09 Feb Tax Law Update: Trusts and Estates
Internal Revenue Service Issues Draft of New IRS Form 8971 to Report Basis
In the summer of 2015, President Obama signed what’s known as the “Highway Bill” (Surface Transportation and Veterans Health Care Choice Improvement Act of 2015) into law. This law now requires beneficiaries of estates to use the finally determined estate tax value of any property they receive as their income tax basis and imposes a reporting obligation on executors to provide such values to the IRS and the beneficiaries. The law initially applied to all returns required to be filed after July 31, 2015, but Notice 2015-57 (Aug. 21, 2015) delayed the due date for any statement required to be filed with the IRS or provided to a beneficiary prior to Feb. 29, 2016, until Feb. 29, 2016.
On Dec. 18, 2015, the IRS issued a draft Form 8971 for executors of estates to use to report the basis of assets to beneficiaries and to the IRS. The IRS hasn’t yet issued instructions for the form, but the draft form can be found online at www.irs.gov. The first page of Form 8971 requires the executor of the estate to list the names of the beneficiaries, their Social Security numbers or tax identification numbers and addresses. This part of the form is filed with the IRS (but not shared with the beneficiaries). Then, the executor completes a Schedule A for each beneficiary and provides it to him. Schedule A requires the executor to describe the property, note whether it increased estate tax and give the valuation date and value.
As it’s a draft form, executors can’t file it yet. Practitioners continue to wait for the finalized form and instructions as the February deadline approaches.
Transcripts provided in lieu of estate tax closing letters
For all estate tax returns filed after June 1, 2015, the IRS will only issue estate tax closing letters by request of the taxpayer (that is, the estate). If a taxpayer doesn’t wish to request an estate tax closing letter, he may instead obtain an estate tax account transcript. The IRS asks that the executor wait at least four to six months after filing Form 706 to obtain the transcript.
Transcripts will reflect if the IRS has accepted Form 706 and whether it completed an audit. Each line of the transcript shows a transaction code with an explanation of the code, the date and the dollar amount, if applicable. Transaction Code 421 indicates an estate tax return has been accepted as filed or that the examination is complete. If that code isn’t displayed, the tax return is still under review.
There are two ways to access the transcript: (1) registered tax professionals can access it online if they have an executed Form 2848 on file, or (2) the estate can submit Form 4506-T by fax or mail.
Tax Court upholds decedent’s transfers to limited liability company (LLC) as bona fide and qualified for annual exclusion
In Estate of Barbara M. Purdue v. Commissioner, T.C. Memo. 2015-249 (Dec. 28, 2015), the Tax Court evaluated whether the value of the assets held in a family LLC were includible in Barbara’s estate under Internal Revenue Code Section 2036 and whether gifts of LLC interests qualified for the annual exclusion. In addition, the court determined the deductibility of a loan made by Barbara’s children to the estate.
Barbara and her husband, Robert, owned assets of about $28 million in 1999, consisting of marketable securities held in five different brokerage accounts at three management firms, an interest in a commercial building in Honolulu and their primary residence. They met with an estate planner who suggested they form an LLC to consolidate the management of their assets and facilitate gift giving. The attorney also advised them that the LLC could protect the assets from creditors, provide a mechanism to keep the assets within their family and more efficiently manage the assets, among other benefits. The Purdues’ children were all involved in the conversations and received the proposals and correspondence outlining the purposes of the plan.
In 2000, Barbara and Robert formed Purdue Family LLC and funded it with $22 million of marketable securities, the interest in the Hawaiian commercial building, a promissory note from their daughter and a certificate of deposit. The estate planner sent a memo to the family explaining the benefits of the LLC as: (1) limited liability; (2) pass-through income taxation; (3) minimal formalities; and (4) administrative ease of owning real estate.
They also established an irrevocable trust (Purdue Family Trust (PFT)) for the benefit of their children and their children’s spouses. The PFT included Crummey provisions that gave the beneficiaries withdrawal rights over transfers to the trust up to the annual exclusion amount. The PFT was funded with cash.
From 2002 until 2007, Barbara and Robert made gifts of LLC interests to the PFT. The children all signed documents waiving their withdrawal rights to each gift. By waiving their Crummey rights (instead of merely allowing the rights to lapse), the children could be considered to be making gifts to the PFT. The opinion doesn’t discuss the specific language of the documents the children signed—perhaps the opinion used the word “waiver” broadly. In addition, from 2001 to 2007, the children received cash distributions from the PFT totaling almost $2 million, the majority of which was comprised of net cash loans and dividends from the LLC.
In early 2001, the family retained a new investment manager to manage all of the assets held by the LLC.
Robert died unexpectedly in 2001, and his estate plan established trusts for Barbara. On Barbara’s death in 2007, the attorney sent a letter to the children explaining that to pay the estate taxes, the LLC would have to make a loan to the estate or issue a significant dividend. However, one of the children, as a member of the LLC, refused to agree to either, and the LLC operating agreement required unanimous consent. As a result, the other children loaned the estate the funds to pay the estate tax.
The IRS audited the estate tax return and issued a notice of deficiency, asserting that the assets of the LLC should be included in Barbara’s estate.
The Tax Court disagreed. The assets of the LLC (rather than the LLC interests) could be included in the estate under IRC Section 2036 unless the transfer to the LLC is a bona fide sale for adequate and full consideration, and the transferor receives interests proportional to the value of the property transferred. A bona fide sale requires an actual non-tax reason for creating the LLC.
The Tax Court held that Barbara transferred the assets to the LLC to consolidate investments, which was demonstrated by the retention of a single investment manager to handle all of the LLC assets, including the real estate. It noted that after the formation of the LLC, the children and the new investment manager made the investment decisions. It also found that Barbara and Robert didn’t depend on the LLC assets for their living expenses, didn’t commingle assets, respected the formalities of the LLC and were in relatively good health when it was formed. As a result, there was a legitimate non-tax reason for its formation, and the LLC wasn’t merely an attempt to change the form in which Barbara (and Robert) held their assets.
The Tax Court also upheld the annual exclusion gifts. To qualify as an annual exclusion gift, the transfer of property must be of a present interest, which means that the donee must have an unrestricted right to the immediate use, possession or enjoyment of the property or of the income from the property. Because the LLC contained restrictions under the operating agreement, the donees (as beneficiaries of the PFT) didn’t have unrestricted rights to the property. However, the court held that they did have rights to the income from the property sufficient to qualify the gifts for the annual exclusion. The LLC owned a commercial building that was rented and provided income, and the court noted that the operating agreement required the LLC to make proportionate cash distributions to its members to provide for income tax liability. The PFT had also made significant distributions over the years.
Lastly, the Tax Court held that the loan taken by the estate to pay the estate tax was bona fide and actually and necessarily incurred in the administration of the estate and, therefore, the interest on the Graegin loan paid to the children was deductible by the estate.
This case shows how careful planning and good communications with the family, as well as follow-through, are necessary to implement an estate plan using a family LLC or limited partnership effectively.