Supremes rule on Knight:
A unanimous U.S. Supreme Court on Jan. 16, 2008, ruled that trust investment advisory fees (IAFs) are subject to the 2 percent floor, handing a defeat to banks and taxpayers who'd hoped all IAFs would be found to be fully deductible.
In Knight, Trustee of William L. Rudkin Testamentary Trust v. Commissioner (U.S. Supreme Court, Jan. 16, 2008) (which is known both as the Knight case and the Rudkin case), the question was whether IAFs incurred by a trust in managing its investments are subject to Internal Revenue Code Section 67(e)'s 2 percent floor. That section allows a trust to deduct certain expenses from taxable income — but only to the extent the deductions exceed 2 percent of adjusted gross income.
IRC Section 67(e)(1) provides that such expenses may be deducted in full and are not subject to the 2 percent floor if the expenses are paid or incurred in connection with trust administration and would not have been incurred if the property were not held in trust.
The Tax Court held that the trust's IAFs were subject to the 2 percent floor, affirming a ruling by the U.S. Court of Appeals for the Second Circuit (467 F.3d 149 (2006)).
There is one bright spot for banks and trusts: The high court did say that some trust IAFs could be fully deductible. For example, if an investment advisor were to impose special, additional charges applicable only to its fiduciary accounts.
The Second Circuit had held that fees and expenses that could be incurred if the property were held individually and not in trust were subject to the 2 percent floor. But the high court held that the expenses were subject to the 2 percent floor because they would have been incurred if the property were not held in trust. This test follows the phrasing in the relevant statute (“would” instead of “could”), and is arguably more lenient to taxpayers than a “could” test.
The high court explained that “would” requires a prediction of what would happen if the property were held individually and not in trust — whether it would be uncommon or unusual for such expenses to be incurred if not held in trust.
In Knight, the Supreme Court held that a reasonable person would have solicited investment advice and therefore IAFs would have been incurred.
The Knight decision paves the way for the Internal Revenue Service to revise and finalize the regulations it had proposed in July 2007. Those regulations said that only expenses that are “unique” to fiduciary administration are fully deductible and not subject to the 2 percent floor, and required fiduciaries to unbundle their fees to separate state costs that meet this test. In other words, the regs said that if an individual taxpayer could not have possibly incurred the expense, then, and only then, is the expense fully deductible under the proposed regulations. Proposed Treasury Regulations Section 1.67-4.
The IRS standard will likely need to be amended to fall in line with the Supreme Court's “would not have been incurred” and “uncommon and unusual” tests in Knight.
Tax Court in Lee declares the order in which spouses die can't be ignored:
The Tax Court ruled on Dec. 20, 2007, that there is no estate tax marital deduction unless the spouse actually survives.
In Estate of Kwang Lee v. Commissioner, T.C. Memo. 2007-371, the Lees wanted to ensure that they used their estate tax exemptions to the maximum extent. However, most of the assets belonging to Kwang Lee and his wife were held in Kwang's name because of the nature of his employment benefits. So, the couple had their wills prepared so that each one's stated, “For purposes of this Will, any person who shall die within six (6) months after my death shall be deemed to have predeceased me.”
The wife predeceased Kwang by 46 days. Following the terms of his will, his estate was administered as if his wife had survived him: A credit shelter trust was established under his will with the residue of his estate transferred into the wife's name as if she were still alive. His estate tax return claimed the marital deduction as to the residuary purportedly transferred to the wife, and those assets were subsequently included in the wife's estate (making use of her estate tax exemption.)
While a will can make whatever assumptions the testator desires for purposes of disposing of the estate, IRC Section 2056 does not permit the will to modify the order of the actual deaths of a husband and wife for estate and related tax purposes. As a result, the Tax Court held that no marital deduction is allowed for the amounts that passed to the predeceased spouse because she is not a “surviving spouse” within the meaning of IRC Section 2056.
The estate argued that IRC Section 2056(b)(3) allows a six-month survivorship requirement. But that provision merely states that a surviving spouse's interest that is conditioned on the spouse surviving for six months will qualify for the marital deduction, and does not obviate the requirement that the decedent's spouse actually survive him.
This case could be applicable in another situation: when a revocable trust gives the grantor's spouse a testamentary general power of appointment (GPA) over a portion of the trust in order to include trust assets in the spouse's estate if he or she predeceases the grantor, thereby allowing the spouse's estate tax exemption to be utilized. The gift created by granting the spouse a GPA is incomplete until the spouse's death because of the revocable nature of the trust; at the spouse's death, the gift is complete.
The Lee case could be used to hold that the gift completed upon the spouse's death does not qualify for the gift tax marital deduction, because the spouse is dead when the gift is completed.
In Private Letter Ruling 200403094 (Sept. 24, 2003), the IRS held that such a gift qualifies for the marital deduction, but the ruling provided no explanation for the conclusion and cannot be relied upon as precedent.
PLR 200751022 finds rental of a caretaker house didn't nix a QPRT:
In PLR 200751022 (decided Sept. 5, 2007, and released Dec. 21, 2007), the grantor owned property that included seven buildings: a main house, two free standing garages, a maintenance building, two greenhouse buildings and a caretaker house. The grantor represented that the property is assessed as one parcel for local property tax purposes and is similar in size and configuration to other nearby properties.
The grantor uses the main house as a personal residence. In the past, the grantor allowed friends and relatives to occupy the caretaker house for limited periods at no cost. But now the grantor intends to rent the caretaker house to an unrelated third party. The grantor will provide no services in connection with the rental of the caretaker house other than ordinary maintenance.
The grantor deeded the property to a nominee trust and transferred the beneficial interests in the nominee trust to three trusts intended to qualify as qualified personal residence trusts (QPRTs) as set forth in Treas. Regs. Section 25.2702-5(c). During the term of the trusts, the grantor would remain entitled to the exclusive occupancy of the property subject to the rights of the lessee with respect to the caretaker house.
The IRS held that leasing the caretaker house will not cause the property to fail to qualify as a personal residence under Treas. Regs. Section 25.2702-5(c)(2).
PLR 200750019 rules new IRAs created from a decedent's IRAs are inherited IRAs:
In PLR 200750019 (decided Sept. 14, 2007, and issued Dec. 19, 2007), a decedent's revocable trust (which became irrevocable at his death) was named as the beneficiary of his two individual retirement accounts (IRAs). The beneficiaries of the trust were the decedent's three daughters. The trustees proposed dividing the two IRAs into six IRAs by making direct trustee-to-trustee transfers from the original IRAs, so that each daughter would inherit a share of each IRA.
The IRS held that such transfers could be made and the daughters would be treated as designated beneficiaries of the IRAs for purposes of determining the distribution period for the payments, but the life expectancy of the eldest daughter would be used to calculate the minimum distributions each year.