Alternate Valuation and Private Trust Company Guidance

Capital Letter No. 11

August 1, 2008

By Ronald D. Aucutt

The Internal Revenue Service and Treasury Tailor Tax Rules to Their Historic Purposes.

Dear Readers Who Follow Washington Developments:

With the relief that the 2008 presidential campaign has now entered its final hundred days comes confirmation that there will probably be no significant progress on estate tax legislation this year. Congress has gone on vacation for five weeks, and Capital Letters intends to turn its attention away from Congress for a while and take a walk up Pennsylvania Avenue – about a mile to the Internal Revenue Service and another half mile beyond that to the Treasury Department. We find that the IRS and Treasury are accomplishing quite a lot these days. About this time each year, Treasury and the IRS publish a “Priority Guidance Plan” identifying projects to which they intend to apply resources for the period beginning July 1 and ending the following June 30. The Plan for 2007-08, published August 13, 2007 and reported in Capital Letter No. 5, lists the following 13 items under the heading of “Gifts, Estates and Trusts.” (The text is taken word-for-word from the published Plan. Comments in parentheses identify recent actions.)

Final regulations under section 67 regarding miscellaneous itemized deductions of a trust or estate. Proposed regulations were published on July 27, 2007. (Notice 2008-32, 2008-11 I.R.B. 593, was published February 27, 2008, after the Supreme Court’s decision in Knight v. Commissioner, 552 U.S. __, 128 S. Ct. 782 (No. 06-1286, Jan. 16, 2008).)
Guidance under section 642(c) concerning the ordering rules for charitable payments made by a charitable lead trust. (Proposed amendments of Reg. §§ 1.642(c)-3(b)(2) and 1.643(a)-5(b) (REG-101258-08) were published on June 17, 2008.)
Revenue ruling on the division of charitable remainder trusts under section 664. (Rev. Rul. 2008-41, 2008-30 I.R.B. 170, was released July 8, 2008.)
Proposed regulations under section 664(c) to reflect the 2006 Tax Relief Act amendment concerning the effect of UBIT on charitable remainder trusts. (Amendments of Reg. § 1.664-1(c) were proposed on March 7, 2008, and finalized on June 24, 2008.)
Proposed regulations under section 2032(a) regarding the imposition of restrictions on estate assets during the 6 month alternate valuation period. (Proposed amendments of Reg. § 20.2032-1(f) (REG-112196-07) were published on April 24, 2008.)
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. (Notice 2008-63, 2008-31 I.R.B. 261, released for comment a proposed revenue ruling on July 11, 2008.)
Guidance under section 2036 regarding the tax consequences of a retained power to substitute assets in a trust. (Rev. Rul. 2008-22, 2008-16 I.R.B. 796, was released on April 17, 2008.)
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. (Reg. § 20.2036-1(c)(2) was finalized on July 11, 2008.)
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. (There have been no developments since proposed amendments of Reg. § 20.2053-1 (REG-143316-03) were published on April 23, 2007.)
Revenue Procedure under section 2522 containing sample inter vivos Charitable Lead Unitrusts. (Rev. Proc. 2008-45, 2008-30 I.R.B. 224 (inter vivos trusts), and Rev. Rul. 2008-46, 2008-30 I.R.B. 238 (testamentary trusts), were issued July 25, 2008.)
Guidance under section 2642(g) regarding extensions of time to make allocations of the generation-skipping transfer tax exemption. (Proposed Reg. § 26.2642-7 (REG-147775-06) was published on April 16, 2008.)
Guidance under section 2703 regarding the gift and estate tax consequences of the transfer of assets to investment accounts that are restricted. (Rev. Rul. 2008-35, 2008-29 I.R.B. 116, was released on July 18, 2008.)
Guidance under section 2704 regarding restrictions on the liquidation of an interest in a corporation or partnership. (There have been no developments.) A series of Capital Letters, beginning with this one, will consider some of these guidance projects and ask whether it is possible to identify themes, patterns, or trends, much as one might read court decisions and develop a view of the direction the law might be headed. Not likely, one might say, because the guidance comes in so many different forms and deals with so many different subjects. But because some of the same people work on many of these projects, perhaps patterns reflecting a common philosophy should not be so surprising.

This Capital Letter will look at the fifth and sixth items on the Priority Guidance Plan – proposed regulations under section 2032(a) and guidance regarding private trust companies.

Many of us learned in law school that in applying a rule to a difficult set of facts we can be helped by asking what is the “reason for the rule.” If the reason for the rule – the advantage the rule was presumably designed to provide or the abuse the rule was presumably designed to prevent – applies to the new set of facts, then perhaps the rule should too. That is especially good advice after the rule has evolved incrementally, such as through several successive court cases or several successive IRS letter rulings. Precedent is important, but, rather than comparing the present fact pattern to the most recent cases, the law professor might suggest going back to the first cases, identifying the likely reason the rule emerged in the first place, and then analyzing the present facts in light of that reason. That law professor might wonder if today we sometimes have forgotten how to do that.

Alternate Valuation

In proposing changes to the alternate valuation regulations, the IRS provided a good illustration of applying the reason for the rule. In short, the proposed regulations draw on the obvious 1935 economic context and explicit 1935 legislative history to limit the use of alternate valuation to changes in market values of the sort (if not the magnitude) experienced during the Depression.

The notice of proposed rulemaking almost fumbles the reason-for-the-rule analysis by appearing to present itself as an ad hoc reaction to the recent Tax Court decision in Kohler v. Commissioner, T.C. Memo 2006-152, nonacq., 2008-9 I.R.B. 481, to resolve a supposed conflict between Kohler and Flanders v. United States, 347 F. Supp. 95 (N.D. Calif. 1972).

In Flanders, after a decedent’s death in 1968, but before the alternate valuation date, the trustee of the decedent’s (formerly) revocable trust, which held a one-half interest in a California ranch, entered into a land conservation agreement pursuant to California law. The conservation agreement reduced the value of the ranch by 88%. Since that reduced value was the value of the ranch at the alternate valuation date (which until 1971 was one year after death), the executor elected alternate valuation and reported the ranch at that value. Citing the Depression-era legislative history to the effect that alternate valuation was intended to protect decedents’ estates against “many of the hardships which were experienced after 1929 when market values decreased very materially between the period from the date of death and the date of distribution to the beneficiaries,” the court held that “the value reducing result of the post mortem act of the surviving trustee” may not be considered in applying alternate valuation.

Kohler (involving the estate of a shareholder of the well-known plumbing fixture manufacturer) considered the application of alternate valuation to stock received by the executor in a tax-free corporate reorganization that had been under consideration for about two years before the decedent’s death but was not completed until about two months after the decedent’s death. The court rejected the Service’s attempt to base the estate tax on the value of the stock surrendered in the reorganization (which had been subject to fewer restrictions on transferability), on the ground that Reg. § 20.2032-1(c)(1) prevents that result by specifically refusing to treat stock surrendered in a tax-free reorganization as “otherwise disposed of” for purposes of section 2032(a)(1). The court also noted that the exchange of stock must have been for equal value or the reorganization would not have been tax-free as the parties had stipulated (although, ironically, the executor’s own appraiser had determined a value of the pre-reorganization shares of $50.115 million and a value of the post-reorganization shares of $47.010 million – a difference of about 6.2%). Thus, the court readily distinguished Flanders, where the post-death transaction had itself reduced the value by 88%. Significantly, the Tax Court viewed the 1935 legislative history as irrelevant, because Reg. § 20.2032-1(c)(1) (promulgated in 1958) was clear and unambiguous and because “the legislative history describes the general purpose of the statute, not the specific meaning of ‘otherwise disposed of’ in the context of tax-free reorganizations.”

Despite the understandable eagerness of the notice of proposed rulemaking to identify the problem with the courts rather than with the 1958 regulations, it is clear that the drafters of the actual amendments of the regulations resisted the temptation to deal ad hoc with the treatment of corporate reorganizations in Kohler, but instead returned to “the general purpose of the statute” articulated in 1935, relied on in Flanders, and bypassed in Kohler. Significantly – and wisely – the proposed regulations make no change to Reg. § 20.2032-1(c)(1) at all. Rather, they beef up Reg. § 20.2032-1(f), effective April 25, 2008, to clarify and emphasize, with both text and examples, the limitation of the benefits of alternate valuation to changes in value due to “market conditions,” thereby keeping faith with the concerns for deteriorating markets articulated in the Depression-era legislative history and reinforcing the historic role of alternate valuation as a means of ensuring fairness for executors rather than a standalone tool of affirmative estate planning.

By taking the historic view rather than an ad hoc approach, the proposed regulations accomplish much more than merely answer Kohler. Indeed, the Kohler issue itself does not even seem very important, because a value-for-value exchange is unlikely to make much difference in most cases and in Kohler appears to have made only a 6.2% difference. Thus, while the proposed regulations have become known as the “anti-Kohler regulations,” that label greatly understates their significance.

The real impact of the proposed regulations is illustrated by their impact on the technique described in Capital Letter No. 5 as “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)).” Examples 4 and 5 of Proposed Reg. § 20.2032-1(f)(3)(ii) specifically address that technique, Example 4 in the context of a limited liability company and Example 5 in the context of real estate, and clarify that changes in value due to “market conditions” do not include the valuation discounts that might appear to be created by partial distributions. Example 3 reaches the same result with respect to the post-death contribution of estate property to a limited partnership.

These clarifications are neither surprising nor unreasonable. Many Fellows may have been reluctant to try such techniques that seemed “too good to be true” even though section 2032(a)(3) and Reg. § 20.2032-1(f) seemed technically to exclude only changes in value resulting from “mere lapse of time.” Those Fellows’ reluctance will now be vindicated.

Private Trust Companies

Notice 2008-63 illustrates a similar historic perspective in a very different context.

The increased use of family-owned trust companies as alternatives to either individual trustees or publicly-owned institutional fiduciaries has for many years been an important development in the stewardship of family wealth. The tax consequences of creating trusts with a private trust company as a trustee, or of replacing trustees of existing trusts with a private trust company, have been a topic of great interest, especially in the very common circumstance of independent trustees with broad discretion over distributions of income and principal that could create unwelcome tax consequences if imputed to the grantor or beneficiaries. That interest reached a crescendo when the IRS first issued private letter rulings on the subject in 1998 but has been pent up since 2004 when this project first appeared on the Priority Guidance Plan and the IRS has been unwilling to issue rulings while that guidance was pending.

There were several forms the anticipated guidance could have taken – the prescription of global rules in new regulations, the codification of existing private letter rulings through institutionalization of ruling standards, the publication of sample forms for governing documents, the provision of safe harbors in other ways, or something else, or a combination.

The prescription of new rules has seemed to be preferable. The codification of letter rulings could impose limitations on the public on the arbitrary basis that similar limitations did not matter to the individuals who obtained rulings. Safe harbors are always troublesome because of the cloud they cast over other alternatives. The imposition of ruling standards would be most exasperating and would barely put the estate planning community back to where we were three years ago.

Notice 2008-63 solicits public comment on a proposed revenue ruling of about 28 double-spaced pages (about 8,500 words), affirming favorable tax conclusions with respect to the use of a private trust company. The selection of a revenue ruling format was surprising – and actually quite bold. A revenue ruling is essentially a form of a safe harbor. It would not have been this writer’s first choice of format, because revenue rulings invariably are constraining as well as empowering. They tend to artificially force transactions into the mold of the fact pattern posed in the revenue ruling. Inevitably they include factual details that leave us all wondering and asking what they are there for – the details do not seem to be material, but, without identification of the rules of general application the revenue ruling supposedly illustrates, there is no way to tell what is material and what isn’t. Because a revenue ruling is basically just an expression of an opinion, any taxpayer is free to challenge it, but, when the stakes are as high as they typically would be in a context justifying a family-owned trust company, hardly anyone would choose to incur the risk. Thus, a revenue ruling can have a chilling effect with little legal recourse. The proposed revenue ruling in Notice 2006-63 avoids or minimizes most of those liabilities. The three main ways it does this are by addressing all of the most common tax issues, by assuming facts that are for the most part very broad and flexible, and by asking for public comment before it is finalized (thus capturing one of the advantages of regulations in the revenue ruling context). Comments must be submitted by November 4, 2008.

The proposed revenue ruling systematically addresses five tax issues:

(1) inclusion of the value of trust assets in a grantor’s gross estate by reason of a retained power or interest under section 2036 or 2038;

(2) inclusion of the value of trust assets in a beneficiary’s gross estate by reason of a general power of appointment under section 2041;

(3) treatment of transfers to a trust as completed gifts;

(4) effect on a trust’s status under the GST tax either as a pre-effective date trust or as a trust to which GST exemption has been allocated; and

(5) treatment of a grantor or beneficiary as the owner of a trust for income tax purposes.While these are not the only issues that the use of private trust companies can present, these are the most common issues. Thus, the proposed revenue ruling generally avoids creating a safe harbor for one purpose that is a trap for other purposes. Because of the format of addressing different issues in a single continuous series of narrative discussions, the revenue ruling format may actually make it easier to achieve this objective. Because the description of this project in the 2007-08 Priority Guidance Plan referred specifically to “estate, gift and generation-skipping transfer tax provisions” (in contrast to the more generic first description of this project, in the 2004-05 Priority Guidance Plan, as “Guidance regarding family trust companies”), it is especially encouraging to see the proposed revenue ruling address grantor trust treatment, because the guidance would be incomplete without it.

With regard to fact patterns, the proposed revenue ruling helpfully posits not one but several trusts, illustrating both the creation of new trusts and the introduction of a private trust company as a trustee of an old trust. Each trust instrument posited in the proposed revenue ruling provides for complete discretionary authority over distributions of both income and principal, thus precluding speculation about any difference between the two. Likewise, each trust instrument provides each successive primary beneficiary with a reasonably broad testamentary power of appointment (although not as broad as everyone except the beneficiary’s estate and creditors). And each trust instrument provides for the grantor’s or primary beneficiary’s unilateral appointment (but not removal) of trustees, with no restrictions other than on the ability to appoint oneself. Finally, the proposed revenue ruling defines discretionary distributions as any permissible distributions that are not mandated in the trust instrument or by applicable law.

Additional flexibility is built into the proposed revenue ruling by the provision of two scenarios – one in which the private trust company is formed under a state statute with certain limitations and one in which the private trust company is formed in a state without such a statute but comparable limitations are included in the governing documents of the private trust company itself, thus removing one potential concern for unfair discrimination between otherwise similar private trust companies.

Another encouraging feature of the proposed revenue ruling is a paragraph near the end that identifies three factual details that are not material to the favorable tax conclusions, explicitly confirming that the conclusions would not change if those details changed. This feature, not always found in revenue rulings, provides a measure of relief from the anxiety that the departure from factual details could jeopardize reliance on the revenue ruling. No doubt the public comments on the proposed revenue ruling will question the materiality of more factual details than these three. Some likely examples (but not an exhaustive list) are:

the designation of a “primary beneficiary” of each trust, to the possible exclusion of so-called “pot” or “sprinkle” trusts;
the designation of a classical lives-in-being-plus-21-years rule against perpetuities to govern each trust, to the possible exclusion of more modern statutory formulations (including the statutory ability to waive the rule altogether);
the assumed statutory requirement of an independent “Discretionary Distribution Committee” for each trust administered by the private trust company, to the possible exclusion of a differently conceived body with a similar effect, a different committee for different trusts, and any exception for trusts for customers other than family members administered by family-owned trust companies that offer fiduciary services to the public; and
the explicit prohibition of certain express or implied reciprocal agreements regarding distributions, to the possible exclusion of such prohibitions derived from general fiduciary law.These questions about factual details will be important to some clients, and therefore a revenue ruling that does not answer those questions might be unsatisfactory. But the specific identification of three immaterial details in the proposed revenue ruling is a good start, and there is no reason to assume that this feature would not, as appropriate, be expanded to other details and thereby made more useful. The partial recital of immaterial details that is already included in the proposed revenue ruling is a versatile vehicle for addressing appropriate public suggestions in this regard.

While the proposed revenue ruling can undoubtedly be improved, and Notice 2008-63 is likely to attract suggestions to that effect, it is an encouragingly good start. The most obvious reason is the basic premise of the proposed revenue ruling, as stated in the second paragraph of Notice 2008-63:

The IRS and the Treasury Department intend that the revenue ruling, once issued, will 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. Comments are specifically requested as to whether or not the draft revenue ruling will achieve that intended result.To paraphrase, the only reason why the IRS and Treasury should care about a private trust company is that it could provide a pretense of theoretical independence but in practice could be exploited by family member-owners to indirectly exercise control over a trust that would trigger time-honored tax rules, largely dating from the 1930s and 1940s, if such control were held by family members directly. Notice 2008-63 therefore looks to those time-honored rules and strives to come up with rules for a private trust company that are no more onerous. A more onerous rule could bar the private trust company from roles that an individual family member could fill directly. That would push the tax rules beyond what is needed to simply prevent family members from using a private trust company to do indirectly what they could not do directly, which is the reason for having any such rules in the first place. In other words, Notice 2008-63 identifies the reason for the rule and uses that as the standard for crafting the rule.

Indeed, by adding that “[c]omments are specifically requested as to whether or not the draft revenue ruling will achieve that intended result,” the IRS and Treasury have not only adopted a reason-for-the-rule standard, but they have explicitly invited the public to hold them accountable to that standard in public comments.