Tax Law Update: Trusts and Estates
• Ruling on gift-splitting and generation-skipping transfer (GST) tax allocations
—In Private Letter Ruling 201523003 (released June 5, 2015), the taxpayer sought a ruling to clarify the gift tax and GST tax treatment of transfers he’d made to various trusts over several years.
The taxpayer first established a family trust for the benefit of his wife and descendants. The trustees could make distributions to his wife and descendants as they determined in their discretion. In the same year and the year following, he funded two grantor retained annuity trusts (GRATs): GRAT 1 and GRAT 2. At the end of the term, any property remaining in the GRATs was payable to the family trust.
Then, a few years later, he established GRAT 3 and GRAT 4. As with the earlier GRATs, at the end of the term, the remaining property was payable to the family trust.
He filed a gift tax return for the first year and elected to split gifts with his wife. He elected out of automatic GST tax allocation for the GRATs and didn’t affirmatively allocate any GST tax exemption to them. He did allocate GST tax exemption to the family trust, although he didn’t allocate enough to fully cover the value of the property transferred to the family trust in that year (the ruling doesn’t explain why).
When GRAT 1 and GRAT 2 terminated, the taxpayer filed gift tax returns to allocate GST tax exemption to the remaining property that was added to the family trust. With respect to GRAT 1, he just reported the value of the transfer to the family trust and didn’t make any GST tax election, but later took the position that the GST tax exemption was automatically allocated to the remainder of GRAT 1. He and his wife made affirmative GST tax allocations for the remainder of GRAT 2.
He also timely filed a gift tax return several years later for GRAT 3 and GRAT 4. Again, he and his wife elected to split gifts for those years on the gift tax returns.
Spouses may elect to split gifts if they both consent to treat all gifts made to third parties as split gifts during the calendar year, except that if a taxpayer transfers property in part to his spouse and in part to third parties, the consent is only effective with respect to the property transferred to third parties if it’s ascertainable at the time of the gift and severable from the interest transferred to the taxpayer’s spouse.
The Internal Revenue Service explained that although the election to split gifts ordinarily wouldn’t be effective for gifts to the family trust because the wife’s interest wasn’t ascertainable or severable (and she can’t split a gift to herself), the split gift treatment was irrevocable because the statute of limitations had expired. So, the election to split gifts to the family trust, GRAT 1 and GRAT 2, was effective. Surprisingly, even though the election to split gifts shouldn’t have applied to the family trust because the wife’s interest wasn’t ascertainable or severable and therefore fell within the exception, the IRS held that the taxpayer’s position became irrevocable when the statute of limitations ran out. Is the IRS creating a “back door” method to split a gift to a trust that ordinarily can’t be split? If the IRS doesn’t challenge the election before the statute of limitations runs, is the gift split even though it didn’t originally qualify for gift splitting?
The GST tax allocations to these trusts were effective as well and were made one-half by each of the taxpayer and his wife, affirmatively to the family trust (but only for the partial amount reported by the taxpayer), automatically to the GRAT 1 remainder and affirmatively to the GRAT 2 remainder. Because the taxpayer and his wife had elected to split gifts, each was treated as the transferor of one-half of the trust property for GST tax purposes, and the automatic and affirmative allocations of the taxpayer’s and his wife’s GST tax exemptions were confirmed.
The IRS held that the election to split gifts to GRAT 3 and GRAT 4 wasn’t effective. It cited to the regulation regarding a spouse’s interest not being ascertainable or severable and presumably was “looking through” the GRATs to the remainder interests payable to the family trust but noted that the taxpayer could file a supplemental Form 709 to report the transfers as being made entirely by him. If he did so, he could allocate his available GST tax exemption to those GRATs after the estate tax inclusion periods ended. By requiring the taxpayer to file an amended return reporting the gifts as not being split in order to be the sole transferor for GST tax purposes, the ruling implies that, even though the election to split gifts wasn’t effective for gift tax purposes, it was effective for GST tax purposes and that the taxpayer and his wife were treated as the transferor of half the property to GRAT 3 and GRAT 4 for GST tax purposes. This result is supported by Treasury Regulations Section 26.2652-1(a)(4), which provides that in the case of a transfer with respect to which the donor’s spouse makes an election under Internal Revenue Code Section 2513, the electing 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 IRC Section 2513.
• IRS will no longer issue estate tax closing letters unless requested
—The IRS announced on its website that it will no longer automatically issue closing letters. Instead, it will only issue closing letters for estate tax returns filed on or after June 1, 2015 on request. It suggests taxpayers wait at least four months before making the request and provides a phone number to call regarding requests.
The IRS also stated that it won’t issue a closing letter for a return filed after Jan. 1, 2015 but before June 1, 2015, if the estate was under the filing threshold, and the estate’s portability election was rejected (if the return was filed late, was incomplete or otherwise didn’t meet the requirements for electing portability).
• Final portability regulations issued
—On June 16, the IRS issued final regulations (T.D. 9725) regarding portability of the federal estate tax exemption. Of particular note are the provisions regarding the extension of time to elect portability under Treas. Regs. Section 301.9100-3, which may only be granted to those estates that are under the threshold filing amount and not otherwise required to file a return. The regulations also clarified that the executor of an estate who timely files a complete return doesn’t need to file a protective election to confirm the amount of the deceased spouse’s unused exemption (DSUE). A timely filed return is sufficient to elect portability, and if factual elements of the return change (for example, a deduction is ultimately allowed), the recomputed amount of DSUE will be available without additional filings or any protective election. Similarly, when a non-citizen spouse becomes a citizen, if the portability election was made, the amount of DSUE will be adjusted and become available to the spouse on becoming a citizen.
Lastly, and perhaps of most interest, the IRS didn’t address the issue of whether it will respect a qualified terminable interest property (QTIP) election that wasn’t necessary to reduce the estate tax liability to zero. A prior revenue procedure (Rev. Proc. 2001-38) held that the IRS will disregard QTIP elections that aren’t necessary to reduce the estate tax to zero. However, now with portability, there could be a planning strategy to electing QTIP treatment and preserving portability. The preamble to the regulations states that the IRS will provide guidance on this matter in an Internal Revenue Bulletin.
• Court applies investor control doctrine and holds individual liable for tax on income generated in accounts underlying private placement life insurance policies
—In Webber v. Commissioner, 144 T.C. No. 17 (June 30, 2015), the Tax Court applied the investor control doctrine to hold a taxpayer liable for income tax related to investments made within an insurance policy.
Jeffrey Webber established a grantor trust in 1999 that purchased private placement variable life insurance policies from Lighthouse, a Cayman Islands company, on the lives of two elderly relatives. He and his family members were the beneficiaries of the trust. In 2003, he transferred the policies to an offshore trust and then in 2008, the policies were assigned to a domestic (Delaware) trust; at any given time, however, from 1999 to 2008, the policies were held within one of such grantor trusts.
The premium payments, less expenses, were held in separate accounts by the trust and invested. Lighthouse didn’t provide investment management services for the accounts but permitted the policy holder to select an investment manager from an approved list. The policy holder was prohibited from directing investments and was only allowed to give general investment objectives and guidelines.
However, Jeffrey, who managed a series of private equity partnerships, gave recommendations regarding how to invest the assets held in those accounts. His estate-planning attorney had advised him that he shouldn’t appear to exercise any control over the investments and never to directly advise the
insurance company or investment manager handling the accounts. As a result, Jeffrey made the recommendations by phone or email to his attorney and personal accountant, who served as intermediaries and relayed them to the investment manager. The account funds were invested (through special purpose entities) in startup companies in which Jeffrey had a personal interest (by sitting on its board, investing its securities personally or through venture capital funds he managed). The investment manager for the accounts didn’t review, research or recommend any equity investments.
Under IRC Section 72, earnings accruing to cash value in life insurance policies and annuities may not be currently taxable to the policyholder, and, on the death of the insured, under IRC Section 101(a), the death benefit may be excluded from the beneficiary’s taxable income as well. However, this income tax benefit is based on the premise that the insurance company owns the investment assets underlying the policy. Under the investor control doctrine, established by a series of revenue rulings beginning in 1977, if a taxpayer retains sufficient control over the assets, he’ll be deemed to be the true owner of those assets for income tax purposes. This control causes the income tax burden to be borne by the taxpayer, wiping out the deferral or elimination of the income tax.
The court found that Jeffrey had, in practice, full control in selecting investments for the separate accounts by directing the investment manager to buy, sell and exchange securities and that the investment manager took no independent initiative to research or perform due diligence with any of the investments, none of which were publicly traded. The court also found that Jeffrey directed the actions of the special purpose entities (invested in by the trust) as a shareholder and was able to extract cash (over $1 million in less than 12 months) by structuring sales between the special purpose entities and himself.
The court rejected Jeffrey’s contentions that: (1) he wasn’t in constructive receipt of the income; (2) the investor control doctrine shouldn’t apply to life insurance contracts; (3) IRC Section 7702(g) didn’t limit the amount of income taxable to Jeffrey; and (4) IRC Section 817(h) eliminates the investor control doctrine. As a result, it upheld the IRS’ determination of income tax deficiencies (but not the penalties, finding that he reasonably relied on a tax advisor).