimed assets is controlled by the terms of the governing instrument, or if the governing instrument is silent, by state law. See e.g., Reg. §25.2518-2(e)(5), Ex. 4 (“[t]he provisions of the will specify that any portion of the … trust disclaimed is to be …”); Id., Ex. 8 (“[t]he will made no provisions for the distribution of property in the case of a beneficiary’s disclaimer. The disclaimer laws of State X provide that …”). Because the first priority is that the assets pass as provided in the transfer instrument and that provision may be different from how the assets would pass if the disclaimant predeceased, there is no reason for the instrument not to specify that any disclaimed asset will revert to the donor. If the instrument does not direct that disclaimed assets will revert to the donor, do not assume that is what would happen under state law. If a reversion to the donor is desired, the instrument should explicitly direct that, for example, “any disclaimed assets shall revert to me.” e.

Gift Tax Effect of Disclaimer of Inter Vivos Gift. Gift tax regulations make clear that the gift tax does not apply to a donor if, as a result of a qualified disclaimer, “a completed transfer of an interest in property is not effected.” Reg §25.2511-1(c)(1). The disclaimer regulations provide that the disclaimed property is treated “as passing directly from the transferor to the person entitled to receive the property as a result of the disclaimer.” Reg. §25.2518-1(b). If the property is treated as “passing” directly from the donor to the donor (therefore, retained by the donor), obviously, no gift is made.

Income Tax Effect of Disclaimer. If the disclaimer is made in the same taxable year, the doctrine allowing rescissions made in the same taxable year to be respected for income tax purposes (Rev. Rul. 80-58) should apply to the disclaimer. Any taxable income would be returned to the donor and would be taxed to the donor. If the disclaimer is made in a subsequent taxable year, there is no clear authority that the taxable income arising before the disclaimer would be taxable to the donor and not the disclaimant. The disclaimant may have to include the income and rely on the claim of right doctrine to deduct (under §1341) the amount that reverts to the donor in the subsequent year. See Item 20.c(2) below for a discussion of the claim of right doctrine. The best practice is to avoid that uncertainty by disclaiming in the same taxable year in which the gift is made.

Complexities for Disclaimers from a Trust. If a deed from A is given to B, and B disclaims, local law will often provide that the property reverts to A. In that simple example, the manner of disclaiming the property is easy. B simply disclaims, and the property reverts to A. Similarly, if a gift is made to a trust with a single beneficiary and on trust termination the assets pass to that beneficiary or his or her estate, the beneficiary can simply disclaim. But the disclaimer process can get much more complicated when the gift is made to a trust with multiple beneficiaries. Each beneficiary could disclaim his or her interest in the trust, including potential remainder beneficiaries. Determining the portion of the trust represented by each beneficiary’s interest could be difficult. Obtaining disclaimers from multiple beneficiaries, some of whom may be minors and some of whom may have very small potential interests, can become quite complicated. To avoid such complexities, some planners recommend that the trust instrument specify that the property may be disclaimed (1) by a particular beneficiary (on behalf of all beneficiaries) or (2) by the trustee. (1) Disclaimer by Primary Beneficiary. Even without any prearranged agreement, the donor may be comfortable that the primary beneficiary will be willing to disclaim if doing so can avoid the payment of a significant current gift tax by the donor. The mere expectation of a future benefit in return for executing a disclaimer will not render it unqualified. See Estate of Monroe v. Commissioner, 124 F.3d 699 (5th Cir. 1997); Estate of Lute v. U.S., 19 F. Supp.2d 1047 (D. Neb. 1998) (disclaimed property was subsequently transferred to trust with disclaimant as co-trustee).

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One commentator takes the position that while a beneficiary may be authorized to disclaim on behalf of other beneficiaries, that disclaimer of the interests of other beneficiaries may not be recognized as a qualified disclaimer under §2518 based on the theory that a person “cannot disclaim more than what she receives.” Ed Morrow, How Donees Can Hit the Undo Button on Taxable Gifts, LEIMBERG ESTATE PLANNING NEWSLETTER #2831 (Oct. 19, 2020). Even if the disclaimed asset passes to another person pursuant to the terms of the document, he reasons that for purposes of §2518, only the disclaiming person’s interest in the trust would be treated as having been disclaimed. [W]hen someone disclaims only a portion of an asset, it is logical to conclude that only the portion disclaimed negates the gift, even if the entire gift reverts to the donor pursuant to the donative instrument. This does not mean that the entire gift in trust cannot be “undone” by disclaimer, similar to outright gifts. It merely means that all the owners of all the interests must disclaim (such as both current and remainder beneficiaries), or the trust must be designed to reduce or eliminate such other interests (such as by naming a child’s estate to take upon the child’s death). Id.

In order to allow an administratively convenient disclaimer by all beneficiaries, one alternative might be to draft a trust with a single beneficiary (or minimal beneficiaries, all of whom could disclaim) but include a limited power of appointment allowing the addition of more beneficiaries (including remainder beneficiaries) or allowing appointment to another multi-beneficiary trust at a later time. Another alternative might be to provide in the trust agreement that the primary beneficiary would have the authority to direct the trustee to disclaim. A concern with that approach is that while the beneficiary could deliver a qualified disclaimer without being treated as making a gift under §2518, a direction that someone else disclaim might not be entitled to that same protection, and the primary beneficiary might be treated as making a gift of her interest in the trust. To address that potential problem, Christine Quigley (Chicago, Illinois) suggests that the trust agreement might provide that if the primary beneficiary disclaims her interest in the trust, the trustee is directed to disclaim the trust. (2) Disclaimer by Trustee. The difficulty of obtaining disclaimers by all beneficiaries could be avoided by giving the trustee the authority to disclaim the transfer of assets to the trust. (a) Does Local Law Permit Trustee to Disclaim If Authorized in Trust Agreement? If a disclaimer by a trustee is not effective under state law, it is not a qualified disclaimer for purposes of §2518. Rev. Rul. 90-110, 1990-2 C.B. 209. The planner should confirm that local law allows a trustee to disclaim if authorized to do so in the trust agreement. Trustees did not have the authority to disclaim under traditional common law principles. See RESTATEMENT (SECOND) OF TRUSTS §102 (“[i]f a trustee has accepted the trust, whether the acceptance is indicated by words or by conduct, he cannot thereafter disclaim”). Many state statutes now authorize trustees to disclaim, particularly if authorized to do so in the trust agreement. See RESTATEMENT (THIRD) OF TRUSTS §86, cmt. f (2007) (authority to disclaim property or a fiduciary power if in the interest of beneficiaries and consistent with other fiduciary duties; disclaimer cannot be made merely for convenience of trustee or to lessen trustee responsibilities; trustee must exercise reasonable care and skill in exercising power to disclaim, with the assistance of competent financial, tax, and legal advice as needed). The UDPIA authorizes a trustee to disclaim even without express authorization in the trust agreement. Except to the extent a fiduciary's right to disclaim is expressly restricted or limited by another statute of this State or by the instrument creating the fiduciary relationship, a fiduciary may disclaim, in whole or part, any interest in or power over property, including a power of appointment, whether acting in a personal or representative capacity. A fiduciary may disclaim the interest or power even if its creator imposed a spendthrift provision or similar restriction on transfer or a restriction or limitation on the right to disclaim, or an instrument other than the instrument that created the fiduciary relationship imposed a restriction or limitation on the right to disclaim. UDPIA §5(b).

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Some states (such as Texas, discussed below) impose requirements before a trustee may disclaim, such as obtaining a court order or giving notice to all trust beneficiaries. If the trustee must accept the trust, to assure that the trustee is the trustee of the trust before disclaiming certain property contributed to the trust, an initial small “seed gift” might be made to the trust. A subsequent large transfer could then be disclaimed by the trustee. (b) Texas Statutes. Texas statutes permit trustee disclaimers unless the instrument restricts the right to disclaim. TEX. PROP. CODE §240.008(a). The effect of the disclaimer is that the property never becomes trust property. TEX. PROP. CODE §240.053(a)(1). Trustees must either get court approval of the disclaimer or give notice to all current and presumptive remainder beneficiaries of the trust before making the disclaimer. TEX. PROP. CODE §§240.008(d), 240.0081(a). (c) Trustee’s Fiduciary Duty. Even though the trustee may be authorized to disclaim, the trustee must consider whether doing so would be a breach of fiduciary duty. Some of the disclaimer statutes specifically acknowledge that a trustee disclaimer could potentially be a breach of trust. UDPIA §8 cmt (“Every disclaimer by a trustee must be compatible with the trustee’s fiduciary obligations”). The Texas disclaimer statute very explicitly addresses the trustee’s fiduciary duties. The disclaimer must be compatible with the trustee’s fiduciary obligations unless a court approves it, but a disclaimer by a trustee is not a per se breach of the trustee’s obligations. TEX. PROP. CODE 240.008(f). However, the statute makes clear that a possible remedy for breach of fiduciary obligations does not include voiding or otherwise making ineffective an otherwise effective disclaimer. TEX. PROP. CODE §240.008(g). (d) Gift by Beneficiary Who Fails to Object? A qualified disclaimer by a beneficiary clearly means that the beneficiary is not treated as having made a gift. However, if the trustee disclaims and the beneficiary fails to object or take steps to prevent a breach of trust by the trustee, has the beneficiary made a gift by not taking steps to protect and enforce his or her rights as a beneficiary? (e) Drafting Issues. The trust instrument should not only authorize the trustee to disclaim all or any portion (including a fractional portion) of any property contributed to the trust and provide that the property will revert to the donor but should also address fiduciary duty concerns. The agreement can provide specifically that a disclaimer by the trustee will not be considered a breach of fiduciary duty, even though the result is that the property reverts to donor. The trust agreement or particular assignment can make the donor’s intention clear that an amount is being contributed that is not anticipated to cause the payment of gift tax, the trustee is authorized to take actions in order to carry out that settlor intent, and the trustee will incur no liability for disclaiming any portion in excess of the intended amount that would not trigger payment of gift tax. This provision may also provide a reasonable basis for the trustee to execute a defined value formula disclaimer of an amount, as finally determined for gift tax purposes, that does not exceed a specified value or that will not cause the payment of gift taxes. (3) General Disclaimer Considerations. The general disclaimer considerations summarized in Item 11.e above also apply to this planning approach, including that there can be no acceptance of benefits prior to the disclaimer. (a) Nine-Month Limit. The disclaimer must generally be made within nine months of the transfer to the trust. If the disclaimer is by a young beneficiary of the trust, the time period for making the disclaimer is extended until the beneficiary is age 21. For a good discussion of concerns that arise from such a delayed disclaimer period for a trust with minor beneficiaries, see Ed Morrow, How Donees Can Hit the Undo Button on Taxable Gifts, LEIMBERG ESTATE PLANNING NEWSLETTER #2831 (Oct. 19, 2020). The nine-month limit is probably long enough to know if a retroactive decrease in the gift exclusion amount would otherwise result in a taxable gift (just the amount of the decrease would be disclaimed to revert to the donor), but www.bessemertrust.com/for-professional-partners/advisor-insights

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the nine-month limit is shorter than the period allowed for making the QTIP election under the QTIPable trust alternative described in Item 11 above. (b) No Acceptance of Benefits. The donee cannot receive benefits from the trust before making a disclaimer. For a beneficiary disclaimer, this means that the beneficiary could not receive any trust distributions prior to the disclaimer (or would have to establish that the benefits accepted were not out of the severable portion being disclaimed, e.g., PLR 9036028). For a trustee disclaimer, does this require that the trustee not accept the contribution until the decision is made whether or not to disclaim the contribution? The regulations state that “merely taking delivery of an instrument of title, without more, does not constitute acceptance,” Reg. §25.2518-2(d)(1), and actions by a fiduciary “in the exercise of fiduciary powers to preserve or maintain the disclaimed property shall not be treated as an acceptance of such property,” Reg. §25.2518-2(d)(2). But the regulations provide no details about acceptance of benefits in the context of a disclaimer by a trustee that causes property to revert to the donor. (c) Formula Disclaimer Permitted. Formula disclaimers are permitted, which allows the possibility of a defined value formula disclaimer considering values as finally determined for gift tax purposes. See Estate of Christiansen v. Commissioner, 586 F.3d 1061 (8th Cir. 2009). 13. Combinations of Alternatives Combinations of the above alternatives could be used, such as a formula gift with a disclaimer provision reverting assets to the donor, a formula gift with a pourover to a QTIP trust including a disclaimer provision, a gift to a QTIPable trust with a disclaimer provision with disclaimed assets passing to a trust for descendants, or a similar gift to an “estate-type” marital trust with a disclaimer provision. 14. Sale for Note, Leaving Ability Later to Forgive Part of Note a.

Description. A donor might make a gift to a grantor trust of an amount that the client feels comfortable would not exceed an amount to which the gift exclusion amount that might retroactively be reduced. The individual might then sell assets to the grantor trust for a note in a traditional sale to grantor trust transaction. After the dust has cleared on transfer tax legislation, and the gift exclusion amount is known, the individual would have the flexibility to make an additional gift by forgiving part of the note.

Advantage – Subsequent Appreciation Is (Mostly) Transferred; GST Exempt. Even though the large gift is not completed initially, the effect of this transaction is that all appreciation after the sale is transferred to the trust (other than the very nominal interest amount on the note if an AFR note is used). Furthermore, all the appreciation can be in a GST exempt format. Almost all the advantages of making an initial large gift will be realized without taking any risk on a retroactive decrease in the gift exclusion amount.

Disadvantage – Risk of Losing Large Exclusion Amount. The risk of not making a large completed gift currently is the possibility that the exclusion amount is not reduced retroactively to the date of the initial transfer, but that legislation decreasing the gift exclusion amount is enacted suddenly or with some retroactive date subsequent to the date of the initial transfer (for example, the date that the legislation is approved by the House Ways and Means Committee) before there is an opportunity for the seller to forgive some of the note. The ability to take advantage of the “window of opportunity” that exists with the large exclusion amount would have been lost.

Upfront Gift If Intend to Forgive Note? If a taxpayer ostensibly makes a loan and, as part of a prearranged plan, intends to forgive or not collect on the note, the IRS position is that the note will not be considered valuable consideration and the donor will have made a gift at the time of the loan to the full extent of the loan. Rev. Rul. 77-299, 1977-2 C.B. 343. However, if there is no prearranged plan and the intent to forgive the debt arises later, the donor will have made a gift only at the time of the forgiveness. Rev. Rul. 81-264, 1081-2 C.B. 186. The IRS has subsequently reiterated its position. See, e.g., Field Service Advice 1999-837 (donor makes gift of full amount of loan initially if donor

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intends to forgive the loan as part of a prearranged plan); Letter Rul. 200603002 (transfer of life insurance policies to trust in return for note in the amount of the difference between the combined value of the policies and the amount sheltered by gift tax annual exclusions; several months later the donors canceled the note and forgave the debt; taxpayer did not request a ruling on this issue, but IRS stated that it viewed the donors as having made a gift at the outset in the amount of the note where there was a prearranged plan that it would be canceled). The IRS position is contrary to several Tax Court cases (to which the IRS non-acquiesced in Rev. Rul. 77-299). In any event, the donor in the proposed planning alternative does not have any prearranged plan to forgive the note. Depending on what Congress does, the seller may forgive some of the note, but the seller may very intentionally not forgive any of the note if Congress retroactively reduces the gift exclusion amount. e.

Discounting Note Value. Depending on the specific fact situation, a valuation discount may possibly apply in valuing the note. Even though §7520 provides that no gift is considered to have been made when a loan is made in return for a note bearing interest at the AFR, that does not mean the note is necessarily worth its face amount. See Michael S. Strauss & Jerome M. Hesch, A Noteworthy Dichotomy: Valuation of Intra-family Notes for Transfer Tax Purposes, 45 BLOOMBERG TAX MGMT. ESTATES, GIFTS & TR. J. 4 (Jan. 9, 2020). Planners may consider applying a valuation discount if a subsequent gift is made of part of the note. See Alan S. Gassman, Jerome B. Hesch & Martin B. Shenkman, Biden 2-Step for Wealthy Families: Why Affluent Families Should Immediately Sell Assets to Irrevocable Trusts for Promissory Notes Before Year-End and Forgive the Notes If Joe Biden Is Elected, A/K/A What You May Not Know About Valuing Promissory Notes and Using Lifetime Q-Tip Trusts, LEIMBERG EST. PL. NEWSLETTER #2813 (Aug. 10, 2020).

15. Rescission of Part of Gift After Gift Exclusion Amount is Decreased Retroactively a.

General Description. If a taxpayer makes a gift by mistake, rescission may be an available state law remedy. Various cases have allowed rescission of transfers under state law, often based on scrivener’s error or mistake. That’s the easy part. This issue is then whether the rescission will be recognized for federal tax purposes. Generally, the “rescission doctrine” is broadly understood as providing that a transaction may be disregarded for federal tax purposes if the parties to the transaction, during the same taxable year in which they undertake the transaction, rescind the transaction and restore themselves to the same position they would have occupied had they not undertaken the transaction (i.e., they return to the status quo ante). While the Service has issued a few published rulings and a number of private letter rulings dealing with the application of the rescission doctrine to corporate transactions, the case law in this area is somewhat confusing, and some of the private letter rulings extend the rescission doctrine to areas not covered by existing law or the existing published guidance. NEW YORK STATE BAR ASSOCIATION TAX SECTION REPORT ON THE RESCISSION DOCTRINE (April 11, 2010).

Beth Kaufman summarizes the general factors considered in determining the federal tax consequences of rescissions. In determining the consequences of unwinding or rescinding a transaction on federal tax liabilities, courts have considered many factors such as the amount of time between the original transaction and the request to unwind it, the stage of the transaction, the type of the unwinding, the type of the transaction (e.g., sale, gift, payment of compensation or a dividend), the tax motivation for the unwinding, and the relevant operative Code section. [Citing Sheldon I. Banoff, Unwinding or Rescinding a Transaction: Good Tax Planning or Tax Fraud?, 62 TAXES 942, 946-7 (1984) (hereinafter Banoff, Unwinding or Rescinding).] This broad range of factual situations is outside of the scope of this paper, however, as a general matter, it is important to note that there is no clear unified treatment or policy regarding those situations in which the unwinding is of a transaction that was completed in a prior year. This lack of clear unifying principles leads to a case-by-case evolvement of the case law, complete with contradicting court decisions on the same issues and even on very similar facts. Footnote Observation: The likelihood for a successful unwinding for tax purposes is the greatest if the unwinding occurs in the same taxable year. For elaboration and references see Banoff, Unwinding or Rescinding at 990, 993; Davis v. United States, 378 F. Supp. 579 (N.D. Tex. 1974). Beth Shapiro Kaufman, Disclaimers and Rescissions: Special Considerations for 2010 (August 2011)(unpublished manuscript).

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See generally New York State Bar Association Tax Section Report on the Rescission Doctrine (Report No. 1216) (8/11/2010) citing Sheldon I. Banoff, Unwinding or Rescinding a Transaction: Good Tax Planning or Tax Fraud, 62 TAXES 942 (Dec. 1984); David H. Schnabel, Revisionist History: Retroactive Federal Tax Planning, 60 TAX LAWYER 685 (2007). Rescission cases dealing specifically with rescissions of gifts due to a mistake have focused on the kind of mistake. b.

“Same-Year Rule.” A widely held belief is that rescissions must occur in the same year as the underlying transaction to be given effect for tax purposes. However, the notion that rescissions are respected only if they occur in the same taxable year is an income tax concept. See Rev. Rul. 80-58, 1980-1 C.B. 181 (rescission occurring in same year as taxable event is respected if parties are returned to their original positions). Even if the “same-year rule” applied to gift transactions, the rescission of an early-year 2021 gift based on a retroactive law change likely could be made in 2021 because the retroactive law change likely would be known in 2021 (it is extremely unlikely that a law change in 2022 would be made retroactive to gifts made early in the prior year).

Scrivener’s Error; Mistake of Fact. A scrivener’s error presents the easiest situation for recognizing that a transfer was an unintended transfer for gift tax purposes. E.g., Dodge v. United States, 413 F.2d 1239 (5th Cir. 1969) (taxpayer mistakenly transferred all of an asset instead of the intended 20 percent; “[t]hat was simply a technical donation on paper, defective from its inception, immediately subject to recall by the donor, and very likely in fact to be recalled or rendered nugatory”); Touche v. Commissioner, 58 T.C. 565 (1972) (donor transferred twice the dollar amount intended).

Mistake of Non-Tax Federal Law. A rescission was also recognized in a case involving a mistake regarding the government’s conflict of interest rules for high level government appointees. After realizing that transferring assets to an irrevocable trust triggered gift tax, the taxpayer reformed the trust in a state court proceeding to make it revocable and subsequently sought a gift tax refund. The gift tax refund was allowed because local law permitted the revocation of a gratuitous transfer into trust that was made as a result of the transferor’s mistake of fact or law. Berger v. United States, 487 F. Supp. 49 (W.D. Penn. 1980).

Mistake of Tax Law. A mistake of law may be sufficient grounds for a state law rescission. For example, in Stone v. Stone, 29 N.W.2d 271 (Mi. 1947), parents gave a one-half interest in a partnership to their minor children with the understanding that income from that interest would be reported on the children’s income tax returns. The IRS determined, based on a subsequent U.S. Supreme Court decision, that the income was still taxed to the parents. The court allowed rescission of the gift as an equitable remedy. While rescission was allowed as a state law remedy, that does not mean that the federal tax consequences are reversed as well. Recognizing a rescission to disregard a gift for gift tax purposes based on a mistake of law is more problematic than the scrivener’s error or mistake of non-tax law situations; cases have gone both ways. A mistake as to the tax effects of making a gift was not sufficient grounds to void the gift for gift tax purposes in Board v. United States, 13 T.C. 332 (1950) (gift to reduce future estate tax was rescinded by a state court because of mistake in not knowing the gift triggered payment of gift tax, but the gift was still complete for federal gift tax purposes). See also PLR 8205019 (similar situation). More recently however, a mistake regarding a disclaimer (that was not a qualified disclaimer), was recognized as sufficient grounds for rescinding the disclaimer and no gift resulted from the original disclaimer. Breakiron v. Gudonis, 106 A.F.T.R.2d 2010-5999 (D. Mass. 2010). The court discussed that one line of cases does not give effect to a rescission for federal tax purposes “because neither party to the state law reformation proceeding has an interest in paying federal tax on the transfer” and “the possibility of ‘collusion’ to avoid federal liability exists.” Another line of cases does give effect to a state law rescission for federal tax purposes. The court acknowledged that the two lines of cases are not easily reconciled but focused on the fact that the IRS was a party to the state law proceeding in giving effect to the rescission for federal law purposes. The court in Van Wymelenberg required the IRS to be a party to guard against the possibility of “collusion,” that is, usurpation of the federal interest in collecting federal taxes, since both parties to a state court proceeding may

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have a common interest in minimizing federal tax liability. See Van Den Wymelenberg v. United States, 397 F.2d 443, 445 [22 AFTR 2d 6008] (7th Cir. 1968). A contested proceeding in which the IRS is a party would provide it with the opportunity to cross-examine the plaintiff to ensure that there was a genuine mistake (as in Dodge and Berger), rather than a post hoc attempt to minimize a federal tax obligation or to avail oneself of a tax advantage unbeknownst to the plaintiff at the time of the original transfer. … The IRS is a party to the proceeding…. While the mistake was not a mere “scrivener’s error,” it was a mistake at the time he disclaimed-not a hindsight decision by plaintiff to avail himself of a tax advantage. The IRS had an opportunity during this proceeding to adduce evidence that plaintiff’s execution of the disclaimers was something other than a mistake, and did not.

Rescission Because of Mistake Based on Retroactive Law Change Given Effect, Neal v. U.S.. In Neal v. United States, 187 F.3d 626 (3rd Cir. 1999), the donor relinquished a retained contingent reversionary interest in a grantor retained income trust (GRIT) to avoid triggering the old §2036(c), which was later repealed retroactively. The taxpayer paid gift tax when the GRIT was created and again when she released the reversionary interest. The next year, Congress repealed the §2036(c) provision retroactively, and the taxpayer obtained a state court order rescinding the release of the reversionary interest. The state court reasoned that releases executed in reliance on a statute which, in legal effect, did not exist, is certainly as much of a mistake, if not more, as was Mr. Berger's mistake about the conflicts of interest rules in Berger [discussed in Item 15.d above] which the state court and the district court both found to have been a unilateral mistake of law permitting rescission or reformation of the otherwise irrevocable trust.

In effect, the rescission was allowed because of not knowing that §2036(c) would be repealed retroactively. The taxpayer sued for a refund of the gift tax attributable to the release of the interest that had been rescinded under state law. The IRS asserted that there was no mistake of law when the reversionary interest was released, and the later retroactive change in the law was irrelevant as to whether the taxpayer was mistaken as to the law at the time of the release. The court disagreed, with emphasis on the retroactive law change: For all practical purposes, the retroactive repeal of section 2036(c) made the law at the time Neal released her reversionary interests other than what she understood it to be. A transfer based upon a mistake of law is rescindable under Pennsylvania law, and therefore incomplete for tax purposes. See Berger v. United States, 487 F. Supp. 49, 51-52 (W.D. Pa. 1980). The District Court recognized that the IRS would be quick to assert a claim if the tax laws were changed retroactively to indicate that Neal owed a higher tax. Indeed, taxpayers often are forced to pay higher taxes on past events based on later retroactive changes to the law (without complaint from the IRS). … … The only distinction between Berger and this case is that the rules in Berger were contrary to Berger's beliefs at the time he made his transfer of funds, and no retroactive change of the law was involved. We do not find this distinction critical. We agree with the District Court's analysis. While Neal was under no mistake as to the status of the law at that moment, she was mistaken as to the effect that the law would have on her tax liabilities. The general doctrine of mistake is geared toward freeing persons who were mistaken regarding the effect that a particular law would have on their situation. As a result, the District Court and Orphan's Court properly found that Neal released her interests “under a mistake of law.” The IRS's position is essentially that Neal was under no mistake of law when she released her reversionary interests in the GRIT and that the effects of the retroactive repeal of section 2036(c) should not be considered. The IRS asserts that the fact that the later change was made retroactive, nunc pro tunc, is irrelevant to the consideration of whether Neal was mistaken as to the law at the time. We disagree. The IRS further asserts that Neal suffered no injustice because she released the contingent interests in an attempt to avoid tax liability, as if this were somehow wrongful in and of itself. However, Neal was clearly attempting to abide by the law, and was not illegally seeking to avoid liability. The clause she relied on was written specifically to benefit taxpayers in her position. The government should not now claim that she was abusing the system by following the law. We conclude that Neal's releases were rescindable under Pennsylvania [law] and that the District Court properly held that she is due a refund of the 1989 gift tax that she paid on the releases. (Emphasis added.)

Technical Advice Memorandum 9408005 provides a more detailed description of the IRS position regarding a rescission based on a retroactive law change. (The facts of this TAM seem remarkably www.bessemertrust.com/for-professional-partners/advisor-insights

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similar to the Neal facts, suggesting that it may have been issued with respect to the Neal gift tax refund claim.) The IRS reasoned that because the retroactive law change provided no relief for taxpayers whose actions were based on the later repealed statute, the rescission should have no effect for tax purposes. When section 2036(c) of the Code was retroactively repealed by the Revenue Reconciliation Act of 1990, Congress did not provide any relief for taxpayers who had executed instruments in reliance upon the statute. Chapter 14 (the replacement to section 2036(c)) was enacted by the Revenue Reconciliation Act of 1990, and is effective for transfers after October 8, 1990. Although transactions completed before October 9, 1990, are exempt from Chapter 14, they are not exempt from gift tax law that predated repealed section 2036(c). In 1991, in an attempt to return to the same position that A was in prior to Notice 89-99, A rescinded each release. A contends that, because section 2036(c) was revoked retroactively, the rescissions result in treating the interests as if the reversions were never released. Consequently, A contends that, because the reversions were not released, there was no transfer of the reversions that was subject to the gift tax and, thus, A is entitled to a refund of the gift tax paid. … … A's unconditional release of the reversionary interests were transfers that constituted taxable gifts at the time the releases were executed. The releases resulted in beneficial interests in the trusts passing to the holders of the trusts remainder interests that could not be revoked without the consent of the remaindermen. The subsequent rescission of the releases does not serve to treat the transfers as if they never occurred. A taxpayer is not entitled to a refund of federal gift taxes paid attributable to the release of a reversionary interest if the taxpayer later rescinded the release because of the revocation of the underlying section of the Internal Revenue Code. (Emphasis added.)

Modification of Trust to Ignore Disclaimer Because of Mistake Based on Retroactive Law Change Not Given Effect for Tax Purposes, Lange v. U.S.. An earlier district court case with similar facts had reached an opposite result. Lange v. U.S., 78 AFTR 2d 96-6553 (N.D. In. 1996). Edith Lange created a grantor retained income trust (GRIT) in 1989 in which the grantor retained a reversion and general power of appointment if she died within ten years. Edith’s intent was that the trust would avoid the application of §2036(c). Later in 1989 Edith disclaimed the reversionary interest and general power of appointment (apparently in order to avoid §2036(c)) and filed a gift tax return for 1989 and paid gift tax attributable to the value of the disclaimer (apparently the disclaimer was not a qualified disclaimer under §2518). Section 2036(c) was repealed retroactively in 1990, so the disclaimer had been unnecessary. Edith obtained a court order modifying the trust to ignore the disclaimer, and subsequently filed a claim for refund of the gift tax reflected on the 1989 gift tax return as originally filed. The court’s analysis relied on Van Den Wymelenberg v. United States, 397 F.2d 443 (7th Cir. 1968), which refused to give effect to a court order modifying a trust to comply with the requirements of §2503(c) two years after the gift to the trust. Even though Wymelenberg did not involve a modification based on a mistake of law due to a retroactive law change, the Lange court simplistically reasoned “[s]imilarly, the later modification of the trust agreement to disregard the disclaimer does not affect the tax consequences of the disclaimer. The tax consequences attach when the transaction occurs.”

Automatic Rescission Provision in Transfer Document. In light of the uncertainty in late 2021 regarding whether legislation might be enacted causing the transaction to be a recognition event (such as the Van Hollen deemed realization proposal with its retroactive effective date), one planning alternative might be to include a clause rescinding the transaction if legislation is passed during the same calendar year that has the effect of causing the transfer to be a recognition event for income tax purposes. See Tietz, Shenkman & Blattamchr, Recission – Considerations and Application for Planning in 2021, LEIMBERG EST. PL. EMAIL NEWSLETTER #2909 (Sept. 27, 2021) (including analysis of Rev. Rul. 80-58).

Summary. In early 2010 some taxpayers made gifts because the gift tax rate was only 35% and some believed that rates might increase in future years. Instead, the 2010 Tax Act retained the 35% rate and increased the exemption from $1 million to $5 million. Some taxpayers who had made gifts over $1 million to take advantage of what they believed was a beneficially low rate discovered they

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could have avoided any gift tax if they had waited to make gifts until the gift exemption amount had risen to $5 million. The subsequent law change (which was not retroactive) would have resulted in more favorable treatment, and some taxpayers may have preferred to have made their gifts in a later year. The general consensus of planners was that rescissions of the gifts made in early 2010 would not undo the fact that a completed gift had been made and gift tax was owed. Similarly, some donors made gifts in 2012 while the $5 million gift exemption was available out of fear that Congress might reduce the gift exemption amount. When Congress did not do so, some donors had “donorremorse” over having made the gifts and wanted to undo them. Allowing a rescission of the gift because of a mistake in predicting that future laws might be more unfavorable or in making a wrong guess of what the law would be in the following year is generally believed not to be sufficient to apply a mistake of law rescission. The equities are far different, however, for a subsequent retroactive law change that would impose gift tax on a prior transfer that had been made when the law at that time provided that no gift tax would be due on the transfer. Courts may align with the Third Circuit Court of Appeals’ position in Neal in allowing a rescission of a gift in that circumstance that seems egregiously unfair. BUT the case law is widely varied regarding the tax effects of rescissions, and relying on a rescission to unwind a gift that is later retroactively determined to generate gift tax is ripe with uncertainty. As Howard Zaritsky puts it, “Mulligans in tax law are few and far between.” After all, allowing rescissions to undo the effects of retroactive law changes in all situations would seem inconsistent with the established constitutional authority of Congress to adopt retroactive tax laws. 16. Defined Value Clause Using a defined value clause may be a way of anticipating future tax law changes (as well as anticipating future IRS or court value determinations). A defined value clause has the effect of adjusting values based on certain types of retroactive law changes (for example that might disallow valuation discounts.) 17. Conditional Gifts Consider making gifts conditioned on the fact that laws that now apply a certain maximum rate or exclusion amount or that allow discounts remain effective as of the date of the gift. That does not make the gift incomplete because the condition is outside the control of the donor. However, if the law does change, the gift would be reversed. Conditional gifts are generally recognized under the concept of the donor’s freedom to the maximum extent allowed by law unless the condition contradicts public policy. See RESTATEMENT (THIRD) OF TRUSTS §29 cmts. i-m (2003). Drafting suggestions for conditional gifts recommended by Prof. Gerry Beyer in his article Manipulating the Conduct of Beneficiaries With Conditional Gifts include the following -- clearly state the donor’s intent, create a condition precedent, include the consequences of a failed condition, anticipate an attack based on the condition being contrary to public policy, provide objective standards for conditions, and specify who will determine subjective standards. 18. Example Form for Formula Gift Combined With Disclaimer Provision An example of a formula gift equal to the remaining gift exclusion amount taking into consideration future retroactive law changes combined with a disclaimer provision causing disclaimed assets to revert to the donor is provided by Jonathan Blattmachr. He prepared this clause for his drafting system (with Michael Graham) called Wealth Transfer Planning (the clause is included here with his permission): [NOTE: This sample form is provided courtesy of InterActive Legal, for informational purposes only. The attorney-draftsperson is responsible for determining whether this document is appropriate for any particular client, and is responsible for editing the document as needed, using the attorney's professional judgment. Provision of this form does not constitute legal advice.] Assignment I, [DONOR NAME], in consideration of $10 cash received from [TRUSTEE NAME], as Trustee, of the trust dated [TRUST DATE] (known as [TRUST NAME]) and its successors and assigns, the receipt of which is hereby acknowledged, and $10 cash received from [SPOUSE'S NAME], my spouse who is a United States citizen, the www.bessemertrust.com/for-professional-partners/advisor-insights

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receipt of which is hereby acknowledged, hereby make the following assignments of all of my right, title and interest in [PROPERTY DESCRIPTION] (“the Property”) as follows: 1.

To the Trustees of [TRUST NAME] that fractional share of the Property (a) the numerator of which is the lesser of (i) the entire fair market value of the Property as finally determined for Federal tax purposes as of the date of this instrument, or (ii) the amount of my Remaining Gift Tax Exemption, and (b) the denominator of which is the fair market value of the Property as finally determined for Federal tax purposes as of the date of this instrument.

To [SPOUSE'S NAME] the remaining fractional share, if any, of the Property not assigned above to the Trustees of [TRUST NAME];

I authorize [SPOUSE'S NAME], individually as assignee of any interest in the Property and as the principal beneficiary of [TRUST NAME] to renounce and disclaim any of the Property assigned above and to the extent, if any, my spouse makes any such renunciation and disclaimer the property so renounced and disclaimed that otherwise would pass to my spouse directly or to the trust shall be revested in me. For purposes of this instrument, the following terms shall have the following meaning: 1.

The "Gift Tax Exemption" shall mean an amount equal to the maximum fair market value of property which, if transferred by gift (within the meaning of Section 2501 of Code) as of the date of this instrument, would generate a tax equal to the amount allowable as a credit under Section 2505 of the Code, taking into account any amendments to the Code made by legislation enacted after the date of this instrument but which is applicable to transfers made on the date of this instrument.

My "Remaining Gift Tax Exemption" shall mean an amount equal to the Gift Tax Exemption reduced by the amount of such Gift Tax Exemption I have used or been deemed to have used by any prior transfers by me before this transfer including those made earlier this calendar year.

The "Code" shall mean the Internal Revenue Code of 1986, as amended.

IN WITNESS WHEREOF I have executed this Assignment as of the ___ day of ___________, 202__. ____________________________ [DONOR'S NAME] Alternatively, this gift of the amount, if any, in excess of the donor's gift tax exemption, could pass to a trust for the spouse which is designed to qualify for the QTIP election, or to an "incomplete gift" trust created by the donor. The latter may provide a way to use this technique for a client who is not married.

19. Fixing Mistakes; Retroactive Revisions and Reversals The following discussion is a summary of comments by Carol Harrington (Chicago, Illinois). This is a summary of her outstanding paper (which, of course, includes authorities to support the conclusions in the summary). a.

Significance; Situations in Which “Fixes” May be Desirable. Actions that someone might want to reverse at a later time include irrevocable trusts, gifts, transfers by deed or assignment, notes, trustee distributions, and tax returns and tax elections. The reasons for needing a fix may be the result of mistakes by the client or advisor (such as scrivener’s error or mistakes about underlying facts or law), trustee mistakes (such as improper distributions or sales), changed circumstances, tax mistakes (such as missed elections, failure to qualify for a deduction or other favorable treatment, or mistake about the donor’s remaining gift exclusion), or wrongful conduct (such as fiduciary breaches, undue influence, or fraud). Analysis of a fix involves whether it is recognized for state law purposes and, separately, whether it will be respected for tax purposes as a retroactive revision. Many actions can be changed by agreement of the parties for state law purposes, but those changes would typically just operate prospectively. Revisions that are recognized under property law concepts may be given retroactive effect for state law purposes and the retroactive effect may also be respected for tax purposes.

Property Law Remedies and Grounds for Reversal. (1) Bosch Doctrine. Remedies vary state to state, and the IRS generally does not respect an outcome not authorized by state law. A state court decision is not necessarily binding on the IRS for federal tax purposes. The federal government is not bound to give effect to a state court decision to which it is not a party unless it is a decision of the highest state court, but the

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government must give “proper regard” to rulings of other courts of the state. Estate of Bosch v. Commissioner, 387 U.S. 456 (1967). (2) Rescission. Rescission is an action that reverses an agreement or other action and restores the parties to their original positions. Grounds for rescission may be negotiated in the initial contract or agreement and can result from an agreement of the parties after the fact. Also, a person may unilaterally rescind transactions under certain circumstances such as fraud, misrepresentation, mutual mistake, or in some states, unilateral mistake. (3) Reformation. Reformation conforms a document to reflect the parties’ true intentions. Reformation traditionally was a remedy for a mutual mistake of fact (not law), but in many states, now any mistake can be a ground for reformation. UNIF. TRUST CODE §415 (reformation allowed if settlor’s intent and trust terms were affected by a mistake of fact or law if proved by clear and convincing evidence). Typical grounds are scrivener’s error, mistake of law, or changed circumstances. Reformation to conform instruments to the original intent of the parties is retroactive to the date of execution. But a reformation for changed circumstances is generally prospective. Gifts are unilateral actions so a mistake regarding a gift would necessarily be unilateral, and a unilateral mistake is typically a ground for reformation. However, proving the mistake by clear and convincing evidence may be difficult. Some cases (though not all) have allowed reformations to avoid a bad tax result. (4) Constructive Trust; Disgorgement. Constructive trust or disgorgement of unjust enrichment may have the effect of restoring the wronged person to her original status. They may be a remedy for wrongdoing but may also be remedies for mistake or other situations when one party is treated as holding property for someone else. (5) Defenses to Restitution. The most common defense to restitution is that an innocent party has so changed its position that restitution of the entire amount is inequitable. The defense is not available to wrongdoers. c.

Trustee Errors and Breach of Trust. Remedies for trustee errors or breach of trust include money damages, voiding the improper act of the trustee, or applying a constructive trust. (1) Distribution Errors. Distribution errors may be corrected through adjusting subsequent distributions in some circumstances. If that is not possible, the trustee can recover the amounts incorrectly distributed (but defenses may apply based on changed position that would make returning the entire amount of the improper distribution inequitable). (2) Wrongful Sale. A constructive trust is the usual remedy for a wrongful sale, but a bona fide purchaser for value may not be subject to that remedy. (3) Wrongful Conduct. Wrongful conduct can arise from invalid agreements (for example, due to lack of capacity, breach of a confidential relationship, or a violation of public policy) or from fraud, misrepresentation, theft or other improper conduct. In these circumstances, the wrongful party may not be able to restore the property and legal remedies may be inadequate.

Methods for Obtaining Remedies. Methods of obtaining one of the various remedies include (1) court action (which carries more weight despite the Bosch doctrine but is public, expensive, and unpredictable), (2) non-judicial settlement agreement (depending on state law and the availability of virtual representation if no conflict exists avoids the appointment of guardians ad litem), (3) disclaimer (which is a recognized property law measure and, unlike a release, generally relates back to the creation of the interest), (4) agreements by friendly parties (but the agreement may not avoid bad tax consequences if no property rights to reverse the transaction exist; this could include correcting clear mistakes by

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amending the original agreement to reflect the mistake but make clear that the revised agreement is a restatement rather than the original). Another possible approach is to backdate documents in an attempt to give an action retroactive effect. However, if there is no disclosure that the intent is that the parties will merely treat the agreement as retroactive, backdating documents may be misleading or fraudulent. The backdated document should make clear that it memorializes an actual prior agreement. Some cases have held that the use of “as of” language in the date constituted disclosure of the backdating. Proving the terms of the prior agreement may be difficult, however, without contemporaneous written evidence. Backdating that avoids tax effects or that affects another third party can be a criminal act. e.

Transfer Tax Effects. (1) Disclaimers. The tax effects of disclaimers are governed by §2518; the disclaimant is treated as never having received the interest, so the effect of a disclaimer is retroactive to the date of the original transfer. It has a hard deadline of nine months from the date creating the interest, but a “big loophole” is that a person under age 21 has until nine months after reaching age 21 to disclaim. State law may recognize disclaimers by an executor or guardian or behalf of a decedent or minor. If the instrument does not dictate what happens in the event of a disclaimer, consider the effect of any “anti-lapse” statutes. Examples of where a disclaimer could be useful include gifts that dramatically depreciate within nine months after the gift, donor remorse (together with a cooperative donee), repairing gifts that do not qualify for a marital or charitable deduction, and an unexpected death shortly after the gift (a disclaimer could result in causing the predeceased ancestor exception to the GST tax to apply to avoid a taxable termination from a testamentary transfer or a direct skip from a gift, Treas. Reg. §26.2651-1(a)(2)(iii). The income tax effects of disclaimers are not addressed in §2518. Income should not be recognized by the disclaimant if the disclaimer occurs in the same taxable year as the transfer, but if it occurs in a subsequent year, the disclaimant may have to recognize income for the period prior to the disclaimer (and possibly could use the “claim of right” doctrine to deduct that amount in the subsequent year when the disclaimer is made). To avoid that income tax uncertainty, the best practice is to disclaim in the same taxable year in which the gift is made. For a good resource about the income tax effects of disclaimers, see Cline, 848-3rd T.M., Disclaimers— Federal Estate, Gift and Generation-Skipping Transfer Tax Considerations, IV, L. See Item 20.c(2) below regarding the claim of right doctrine. (2) Agreement of Parties. The agreement of unrelated parties to modify transactions probably has no transfer tax consequences because the gift tax does not apply to ordinary business transactions, but gift tax consequences may arise for agreements among family members that do not reflect enforceable rights. (3) Reformation for Scrivener’s Error. For transfer tax purposes, cases and PLRs generally have respected retroactive reformations to correct a scrivener’s error. (4) Reformation for Other Mistakes. Cases have not consistently respected retroactive reformations to correct other mistakes for transfer tax purposes, but various private letter rulings have respected the retroactive effect of reformations where the instrument is reformed to conform to the settlor’s original intent (even if the mistake is not a scrivener’s error). See Item 15.e-g above for a summary of several cases dealing with a reformation resulting from a mistake of law as a result of a retroactive tax law change.

Income Tax Effects. (1) Rescission “Same Year” Doctrine. A rescission in the same taxable year results in ignoring the transaction for income tax purposes, even if the rescission has no underlying legal basis. See Rev. Rul. 80-58. The rationale for this doctrine is the “annual accounting concept” “that one must look at the transaction on an annual basis using the facts as they exist at the end of the year. “ Id. A rescission in the subsequent year is treated as a separate independent transaction. The IRS

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announced in 2021 that it is studying issues with rescissions and since that time the IRS currently has had a no-rule policy about whether a completed transaction may be rescinded for federal income tax purposes. (2) Claim of Right Doctrine. A taxpayer who receives income under a “claim of right” must recognize the income as taxable income in that year even if the validity of the claim is disputed and even if the taxpayer must repay the income in later year if three conditions exist: (1) the taxpayer receives the income (2) under a claim of right and (3) no restrictions exist on the taxpayer’s economic use of the income. This concept applies even if the transaction is later determined to be void ab initio. Even if the disputed income is eventually returned, the taxpayer cannot claim a refund for the year of receipt even if the statute of limitations is still open for that year, but generally will be entitled to a deduction in the year of repayment. See generally Maule, 502-4th T.M., Gross Income: Tax Benefit, Claim of Right and Assignment of Income. Section 1341 provides that if (1) an item of income was included in a prior year because the taxpayer appeared to have had an unrestricted right (the claim of right doctrine), (2) after the close of the prior year it was established that the taxpayer did not have an unrestricted right to the income, and (3) the amount of the repayment exceeds $3,000, then the tax liability for the year of repayment is the lesser of (a) the tax computed after deducting the repayment and (b) a hypothetical tax for the repayment year, computed without a deduction, less the decrease in tax that would have resulted for the earlier year if the repaid amount had been excluded from the prior year’s gross income. The taxpayer does not receive interest on the “overpaid” tax amount from the original year of receipt. No deduction is allowed under §1341, however, if the repayment is voluntary (to avoid reversing a receipt of income that is not based on enforceable property law rights). The IRS regularly objects to relief under §1341 and the cases have been very fact specific. (3) Tax Benefit Rule. A taxpayer must include in income in a current year any previously deducted amount that otherwise produced a tax benefit in a prior year that is recovered in the current year, whether or not the prior year is closed for limitations purposes. The inclusion in the current year is not required, though, if the deduction in the prior year produced no tax benefit. §111. The taxpayer does not have the choice to amend a prior open year to eliminate the benefit of the earlier deduction but must recognize the income in the year received. Letter Ruling 9236003 in effect concluded that there is no estate tax analogy to the income tax benefit rule (though without using that term). In that ruling an estate tax charitable deduction was allowed for a restricted gift to a university. Eventually the university had to refund the gift for failure to satisfy the restrictions. The executor initially reported the amount that had been allowed as an estate tax charitable deduction on the estate’s income tax return for the year that the gift was returned. Several years later the estate filed for a refund of the additional income taxes paid because “there was no support for including the value of the property in the estate’s gross income following the transfer from the university.” The IRS agreed that the amount is not required to be included in gross income for the year the property was returned. It reasoned that the regulations under §2055 allow an estate tax charitable as long as any conditions that would defeat the charitable transfer are “so remote as to be negligible.” The amount returned to the estate for ultimate disposition to the beneficiaries under the will are treated as a devise under §102 and are excluded from gross income. g.

9100 Relief for Mixed Tax Elections. Regulations §§301.9100-1 through 301.9100-3 provide procedures for obtaining extensions to make certain elections and applications for relief. “9100 relief” is not in the Internal Revenue Code. It is a creature of IRS regulations. The number 9100 was

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selected because it was a number so far beyond any Code provisions that it would be a safe number to use for the regulation that would not be confused with regulations for any Code section. (1) Automatic Relief under Reg. §301.9100-2. Reg. §301.9100-2(a) provides an automatic 12month extension from the extended due date of a return on which an election was required for certain specifically identified regulatory elections, including the §754 election and the election for special use valuation, if the examination of the estate tax return has not commenced. Reg. §301.9100-2(b) grants an automatic extension of 6 months from the due date of the return, excluding extensions, for making regulatory or statutory elections having deadlines prescribed as the due date of the return or the due date of the return including extensions, but not including elections that by their terms must be made by the due date of the return, excluding extensions. To qualify for the automatic 6-month extension, the taxpayer must have timely filed the return and taken the corrective action prescribed in the regulation within the 6-month extension period. The 6-month extension apparently is available for a late inter vivos QTIP election, which the IRS views as having a statutory deadline. If the donor filed a timely gift tax return, the donor would have until October 15 of the year following the year in which the gift was made to file an amended Form 709 to make the corrective action for the automatic 6-month extension. (2) Non-Automatic Extensions for Relief, Reg. §301.9100-3. Reg. §301.9100-3 authorizes nonautomatic extensions if (1) the taxpayer acted reasonably and in good faith (request relief before the IRS discovers the failure or show the taxpayer relied on a qualified tax professional who failed to make or to advise the taxpayer to make the election), and (2) granting relief will not prejudice the interests of the government. Reg. §301.9100-3(a). (Prejudicing the interests of the government refers to putting the taxpayer in a better position than if the taxpayer had made the election timely.) The specific procedures under Reg. §301.9100-3 are the exclusive method of obtaining an extension of time to make an election that does not qualify for automatic extensions under Reg. §301.9100-2. Relief is not available for any election the time for which is prescribed by statute. Some examples are (1) QTIP elections for estate tax purposes (but not for gift tax purposes because the QTIP election deadline for a lifetime gift is set by statute), (2) reverse QTIP elections for GST tax purposes, (3) splitting trusts for GST tax purposes as of the date of death but after the due date has passed for filing Form 706, (4) allocations of GST exemption (considering all relevant circumstances including evidence of intent to be exempt from the GST tax in the trust instrument), and (5) portability elections if the estate was not required to file Form 706. 9100 relief cannot be used to “unmake” an election, such as unmaking an election in or out of automatic allocation of GST exemption or revoking an actual allocation of GST exemption. Carol Harrington and Julie Kwon believe that an election out of automatic allocation of GST exemption should not preclude relief to affirmatively allocate GST exemption late as if made timely. (A taxpayer can always allocate GST exemption to a trust that is not a “GST trust,” which is what the election out of automatic allocation makes the trust.) Because of this position of the IRS, if the return preparer does not know what GST exemption allocation election to make, the safest approach (other than actually finding out what to do) is to make no election. At least in that case, 9100 relief could be granted if other requirements for relief exist. Fees for 9100 relief private letter rulings for requests filed after February 3, 2021 range from $3,000 to $12,600 depending on the level of gross income of the requesting taxpayer. Rev. Proc. 2021-1, Appendix A. (3) Resource. For further discussion about the details of 9100 relief, see Items 14-22 of ACTEC 2018 Annual Meeting Musings (March 2018) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights). h.

Amended Returns. If a return is filed before its due date or extended due date, the taxpayer can file an amended return before the due date, and it will be the “return” for all purposes. Rev. Rul. 83-36. But the IRS can treat an amended return filed after the due date as a return or as something else, in

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its discretion. Amended returns filed after the due date often have no effect. Even if an amended return is accepted, the original return generally determines the date of filing for limitations purposes. A special exception exists to recognize an amended return filed to make adequate disclosure of a previously undisclosed or inadequately disclosed gift. See Rev. Proc. 2000-34. i.

Late Elections. Late elections may sometimes qualify retroactively to the date of transfer if made on the first return filed (such as the split gift election and the QTIP election for a testamentary transfer).

Liability Issues in Connection With Fixing Mistakes. A planner who makes a mistake should get independent help in fixing the mistake for various reasons (impaired judgment by guilt or fear, conflict of interest, failure to fully inform client of risks and options, and actions taken may look bad even if motives are good). In assisting to correct the mistakes of others, advise the client of malpractice claim deadlines, which vary from state to state. Damages can be speculative and hard to prove, so fixing the problem is usually better than trying to enforce a claim. Best practices include (1) give advice in writing, (2) recommend that the client consult a malpractice expert, and (3) immediately seek a tolling agreement with the professional involved.

20. Tax Effects of Settlements and Modifications; Early Termination of Trust; Commutation of Spouse’s Interest in QTIP Trust The tax effects of court modifications, other trust modifications, decanting, and settlements are summarized in Items 42-51 of the ACTEC 2015 Annual Meeting Musings (April 2015) summary found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. Item 15 above addresses the tax effects of rescission actions and Item 19 above addresses various ways for making retroactive revisions and reversals, including rescissions and reformations. This Item includes several brief miscellaneous comments. a.

Background; Bosch and Ahmanson. In Commissioner v. Estate of Bosch, 387 U.S. 456 (1967), the Supreme Court observed that legislative history regarding the marital deduction directed that “proper regard” be given to state court construction of wills. Because the Senate Finance Committee used “proper regard” rather than “final effect,” the opinion concluded that state court decisions should not be binding on the issue, and that federal courts in tax cases will be bound only by the state’s highest court in the matter before it. The Bosch approach is applied to settlements in Ahmanson Foundation v. United States, 674 F.2d 761 (9th Cir. 1981). A four-part test is used to determine if the results of a settlement will govern the tax consequences. The courts and national office of the IRS typically realize that the four-part analysis applies, but individual examiners are extremely suspicious of collusion in settlements.

Revenue Ruling 73-142—Pre-Transaction Actions Can Avoid Bosch Analysis. In Rev. Rul. 73142, a settlor reserved the power to remove and replace the trustee with no express limitation on appointing himself, and the trustee held tax sensitive powers that would cause estate inclusion under §§2036 or 2038 if held by the grantor at his death. The settlor obtained a local court construction that the settlor only had the power to remove the trustee once and did not have the power to appoint himself as trustee. After obtaining this ruling, the settlor removed the trustee and appointed another, so the settlor no longer had the removal power. In Revenue Ruling 73-142, the state court determination, which was binding on everyone in the world after the appropriate appeals periods ran, occurred before the taxing event, which would have been the settlor's death. The IRS agreed that it was bound by the court's ruling as well, “regardless of how erroneous the court's application of the state law may have been.” The court order must be obtained prior to the event that would otherwise have been a taxable event in order for the IRS to be bound under the analysis in Revenue Ruling 73-142.

Construction vs. Reformation/Modification Proceedings. A construction proceeding interprets a document as signed. It often involves an ambiguous document. The IRS is essentially bound regarding the availability of a marital or charitable deduction, because the interpretation relates back

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to the date of execution of the instrument (assuming the four-part analysis of settlement agreements can be satisfied). A reformation modifies a document, and the IRS position is that the reformation generally applies prospectively only. Accordingly, a post-death reformation may not result in an action causing assets to have passed to a surviving spouse or charity as of the date of death to qualify for an estate tax marital or charitable deduction. Some rulings have given reformations retroactive effect, however, in “unique circumstances.” d.

Income Tax Consequences of Early Termination of Trusts. Letter Rulings 201932001-201932010 ruled that the early termination of a trust (under a nonjudicial settlement agreement with court approval), with all of the beneficiaries being paid the actuarial value of their interests in the trust, had very significant income tax consequences. That is contrasted with the fact that trust distributions, even at the normal termination of a trust, are not typically treated as sale or exchange events. The remainder beneficiaries in the 2019 PLRs were treated as having purchased the interests of the life beneficiary and the contingent remainder beneficiaries (and the life beneficiary had a zero basis in his interest under the uniform basis rules of §1001(e) so the total amount paid to the life beneficiary was capital gain). The remainder beneficiaries, as the deemed purchasers, do not pay tax on amounts received in the commutation (as the fictional purchasers, they are just receiving what is left in the trust after they have bought out everyone else), but they “realize gain or loss on the property exchanged.” So they recognize gain on the assets paid out to others less the amount of their uniform basis attributable to those assets. Massive income taxation can result, which could be totally avoided by not terminating the trust early. Various commutation PLRs have reached similar results, and some case law supports the rationale, including Cottage Savings Association v. Commissioner, 499 U.S. 554, 559 (1991) (exchange of participation interests in a group of mortgages for participation interests in another group of mortgages constituted an exchange of property for other property differing materially either in kind or in extent and therefore loss on the exchange could be recognized). Cf. Letter Ruling 202047005 (gift of annuity interest in charitable remainder trust to the private foundation remainder beneficiary resulted in termination of the trust, but was treated as a charitable gift rather than as a sale or exchange of a capital asset that would have resulted in taxable income to the taxpayer). For a detailed discussion of planning implications of these rulings, see Item 16 of Estate Planning Current Developments and Hot Topics (December 2020) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights.

Section 2519 Brief Overview. Transfers to QTIP trusts qualify for the gift and estate tax marital deduction. The QTIP trust is subject to transfer taxes at the earlier of (1) the date on which the surviving spouse disposes (either by gift, sale, or otherwise) of all or part of the qualifying income interest (under §2519), or (2) upon the surviving spouse’s death (under §2044). Section 2519(a) provides that for estate and gift tax purposes, any disposition of all or part of a qualifying income interest for life in any property to which this section applies [i.e., property for which a QTIP election was made and a marital deduction was allowed under §2056(b)(7) or §2523(f)] shall be treated as a transfer of all interests in such property other than the qualifying income interest.

Reg. §25.2519-1(c)(1) clarifies what is deemed transferred when §2519 is triggered: (c) Amount treated as a transfer.—(1) In general.—The amount treated as a transfer under the section upon a disposition of all or part of a qualifying income interest for life in qualified terminable interest property is equal to the fair market value of the entire property subject to the qualifying income interest, determined on the date of the disposition (including any accumulated income and not reduced by any amount excluded from total gifts under section 2503(b) with respect to the transfer creating the interest), less the value of the qualifying income interest in the property on the date of the disposition. The gift tax consequences of the disposition of the qualifying income interest are determined separately under §25.2511-2.

If the surviving spouse disposes of all or part of a qualifying income interest for life, §2519 treats the disposition as a transfer of all interests in the QTIP other than the qualifying income interest (i.e., as a transfer of the remainder interest). www.bessemertrust.com/for-professional-partners/advisor-insights

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The effect is that if the spouse disposes of any portion of the qualifying income interest in a QTIP trust, the spouse is treated as having transferred the remainder interest in the trust. Whether the amount of the gift resulting from the deemed transfer of the remainder interest is offset by any consideration received by the spouse-beneficiary in the transaction the resulted in triggering §2519 is unclear, but is addressed in Kite II and in CCA 202118008 (both discussed below). The transfer of the income interest itself can be a gift under §2511 if the spouse receives less than full value in return for the income interest. The conversion of QTIP assets into other property in which the surviving spouse continues to have a qualifying income interest for life is not a disposition for purposes of §2519. Reg. §25.2519-1(f)(sale and reinvestment of assets of a QTIP trust is not a disposition under §2519 provided that the surviving spouse continues to have a qualifying income interest for life in the trust after the sale and reinvestment). A spouse-beneficiary of a QTIP trust may purposefully dispose of a small part of the income interest as a way of making a substantial gift without relinquishing significant retained economic rights. See Item 20.i(4) below. f.

Kite v. Commissioner Brief Summary. Mrs. Kite (“Wife”) created a QTIP trust for Mr. Kite (“Husband”) who died a week later. (Presumably, that inter vivos QTIP trust was created to obtain a basis adjustment at Husband’s death, despite the limitations imposed by §1014(e).) Under the terms of the trust the assets remained in the QTIP trust for Wife’s benefit, and Husband’s estate made the QTIP election to qualify for the estate tax marital deduction. Subsequently, the assets of the QTIP trust as well as another QTIP trust and a general power of appointment marital trust (collectively the “Marital Trusts”) were invested in a limited partnership. Eventually the trusts’ interest in a restructured partnership was sold the Wife’s children (and trusts for them) for notes and the notes were contributed a general partnership. In a three-day series of planned transactions, Wife replaced trustees of the Marital Trusts with her children as trustees, the children as trustees terminated the Marital Trusts (effective three months earlier) and distributed all of the trust assets (i.e., the interest in the general partnership) to Wife’s revocable trust, the children contributed additional assets to the general partnership, and Wife (almost age 75) sold her partnership interests to her children for a deferred private annuity (annuity payments would not begin for 10 years). Wife died three years later before receiving any annuity payments. (The children’s authority as trustees to terminate the Marital Trusts and distribute all of the assets to Wife is unclear. The opinion describes the principal distribution standards for the QTIP trust that Wife originally created but not for the other trusts. Principal from that QTIP trust could be distributed for “maintenance” and the trust could be terminated if the trust corpus was too small to justify management as a trust.) The court’s initial decision, Kite v. Commissioner, T.C. Memo. 2013-43 (decision by Judge Paris) (referred to as “Kite I”), held as follows. 1. The transfer of assets in return for the private annuities was for full consideration, was not illusory, and did not lack economic substance. Using the IRS actuarial tables was appropriate, even though the annuity payments would not begin for 10 years and Wife had only a 12 1/2 year life expectancy, because Wife was not terminally ill at the time of the sale and she had at least a 50% chance of living more than one year. The sale was not illusory and was bona fide because the annuity agreement was enforceable and the parties demonstrated their intention to comply with the annuity agreement. “The annuity transaction was a bona fide sale for adequate and full consideration.” 2. The transfer of assets from the QTIP Trusts to a limited partnership in return for limited partnership interests, the subsequent reorganization of the partnership as a Texas partnership (to save state income taxes), and the trusts’ sale of the interests in the limited partnership in return for 15-year secured notes did not constitute a disposition triggering §2519.

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3. The liquidation of the QTIP trusts and the sale of the interests in the general partnership for the private annuities were part of an integrated transaction that was deemed to be a disposition of her qualifying income interest for life, that triggered §2519 and in turn caused a deemed transfer of the remainder interests in the QTIP trusts. The deemed transfer of the income interest was not a taxable gift under §2511 because Wife received full value. Kite I did not discuss what, if any, taxable gift resulted from the deemed transfer of the remainder interest. (The effect of the transfer of the income interest is determined under the general gift tax principles of §2511—the value of the portion of the income interest that is transferred less the consideration received for such transfer). 4. The transfer of assets from the general power of appointment marital trust to Wife was not a release of her general power of appointment causing a transfer under §2514 for gift tax purposes. The court only considered the termination of the marital trust and did not also consider the subsequent private annuity transaction as part of an integrated transaction in determining tax consequences of the transactions involving the general power of appointment marital trust. Kite II is the court’s Order and Decision regarding the Rule 155 computations of the gift tax as a result of the decision in Kite I. (Cause No. 6772-08, unpublished op. Oct. 25, 2013). The estate argued that no gift resulted from the deemed transfer of the remainder interest under §2519 because of the court’s decision in Kite I that the Wife’s sale of assets that she received from the QTIP trust in return for a deferred private annuity was a bona fide sale for adequate and full consideration. Neither the statute nor regulations make clear whether the gift that results from a deemed transfer of the QTIP remainder interest under §2519 is the full value of the remainder interest or whether it is reduced by any amounts paid to the spouse to replace the value of the remainder interest in his or her estate. There is one regulation referring to the spouse “as making a gift under section 2519 of the entire trust less the qualifying income interest….” Reg. §25.25191(a)(third sentence). The court pointed out that regulation, reasoning that “the term ‘gift’ [in that regulation] is not an accident.” The reason the court gives for this statement is that [t]he remainder interest is a future interest held by the remainderman and not the donee spouse. Accordingly, the donee spouse cannot receive full and adequate consideration, or indeed any consideration, in exchange of the remainder interest.

The court does not mention that the statute and numerous other places in the regulations refer merely to the deemed “transfer” under §2519. §2519(a); Reg. §§ 25.2519-1(a)(first sentence and second sentence), 25.2519-1(c)(1), 25.2519-1(c)(2), 25.2519-1(c)(4), 25.2519-1(c)(5). There are various examples in Reg. §25.2519-1(g) that refer to the amount of the gift, but no consideration was paid to the spouse in any of those examples to replace the remainder value in the spouse’s estate. If §2519 merely results in a deemed “transfer,” traditional gift principles would suggest that any consideration received by the deemed transferor would be subtracted to determine the amount of the “gift.” E.g., Commissioner v. Wemyss, 324 U.S. 303, 307 (1945); Reg. §25.2511-1(g) (“[t]he gift tax is not applicable to a transfer for a full and adequate consideration in money or money’s worth”). One sentence in the legislative history to §2519 suggests that the gift amount would be determined after subtracting any amounts paid to the spouse. If the property is subject to tax as a result of the spouse’s lifetime transfer of the qualifying income interest, the entire value of the property, less amounts received by the spouse upon disposition, will be treated as a taxable gift by the spouse under new Code sec. 2519.” H.R. Rept. No. 97-201 at 161, 1981-2 C.B. at 378.

The court attempts (feebly) to rebut what seems to be the clear intent of that sentence by references to the immediately preceding and following sentences in the House Report. See a discussion of the court’s analysis in Item 4.h of Akers, Kite v. Commissioner, Rule 155 Order and Decisions (Cause No. 6772-08, unpublished opinion October 25, 2013) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights). Despite these countervailing indications in the statute, regulations, and legislative history, the court in Kite II interpreted §2519 to mean that the full amount of the deemed transfer of the QTIP trust remainder interest is a gift, regardless of any consideration received by the surviving spouse. “[A] www.bessemertrust.com/for-professional-partners/advisor-insights

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deemed transfer of a remainder interest under section 2519 cannot be made for adequate and full consideration or for any consideration.” For a more detailed discussion of Kite I and Kite II, see Akers, Kite v. Commissioner, Rule 155 Order and Decisions (Cause No. 6772-08, unpublished opinion October 25, 2013) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights). g.

Commutation of Spouse’s Interest in QTIP Trusts With Charitable Trust as Remainder Beneficiary, PLR 202016002. The commutation of a spouse’s qualifying income interest in a QTIP trust in return for the actuarial value of the income interest not only has potential income tax effects, as discussed in Item 20.d above, but also is treated as a transfer under §2519 of all interests in the trust other than the qualifying income interest. Letter Ruling 202016002 addresses the tax effects of a settlement agreement terminating QTIP trusts. A specified amount was paid from one QTIP trust to the spouse-beneficiary in consideration of her resignation as trustee and in resolution of her demands for principal invasion and various disputes; that amount was paid under the trustee’s authority to make principal distributions for the health, education, support, and maintenance of the spouse. In addition, the QTIP trusts were terminated by paying to the spouse-beneficiary the actuarial value of her income interest and distributing the remaining assets to the charitable trust that is the remainder beneficiary of the QTIP trusts. •

The payment to the spouse of the actuarial value of the income interest in exchange for her lifetime income interest is a disposition of her income interest for purposes of §2519, resulting in a deemed transfer of all interests in the trust other than the qualifying income interest (i.e., the remainder interest).

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The transfer of the qualifying income interest itself is subject to potential treatment as a gift under §2511, but the transfer is not a gift because the spouse receives the present value of the qualifying income interest.

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The deemed transfer of the remaining assets to the remainderman is a gift by the spouse under §2519, but the spouse is entitled to a gift tax charitable deduction where the assets pass to a charitable trust.

Commutation of Spouse’s Interest in QTIP Trusts With Individuals as Remaindermen, CCA 202118008. Chief Counsel Advice 202118008 also involves the commutation of a QTIP trust, but with individuals as remaindermen rather than a charitable trust (so the deemed gift of the remainder interest under §2519 could not be offset by the gift tax charitable deduction). The CCA is an excellent illustration of the difficulty and complexity of planning with QTIP interests. The spouse-beneficiary (“Spouse”) held a testamentary limited power of appointment. The Spouse, and the children as remaindermen (“Children”) and a virtual representative of the contingent remaindermen entered into an agreement to have all the trust property distributed to the Spouse. On the same day, the Spouse transferred the trust assets to trusts for the Children and their descendants, partly as a gift and partly as a sale in return for a promissory note (the “Gift/Sale Transactions”). The CCA addressed various issues. (1) Transaction Viewed as Commutation. The transaction is viewed as a commutation (though the CCA acknowledged that a commutation is typically the distribution of trust assets to all holders of beneficial interests equal to the actuarial value of their interests). The commutation “constitutes a disposition by Spouse of Spouse’s qualifying income interest within the meaning of §2519” and therefore as a “gift of all interests in Trust 1 other than the qualifying income interest.” (2) Children Treated as Making Gifts to Spouse of Remainder Interest. The Children were also treated as making gifts to the Spouse of their interests as remaindermen. The Children argued that they should not be treated as making a gift but that the transaction was a reciprocal exchange for consideration. The IRS disagreed, reasoning that the Spouse was treated as not receiving any consideration for the deemed transfer to the Children, because transferring all of the QTIP assets to the Spouse did not augment the Spouse’s estate beyond the amount that would be included in the gross estate under §2044 if the transaction had not occurred. But the fact that the Spouse was treated as receiving no consideration did not nullify the Children’s

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transfers of their remainder interests. The IRS viewed the transaction as a two-step process. First, “the remainder interest vested outright, equally, in Children, the then remaindermen.” Second, “Children then transferred their valuable property interest to Spouse and received nothing in exchange.” (Thus, the Children were treated as making a gift of their remainder interests even though the Spouse held a testamentary power of appointment and the Children were not assured of receiving anything. Apparently, the IRS got around that hurdle by reasoning that the transaction was viewed as first “vesting” the remainder interest in the Children.) The IRS looked to Revenue Ruling 98-8 and Kite II as supporting its position that the deemed transfer of the remainder interest by Spouse to the Children and the deemed transfer of trust property from the Children to the Spouse do not offset each other. (a) Revenue Ruling 98-8 Analysis. The CCA’s conclusion that Rev. Rul. 98-8 supports its conclusion that the two deemed transfers do not offset each other is off base. Rev. Rul. 98-8 merely addresses an indirect commutation of a QTIP trust. (The factual scenario considered in Rev. Rul. 98-8 was (i) the purchase of the remainder interest by the spouse for a note, (ii) the distribution of all trust assets to the surviving spouse, followed by (iii) the spouse paying off the note with a portion of the trust assets. The net result was that the spouse ended up with assets equal to the value of the income interest.) The key result of the transaction considered in Rev. Rul. 98-8 was that the value of the remainder interest was not owned by the spouse and was no longer in a QTIP trust subject to taxation at the spouse’s subsequent death under §2044. Therefore, the remainder value would escape gift and estate taxation. That is not the case under the facts of the CCA – the Spouse utilized unified credit and received a promissory note that will be included in the Spouse’s gross estate. (b) IRS Reasoning That Kite II Supported Its Conclusion. The IRS also argued that the Kite case supported its conclusion. The Rule 155 order in Kite (sometimes referred to as Kite II) concluded that the spouse in that case was treated as making a gift of the entire remainder interest value even though the spouse received an annuity interest having an actuarial value equal to the value of the remainder interest. No. 6772-08 (T.C. Oct. 25, 2013) (order and decision under Tax Court Rule 155). (The Kite decision on which the Rule 155 Order was based is T.C. Memo. 2013-43, sometimes referred to as Kite I.) The CCA reasoned that under the Kite analysis, the QTIP statutory scheme and legislative history support the view that the separate transfers by Spouse and Children cannot be offset by consideration for gift tax purposes. … Eliminating the taxable transfer by Spouse based on a deemed reciprocal gift transfer by the remaindermen would allow the value of the remainder of Trust 1 to escape transfer tax under both §§ 2519 and 2044, which would be contrary to the QTIP statutory scheme and legislative history. (emphasis added; emphasized words are addressed below)

(c) Strong Criticism of Kite II Reasoning. The conclusion in Kite II that the amount of the gift resulting from the deemed transfer of the remainder interest was not offset by any payments made to the spouse has been strongly criticized. See Recent Developments, 48th ANN. HECKERLING INST. ON EST. PL. (2014) (Ronald Aucutt ed.). Most planners and commentators had believed following Kite I that a zero gift would result from the deemed transfer of the remainder interest in light of the court’s determination that the wife received full value (an annuity) when she transferred the assets of the QTIP trust. See e.g., Jeffrey Pennell, Jeff Pennell on Estate of Kite: Will It Fly? LEIMBERG EST. PL. EMAIL NEWSLETTER, Archive Message #2062 (February 11, 2013). (d) QTIP Statutory Scheme. The CCA’s reasoning that the “QTIP statutory scheme” supports its conclusion is quite ironic. The CCA correctly observes that the purpose of the marital deduction is merely to defer the transfer tax until a subsequent lifetime transfer or the death of the donee-spouse. But in this case the Spouse received back assets (the promissory note), directly owned by the Spouse, and made use of the Spouse’s unified credit amount with a combined value equal to the full value of assets that had been in the QTIP trust. Those assets would later be subject to gift or estate tax (or already made use of unified credit amount). The www.bessemertrust.com/for-professional-partners/advisor-insights

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policy and intent of the marital deduction seems to support (indeed to require) that replenishment of the value to the surviving spouse must be considered in determining the amount of gift that is made under §2519. Otherwise, as discussed immediately below, there is a double inclusion of assets subject to the gift and estate tax. (e) Double Inclusion. The CCA does not address the distinct possibility of taxing the same value twice as a result of its conclusion—once as a gift equal to the value of the deemed transfer of the remainder interest under §2519 and the second time at the spouse’s death when the assets that the spouse received as consideration are subject to estate tax and the spouse had made use of unified credit in making a gift of assets to trusts for descendants in the combined Gift/Sale Transaction. The CCA interprets §2519 as resulting in a taxable gift of the full actuarial value of the remainder interest, even though that value is replenished in the wife’s direct ownership of assets (or utilization of unified credit). Would the double inclusion be avoided by the provision in §2001(b) that any gifts that are also included in the decedent’s gross estate will not be added back into the estate tax calculation as adjusted taxable gifts. Apparently not under the CCA’s reasoning that the Spouse did not merely make a deemed gift and retain an interest in the trust, but the Spouse received back assets as the result of an independent gift from the Children. (f) Legislative History. The CCA reasons that the legislative history to §2519 makes clear that an unlimited deduction is allowed under §2056(b)(7) for QTIP property and §§ 2044 and 2519 were added to ensure that the transfer tax deferred by § 2056(b)(7) becomes subject to tax, either on the surviving spouse’s death or after a lifetime disposition of spouse’s qualifying income interest. See H. REP. NO. 97-201, at 161-62.

That legislative history would be satisfied by the inclusion of the promissory note in Spouse’s estate and the utilization of Spouse’s unified credit, both resulting from the Gift/Sale Transaction. The estate tax on the value in the original decedent’s estate was deferred at the decedent’s death and will be subject to the transfer tax by the Spouse. (g) Comparison to Outright Transfer to Spouse. Observe the dramatically different result under this reasoning than if the original transfer had been made outright to the Spouse instead of into a QTIP trust for the Spouse. For an outright transfer to the Spouse, the estate tax otherwise payable at the first spouse’s death would have still have been deferred, but the Spouse could have made the gifts and sales of those interests to trusts for the descendants without any interim deemed gift from the Spouse to Children and an immediate return gift from Children to Spouse. What is the policy reason behind treating outright transfers to spouses and QTIP transfers so radically differently? In any event, this difference illustrates the wisdom of including liberal distribution standards in QTIP trusts for future planning flexibility. If the trustee simply transfers all the assets to the spouse, that is merely a distribution from the QTIP and is not a deemed transfer of the remainder interest under §2519, at least if the spouse does not make an immediate transfer of those assets in an integrated transaction. Cf. Reg. §25.2519-1(e) (the exercise of a power to appoint QTIP property “to the donee spouse is not treated as a disposition under section 2519, even though the donee spouse subsequently disposes of the appointed property”). (3) Value of Spouse’s Gift Is Full Actuarial Value of Remainder Interest. The value of the Spouse’s gift of the remainder interest under §2519 is the full actuarial value of the remainder interest, because [without citing any authority] possible “[d]iscretionary principal distributions and the testamentary limited power of appointment are not taken into account.” In its discussion of the value of the Spouse’s gift, the CCA does not directly address why the gift amount is not reduced by the value of the promissory notes received and the use of the Spouse’s unified credit amount in the Gift/Sale Transaction when the Spouse gave and sold assets to the trusts for descendants. But in its “reciprocal exchange” analysis, the CCA quoted Kite II for its conclusion that the gift by the spouse is the full value of the remainder interest, not reduced by the consideration received when the spouse transferred the remainder interest. In www.bessemertrust.com/for-professional-partners/advisor-insights

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Kite I, the court treated the distribution of assets to the spouse (not authorized in the trust instrument) and the sale of the remainder interest in return for an annuity as an integrated transaction that triggered §2519. As discussed above, the result of not allowing a reduction in the amount of the deemed gift under §2519 is that the value of the remainder interest is subject to transfer tax twice – first in the §2519 deemed gift of the remainder interest and second in the use of unified credit and transfer tax that will ultimately be applied on the promissory notes resulting from the Gift/Sale Transaction. For a detailed criticism of the reasoning and effect of the Kite II analysis see Akers, Kite v. Commissioner, Rule 155 Order and Decisions (Cause No. 677208, unpublished opinion October 25, 2013) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights). (4) Value of Gift by Children Is Full Actuarial Value of Remainder Interest. The value of the gift by the children of the remainder interest to the Spouse (following the deemed transfer of the remainder interest from the Spouse to the Children) does take into account restrictions on the beneficial interests, but the CCA reasons that the possibility of principal invasion for the Spouse was negligible given that the annual income from the QTIP trust would have been sufficient for the Spouse’s support needs. The CCA also concludes that “the testamentary limited power of appointment would be appropriately treated as having no measurable effect on the value of these interests.” Why not? The CCA merely says that conclusion is “based on all the facts and circumstances” – even though the Spouse in fact on the same day made a transfer other than outright to the Children who were the remaindermen. i.

Planning For Surviving Spouses’ Interests in QTIP Trusts. Planning for surviving spouses who are beneficiaries of substantial QTIP trusts is complicated. This CCA is an example of clients entering into complicated transactions in planning with QTIP trusts – with bad tax results in the eyes of the IRS. (1) Moore, Kawashima & Miyasaki Paper. For an outstanding detailed discussion of planning alternatives for a surviving spouse who is the beneficiary of a QTIP trust, see Read Moore, Neil Kawashima & Joy Miyasaki, Estate Planning for QTIP Trust Assets, 44th U. MIAMI HECKERLING INST. ON EST. PLAN. ch. 12 1202.3 (2010). (2) Distributions. One of the primary planning options is for the QTIP trust to make a distribution of substantial assets to the spouse-beneficiary, who could then engage in traditional transfer planning alternatives. The biggest hurdle to this planning option is that the trust agreement may have a restrictive standard for principal distributions, and the trustee may not be able to justify a large principal distribution under that standard. Commentators have pointed to possible gift implications of unauthorized distributions (or the failure to object to unauthorized distributions) from trusts: If a trustee makes a principal distribution to the surviving spouse to allow him or her to make gifts but the trust instrument does not permit the distribution, the remainder beneficiaries may be deemed to have made taxable gifts by not objecting to the distributions. There is clear authority stating that the release of a right or acquiescence to termination of rights for less than adequate consideration will constitute a gift for gift tax purposes. The seminal case of Dickman v. Commissioner [citation omitted] established that a gift need not be in the form of an actual transfer of property. Rather, foregoing a valuable right or property interest (in the case of Dickman, interest) also constitutes a gift. IRS § 2501 imposes a gift tax on a broad category of transfers, described in IRS § 2511. The broad nature of gift transfers is discussed in Treas. Reg. § 25.2511-1. In addition, the IRS has confirmed in a number of rulings that acquiescence by a property owner to a transaction that will reduce the value of the property owner’s interests is effectively the release of a general power of appointment that will be treated as a gift under IRS § 2501 [citing Rev. Ruls. 84-105 & 86-39]. … The strategies discussed above in many cases will require the cooperation of formal agreement of multiple parties. The gift tax implications of any such strategy should be considered prior to such an agreement. Read Moore, Neil Kawashima & Joy Miyasaki, Estate Planning for QTIP Trust Assets, 44th U. MIAMI HECKERLING INST. ON EST. PLAN. ch. 12 ¶ 1201.5 (2010).

(a) Possible Collapsed Transactions Argument by IRS. Note, however, that the IRS may claim that a distribution followed by a gift should be collapsed and deemed to be a prearranged and www.bessemertrust.com/for-professional-partners/advisor-insights

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simultaneous transaction, resulting in a distribution from the nonexempt trust to the end recipient. Cf. Estate of Kite v. Commissioner, T.C. Memo. 2013-43 (QTIP context; surviving spouse’s children as trustees distributed all principal to spouse and she sold the assets to her children two days later in deferred private annuity arrangements; transactions were treated as a disposition by the spouse of her income interests in the QTIP, triggering §2519; suggesting that the combination of a trust distribution to a beneficiary followed by transfers by the beneficiary might be treated as if the subsequent transfers were made by the trust). (b) Effect of Unauthorized Distributions. To the extent distributions are made that are not authorized in the trust agreement, the IRS might argue that it should ignore the distributions. See Estate of Lillian Halpern v. Commissioner, T.C. Memo. 1995-352 (distributions from general power of appointment marital trust to descendants; spouse consented but the distributions were not authorized; court recognized the distributions that were made when the spouse was competent but did not recognize distributions made after the spouse had become incompetent because a guardian could have set aside the distributions, so those distributions were included in the spouse’s estate under §2041); Estate of Hurford v. Commissioner, T.C. Memo. 2008-278 (beneficiary-trustee made distribution to self, contrary to standards in trust, and sold those assets for private annuity; trust assets included in decedent’s gross estate under §2036 and the distributed assets were not excluded from the decedent’s gross estate merely because of ascertainable standards in the trust); Estate of Hartzell v. Commissioner, T.C. Memo. 1994-576 (court rejected IRS argument that assets distributed from marital trust to decedent during her lifetime and given to family were includable in her gross estate because the distributions were improper transfers from the trust; Ohio court would have approved the transfers because distribution standard of “comfort, maintenance, support, and general well being” would include distributions to assist her desire to continue giving gifts to family members to ensure family control of family businesses); Estate of Council v. Commissioner, 65 T.C. 594 (1975) (IRS argued that trustee did not have the authority to distribute trust assets to spouse for gifting purposes; court stated that the issue was not whether a state court would have approved the distributions beforehand but whether a state court would rescind the distributions after made; conclusion that trustees acted within the bounds of reasonable judgment). Several cases have concluded that the failure to follow restraints on distributions caused trusts to be treated as grantor trusts for non-tax purposes. United Food & Commercial Workers Unions v. Magruder Holdings, Inc., Case No. GJH-16-2903 (S.D. Md. March 27, 2019) (failure to comply with fiduciary constraints regarding trust distributions caused a trust to be treated as a grantor trust for non-tax purposes); SEC v. Wyly, 2014 WL 4792229 (S.D.N.Y. September 25, 2014) (SEC recoupment case; court reasoned that a failure to comply with fiduciary constraints regarding trust distributions caused a trust to be treated as a grantor trust for non-tax purposes) (case summary is in Item 17 of Current Developments and Hot Topics Summary (December 2015) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. (c) Issue Not Addressed in Kite. In Kite v. Commissioner, discussed in Item 20.f above, the Wife substituted her children as trustees of QTIP trusts and the same day they transferred all of the QTIP trust assets to the Wife. The case did not address whether the principal invasion standard in the trust instruments authorized such distributions and whether the children made gifts as a result of making unauthorized distributions. Despite the IRS’s failure to raise the beneficiary gift issue in Kite, planners structuring planning opportunities with QTIP trusts cannot ignore the potential gift issues by beneficiaries if the beneficiaries either make distributions as trustees or fail to object to distributions made by others as trustees that are not authorized under the trust agreement (see Dickman v. Commissioner, 465 U.S. 330 (1984); Rev. Rul. 84-105; Rev. Rul. 86-39). (3) Spousal Power of Withdrawal. A power by the spouse to withdraw assets does not disqualify the trust for the marital deduction as long as the spouse is not legally bound to transfer the withdrawn assets without full consideration. Reg. §20.2056(b)-7(d)(6). (A withdrawal power might www.bessemertrust.com/for-professional-partners/advisor-insights

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be structured to arise only after a year so the trust clearly would not qualify for the marital deduction under §2056(b)(5), which would avoid a possible argument by the IRS that the QTIP election could not be made for that trust, which would cause a loss of some of the flexibilities afforded under the QTIP rules, such as using partial QTIP elections and reverse QTIP elections.) (4) Triggering Section 2519 Deemed Disposition. A type of transfer that offers the ability to take advantage of the increased $10 million (indexed) gift exclusion amount in the event that the exclusion amount later sunsets back to $5 million (indexed) while still leaving cash flow for a surviving spouse who is the beneficiary of a QTIP trust is to make a §2519 transfer. The tax effects are summarized below. •

The surviving spouse could release a small portion of the income interest (say 1%).

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The spouse would be making a gift of the value of the 1% income interest that is released.

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The spouse would also be treated as making a transfer of the entire remainder interest under §2519.

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If §2702 applies (i.e., if the remainder beneficiary is a “member of the family” as described in §2704(c)(2), as referenced in §2702(e)), “100% of the QTIP Trust is treated as a deemed gift.” Richard Franklin & George Karibjanian, Portability and Second Marriages – Worth a Second Look, BNA ESTATES GIFTS & TRUSTS J. (Sept. 11, 2014). See Reg. §25.2519-1(g) Ex. 4 (addressing the application of §2702 in a §2519 disposition).

•

Because the spouse retains 99% of the income, 99% of the QTIP assets would be included in the spouse’s estate under §2036 (rather than having the QTIP assets included in the surviving spouse’s estate under §2044), which would mean that the 99% of the §2519 gift of the remainder interest that is included in the gross estate under §2036 would be excluded from the adjusted taxable gifts in the estate tax calculation. §2001(b)(last sentence); Reg. §20.2044-1(e), Ex.5.

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Under the anti-clawback regulation, the estate uses the higher of the basic exclusion amount (BEA) applicable to gifts made during life or the BEA applicable on the date of death. Reg. §20.2010-1(c). Therefore, the BEA at the date of the gift would be available at death even if the BEA has been reduced by the date of death. Only the net appreciation of the QTIP assets after the date of the §2519 deemed transfer is effectively subjected to estate tax– thus making use of the larger gift exclusion amount that was available at the time of the gift. BUT BEWARE that the IRS is considering amending the anti-clawback regulation to remove this type of planning alternative. See Katie Lynagh, Potential AntiAbuse Rules May Limit Use of the Temporarily Increased Gift Tax Exclusion, BNA ESTATES, GIFTS & TRUSTS J. (May 14, 2020); Item 8.f(6) of Heckerling Musings 2021 and Estate Planning Current Developments (August 2021) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights).

•

The deemed gift would not eliminate the benefit of GST exemption allocated to the trust under a “reverse QTIP election.” Reg. §26.2652-1(a)(3). (This approach does not make the most efficient use of the gift exemption because the QTIP trust (that constitutes the deemed gift) is not a grantor trust, but this §2519 approach may be all that the surviving spouse is willing to do in terms of making gifts.)

If the QTIP trust is larger than the gift that the spouse wants to make, the QTIP trust can be divided into two separate QTIP trusts under state law, and a number of private letter rulings have ruled that the §2519 deemed transfer could be made from only one of the severed trusts. See, e.g., PLR 20171006. Consider obtaining a ruling, though, because §2519 and Reg. §25.2519-1(a) literally would cause §2519 to be triggered for both of the resulting trusts. Cf. Reg. §25.25191(c)(5) (only property in severed portion of trust is treated as transferred under §2519, but that regulation applies only if the severance was accomplished by the time of filing the estate tax return or the intent to divide the trust was unequivocally signified on the estate tax return). www.bessemertrust.com/for-professional-partners/advisor-insights

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From a drafting perspective, consider revising the spendthrift clause for QTIP trusts to permit an assignment of a 1% income interest (or greater interest) to descendants of the settlor/testator (or other family members). However, the “release” of 1% of the income interest probably does not violate the typical spendthrift provision. See RESTATEMENT (THIRD) OF TRUSTS §58 cmt (2003) (“Even the release of an interest in a spendthrift trust … is permissible and serves to terminate the beneficiary’s interest even though the release is treated for other purposes as a transfer”); UNIFORM TRUST CODE §502 cmt (2010 amendments) (“Releases and exercises of powers of appointment are also not affected because they are not transfers of property”). See Richard Franklin & George Karibjanian, Portability and Second Marriages – Worth a Second Look, BNA ESTATES GIFTS & TRUSTS J. (Sept. 11, 2014). (5) Freezing Transactions. The QTIP trust might engage in freezing transactions (for example, by selling trust assets for a long-term note or contributing trust assets to a partnership in return for preferred interests). (6) Additional Resources. Some of the planning alternatives for planning with QTIP trusts are summarized in Item 8 of the Observations in Akers, Kite v. Commissioner, Rule 155 Order and Decisions (Cause No. 6772-08, unpublished opinion October 25, 2013) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights). Transfer planning utilizing a §2519 deemed transfer is discussed in Item 3.j.(8) of the Estate Planning Current Developments Summary (December 2018) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. See also Richard S. Franklin, Lifetime QTIPs—Why They Should Be Ubiquitous in Estate Planning, 50th HECKERLING INST. ON EST. PL. ch. 16 (2016); Richard S. Franklin & George Karibjanian, The Lifetime QTIP Trust – the Perfect (Best) Approach to Using Your Spouse’s New Applicable Exclusion Amount and GST Exemption, 44 BLOOMBERG TAX MGMT. ESTATES, GIFTS & TR. J. 1 (March 14, 2019). 21. GST Tax Planning Issues—Queries and Conundrums The GST tax planning issues discussed below are based in large part on a presentation by Julie Kwon at the 55th Annual Heckerling Institute on Estate Planning. a.

Split Gift Election Issues. (1) Split Gift Election Applies for Gift and GST Tax Purposes (But Not For Estate Tax Purposes). Section 2513 permits spouses to elect to treat gifts made by either spouse during the year as being made one-half by each spouse for gift tax purposes. In addition, §2652(a) provides that the split gift is treated being made one-half by each spouse for determining who is the transferor for GST tax purposes. Each spouse may either allocate or not allocate GST exemption to his or her one-half deemed part of the gift. There is no analogous provision in the estate tax statutes, so the consenting spouse who did not actually make the gift is not treated as a grantor of the gift for purposes of applying the estate tax string statutes (§§2036, 2038, 2042). See Rev. Rul. 74-556 (no inclusion under §2038). That is very helpful; the consenting spouse can have powers or interests over the gifted property that would otherwise cause estate inclusion in the consenting spouse’s gross estate. If the consenting spouse retains powers that would cause the gift to be incomplete if actually made by that spouse (such as a power to shift benefits to other donees), the gift is probably still treated as a completed gift by the consenting spouse, but there is no clear authority to confirm that logical result. See Diana Zeydel, Gift Splitting—A Boondoggle or a Bad Idea? A Comprehensive Look at the Rules, 106 J. TAX’N 334 (June 2007). (2) SPLIT Gift Election for Gifts to a SLAT. Under §2513, the split gift election applies to gifts to any person other than the donor’s spouse; if the interest of the beneficiaries other than the spouse can be ascertained and severed from the interest of the spouse, the election is effective for the transfer to the severed interest for other beneficiaries. See Reg. §25.2513-1(a)(4); Rev. Rul. 56-439. To assist in structuring a SLAT so that the consenting spouse’s portion can be severed (and hopefully will be de minimis), include a “HEMS” (or more restrictive) distribution

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standard considering the spouse’s other available resources, and hopefully the other resources are substantial enough that the likelihood of having a distribution to the spouse from the trust is very remote. Another alternative is to provide that the consenting spouse is not a beneficiary at all of the trust receiving the gift, but a third party has a power of appointment broad enough to appoint assets to the spouse. In Nelson v. Commissioner, (discussed in Item 31 below29 below) the IRS allowed split gift treatment for a gift to a SLAT, but the terms of the recipient trust are unknown. For a more detailed discussion of this issue, see Item 15.e. of the Hot Topics and Current Developments Summary (December 2013) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights). (3) Consenting Spouse is Transferor of a Full One-Half of the Transfer for GST Tax Purposes If Any Part of Gift Qualifies for Split Gift Treatment. The GST tax regulations state that the consenting spouse “is treated as the transferor of one-half of the entire value of the property transferred by the donor, regardless of the interest the electing spouse is actually deemed to have transferred under section 2513.” Reg. §26.2652-1(a)(4). Various private letter rulings have taken the position that the actual donor spouse is treated as the sole transferor of the transfer if the entire transfer is ineligible for split gift treatment because the spouse’s interest is not ascertainable and severable. E.g. PLR 201125016. (4) Timing of Split Gift Election. The election to split gifts can be made on a late gift tax return if no return was filed for that year by either spouse and if a notice of deficiency for the gift tax for that year has not been sent to either spouse. §2513(b)(2). For example, if T makes a gift in 2019 of $2 million to a trust and fails to file a timely gift tax return, if GST exemption automatic allocation applies, T is treated as having allocated $2 million of GST exemption. However, if the spouses in 2021 file a late gift tax return reporting the 2019 gift in 2021 and make the split gift election, it is effective (as long as neither spouse had previously filed a 2019 gift tax return), and apparently relates back to the original 2019 transfer, so each spouse is treated as having allocated $1 million of GST exemption, rather than the actual donor-spouse being treated as allocating $2 million of GST exemption. (5) ETIPs and Split Gift Election. The estate tax inclusion period (ETIP) is the period during which the value of transferred property would be included in the gross estate (other than under §2035) of the transferor or transferor’s spouse if either of them died during that period. Reg. §26.26321(c)(2)(i). The inclusion ratio of the trust is determined at the end of the ETIP (generally speaking, at the transferor’s death or when no portion of the transfer would be included in the gross estate). If a split gift election is made for a transfer to a trust subject to an ETIP, the ETIP applies to the entire transfer, not just one-half attributable to the donor’s deemed gift. The time of termination of the ETIP is determined with respect to the actual donor whose interest caused the ETIP, even though each of the spouses can allocate GST exemption to one-half of the transfer. The split gift election does not change the actual donor for purposes of determining if an ETIP applies (and when it terminates). Stated differently, the split gift election does not create an ETIP if none exists without the election. (6) Consent Agreement. If the parties anticipate that the split gift election will be made, consider having the donor’s spouse contractually agree to consent to the election at the time the gift is made (in case a divorce occurs before the gift tax return is filed in which event the donor’s spouse might express reluctance to consent to gift splitting). b.

Calculation of Applicable Fraction/Inclusion Ratio. The applicable fraction is a fraction, the numerator of which is the transferor’s GST exemption allocated to the trust (or direct skip property) and the denominator of which is the value of the property transferred to the trust (subject to certain reductions). §2642(a)(2). The inclusion ratio is 1 minus the applicable fraction. The regulations state that the inclusion ratio is determined “by rounding to the nearest one-thousandth (.001).” Reg. §26.2642-1. For large trusts, rounding to the right decimal place can be significant. Do not just use a spreadsheet that calculates the ratio to many decimal points but just displays the result to the nextlowest thousandth.

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Late and Retroactive Allocation of GST Exemption—Death Out of Order. A special late allocation rule applies for situations in which a death out of order occurs. An example is when the transferor creates a nonexempt trust for the benefit of a child who would receive the assets at age 30, but with assets going to the child’s issue if the child dies before age 30. If the child dies before the transferor’s death and before age 30 with surviving issue, that would result in an unexpected taxable termination (which could trigger payment of a 40% GST tax). Under §2632(d)(1), the transferor in such a situation (or the transferor’s personal representative, if the transferor died in the same year as the child) can make a late allocation of GST exemption to previous transfers with retroactive effect. The retroactive allocation might also apply even if the non-skip person’s death does not produce an immediate taxable termination (for example if the trust would last for the life of the grantor and grantor’s spouse and then pass to the grantor’s descendants, and a child of the grantor predeceases the grantor.) The transferor allocates GST exemption on the basis of the value of the assets one the date of the original gift, regardless of what the assets are worth at the date of the generationskipping transfer. The allocation is effective immediately before the child’s death, which can negate any GST tax due as a result of the taxable termination at the child’s death. However, it would not negate any GST tax that was paid on prior generation-skipping transfers from the trust. Possibly the biggest benefit of this type of retroactive allocation is that the transferor can allocate his or her exemption amount as of the date of the generation-skipping transfer, regardless of the amount of exemption he or she had on the date of the original gift. The retroactive allocation applies beyond just predeceasing children of a transferor. It can apply if the predeceasing person is a lineal descendant of a grandparent of the transferor or of the transferor’s spouse or former spouse. In effect, it can apply to predeceasing collateral relatives as well as lineal descendants. The retroactive allocation must be made on a timely filed gift tax return for gifts made in the year of the death of non-skip person (i.e., the child in the above example). Rapid planning may be required if a non-skip person dies late in a calendar year. The election must be made on the gift tax return by the next April 15 (or October 15 if the return is extended, but the extension only extends the date of filing, not the date for payment of any GST tax in case the election ultimately is not made). There have been no regulations or private letter rulings under §2632(d). No guidance is available regarding the application of the retroactive exemption allocation if additional allocations or trust divisions or qualified severances have occurred. A literal interpretation of the statute suggests that the retroactive exemption allocation would be to the entire original transfer (or transfers on a chronological basis). (The retroactive allocation under §2632(d) is to transfers to “the trust” in which the predeceasing non-skip person “has an interest or future interest.”) The effect of the transferor’s prior allocations of GST exemption to the trust or whether the retroactive allocation can be targeted to a particular trust if the original trust has been divided into separate trusts (either by the trust terms or pursuant to a discretionary trustee power) or by a qualified severance is unknown. The purpose of the statute seems to be to provide a way to avoid the unexpected taxable termination, and requiring that the exemption be allocated to the original entire transfer to the trust (which would likely be wasted as to the interests of other children who do not predecease the termination of the trust) seems unfair. Because of the uncertainty regarding the ability to target the retroactive allocation to specific subtrusts that have been created from the original trust, consider making serial allocations, first to the targeted specific trust, and if that is not permitted describe a waterfall of allocations to the extent that exemption is still available. A retroactive allocation may be combined with a qualified severance to optimize the benefit of the allocation. For example, assume that a trust was created in 2000 with $1,000,000 providing for discretionary distributions to the grantor’s spouse, and following the deaths of the grantor and grantor’s spouse, the trust would pass to the grantor’s issue, per stirpes. Assume the grantor has four children and one of them dies in 2007 survived by children when the trust has a value of $2,000,000. If nothing is done, at the termination of the trust, assets will pass in part to the deceased child’s children, causing GST tax from a taxable termination. A combination of (1) the retroactive allocation rule, and (2) a qualified severance can be quite helpful in this situation.

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In the example, a two-step process would be used. First, allocate GST exemption under the retroactive allocation rule of §2632(d). The transferor would file a timely filed gift return for the year of the child’s death (§2632(d)(2)) allocating GST exemption equal to ¼ of the original $1,000,000 gift amount, or $250,000. This would create an inclusion ratio of 75% (and the “non-taxable” portion, or the applicable fraction, would be 25%). Second, make a qualified severance under §2642(a)(3), to create a trust with $500,000 (i.e., one-fourth of the trust) for the predeceased child’s family and another trust with the remaining $1,500,000 for the remaining descendants. Bottom line: Only $250,000 of exemption had to be allocated to protect a $500,000 trust (and subsequent appreciation) that will eventually pass to the predeceased child’s family. (A regular late allocation may be preferable if the assets are worth less than the gift amounts when the GST exemption allocation is made; for example, this may be the case with ILITs. Also, if the original gift was a split gift, each spouse is treated as a transferor of half of the trust, and if the child predeceases just one of the parents, the retroactive allocation would only work for one-half of the trust.) d.

GST Exemption Allocations for Transfers to GRATs. One situation in which the automatic allocation election should not be made is for GRAT transfers. (1) Does the ETIP Rule Apply Before the Termination of the GRAT? A strange regulation could be interpreted to mean that GRATs are not generally subject to the ETIP rules. Reg. §26.26321(c)(2)(ii)(A) says that the ETIP rules do not apply “if the possibility that the property will be included [in the gross estate of the grantor or the grantor’s spouse] is so remote as to be negligible,” which is the case if there “is less than a 5 percent probability that the property will be included in the gross estate.” The regulation could be interpreted to say that the ETIP rule applies only if a 5% or greater probability exists that the grantor will die within the 2-year GRAT term, in which event the assets would be included in the grantor’s gross estate. There is probably less than a 5% chance that the grantor will die within two years (unless the grantor is older than about age 68). The regulation might suggest that a typical GRAT is therefore not subject to the ETIP rules. The context of the definition of an ETIP in the regulation before the “so remote as to be negligible” clause may suggest that the intent is to inquire whether there is a 5% chance that the value would be included in the grantor’s estate if the grantor were to die within the GRAT term (and typically a high likelihood of estate inclusion would exist if the grantor were to die during the GRAT term). But, the regulation does not literally say that. As a practical matter, attorneys are not relying on this possible interpretation to allocate GST exemption at the creation of GRATs. (As discussed below, however, little downside may exist to making an allocation capped by the nominal value of the remainder interest.) (2) If the ETIP Rule Does Not Apply to GRATs, How Much GST Exemption Would Have to Be Allocated To Achieve an Inclusion Ratio of Zero? The answer is not totally clear, but the denominator of the inclusion ratio is probably based on the full value transferred to the GRAT, not just the nominal value of the remainder interest. See §2642(a)(2)(B) (denominator of the applicable fraction is “the value of the property transferred to the trust”). Some planners have suggested, however, allocating GST exemption to the GRAT when it is created just in case the ETIP rule does not apply and in case allocating exemption equal to the nominal remainder value is sufficient to cause the trust to be fully exempt. For example, a formula allocation could be made of “so much as is necessary to achieve a zero inclusion ratio, but not more than the value of the remainder.” In light of the uncertainty over the amount of GST exemption needed in this circumstance, if GST exemption is allocated at the creation of a GRAT, it is essential to put a cap on the amount allocated. (3) Risk of Automatic Allocation of GST Exemption to GRAT. If the GRAT remainder will pass in a manner that could potentially have distributions to skip persons, and IF the ETIP rule does not apply, GST exemption would automatically be allocated when the GRAT is created. The amount allocated would likely be the entire value of the property transferred to the trust, even though all that current value (and more) will be distributed back to the donor—thus likely wasting GST

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exemption. To be sure of preventing this result, an election against automatic allocation of GST exemption could be filed when the GRAT is created. (4) Electing-Out of Automatic Allocation at End of ETIP. The gift tax return that is filed for the GRAT when it is created can elect out of automatic allocation at the end of the ETIP—to avoid automatically allocating an undetermined amount of GST exemption when the GRAT terminates. See Reg. §26.2632-1(b)(2)(iii)(A)(1). The election in or out of automatic allocation can be changed before the ETIP ends. Reg. §26.2632-1(b)(2) and (3), and (c). Do not allocate GST exemption to a GRAT at its creation, either by affirmative allocation or automatic allocation, unless the allocation is capped at a very nominal value of the remainder interest. (If the automatic allocation is made inadvertently or purposefully at the beginning of the GRAT, however, it can be changed before the end of the ETIP.) (5) Affirmative Allocation of GST Exemption Prior to End of ETIP. If an affirmative allocation of GST exemption is made before the end of the ETIP, the allocation is irrevocable and cannot be changed. Reg. §26.2632-1(c)(1)(ii). Exemption should not be affirmatively allocated to GRATs (other than the possible strategy discussed above of allocating exemption equal to the nominal value of the remainder value in the unlikely event that might be enough to cause the trust to be GST-exempt.) However, Pam Schneider suggests that regulation is suspect and could be challenged if a large amount were at issue. (The statute states that GST exemption “shall not be made before the close” of the ETIP. §2642(f). “How can the IRS write a regulation that something you are not allowed to do is irrevocable because they told you that you are able to do it?”) (6) Allocation at End of GRAT Term. There is considerable uncertainty as to how GST exemption can be allocated at the end of the GRAT term if the goal is to make the allocation to some but not all trusts that receive the GRAT assets at the end of the GRAT term. (For example, some of the assets might pass to the grantor’s children outright and the balance might pass to long-term trusts. There would be no need to allocate any exemption to the portion passing outright to the grantor’s children.) One possible alternative might be to sever the GRAT before the end of the trust term, but it is not clear how that would be done (before the GRAT has split into separate trusts). The retroactive allocation rules do not seem to help; they apply if the child unexpectedly dies “out of order.” 22. Maintaining Client Confidentiality and Other Ethical Challenges While Working Remotely This summary is based, in part, on comments by John Bergner, Jeff Chadwick, and Lauren Wolven at the 55th Annual Heckerling Institute. a.

Ethical Issues While Working Remotely. The American Bar Association Model Rules of Professional Conduct (the “Model Rules”) have various provisions with special application for attorneys working remotely. (1) Rule 1.1 – Competence. “A lawyer shall provide competent representation to a client. Competent representation requires the legal knowledge, skill, thoroughness and preparation reasonably necessary for the representation.” A new addition to comment 8 provides that lawyers should “keep abreast of changes in the law and its practice, including the benefits and risks associated with relevant technology….” The duty of competence includes overseeing the execution of documents in a manner that they will be enforced and carry out the client’s wishes. For remote witnessing, the attorney not only must make sure that the state authorizes the remote notarization but should also take additional steps such as asking who is present including those outside the range of the camera, asking questions to assure that all signers are aware of what they are doing, and making an appropriate record. In addition, the attorney must keep up to date on changing laws and procedures and must keep current regarding technology issues.

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(2) Rule 1.3 – Diligence. Comment 5 requires that lawyers must have a plan for their own incapacity or demise. Attorneys working from home are somewhat like sole practitioners. Make sure that staff personnel know where things are located and what is going on. Have a plan for internet outage during meetings. (3) Rule 1.6 – Confidentiality. “A lawyer shall make reasonable efforts to prevent the inadvertent or unknown unauthorized disclosure of, or unauthorized access to, information relating to the representation of a client.” Comment 18 states that Rule 1.6(c) requires lawyers to act competently to safeguard information. Furthermore, comment 18 provides that a client may require the lawyer to implement special security measures not required by Rule 1.6(c) or may give informed consent to forego security measures that would otherwise be required. Comment 18 clarifies that “reasonable efforts” factors include sensitivity of the information, likelihood of disclosure if additional safeguards are not employed, cost of employing additional safeguards, difficulty of implementing the safeguards, and the extent to which safeguards adversely affect the lawyer’s ability to represent clients (for example, because of their difficulty of use). The attorney must know who is within earshot of a client when talking with a client in Zoom sessions. Avoid discussing sensitive information during Zoom conferences, but use a telephone for discussing those issues. (4) Model Rule 1.18 – Duties to Prospective Client. Model Rule 1.18 provides that “[a] person who consults with a lawyer about the possibility of forming a client-lawyer relationship with respect to a matter is a prospective client.” While exceptions exist, an attorney generally cannot use or reveal information learned from a prospective client (Model Rule 1.18(b)) and cannot represent anyone with interests materially adverse to those of the prospective client if the information received from the prospective client could be significantly harmful to that prospective client. Model Rule 1.18(c). There is a fine line between confidential communications with a prospective client and informal communications that do not create a duty of confidentiality. (5) Rule 4.3 – Communicating With Unrepresented Parties. Model Rule 4.3 requires an attorney to correct any possible misunderstanding with unrepresented persons about the lawyer’s role in a matter. It also prohibits a lawyer from giving legal advice to an unpresented person “other than the advice to secure counsel, if the lawyer knows or reasonably should know that the interests of such a person are or have a reasonable possibility of being in conflict with the interests of [a client of the attorney].” If the attorney is representing a fiduciary and communicating with beneficiaries, the attorney should constantly remind the beneficiaries that they are not represented by the attorney. Communicating that clearly is more difficult in remote sessions. (6) Rule 5.1 – Supervising Subordinate Lawyers and Staff. Supervising subordinate employees is more difficult when all are working from home. Assure that staff and any outsourcing resources are using secure communication procedures. (7) Rule 5.5 – Multijurisdictional Practice. Under Rule 5.5(b) if an attorney is not admitted to practice in the state, the attorney cannot have a presence in the jurisdiction for the practice of law. What if the attorney is out of state at a vacation home and is working from that jurisdiction in representing clients in the home state, even though the attorney is not licensed in the vacation home state? This is probably not a big concern with bar associations. Rule 5.5(c) permits providing “legal services on a temporary basis” in certain cases, including situations “reasonably related to the lawyer’s practice in a jurisdiction in which the lawyer is admitted to practice,” but some states have not adopted that subsection or have altered it. The District of Columbia Court of Appeals issued an opinion applying the temporary exception to an attorney who is in the District because of the pandemic. Several cases (in Ohio and Oregon) have applied the temporary basis exception to attorneys awaiting acceptance to the bar of a new state under a reciprocal admission arrangement between states.

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Engagement Letters; Communications With Non-Clients. An attorney-client relationship should begin with a written engagement letter that clearly identifies the client (and in some situations, who is not the client) as well as the scope of the representation and other important matters.

Sample Letters. Written materials at the 55th Heckerling Institute have a number of excellent samples of letters for communicating with persons who are not clients that the attorney may have communications with, but whom the attorney does not represent. Examples include sample letters (i) about assets in a probate estate and about the administration process generally, (ii) forwarding a Receipt, Release, and Refunding Agreement at the conclusion of an estate administration, and (iii) for owners of a business where the attorney represents only the entity. There are also sample letters to a client whose legal fees are being paid by a parent and to the parent in that situation clarifying the attorney’s relationship to each party. Sample letters also address disclosing potential conflicts of interest (for example in spousal joint representations, in situations where an attorney represents multiple family members, and in representing co-fiduciaries).

Safeguarding Client Information. As discussed in Item 22.a(3) above, Model Rule 1.6(a) requires attorneys to safeguard confidential information. (1) ABA Formal Opinions. ABA Formal Opinion 11-459 states that a lawyer communicating with the client by email “ordinarily must warn the client about the risk of sending or receiving electronic communications … where there is a significant risk that a third party may gain access.” ABA Formal Opinion 477R addresses the requirement that a lawyer use reasonable efforts to prevent inadvertent or unauthorized access. It states that using unencrypted routine email generally constitutes an acceptable method of communication but is not always reasonable. It includes guidelines about reasonable efforts that should be taken with respect to technology and information security issues. ABA Formal Opinion 480 addresses confidentiality obligations for lawyer blogging and other public commentary. ABA Formal Opinion 483 discusses lawyers’ obligations after an electronic data breach or cyberattack. ABA Formal Opinions 11-459 and 477R both recommend informing clients about certain risks involved in electronic communications. Lawyers should consider including such a provision in engagement letters. The general approach of the ABA opinions is that security should be balanced with practicality. (2) Practical Tips Generally for Safeguarding Client Information.

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Appreciate the significance of the threat; information in client files is a treasure trove of sensitive information.

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Understand how client information is transmitted and stored; it is not enough to “let IT handle it.”

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Understand and use reasonable electronic security measures. Potential cybersecurity threats increase dramatically with remote work. Reasonable electronic security measures include using a virtual private network (VPN) on all devices, installing a security and antivirus system for the home network, keeping the home router updated and secure (consider updating it about every five years), changing password periodically, encrypting data, and relying on dual factor authentication.

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Label confidential information.

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Train layers and assistants in technology and information security.

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Conduct due diligence on vendors providing communication technology.

Practical Tips for Zoom or Other Remote Meetings.

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Understand the basics of video conferencing technology and how to set up virtual meetings, including protocols to avoid “zoom bombing.”

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Use up to date video conferencing software and security software.

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Clearly understand who is present in virtual meetings (including who is within hearing range).

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How secure is the conferencing platform?

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Use a password.

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Use a waiting room.

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Use a random meeting id number.

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Give the id number just to people invited to the meeting.

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All participants should have the Zoom app for Zoom calls (that is more secure).

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A recording of the Zoom meeting should be saved on the attorney’s own computer and not posted to the Zoom cloud.

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Weigh the amount of security needed based on the sensitivity of the conversation (and for really sensitive issues, use a landline telephone).

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For multi-party negotiations, do not use the private chat, for fear it may not be hidden from others. Have a telephone handy for private text messages.

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Don’t forget the mute button.

Practical Tips for Safeguarding Verbal Communications. •

When not in use, cover cameras and disable microphones.

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When working at home, be mindful of who may be within earshot of a family member that might waive the attorney-client privilege.

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Lawyer and clients should be aware of “what” might be listening (“Alexa” and her colleagues); disable self-listening devices altogether when speaking with clients.

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When appearing on video, make sure that confidential files related to other clients are not visible.

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To the extent possible avoid verbally communicating with clients in public places or using unsecured public WIFI networks.

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Stay up to date on current technology and cybersecurity developments.

Practical Tips for Safeguarding Written Communications. •

Model Rule 1.6(c) requires lawyers to use reasonable efforts to safeguard written communications from inadvertent disclosure.

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Inform clients of potential foreseeable breaches of electronic communications. For example, ABA Formal Opinion 11-459 states that if a client in an employment dispute uses her work computer for communications, the attorney should warn the client that her employer may access and review the client’s email communications, resulting in loss of the attorney-client privilege. (For highly sensitive matters, the attorney might advise the client to use a standalone personal email address and not use a work or shared email address.)

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In light of the foregoing comment, consider the email address that a client is communicating from.

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Written communications are virtually impossible to delete.

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Be careful about who is copied on written communications.

Safeguarding Electronic Files.

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Electronic files are “always there.”

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Electronic files are often stored in multiple places (the firm’s document management system, each lawyer’s individual desktop, in the “cloud,” or on flash drives). Each must be safeguarded.

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When providing documents to client electronically, emphasize the importance of storing documents in a safe place.

23. Consideration of Beneficiary’s Other Resources in Making Discretionary Distribution Decisions a.

Great Variance in Default Rules. If a trust instrument does not address whether a beneficiary’s outside resources should be considered in making distribution decisions, the traditional rule has been that a beneficiary’s other resources are not considered for support trusts, and was the position of the Restatement (Second) of Trusts: e. Trust for support. … It is a question of interpretation whether the beneficiary is entitled to support out of the trust fund even though he has other resources. The inference is that he is so entitled. It is a question of interpretation whether the trustee is authorized to pay the funeral expenses of the beneficiary. The inference is that he is so authorized. RESTATEMENT (SECOND) OF TRUSTS § 128, cmt. e (1992) (Reporter’s notes cite numerous cases holding that a beneficiary is entitled to distributions irrespective of other resources as well as contrary cases).

Eleven years later, the Restatement (Third) of Trusts changed positions, stating as a default rule that a beneficiary’s other resources should be considered: Significance of beneficiary’s other resources. It is important to ascertain whether a trustee, in determining the distributions to be made to a beneficiary under an objective standard (such as a support standard), (i) is required to take account of the beneficiary’s other resources, (ii) is prohibited from doing so, or (iii) is to consider the other resources but has some discretion in the matter. If the trust provisions do not address the question, the general rule of construction presumes the last of these. RESTATEMENT (THIRD) OF TRUSTS § 50, cmt. e (2003).

The Restatement (Third) also states in §60 that there should be no difference between a support trust and a discretionary trust as to this issue. Further statements in that comment of the Restatement (Third) are somewhat schizophrenic: Specifically, with several qualifications (below), the presumption is that the trustee is to take the beneficiary’s other resources into account in determining whether and in what amounts distributions are to be made, except insofar as, in the trustee’s discretionary judgment, the settlor’s intended treatment of the beneficiary or the purposes of the trust will in some respect be better accomplished by not doing so. … Another qualification is that, to the extent and for as long as the discretionary interest is intended to provide for the support, education, or health care of a beneficiary (or group of beneficiaries, Comment f) for periods during which a beneficiary probably was not expected to be self-supporting, the usual inference is that the trustee is not to deny or reduce payments for these purposes because of a beneficiary’s personal resources. (But contrast the effect of another’s duty to support the beneficiary, Comment e(3)).

Extensive comments and Reporter’s notes to section 50 of the Restatement (Third) of Trusts make clear that states have adopted varying default rules, and trust agreements should make the settlor’s intent clear as to this issue. See Michael J. Cenatiempo and Caroline S. Marciano, Discretionary Trusts Primer, TRUSTS & ESTATES, at 42 (Feb. 2008). Cases in 2019 and 2020 in Missouri and Nevada take opposite positions regarding the issue. The Missouri court in In re Potter Exempt Trust, 593 S.W.3d 556 (Mo. Ct. App. 2019), interpreted a provision directing the trustee to “use and apply so much of the net income of [the trust] as they may deem necessary or advisable to or for [the beneficiary’s] benefit” as creating a “need” trust. The court relied heavily on the Restatement (Third) position and concluded (somewhat inconsistently) that “the trustees have authority to examine [the beneficiary’s] other financial resources in making their decision regarding what is ‘necessary and advisable’ … [but] broad discretion granted to the trustees does not require them to do so.” In stark contrast, the Nevada Supreme Court held that a trustee was not required to consider other resources in light of the applicable Nevada statute and a www.bessemertrust.com/for-professional-partners/advisor-insights

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provision in another part of the trust instrument that other income or resources should be considered for other beneficiaries. In re Raggio Family Trust, 460 P.3d 969 (Nev. 2020). b.

Other Issues Even if Other Resources Should be Considered. Once a determination is made whether outside resources should be considered under the applicable state law, various other issues arise: •

What impact should the beneficiary’s other resources have on the distribution decision (for example, the trustee might be more liberal in making distributions in some situations if the trustee knows that the beneficiary will not have to rely on the trust for support, but if the beneficiary has no resources, the trustee might be more restrictive in making distributions so the trust will not be exhausted during the beneficiary’s lifetime);

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Should principal as well as income resources be considered; beneficiaries generally do not have to become impoverished before distributions may be made to them, see, e.g., Keisling v. Landrum, 218 S.W.3d 737 (Tex. App.–Fort Worth, 2007, no writ);

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What evidence of other resources should the trustee seek to document its due diligence in considering outside resources (examples include tax returns, bank and financial statements, or statements of assets prepared by the beneficiary)?

Planning Pointers. (1) Be Explicit. The drafter cannot be too explicit in stating whether outside resources should be considered. (2) Ascertaining Settlor’s Intent About Outside Resources Based on Particular Words in Distribution Standard is Unrealistic. Determining the settlor’s intent regarding outside resources from particular words used in the distribution standard (“may vs. shall,” “necessary vs. appropriate”) is unrealistic; as a practical matter, the wording of the distribution standard may simply be the drafter’s routine drafting convention. (3) Flexibility. In many situations, giving the trustee maximum flexibility in deciding whether to consider other resources and abilities will be desirable. For example, the trust agreement could provide that the trustee “may but need not” consider outside resources. (4) Discuss With Settlor. This issue should not just be standard boilerplate in trusts, but the planner should always discuss the issue with the settlor. The settlor must understand that if the trust requires the trustee to consider other resources, a knowledgeable trustee will ask for information about income each year (perhaps asking for the beneficiary’s Form 1040) and other information. This will likely be irksome to beneficiaries.

24. Planning for Non-U.S. Citizen Spouses This summary is based on a presentation by Michelle Graham and Michael Rosen-Prinz at the 55th Annual Heckerling Institute. a.

Marital Deduction. The default rule is that there is no marital deduction allowed if the surviving spouse is not a U.S. citizen. However, there are some exceptions to this rule. (1) Qualified Domestic Trust (“QDOT”). Under §2056(d)(2)(A), if the decedent spouse’s assets pass to a QDOT for the benefit of the surviving spouse, the marital deduction will be allowed. (2) Reformed Trust. If the decedent spouse’s assets pass to a trust for the benefit of the surviving spouse that otherwise qualifies for the marital deduction but for the provisions of §2056(d)(1)(A), such trust may be reformed after the decedent spouse’s death to meet the requirements of a QDOT. Reg. §20.2056A-4(a). Such a reformation may be made pursuant to the terms of the trust agreement or a judicial proceeding. A nonjudicial reformation must be completed by the time prescribed for filing the decedent spouse’s estate tax return. For purposes of determining this deadline, returns filed early are deemed to be filed on the due date for the return (including extensions), and late returns are deemed to be filed on the date actually filed. A judicial

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reformation must be commenced on or before the due date for the decedent spouse’s estate tax return (including extensions actually granted), regardless of the date the return is actually filed. Note that the judicial reformation need not be completed by such date, only commenced. (3) Transfer or Assignment to QDOT. Under §2056(d)(2)(B), property that passes from the decedent spouse to the surviving spouse outright may be treated as though it passed to a QDOT if such property is transferred or irrevocably assigned to a QDOT. Such transfer or assignment must be made “before the estate tax return is filed and on or before the last date prescribed by law that the QDOT election may be made.” Reg. §20.2056A-4(b)(1). (4) Assets That Cannot be Transferred or Assigned. In the event property is not transferable to a QDOT, such as certain retirement plans or annuities, the property may still be treated as passing in the form of a QDOT if certain requirements are met. Reg. §20.2056A-4(c). The following requirements must be met: (a) The surviving spouse must agree to pay the deferred tax due on the corpus portion of each payment received on an annual basis; (b) Form 706-QDT must be filed and tax payments must be made each April 15th following the year in which the surviving spouse receives a payment (with exceptions for the years of the decedent spouse’s death and the surviving spouse’s death); (c) The decedent spouse’s executor must file the Information Statement with the estate tax return; see Reg. §20.2056A-4(c)(5) for a description of the Information Statement; (d) The decedent spouse’s executor must file the Agreement to Pay Section 2056A Estate Tax with the estate tax return; see Reg. §20.2056A-4(c)(6) for a description of the Agreement; and (e) The decedent spouse’s executor must make an election under Reg. §20.2056A-3 for the property that cannot be transferred or assigned. In the event the surviving spouse does not wish to receive the payments outright, the surviving spouse may instead agree to roll over the corpus of each payment received to a QDOT within sixty days of receipt. Reg. §20.2056A-4(c)(3). (5) Spouse Becomes Citizen. Under §2056(d)(4) and Reg. §20.2056A-1(b), the marital deduction will be allowed if (i) the surviving spouse becomes a citizen before the estate tax return is filed for the decedent spouse’s estate and (ii) the surviving spouse was a U.S. resident at all times after the decedent spouse’s death. For purposes of determining this deadline, returns filed early are deemed to be filed on the due date for the return (including extensions), and late returns are deemed to be filed on the date actually filed. b.

QDOT Requirements and Taxation. (1) Requirements. Several requirements must be satisfied in order for a trust to qualify as a QDOT: (1) The trust must be an “ordinary trust” as defined in Reg. §301.7701-4(a); (2) the trust must be maintained under and the administration governed by the laws of a state of the United States or the District of Columbia; (3) the trust instrument must require at least one U.S. Trustee (either individual U.S. citizen or domestic corporation); (4) the trust instrument must provide that no corpus distribution may be made unless the U.S. Trustee has the right to withhold for the QDOT tax; (5) an irrevocable election must be made by the decedent spouse’s executor; and (6) the trust instrument must contain provisions to ensure collection of the QDOT tax. Reg. §20.2056A2. (2) Taxation. Under §2056A(b), a deferred estate tax is imposed upon the occurrence of a taxable event. The three main taxable events include: (1) any distribution of principal during the surviving spouse’s lifetime; (2) the death of the surviving spouse; and (3) the trust ceasing to qualify as a QDOT. Reg. §20.2056A-5(b).

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(3) Distributions Not Subject to QDOT Tax. Certain distributions can be made from the QDOT that will not be subject to the QDOT tax. (a) Income Distributions. Distributions of income (as defined in §643(b), except that income does not include capital gains) to the surviving spouse are not subject to the QDOT tax. Distributions made in accordance with local law that permits a right to income to be satisfied by a unitrust amount will be considered distributions of income for these purposes if such unitrust amount meets the requirements of Reg. §1.643(b)-1. Lastly, income does not include IRD under §691, and the method specified in Reg. §20.2056A-4(c) may be used for determining the allocation between income and corpus for such annuity payments. (b) Hardship Distributions. Distributions made to the surviving spouse for a substantial and immediate need relating to the health, education, maintenance, or support of the spouse or any person the spouse is legally obligated to support are not subject to the QDOT tax unless such amount could have been obtained from another reasonably available source. Reg. §20.2056A-5(c)(1). (c) Payment of Certain Expenses and Taxes. Reg. §20.2056A-5(c)(3) lists certain miscellaneous dispositions of trust assets that are exempt from the QDOT tax, including but not limited to the payment for ordinary and necessary expenses of the QDOT, payment of income taxes imposed on the QDOT, and sales of assets for full and adequate consideration. (d) Distributions After Spouse Becomes U.S. Citizen. Under §2056A(b)(12), if the surviving spouse becomes a U.S. citizen and meets other requirements, distributions of corpus from the QDOT will no longer be subject to the QDOT tax. c.

Hot Topics in International Tax and Estate Planning. (1) Substantial Presence Test. An individual will be considered a U.S. resident for tax purposes if the individual meets the substantial presence test under §7701(b)(3). To meet this test, the individual must be physically present in the U.S. on at least (1) 31 days during the current year and (2) 183 days during the three-year period that includes the current year and the two prior years, counting (a) all such days in the current year, (b) one-third of such days in the immediately preceding year, and (c) one-sixth of such days in the year before that. For purposes of the substantial presence test, an alien may exclude certain days from the calculation if the individual qualifies for the Medical Condition Exception. Revenue Procedure 2020-20 (released May 11, 2020) expanded the Medical Condition Exception to account for the pandemic, allowing certain individuals to exclude from the calculation up to sixty consecutive calendar days starting on or after February 1, 2020 and on or before April 1, 2020. (2) The Corporate Transparency Act (“CTA”). The CTA was enacted on January 1, 2021 and requires certain reporting companies to report their “beneficial owners” to Financial Crimes Enforcement Network (FinCEN), starting as of the effective date of the regulations, which must be promulgated by January 1, 2022. The goal of CTA is to prevent the use of shell companies to hide illegal activities; it is not directed toward large operating companies. The question remains whether trusts will be required to report under the CTA. Most trusts do not fall under the definition of “Reporting Companies” since they are not created pursuant to a filing with the secretary of state. However, it is possible that statutory trusts will be considered a “similar entity” as described in the definition and therefore covered. See Item 3 above. (3) Virtual Currency Reporting. FinCEN Notice 2020-2 was issued on December 31, 2020, acknowledging that the FBAR regulations do not include foreign accounts holding virtual currency as a type of reportable account under 31 CFR 1010.350(c). However, FinCEN intends to propose an amendment to the regulations to include virtual currency as a type of reportable account. The IRS believes there is rampant underreporting of taxes with virtual currency, and practitioners in this area believe there will soon be a tremendous amount of attention focused on it, similar to the resources dedicated to offshore accounts in the past.

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25. “Descendants”—Issues Arising from DNA Testing; Inheritance; Adoption The discussion in this Item is based on remarks by Sarah Johnson, who has also spoken at length previously at the Heckerling Institute and other courses regarding planning issues surrounding the definition of “descendants” in various contexts. See Sarah Moore Johnson, Sweet Child O’Mine: Planning for Parents of Minors, 53rd ANN. HECKERLING INST. ON EST. PL. (2019). Much of this summary is verbatim from her comments at the 2021 Heckerling Institute. a.

One-Set of Parents Rule, In re Estate of Heater. In re Estate of Heater, 466 P.3d 728 (Utah Ct. App. 2020), cert. granted, addresses the “one-set-of-parents” rule, established by the Uniform Parentage Act (UPA) that reflects the “adopted-treated-as-natural-born principle that also applies under most probate laws. Utah’s version is that upon adoption, an individual’s parentage becomes that of the adoptive parents and the individual’s relationship and entitlements and responsibilities to, from, and through the individual’s natural parents is severed. The case involves much family drama, both before and after the death of John Heater. Mr. Heater was a married man, with two children, a son and a daughter. Apparently, John had an affair with one of his employees who was also married and already had a child of her own. During the affair, the employee had a son, whom she named John Carlon, and John Heater sent the young John Carlon $100 every year on his birthday and paid for his nanny. John Carlon was raised by his mother’s husband, Mr. Carlon, whom everyone assumed to be his father. When Mr. Heater died intestate, his son and daughter were appointed co-personal representative, and they apparently fought about various things throughout the estate administration. In the eighth year after Mr. Heater’s death, with the probate still open, and the son reached out to John Carlon by social media and told him, I think you’re my brother. DNA testing confirms that John Carlon and the son were identified as half-siblings. Ancestry.com also revealed that John Carlon shared DNA with Mr. Heater’s mother’s relatives. John Carlon asserted his right as beneficiary of the estate, and Mr. Heater’s daughter strenuously objected. Complexities arose because Utah Code’s various definitions of children create an infinite loop of cross-reference. The probate code definition says that for purposes of intestate succession, an individual is the child of the individual’s natural (i.e., biological) parents, regardless of their marital status. It further states that the parent and child relationship may be established as provided in the Utah UPA. The UPA says that a child is the child of the man who was married to the child’s mother at the time of the child’s birth, and this definition applies unless another statute of the state expressly contravenes it. So, the probate code looks to the UPA, and the UPA looks to the probate code. As a result, John Carlon is either the son of Mr. Heater, his biological father, or he is the son of Mr. Carlon, his presumptive father, or maybe he is the son of both. The daughter argued that John cannot be the son of both, because Utah case law has developed a “one-set-of-parents” inheritance rule that prohibits a person from inheriting from two different fathers. The court says this one-set-of-parents rule only applies to adopted children, and the UPA is subordinate to the probate code, so using the probate code rule that biology prevails, John Carlon is a beneficiary of Mr. Heater’s estate. How the Utah Supreme Court reacts to this case will be interesting because we all know that the purpose of intestacy laws is to honor the probable intent of the decedent. Mr. Heater very likely would not have wanted his son and daughter to split their inheritance with John Carlon.

Pre-2008 Uniform Probate Code Approach. (1) Right of Child to Inherit From Genetic Parent. The Uniform Probate Code has not caught up to the problem of DNA test kits. For states that rely on the pre-2008 version of the UPC, a “natural parent” or “genetic parent” definition is used to establish the parent-child relationship, and the status of a child born out of wedlock can be proved through genetic testing. A genetic match creates a presumption of parentage that may be rebutted only by clear and convincing evidence. So, in pre-2008 UPC states, children of extramarital affairs and perhaps the biological offspring of sperm or egg donors can inherit from their biological parent. Some years ago, it was pretty common for guys in college to donate their sperm to raise beer money for parties. The news that

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their previously unknown offspring can easily track them down through DNA test kits and inherit from them is probably pretty shocking. The DNA test kit market has doubled in sales each year since 2015, and it is predicted that over 90 million kits will be sold in 2021 alone. That’s 90 million opportunities a year to find a surprise relative. Fertility clinics now make all parties sign a contract that terminates the donor’s parental rights, including the right of inheritance, but things were not quite as professional in the early days of reproductive science when fertility doctors would sometimes inject their own sperm into the mix without the patient’s knowledge to increase her odds of pregnancy. (2) Right of Genetic Parent to Inherit From Child. One bit of good news for pre-2008 UPC states, is that even though the biological child can inherit from the out of wedlock parent, the out of wedlock parent and his or her kindred cannot inherit “from or through” the biological child unless the parent has openly treated the child as his own and has not refused to support the child. (3) Rights of “Diblings” to Inherit From Each Other. The requirement that the parent acknowledge and not refuse to provide support in order for the parent or his family to inherit through the out-of-wedlock child means that test-kit discovered half-siblings would not inherit from one another if their common father had either not known of his paternity, or had known but kept it a secret, or had refused support. So that’s good. Especially when you hear about the prolific sperm donors who have fathered 100 to 200 children. Those sperm donor siblings, or “diblings” as they are called, would not all be able to inherit from one another as long as donor dad did not hold himself out as their father. c.

2008 Uniform Probate Code Approach. What about states that have adopted the 2008 and later versions of the UPC? The modern versions of the UPC recognize that the starting point of “natural” or “genetic” parent does not work when applied to children born of reproductive technology. These statutes now have complicated rules meant to include non-genetic intended parents and exclude genetic donors, surrogate mothers, diblings, and the like. But the modern UPC unfortunately dropped the abandonment language of the older statutes. This flaw allows half-siblings who unknowingly shared the same biological parent through extramarital affairs or prior marriages to inherit from one another, even if the parent had no knowledge of his paternity. Some of these states are Colorado, Maine, Montana, New Jersey, New Mexico, and North Dakota.

Drafting Pointers; Additional Resource. The point here, is that there is an urgent and increased need to make sure the definition of descendants in our wills and trusts have intent-based language that not only brings in children who have been equitably adopted by a family, but also excludes unknown descendants. For example, consider defining “descendant” to require that the ancestor designated openly acknowledged the child as his or her own and did not refuse to support such child. For an additional discussion of the inheritance issues arising from DNA testing (including inheritance rights of diblings) and estate planning issues from artificial reproduction technologies see Items 3135 of the ACTEC 2020 Annual Meeting Musings (March 2020) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights.

Adopted Child Not Limited to One-Set-of-Parents Rule, Rogers v. Pratt. There have also been some developments in the areas of adoption and inheritance. In Rogers v. Pratt, 467 P.3d 651 (Okla. 2020), a mother had reconnected with the son she gave up for adoption as an infant – the son had even lived with her for several months after his adoptive parents had died. The mom stated in her will that she had no children, and then expressly disinherited all other family members. The son asserted his rights as a pretermitted heir, took his case all the way to the Oklahoma Supreme Court, and won. But doesn’t adoption sever the right to inherit? Oklahoma is one of the five states (perhaps there are others as well) that expressly allows an adopted-out child to inherit from his or her biological parent, even though the biological parent cannot adopt through the adopted-out child. Those states are Kansas, Louisiana, Oklahoma, Rhode Island, and Texas. Also, Alaska, Illinois, and Maine provide for a

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continuation of inheritance rights between the adopted-out child and the genetic parents if it is so stated in the adoption decree. In these states, client questionnaires should ask whether the client has given up a child to adoption; if so, that child needs to be expressly disinherited if that is the client’s intent. f.

Stepchild and Adult Adoption Issues, Parris v. Ballantine. Parris v. Ballantine, 2020 WL 5740810 (Ala.), involved a dynasty trust created by a member of the DuPont family in 1971. This was THE DuPont family, so significant dollars were likely at stake. The Trust had divided into shares for children and then grandchildren, and eventually, one of the grandchildren, Aimee, found herself diagnosed with terminal cancer. She had no children but had helped raise her husband’s now-adult son. She adopted her stepson on her deathbed so that he would be the beneficiary of her trust, rather than allowing her trust to be added to her siblings’ shares. The trust definition of descendants made no reference to adoption, so Alabama law controlled. Like most states, Alabama adopted a statute in 1931 that allowed adopted children to be included as descendants of their adopted parents and ancestors for purposes of inheritance. But the Supreme Court noted that the statute’s use of the word “children” had been ruled in prior cases to include only those adopted as minor children. Further, at the time the trust was written in 1971, there was no legal mechanism for adult adoptions in Alabama; therefore, the court concluded that the adopted stepson was not a beneficiary of the trust.

Drafting Pointer for References to Adult Adoptions. Many planners use definitions of descendants that limit the inclusion of adopted children to those who were adopted prior to age 18, consistent with the Alabama statute. Ben Pruett (Bessemer Trust in Washington, D.C.) recommends increasing the age of adoption to 19 because there are many stepparents who want to adopt their stepchildren as minors, but are prevented from doing so by the biological parent, who could be a real jerk and refuse to terminate their parental rights out of spite. Increasing the age to 19 or 21 gives the family time to accomplish an adult adoption, which can no longer be contested by the biological parent. Since adopting that change, Sarah Johnson has seen this exact scenario play itself out in two different client matters, and she definitely recommends this change.

26. Planning Developments With Deemed Owner Trusts Under Section 678 a.

Grantor Trusts Overview. For a rather detailed discussion of grantor trusts, including powers and interests that trigger grantor trust treatment under §§674-677, beneficiary deemed owned trusts under §678, dividing partial grantor trusts, portion rules, toggling, sales to grantor trusts, and other uses and benefits of grantor trusts, see Items 11-23 of ACTEC 2016 Summer Meeting Musings (Including Fiduciary Income Tax “Bootcamp”) (September 2016), found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights and Item 23 of Heckerling Musings 2020 and Estate Planning Current Developments (August 2020) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights.

Creation of Beneficiary “Deemed-Owner” Trusts under Section 678. A person other than the grantor will be considered the owner of trust property under §678 in various ways, including these three alternatives – a (i) BDOT, (ii) BDIT, or (iii) QSST. (1) Beneficiary Defective Owned Trust (“BDOT”). Under Section 678(a)(1), “a person other than the grantor shall be treated as the owner of any portion of a trust with respect to which . . . such person has a power exercisable solely by himself to vest the corpus or the income therefrom in himself . . . .” If a beneficiary has the power to withdraw all the net taxable income from the trust which can be satisfied out of the entire accounting income, corpus, and/or proceeds of the corpus, such beneficiary will be considered the owner of trust property. Trusts with such provisions are commonly referred to as BDOTs. For a detailed discussion of the use of BDOTs, see Item 16 of the Estate Planning Current Developments Summary (December 2018) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. See also Edwin P. Morrow III, IRC Section 678(a)(1) and the Beneficiary Deemed Owner Trust (BDOT), LEIMBERG

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ESTATE PLANNING NEWSLETTER #2587 (September 5, 2017) (outstanding summary of technical issues; article has been updated various times through 2020; contact author for updated version). (2) Beneficiary Defective Inheritor’s Trust (“BDIT”). Under §678(a)(2), “a person other than the grantor shall be treated as the owner of any portion of a trust with respect to which . . . such person has previously partially released or otherwise modified [a §678(a)(1)] power and . . . retains such control” that would cause the grantor to be treated as the owner pursuant to §671 to §677. If a gift is made to a trust and the beneficiary is granted a withdrawal right over the entire contribution, such power will cause the beneficiary to be considered the owner pursuant to §678(a)(1). Once the withdrawal right lapses, if income of the trust may be distributed to the beneficiary, the beneficiary will continue to be considered the owner pursuant to §678(a)(2) in conjunction with §677(a). (One of the technical issues surrounding BDITs is that the “partial release or modification” of a withdrawal power arguably is not the same as the mere “lapse” of a withdrawal power; despite this argument, the IRS in a number of private letter rulings has treated the beneficiary as an owner of the trust with respect to lapsed withdrawal rights.) Trusts with such provisions are commonly referred to as BDITs. For a detailed discussion of the use of BDITs, see Item 31 of the Current Developments and Hot Topics Summary (December 2013) found here and Item 16.n. of the Estate Planning Current Developments Summary (December 2018) found here, both available at www.bessemertrust.com/for-professional-partners/advisor-insights. (3) Qualified Subchapter S Trust (“QSST”). Section 1361(d)(1)(B) provides that “for purposes of Section 678(a), the beneficiary of [a QSST] shall be treated as the owner of that portion of the trust which consists of stock in an S corporation . . . .” c.

Trust Treated as Deemed Owned Trust Under §678 Despite HEMS Standard; Beneficiaries/Trustees Did Not Pay Attention to HEMS Limitation. An ERISA case that turned on the ownership of various entities ignored trusts as separate taxpayers but treated them as being owned by the respective beneficiaries under §678 despite the fact that the beneficiaries’ power to withdraw income and principal of the trusts was limited by a health, education, maintenance, and support (“HEMS”) standard; the court disagreed because the HEMS limitation was not “dutifully followed.” United Food & Commercial Workers Unions v. Magruder Holdings, Inc., Case No. GJH-162903 (S.D. Md. March 27, 2019). For a more detailed discussion of this case (and a reference to a case with similar reasoning, SEC v. Wyly, 2014 WL 4792229 (S.D.N.Y. Sept. 25, 2014)), see Item17.c. of Estate Planning Current Developments and Hot Topics (December 2020) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights.

Trust Treated as §678 Trust as to Sale Transaction Because Beneficiary Could Withdraw Proceeds of Sale; Sale from §678 Trust to Grantor Trust Afforded Non-Recognition Treatment Under Rev. Rul. 85-13. PLR 202022002 addressed the sale from a trust (Trust 1) to an irrevocable grantor trust (Trust 2) that is a grantor trust as to A. In the ruling, Trust 1 prohibits a distribution of “Shares,” but allows for a distribution of the proceeds from the sale of the Shares, and because the beneficiary had reached age 40, the beneficiary could withdraw the proceeds of the sale. A Subtrust of Trust 1 agreed to sell an LLC that held the Shares (the only asset of the Trust 1 Subtrust) to Trust 2 in return for cash and a promissory note. The IRS reasoned that the Trust 1 Subtrust was treated as owned by A under §678 for purposes of the sale even though A could only withdraw the proceeds of the sale and not the Shares or LLC prior to the sale. (This was somewhat similar to the situation in Rev. Rul. 85-13, in which a trust was treated as a grantor trust with respect to a sale to the grantor for an unsecured promissory note, which was treated as a borrowing by the grantor that triggered §675(3).) No ruling or case has previously addressed whether non-recognition treatment under the reasoning of Rev. Rul. 85-13 would be applied to transactions between a §678 trust and the beneficiary-deemed owner of the §678 trust. This ruling does not directly address that issue, but analogously ruled that “the transfer of the LLC interests to Trust 2 is not recognized as a sale for federal income tax purposes because Trust 2 and Subtrust are both wholly owned by A.”

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The ruling’s reasoning for applying Rev. Rul. 85-13’s non-recognition treatment to this §678 situation is as follows: Rev. Rul. 85-13 states that although A did not engage in a direct borrowing of the Corporation Z shares, A’s acquisition of the T corpus in exchange for the unsecured note was, in substance, the economic equivalent of borrowing trust corpus. Accordingly, under § 675(3), A was treated as owner of the portion of T represented by A’s promissory note. Further, because the promissory note was T’s only asset, A was treated as owner of the entire trust. Moreover, because A was considered owner of the promissory note held by the trust, the transfer of the Corporation Z shares by T to A was not recognized as a sale for federal income tax purposes because A was both the maker and owner of the promissory note. Citing Dobson v. Commissioner, 1 B.T.A. 1082 (1925), the ruling states that a transaction cannot be recognized as a sale for federal income tax purposes if the same person is treated as owning the purported consideration both before and after the transaction.

Overview of Section 2036 Issues. The most litigated transfer tax issue is whether assets contributed to an FLP/LLC should be included in the estate under §2036 (without a discount for restrictions applicable to the limited partnership interest). About 39 reported cases have arisen. The cases seem to be decided largely on a “smell test” basis. (1) Bona Fide Sale for Full Consideration Defense. The bona fide sale for full consideration defense is the key for defending both §2036(a)(1) and §2036(a)(2) cases. Almost every one of these cases that the taxpayer has won was based on the bona fide sale for full consideration exception to §2036. The three exceptions are Kelly, Mirowski, and Kimbell (at least as to some assets). See Item 28.f below. (a) Bona Fide Sale Test – Legitimate and Significant Nontax Reason. The key is whether “legitimate and significant nontax reasons” existed for using the entity, as announced in Bongard v. Commissioner, 124 T.C. 95 (2005). Having tax reasons for creating entities is fine; the test is whether “a” legitimate and significant nontax reason applied as well. The tax purposes are not weighed against the nontax purposes. For a listing (with case citations) of factors that have been recognized in particular situations as constituting such a legitimate nontax reason, see Item 8.g. of the Current Developments and Hot Topics Summary (December 2016) found here and available at www.bessemertrust.com/for-professionalpartners/advisor-insights. Also, make sure that other planning is consistent with the purposes of the partnership. Consider documenting the nontax reasons. Contemporaneous evidence really helps satisfy

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the court. John Porter has tried a number of §2036 cases that have gone to decision and in every one the estate planning lawyer testified and in some the CPA testified as well. If the estate planning attorney testifies, the client will have to waive the attorney-client privilege. The taxpayer is willing to do that because the taxpayer has the burden of proof to establish a legitimate and significant nontax reason. The estate planning attorney’s files can significantly help (or hurt) at trial. (b) Full Consideration Test. To satisfy the full consideration requirement, as described in Bongard, the interest received by the parties making contribution to the entity should be proportionate to their contributions, and the value of contributed property should be credited to capital accounts. This must be done when the entity is created. On liquidation the owners will receive their proportionate interest in the partnership based on the capital accounts. (2) Section 2036(a)(1). The IRS typically argues that assets should be included under §2036(a)(1) as a transfer to the FLP/LLC with an implied agreement of retained enjoyment. The government wins about 2/3 of those cases. (In some of those cases, the FLP/LLC assets have been included in the estate under §2036 even though the decedent had transferred the partnership interests during life (Harper, Korby).) Agreement of Retained Enjoyment. If the bona fide sale for full consideration exception does not apply, the IRS must still establish an implied agreement of retained enjoyment in the assets that were transferred to the partnership or LLC. For a summary list (with case citations) of factors that suggest an implied agreement retained enjoyment, see Item 8.g. of the Current Developments and Hot Topics Summary (December 2016) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. (3) Section 2036(a)(2). In a few cases, the IRS has also made a §2036(a)(2) argument, that the decedent has enough control regarding the FLP/LLC to designate who could possess or enjoy the income or property contributed to the entity. Two cases have applied §2036(a)(2) where the decedent had some interest as a general partner (Strangi and Turner), and one case applied §2036(a)(2) when the decedent held merely a limited partnership interest (Powell, as discussed in Item 28.c.(1) below). (a) Possible Defenses Even as General Partner. The Tax Court in Cohen (79 T.C. 1015 (1982)) said that being co-trustee of a Massachusetts business trust does not necessarily require inclusion under §2036(a)(2) if cognizable limits on making distributions apply rather than a situation in which trustees could arbitrarily and capriciously withhold or make distributions. Traditionally, planners have relied on the Byrum Supreme Court case for the proposition that investment powers are not subject to §2036(a)(2). As discussed in Strangi, §2036(a)(2) applies even if the decedent is just a co-general partner or manager, but as a practical matter, the IRS does not view co-manager situations as critically as if the decedent was the sole manager. Having co-managers also typically helps support the nontax reasons for the partnership or LLC. (b) Overview of Powell and Cahill. Powell (discussed in Item 28.c.(1) below) and Cahill (discussed in Item 28.c.(2) below) add a significant additional risk under §2036(a)(2), based on whether the decedent could act with third parties to undo whatever is causing a discount. The focus seems to be on the ability to join with others to cause a liquidation of an entity (or termination of an agreement, as in Cahill), and would seem to extend to the ability to join with others in amending documents to permit liquidation or termination. (The ability to amend the partnership agreement without consent of limited partners was one of the factors that the court mentioned in Turner I for applying §2036(a)(2)). One possible response is to provide in the underlying agreements that the decedent owns a class of interest that does not permit joining with others to liquidate the entity or amend the agreement. Query whether the absence of a right to vote on liquidation or amendment would be a §2703 restriction that is ignored under the Cahill reasoning?

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Other cases have limited the broad application of the “in conjunction with” argument relied on in Powell and Cahill. (See Item 28.e below for a discussion of the Helmholz, Tully, and Bowgren cases.) The taxpayer in Morrissette made these arguments, but the court determined that §2036 did not apply because of the bona fide sale for full consideration exception, as discussed in Item 39.c-d below. (c) IRS Agents Are Making the Powell Argument. John Porter tried Estate of Wittingham v. Commissioner in February 2018. The case was ultimately settled, but the IRS made the Powell argument with respect to an LLC created by the decedent, in which the decedent and her two sons were the managing members and held the Class A units with voting rights. The case involved the sale of units in return for a private annuity even though the decedent had just found out that she had pancreatic cancer. The case ultimately settled with the taxpayer conceding that some prior purported loans were gifts and conceding about 20% of the private annuity issue because of uncertainty about some medical issues. (4) Some Relatively Recent §2036 Cases. For a detailed summary of some §2036 cases (other than Powell) over the last six years (Purdue, Holliday, and Beyer cases), and a planning checklist for structuring the proper formalities for FLPs and LLCs, see Items 10 and 29 of the Current Developments and Hot Topics Summary (December 2016) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. b.

Overview of Other Issues – §2703 and Indirect Gift. Other issues that the IRS sometimes raises in audits regarding FLP/LLCs are (1) whether specific restrictions in partnership agreements should be ignored for tax purposes under §2703 (see Holman, Fisher II, and Kress, and §2703 is discussed in the context of intergenerational split dollar situations in Cahill and Morrissette)) and (2) whether contributions to an FLP/LLC immediately followed by gifts of interests in the entity should be treated as indirect gifts of the underlying assets of the entity (see Holman, Gross, Linton, and Heckerman).

FLP Assets Includable under §2036(a)(2) – Powell, Cahill, and Morrissette. (1) Synopsis of Estate of Powell. Estate of Powell v. Commissioner, 148 T.C. 392, is a “reviewed” Tax Court decision that may be the most important Tax Court case addressing FLPs and LLCs since the Bongard case 15 years ago. The Tax Court breaks new ground (1) in extending the application of §2036(a)(2) to decedents owning only limited partnership interests, and (2) in raising the risk of double inclusion of assets under §2036 and a partnership interest under §2033, which may (in the court’s own words) result in “duplicative transfer tax.” (The case was decided on cross motions for summary judgement and is not an opinion following a trial.) The facts involve “aggressive deathbed tax planning,” and the fact that the taxpayer lost the case is no surprise. But the court’s extension of the application of §2036(a)(2) and the extensive discussion of possible double inclusion for assets contributed to an FLP or LLC were surprising (but whether a majority of the judges would apply the double-inclusion analysis is not clear). The “plurality” and concurring opinions both agreed that §2036(a)(2) applied (though the concurring opinion did not address the reasoning for applying §2036(a)(2)). The plurality opinion reasoned (1) that the decedent, in conjunction with all the other partners, could dissolve the partnership, and (2) that the decedent, through her son as the GP and as her agent, could control the amount and timing of distributions. The opinion adopted the analysis in Strangi regarding why the “fiduciary duty” analysis in the Supreme Court Byrum case does not apply to avoid inclusion under §2036(a)(2) under the facts of this case. The court held that any such fiduciary duty here is “illusory.” The §2036(a)(2) issue is infrequently addressed by the courts; it had been applied with any significant analysis only in four prior cases (Kimbell and Mirowski [holding that §2036(a)(2) did not apply], and Strangi and Turner [holding that §2036(a)(2) did apply]). In both Strangi and Turner, the decedent was a general partner (or owned a 50% interest in the corporate general partner). Powell is the first case to apply §2036(a)(2) when the decedent owned merely a limited partnership interest. In this case the decedent owned a 99% LP interest, but the court’s analysis drew no distinction between owning a 99% or 1% LP interest; the court reasoned that

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the limited partner “in conjunction with” all the other partners could dissolve the partnership at any time. The combination of applying §2036(a)(2) even to retained limited partnership interests and the risk of “duplicative transfer tax” on future appreciation in a partnership makes qualification for the bona fide sale for full consideration exception to §§2036 and 2038 especially important. In one respect, this means that Powell does not reflect a significant practical change for planners, because the §2036 exception has been the primary defense for any §2036 claim involving an FLP or LLC. For excellent discussions of the Powell case, see Todd Angkatavanich, James Dougherty & Eric Fisher, Estate of Powell: Stranger Than Strangi and Partially Fiction, TR. & ESTS. 30 (Sept. 2017) and Mitchell M. Gans & Jonathan G. Blattmachr, Family Limited Partnerships and Section 2036: Not Such a Good Fit, 42 ACTEC L.J. 253 (Winter 2017). For a detailed discussion of the facts and court analysis in and planning implications of Powell, see Item 15.g. of the Current Developments and Hot Topics Summary (December 2017) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. (2) Synopsis of Estate of Cahill and Settlement. In Estate of Cahill v. Commissioner, T.C. Memo. 2018-84 (Judge Thornton), the decedent’s revocable trust had advanced $10 million to an irrevocable trust under a split dollar agreement for the trust to purchase life insurance policies on the lives of the decedent’s son and his wife. The estate valued the estate’s right eventually to be reimbursed for its advances at only $183,700, because of the long period of time before the policies would mature at the insureds’ deaths. The IRS argued, among other things, that the reimbursement right should have a value equal to the full cash surrender value of the policies (about $9.6 million) in part because of §§2036, 2038, and 2703. The court rejected the estate’s motion for a partial summary judgment that §§2036(a)(2), 2038(a)(1), and 2703(a) did not apply and that Reg. §1.61-22 applied in valuing the decedent’s reimbursement rights. The court reasoned that §§2036(a)(2) and 2038(a)(1) could apply because the decedent, in conjunction with the irrevocable trust, could agree to terminate the split dollar plan and the decedent would have been entitled to the cash surrender value of the policies (without waiting until the insureds’ deaths), and because the advance of the premiums in this situation was not a bona fide sale for full and adequate consideration. (The court cited its recent decision in Powell v. Commissioner.) In addition, the court in Cahill concluded that §2703(a) applies, to disregard the irrevocable trust’s ability to prevent an early termination of the agreement in valuing the reimbursement right, because the provision preventing the decedent from immediately withdrawing his advance was an agreement allowing the third party to acquire or use property at a price less than fair market value (§2703(a)(1)), and because the agreement significantly restricted the decedent’s right to use his “termination rights” under the agreement (§2703(a)(2)). The estate tax audit was settled on August 16, 2018, with the estate conceding all the issues regarding the intergenerational split dollar arrangement (agreeing that the value of the decedent’s reimbursement right was the $9.6 million cash surrender value of the policies) and the imposition of a 20% accuracy-related penalty under §6662; the IRS conceded regarding the value of certain notes from family members unrelated to the split dollar transaction. For a more detailed summary of the Cahill case (including ramifications of its §2703 analysis) see Item 13 of Estate Planning Current Developments and Hot Topics (December 2019) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. (3) Tax Court Follows Same Position in Estate of Morrissette v. Commissioner. The initial case in Estate of Morrissette v. Commissioner, 146 T.C. 171 (2016), determined that the economicbenefit regime applies to the split dollar arrangement in that case. The IRS made arguments under §§2036, 2038, and 2703, similar to its arguments in Cahill.

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The taxpayer’s Memorandum in support of its motion that §§2036, 2038, and 2703 do not apply emphasized the prior cases that have limited the broad application of the “in conjunction with” clause to rights already provided by state law. The Memorandum made strong arguments regarding (1) cases that applied outer limits in applying the “in conjunction with” phrase in §2038 and (2) that the restriction on the trust’s right unilaterally to terminate the split dollar agreements is provided under common law and is not a basis for applying §2703. Excerpts from the Memorandum are quoted at length in Item 13.c.(6) of Estate Planning Current Developments and Hot Topics (December 2019) found here and available at www.bessemertrust.com/forprofessional-partners/advisor-insights. The court entered an Order dated February 19, 2019 denying the taxpayer’s motions for summary judgment that §§2036(a)(2), 2038(a)(1), and 2703(a) do not apply, reasoning merely that Estate of Cahill “is directly on point” regarding §§2036(a)(2) and 2038(a)(1). The court ultimately held that the bona fide sale for full consideration exception to §2036 and 2038 and the §2703(b) safe harbor applied, and the court valued the estate’s reimbursement right, T.C. Memo. 2021-60 (May 13, 2021), discussed in Item 39.c-f below. For a much more detailed discussion of the Morrissette developments before the 2021 opinion, see Item 13 of Estate Planning Current Developments and Hot Topics (December 2019) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. (4) Significant Extension of Application of §2036(a)(2) to Retained Limited Partnership Interests and Conceivably Other Co-Ownership Situations. As noted above, Powell is the first case to apply §2036(a)(2) when the decedent owned merely a limited partnership interest. The net effect is that, under the Powell reasoning, §2036 conceivably will apply to almost all FLPs/LLCs, whether or not the client retains a general partner or managing member interest, unless the bona fide sale for full consideration exception to §2036 applies. Furthermore, the same reasoning would seem to apply to a contribution to practically any enterprise or investment involving other parties. For example, interests in C corporations, S corporations, or undivided interests in real estate would be subject to the same reasoning that the decedent could join with the other shareholders/co-owners (perhaps even if unrelated?) and dissolve the entity/coownership, with all parties receiving their pro rata share of the assets. d.

What to Do? Planning in Light of Powell. (1) Overview of Planning Alternatives. Planning alternatives for avoiding inclusion under §2036 (and in particular, §2036(a)(2)) in light of Powell and Cahill include the following: •

No revocable transfers;

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Avoid transfers under a power of attorney;

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Satisfy the bona fide sale for full consideration exception;

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Transfer all voting rights, including power to amend or revoke the agreement;

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Eliminate unanimous partner approval requirement for dissolution (which was present in Powell);

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Avoid having the decedent or decedent’s agent as general partner of an FLP;

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Provide for slicing and dicing of voting rights and manager powers (discussed in more detail below);

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No participation in removal of managers unless replacement must be not related or subordinate to the donor;

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Use trusts as owners of entity interests with an independent trustee;

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Transfer all interests during life; and

•

“Claim victory” and dissolve the FLP/LLC following prior successful transfers.

For a more detailed discussion of these and other planning steps in light of Powell, see Item 19.d. of Estate Planning Current Developments and Hot Topics (December 2020) found here www.bessemertrust.com/for-professional-partners/advisor-insights

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and Item 15.g. of the Current Developments and Hot Topics Summary (December 2017) found here, both available at www.bessemertrust.com/for-professional-partners/advisor-insights. (2) Slicing and Dicing of Voting Rights. If the donor retains any voting rights, create classes of voting rights. For example Class A limited partners and members would possess full voting rights normally provided to limited partners or members, and Class B limited partners or members (including the donor) could vote on all matters other than (a) the liquidation or dissolution of the entity, (b) distributions from the entity, (c) the right to approve a proposed transfer of an interest in the entity, or (d) the amendment of the entity agreement in a way that would alter any of those restrictions. (3) Limiting Donor’s Powers as Manager of LLC or as General Partner of Limited Partnership. (a) Distribution Decisions. If the donor will continue to be a general partner or hold an interest in a general partner or will be the manager of an LLC, limit the donor from having the right to participate in any distribution decisions. For example, use a separate “distribution general partner” or “distribution manager” who has exclusive authority over decisions about when the entity would make distributions to its owners. If the donor insists on participating in distribution decisions, §2036 and §2038 should not apply if distributions decisions are subject to a definite standard that is specific enough that it can be enforced by a court (based on old cases under §2036 and §2038). Consider providing that Class A limited partners or a “special general partner” or “special manager” (other than the donor) must consent to establishing reasonable reserves (at least for more than a baseline established in a budget that is approved from time to time by all the partners). (b) Investment and Management Decisions. There are strong arguments that investment and administrative powers held by the donor as a general partner (or manager of an LLC) should not trigger estate inclusion under §2036 or §2038. See, e.g., Estate of Ford v. Commissioner, 53 T.C. 114 (1969), nonacq. 1978-2 C.B. 3, aff’d per curiam, 450 F.2d 878 (2d Cir. 1971) (“the power to invest in 'nonlegals' (i.e., investments not classified under a particular State law or ruling of the pertinent court as legal investments for trust funds) and the power to sell or exchange the trust property do not amount to a right to designate who shall enjoy the trust property or a right to alter, amend, or revoke the terms of the trust”); United States v. Powell, 307 F.2d 821 (10th Cir. 1962) (trustee-grantor had power to invest assets as he deemed “most advisable for the benefit of the trust estate”; held that trustee’s acts were subject to review by a court of equity and did not invoke the predecessor to §2038); Estate of Graves v. Commissioner, 92 T.C. 1294, 1302-03 (1989) (“Even if the decedent had the power to direct the investment of the trust property, this power would not constitute a power to alter, amend or revoke because she would have effectively been a trustee. As a trustee, she would have had to act in good faith, in accordance with her fiduciary responsibility, and safeguard and conserve the trust principal.”); Estate of King v. Commissioner, 37 T.C. 973 (1962), nonacq. 1963-1 C.B. 5 (grantor had the right to direct the trustee regarding investment of trust assets, but the court reasoned that “the grantor had in effect made himself a fiduciary” and held that there was “no retained right or power in the decedent to divert any of the corpus to the income beneficiaries or to divert any income to the remaindermen”). The key under these cases is the existence of a fiduciary duty that a court can supervise and ensure that the fiduciary will act impartially. See Estate of Bowgren v. Commissioner, 105 F.3d 1156 (7th Cir. 1997) (absence of fiduciary duty by donor to donee who received an assignment of an interest in a land trust caused §§2036(a)(2) and 2038 to apply). Despite this strong authority, some planners are reluctant, considering the Powell and Cahill broad “in conjunction with” reasoning, to allow a donor to serve as manager of an LLC with management authority regarding investment decisions. Conceivably, the IRS might argue that the donor could make investments in non-income-producing assets that would deprive the entity of any cash flow to make distributions to the owners, and therefore retain the ability to designate who shall possess or enjoy the property or the income therefrom (§2036(a)(2)) or alter, amend, revoke, or terminate enjoyment of the property (§2038(a)(1)). Bear in mind that www.bessemertrust.com/for-professional-partners/advisor-insights

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§2038 is triggered by the mere ability to affect the timing of enjoyment of the property even though the identity of the beneficiary is not affected, Reg. §20.2038-1(a), and §2038 is based on powers that exist at death rather than powers that are retained at the time of the transfer. Even if the transfer is to a trust with an independent trustee that is a member of the entity, if the donor serves as a manager of or in some other management position with the entity, the IRS could possibly argue under Powell that the donor’s authorities “in conjunction with others” could impact beneficial enjoyment of the transferred assets. Because of these concerns, if the donor makes a gift of an interest in the entity, some respected planners structure the entity to avoid having the donor as a general partner or manager or limit the donor’s authority as manager or other management position to participate in “tax-sensitive” activities. Diana Zeydel (Miami, Florida) has noted the possibility of limiting the donor’s authority as manager with respect to decisions, approvals, or consents relating to various potentially tax sensitive activities such as distributions, allocations to reserves, determining the fair market value of interests, making loans to or guarantees of loans of any entity owner, withdrawal or resignation of any owner, dissolution or liquidation of the entity, any incident of ownership in any life insurance policy on the life of any entity owner, voting the stock of any “controlled corporation” as described in §2036(b), or an amendment of the governing instruments with respect to any of those matters. If the donor merely makes a sale of an interest in an entity (and does not make a gift), planners may still encourage the appointment of a distribution officer and a liquidation officer to be safe and just let the donor manage the assets. Other respected planners are not as concerned with the donor serving as the manager of an LLC with authority over LLC investments, especially if the owners of the entity are family trusts with independent trustees. They believe that only the independent trustee of the trust can control the beneficiary’s enjoyment of the gifted asset, and the LLC manager has a fiduciary duty to the LLC members a la the Supreme Court’s fiduciary duty analysis in United States v. Byrum; therefore it is the trustee of the trust and not the grantor as manager who controls the income and distribution spigot to the recipients of the gifted property. e.

Prior Cases That Have Limited the Broad Application of the “in Conjunction with” Phrase in §§2036 and 2038. Section 2036(a)(2) was enacted with almost identical “in conjunction with” statutory language as in §2038. Several cases have limited the application of the “in conjunction with” provision in determining whether §2038 applied. E.g., Helvering v. Helmholz, 296 U.S. 93 (1935), aff’g 75 F.2d 245 (D.C. Cir. 1934) (power in a trust agreement to terminate the trust with the consent of all beneficiaries was not a power to revoke, alter, or amend the trust in conjunction with others because state law conferred the right to terminate a trust with the consent of all beneficiaries, and the trust provision “added nothing to the rights which the law conferred”); Tully Estate v. Commissioner, 528 F.2d 1401 (Ct. Cl. 1976) (“Congress did not intend the ‘in conjunction’ language of section 2038(a)(1) to extend to the mere possibility of bilateral contract modification”); Estate of Bowgren v. Commissioner, T.C. Memo. 1995-447, rev’d and remanded on other grounds, 105 F.3d 1156 (7th Cir. 1997) (ability of decedent to have terminated or modified the beneficial interests of children was with the unanimous consent of the children and “[s]uch a power is not a retained power under section 2036(a)(2), see Stephens, Maxfield, Lind & Calfee, Federal Estate and Gift Taxation 4148 n.52 (6th ed. 1991), and is a power to which section 2038(a) does not apply, see sec 20.20381(a)(2)”). For further discussion of these cases, see Item 19.e. of Estate Planning Current Developments and Hot Topics (December 2020) found here and available at www.bessemertrust.com/forprofessional-partners/advisor-insights.

Summary of §2036 FLP/LLC Cases (14-23, with 2 on Both Sides). Of the various FLP/LLC cases that the IRS has chosen to litigate, 14 have held that at least most of the transfers to an FLP/LLC qualified for the bona fide sale exception —

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(1) Church v. United States, 2000-1 USTC ¶60,369 (W.D. Tex. 2000) (preserve family ranching enterprise, consolidate undivided ranch interests); (2) Estate of Eugene Stone v. Commissioner, T.C. Memo. 2003-309 (partnerships to settle family hostilities); (3) Kimbell v. United States, 371 F.3d 257 (5th Cir. 2004), vacating and rem’g 244 F. Supp. 2d 700 (N.D. Tex. 2003) (“substantial business and other nontax reasons” including maintaining a single pool of investment assets, providing for management succession, and providing active management of oil and gas working interests); (4) Bongard v. Commissioner, 124 T.C. 95 (2005) (placing ownership of closely held company in a single entity for purposes of shopping the company by a single seller rather than by multiple trusts); (5) Estate of Schutt v. Commissioner, T.C. Memo. 2005-126 (maintaining buy and hold investment philosophy for family du Pont stock); (6) Estate of Mirowski v. Commissioner, T.C. Memo. 2008-74 (joint management and keeping a single pool of assets for investment opportunities); (7) Estate of Miller v. Commissioner, T.C. Memo. 2009-119 (continue investment philosophy and special stock charting methodology); (8) Keller v. United States, 2009-2 USTC ¶60,579 (S.D. Tex. 2009) (protect family assets from depletion in divorces); (9) Estate of Murphy v. United States, No. 07-CV-1013, 2009 BL 223971 (W.D. Ark. Oct. 2, 2009) (centralized management and prevent dissipation of family “legacy assets”); (10) Estate of Black v. Commissioner, 133 T.C. 340 (2009) (maintaining buy and hold investment philosophy for closely held stock); (11) Estate of Shurtz v. Commissioner, T.C. Memo. 2010-21 (asset protection and management of timberland following gifts of undivided interests); (12) Estate of Joanne Stone v. Commissioner, T.C. Memo. 2012-48 (desire to have woodland parcels held and managed as a family asset and various other factors mentioned); (13) Estate of Kelly v. Commissioner, T.C. Memo. 2012-73 (ensuring equal estate distribution, avoiding potential litigation, and achieving effective asset management); and (14) Estate of Purdue v. Commissioner, T.C. Memo. 2015-249 (centralized management and other factors). (In the context of intergenerational split dollar life insurance scenario rather than an FLP/LLC, situation, Estate of Morrissette held that the bona fide sale for full consideration exception applied, and Estate of Cahill held that it did not apply on the facts of those cases.) Three cases (Kelly, Mirowski, and Kimbell) held that §2036 did not apply (at least for some assets) without relying on the bona fide sale for full consideration exception. All the FLP cases resulting in taxpayer successes against a §2036 attack have relied on the bona fide sale exception to §2036 except Kelly, Mirowski, and Kimbell. Kelly relied on the bona fide sale exception to avoid treating the contributions to partnerships as transfers triggering §2036, but reasoned that no retained enjoyment existed under §2036(a)(1) regarding gifts of limited partnership interests [that obviously did not qualify for the bona fide sale for full consideration exception]. Mirowski similarly relied on the bona fide sale exception with respect to contributions to the partnership, but not as to gifts of partnership interests. Kimbell relied on the bona fide sale for full consideration exception for transfers to a partnership, but for other transfers to an LLC, the Fifth Circuit refused to apply §2036 (the particular issue was about §2036(a)(2)) without addressing whether the bona fide sale for full consideration exception applied to those transfers. Interestingly, six of those 14 cases have been decided by (or authored by) two Tax Court judges. Judge Goeke decided the Miller, Joanne Stone, and Purdue cases and authored the Tax Court’s www.bessemertrust.com/for-professional-partners/advisor-insights

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opinion in Bongard. Judge Chiechi decided both Stone and Mirowski. (Judge Wherry decided Schutt, Judge Halpern decided Black, Judge Jacobs decided Shurtz, Judge Foley decided Kelly, and Church and Kimbell were federal district court opinions ultimately resolved by the Fifth Circuit. Keller and Murphy are federal district court cases.) Including the partial inclusion of FLP/LLC assets in Miller and Bongard, 23 cases have applied §2036 to FLP or LLC situations: Estate of Schauerhamer v. Commissioner, T.C. Memo. 1997242, Estate of Reichardt v. Commissioner, 114 T.C. 144 (2000), Estate of Harper v. Commissioner, T.C. Memo. 2002-121, Thompson v. Commissioner, T.C. Memo. 2002-246, aff’d, 382 F.3d 367 (3d Cir. 2004), Estate of Strangi v. Commissioner, T.C. Memo. 2003-15, aff’d, 417 F.3d 468 (5th Cir. 2005), Estate of Abraham v. Commissioner, T.C. Memo. 2004-39, Estate of Hillgren v. Commissioner, T.C. Memo. 2004-46, Estate of Bongard v. Commissioner, 124 T.C. 95 (2005) (as to an LLC but not as to a separate FLP), Estate of Bigelow v. Commissioner, T.C. Memo. 2005-65, aff’d, 503 F.3d 955 (9th Cir. 2007), Estate of Edna Korby v. Commissioner, T.C. Memo. 2005-102, aff’d, 471 F.3d 848 (8th Cir. 2006), Estate of Austin Korby v. Commissioner, T.C. Memo. 2005-103, aff’d, 471 F.3d 848 (8th Cir. 2006), Estate of Rosen v. Commissioner, T.C. Memo. 2006-115, Estate of Erickson v. Commissioner, T.C. Memo. 2007-107, Estate of Gore v. Commissioner, T.C. Memo. 2007-169, Estate of Rector v. Commissioner, T.C. Memo. 2007-367, Estate of Hurford v. Commissioner, T.C. Memo. 2008-278, Estate of Jorgensen v. Commissioner, T.C. Memo. 2009-66, aff’d, 431 Fed. Appx. 544 (9th Cir. 2011), Estate of Miller v. Commissioner, T.C. Memo. 2009-119 (as to transfers made 13 days before death but not as to prior transfers), Estate of Malkin v. Commissioner, T.C. Memo. 2009-212, Estate of Holliday v. Commissioner, T.C. Memo. 2016-51, Estate of Beyer v. Commissioner, T.C. Memo. 2016-183, Estate of Powell v. Commissioner, 148 T.C. 392 (2017), and Estate of Moore v. Commissioner, T.C. Memo. 202040. In addition, the district court applied §2036 in Kimbell v. United States but the Fifth Circuit reversed. g.

Review of Court Cases Valuing Partnership Interests. Despite the many cases that have addressed the applicability of §2036 to limited partnership or LLC interests, fewer cases have actually reached the point of valuing partnership interests. John Porter, an attorney in Houston, Texas who has litigated many of the family limited partnership cases, summarizes discounts that have been allowed by the courts in FLP/LLC cases as follows (the Streightoff, Estate of Jones, Grieve, and Nelson case results have been added to the table):

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Case

Assets

Court

Strangi I Knight Jones Dailey Adams Church McCord Lappo Peracchio Deputy Green Thompson Kelley Temple Temple Temple Astleford Holman Keller Murphy Pierre II Levy

Securities Securities/real estate Real estate Securities Securities/real estate/minerals Securities/real estate Securities/real estate Securities/real estate Securities Boat company Bank stock Publishing company Cash Marketable securities Ranch Winery Real estate Dell stock Securities Securities/real estate Securities Undeveloped real estate

Giustina

Timberland; forestry

Tax Tax Tax Tax Fed. Dist. Fed. Dist. Tax Tax Tax Tax Tax Tax Tax Fed. Dist. Fed. Dist. Fed. Dist. Tax Tax Fed. Dist. Fed. Dist. Tax Fed. Dist. (jury) Tax

Koons

Securities

Tax

Gallagher Streightoff

Publishing company Securities

Tax Tax

Kress

Manufacturing

Tax

Jones

Sawmill & timber

Tax

Grieve

Securities

Tax

Nelson

FLP owned 27% of holding company that owned various subsidiaries with operating businesses

Tax

Discount from NAV/Proportionate Entity Value 31% 15% 8%; 44% 40% 54% 63% 32% 35.4% 29.5% 30% 46% 40.5% 32% 21.25% 38% 60% 30% (GP); 36% (LP) 22.5% 47.5% 41% 35.6% 0 (valued at actual sales proceeds with no discount) 25% with respect to cash flow valuation (75% weighting to cash flow factor and 25% weighting to asset method); BUT reversed by 9th Circuit and remanded to reconsider without giving 25% weight to asset value 7.5%; Estate owned 70.42% of voting interests and could remove limitation on distributions 47% 0% lack of control discount because the 88.99% LP interest could remove the general partner and terminate the partnership; 18% lack of marketability discount Lack of marketability discounts of 25% for 20072008 gifts & 27% for 2009 gifts (those numbers included 3% downward adjustment because family transfer restriction was not taken into account); adjustment also made for minority interest in evaluating non-operating assets 35% lack of marketability discount from noncontrolling interest value 35% for one LLC and 34.5% for another LLC (98.8% non-voting LLC interest) FLP’s interest in holding company valued with 15% lack of control discount and 30% lack of marketability discount; transferred limited partner interest in FLP valued with 5% lack of control discount and 28% lack of marketability discount

John Porter, The 30,000 Foot View from the Trenches: A Potpourri of Issues on the IRS’s Radar Screen, 49th ANN. HECKERLING INST. ON EST. PL. ¶ 511 (2015).

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29. FLP Assets Included Under §2036(a)(1); Application of §2043 Consideration Offset; Formula Transfer to Charitable Lead Trust Not Respected; Loans Not Respected; No Deduction for Attorney’s Fee, Estate of Howard V. Moore v. Commissioner, T.C. Memo. 2020-40 a.

Synopsis. In a pre-death planning context beginning in late 2004, after contracting to sell a farm for about $16.5 million the decedent transferred a 4/5ths interest in the farm to an FLP in return for a 95% limited partnership interest. A Management Trust (with two children as co-trustees) was the 1% general partner, but the decedent exercised practical control over the FLP and caused transfers of $2 million of the sale proceeds to himself, $2 million to his children (who gave notes for their transfers), and $500,000 to a grandson as a gift. The decedent subsequently gave $500,000 to an Irrevocable Trust (for his children) and several weeks later transferred his 95% limited partnership interest to the Irrevocable Trust for a $500,000 cash down payment and a $4.8 million note (the gift and sale amount represented a discount of just over 50% for the FLP interest). The decedent’s revocable trust provided a formula bequest to a charitable lead trust in an amount to “result in the least possible federal estate tax.” In addition, the Irrevocable Trust provided that the trustee would distribute to the revocable trust “the value of any asset of this trust which is includible in my gross estate.” Following the decedent’s death at the end of March 2005, the charitable lead trust apparently was funded with a substantial amount under the revocable trust’s formula transfer. An IRS examination resulted in this case alleging additional gift and estate taxes. Not surprisingly, the court determined that the farm was included in the gross estate under §2036(a)(1). The bona fide sale for full consideration exception in §2036(a) did not apply because no businesses required active management, the children did not actually manage sale proceeds in the FLP, no legitimate creditor concerns existed, and the “whole plan” involving the FLP had a “testamentary essence.” The decedent retained enjoyment or possession of the assets transferred to the FLP under §2036(a)(1) (at least by implied agreement) because, although he kept sufficient assets for personal needs, he instead “scooped into FLP assets to pay personal expenses,” and his relationship to the assets remained unchanged after the transfer to the FLP. The court followed up on the discussion of §2043 in Estate of Powell v. Commissioner with its own lengthy analysis, but on the facts of the case the application of §2043 had little practical impact. The court refused to allow any additional charitable deduction under the formula transfer provision in the Irrevocable Trust as a result of the inclusion of the farm in the gross estate because (1) specific wording in the formula limits any transfer, and (2) the charitable amount was not ascertainable at the decedent’s death but depended on subsequent events (the IRS audit and tax litigation). The Christiansen and Petter cases were distinguished because they merely involved valuation issues to determine what passed to charity, but in this case the charity did not know it “would get any additional assets at all.” The court also determined that (1) the $2 million transfers to the children in return for notes were actually gifts (with a detailed review of factors considered in determining whether bona fide debt exists), (2) additional gift taxes resulting from those gifts must be included in the gross estate under §2035(b) because the gifts were made within three years of death, and (3) a flat fee of $475,000 for attorney’s fees was not deductible because the evidence did not establish what services were performed for the fee and that it was necessarily incurred in the administration of the estate. The case is being appealed to the Ninth Circuit Federal Court of Appeals. Estate of Howard V. Moore v. Commissioner, T.C. Memo. 2020-40 (April 7, 2020, Judge Holmes). For a detailed discussion of Estate of Moore, see Item 20 of Estate Planning Current Developments and Hot Topics (March 2021) found here and available at www.bessemertrust.com/forprofessional-partners/advisor-insights.

Very Brief Overview of Facts. In a very convoluted pre-death planning scenario (this really is a very brief and overly simplified overview of the facts), the decedent (knowing he had less than six months

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to live) transferred 4/5ths of a farm (that he had already contracted to sell) to an FLP in return for a 95% limited partnership interest. He subsequently sold the 95% interest to an Irrevocable Trust for a cash down payment and $4.8 million note at a price representing a discount of about 50%. The decedent’s revocable trust provided a formula bequest to a charitable lead trust in an amount to “result in the least possible federal estate tax.” In addition, the Irrevocable Trust provided that the trustee would distribute to the revocable trust “the value of any asset of this trust which is includible in my gross estate.” The FLP transferred $500,000 to each of his four children in return for a five-year note bearing interest at a rate of 3.6% from each of the children. (The mid-term applicable federal rate for February 2005 was 3.83%. Rev. Rul. 2005-8, 2005-1 C.B. 466.) The notes had no amortization schedule, no payments were made, no efforts were made to collect the notes, and the court ultimately did not respect the notes. In addition, the FLP transferred $2 million to the decedent’s revocable trust, which was used to pay various expenses, including Mr. Moore’s income tax attributable to the sale of the farm. Mr. Moore’s daughter treated this as a loan from the FLP (the estate claimed a $2 million debt deduction and treated the loan as a receivable of the FLP), but there was no further evidence that it was a loan, the Living Trust never repaid the FLP, and the court did not respect it as a loan. Mr. Moore died at the end of March 2005, as a resident of Arizona. The case is on appeal to the Ninth Circuit Federal Court of Appeals. c.

Issues. The court said that it had to decide the following issues. (1) Is the value of the farm included in the gross estate under §2036 despite its sale by the FLP? (2) If so, does the subsequent transfer of the Living Trust’s interest in the FLP to the Irrevocable Trust remove that value from the gross estate? (3) Can the estate deduct the $2 million ostensible debt from the Living Trust to the FLP, “future charitable contributions,” and $475,000 in attorney’s fees? (4) Were the $500,000 transfers to each of the children loans or gifts? Interestingly, whether the transfer of the limited partnership interests for $5.3 million (reflecting a 53% discount) was a gift (with resulting penalties and interest) was not an issue addressed by the court.

Estate Inclusion Under §2036(a). Not surprisingly, the court determined (after a lengthy analysis) that the farm was included in the gross estate under §2036(a)(1). The bona fide sale for full consideration exception in §2036(a) did not apply because no businesses required active management, the children did not actually manage sale proceeds in the FLP, no legitimate creditor concerns existed, and the “whole plan” involving the FLP had a “testamentary essence.” The decedent retained enjoyment or possession of the assets transferred to the FLP under §2036(a)(1) (at least by implied agreement) because, although he kept sufficient assets for personal needs, he instead “scooped into FLP assets to pay personal expenses,” and his relationship to the assets remained unchanged after the transfer to the FLP.

Section 2043 Consideration Offset Discussion. (1) Court Analysis. The court followed up on the discussion of §2043 in Estate of Powell v. Commissioner with its own lengthy analysis. The court proceeded with an extended discussion of §2043, fortunately avoiding Powell’s doughnut and doughnut hole analogies, but applying a formula approach. The court’s analysis ended up with the following formula: Value in Gross Estate = Value of farm at date of death – money that left the estate between the time of the sale and date of death. The court discussed five examples of how §2043 would apply in different circumstances, but on the facts in the Moore case the application of §2043 had little practical impact.

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(2) Section 2043 Background. The §2043 analysis was not actually “discovered” in Powell. The plurality opinion’s summary of how §2043 applies in the context of §2036 FLP cases is similar to what Professor Jeffrey Pennell has been telling planners for decades. See, e.g., Pennell, Recent Wealth Transfer Developments, ABA REAL PROP., PROB. & TR. LAW SECTION 14TH ANN. EST. PL. SYMPOSIUM, at 21-23 (2003). (3) Double Inclusion Approach Is Often Not Applied in Other Contexts. In other contexts, the IRS has not used the double inclusion approach where doing so would result in unfair results. The IRS has previously ruled that life insurance proceeds received by a partnership should not be includible in the gross estate both under §2042 and under §2033 as to the decedent’s partnership interest. For example, in Revenue Ruling 83-147, 1983-2 C.B. 158, the IRS refused to include life insurance proceeds payable to a partnership both as part of a partner’s interest in the partnership and under §2042 as a result of incidents of ownership attributed to the decedent as partner of the partnership, because doing so would result in “unwarranted double taxation”: In Estate of Knipp v. Commissioner, 25 T.C. 153 (1955), acq. in result, 1959-1 C.B. 4, aff’d on another issue 244 F.2d 436 (4th Cir. Cir), cert denied, 355 U.S. 827 (1957), a partnership held 10 policies on the decedent’s partner’s life, at his death…. The court found that the decedent, in his individual capacity, had no incidents of ownership in the policies, and held that the insurance proceeds were not includible in the gross estate under the predecessor to section 2042(2) of the Code. The Service acquiesces in the result of Estate of Knipp on the basis that in that case the insurance proceeds were paid to the partnership and inclusion of the proceeds under the predecessor of section 2042 would have resulted in the unwarranted double taxation of a substantial portion of the proceeds, because the decedent’s proportionate share of the proceeds of the policy were included in the value of the decedent’s partnership interest. See also section 20.2042-1(c)(6) of the regulations (which adopts a similar rule with regard to life insurance proceeds paid to or for the benefit of a corporation). (Emphasis added.)

A distinction regarding life insurance inclusion under §2042, however, is that §2043(a) refers to transfers under §2035-§2038 and §2041, but not transfers under §2042. Similarly, the regulations regarding GRATs state that if the GRAT assets are included under §2036, the retained annuity interest payments that are payable after the decedent’s death are not also included under §2033 “because they are properly reflected under this section.” Reg. §20.2036-1(c)(1)(i). Over the last 24 years preceding the Moore decision, 22 cases (listed in the last paragraph of Item 28.f above) had held that the value of assets contributed to a family limited partnership or LLC were included in a decedent’s estate under §2036, but none of those cases, other than Powell, included both the FLP assets and the FLP interest in the gross estate. Despite this long history of FLP/§2036 cases and other examples of avoiding double inclusion described above, the Moore opinion responds: Excluding the value of the partnership interest from Moore’s gross estate might appear to be the right result because it would prevent its inclusion in the value of the estate twice. The problem is that there is nothing in the text of section 2036 that allows us to do this.

(4) Practical Impact of Applying §2043 in FLP/§2036 Context. Applying the double inclusion with a §2043 consideration offset analysis (rather than simply including the §2036 amount in the gross estate) has a practical impact on the overall result primarily in situations in which (1) the assets contributed to the entity have appreciated or depreciated by the time of death, or (2) distributions from the entity have been made that are still owned by the decedent at death. For detailed examples of the effects of subsequent appreciation, subsequent deprecation, or subsequent distributions from an entity, see Summary of Estate of Moore v. Commissioner (April 2020) found here and available at www.bessemertrust.com/for-professionalpartners/advisor-insights. (5) Summary: Double Inclusion Analysis Going Forward in FLP Context. Using the double inclusion §2036 approach with a §2043 consideration offset rather than the single inclusion §2036 approach results in “unfair” double taxation if appreciation occurs and still allows the

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partnership discount if significant depreciation occurs. From a policy standpoint, the single inclusion §2036 approach seems preferable. The fact that eight (but less than a majority) of the judges in Powell and now Moore adopted the double inclusion analysis may embolden the IRS to take that position in future cases. But we do not yet know how a majority of the Tax Court judges would rule as to that issue. In any event, the double inclusion analysis applied in Powell and Moore raises a risk that contributing assets to an FLP (or for that matter, any entity) may leave a taxpayer in a significantly worse tax position than if the taxpayer had merely retained the assets, if the assets appreciate between the time of contribution to the entity and the date of death and if §2036 applies to the transfer of assets to the FLP (or other entity). (6) ACTEC Comments to IRS Recommending Adoption of the Position of the Powell Concurring Opinion. The American College of Trust and Estate Counsel (ACTEC) filed comments with the Internal Revenue Service on May 26, 2021, recommending issues for inclusion in the 2021-2022 Treasury Priority Guidance Plan. The comments include a recommendation that if assets contributed to a partnership (or LLC) are included in the contributor’s gross estate under §2036, unless what was transferred into the entity has been retransferred or unless some third party paid consideration for what is included in the estate under §2036, the entity interest itself should not also be included under §2033. The comments observe that this would be consistent with the treatment of assets transferred to a GRAT if the grantor dies before the end of the GRAT term and value attributable to the GRAT is included in the decedent’s gross estate under §2036. Section 2043 is not used; instead the annuity payments that are due after the date of death are not also included in the gross estate under §2033. Reg. §20.2036-1(c)(1)(i). The comments recommend a proposed solution to the complexities, inconsistencies, and unfairness that results under the double inclusion/§2043 analysis in Powell and Moore: Under the concurring opinion in Powell, the entire lifetime transaction should be disregarded and the transferred property should be entirely included in the gross estate at its date of death value and the partnership units ignored for such purposes. This approach would avoid the complicated analysis that results from the application of Section 2043, i.e., the valuation of the retained interest under Section 2036(a) inclusion/Section 2043(a) offset that leads to illogical results which are unfair to either the taxpayer (doubling counting post transaction appreciation) or the Service (doubling counting of post transaction depreciation). The concurring opinion would result in tax on the value of the assets actually transferred. The solution proposed here is not only the more practical one, but also the outcome that is the most “fair” to the taxpayer and to the government. And it is the most theoretically satisfying. We propose that Section 2043 should not apply where there is no consideration provided by a third party because the taxpayer’s estate has received no additional assets or value in a transaction that is essentially with himself or herself. In cases where the consideration received in the transfer is from a third party, the estate is actually enlarged by the consideration received and Section 2043 should apply to exclude the additional value. (If the partnership interest received upon formation of the partnership is sold within three years of a partner’s death and the sale does not qualify for the bona fide exception under Section 2035, the amount of the Section 2035 inclusion would need to be reduced by the consideration received from the third party in the sale.) [footnote omitted] … Conclusion and Recommendation Although the Tax Court has eliminated any concern that both the underlying assets contributed to a partnership as well as the partnership interest itself may be subject to full estate tax, Section 2043 is at best a crude tool to avoid double taxation. And its application in Powell and Moore runs counter to the Section 2036 regulations because it provides for both the assets transferred to be included in Section 2036 as well as the interest received in exchange (such as a partnership interest) to be included under Section 2033. The better result would be simply to include only the assets transferred by the decedent in the pre-death transaction (e.g., to the partnership) where the taxpayer had retained such a power or interest (in the partnership) and to cause Section 2036 to apply.

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Accordingly, we respectfully recommend that the Treasury Department and the Internal Revenue Service issue guidance, perhaps in the form of a revenue ruling, adopting the position taken in the concurring opinion in Estate of Powell.

Charitable Formula Transfer Provision Not Respected. The court refused to allow any additional charitable deduction under the formula transfer provision in the Irrevocable Trust as a result of the inclusion of the farm in the gross estate because (1) specific wording in the formula limits any transfer and (2) the charitable amount was not ascertainable at the decedent’s death but depended on subsequent events (the IRS audit and tax litigation). The Christiansen and Petter cases were distinguished because they merely involved valuation issues to determine what passed to charity, but in this case the charity did not know it “would get any additional assets at all.” The Moore opinion draws a distinction between estate tax examinations and court determinations of value vs. other issues. A contingency based on ultimate determination of valuation issues is not a “transfer … contingent on the happening of some event.” The court reasoned that in Christiansen, in which the opinion was also written by Judge Holmes and recognized a formula transfer) and Petter, “we knew the charity clearly would receive assets, just not how much. Here we don’t know if the charity would get any additional assets at all.” (Emphasis in original.) Under this approach, formula transfers to charity that depend on IRS or court determinations as to any issues other than values are suspect. The Moore opinion, however, offers no support for making a distinction between a court resolution of valuation issues vs. the resolution of other issues (such as §2036 inclusion) that impacts the amount passing to charity under a formula bequest. Both involve significant uncertainties about how the issues will ultimately be resolved, based on a set of facts that existed at the date of death. For example, the opinion cites Estate of Marine v. Commissioner, 97 T.C. 368, 378-79 (1991), aff’d, 990 F.2d 136 (4th Cir. 1993), in support of its position that charitable deductions must be ascertainable at the decedent’s date of death. But in Marine, the personal representative could make bequests to compensate individuals chosen by the representative who contributed to the decedent’s well-being, with no limit on the number of persons who could receive such bequests, which would reduce the amount that could pass to charity under the residuary estate. That is a contingency based on future events and exercises of discretion involving distributions to an unlimited number of non-charitable beneficiaries, far different from a court determination of the tax effects of facts as they existed at the date of death. A court determination of the tax effects of transactions that had occurred involving the FLP by Mr. Moore is something that “depends only on a settlement or final adjudication of a dispute about the past” (to quote Judge Holmes’ reasoning in Christiansen). “It should make no difference whether inclusion as of the date of death is the trigger, rather than the value of the gross estate. Both cases turn on resolution of a dispute involving the ultimate size of the gross estate.” Larry Katzenstein and Jeff Pennell, Estate of Moore v. Commissioner – Discount Planning Debacle, LEIMBERG ESTATE PLANNING NEWSLETTER #2790 (April 20, 2020). Classic testamentary marital deduction formula clauses traditionally take into account a wide variety of factors, not just valuation issues, to leave enough assets to a surviving spouse in order to avoid or minimize federal estate tax (analogous to the “least possible federal estate tax” formula charitable clause in Moore). Adjustments in estate tax examinations or litigation are taken into consideration in applying the formula marital bequest. If the formula transfer in the Moore case had been to a surviving spouse or marital trust, presumably the formula bequest would have been respected, assuming sufficient estate assets were available to satisfy the formula bequest. E.g., Estate of Turner v. Commissioner, 138 T.C. 306 (2012) (sometimes referred to as “Turner II”). The appeal of Estate of Moore will be heard by the Ninth Circuit Federal Court of Appeals, which approved the Petter defined value clause case involving a formula charitable transfer.

Transfers in Return for Notes Not Respected as Loans but Are Treated as Gifts. Mr. Moore directed the FLP to transfer $500,000 to each of his four children in return for a five-year note bearing interest at a rate of 3.6% from each of the children. The notes had no amortization schedule, no payments were made, and no efforts were made to collect on the notes. The IRS asserted that these transfers “were gifts and not loans because they lack a legitimate debtor-creditor relationship.”

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Various factors relevant in determining if a transfer creates a bona fide debt were summarized (citing Estate of Rosen v. Commissioner, T.C. Memo. 2006-115, as well as other cases). Even though the children signed notes and the debt was not proportionate to the children’s ownership in the FLP (both of which weighed in favor of a bona fide debt), the court found it was “more likely than not” that these were gifts based on a variety of other factors: •

The notes had no fixed payment schedule;

•

The children never made required interest payments;

•

The FLP never demanded repayment of the loans;

•

There was no evidence the children had the resources to repay the loans, and thin capitalization weighs against a finding of bona fide debt;

•

Repayment depending solely on earnings does not support a finding of bona fide debt;

•

The notes were not secured;

•

Comparable funding from another lender was unlikely;

•

The children did not set aside funds to repay the notes; and

•

Most important, Mr. Moore had listed a desire that each of his children receive $500,000 as one of his estate planning goals, and the attorney testified that the payments needed to be loans for tax purposes because “having [them] as a gift wouldn’t be the best use of the tax laws.”

These transfers from the FLP to the children, totaling $2 million, were treated as gifts, and the additional resulting gift tax was included in the gross estate under §2035(b) because the gifts had been made within three years of death. The loan vs. gift issue was also addressed by the court in Estate of Bolles v. Commissioner, T.C. Memo. 2020-71, discussed in Item 30 immediately below. 30. Treatment of Advances to Son as Legitimate Loans vs. Gifts, Estate of Bolles v. Commissioner, T.C. Memo. 2020-71 a.

Synopsis. The Tax Court addressed whether advances from a mother to her children (and particularly, over $1 million of advances to a struggling son) were legitimate loans or were gifts. Although the mother documented the advances, there were no loan agreements, security, or attempts to force repayment. She forgave the “gift tax exemption amount” of the debts each year. Large amounts were advanced to a struggling son ($1,063,333 over 23 years), and at some point, the mother realized that the son would never be able to repay the advances; on October 27, 1989, she prepared her revocable trust to exclude that son from any distribution of her estate at her death. The court treated advances through 1989 as loans but treated subsequent advances as gifts. Estate of Bolles v. Commissioner, T.C. Memo. 2020-71 (June 1, 2020, Judge Goeke).

Basic Facts. A mother generally wanted to treat her five children equally. She made advances to her children, keeping records of the advances and “occasional repayments for each child,” but there were no notes, no collateral, and no attempts to force repayment. She treated the advances as loans, but she “forgave the ‘debt’ account of each child every year on the basis of the gift tax exemption amount.” The court observed that “[h]er practice would have been noncontroversial but for the substantial funds she advanced to Peter.” Peter was the oldest of the children. He took over his father’s architecture practice. He experienced success in attracting clients but had financial difficulties largely because his expectations exceed realistic results. A family trust became liable for $600,000 of his bank loans. Because of his financial difficulties, the mother advanced substantial funds ($1,063,333) to Peter from 1985 through 2007. The mother prepared a revocable trust dated October 27, 1989 that “specifically excluded Peter from any distributions of her estate upon her death.” She subsequently amended the revocable trust to permit Peter to share in her estate but only after accounting for “loans” made to him plus accrued

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interest. Peter signed an acknowledgement that $771,628 plus accrued interest using the AFR for short-term debt determined at the end of each calendar year, would be subtracted from Peter’s share of the estate at the mother’s death. Presumably, the mother forgave some of the advanced amounts to Peter under her annual gift plan, and Peter apparently made some repayments on the loans through 1988, but the IRS asserted that the entire $1,063,333 amount, plus $1,165,778 of accrued interest, was an asset of the mother’s gross estate or that $1,063,333 was an adjusted taxable gift to be included in computing her estate tax liability. c.

Court Analysis. Both parties pointed to Miller v. Commissioner, T.C. Memo. 1996-3, aff’d, 113 F.3d 1241 (9th Cir. 1997), for the traditional factors used to decide whether an advance is a loan or a gift: Those factors are explained as follows: (1) there was a promissory note or other evidence of indebtedness, (2) interest was charged, (3) there was security or collateral, (4) there was a fixed maturity date, (5) a demand for repayment was made, (6) actual repayment was made, (7) the transferee had the ability to repay, (8) records maintained by the transferor and/or the transferee reflect the transaction as a loan, and (9) the manner in which the transaction was reported for Federal tax purposes is consistent with a loan. These factors are not exclusive. See, e.g., Estate of Maxwell v. Commissioner, 98 T.C. 594 (1992), aff’d, 3 F.3d 591 (2d Cir. 1993). In the case of a family loan, it is a longstanding principle that an actual expectation of repayment and an intent to enforce the debt are critical to sustaining the tax characterization of the transaction as a loan. Estate of Van Anda v. Commissioner, 12 T.C. 1158, 1162 (1949), aff’d per curiam, 192 F.2d 391 (2d Cir. 1951).

The court observed that the mother had recorded the advances and kept track of interest, but there were no loan agreements, collateral, or attempts to force repayment. A critical factor to the court was “that the reasonable possibility of repayment is an objective measure of [the mother’s] intent.” Peter’s creative ability as an architect and ability to attract clients likely convinced the mother that he would be successful and “she was slow to lose that expectation.” But she must have realized he would be unable to repay her loans by October 27, 1989, when her revocable trust blocked Peter from receiving additional assets from her at her death. The court concluded that advances to Peter were loans through 1989 but after that were gifts. Also, the court “considered whether she forgave any of the prior loans in 1989, but [found] that she did not forgive the loans but rather accepted they could not be repaid on the basis of Peter’s financial distress.” d.

Planning Observations. (1) Significance Generally. The IRS may treat the transfer as a gift, despite the fact that a note was given in return for the transfer, if the loan is not bona fide or (at least according to the IRS) if there appears to be an intention that the loan would never be repaid. (If the IRS were to be successful in that argument, the note should not be treated as an asset in the lender’s estate.) A similar issue arises with sales to grantor trust transactions in return for notes. The IRS has made the argument in some audits that the “economic realities” do not support a part sale and that a gift occurred equal to the full amount transferred unreduced by the promissory note received in return. Another possible argument is that the seller has made a transfer and retained an equity interest in the actual transferred property (thus triggering §2036) rather than just receiving a debt instrument. (2) Gift Presumption. A transfer of property in an intra-family situation will be presumed to be a gift unless the transferor can prove the receipt of “an adequate and full consideration in money or money’s worth.” Reg. §§25.2512-8; 25.2511-1(g)(1)(“The gift tax is not applicable to a transfer for a full and adequate consideration in money or money's worth, or to ordinary business transactions ...”). See Harwood v. Commissioner, 82 T.C. 239, 258 (1984), aff’d, 786 F,2d 1174 (9th Cir. 1986), cert. den., 479 U.S. 1007 (1986). (3) Treatment as Bona Fide Loan. In the context of a transfer in return for a promissory note, the gift presumption can be overcome by an affirmative showing of a bona fide loan with a “real

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expectation of repayment and an intention to enforce the collection of indebtedness.” Estate of Van Anda v. Commissioner, 12 T.C. 1158, 1162 (1949). The bona fide loan issue has been addressed in various income tax cases, including cases involving bad debt deductions, and whether transfers constituted gross income even though they were made in return for promissory notes. E.g., Santa Monica Pictures, LLC v. Commissioner, T.C. Memo. 2005-104 (no basis was established for assumption of debt that was not a bona fide indebtedness); Todd v. Commissioner, T.C. Memo. 2011-123, aff’d, 110 AFTR 2d ¶ 2012-5205 (5th Cir. 2012) (unpublished decision) (appellate decision emphasized post hoc note execution and that the loan was never repaid as supporting that the note was merely a formalized attempt to achieve a desired tax result despite a lack of substance). The Bolles court cited Miller v. Commissioner, which is often cited regarding whether transfers are treated as bona fide loans. It involved transfers made to a son in return for a non-interestbearing unsecured demand note, and the Miller court analyzed in detail the nine factors that it listed. Miller cited a number of cases in which those same factors have been noted to determine the existence of a bona fide loan in various contexts, and those nine factors have been listed in various subsequent cases. A recent case addressing advances from a family limited partnership analyzed eleven factors that were important in determining whether the transfers were gifts or loans. Estate of Moore v. Commissioner, T.C. Memo. 2020-40 (discussed in Item 20.g above) See also Estate of Rosen v. Commissioner, T.C. Memo. 2006-115 (detailed analysis of eleven bona fide loan factors as applied to transfers from an FLP). (4) Other Transfer Tax Related Contexts in Which Loan Issue May Arise. Whether a loan is respected for federal tax purposes can arise in a variety of estate planning contexts: •

Whether §2036 applies in a sale-leaseback transaction if the sale for a note is not recognized as a bona fide sale;

•

Possible estate inclusion under §§2033, 2035 and 2038 for property transferred in return for a note if the note is not respected;

•

The treatment of advances from an FLP as distributions (even though notes were given for the advances) may support the inclusion of FLP assets under §2036; and

•

Whether a note owed by the estate is valid debt for purposes of qualifying for a §2053 deduction.

Cases involving each of these scenarios are summarized in Item 21.d.(4) of Estate Planning Current Developments and Hot Topics (May 2021) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. (5) Upfront Gift If Intend to Forgive Loan? In Bolles, the mother made advances and, according to the opinion, “forgave the ‘debt’ account of each child every year on the basis of the gift tax exemption amount.” The court said that “practice would have been noncontroversial but for the substantial funds” the mother advanced to Peter. While the court may have thought that plan was “noncontroversial,” the IRS has taken the position that advances made with the intention of forgiving the purported “loans” are treated as upfront gifts, but cases have not always agreed with that position. (a) IRS Position. Revenue Ruling 77-299 announced the IRS position that if a taxpayer ostensibly makes a loan and, as part of a prearranged plan, intends to forgive or not collect on the note, the note will not be considered valuable consideration and the donor will have made a gift at the time of the loan to the full extent of the loan. The IRS relied on the reasoning of Deal v. Commissioner, 29 T.C. 730 (1958), for its conclusion in Rev. Rul. 77-299. However, if there is no prearranged plan and the intent to forgive the debt arises at a later time, the donor will have made a gift only at the time of the forgiveness. Rev. Rul. 81-264, 1081-2 C.B. 186. The IRS has subsequently reiterated its position. See, e.g., Field Service Advice 1999-837 www.bessemertrust.com/for-professional-partners/advisor-insights

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(donor makes gift of full amount of loan initially if donor intends to forgive the loan as part of a prearranged plan); Letter Rul. 200603002. (b) Case Law. The Tax Court reached a contrary result in several cases that were decided before the issuance of Rev. Rul. 77-299 (and the IRS non-acquiesced to those cases in Rev. Rul. 77299). Those cases reasoned that there would be no gift at the time of the initial loan as long as the notes had substance. The issue is not whether the donor intended to forgive the note, but whether the note was legally enforceable. See Haygood v. Commissioner, 42 T.C. 936 (1964) (gift that occurred at the time of the initial transfer was reduced by the full face amount of the secured notes even though the taxpayer had no intention of enforcing payment of the notes and the taxpayer in fact forgave $3,000 per year on the notes from each of the transferees); Estate of Kelley v. Commissioner, 63 T.C. 321 (1974) (no upfront gift even though parents extinguished notes without payment as they became due). The court in Estate of Maxwell v. Commissioner, 3 F.3d 591 (2d Cir. 1993), distinguished Haygood and Kelley in a §2036 case involving a transfer of property subject to a mortgage accompanied with a leaseback of the property. Other cases have criticized the approach taken in Haygood and Kelley (though in a different context), observing that a mere promise to pay in the future that is accompanied by an implied understanding that the promise will not be enforced should not be given value and is not adequate and full consideration in money or money’s worth. E.g., Miller v. Commissioner, T.C. Memo. 1996-3, aff’d without opinion, 113 F.3d 1241 (9th Cir. 1997); Estate of Musgrove v. United States, 33 Fed. Cl. 657, 664 (1995); Estate of Lockett v. Commissioner, T.C. Memo. 2012-123. (c) Which is the Best Reasoned Approach? One commentator gives various reasons in concluding that the taxpayers’ position is the more reasoned position on this issue. The IRS has not done well with this approach, and there are reasons for this. Even if the lender actually intends to gradually forgive the entire loan, (1) he is free to change his mind at any time, (2) his interest in the note can be seized by a creditor or bankruptcy trustee, who will surely enforce it, and (3) if the lender dies, his executor will be under a duty to collect the note. Therefore, if the loan is documented and administered properly, this technique should work, even if there is a periodic forgiveness plan, since the intent to make a gift in the future is not the same as making a gift in the present. However, if the conduct of the parties negates the existence of an actual bona fide debtor-creditor relationship at all, the entire loan may be recharacterized as a gift at the time the loan was made or the property lent may be included in the lender's estate, depending on whether the lender or the borrower is considered to “really” own the property. … If the borrower is insolvent (or otherwise clearly will not be able to pay the debt) when the loan is made, the lender may be treated as making a gift at the outset.

KATHRYN G. HENKEL, ESTATE PLANNING AND WEALTH PRESERVATION ¶28.05[2][a](Warren Gorham & Lamont 1997). Other commentators agree that the Tax Court analysis in Haygood and Kelley is the preferable approach. E.g., HOWARD M. ZARITSKY & RONALD D. AUCUTT, STRUCTURING ESTATE FREEZES: ANALYSIS WITH FORMS, §12.02 (2d ed. 1997). (d) Planning Pointers. While the cases go both ways on this issue, taxpayers can clearly expect the IRS to take the position that a loan is not bona fide and will not be recognized as an offset to the amount of the gift at the time of the initial transfer if the lender intends to forgive the note payments as they become due. Where the donor intends to forgive the note payments, it is especially important to structure the loan transaction to satisfy as many of the elements as possible in distinguishing debt from equity. In particular, there should be written loan documents, preferably the notes will be secured, and the borrower should have the ability to repay the notes. If palatable, do not forgive all payments, but have the borrowers make some of the annual payments.

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31. Gift and Sale of Partnership Interests Expressed as Dollar Amounts Based on Subsequent Appraisals, Lack of Control and Lack of Marketability Discounts, Multi-Tiered Discounts, Nelson v. Commissioner, T.C. Memo. 2020-81 a.

Synopsis. This gift tax case determined the value of gifts and sales of interests in a limited partnership, the primary asset of which was 27% of the common stock of a holding company that owned 100% of eight subsidiaries (six of which were operating businesses). The gifts and sales were of limited partner interests having a specified dollar value on the transfer date “as determined by a qualified appraiser within ninety (90 days) of the effective date of the Assignment” (180 days in the case of the sale). An appraisal was prepared for the holding company, which was then used to prepare an appraisal for the transferred limited partner interests. The percentage limited partner interests that were transferred were based on those appraisals and documented in the partnership’s records and used for preparing subsequent income tax returns. The IRS took the position that the transfers resulted in additional gifts of about $15 million. The taxpayers first argued that the transfers were actually of interests worth a particular dollar value rather than of particular percentage interests. The court disagreed, observing that the clauses in the assignments “hang on the determination by an appraiser within a fixed period; value is not qualified further, for example, as that determined for Federal estate tax purposes.” Observation: This is a practical approach that is often used in structuring assignments of hard-tovalue assets. The IRS did not object to this type of assignment (determining the percentage interest transferred based on an appraisal completed relatively soon after the transfer) as abusive, but merely proceeded to enforce the assignment as drafted and then value the interests so transferred. The court ultimately determined that the 27% interest that the partnership owned in the holding company was valued using a 15% lack of control discount (slightly lower than the taxpayers’ expert’s position of a 20% discount but higher than the IRS’s expert’s 0% discount) and 30% for lack of marketability (agreed to by experts for both the taxpayers and the IRS). The holding company value was then used to determine the value of the limited partner interests, which the court determined using a 5% lack of control discount (compared to 15% by the taxpayer’s expert and 3% by the IRS’s expert) and a 28% lack of marketability discount (compared to 30% by the taxpayers’ expert and 25% by the IRS’s expert). The values determined by the court resulted in an additional gift value of about $4.5 million. On October 16, 2020, Mr. and Mrs. Nelson filed notices of appeal of the Tax Court’s decision to the Court of Appeals for the Fifth Circuit. Nelson v. Commissioner, T.C. Memo. 2020-81 (Judge Pugh).

Facts and Court Analysis. For a detailed summary of the basic facts in the case and of the court’s analysis, see Item 24 of Estate Planning Current Developments and Hot Topics (December 2020) found here and available at www.bessemertrust.com/for-professional-partners/advisorinsights.

Observations. (1) Not a Rejection of Defined Value Clauses. The court’s refusal to treat this as a transfer of a dollar amount based on values as finally determined for gift tax purposes might on first blush be viewed as a rejection of a defined value transfer. That is not the case. The transfer was of a defined value of interests not as finally determined for gift tax purposes but as determined by a qualified appraisal that would be completed shortly after the date of the transfer. The taxpayers argued that the transfers were intended to be dollar amounts of units of the partnership based on values as finally determined for gift tax purposes. But was that really the intent in 2008-2009? In effect, they argued that the assignments were intended to have “Wandry clauses,” but bear in mind that the Wandry case was not decided until 2012. Wandry v. Commissioner, T.C. Memo. 2012-88. (2) Importance of Using Grantor Trusts With Defined Value Transfers. The facts of Nelson illustrate the importance of using grantor trusts with defined value transfers. If the amount

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transferred depends on values as finally determined for gift tax purposes, the amounts actually transferred may not be determined for years. In the meantime, income tax returns are filed, reflecting the anticipated amounts that were transferred. If the defined value transfer is made to a grantor trust, even if the ownership percentages change as a result of a gift tax audit, all the income and deductions will have been reported on the grantor’s income tax return in any event, and no corrective returns should be necessary (unless the parties wish to file corrected entity level returns to make clear the appropriate sharing of profits and losses of the entity’s owners). (3) Potential Disadvantage of Defined Value Clauses. This case illustrates a potential disadvantage of using defined value clauses. This case did not involve a defined value clause, so the percentage interests transferred did not have to be adjusted to reflect the values determined by the court. Instead, the donors made additional taxable gifts and may have had to pay additional gift taxes. The court ultimately determined that the taxpayers made additional gifts of about $4.5 million, resulting in additional gift taxes of just over $2 million. As a result of the settlement discussions with IRS Appeals, the taxpayers attempted to adjust the percentage interests transferred from 64.79% (for the gift and sale) to only 38.55%. If that had been the effect of the assignment clauses, the parties would have decreased the Trust’s interest in the FLP (with underlying assets of over $60 million) by 26.24%, or a reduction of the Trust’s value by about $15.9 million, without counting subsequent appreciation and income. In effect, the taxpayers will pay an additional $2 million of gift tax (if the Tax Court case is upheld on appeal) in order to keep in the Trust an additional $15.9 million, plus untold subsequent appreciation and income (unreduced by income tax because the grantor pays it) that has accumulated in the Trust during the intervening twelve years, which amount could now be multiples of $15.9 million. Even in the face of that seemingly outstanding result compared with the taxpayers’ apparent settlement position, however, on October 16, 2020, Mr. and Mrs. Nelson filed notices of appeal of the Tax Court’s decision to the Court of Appeals for the Fifth Circuit. (4) Support of Planning Alternative for Transferring Hard-To-Value Assets; 90 vs. 180 Days for Appraisals. As a practical matter, valuing hard-to-value assets on the date of the transfer is impossible. A formula transfer of a dollar value worth of a particular asset, based on an appraisal to be obtained within a specified term in the near future, is routinely used, and is not viewed by the IRS as abusive. By the time the gift tax return is filed, the appraisal will be at hand, and a specific number of shares or units that have been transferred pursuant to the formula will be known and listed on the gift tax return. See Rev. Rul. 86-41, 1986-1 C.B. 300 (“In both cases, the purpose of the adjustment clause was not to preserve or implement the original bona fide intent of the parties, as in the case of a clause requiring a purchase price adjustment based on an appraisal by an independent third party retained for that purpose”). The IRS apparently raised no objections to these assignments based on values as determined by appraisals within a short time after the transfers, and indeed simply proceeded to enforce the terms of the assignments. Obviously, that approach provides no protection against gift taxes in the event of an audit. The key distinction of a classic defined value type of transfer is that the formula dollar value being transferred is based on values as finally determined for federal gift tax purposes. (5) Partnership Respected by IRS Despite Being Created Shortly Before Transfers. The FLP was created only about three months before the transfers, but the IRS did not argue that the partnership should be ignored as simply an artificial device to produce more valuation discounts. (6) Transfer Restrictions Not Addressed in Appraisals, So No Section 2703 Issues Arose. Both the WEC corporate documents and the FLP agreement contained transfer restrictions, generally just allowing transfers to family members. For the corporation, shareholders could also sell their shares back to the corporation or other shareholders, and for the FLP, the partners could also sell interests with the approval of the general partners (who happened to be Mr. and Mrs. Nelson) or subject to a right of first refusal by the FLP and the other partners. None of the experts applied

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any valuation discounts because of the transfer restrictions. Therefore, no issues arose as to whether the restrictions should be disregarded in valuing the transfers under §2703. (7) Sale for Note Using AFR Was Respected. The sale in early 2009 in return for a note using the mid-term AFR that was secured by the limited partner interest that was sold was respected by the IRS. The IRS did not attempt to argue that the note’s value should be discounted because the interest rate was less than a market interest rate. Anecdotal indications are that the IRS has recently raised questions in some audits as to whether notes using the AFR in sale transactions should be discounted in value because of the interest rate. So far, there is no case law supporting that position. But see PLR 200147028, in which the IRS seemed to embrace a market interest rate standard when it ruled that partitioned and reformed trusts “will retain their GST tax exempt status … [i]f the trustee elects to make one or more loans to the beneficiaries … provided that such loans are adequately secured and subject to a market rate of interest.” There is no indication in the ruling whether the taxpayers who had requested the ruling had included that proviso on their own or if perhaps the IRS had required them to add it. (The ruling states that the taxpayers had asked a court to grant that discretion and the court had agreed, but it doesn’t indicate whether that request had been made at the suggestion of the IRS after the ruling request had been submitted). Most planners use the applicable federal rate, under the auspices of §7872, as the interest rate on notes for intra-family installment sales. Section 7872 addresses the gift tax effects of “belowmarket” loans, and §7872(f)(1) defines “present value” with reference to the “applicable Federal rate.” Using §7872 rates would seem to be supported by the position of the IRS in a Tax Court case and in several private rulings. In Frazee v. Commissioner, 98 T.C. 554 (1992), the IRS urged, as its primary position, that the interest rate under §7872 (rather than the interest rate under §483 or any other approach), should apply for purposes of determining the gift tax value of a promissory note in the context of a sale transaction. Whether the §7520 rate or some other market rate should apply was not strictly before the court, because the IRS proposed using the lower §7872 rate. However, the court analyzed §7872 and concluded that it applied for purposes of valuing a note given in a seller financed sale transaction: Nowhere does the text of section 7872 specify that section 7872 is limited to loans of money. If it was implicit that it was so limited, it would be unnecessary to specify that section 7872 does not apply to any loan to which sections 483 or 1274 apply. The presence of section 7872(f)(8) signaled Congress' belief that section 7872 could properly be applicable to some seller financing. We are not here to judge the wisdom of section 7872, but rather, to apply the provision as drafted. 98 T.C. at 588.

The opinion concluded with an acknowledgement that this approach was conceded by the IRS in its position that §7872 applied rather than valuing the note under a market rate approach: “We find it anomalous that respondent urges as her primary position the application of section 7872, which is more favorable to the taxpayer than the traditional fair market value approach, but we heartily welcome the concept.” Id. at 590. The concept is welcome, probably because rates under §7872 are objective and do not burden the court with the need for evidence, argument, and judgment. The use of the §7872 rate for intra-family note transactions was subsequently approved in True v. Commissioner, T.C. Memo. 2001-167 (“We concluded in Frazee v. Commissioner, supra at 588589, that section 7872 does not apply solely to loans of money; it also applies to seller-provided financing for the sale of property. In our view, the fact that the deferred payment arrangement in the case at hand was contained in the buy-sell agreements, rather than in a separate note as in Frazee, does not require a different result.”), aff’d on other grounds, 390 F.3d 1210 (10th Cir. 2004). Private letter rulings have also taken the position that using an interest rate that is equal to or greater than the AFR will not be treated as a gift, merely because of the interest rate that is used on the note. E.g., PLRs 9408018; 9535026. www.bessemertrust.com/for-professional-partners/advisor-insights

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(8) No Issue of “Equity” in the Sale Transaction. Although PLR 9535026 (which often is cited as the IRS’s first approval of an installment sale to a grantor trust) does not refer to any “equity” in the trusts, such as other property to help secure the debt or property with which to make a down payment, it is well known that the IRS required the applicants for the ruling to commit to such an equity of at least 10% of the purchase price. See generally Michael Mulligan, Sale to a Defective Grantor Trust: An Alternative to a GRAT, 23 EST. PLAN. 3, 8 (Jan. 1996). (In PLR 9251004, the IRS had held that a transfer of stock to a trust with no other assets, in exchange for the trust’s installment note, “must be considered a retention of the right to receive trust income” for purposes of §2036.) In Nelson, a gift to the Trust believed to be $2,096,000 was followed by a sale of property believed to have a value of $20,000,000. That would have resulted in “equity” of only about 9.5%. No mention was made of that in the opinion, and it cannot be determined whether that was a part of the IRS’s concerns about the transactions. Of course, after the gift component had been adjusted by the Tax Court to a total of $6,643,916 ($2,524,983 as the gift made on December 31, 2008, plus $4,118,933 as the additional gift at the time of the sale on January 2, 2009) and the sale component remained $20,000,000, this issue disappeared. (9) Multi-Tiered Discounts. The IRS did not question applying substantial discounts at both the level of assets owned by the FLP and also of interests in the FLP itself. Discounts at multiple levels of interests owned by partnerships were allowed in Astleford v. Commissioner, T.C. Memo. 2008-128. The court in Astleford allowed full lack of control and marketability discounts at both the subsidiary level and the parent level. The cases cited by the court suggest that this is appropriate when there are minority interests being valued at both levels. Footnote 5 of the Astleford opinion cites four Tax Court and Tax Court memorandum cases that have allowed multi-level discounts where there were minority interests in both levels. (Estate of Piper, Janda, Gow, and Gallun.) However, footnote 5 also identifies cases that have refused to apply multi-level discounts where minority interests in subsidiaries were a significant portion of the parent entity’s assets (Martin) or for a subsidiary that was the parent’s “principal operating subsidiary” (Estate of O’Connell). Other cases that have addressed multi-tiered discounts include Kosman (1996), Dean (1960), and Whittemore v. Fitzpatrick (D. Conn. 1954). The multi-tiered discounts were not questioned in Nelson even though both of those conditions (addressed in Martin and Estate of O’Connell) were applicable. Grieve v. Commissioner, T.C. Memo. 2020-28 (March 2, 2020), rejected on procedural and prudential grounds the approach offered by the taxpayer’s expert at trial for the taxpayer to apply tiered discounts that would have resulted in a value considerably lower than the value reported on an appraisal attached to the gift tax return. The court explained that it had found no justification for using a net value significantly lower than the value to which the taxpayer had previously admitted on the appraisal attached to the gift tax return (without any specific criticism of the multiple-tiered discounting approach). (10) Split Gift Election for Gift to SLAT. Mrs. Nelson made a gift to the Trust on December 31, 2008, and Mr. Nelson consented to making the split gift election with respect to that gift. The effect of the split gift election is that the transfer is treated as having been made one-half by each of the spouses for gift and GST tax purposes (meaning that the consenting spouse’s gift and GST exemption could be used), but not for estate tax purposes. Because the election does not treat the spouses as making equal transfers to the trust for estate tax purposes, Mr. Nelson could be a beneficiary of the trust without causing estate inclusion under §2036(a)(1) and Mr. Nelson could serve as trustee without risking estate inclusion for him under §2036(a)(2) or §2038. The case has no discussion of any problems with the split gift election (other than to note that any resulting gifts are made one-half by each of the spouses). A potential problem, however, with making the split gift election for a transfer to a SLAT is that split gift treatment is not allowed if the consenting spouse is a beneficiary of the trust unless the spouse’s interest in the trust is ascertainable and severable, so that the gift amount by the spouse is the amount of the transfer other than the spouse’s severable interest (because one cannot make a gift to himself or herself). www.bessemertrust.com/for-professional-partners/advisor-insights

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The terms of the trust are unknown; perhaps Mr. Nelson’s interest is ascertainable, severable, and de minimis based on the terms of the agreement. See Item 21.a above for a discussion of issues regarding the split gift election. 32. Charitable Gift Followed by Redemption Not Treated as Anticipatory Assignment of Income, Dickinson v. Commissioner, T.C. Memo. 2020-128 a.

Basic Facts. A shareholder and chief financial officer of a privately held company desired to donate shares of stock to the Fidelity Investments Charitable Gift Fund (Gift Fund). In 2013, 2014, and 2015, the board of directors authorized donations of shares to the Fidelity Gift Fund because it had a written policy requiring that it immediately liquidate donated shares and would promptly tender the donated stock to the issuer for cash. In each of those years, the taxpayer donated appreciated shares to the Gift Fund. Separate documents were signed by the taxpayer, by the corporation, and by the Gift Fund making clear that the Gift Fund owned and had exclusive control of the shares prior to the redemption and had full discretion over all conditions of subsequent sale and was not under any obligation to sell the shares. The Gift Fund redeemed the shares shortly after each donation, and the IRS ultimately claimed that the redemptions resulted in an assignment of income, as if the shareholder first sold the shares (realizing gain) and then contributed the cash to the Gift Fund. Dickinson v. Commissioner, T.C. Memo. 2020-128 (Sept. 3, 2020) (Judge Greaves, summary judgment).

Court Analysis. (1) Humacid v Commissioner Analysis. The court looked to its reasoning from more than 50 years earlier in Humacid Co. v. Commissioner, 42 T.C. 894, 913 (1964). In that case the court respected “the form of this kind of transaction [i.e., as a donation of shares followed by the charity’s redemption of the shares rather than as a sale of shares by the taxpayer followed by a donation of the cash proceeds] if the donor (1) gives the property away absolutely and parts with title thereto (2) before the property gives rise to income by way of a sale.” The donor met the first prong because it transferred all rights in the donated property (as confirmed by the various documents signed by the taxpayer, the corporation and the Gift Fund). Even a preexisting understanding that the charity “would redeem donated stock does not convert a postdonation redemption into a predonation redemption” or suggest “that the donor failed to transfer all his right in the donated stock.” The second prong, that the donation was made before the “property gives rise to income” implements the assignment of income doctrine, that a taxpayer who has earned income cannot escape taxation by assigning his right to receive payment. A key to the court’s analysis is its view that this second prong “ensures that if stock is about to be acquired by the issuing corporation via redemption, the shareholder cannot avoid tax on the transaction by donating the stock before he receives the proceeds.” (2) Dickinson Test. The court summarized its test in this type of situation as follows: The assignment of income doctrine applies “only if” (1) “the redemption was practically certain to occur at the time of the gift, and” (2) “would have occurred whether the shareholder made the gift or not.” The first leg was probably satisfied on these facts, in light of Fidelity’s strict written policy that it would immediately sell such donated stock. But the second leg was not satisfied. The taxpayer set out on three occasions to make charitable gifts. There was no indication whatsoever that the taxpayer would have sold shares to the corporation if the shares had not been donated to the Gift Fund. (3) Refusal to Apply “Legally Bound” Test of Rev. Rul. 78-197. The IRS announced in Rev. Rul. 78-197, 1978-1 C.B. 83, that it refuses to treat a redemption in this type of situation as an anticipatory assignment of income as long as the charity is not legally bound to sell the donated shares and cannot be compelled to surrender the shares for redemption. The IRS argued in

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Dickinson that taxpayer’s and corporation’s reliance on the Fidelity policy of immediately offering donated shares for redemption, “may suggest the donor had a fixed right to redemption income at the time of the donation.” The court disagreed, reasoning that it refused to adopt Rev. Rul. 78197 as the test for resolving anticipatory assignment of income claims in Rauenhorst v. Commissioner, 119 T.C. 157 (2002), and does not do so in this case either. c.

Observations. (1) “Palmer Issue.” This type of situation is often referred to colloquially as the “Palmer issue,” based on Palmer v. Commissioner, 62 T.C. 684 (1974) (taxpayer donated stock to foundation and then caused corporation to redeem the stock the following day), aff’d, 523 F.2d 1308 (8th Cir. 1975). (2) Refusal to Adopt Rev. Rul. 78-197 Bright Line Rule. Planners and taxpayers have been comforted by a bright line test in Rev. Rul. 78-197, 1978-1 C.B. 83, refusing to treat a redemption in this type of situation as an anticipatory assignment of income as long as the charity is not legally bound to sell the donated shares and cannot be compelled to surrender the shares for redemption. (Ironically, while the court in Rauenhorst did not adopt the “legally bound” test in Rev. Rul. 78-197 as the appropriate test, it strongly criticized the IRS for taking a position contrary to its own published ruling that it had not withdrawn.) On one hand, not having the bright line test is concerning for taxpayers and planners. On the other hand, the court’s test is for many situations an even stricter standard for the IRS to meet. (Indeed, the IRS might have satisfied the “compelled to redeem the shares” test of Rev. Rul. 78197 in this situation because of Fidelity’s written policy that it would sell any such donated shares, but it did not meet the second leg of the court’s test – that the redemption would have occurred whether the shareholder made the gift or not.) (3) Practical Effect of Court’s Approach vs. Rev. Rul. 78-197 Approach. Ron Aucutt summarizes the practical effect of the court’s approach: [T]his analysis should leave no cause for concern about a typical, perhaps recurring, donation of stock of an ongoing corporation, when there would have been no redemption in the absence of the gift. Dickinson offers less comfort for the case of, for example, a scheduled liquidation, or even a scheduled partial buy-back of shares, which a shareholder tries to beat by making a charitable donation. Ronald D. Aucutt, The Top Ten Estate Planning and Estate Tax Developments of 2020 (January 2021) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights).

(4) Roadmap for Planners. The court’s emphasis on the documentation of the transaction provides a roadmap to planners. •

The corporation confirmed in a letter to the Gift Fund that the corporation’s books and records reflected the Gift Fund as the new owner of the shares.

•

The taxpayer signed a letter of understanding indicating that the stock was “exclusively owned and controlled by Fidelity” and that Fidelity “maintains full discretion over all conditions of any subsequent sale” and “is not and will not be under any obligation to redeem, sell, or otherwise transfer the stock.”

•

The Gift Fund sent confirmation letters explaining that it had “exclusive legal control over the contributed asset.”

33. Decanting That Violates Duty of Impartiality, Hodges v. Johnson Decanting has become a popular trust modification alternative, particularly for making administrative adjustments to trusts. Trustees should keep in mind, though, that just because they have the power to take an action does not mean that they cannot be held accountable for exercising that power in an improper manner. Decantings that change the beneficial interests of beneficiaries in particular may raise questions. Hodges v. Johnson provides a good reminder that even though trustee has the POWER to decant to a trust for some but not all beneficiaries, the trustee must exercise that power consistently with settlor www.bessemertrust.com/for-professional-partners/advisor-insights

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intent and in accordance with the trustee’s duties, one of which is the duty of impartiality. In 1997, the New Hampshire Supreme Court upheld a finding that a decanting to eliminate as beneficiaries the settlor’s two stepchildren and one child with whom he had become estranged was void, violated the trustee’s duty of impartiality, and failed to consider the interests of all beneficiaries, both present and remainder, and upheld the removal of the trustee. 177 A.3d 86 (N.H. 2017). The removed trustees subsequently sought reimbursement of their expenses related to the decanting. The New Hampshire Supreme Court in 2020, upheld a trial court finding that the removed trustees should not have their posttrial fees and costs they incurred personally in defending the decants reimbursed from the trust. The court reasoned that they committed a serious breach of trust and should not be reimbursed, observing that they could have submitted a petition for instruction as to whether the decanting was appropriate. 244 A.3d 245 (N.H. No. 2019-0319, Sept. 23, 2020). 34. Titling of Casualty Insurance Policy, Jones v. Phillips a.

Synopsis. Jones v. Phillips, 859 S.E.2d 646 (Va. 2020) addresses a marital residence that was owned by spouses as tenants by the entireties and that they transferred 99% to wife’s revocable trust and 1% to husband’s revocable trust. (Virginia law preserves creditor protection even after tenancy by the entireties property is transferred to a trust.) The dwelling was destroyed by a fire and the casualty insurance policy was in the husband’s name. The issue was whether the husband’s creditor could garnish the casualty insurance proceeds. The couple argued unsuccessfully that the proceeds were tenancy by the entireties property and were therefore immune to claims of the spouses’ individual creditors. There is a difference between ownership of underlying property (which may be tenants by the entireties) and of the casualty insurance policy (which was owned just by the husband). Therefore, the husband’s creditors could reach the proceeds.

Practical Pointer. If underlying property is held as joint tenancy with right of survivorship or as tenants by the entireties, considering titling the casualty insurance policy the same way (if the insurance policy can be held by those titles under state law).

35. John Doe Summons Upheld to Determine Identity of Law Firm’s Clients Seeking Advice Regarding Particular Issues, Taylor Lohmeyer Law Firm P.L.L.C. v. United States A client of the Taylor Lohmeyer law firm was audited, and the client agreed to pay about $4 million in tax, interest, and penalties regarding the assignment of income to foreign accounts that the law firm had helped him structure. The IRS issued a “John Doe summons” to the law firm to disclose the names of all clients over a 12-year period that had used the law firm’s services regarding establishing any foreign account, any foreign legal entity, or any asset in the name of any such foreign entity. Section 7609 addresses special procedures for third-party summonses, and lists requirements for a John Doe summons, “which does not identify the person with respect to whose liability the summons is issued.” One of those requirements is that “there is a reasonable basis for believing that such person or group or class of persons may fail or may have failed to comply with any provision of any internal revenue law.” §7609(f)(2). The law firm acknowledged the general rule that a client’s identity is not protected from the attorneyclient privilege and is subject to subpoena, but argued that an exception applies when disclosure of the identity necessarily discloses the substance of the legal advice. The Fifth Circuit upheld the subpoena in a three-judge panel decision, relying primarily on a case involving an accounting firm, U.S. v. BDO Siedman, 337 F.3d 802 (7th Cir. 2003) (and obviously not involving the attorney-client privilege). The court summarized that the summons would not reach motive, or other confidential communications of [legal] advice…. Consequently, the Firm’s clients’ identities are not “connected inextricably with a privileged communication”, and therefore, the “narrow exception” to the general rule that client identities are not protected by the attorney-client privilege is inapplicable.

Taylor Lohmeyer Law Firm P.L.L.C. v. United States, 957 F.3d 505, 513 (5th Cir. 2020). The Fifth Circuit voted 9-8, on a petition seeking an en banc rehearing, not to grant the petition without giving any reasons for their decision, despite a strong eight-judge dissenting opinion, which emphasized www.bessemertrust.com/for-professional-partners/advisor-insights

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that “[w]hen the IRS pursues John Doe summonses against law firms, serious tensions with the attorneyclient privilege arise.” Taylor Lohmeyer Law Firm P.L.L.C. v. United States, Cause No. 19-50506 (Dec. 14, 2020). Concern regarding the erosion of the attorney-client privilege was summarized in an American College of Tax Counsel Amicus Brief: [T]he panel’s decision could facilitate the issuance of John Doe summons to a law firm seeking documents identifying any companies who retained the firm for legal advice regarding structuring their businesses so that intellectual property assets were located in low tax jurisdictions, or identifying any individuals who engaged the firm for legal advice regarding structuring a family limited partnership or annuity trust. Departing from longstanding and established precedent in this and other circuits, the panel’s decision subjects the John Doe summons power to abuse by allowing the IRS to make broad requests to law firms to circumvent the privilege. American College of Tax Counsel Amicus Brief at 14-15 (emphasis added).

Advisors have indicated that the IRS “is actively challenging the assertion of attorney-client privileges in tax cases” and the Fifth Circuit’s decision “could deter individuals from seeking legal advice.” See Kristen Parillo, SCOTUS Won’t Review John Doe Summons Dispute, TAX NOTES (Oct. 5, 2021). The Supreme Court denied certiorari in an October 4, 2021 order. The case is summarized (and strongly criticized) in James P. Dawson & Kevin E. Packman, IRS Fishing Expedition Leads to Erosion of Attorney-Client Privilege, LEIMBERG INC. TAX PLANNING NEWSLETTER #209 (Dec. 29, 2020). 36. Valuation of Majority Interests in LLCs Owning Real Estate; Estate Tax Charitable Deduction Based on Values Passing to Each Separate Charity, Estate of Warne v. Commissioner, T.C. Memo. 2021-17 a.

Synopsis. Ms. Warne made gifts of interests in five LLCs owning real estate investments in 2012 and died owning (actually in a revocable trust) majority interests in the LLCs (all over 70% and three over 80%). The operating agreements all gave significant powers to the majority interest holders (including the power to dissolve the LLCs and to remove and appoint managers). Ms. Warne owned 100% of one LLC at her death, which she left 75% to a family foundation and 25% to a church. The real estate interests were substantial; the remaining LLC interests owned by Ms. Warne at her death were valued on her estate tax return at about $73.7 million. The parties agreed on most of the values, but the court determined the values of three leased fee interests at the date of the gift and at the date of death. The court also determined appropriate lack of control and lack of marketability discounts for the LLC majority interests owned at death. The court suggested that it might have found zero lack of control discount for the majority interests, but the parties had agreed that some level of lack of control discount should apply. The court generally adopted the approach of the estate’s expert, who compared premiums from completely controlling interests in companies (90% - 100% interests) with premiums from interests that lacked full control (50.1% - 89.9% interests) and concluded that the discount should be in the 5% - 8% range (compared to the IRS’s expert’s 2% lack of control discount). However, in reaching that conclusion the expert took into consideration that strong opposition and potential litigation would arise if the majority holder attempted to dissolve. The court found no evidence of future litigation risks and lowered the lack of control discount to 4%. Both experts used restricted stock studies to determine the lack of marketability discount (5% - 10% by the estate’s expert and 2% by the IRS’s expert). The court concluded that a 5% lack of marketability discount was appropriate. The estate argued that the 100% interest in the LLC that was left to two charities should be completely offset by the estate tax charitable deduction (because the 100% interest was donated entirely to charities), but the court concluded that a charitable deduction was allowed only for the value passing to each charity. The parties had agreed that a 27.385% discount applied for the 25% passing to the church and a 4% discount applied for the 75% passing to the foundation. (Applying discounts to the charitable deduction reduced the charitable deduction by over $2.5 million.)

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The failure to file penalty was applied for the late filing of the gift tax return because the estate offered no evidence of reasonable cause for the late filing. The case is appealable to the Ninth Circuit Court of Appeals if it is appealed. Estate of Warne v. Commissioner, T.C. Memo. 2021-17 (Feb. 18, 2021) (Judge Buch). b.

Basic Facts. Mr. and Ms. Warne amassed various real estate properties beginning at least in the early 1970s. Over time, the real estate properties were owned in five separate LLCs. Mr. Warne died in 1999. Ms. Warne made gifts of various minority interests in the LLCs to her two sons in 2012, and Ms. Warne died in 2014. The 2012 gift tax return was filed (late) at the same time as Ms. Warne’s estate tax return (which was timely filed), in May 2015. At the time of Ms. Warne’s death, the Warne Family Trust (the “Family Trust,” apparently a revocable trust), the value of the assets of which was included in Ms. Warne’s gross estate, owned the following majority interests in the five LLCs: 78%, 72.5%, 86.3%, 87.432%, and 100%. The remaining minority units were owned in various amounts by one of more of the sons, by three granddaughters, and by a sub-trust of the Family Trust. All of the LLC agreements “grant significant power to the majority interest holder, such as the ability to unilaterally dissolve the LLCs and appoint and remove managers.” The LLC of which the Family Trust owned 100% was Royal Gardens, LLC (“Royal Gardens) and the trust agreement provided that following Ms. Warne’s death the Royal Gardens units were left 75% to the Warne Family Charitable Foundation and 25% to a church. The estate tax return listed the values of the Family Trust’s majority interest in each of the LLCs at $18,006,000, $8,720,000, $11,325,000, $10,053,000, and $25,600,000 (Royal Gardens), respectively, or a total value of $73,704,000. Those values were determined by first valuing the underlying real property interest in each LLC, and by applying lack of control and lack of marketability discounts to the LLC interests owned by the Family Trust. The IRS asserted a gift tax deficiency for the 2012 gifts (and before trial increased the deficiency to $368,462) and asserted an estate tax deficiency of $8,351,970. The unresolved issues addressed at trial were (i) the date of gift value of three leased fee interests (that were owned by two of the LLCs), (ii) the date of death value of those same three leased fee interests, (iii) the appropriate discount for lack of control and lack of marketability of the majority interests in the LLCs held by the Family Trust at Ms. Warne’s death, (iv) whether discounts apply to the 25% and 75% interests left to separate charities in the Royal Gardens LLC, and (v) whether a failure to file penalty under §6651(a)(1) applies for the 2012 gift tax return that was filed late. Apparently, the parties came to agreement with respect to the values of the remaining real estate properties and as to the appropriate lack of control and lack of marketability discounts for the gifted LLC interests. The two sons were co-executors of Ms. Warne’s estate, and they both resided in California when the petitions were filed (so the case would be appealable to the Ninth Circuit Court of Appeals).

Analysis. (1) Values of Leased Fee Interests. Three leased fee interests were valued by appraisers for the estate and for the IRS. The appraisers, in appraiser-speak fashion, referred to various approaches such as the “direct capitalization approach” (which the court determined was inappropriate for the particular property involved), “yield capitalization approach,” appropriate discount rates, “discounted cashflow analysis,” “sales comparison approach,” and “buildup method” (for determining a discount rate). The court weighed the arguments made by the appraisers, putting more weight on the expert’s appraiser as to some issues and on the IRS’s expert as to other issues. The court determined which of various comparable properties were most appropriate for valuing the three leased fee interests.

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(2) Lack of Control Discount for Majority LLC Interests. The estate and IRS each used a different appraiser than the appraiser used to value the underlying leased fee interests in order to determine appropriate lack of control and lack of marketability discounts for the majority percentage interests owned by the Family Trust at Ms. Warne’s death. The court emphasized that majority interests were being valued and that the LLCs all grant significant powers to the majority interest holder (including the power to dissolve and to remove and appoint managers). The court pointed to cases that have held that no lack of control discount applies in similar situations (Estate of Jones v. Commissioner, 116 T.C. 121, 135 (2001); Estate of Streightoff v. Commissioner, T.C. Memo. 2018-178) and hinted that it might have concluded that no lack of control discount was allowed, but “[b]ecause the parties agree to a discount for lack of control, we will find one; however, given the control retained by the Family Trust, the discount should be slight.” The IRS’s expert used data from nine closed-end funds to estimate a lack of control discount of 2%. The estate argued that discounts from closed-end funds are sometimes used to discern minority-interest discounts, but not discounts for lack of control for a majority interest. The court was sympathetic to that position, citing the Richmond (T.C. Memo. 2014-26), Kelley (T.C. Memo. 2005-235), and Peracchio (T.C. Memo. 2003-280) cases as examples of using closed-end funds for valuing minority-interest discounts, and noting that while the Grieve case (T.C. Memo. 202028) used closed-end funds for analyzing the lack of control discount for majority interests in LLCs, the majority interests valued in Grieve lacked voting rights, making the interests more similar to minority interests. The court also thought the nine closed-end funds selected as comparables were too dissimilar to the LLCs in the estate, and that a larger sample size should be used when comparables are more dissimilar (citing Lappo, T.C. Memo. 2003-258, and Heck, T.C. Memo. 2002-34). Because the IRS’s expert’s database was inappropriate, the court refused to adopt its 2% discount. The estate’s expert compared premiums from completely controlling interests in companies (90% - 100% interests) with premiums from interests that lacked full control (50.1% - 89.9% interests), and after considering qualities specific to the five LLCs (including “strong opposition and potential litigation” if the majority owner attempted to dissolve), concluded that a lack of control discount of 5% - 8% should apply. The court found no evidence that the minority interest holders were litigious or would pursue litigation to contest a dissolution. Citing Olson v. United States, 292 U.S. 246, 257 (1934), for its statement that potential occurrences “not fairly shown to be reasonably probable should be excluded from consideration,” the court concluded that no adjustment should be made for future litigation risks so the discount should be lower than the 5% - 8% range suggested by the estate and that a 4% lack of control discount was appropriate. (3) Lack of Marketability Discount. Both experts used restricted stock equivalent discounts to determine the lack of marketability discount. The estate’s expert determined that a 5% - 10% discount should apply and the IRS’s expert used a 2% discount. The court concluded that the estate’s expert “considered additional metrics and provided a more thorough explanation of his process.” Furthermore, the IRS’s expert reached a 14.5% restricted stock equivalent discount but from that determined a mere 2% discount for lack of marketability “without justifying the substantial decrease in the discount.” The court accepted the 5% - 10% range suggested by the estate’s expert but believed that the lower end of the range was appropriate, so concluded that a 5% lack of marketability discount applied. (4) Charitable Deduction Discount. The Family Trust’s 100% interest in Royal Gardens passed entirely to charity, but was split between two charities, 25% to a church and 75% to a family foundation. The estate maintained that applying a discount in determining the charitable deduction because each charity received less than 100% was not appropriate: The estate insists that discounts are inappropriate and would subvert the public policy of motivating charitable donations. It claims that because 100% of Royal Gardens was included in the estate and the estate donated 100% of Royal Gardens to charities, the estate is entitled to a deduction of 100% of Royal Gardens’ value. www.bessemertrust.com/for-professional-partners/advisor-insights

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The court disagreed, applying a two-step analysis. First, the court reasoned that in valuing the gross estate, “we value the entire interest held by the estate, without regard to the later disposition of that asset.” Second, the court noted that a charitable deduction is allowed “for what is actually received by the charity” (quoting Ahmanson Foundation, discussed immediately below). “In short, when valuing charitable contributions, we do not value what an estate contributed; we value what the charitable organizations received.” The court cited Ahmanson Foundation v. United States, 674 F.2d 761 (9th Cir. 1981), in support of both of those steps of the analysis. In Ahmanson, the decedent owned the one voting share and all 99 nonvoting shares of a corporation. The voting share was left to the decedent’s sons and the 99 nonvoting shares were left to a charitable foundation. The gross estate value of the 100 shares took into consideration that the decedent held full voting control of all the shares, but “the estate’s deduction attributable to the donation of the 99 nonvoting shares necessitated a 3% discount to account for the foundation’s lack of voting rights.” The fact that the asset in Ahmanson was split between an individual and a charity rather than between two charities made no difference because that did not affect the value of the church’s and foundation’s respective interests that they received “and it is the value of the property received by the donee that determines the amount of the deduction available to the donor.” The parties reached agreement regarding the amounts of discounts if the court determined that discounts were appropriate in determining the charitable deduction for the charitable transfers to the church and to the foundation. The parties stipulated a 27.385% discount for the 25% passing to the church and a 4% discount for the 75% passing to the foundation. Discounting the interests passing to the separate charities resulted in a reduction of the charitable deduction of over $2.5 million, a quite significant reduction. (5) Failure to Timely File Penalty. The IRS met its burden of showing that the taxpayer filed late, but the estate did not meet its burden of establishing reasonable cause, offering no evidence in support of that position. Therefore, the failure to timely file penalty under §6651(a)(1) was applicable as to any gift tax deficiency. d.

Observations. (1) Small Lack of Control and Marketability Discounts Allowed for Controlling Majority Interest in LLCs. Lack of control and lack of marketability discounts were determined for the estate tax value of the estate’s super-majority in five LLCs owning real estate (all over 70% and three over 80%). Several of the LLCs owned multiple real estate investments; one owned multifamily apartment buildings and a retail shopping center and another owned a multifamily apartment complex and another unleased property. The other three LLCs each owned a single real property investment (an operating farm, property surrounding a gas station, and a mobile home park). The LLC operating agreements all “grant significant power to the majority interest holder, such as the ability unilaterally to dissolve the LLCs and to appoint and remove managers.” Even so, the 4% lack of control discount and 5% lack of marketability discount, a combined seriatim discount of 8.8% (.04 + [.05 x .96] = .088), might seem low for interests in LLCs owning real estate. Fractional undivided interests in real estate are often valued with a 15% - 25% discount or more, (but a few cases have allowed lower discounts). E.g., Estate of Mitchell v. Commissioner, T.C. Memo. 2011-194 (estate and IRS stipulated to the following fractional interest discounts: Beachfront property: 32% discount for 5% gifted interest and 19% discount for 95% interest owned at death; Ranch property: 40% discount for 5% gifted interest and 35% discount for 95% interest owned at death); Ludwick v. Commissioner, T.C. Memo. 2010-104 (17.2% discount for 50% interests in Hawaiian vacation home); Estate of Baird v. Commissioner, T.C. Memo. 2001258 (60% discounts for undivided interests in timberland). A distinction from the fractional undivided interest situation, however, is that the majority interest holder of an LLC generally may have the power to decide to sell the assets and divide the proceeds among the members, without a court supervised partition proceeding.

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(2) Discounts Considered for Estate Tax Charitable Deduction Purposes. Warne is consistent with other cases and rulings that have considered the values actually passing to specific charities in determining the estate tax charitable deduction. The Ahmanson case is described in the Warne opinion (and summarized above). Estate of Schwan v. Commissioner, T.C. Memo. 2001-174, also determined the estate tax charitable deduction based on the value actually passing to a charity, which was less than the value in the gross estate. The decedent in Schwan owned two-thirds of the voting and non-voting stock of a corporation. The decedent’s estate plan provided that the shares would be distributed to a charitable foundation, and a redemption agreement provided that the voting shares would be redeemed. The court determined that the value to be included in the gross estate was a unitary unrestricted two-thirds interest in the corporation. However, the redemption agreement provided that the voting stock left to the foundation would be redeemed, leaving the foundation with only non-voting stock. The IRS took the position that the foundation received a bequest of money equal to the value of the voting stock and the non-voting stock—which should be valued at a discount for purposes of determining the amount of the charitable deduction. Thus, the amount of the deduction was less than the value in the gross estate. The estate argued that the foundation had the right to require the redemption of all its stock, because it received two-thirds of the voting stock, and before its redemption, it would have control and the ability to recapitalize the corporation and remove any distinction between the two classes of stock. The court concluded that it could not grant the estate’s summary judgment motion on this issue because of the possibility under state law of rights of minority shareholders that would restrict the foundation’s right to recapitalize and to force the redemption of all its stock. The IRS took a similar position in a 2006 Technical Advice Memorandum. Tech. Adv. Memo. 200648028 (minority interest applies for charitable deduction purposes). (3) Charitable Deduction Discount Analysis Is Similar to Comparable Marital Deduction Cases. If a controlling interest in an asset is left to the marital share, a control premium may be appropriate in determining the value of that asset. See Estate of Chenoweth v. Commissioner, 88 T.C. 1577 (1987) (bequest of 51% of stock of family company to surviving widow entitled to premium "control element" to increase marital deduction). However, this principle also works in reverse. The IRS took the position in several Technical Advice Memoranda that valuation discounts should be considered in funding marital bequests. In Tech. Adv. Memo. 9050004, the decedent left 51% of the stock of a closely held corporation to a trust for his son, and the remaining 49% to a QTIP trust. The IRS, citing the Chenoweth case, concluded that the stock passing to the QTIP trust should be valued with a minority interest discount. Tech. Adv. Memo. 9403005 concluded that the minority stock interest that passed to the surviving spouse had to be valued as a minority interest for purposes of the estate tax marital deduction, even though the decedent owned a controlling interest in the corporation. See AOD CC-1999-006, describing acquiescence in Estate of Mellinger v. Commissioner, 112 T.C. 26 (1999), and stating that “[t]he proper funding of the QTIP trust should reflect, for example, the value of minority interests in closely-held entities or fractional interests in real estate that are used in satisfying the marital bequest”. A 1999 Tax Court memorandum case is the first case recognizing that the value of assets passing to a spouse must take into account minority interests for purposes of determining the marital deduction. In Estate of Disanto v. Commissioner, T.C. Memo. 1999-421, the surviving wife signed disclaimers so that only a minority interest in closely held stock passed to the wife. The court held that the stock passing to the wife must be valued as a minority interest for purposes of determining the amount of the marital deduction. (4) Planning Alternatives to Avoid Reduction of Charitable Deduction. Under the Warne facts, if the Family Trust had left the entire 100% LLC interest to the foundation or a donor advised fund (DAF), and if 25% of the LLC had been later distributed to the church from the foundation or the DAF (perhaps based on knowing the decedent’s desires, but under no legal obligation or even formal understanding to do so), the overall economic effect would have been the same, but no www.bessemertrust.com/for-professional-partners/advisor-insights

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reduction of the charitable deduction would have applied because the entire 100% interest would been transferred from the estate to a single charity. (5) Policy Rationale for Discounts When Asset Passes Entirely to Multiple Charities. The ability to avoid the reduction of the charitable deduction under the Warne analysis merely by leaving the asset first to a foundation or donor advised fund, which could then distribute the asset to multiple charities, raises the question of the policy rationale of denying a full charitable deduction when an asset is left in its entirety to multiple charities. The court rejected the estate’s attempt to distinguish Ahmanson because if involved splitting an asset between an individual and a charity rather than between two charities. The estate argued that applying discounts when the asset passed entirely to charities “would subvert the public policy of motivating charitable donations” and that leaving 100% of the LLC to charities should entitle the estate to a deduction of 100% of the value of the LLC. The court disagreed, focusing on allowing a charitable deduction for the value received by each donee. Commentators have questioned the public policy rationale of denying a full charitable deduction when an asset is left entirely to charity, whether that is one charity or multiple charities, and suggesting that the case should be appealed for that reason: Unlike in Ahmanson Foundation, the decedent in Warne did not adopt a testamentary plan severing the voting power of Royal Gardens from its economic entitlement and then give only an economic entitlement to charity. Nor did she take any other affirmative steps to diminish the value ultimately passing to charity. Instead, the decedent merely gave a 75% membership interest in Royal Gardens to one charity and the remaining 25% membership interest to another charity. Query whether the purpose of the charitable deduction of encouraging charitable gifts would be any better effectuated by requiring the decedent in this situation to give her entire interest in Royal Gardens to either her family foundation or to her church, rather than allowing her to allocate such interests among charities as she desires? The IRS has actually been more lenient in certain cases when it comes to the application of valuation discounts for property contributed to charity. In Rev. Rul. 57-293, 1957-2 CB 153, for example, the IRS ruled that the charitable income tax deduction for a contribution of a fractional interest in artwork to a museum was equal to its fair market value multiplied by the fractional interest conveyed…. Query what the result would be where an individual who owns a $10 billion art collection gives at his or her death a 50% fractional interest in the collection to the Metropolitan Museum of Art and the remaining 50% fractional interest to the National Gallery of Art? The $10 billion would clearly be included in his gross estate but should the charitable estate tax deduction be any less than the same $10 billion included in the gross estate? Any valuation discount applied in determining the charitable estate tax deduction on the basis of what is actually received by the charities would result in significant estate taxes being imposed merely because the decedent desires for the collection to be displayed at two of the country’s great museums following his death. Would the purpose of the charitable deduction be better served by requiring the collection in such a case to be given to only one of the museums? Or should a valuation discount not be applied where the asset being donated is used directly for the charitable purposes of the donee charity, such as works of art to be displayed by a museum? The Warne case, which is appealable to the United States Court of Appeals for the Ninth Circuit, the same court that decided Ahmanson Foundation, would seem ripe for appeal. Richard L. Fox & Jonathan G. Blattmachr, Estate of Miriam M. Warne - Decedent’s Splitting of Charitable Bequest of 100% LLC Membership Interest Between Two Separate Charities Results in Mismatch of Value Included in Gross Estate and Amount Allowed As Estate Tax Charitable Deduction, LEIMBERG CHARITABLE PL. NEWSLETTER #306 (March 1, 2021).

(6) Entire Interest Passing to Charity and Spouse. A similar situation arises if the entire interest in an asset owned by an estate (or the entire estate) passes partly to a charity and partly to a surviving spouse. The intuitive reaction may be that all the interest is passing in a manner that qualifies for a deduction, thus resulting in no estate tax, but the rationale of Warne (and Disanto and Ahmanson) results in a reduction of the overall charitable and marital deduction when the valuation of the asset is subject to discounts, possibly resulting in an estate tax being due. (7) Somewhat Analogous “Marital Deduction Mismatch” Argument for §2036 FLP Situations. The IRS has made the similar argument in cases involving family limited partnership cases if the undiscounted value of the assets contributed to the partnership is included in the gross estate under §2036, arguing that a marital deduction is allowed only for the discounted limited www.bessemertrust.com/for-professional-partners/advisor-insights

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partnership interest that actually passes to the surviving spouse. This situation arises when a spouse contributes assets to an FLP, retains most of the partnership interests until his death, and dies with a formula marital deduction clause that leaves assets to the surviving spouse to minimize estate taxes, and the value of the assets contributed to the partnership is included in the gross estate under §2036. In two reported cases (Estate of Black v. Commissioner, 133 T.C. 340 (2009), and Estate of Shurtz v. Commissioner, T.C. Memo. 2010-21) the IRS has made the argument that while the value of the partnership assets is included in the gross estate (without a discount), the estate actually owns only a limited partnership or LLC interest and does not own the assets directly. The government’s brief in Black stated the argument as follows: Petitioner overlooks the fact that §§2036 and 2035 include the value of property that has previously been transferred, while the marital deduction is limited to the value of the property actually passing to the surviving spouse. There is good reason for this limitation. On the death of the surviving spouse, only that property (here, the discounted value of the BILP interest) will be in includable in the spouse’s gross estate under I.R.C. §2044.

All the estate can leave the spouse (i.e., all that can “pass” to the spouse for marital deduction purposes under §2056) is a discounted entity interest. Thus, there would be estate inclusion at a high level (without a discount) but the marital deduction would be allowed at a much lower level (taking into account discounts). That difference would first reduce the amount passing to the bypass trust, but if that difference were more than the remaining estate tax exemption amount available to the estate, there would be estate taxes due at the first spouse’s death. See generally Angkatavanich, Black Shirts (Black, Shurtz) and the Marital Deduction Mismatch, Trusts & Estates 37 (June 2010). The Tax Court considered a different marital deduction issue in Estate of Turner v. Commissioner, 138 T.C. 306 (2012). (That is the second of three reported cases involving that fact situation and is sometimes referred to as “Turner II.”) The estate argued that the decedent’s will contained a formula marital deduction clause and that the marital deduction should offset any value included in the gross estate under §2036. The marital deduction issue addressed in this supplemental opinion is whether a marital deduction is allowed for partnership assets attributable to 21.7446% limited partnership interests that the decedent had given to various family members (other than his spouse) during his lifetime. The court concluded that because the surviving spouse did not receive those 21.7446% limited partnership interests, no marital deduction is allowed for the value of assets attributable to those interests that is included in the gross estate under §2036. The court reasoned that the statutory and regulatory marital deduction provisions as well as the overall structure of the wealth transfer system support that result. The classic marital deduction mismatch issue does not arise in Turner II because the IRS allowed a marital deduction for the full value of assets attributable to partnership interests that the decedent owned at his death and could pass to the surviving spouse under the formula marital deduction bequest in the decedent’s will. In short, the Tax Court did not have to address the marital deduction mismatch issue in Black and Shurtz because the court held that §2036 did not apply in those cases. The classic marital deduction mismatch issue did not arise in Turner II because the IRS allowed a marital deduction for the full value of assets attributable to partnership interests that the decedent owned at his death and could pass to the surviving spouse under the formula marital deduction bequest. No court has yet faced the marital deduction mismatch issue in the context of §2036 FLP cases. A tax fiction deems the value of the assets that were transferred in the §2036 transaction to be in the gross estate, and the issue is whether that same tax fiction is applied for deduction purposes as well. On the one hand, the estate owns only the discounted limited partnership interest, so arguably that is all that can “pass” to the surviving spouse for purposes of the marital deduction’s “passing” requirement. On the other hand, a sense of consistency and fairness arguably may suggest that the fiction should apply for marital deduction purposes as well as estate inclusion purposes. The concept of the marital deduction is that a couple can avoid estate taxes at the first spouse’s death, deferring estate taxes until the second spouse’s death, and it may not be possible to avoid having to pay large estate taxes at the first spouse’s death if a full www.bessemertrust.com/for-professional-partners/advisor-insights

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marital deduction is not allowed. Take the simple situation in which all the estate is passing to the surviving spouse and the estate owns a 99% interest in the partnership that is left to the spouse. That is not a situation (like in Turner II) where the decedent had made gifts of most of the partnership interests to persons other than the spouse. The spouse is receiving all the estate and all the partnership interest related to the value of the assets included under §2036, so arguably there should be a marital deduction for all that value. Or consider a situation in which the decedent made a lifetime gift of all his partnership interests to the surviving spouse, but the court applies §2036. Again, the very asset that gives rise to §2036 also ends up in the hands of the surviving spouse, and a sense of consistency may suggest that the marital deduction should match the inclusion amount. The effect of allowing a full marital deduction for the undiscounted value included under §2036, however, is that no particular disadvantage exists for having §2036 apply at the first spouse’s death regarding assets contributed to the FLP by that spouse (and §2036 would not apply at the surviving spouse’s subsequent death as to assets contributed to the FLP by the first-decedent spouse). 37. Sale Decisions by Sponsors of Donor Advised Funds Contrary to Expectations of Donors, Fairbairn, et al. v. Fidelity Investments Charitable Gift Fund, Pinkert v. Schwab Charitable Fund a.

Synopsis of Fairbairn. On December 28 (that is a key fact), successful hedge fund managers contributed 1,930,000 shares of a publicly traded company (worth over $100 million) to a DAF. The DAF sold all those shares the next day (December 29, the last trading day of the calendar year), all within 2½ hours. At the completion of trading all those shares, the stock had declined in value by about 30%, or about $9.6 million, which reduced the charitable deduction by $3.3 million. An executive of the company that was sponsor of the DAF sent text messages saying “[we] botched the trades” and the company “has been an awful biz partner [to the Fairbairns] throughout all of this.” The Fairbairns testified that the company representatives had orally promised various things: (1) employ state-of-the-art methods for liquidating large blocks of stock; (2) not trade more than 10% of daily trading volume [which they didn’t]; (3) not liquidate any shares until the new year; and (4) allow the Fairbairns to advise on a price limit. The Fairbairns sued for common law misrepresentation, breach of contract, promissory estoppel, violation of unfair competition law, and negligence. The federal district court held for the Fund, reasoning: (1) the plaintiffs did not establish by a preponderance of evidence that the sponsor had agreed to those items; (2) the plaintiffs did not establish that the sponsor did not in fact employ “sophisticated state-of-theart methods”; (3) even if the sponsor owed the Fairbairns a duty of care, due to a special relationship, there was no proof that it breached that duty; (4) the plaintiffs did not prove that a reasonably prudent DAF would not have sold all shares within 2½ hours under the market conditions on December 29, but would have spread out liquidation over several days; and (5) the sponsor acted consistently with its published, written policies regarding the liquidation of contributed shares. Fairbairn, et al. v. Fidelity Investments Charitable Gift Fund, No. 3:18-cv-04881-JSC (N.D. Calif, Feb 26, 2021).

Planning Pointers from Fairbairn.

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•

Many DAFs have similar written policies (perhaps not to sell $100 million worth of shares ALL the NEXT day and all within 2½ hours).

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This is a recent case that made headlines in the public media.

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The DAF is in control of when to liquidate assets contributed to the fund.

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A contributor should assume the DAF will sell all the next day.

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The contributor should spread out contributions to assure the fund will not sell $100 million worth the next day, all within 2½ hours (ostensibly causing a huge price decline within that short time frame). That’s why the December 28 contribution date is significant in this case. The donor did not have time to spread out contributions and still get a charitable contribution for 2017.

Synopsis of Pinkert. A Magistrate Judge for the federal district court in the Northern District of California has similarly denied relief for a donor of a donor advised fund against the fund’s sponsor, but the rejection of the donor’s claim was based on a lack of standing rather than a substantive finding that the sponsor did not breach a fiduciary duty as in Fairbairn. The Schwab Charitable Fund (the “Fund”) is legally independent of the Schwab Corporation, but the Fund used the brokerage services and investment products of Schwab Corporation, and “every person working for [the Fund] is actually an employee of the Schwab Corporation.” The donor’s assertions included that (i) cheaper alternative index funds and money-market funds could have been used, (ii) the Fund invested in retail products rather than lower-priced wholesale products available to institutional investors, (iii) the Fund could have used its marketing power to negotiate lower rates, and (iv) the Fund benefitted Schwab Corporation to the Fund’s detriment. The order reasoned that the donor gave up exclusive legal control and ownership of the assets contributed to the Fund. To have standing under Article III of the U.S. Constitution, the plaintiff must have (i) suffered an injury in fact (an invasion of a legally protected interest that is concrete and particularized and actual or imminent), (ii) that is fairly traceable to the defendant’s alleged conduct, and (iii) that is likely to be redressed by a favorable judicial decision. The court stated that the donor’s advisory privileges regarding distribution or investment decisions do not equate to a concrete protected interest considering the Fund’s exclusive legal control over the donated assets. A plaintiff must asset injury to his own legal rights, not the legal rights of others, and the plaintiff is not a beneficiary of the Fund. The court distinguished Fairbairn because it was a misrepresentation and breach of contract case involving allegations that the sponsor broke specific promises rather than a general claim of mismanagement (but, in fact, the court in Fairbairn stated that the plaintiff contended, apart from alleged promises, that the sponsor “violated the duty of care” owed to the donor). The order also reasoned that the plaintiff lacked standing under California law. Pinkert v. Schwab Charitable Fund, No. 3:20-cv-07657 (N.D. Calif. Order dated June 17, 2021).

38. Valuation of Publicity Rights, Undervaluation Penalties, Estate of Michael Jackson v. Commissioner, T.C. Memo. 2021-48 a.

Brief Synopsis. The court in a 265 page opinion addressed the value of three assets in the estate of Michael Jackson, the “King of Pop”-- the value of the decedent’s “image and likeness” (i.e., publicity rights) and the value of two entities. There were huge differences between the estate’s position and the IRS position for all three assets. (The values of other assets in the estate were stipulated.) For the decedent’s image and likeness, the estate’s and the IRS’s value positions were $3.078 million and $161 million, respectively. The court valued the rights at only $4.15 million, considering the poor state of Michael Jackson’s reputation at his death. The court used a discounted cash flow analysis based on projected revenues and expenses. The other two assets were interests in bankruptcy trusts that owned music catalogs. One of them owned a large catalog of Beatles songs; the assets were very valuable (the IRS valued the interest at $206 million in the notice of deficiency) but the decedent had borrowed heavily against the trust to fund his lifestyle and the court found that it had a net zero value. The second owned another large catalog of songs (most notably from Jackson himself). The estate and IRS valued it at $2.27 million

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and $114 million, respectively, and the court valued it at $107 million using a discounted cash flow analysis. In valuing these assets, the court refused to “tax affect” the income under an assumption that a C corporation would be the most likely hypothetical purchaser of the assets. The IRS assessed penalties, but the court found that the estate acted with reasonable cause and in good faith in relying on the appraisals for the reported values. Estate of Michael L. Jackson v. Commissioner, T.C. Memo. 2021-48 (May 3, 2021) (Judge Holmes). For an insightful discussion about case, see Scott St. Amand, Valuing a Complex Legacy: Lessons in Valuation From Estate of Jackson, BLOOMBERG ESTATES, GIFTS & TRUSTS J. (Sept. 9, 2021). b.

Wild Variances in the Positions of the Estate and the IRS. The estate’s position was that the value of the entire estate was about $7.2 million vs. $1.125 BILLION as the IRS’s position in the notice of deficiency. Eventually, the parties agreed on the values of all assets except for three assets. Here are the positions of the estate and IRS, as summarized by the court: Reported on Estate Return

Notice of Deficiency

Estate on Brief

Commissioner on Brief

Image and likeness

$2,105

$434,264,000

$3,078,000

$161,307,045

New Horizon Trust II

-0-

469,005,086

-0-

206,295,934

60,685,944

2,267,316

114,263,615

New Horizon Trust III 2,207,351 c.

Valuation of Decedent’s Image and Likeness; Publicity Rights. The decedent’s legal rights in property are determined under California law, where the decedent was domiciled at his death. After the California Supreme Court held that the “right to exploit name and likeness is personal to the artist” and post-mortem uses of a person’s identity are not actionable in Lugosi v. Universal Pictures, 603 P.2d 425 (Cal. 1979), California created a statutory post-mortem right of publicity. Accordingly, this state law property right was an asset included in the gross estate. (Many states have not recognized a post-death name and likeness property right (sometimes referred to as a post-death right of publicity) to exploit the right financially and to prevent others from exploiting the decedent’s name and likeness; a decedent domiciled in one of those states might have no value to be included in the gross estate attributable to enforceable post-death publicity rights.) The estate’s and IRS’s values of the decedent’s image and likeness on the estate tax return and in the notice of deficiency were $2,105 and $434,264,000 -- an incredibly wide variance. After years of doing additional valuation work, their positions changed at trial to $3.078 million and $161.3 million, respectively – still a very wide difference. Michael Jackson in reality had received almost no revenue for about a decade prior to his death, and the appraisal that was used to support the $2,105 value reported on the estate tax return was based on those facts. An expert for the estate (“the CEO of CMG Worldwide, Inc., an international licensing and rights-management company that specializes in representing celebrities both dead and alive”) did substantial additional appraisal work after the estate tax return was filed. He projected 10 years of post-death revenues from the exploitation of Jackson’s image and likeness and associated trademarks, and another expert estimated the date of death value based on those projections. The IRS’s expert “considered five ‘opportunities’ that he believed a hypothetical buyer could reasonably foresee at Jackson’s death: themed attractions and products, branded merchandise, a Cirque du Soleil show, a film, and a Broadway musical. The court viewed the IRS’s expert’s analysis “as fantasy.” The expert (1) valued the wrong asset (because the California statutory definition of the post-death image and likeness property right excludes musical compositions among other things, the consideration of a Cirque du Soleil show, film, and Broadway musical all involved musical copyright rights not included in the image and likeness property right, and the themed attractions and branded merchandise both involved existing intellectual property rights licenses that are distinct from image and likeness), (2) included unforeseeable events in his valuation, and (3) miscalculated the assets’ value because of “faulty” math.

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The court the valued the rights at only $4.15 million, providing a lengthy (and quite interesting) factual background about the poor state of Michael Jackson’s reputation at this death and observing that the estate would have to spend a significant amount of money to rehabilitate his image. A discounted cash flow analysis was used after projecting revenue and expenses separately for the first 10 years and decreasing net income by 5% for each of years 11-70, and using a discount rate of 15.4%. d.

New Horizon Trust II. The second asset valued by the court was an interest in a Delaware trust (a bankruptcy trust) that owned the copyrights to The Beatles catalog, which included at least 175 songs that had been co-authored by John Lennon and Paul McCartney, as well as other copyrights. The estate valued this asset at $0 and the IRS valued it on the notice of deficiency at $206 million. The court concluded that the assets were worth about $227 million but were subject to over $300 million of debts (borrowed to fund Michael Jackson’s very expensive lifestyle) and had a net value of zero.

New Horizon Trust III. The third asset was also a bankruptcy trust, the major asset of which is a music catalog that owns compositions from a variety of artists, most notably Jackson himself. The catalog included five different groups of songs with income coming primarily from three sources. The estate valued this asset at $2.27 million and the IRS valued it at $114 million. The court adopted the experts’ approach of using a discounted cash flow analysis and determined a value of $107 million.

Credibility of IRS’s Expert. The court made a point of noting that the IRS’s expert lied twice at trial. (1) When asked if he had ever represented the IRS before and whether he wrote a valuation report for the IRS in Whitney Houston’s estate tax case, he said “No, Absolutely not.” The court responded “That was a lie.” (After “recess and advice from the Commissioner’s counsel,” the expert admitted he had been retained by the IRS in that case.) (2) The expert also “testified that neither he nor his firm ever advertised to promote business. This was also a lie.” He had sent an email blast bragging that he “is the expert of the century and will be testifying on behalf of the IRS,” and he referred to his involvement in this “Billion Dollar Case” in a lecture given before trial. The estate moved to strike his entire testimony, as tainted by perjury. The court found that remedy “too severe,” but concluded that the court would “discount the credibility and weight we give to [the expert’s] opinions.”

Tax-Affecting. One of the issues involved in valuing all three assets was whether to “tax-affect” the income on an assumption that a C corporation would be the most likely hypothetical buyer and would have to pay a corporate level income tax on the income. The court refused to extend the analysis of Estate of Jones v. Commissioner and refused to tax affect the income. This tax-affecting analysis is quite different from the tax-affecting rationale in valuing interests in S corporations and pass-through entities in many prior cases. The traditional core justifications for taxaffecting are generally (1) that a hypothetical willing buyer in the willing-buyer-willing-seller construct of fair market value is looking for a return on the investment and necessarily will enjoy and therefore evaluate that return only on an after-tax basis and (2) that comparable data to use in the valuation process typically comes from public sources and therefore largely comes from C corporations, for which earnings are, again, necessarily determined on an after-tax basis. Corollaries to those justifications are that passthrough status (3) confers a benefit of a single level of tax compared to a C corporation, but also (4) limits the universe of potential buyers and investors, who might not be able to buy or invest without forfeiting or jeopardizing (or at least complicating) the S corporation status or other passthrough status. Thus, tax-affecting sometimes includes adjustments to accommodate those corollaries, or sometimes is followed by the application of, for example, an “S corporation premium” as the next step following the tax-affecting. That approach is incorporated in a well-known model used by many appraisers in valuing S corporation stock, referred to sometimes as the S Corporation Economic Adjustment Model and sometimes as the S Corporation Equity Adjustment Model, or, in either case, “SEAM.” For example, the IRS’s internal examination technique handbook for estate tax examiners more than 20 years ago (before the Gross case, discussed below) stated: If you are comparing a Subchapter S Corporation to the stock of similar firms that are publicly traded, the net income of the former must be adjusted for income taxes using the corporate tax rates applicable for each year in question, and certain other items, such as salaries. These adjustments will avoid distortions when applying industry ratios such as price to earnings.

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In the Estate of Jackson case, however, the rationale of the estate’s experts was based on an assumption that “the appropriate hypothetical buyer of each asset would be a C corporation, and therefore, each of them reduced cashflows by the income-tax liability that would be paid by a hypothetical C corporation buyer.” However, the court concluded that “the Estate has failed to persuade us that a C corporation would be the hypothetical buyer of any of the three contested assets.” The Tax Court refused to allow tax-affecting in valuing an S corporation on the income method in Gross v. Commissioner, T.C. Memo. 1999-254, and Tax Court cases after that time consistently refused to allow tax-affecting until the Estate of Jones v. Commissioner case in 2019, T.C. Memo. 2019-101 (Judge Pugh). In Jones, the court explained that prior cases such as Gross, Gallagher, and Giustina did not prohibit tax-affecting the earnings of a flowthrough entity per se. The court viewed those cases as concluding that (1) assuming a zero income tax rate on the earnings properly reflected the overall tax savings of operating as an S corporation (Gross v. Commissioner), (2) the taxpayer’s expert did not justify tax-affecting the earnings in balancing the burden of the individual level tax with the benefit of the reduced total tax burden (Estate of Gallagher v. Commissioner), and (3) taxaffecting the earnings resulted in a post-tax cash flow but the expert applied a pre-tax discount rate (Estate of Giustina v. Commissioner). In Jones, on the contrary, Judge Pugh concluded that the taxpayer’s appraiser considered both the advantages as well as the disadvantages of operating as an S corporation and that the taxpayer’s expert’s “tax-affecting may not be exact, but it is more complete and more convincing than respondent’s zero tax rate.” Judge Pugh viewed the issue as fact-based, and noted that the court in the prior cases had simply concluded that tax-affecting was not appropriate for various reasons on the facts of those cases. For a more detailed discussion of Estate of Jones (as well as another 2019 federal district court case that accepted an expert’s report using tax-affecting, Kress v. United States, 123 AFTR 2d 2019-1224 (E.D. Wis. 2019)), see Items 33 and 34 of Estate Planning Hot Topics and Current Developments (December 2019) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights). Some planners thought that the Estate of Jones case might represent a “crack in the 20-year old dam” of the Tax Court’s reluctance to recognize tax-affecting. Judge Holmes’s discussion in Estate of Jackson suggests otherwise. Judge Holmes distinguished Estate of Jones primarily as a case in which the IRS’s expert did not contest tax affecting: We distinguish Estate of Jones as an instance where the experts agreed to take into account the form of the business entity and agreed on the entity type. The Commissioner argued there, as he does here, that we shouldn’t tax affect, but his own experts didn’t seem to be on board. As we observed, “[t]hey do not offer any defense of respondent’s proposed zero tax rate. Thus, we do not have a fight between valuation experts but a fight between lawyers.” Estate of Jones, at *39. We do not hold that tax affecting is never called for. But our cases show how difficult a factual issue it is to demonstrate even a reasonable approximation of what that effect would be. In Estate of Jones, there was expert evidence on only one side of the question, and that made a difference. That was not the case here.

Penalties. The IRS asserted valuation understatement penalties and penalties for negligence or disregard of the rules under §6662. A procedural issue under §6751 requires that no penalty assessment is allowed unless it is personally approved by the immediate supervisor of the individual making the penalty determination. Neither the estate nor the IRS offered any evidence at trial about approval by the immediate supervisor. The estate asserted that requirement was not met, but the estate had the burden of persuasion on this issue and the court concluded that the estate failed to enter any evidence of the failure to obtain supervisory approval. (This is the classic difficulty of “proving a negative.”) In Judge Holmes’ unique and witty style: “Thriller is part of the record here. So are demons, vampires, monsters, ghosts, and even the funk of 40,000 years. But the record lacks any evidence that the Commissioner’s agent failed to obtain supervisory approval.” The court concluded, though, that reasonable cause and good faith existed because the estate based its values on an appraisal from a reputable accounting firm and reliance on the appraisal was

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reasonable even though the value of the assets was far different than the court’s value. The $2,105 appraised value of the post-death image and likeness rights reported on the estate return was very low but was because Jackson “made almost no money attributable to his name and likeness in the last decade of his life.” The appraisal “followed standard appraisal procedure in this area -- it focused on the last 10 years of Jackson’s life.” Even though the court disagreed with the appraisal, “the Estate reasonably relied on it in good faith once it discovered how little revenue Jackson had been earning from use of his name and likeness.” Similarly, the court noted that its opinion shows how complicated the valuation of that second bankruptcy trust (New Horizon Trust III) was, that the appraisal was reasonable given all the facts and circumstances, and that it was reasonable for the estate to rely on it and it did so in good faith. i.

Planning Considerations Regarding Post-Death Right of Publicity. The right of publicity allows an individual to exploit the commercial use of his name, image, and identity and to sue others who misappropriate the individual’s name and likeness. The right of publicity developed out of the right of privacy. Most states now recognize the right, either by case law or statutes, and about half the states recognize that it survives death. There is little uniformity among the states; some states are explicit about the ability to transfer the right, and others aren’t. Jurisdiction and governing law issues are still being developed. As expressed in Estate of Jackson, the general rule is that the law of the decedent’s domicile governs as to the contours of any post-death right of publicity. The law is still developing as to whether an individual can incorporate the laws of another state’s statute regarding post-death rights by transferring the publicity rights to an entity created and operated in that state prior to death. Two major estate planning issues need to be addressed: (1) What is the individual’s vision of how his or her reputation should be preserved and used (if the individual wants those rights restricted, will that restriction be recognized to diminish the value of the rights for estate tax purposes?); and (2) How can ownership of the publicity right by structured to integrate with the individual’s estate plan? Exploiting an individual’s right of publicity requires management as a business, and ideally it will be housed in a business structure. Issues that arise generally regarding business succession will also apply to this property right. Tom Abendroth (Chicago, Illinois) suggests several specific planning considerations: (1) Place the right of publicity (and related copyrights, trademarks, and endorsement contracts) in multiple entities to allow the desired division of control and ownership (including transfers of particular interests to irrevocable trusts). (2) Transfer methods are generally the same that we use for other business structures (such as a seed gift and subsequent sale to an irrevocable grantor trust, or GRATs, or growing businesses). (3) Divide the various attributes among different entities, and owners can dis-aggregate the interest and potentially lower its value for estate tax purposes, as opposed to the decedent’s owning all rights associated with the right of publicity at his death. For example, one entity could be created to manage endorsement contracts, appearance contracts and related existing contracts. It could receive a percentage fee for this, or actually be the recipient of the contract income. Another entity could own and license the right of publicity (to the management entity). A third could own memorabilia and other tangible assets (a potentially significant category in its own right for athletes). Tom Abendroth, Estate Planning With the Right of Publicity, ACTEC Estate & Gift Tax Committee (June 2021).

(Judge Holmes in Estate of Jackson noted that the IRS’s expert kept trying to aggregate all assets associated with his right of publicity, including copyrights in musical compositions and performances, but those had already been transferred to separate entities.) (4) To the extent possible, give the structure the characteristics of an active business (which may not be possible if all management responsibilities are outsourced). A business structure may achieve income tax benefits (such as qualifying for business deductions and avoiding the 3.8% NII tax) and estate tax benefits (such as qualifying for the bona fide sale for full consideration exception to §2036 and §2038). Id. www.bessemertrust.com/for-professional-partners/advisor-insights

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39. Intergenerational Split Dollar Life Insurance, Estate Tax Treatment of Repayment Right, Estate of Morrissette v. Commissioner, T.C. Memo. 2021-60 a.

Synopsis. Mrs. Morrissette (actually her revocable trust) paid large lump sum premiums ($29.9 million) for Dynasty Trusts to purchase universal life insurance policies on the lives of her three sons to fund buy-sell agreements to assure that ownership of a long-term very successful business would remain in the family. The advances were made under split dollar arrangements providing that Mrs. Morrissette would be repaid the amount of the advances or, if greater, the cash surrender values of the policies. The reimbursement amount would be repaid when the split dollar agreements were terminated at the respective deaths of the sons, when the trusts cancelled the policies, or when the parties mutually agreed to terminate the agreements. The estate valued the rights to be repaid for the premium advances at about $7.5 million (primarily because of the delay of when the repayments would be made), and the IRS valued the reimbursement rights at the cash surrender value of the policies at the date of Mrs. Morrissette’s death (about $32.6 million). The court held that (a) the advanced premiums or cash surrender values are not included in the estate under §2036 or §2038 because the $29.9 million premium advance transfers were made in a bona fide sale for adequate and full consideration, (b) the special valuation rules of §2703 do not require inclusion of the cash surrender values of the policies in the estate because the safe harbor exception in §2703(b) was satisfied, (c) the value of the estate reimbursement rights was determined under a discounted cash flow analysis, using an assumption that the repayment would be made three years after the estate tax return was filed (which greatly increased the value as compared to assuming that the repayment would not be made until the sons’ respective deaths), and (d) the 40% gross valuation misstatements penalty under §6662 was appropriate, and the estate’s reliance on its appraiser’s valuation of the rights was not reasonable. Estate of Morrissette v. Commissioner, T.C. Memo. 2021-60 (May 13, 2021) (Judge Goeke). For an excellent summary of this second Morrissette opinion (sometime referred to as “Morrissette II”) and of general planning issues involving intergenerational split dollar life insurance, see Mitchell Gans & Martin Shenkman, Morrissette II: Why the Tax Court May Have Improperly Applied the Hypothetical Purchaser Framework, LEIMBERG ESTATE PLANNING NEWSLETTER #2896 (July 19, 2021).

Basic Facts. The Morrissette family owned a moving and logistics company with a history going back to 1943. Three sons were involved in the business, and significant family disharmony endangered a long-term goal of maintaining ownership of the business within the family. Mrs. Morrissette (actually her revocable trust) paid large lump sum premiums ($29.9 million) for Dynasty Trusts to purchase universal life insurance policies on the lives of her three sons. (The advance was made by Mrs. Morrissette’s sons as trustees of the revocable trust, when Mrs. Morrissette could not participate because of her Alzheimer’s disease.) Each trust purchased policies on the lives of the other two sons, and a shareholder’s agreement provided that at the death of a son, trusts for the surviving sons would purchase the shares owned by the deceased son. Under split dollar agreements with each of the Dynasty Trusts, the revocable trust would be repaid the advance solely from the cash surrender values of the policies if the split dollar agreement was terminated before a son’s death or from the death benefit if an agreement terminated as a result of a son’s death. Accordingly, the revocable trust was entitled to receive the aggregate premiums paid (without added interest) on the policies on that child’s life (or the cash surrender value of such policies, if greater). In addition, the split dollar agreement could be terminated by the cancellation of policies by a Dynasty Trust or by the mutual agreement by both parties to terminate the agreement. Mrs. Morrissette’s revocable trust provided that the split dollar reimbursement rights would be distributed at Mrs. Morrissette’s death to each Dynasty Trust that was the counterparty to the agreements. Mrs. Morrissette died in September 2009. About ten months later, one of the sons inquired about cancelling the policies (his reasons for the inquiry are unclear), but the estate planning attorney advised “that the IRS had three years to audit the estate tax return and insisted that the policies remain in effect until the IRS audit was settled.” The estate filed the estate return about six months later, including the reimbursement rights under the split dollar arrangements in her estate at a value of about $7.5 million (compared to the $29.9 million lump sum premiums she had paid), considering

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the fact that her revocable trust would not receive the payments for many years in the future (as her children died—actuarially expected to be about 15 years later) or when the split dollar agreements were terminated before that time. In an initial opinion, the court held that the split dollar agreements complied with the economic benefit regime, the decedent did not make taxable gifts of the premiums when the $29.9 million advance was made, and the Dynasty Trusts did not have current access to the cash surrender values immediately. Estate of Morrissette v. Commissioner, 146 T.C. 171 (2016). The court entered an Order on June 21, 2018 denying the taxpayer’s motion for summary judgment that §2703(a) was inapplicable (based on the court’s reasoning in Cahill v. Commissioner) concluding that “[t]he restriction on the decedent’s termination rights is a restriction for purposes of section 2703(a)(2).” The IRS and estate subsequently filed motions for partial summary judgment regarding §2036(a)(2), §2038(a)(1), and trying again regarding §2703(a). The court entered an Order dated February 19, 2019 denying the taxpayer’s motions for summary judgment that §2036(a)(2), §2038(a)(1), and §2703(a) do not apply. The court merely reasoned that Estate of Cahill “is directly on point” as to §2036(a)(2) and §2038(a)(1) but denied the IRS’s motion for summary judgment regarding those sections because a material factual dispute exists concerning the issue of full and adequate consideration as to §2036 and §2038 and concerning whether the transfer satisfied the safe harbor in §2703(b). For a more complete discussion of the facts and the holdings of the prior decision and orders, see Item 27 of Estate Planning Current Developments and Hot Topics (December 2016) found here and Item 13.c.(6) of Estate Planning Current Developments and Hot Topics (December 2019) found here, both of which are available at www.bessemertrust.com/for-professional-partners/advisorinsights). c.

Business Purpose. A key to the court’s conclusion that §2036, §2038, and §2703 do not apply (as discussed below) is the business purpose for the life insurance based on the family disharmony and the need for insurance to fund the buy-sell agreements in order to persuade Mrs. Morrissette’s sons to retain the business and to keep the ownership of the business within the family. Those facts would not be present in every case involving intergenerational split dollar life insurance, and without those facts and the need for the life insurance (apart from potential tax advantages), those Code sections may have applied to negate any significant valuation discount advantages from the intergenerational split dollar arrangement.

Sections 2036 and 2038. The IRS argued, among other things, that the reimbursement rights should be included in the estate at an amount “at least in the amount of the transferred premiums, $30 million total, or the cash surrender value of the underlying policies, approximately $32.6 million total” in part because of retained possession, enjoyment or a right to income from the transferred property under §2036(a)(1), a retained right to designate who can enjoy the property or income under §2036(a)(2), and a power to alter enjoyment of the property under §2038(a). The court rejected that argument, reasoning that the bona fide sale for adequate and full consideration exception under those sections was satisfied. The exception requires (1) a legitimate and significant nontax purpose and (2) adequate and full consideration in money or money’s worth. Nontax reasons existed for the arrangement (to keep the business in the family). The opinion had a long discussion of the family disharmony and the plan to retain the sons in the business management, maintain control over the business, assure that ownership remained in the family, and avoid the need to sell the business to pay estate taxes as sons died. Adequate and full consideration existed even though the economic value of the right to sell or collect on reimbursement rights was worth less than the $29.9 million advance because other benefits were present than just the economic value of the reimbursement rights “such as management succession and efficiency and capital accumulation.”

Section 2703. The IRS also argued that the reimbursement right should be valued at the full cash surrender value of the policies because the revocable trust would receive the cash surrender value upon the termination of the split dollar agreement and the restriction that the split dollar agreement could be terminated only with the mutual agreement of the parties was a “restriction on the right to sell or use” property that had to be ignored in valuing the property under §2703(a). The court had previously denied the estate’s motion for summary judgment that §2703(a) did not apply (relying on

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the decision in Estate of Cahill v. Commissioner, T.C. Memo. 2018-84) but left open for trial whether the safe harbor exception under §2703(b) applied. “Section 2703(b) provides an exception where the restriction is a bona fide business arrangement, not a device to transfer property to members of the decedent’s family for less than adequate and full consideration, and comparable to the terms of similar arrangements in arm’s-length transactions,” and in this Morrissette II decision the court concluded that the §2703(b) exception applied. The §§2036, 2038, and 2703 rulings were unequivocal taxpayer victories. But the taxpayer victories ended there. f.

Value of Reimbursement Rights. The estate valued the reimbursement rights on the estate tax return at about $7.5 million. The estate conceded that a mechanical mistake in one of the taxpayer’s expert’s appraisal meant that the appraiser’s value would have been about $10.4 million, but another appraiser for the estate valued the reimbursement rights at about $7.8 million. (The reimbursement payment rights at the date of the decedent’s death would have been about $32.6 million, the cash surrender value of the policies, but the revocable trust had no way to force the immediate cancellation of the split dollar agreements and immediate payment.) The IRS’s notice of deficiency valued the reimbursement rights at about $32 million, the cash surrender value of the policies. The IRS’s expert valued the reimbursement rights at about $17.5 million assuming the split dollar agreements remained in effect until the sons’ deaths and at about $27.9 million assuming they were terminated three years after the estate tax return was filed. (Observe: The assumed termination date has the biggest impact on the valuation of the reimbursement rights – in this case $17.5 million vs. $27.9 million in the IRS’s expert’s opinion.) In valuing the reimbursement rights of the revocable trust, the estate’s and IRS’s experts both applied a discounted cash flow analysis. The primary factors in the analysis were determining (a) the appropriate discount rates to determine the present value of the anticipated cash flows and (b) the repayment schedule. For the discount rates, the court agreed with the IRS’s expert’s use of returns on corporate bonds and company specific debt (discount rates of 6.4% and 8.85% for the two insurance companies after applying a small illiquidity premium) and rejected the taxpayer’s expert’s use of life settlement data (which reflected discount rates of 15% and 18%) because of the lack of transparency in that data. Much more important in the ultimate valuation determination was the court’s agreement with the IRS position assuming that the split dollar agreement would be ended following the decedent’s death (three years after the estate tax return was filed) rather than much later at the sons’ subsequent deaths. The taxpayer argued that no pre-arranged plan for early termination existed and that the policies would be retained until the sons’ respective deaths. The court pointed to an inquiry by one of the sons 10 months after the decedent’s death about cancelling the policies, but an attorney advised “that the IRS had three years to audit the estate tax return and insisted that the policies remain in effect until the IRS audit was settled.” The court accepted the IRS’s proposed termination date of three years after the estate tax return was filed. The court said that the “key factor in setting the December 31, 2013, maturity date [i.e., about three years after the estate tax return was filed] is the brothers’ complete control over the split-dollar agreements.… [T]here are grounds for setting an earlier maturity date, but we will use respondent’s date.” A significant factor in the court’s reasoning is that the trusts that owned the policies could trigger the acceleration of the decedent’s reimbursement rights by cancelling the policies, and one of the sons actually asked about cancelling the policies before the estate tax return was filed for the estate. Furthermore, the revocable trust left to each Dynasty Trust the decedent’s interest in the reimbursement rights that were attributable to the policies owned by that trust. Changes in those facts might have led to a somewhat different outcome as to the termination date used for valuing the reimbursement rights considering that the assumed termination date was the biggest factor in the valuation of the reimbursement rights. But the judge’s ultimate decision regarding the valuation issue appears colored by the court’s “gut reaction” that the estate had grossly undervalued the rights. For example, the court rationalized that the decedent received adequate and full consideration for purposes of satisfying the bona fide sale for adequate and full consideration exception to §2036 and §2038 even though the immediate value of the reimbursement right was economically worth far less

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than the $29.9 million advance because of other nontax benefits the overall insurance and business succession plan achieved, but the court observed its agreement with the IRS “that a rational investor would not give up approximately $23 million in value to achieve the nontax purposes achieved through the split-dollar agreements.” And in the discussion of penalties, the court made very clear its view of having the revocable trust “pay $30 million and [turn] it into $7.5 million for estate tax reporting purposes. They should have known that the claimed value was unreasonable and not supported by the facts.” g.

Penalties. The IRS revenue agent initially did not believe that an accuracy related penalty was appropriate, but his supervisor convinced him that the 40% gross valuation misstatement penalty under §6662(h) should be imposed. While reliance on professional advice may provide a reasonable cause defense if the reliance was reasonable and in good faith, the court reasoned that the estate’s reliance on its professional appraisal was not reasonable (among other things, the court pointed out that the sons should have known that valuing a right to receive repayment of about $30 million (or more) at only $7.5 million “was unreasonable and not supported by the facts,” and the appraiser lowered the value from his initial opinion following a review of the appraisal by the estate’s attorney), and the estate did not rely on it in good faith. The harsh 40% penalty may deter taxpayers and planners from using intergenerational split dollar life insurance arrangements and claiming extremely large valuation discounts. See Kristen A. Parillo, Tax Court Decision Could Chill Split-Dollar Arrangement, TAX NOTES (June 9, 2021). The court did not criticize the professional appraiser’s credentials or experience as a professional appraiser. Indeed, the estate produced a second professional appraiser from a highly respected appraisal firm who also valued the reimbursement right at the trial and similarly valued the reimbursement right at far less than the court’s determination. This factual situation is unlike that in Estate of Richmond v. Commissioner, T.C. Memo. 2014-26, in which the court held that reliance on an appraisal did not meet the reasonable cause exception where the estate relied on an unsigned draft report by an accountant who had some experience preparing appraisals (having written 10-20 valuation reports) but did not have any appraiser certifications. This leaves taxpayers (and their planners) in the precarious position of having to determine the correctness of a professional appraisal that is based on technical analysis and is not just a summary estimate of value. Morrissette II’s approach as to penalties is contrasted with the approach in the recent Estate of Michael Jackson case (discussed in Item 38 above), in which the court held that reliance on a professional appraisal constituted reasonable cause even though the appraised value was miniscule compared to the court’s determination of value ($2,105 vs. $4.15 million for the value of the decedent’s image and likeness).

40. Savings Clause Rejected in Conservation Easement Cases, TOT Property Holdings, LLC v. Commissioner (And Others) a.

Synopsis of TOT Property Holdings, LLC v. Commissioner. In a case reminiscent of the Belk v. Commissioner Fourth Circuit Court of Appeals case seven years ago, the Eleventh Circuit has similarly rejected a savings clause as an impermissible “condition subsequent” clause (citing Commissioner v. Procter) in a conservation easement case, with an extended discussion of savings clauses. The court concluded that the easement did not satisfy the “protected in perpetuity” requirement of §170(h)(5)(A) because upon termination or extinguishment of the easement, the grantee would receive an amount reduced by the increase in value of the easement after the grant attributable to improvements, which is inconsistent with the regulations. The taxpayer argued that several clauses in the easement deed overrode extinguishment payment provision to the extent required by regulations. The last phrase of the extinguishment clause provided that the payment proceeds be “determined in accordance with Section 9.2 or 26 C.F.R. Section 1.179A-14, if different.” Section 9.2 (which provided how the payment amount would be calculated) concluded as follows: “It is intended that this Section 9.2 be interpreted to adhere to and be consistent with 26 C.F.R. Section 1.179A-14.” These savings clauses were referred to by the court as the “Treasury Regulation Override.” The court also upheld substantial taxpayer penalties. TOT Property Holdings, LLC v. Commissioner, 127 AFTR 2d 2021-2420 (11th Cir. June 23, 2021).

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The court emphasized the difference between clauses that merely assist in interpreting operative provisions in a deed or other agreement (which are taken into consideration for tax purposes) and clauses that impose a condition subsequent – a subsequent IRS or court determination that the provision in the deed would be inconsistent with regulations -- and are not respected for tax purposes. The court relied primarily on two Fourth Circuit Court of Appeals cases in its analysis, Belk v. Commissioner, 774 F.3d 221 (4th Cir. 2014), and Commissioner v. Procter, 142 F.2d 824 (4th Cir. 1944). The court observed that in Belk, The Fourth Circuit held that the clause was unenforceable because it rested on a future occurrence to save the deed and deduction and amounted to an “ask . . . to 'void' the offending . . . provision to rescue the[ ] tax benefit.” Id. There was also “no open interpretive question for the savings clause to 'help' clarify.” Id. at 230. Instead, the Belks hoped for the court to rewrite their easement deed where — if their intent had truly been as they said — they would have written the deed to be compliant with the applicable regulations in the first place. Id. “[T]o apply the savings clause as the Belks suggest[ed]” would be “sanctioning the very same 'trifling with the judicial process' [the court] condemned in” the second of our guiding Fourth Circuit cases (discussed next), and would lead to the “dramatic[ ] hamper[ing] [of] the Commissioner's enforcement power” and tax collection “grind[ing] to a halt.” Id. (citation omitted).

The court also relied on Procter, which refused to give effect to a clause that would reduce the amount of a gift if a court of last resort determined any part of the transfer was subject to gift tax because the only way a gift tax could be assessed was by way of collection and court proceedings, and the above-quoted clause, if valid, would operate to nullify any such proceedings. Id. Such a condition subsequent was void as “contrary to public policy.” Id. “It is manifest,” explained the court, “that a condition which involves this sort of trifling with the judicial process cannot be sustained.” Id. Thus, the clause impermissibly contained a condition subsequent that attempted to save the assignment from taxation and was unenforceable. Procter reasoned that the clause “ha[d] a tendency to discourage the collection of the tax by the public officials charged with its collection, since the only effect of an attempt to enforce the tax would be to defeat” the attempt. Id. The Fourth Circuit also held that “the effect of the condition would be to obstruct the administration of justice by requiring the courts to pass upon a moot case” since “the only possible controversy” would be “the validity of the” clause's operation “between the donor and persons not before the court.” Id.

The taxpayer argued that the Override provisions in the easement deed were not conditioned on any adverse action by the IRS or a court, so the Override clauses were interpretive provisions that should be recognized for tax purposes. The court disagreed because “whether Section 9.2 is ‘different’ from §1.170A-14(g) or whether Section 9.2's formula can be interpreted as consistent with the regulation are questions that only the IRS or a court can determine.” In summary, the court held that the Override provisions are unenforceable savings clauses, not merely interpretive provisions “because the formula in Section 9.2 is unambiguous, the Override nullifies it, and it does so only in the event of some future occurrence.” b.

Similar Cases. Other conservation easement cases have reasoned similarly. E.g., Coal Property Holdings LLC v. Commissioner, 153 T.C. 126 (2019); Pine Mountain Preserve, LLLP v. Commissioner, 51 T.C. 247 (2018); Palmolive Building Investors, LLC v. Commissioner, 149 T.C. 380 (2017); Railroad Holdings LLC v. Commissioner, T.C. Memo. 2020-22; Carter v. Commissioner, T.C. Memo. 2020-21. For a discussion of the court’s analysis in Coal Property Holdings, Belk, and other savings clauses cases, see Item 37 of Estate Planning Current Developments and Hot Topics (December 2019) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights. For a summary of Railroad Holdings see Item 39.b. of Heckerling Musings 2020 and Estate Planning Current Developments (August 2020) found here and available at www.bessemertrust.com/forprofessional-partners/advisor-insights.

Guidance From IRS Chief Counsel. Chief Counsel Advice 202130014 (July 30, 2021) discusses extinguishment clauses that remove post-donation increases in property value in the charity’s share of proceeds if a conservation easement is extinguished. Chief Counsel Memorandum AM 2020-01 (March 27, 2020), provides that an amendment clause in an easement does not necessarily violate the requirements of §170(h), but the amendment clause must be considered in the context of the deed as a whole and the surrounding facts and circumstances. The Memorandum provides an example of a permissible amendment clause.

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Application to Defined Value Clauses and Savings Clauses Generally. These cases are interesting regarding their discussion of savings clauses generally and their strict rejection of clauses that change results after the fact based on court or IRS determinations. For a discussion of the application of these cases to defined value clauses and savings clauses generally, see Item 21.e.-f. of Estate Planning Current Developments and Hot Topics (December 2020) found here and Item 39.e. of Heckerling Musings 2020 and Estate Planning Current Developments (August 2020) found here, both available at www.bessemertrust.com/for-professional-partners/advisor-insights.

Analysis of Status of Intense Attack on Conservation Easements. For a review of the status of the extensive case law developments regarding the “proceeds regulation,” see Nancy A. McLaughlin, Conservation Easements and The Proceeds Regulation, 56 REAL PROP., TRUST & EST. LAW J. (Summer 2021). For an analysis of the 26 (26!! – talk about an area of intense IRS focus) decided conservation easement cases in 2020, see Ronald D. Aucutt, The Top Ten Estate Planning and Estate Tax Developments of 2020 (January 2021) found here and available at www.bessemertrust.com/for-professional-partners/advisor-insights).

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