Update of the 2011-2012 Treasury-IRS Priority Guidance Plan

Capital Letter No. 32

June 8, 2012

Ronald D. Aucutt

This year has seen a resurgence of administrative guidance and a new role for ACTEC.

Dear Readers Who Follow Washington Developments:

On September 2, 2011, the Treasury Department and the Internal Revenue Service published their Priority Guidance Plan for the 12 months beginning July 1, 2011, confirming the public guidance projects to which they intended to commit resources throughout that period. Now, in the last month of that 12-month Plan, it is time to take stock of the progress made.

Moreover, we can assume that the authors are working on the corresponding Plan for the 12 months beginning this July 1 (which again, of course, might not be published until later in the summer). Notice 2012-25, 2012-15 I.R.B. 789, released on March 8, asked for input to the 2012-2013 Plan, which the Notice indicated may be called the “Guidance Priority List” this year.

This year ACTEC started what should be an annual custom of proactively submitting suggestions for the Guidance Priority List. ACTEC’s committees had been working for a few months on their inputs to those suggestions, and on April 30 ACTEC submitted its compilation of those Recommendations for consideration by our friends in the Government. For next year, the Government Affairs Committee intends to encourage the initiation of that process even sooner, with the goal that the practical experience of ACTEC Fellows with studying and following federal tax rules can become a permanent resource to Treasury and the Service in the development of guidance priorities from year to year.

PROGRESS UNDER THE 2011-2012 PLAN

1. Regulations under §67 regarding miscellaneous itemized deductions of trusts and estates

Section 67, added to the Internal Revenue Code in 1986, is the source of the limitation of “miscellaneous itemized deductions” to 2 percent of adjusted gross income. In the case of an estate or trust, section 67(e)(1) exempts from the 2 percent 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.” (The last 16 words were added in the 1986 House-Senate conference, but without an explanation other than repeating the statutory words in the conference report.)

This project, which first appeared in the 2006-2007 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 William L. Rudkin Testamentary Trust v. Commissioner, 467 F.3d 149 (2d Cir. 2006), aff’d sub nom Michael J. Knight, Trustee v. Commissioner, 552 U.S. 181 (2008). I participated in the Scott case and have personally criticized the approaches of both the proposed regulations and the Government’s litigation.

On September 6, 2011, after the Supreme Court’s Knight opinion had rejected the harsher approach of the Second Circuit’s Rudkin opinion, the Internal Revenue Service withdrew the proposed regulations published in 2007 when Rudkin was the latest judicial word and released new proposed regulations. (ACTEC had submitted Comments on the first proposed regulations on May 27, 2008.) Proposed Reg. §1.67-4(a) would provide that a miscellaneous itemized deduction of an estate or non-grantor trust is subject to the 2 percent floor if it “commonly or customarily would be incurred by a hypothetical individual holding the same property.” Examples, in Proposed Reg. §1.67-4(b)(1), are “costs incurred in defense of a claim against the estate, the decedent, or the non-grantor trust that are unrelated to the existence, validity, or administration of the estate or trust.” Other examples, in Proposed Reg. §1.67-4(b)(2), are “ownership costs” that attach to a particular asset, such as “condominium fees, real estate taxes, insurance premiums, maintenance and lawn services, automobile registration and insurance costs, and partnership costs deemed to be passed through to and reportable by a partner.” Under Proposed Reg. §1.67-4(b)(3), the costs of preparing tax returns would be characterized with reference to the type of return. The costs of returns that by their nature are filed only by executors or trustees are not subject to the 2 percent floor, including estate and GST tax returns and fiduciary income tax returns, of course, but also including a decedent’s final income tax return.

Under Proposed Reg. §1.67-4(b)(4), the cost of investment advice would continue to be subject to the 2 percent floor, and Proposed Reg. §1.67-4(c)(1) would retain the requirement for single fees to be “unbundled” into components that are subject to the 2 percent floor and components that are not, except that, under Proposed Reg. §1.67-4(c)(2), if the fee “is not computed on an hourly basis,” only the investment advice component would have to be unbundled, and could be unbundled by “[a]ny reasonable method.” Payments made out of the bundled fee to third parties, or fees assessed on top of the bundled fee, for services subject to the 2 percent floor would also have to be accounted for separately.

Proposed Reg. §1.67-4(d) provides that the regulations will apply to taxable years beginning on or after the date that the final regulations are published in the Federal Register. Thus, for example, if regulations are finalized in 2013, they will not apply to a calendar year trust until 2014. But these regulations, interpreting a 28-year-old statute, do not seem to be on a fast track, which could reflect the differences in views on this subject seen in the litigation and in the comments on the proposed regulations.

2. Final regulations under §642(c) concerning the ordering rules for charitable payments made by a charitable lead trust

This project, which first appeared in the 2007-2008 Priority Guidance Plan, was completed by the publication of final regulations on April 16, 2012. Reg. §§1.642(c)-3(b)(2) & 1.643(a)-5(b) require the amount of income distributed to each beneficiary to consist of the same proportion of each class of items of income of the estate or trust as the total of each class bears to the total of all classes. Provisions in the governing instrument of an estate or trust that specify the source from which income amounts are to be paid will be respected for federal tax purposes only when the provisions have “economic effect independent of income tax consequences” – that is, apparently only if those provisions affect the amount that is paid. In the case of a charitable lead trust, because of the inflexibility in defining income distributions, such provisions will never be respected.

These rules are to be distinguished from the ordering rules (sometimes unflatteringly described as “worst-in-first-out”) mandated by section 664(b) and applied within statutory classes with explicit reference to tax rates under Reg. §1.664-1(d). Those ordering rules apply to distributions to noncharitable beneficiaries from charitable remainder trusts. By statute, the treatment of charitable remainder trusts and charitable lead trusts is not symmetrical in this respect.

The regulations are effective on April 16, 2012, the date of publication in the Federal Register. It is not explicitly stated that the regulations will apply to existing irrevocable trusts, but the preamble to the proposed regulations expressed the belief of the IRS and Treasury, based on “the structure and provisions of Subchapter J as a whole” and supported by a chain of references and cross-references, that the result in the proposed regulations was already required by the law and regulations. Also, when publishing sample charitable lead unitrust forms in July 2008, the Service stated: “A provision in the governing instrument of a charitable lead trust that provides for the payment to charity to consist of different classes of income determined on a non pro rata basis will not be respected because such a provision does not have economic effect independent of the income tax consequences of the payment. See §1.642(c)-3(b)(2) and (3).” Rev. Proc. 2008-45, 2008-30 I.R.B. 224, §5.02(10); Rev. Proc. 2008-46, 2008-30 I.R.B. 238, §5.02(10).

3. Final regulations under §642(c) concerning the ordering rules for charitable payments made by a charitable lead trust

When it published sample charitable lead unitrust forms in Rev. Procs. 2008-45 and 2008-46, the Service completed a round of sample forms for various split-interest trusts. This project, which first appeared in the 2008-2009 Priority Guidance Plan, apparently represents just a routine updating sweep, with few or no new substantive implications.

4. Guidance concerning private trust companies under §§671, 2036, 2038, 2041, 2042, 2511, and 2601

Under this project, which first appeared in the 2004-2005 Priority Guidance Plan, Notice 2008-63, 2008-31 I.R.B. 261, solicited comments on a proposed revenue ruling that would affirm favorable tax conclusions with respect to the use of a private trust company in various circumstances. ACTEC submitted Comments on November 4, 2008. In the 2010-2011 Priority Guidance Plan, the reference to a revenue ruling was dropped, possibly indicating that Treasury and the IRS are reviewing the basic approach of the proposed revenue ruling, which attracted a large number of diverse public comments. But a revenue ruling as the vehicle for the guidance would be much easier to finalize than would, for example, amendment of the many regulations that would have to be amended.

The simple and noncontroversial basic premise of the proposed revenue ruling, as stated in the second paragraph of Notice 2008-63, is to “confirm certain tax consequences of the use of a private trust company that are not more restrictive than the consequences that could have been achieved by a taxpayer directly, but without permitting a taxpayer to achieve tax consequences through the use of a private trust company that could not have been achieved had the taxpayer acted directly.” But that, it seems, is easier said than done.

5. Regulations under §1014 regarding uniform basis of charitable remainder trusts

This project, which first appeared in the 2008-2009 Priority Guidance Plan, is likely intended to address the results when the income and remainder beneficiaries of a charitable remainder trust sell their respective interests in a coordinated sale designed to circumvent the rules governing commutation of CRT interests. Indeed, Notice 2008-99, 2008-47 I.R.B. 1194, described this type of transaction and stated that “the IRS and Treasury Department are concerned about the manipulation of the uniform basis rules to avoid tax on the sale or other disposition of appreciated assets.” Accordingly, the Notice identified this type of transaction as a reportable “transaction of interest” for purposes of sections 6111 and 6112 and Reg. §1.6011-4(b)(6).

6. Guidance under §1022 concerning estates of decedents who die during 2010

The Priority Guidance Plan quarterly update indicates that this guidance was completed by the publication of Rev. Proc. 2011-41, 2011-35 I.R.B. 188, and Notice 2011-66, 2011-35 I.R.B. 179, released on August 8, 2011, and Notice 2011-76, 2011-40 I.R.B. 479, released on September 13, 2011. Form 8939 and its instructions and Publication 4895 basically follow and confirm that guidance.

Although the public guidance has essentially ended and Form 8939 was due January 17, 2012, Notice 2011-66 recognizes occasions in which our work with Form 8939 may still be ongoing. An executor may make changes to a timely filed Form 8939, except making or revoking a Section 1022 Election, on or before July 17, 2012 (six months after January 17). The IRS also retains the discretion, under “9100 relief” procedures, to allow an executor to amend or supplement a Form 8939 or even to file a Form 8939 (and thus make the Section 1022 Election) late. And even in less exciting contexts, the executor may file supplemental Forms 8939 to make additional allocations of Spousal Property Basis Increase as additional property is distributed to the surviving spouse; each such supplemental Form 8939 must be filed no later than 90 days after such distribution.

7. Guidance on portability of Unified Credit between spouses under §2010(c)

Portability of a deceased spouse’s unified credit – or applicable exclusion amount – to the surviving spouse, an elegantly simple concept, has proven to be bafflingly complex in its operation, largely because of the various restrictions imposed and the need for an election when the predeceased spouse dies. Eventually, portability may be a welcome simplification, but, recalling the check-the-box challenges originally experienced with the QTIP election, we will surely be forgiven for expecting that to take ten years or longer. Administrative guidance on portability is certainly a top priority in 2012, but legislative attention is also needed.

Meanwhile, Notice 2012-21, 2012-10 I.R.B. 450, released on February 17, 2012, grants a six-month extension of time to file a federal estate tax return (Form 706) to make the portability election in the case of married decedents who died in the first six months of 2011 with gross estates no greater than $5 million, even if no extension was requested. Thus, the first extended returns for decedents who died January 1, 2011, and the first unextended returns for decedents who died July 1, 2011, were both due April 2, 2012 (because April 1 was a Sunday). With apologies for venturing into this twilight zone at all, that means that on Friday, June 8, for example, it is still not too late to file an estate tax return to make that election in the case of any decedent who died from March 8 through June 30, 2011, or on or after September 8, 2011. It’s as simple as that. (Of course, Fellows who share Capital Letters’ optimism will just file any return for 2011 anytime, in the hope that it all will be simplified in ten years or so after all.)

Notice 2012-21 contains no substantive rules, but it states that “Treasury and the Service have received comments on a variety of issues.” ACTEC submitted Comments on October 28, 2011.

8. Regulations under §2032(a) regarding imposition of restrictions on estate assets during the six month alternate valuation period

This project first appeared in the 2007-2008 Priority Guidance Plan, and the first proposed “anti-Kohler” regulations (see Kohler v. Commissioner, T.C. Memo 2006-152, nonacq., 2008-9 I.R.B. 481) were published on April 25, 2008. ACTEC submitted Comments on those proposed regulations on July 22, 2008.

In contrast to the 2008 approach of ignoring certain intervening events – and thereby potentially valuing assets six months after death on a hypothetical basis – new proposed regulations published on November 18, 2011 (REG-112196-07), expand the description of events that are regarding as dispositions, triggering alternate valuation as of that date. The expanded list, in Proposed Reg. §20.2032-1(c)(1)(i), includes distributions, exchanges (whether taxable or not), and contributions to capital or other changes to the capital structure or ownership of an entity, including “[t]he dilution of the decedent’s ownership interest in the entity due to the issuance of additional ownership interests in the entity.” Proposed Reg. §20.2032-1(c)(1)(i)(I)(1). But under Proposed Reg. §20.2032-1(c)(1)(ii), an exchange of interests in a corporation, partnership, or other entity is not counted if the fair market values of the interests before and after the exchange differ by no more than 5 percent (in contrast to the 6.2 percent difference in Kohler). If the interest involved is only a fraction of the decedent’s total interest, an aggregation rule in Proposed Reg. §20.2032-1(c)(1)(iv) values such interests at a pro rata share of the decedent’s total interest.

While referred to as the “anti-Kohler regulations,” the most significant impact of these proposed regulations may be felt by efforts to bootstrap 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)). Examples 7 and 8 of Proposed Reg. §20.2032-1(c)(5) specifically address the discount-bootstrap technique – Example 8 in the context of a limited liability company and Example 7 in the context of real estate – and leave no doubt that changes in value due to “market conditions” do not include the valuation discounts that might appear to be created by partial distributions. Example 1 reaches the same result with respect to the post-death formation of a limited partnership.

The 2008 proposed regulations were to be effective on the date the proposed regulations were published. The new proposed regulations, more traditionally, state that they will be effective when published as final regulations.

9. Final regulations under §2036 regarding graduated grantor retained annuity trusts

This project was completed with the publication of final regulations on November 8, 2011. New Reg. §20.2036-1(c)(2)(iii) provides for the calculation of the amount includible in the gross estate of the grantor of a graduated GRAT, in which the annuity amount payable increases in any future year after the year of the decedent’s death.

10. Revenue ruling on whether a grantor’s retention of a power to substitute trust assets in exchange for assets of equal value, held in a nonfiduciary capacity, will cause insurance policies held in the trust to be includible in the grantor’s gross estate under §2042

This project was completed with the publication of Rev. Rul. 2011-28, 2011-49 I.R.B. 830, on December 5, 2011.

11. Guidance under §2053 regarding personal guarantees and the application of present value concepts in determining the deductible amount of expenses and claims against the estate

This project first appeared in the 2008-09 Priority Guidance Plan. It is an outgrowth of the project that led to the final amendments of the section 2053 regulations in October 2009. The part of this project relating to “personal guarantees” may be surprising and bears watching. The part relating to “present value concepts” is evidently aimed at the leveraged benefit obtained when a claim or expense is paid long after the due date of the estate tax, but the additional estate tax reduction is credited as of, and earns interest from, that due date. Graegin loans (see Estate of Graegin v. Commissioner, T.C. Memo 1988-477) are an obvious target.

12. Revenue procedure providing procedures for filing protective claims for refunds for amounts deductible under §2053

This project, which is also an outgrowth of the project that led to the amendments of the section 2053 regulations in October 2009 (Reg. §20.2053-1(b)(3)(iv)), also first appeared in the 2008-09 Priority Guidance Plan. It was completed by Rev. Proc. 2011-48, 2011-42 I.R.B. 527, released on October 14, 2011, which provides the procedural guidance regarding protective claims for refund promised by the preamble to the 2009 regulations.

Under section 4.04 of Rev. Proc. 2011-48, the protective claim may be made (i) for estates of decedents dying in 2012 and later, by attaching a new “Schedule PC” to Form 706 for each claim or expense, or (ii) for estates of any decedents dying on or after October 20, 2009, by filing a Form 843 for each claim or expense with the notation “Protective Claim for Refund under Section 2053” entered at the top of page 1. Other important details are provided in Rev. Proc. 2011-48, which anyone considering a protective claim for refund needs to read.

13. Notice on decanting of trusts under §§2501 and 2601

This project is new this year. On December 20, 2011, the IRS published Notice 2011-101, 2011-52 I.R.B. 932, asking for comments from the public on the tax consequences of decanting transactions – the transfer by a trustee of trust principal from an irrevocable “Distributing Trust” to another “Receiving Trust.” ACTEC submitted Comments on April 2, 2012.

14. Final regulations under §2642(g) regarding extensions of time to make allocations of the generation-skipping transfer tax exemption

This project first appeared in the 2007-08 Priority Guidance Plan. Proposed Reg. §26.2642-7 (REG-147775-06) was published on April 16, 2008, to provide for extensions of time to allocate GST exemption or to elect out of statutory allocations of GST exemption (when those actions are missed on the applicable return or a return is not filed), as directed in section 2642(g), which was added to the Code by the Economic Growth and Tax Relief Reconciliation Act of 2001. These regulations should be near completion – which is ironic, because section 2642(g) itself is scheduled to sunset at the end of 2012. Meanwhile, the Service grants that relief under the traditional rules of Reg. §301.9100-3, as affirmed shortly after the enactment of the 2001 Act in Notice 2001-50, 2001-2 C.B. 189.

When finalized, the new regulations will oust Reg. §301.9100-3 in GST exemption cases and become the exclusive basis for seeking the extensions of time Congress mandated in section 2642(g)(1), except for a simplified procedure for dealing with pre-2001 annual exclusion gifts under Rev. Proc. 2004-46, 2004-2 C.B. 142.

15. Regulations under §2704 regarding restrictions on the liquidation of an interest in certain corporations or partnerships

This item is carried over from every Priority Guidance Plan since 2003-04. It is apparently intended to address section 2704(b)(4), which states, in the context of corporate or partnership restrictions that are disregarded:

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.

Since May 2009, this regulation project must be reevaluated in light of the proposal to “Modify Rules on Valuation Discounts” that has appeared in each of the four budget proposals of the Obama Administration. Using section 2704(b) as a framework, the Greenbook proposal would create a more durable category of “disregarded restrictions,” which would “include” restrictions on liquidation of an interest that are measured against standards prescribed in Treasury regulations, not against default state law. This proposal was described in more detail in Capital Letter No. 17.

16. Guidance under §2801 regarding the tax imposed on U.S. citizens and residents who receive gifts or bequests from certain expatriates

This represents the guidance regarding the new succession tax on anyone who receives a gift or bequest from someone who expatriates on or after June 17, 2008, enacted by the Heroes Earnings Assistance and Relief Tax Act of 2008 (the “HEART” Act). Announcement 2009-57 (released July 16, 2009), helpfully stated:

The Internal Revenue Service intends to issue guidance under section 2801, as well as a new Form 708 on which to report the receipt of gifts and bequests subject to section 2801. The due date for reporting, and for paying any tax imposed on, the receipt of such gifts or bequests has not yet been determined. The due date will be contained in the guidance, and the guidance will provide a reasonable period of time between the date of issuance of the guidance and the date prescribed for the filing of the return and the payment of the tax.

17. Final regulations under §7520 updating the mortality-based actuarial tables to be used in valuing annuity interests for life, or term of years, and remainder or reversionary interests

This decennial project was completed by the publication of T.D. 9540 on August 10, 2011.

Ronald D. Aucutt