√ Donee Transferee Liability
When clients make gifts few donees give thought to the tax issues, which is in the donor’s domain. That is not correct; it is clear that the donees can bear a tax cost if the donor does not pay the gift tax due on the transfer. The only issue is how far the donee’s pain can extend. There is a split in the circuit courts on whether donee liability for gift tax is limited to value of gift received (3rd and 8th Circuits), or whether that responsibility includes unlimited liability for interest (5th and 11th circuits). This is important concerning filing adequate disclosure for note sale transactions. The statute of limitations for the donee expires one year after donor’s statute of limitations.
√ Portability Audit Considerations
Should or must the surviving heirs file to secure portability? This will become a common planning challenge facing practitioners in future years now that portability is permanent. Especially in the context of second or later marriages when different parties may bear the cost and liability of filing, and different parties will benefit from the ported exemption, conflicts will arise. If there is a contractual obligation to file that should govern then the decedent’s heir will have to file and DSUE (deceased spouse unused exclusion) should carryover. If there is no prenuptial or other binding agreement there may still be a fiduciary obligation on the executor to file to secure the exemption. But this possible obligation on the executor (or other fiduciary) is not simple. The executor has a fiduciary duty of impartiality and if an estate tax return is filed to secure portability, that filing will create a tax audit risk based on the valuation of the assets of the deceased spouse reported on that Form 706. Instead, if no Form 706 were filed, the audit exposure would not be triggered. The executor might view the filing of a Form 706 for portability as exposing the estate and other beneficiaries to greater risk of tax audit, the costs and administrative burdens of an audit, etc.
√ Partnerships
FLP (family limited partnership) audits remain a focus of IRS audit efforts. Following are some of the common considerations:
• Is there a significant and legitimate non-tax reason for creating the entity?
• Is centralized asset management an objective?
• Involvement of the next generation in the management and operations of the partnership can demonstrate a non-tax purpose.
• Protection from creditors or failed marriages can be a valid non-tax motive.
• Preservation of a special investment philosophy has been recognized in a number of cases.
• Partnerships can be used to avoid fractionalization of assets. For example, placing a family ranch or vacation home inside an entity may be used to avoid partition, provide for centralized management and preserve the desired asset.
• FLPs can be used to avoid imprudent expenditures by next generation family members.
• If the senior family member will be a GP (general partner) of FLP (family limited partnership), or manager of LLC, include a business judgment ascertainable standard. The entity can mandate that available cash should be distributed but entity can hold cash reserves determined by general partner though fiduciary obligation and their reasonable business judgment.
There are a number of audit hot button issues that should be avoided:
• Non-prorata distributions can undermine the integrity of the partnership.
• Having the partnership pay personal expenditures with partnership funds can undermine the reality of the partnership.
• Having personal use asset, like the family home, held in a partnership can compromise the reality and independence of the entity.
• Payment of estate tax and expenses when asset transferred to partnership close to death is often argued by the IRS as a factor indicating that the partnership was not real.
• Not maintaining accurate books and records can be negative.
• Having insufficient assets outside of the partnership can be quite negative. If this is identified in advance a partial liquidation of the partner’s interest can shift assets back to possibly rectify this.
This so often seems to be a struggle with clients and a gap in many plans. Great attention is paid to the governing trust instrument and appraisal but the entity documents governing the entity interests transferred are too often not given enough attention. It certainly seems from the above comment that these formalities are on the IRS radar screen. Sometimes transactions are completed with the least entity documentation possible. Perhaps that is not the optimal approach in light of the above comment.
Some of the issues/steps worth considering might include:
• Creating governing entity documents before and after a transfer (e.g., a signed operating agreement before the entity interests are gifted or sold, and again after with the new trust owner signing as a member).
• Obtaining copies of underling documents for the entity, such as a deed for a real estate LLC to confirm it is held in the name of the entity.
• Corroborating the compensation arrangement for family members (e.g.., to deflect a later challenge that under compensation constituted an impermissible transfer by the founder/GRAT settlor to the GRAT).
• Obtaining certificates of good standing for entities whose interests are transferred to identify and correct issues.
• Enhancing nexus to a trust friendly jurisdiction by taking steps in addition to just naming an institutional trustee in that jurisdiction.
• Using arm’s length documents and security arrangements.
• Having annual minutes or even meetings.
√ Note Sales to Grantor Trusts
One of the big worries about this common estate tax minimization planning technique is the case of Donald Woelbing and Marion Woelbing Estate. This case is still unresolved, but the issues raised by the IRS are worrisome to every practitioner with a client who has engaged in these transactions. In the Woelbing case the taxpayer sold interest in a profitable company that manufactures lip balm to a trust. The interest sold was valued by the taxpayer at $60 million dollars. The sale was consummated for a note to a grantor trust. The transaction in many respects was structured in a manner in which many advisers would consider reasonable. The trust had assets in excess of 10% of the value of the note. This is an often-quoted (though baseless) convention of the equity in a trust to support a note sale transaction. There was also a guarantee further supporting the validity of the note.
The taxpayer died in 2009 and the note was still outstanding at his death, and the gift tax audit was still outstanding. The IRS has argued that the value of the shares transferred was $116 million, not the $60 million the taxpayer claimed. More damaging, the IRS claimed that the transaction was not a sale but rather a transfer to a trust with a retained interest. Further, that retained interest did not qualify as a “qualified retained interest” under Chapter 14 so the transaction should be deemed a transfer of the entire interest, i.e. a gift of $116 million. The value definition mechanism should be disregarded so that the taxpayer’s valuation safety net would be ineffective. The IRS asserted valuation penalties.
While this case is pending, consider what can be done with similar transactions to perhaps shore up the plan:
• Inform clients that the IRS may attack such transactions.
• On new transactions, evaluate the use of GRATs (grantor retained annuity trust) instead of note sales until the issue is resolved. Many commentators do not believe that is necessary and the loss of GST (goods and services tax) benefits by using GRATs rather than note sale to dynastic trusts, is significant. While GRATs are safer, sales to a grantor trust can be more effective.
• You could use a note sale but structure the payments to conform to GRAT annuity payments. This too, while theoretically a possibility, may not be feasible.
• The IRS may argue that decedent interest in the note payments is tantamount to a retained right to income from partnership (or other entity interest transferred in the note sale transaction) because distributions from the partnership were used to pay note payments. Endeavor to structure the transaction so the paper trail of payments from the partnership does not correlate nor equal the note payments as to amounts or timing.
√ Defined Value Clauses
• These safety mechanisms have grown more popular in estate and gift tax planning. The concept is simple, although the details and implementation can be varied and complex. If the IRS successfully challenges the value of a transfer, the excess amount, instead of creating a taxable gift, is transferred (depending on the manner of mechanism used) to another receptacle, which will minimize or eliminate the gift tax.
• A number of cases have approved the transfer of the excess to charity.
• Another approach some practitioners have used is a transfer of the excess to a GRAT. This can reduce the value of the excess to near zero and provides an option for a client who is simply too uncomfortable risking the transfer of family business interests or other special assets, to a charity. Other practitioners have raised the question as to whether the use of a GRAT as the defined value receptacle might be against public policy because the annuity payments from the GRAT are made to the grantor. This might be argued to be tantamount to the landmark Procter case, which proscribed returning the excess value to the grantor/transferor. Another concern some commentators raise is whether or not the spillover of the excess value to the GRAT would be tantamount to a deemed contribution when GRATs do not permit additional contributions. A number of practitioners have and continue to use this technique of having the excess value spillover into a zeroed out GRAT. So many experts believe there is no issue with the GRAT approach. Practitioners might consider informing clients who have used (or will use) this technique of the potential issues.
• Another consideration is for practitioners to review all transactions that used defined value mechanism to be certain the transaction reported consistently with the formula clause used. Most comments concerning consistent with the defined value mechanism have generally focused on gift tax reporting, but is more advisable even if not perhaps necessary? If entity interests are sold to a trust subject to a defined value mechanism should anything be indicated on the Form K-1? Might the K-1 report the percentage interest with an asterisk and an indication that the percentage reported is subject to a defined value mechanism? Should the potential receptacle under the defined value mechanism (e.g., a GRAT or QTIP) indicate on its income tax filings that it has a possibility of an interest in an entity under that mechanism? What about on a QSST (qualified subchapter S trust) or ESBT (electing small business trust) election? Should there be an indication of the potential for shares being held by another entity?
• Under landmark Procter, Commr. v. Procter 142 F.2d 824, case the court did not uphold a defined value mechanism that resulted in the excess value reverting to the donor. One problem the court identified was the fact that the mechanism resulted in no tax after a successful audit. The court determined that the mechanism violated public policy. Is there any advantage to using a mechanism that will trigger some current tax on audit? Consider adjusting whatever mechanism is used have the first $X or Y% of interests remain with the donee/buying trust knowingly triggering some gift and GST tax. Then the remainder resulting from the valuation increase on audit spillover into a private foundation, GRAT, QTIP, etc.
√ Valuation Issues
These have historically focused on discounts, etc. But in the new tax paradigm for moderate wealth clients who will not be subject to the estate tax, valuing assets as high as possible, short of triggering an estate tax can lead to the opposite planning. Will Congress have to enact valuation overstatement penalties?
√ Step Transaction
Practitioners should be alert for step-transaction issues in complex or multi-part plans. If a gift is to be made, e.g., from wife to husband, and thereafter husband will be gifting or selling some or all of those interests to a trust, endeavor to separate the two steps of the transaction into separate tax years. If feasible, the preferable approach would be for independent substantive economic events to occur during the intervening period.
√ Promissory Notes
Loan transactions are ubiquitous in family and estate planning. When a client dies holding notes practitioners often have those notes appraised for estate planning purposes. In other transactions, clients may have the holder of a note resulting from a family transaction gift the note based on its appraised value. The IRS has challenged value of notes at less than face value. There is a presumption (IRC Sec. 7872) interest rate is a safe harbor.
Another audit issue for notes is whether or not they are real loans (valid indebtedness). Some of the factors to evaluate the validity of a note include:
• Reasonable expectation for repayment of the note.
• The interest rate charged.
• The existence and adherence to a repayment schedule.
• Security for the loan.
• Whether a demand for payment has been made and whether it was respected.
• Books and records of the transaction. How the parties reported.
• Repayment of the loan.
• Solvency of the borrower.
Another audit issue is challenging the refinancing of loans as interest rates decline. Many AFR (applicable federal rate) notes have been refinanced. The IRS has argued that the refinancing of a note at a lower rate is a gift. Some commentators suggest shortening the term of the renegotiated note or providing another modification that could constitute consideration for the change. Consider the fiduciary obligations of the trustee in all these matters, especially if the note prohibited prepayment.
√ GRAT Audit Issues
Are all provisions required by the Regulations included in the trust agreement? Are the formalities of the GRAT being complied with? Is the GRAT being operated in accordance with its terms? Consider Atkinson analysis based on CRT. Have annuity payments been properly and timely made? Valuation on initial transfer. Re-valuation provision may help. Was there a disguised gift compared to what grantor received on a substitution? Were in-kind distributions made? Were they properly valued? Consider using a Wandry formula with respect to exercise of power of substitution and paying an annuity in kind. Perhaps this is a result of increasing audits of GRAT annuity payments and/or a desire to shift appreciated assets back into a client/settlor’s estate for basis step up purposes. In contrast in the past it may have been more desirable to use cash in the GRAT to make the annuity payment. At any rate, it seems the use of valuation formulas in GRAT payments in-kind might become the new way to go.
√ Gift and Income Tax Auditors Speak to Each Other
Cavalera Case. Audit of a company that sold all of its assets. It had merged with a company owned by three sons and company owned by parents. Income tax agent referred to gift tax auditors who audited the return and found a $27 million gift. Practitioners should not assume these referrals to gift tax auditors don’t happen, they do. Consider filing gift tax returns in these issues.
Martin M. Shenkman, CPA, MBA, PFS, AEP, JD is a regular tax expert source in The Wall Street Journal, Fortune, Money and The New York Times.
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