The 2007-08 Treasury-IRS Priority Guidance Plan

Capital Letter No. 5

August 17, 2007

By Ronald D. Aucutt

Thirteen “Gifts, Estates and Trusts” projects include eight that are new this year.

Dear Readers Who Follow Washington Developments:

The annual Treasury-IRS Priority Guidance Plan, covering the twelve months from July through the following June, is used by the Treasury Department and the Internal Revenue Service to allocate resources to regulations, revenue rulings, notices, and ot her published guidance. On August 13, 2007, the 2007-08 Plan, for the twelve months beginning July 1, 2007, was published. It lists 303 guidance projects, including the following thirteen under the heading “Gifts, Estates and Trusts“:

1. Final regulations under section 67 regarding miscellaneous itemized deductions of a trust or estate.

Section 67, added to the Code in 1986, is the source of the limitation of “miscellaneous itemized deductions” to 2% of adjusted gross income. In the case of an estate or trust, section 67(e)(1) exempts from the 2% floor “costs which are paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in such trust or estate.”

This guidance project, which first appeared on the 2006-07 Priority Guidance Plan, addresses the conflict between O’Neill Irrevocable Trust v. Commissioner, 994 F. 2d 302 (6th Cir. 1993) (holding that section 67(e)(1) exempts the investment advice expenses of multi-generation trusts) and the opposite holdings in Mellon Bank v. United States, 265 F.3d 1275 (Fed. Cir. 2001), Scott v. United States, 328 F.3d 132 (4th Cir. 2003), and now William L. Rudkin Testamentary Trust v. Commissioner, 467 F.3d 149 (2d Cir. 2006).

The Supreme Court granted certiorari in Rudkin, under the name of Knight v. Commissioner (No. 06-1286) on June 25, 2007. Barely one month later, on July 27, 2007, the Service published proposed regulations (Prop. Reg. § 1.67-4, REG-128224-06).

Proposed Reg. § 1.67-4(a) would apply the 2% floor to all expenses of an estate or trust except expenses that are “unique” to an estate or trust. Under Proposed Reg. § 1.67-4(b), an expense is considered “unique” only if “an individual could not have incurred that cost in connection with property not held in an estate or trust.” As examples, Proposed Reg. § 1.67-4(b) cites fiduciary accountings, required judicial filings, fiduciary income tax returns, estate tax returns, distributions and communications to beneficiaries, will or trust contests or constructions, and fiduciary bonds. Under the proposed regulations, the cost of those items would be fully deductible.

As examples of services that are not “unique” to a trust or estate, the costs of which are subject to the 2% floor, Proposed Reg. § 1.67-4(b) cites the custody and management of property, “advice on investing for total return,” preparation of gift tax returns, defense of claims by creditors of the grantor or decedent, and the purchase, sale, maintenance, repair, insurance, or management of property not used in a trade or business.

In addition, Proposed Reg. § 1.67-4(c) would require the “unbundling” of unitary fiduciary fees or commissions, so as to identify the portions attributable to activities and services that are not “unique” and are therefore subject to the 2% floor.

The phrase “advice on investing for total return,” as an example of a service that is not unique to an estate or trust, has generated a lot of speculation. The litigated cases have included the taxpayers’ argument that the demands of the duty of prudent investment and the duty of impartiality distinguish investment advice to a fiduciary from investment advice to an individual, especially in the context of a multi-generation trust. Thus, the specific reference to the “total return” that is an element of prudent investment might be read as an explicit repudiation of that argument. On the other hand, it could be read as an acknowledgment that advice on investing not just to get richer (“total return”) but to help a fiduciary balance successive interests (often expressed as interests in “income” and “principal”) really is different — maybe even “unique.” If that is the way the final regulations are clarified, then efforts to create a modern, flexible trust that minimizes the role of archaic concepts of “income” and “principal” might be penalized with higher income taxes. That would not be the first irony in tax law, but it is sure to be one of the most widely discussed.

ACTEC Fellows and professional fiduciaries have watched these issues unfold in the courts with great interest. Now we have two ongoing developments to watch closely — the Knight case in the Supreme Court and these pending regulations. Comments from the public on the proposed regulations are invited before October 24, 2007, and the Service has scheduled a public hearing on the proposed regulations on November 14, 2007.

2. Guidance under section 642(c) concerning the ordering rules for charitable payments made by a charitable lead trust.

This is the first time this item has been on the Priority Guidance Plan.

3. Revenue ruling on the division of charitable remainder trusts under section 664.

Also new to the Priority Guidance Plan, the project is presumably intended to reduce the number of IRS ruling requests related to common severance transactions. The straightforward nature of this project is reflected in the fact that it is not called “guidance”; Treasury and the Service expect that a revenue ruling will be enough. It should not be groundbreaking or controversial.

4. Proposed regulations under section 664(c) to reflect the 2006 Tax Relief Act amendment concerning the effect of UBIT on charitable remainder trusts.

Section 424 of the Tax Relief and Health Care Act of 2006 (P.L. 109-432) replaced the rule of section 664(c) of the Code that a charitable remainder trust (CRT) would lose its exemption from income tax if in any year it had unrelated business taxable income (UBTI) with a rule preserving tax exemption but imposing a 100% excise tax on any UBTI. Before this amendment, loss of exemption was a serious risk. For example, in Leila G. Newhall Unitrust v. Commissioner, 104 T.C. 236 (1995), aff’d, 105 F.3d 482 (9th Cir. 1997), a CRT lost its exemption because a public corporation in which it owned stock began operating as a publicly-traded partnership. Under the 2006 Act, a 100% tax is indeed harsh and warrants continued vigilance to avoid UBTI in CRTs, but a stiff fine is still better than a death sentence.

It is not self-evident that the 100% tax removes the UBTI from distributable net income, meaning that it might be possible to incur total taxes that are greater than 100%. The regulations may address that.

5. Proposed regulations under section 2032(a) regarding the imposition of restrictions on estate assets during the 6 month alternate valuation period.

This new project on the Priority Guidance Plan is evidently aimed at the technique of bootstrapping an estate into a valuation discount by distributing or otherwise disposing of a minority or other noncontrolling interest within the six-month period after death (valuing it as a minority interest under section 2032(a)(1)) and leaving another minority or noncontrolling interest to be valued six months after death (also valued as a minority interest under section 2032(a)(2)).

6. Guidance regarding the consequences under various estate, gift and generation-skipping transfer tax provisions of using a family-owned trust company as the trustee of a trust.

Privately owned and operated trust companies are becoming an option that families with large trusts are turning to in increasing numbers, and state law authority for such private trust companies is being continually refined. When a trustee with broad discretion, especially over trust distributions, is owned by one or a few families of beneficiaries, the potential tax issues include grantor trust status by reason of section 672(c), inclusion in the gross estate under section 2036 or 2038, and general powers of appointment under sections 2041 and 2514. Occasional sets of letter rulings reveal the Service’s thinking about some of these issues, although the Service is now reluctant to issue such rulings pending publication of this contemplated guidance.

When this project first appeared, on the 2004-05 Priority Guidance Plan, it was described as “Guidance regarding family trust companies.” The omission of income tax issues from subsequent formulations is important, because income tax issues have frequently been addressed in the letter rulings. Indeed, in the first such letter rulings, Letter Rulings 9841014 and 9842007, the only issue was whether a family-owned trust company was a “related or subordinate party” with respect to the living grantors of various trusts, within the meaning of section 672(c), an income tax rule. The omission of income tax from subsequent Priority Guidance Plans might be inadvertent and insignificant, but some Fellows will find it ominous and will worry about guidance that addresses some but not all tax issues.

7. Guidance under section 2036 regarding the tax consequences of a retained power to substitute assets in a trust.

This new project apparently focuses on a power under section 675(4)(C), exercisable in a nonfiduciary capacity, to reacquire trust corpus by substituting other property of an equivalent value. This power is often the feature of choice to make a trust a grantor trust.

Because such a power requires a value-for-value exchange, many estate planners assume that it should not create a risk of inclusion in the grantor’s gross estate, under section 2036 or otherwise. Often this result is viewed as supported by Estate of Jordahl v. Commissioner, 65 T.C. 92 (1975), acq., 1977-1 C.B. 1 (power to reacquire an insurance policy from a trust and substitute other property of equal value held not to be the retention of incidents of ownership in the policy and therefore held not to bring the insurance into the insured’s gross estate). In Jordahl, the grantor was one of three trustees, and the Tax Court referred to his fiduciary duty, which presumably would prevent the power from conferring grantor trust status under section 675(4)(C). But this feature has not been emphasized by the Service in the rulings that follow Jordahl, such as Letter Rulings 9227013 and 9413045. In any event, the capacity in which a power is held — that is, fiduciary or nonfiduciary — usually makes no difference for estate tax purposes. Reg. §§ 20.2036-1(b)(3)(ii); 20.2038-1(a)(3).

We’ll see how the guidance emerging from this project affects our confidence in relying on Jordahl.

8. Final regulations under sections 2036 and 2039 regarding the portion of a split-interest trust that is includible in a grantor’s gross estate in certain circumstances in which the grantor retains an annuity or other payment for life.

In determining what is included in the gross estate of a grantor of a GRAT, there can be a large difference, for example, between the present value of the unpaid annuity amounts, the amount needed to generate the prescribed annuity without depleting the principal (cf. Rev. Rul. 82-105, 1982-1 C.B. 133, describing the portion of a charitable remainder trust that is included in the gross estate), and the entire value of the trust assets that the Service has viewed as included in the gross estate under section 2039 (Letter Ruling 9345035; Technical Advice Memorandum 200210009).

Under this project, proposed regulations (REG-119097-05, amending Reg. § 20.2036-1(c)) were published in the Federal Register on June 7, 2007, taking the relatively welcome position that section 2036 applies.

The proposed regulations offer one GRAT example — Proposed Reg. § 20.2036-1(c)(2)(ii), Example (2) — which is striking for its dissimilarity from everyday GRATs. Unlike most GRATs, the GRAT in the example (i) runs for the shorter of the stated term or the grantor’s life, not as a Walton-style GRAT for a fixed term with annuity payments to the grantor’s estate; (ii) does not include a 20% increase in the annuity payment each year; (iii) provides for monthly, not annual, payments; (iv) continues for ten years, relatively long as modern GRATs go; and (v) produces a high taxable gift, equal to about 14% of the initial value transferred to the GRAT. Because of these factual anomalies, the proposed regulations really give little guidance for how the includable amount would be calculated in the case of a typical GRAT. Perhaps the final regulations will.

9. Final regulations providing guidance under section 2053 regarding the extent to which post-death events may be considered in determining the value of the taxable estate.

This project, which originally appeared in the 2003-04 Priority Guidance Plan, addresses the valuation of claims against the estate, especially claims being pursued in litigation against the decedent at the date of death. Proposed regulations (REG-143316-03, amending Reg. § 20.2053-1(b) & 20.2053-4) were published in the Federal Register on April 23, 2007. In general, the proposed regulations will allow a deduction of otherwise deductible claims (that is, claims existing at the date of death and legally enforceable) only if and when they are paid or ascertainable with reasonable certainty. If that does not occur before the estate tax statute of limitations runs, the executor’s recourse is to file a protective claim for refund.

Under the proposed regulations, (i) a court decree will be respected if the court reviews the relevant facts and its decision is consistent with applicable law; (ii) a consent decree will be respected if the consent is a bona fide recognition of the validity of the claim and is accepted by the court as satisfactory evidence upon the merits; (iii) a settlement will be respected if it resolves an active and genuine contest, is the product of arm’s length negotiations by parties with adverse interests, and is within the range of reasonable outcomes under applicable law; and (iv) claims by family members will be presumed to be nondeductible, although this presumption may be rebutted by evidence of circumstances that would reasonably support a similar claim by unrelated persons.

The new rules will apply to the estates of decedents dying on or after the date that final regulations are published in the Federal Register.

10. Revenue Procedure under section 2522 containing sample inter vivos Charitable Lead Unitrusts.

This is the first time this particular project has been on the Priority Guidance Plan, although sample forms of some sort have become a nearly annual event.

11. Guidance under section 2642(g) regarding extensions of time to make allocations of the generation-skipping transfer tax exemption.

There is usually at least one GST tax project on the list, especially since the legislative changes made in 2001. This new project is the GST tax representative this year.

12. Guidance under section 2703 regarding the gift and estate tax consequences of the transfer of assets to investment accounts that are restricted.

Appearing for the first time on the Priority Guidance Plan, this project is evidently aimed at “restricted management accounts,” which are often viewed as substitutes for family limited partnerships, with comparable effects on valuation.

13. Guidance under section 2704 regarding restrictions on the liquidation of an interest in a corporation or partnership.

This item, carried over from the 2003-04, 2004-05, 2005-06, and 2006-07 plans, is probably intended to address section 2704(b)(4), which states:

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

Many observers have noted that this provision is broad enough to justify regulations that effectively end planning that produces entity-based valuation discounts. Now that is worth watching!

Ronald D. Aucutt