In Part 1 of this article on topics discussed at the Heckerling Institute of Estate Planning, I covered planning for diminishing cognitive abilities and avoiding guardianships. Now, let’s move onto self-cancelling installment notes (SCINs) and an update on Crummey notices.
SCINs (Estate of Davidson)
Much attention was devoted at Heckerling to the Estate of William Davidson –both to the Internal Revenue Service challenge on audit to sales to trusts involving SCINs and to the subsequent malpractice case that followed the settlement of the IRS audit.
SCINs are promissory notes that contain a provision cancelling any future payments on the death of the note’s obligee. This feature is intended to prevent estate tax inclusion of any remaining payment obligations under the promissory note (although cancellation on death produces taxable income in the amount of the deferred gain on the estate’s first Form 1041 fiduciary income tax return). For the value of the SCIN to equal the value of the property sold, the seller of the property must be compensated for the risk that the seller may die during the term of the note, and therefore not receive the full purchase price. The risk premium on SCINs can be structured using a higher than “normal” interest rate, a higher principal face amount of the note or a combination of these two features.
Bill Davidson was the president, chairman and CEO of Guardian Industries Corp., a manufacturer of glass, automotive and building products, as well as the owner of the Detroit Pistons basketball team. At age 86, he entered into various gift and sale transactions, as well as transactions with grantor retained annuity trusts (GRATs). Many of these transactions involved SCINs. Soon after these transactions, he was diagnosed with a serious illness and died approximately two months later (before he’d received any payments on the SCINs). The IRS Notice of Deficiency alleged total gift, estate and generation-skipping transfer (GST) taxes owed in excess of $2.6 billion.
The primary issues on the IRS audit included the valuation of the Guardian stock and whether the SCINs constituted bona fide consideration given in exchange for Bill’s sale of the Guardian stock to various children’s trusts and grandchildren’s trusts. All of the sale transactions were in exchange for notes providing annual interest payments and balloon principal payments due in five years. The SCINs issued by the children’s trusts and the grandchildren’s trusts were more than 100 percent secured by Guardian shares. The SCINs had very substantial interest rate premiums in excess of the Internal Revenue Code Section 7520 rate in effect on the date of the transaction. On the same day as the sales transaction, Bill contributed the SCINs he received from the children’s trusts to a five-year GRAT. If Bill were still alive at the end of the five-year term, the GRAT’s remainder interest would be distributed to the same children’s trusts that had issued the SCIN notes.
The IRS mortality tables under IRC Section 7520 indicated that Bill’s life expectancy was 5.8 years at the time of the sales transaction. The estate and the IRS disagreed over Bill’s actual life expectancy at the time of the sales transaction. All four medical consultants used in the audit (two of whom the IRS selected and two of whom the estate selected ) concluded that Bill had a greater than 50 percent probability of living at least one year at the time of the sales transaction. Assuming that Section 7520 were to apply, that mortality conclusion would ordinarily cause the Section 7520 tables to be available to value the transaction.
The IRS took the position, however, that the Section 7520 tables don’t apply to SCINs. Rather, the IRS maintained that Section 7520 applies only in valuing annuities and life estates. According to the IRS, the term of years component of SCIN transactions rendered Section 7520 inapplicable to them, and therefore a willing-buyer/willing-seller analysis instead applied to determine the “normal” interest rate prior to adjustment for the risk premium.
The IRS also took the position that the sales weren’t bona fide transactions because, at the time of the transactions, there was no reasonable expectation of repayment of the loans that were used by the trusts to pay for the property sold to the trusts.
The parties settled the IRS audit. According to the stipulated decision entered in the Tax Court, the total federal estate and GST tax deficiency with respect to the Form 706 was approximately $152 million, which is a small fraction of the more than $2.6 billion deficiency asserted in the Notice of Deficiency. Additional gift and GST tax deficiencies of approximately $178 million were stipulated on the SCIN transactions (as compared to the combined gift and GST tax deficiency asserted by the IRS of almost $876 million).
As a postscript to the IRS audit settlement, Bill’s estate has sued Deloitte Tax LLP in New York Supreme Court to recover approximately $500 million in taxes, fees and penalties relating to the sale transaction. The consensus at Heckerling was that the Davidson audit has had a considerable chilling effect on SCIN transactions.
A Swan Song for Crummey Powers?
We may soon witness the swan song for Crummey powers of withdrawal. The IRS doesn’t like the use of Crummey powers in trusts to generate multiple annual exclusions by having the terms of the trust or other governing instrument confer on a multitude of beneficiaries rights of withdrawal that will likely go unexercised notwithstanding that notices may be given to the beneficiaries by the trustee and carefully documented.
The IRS continues to challenge Crummey powers without any success, as demonstrated by the 2015 case of Mikel v. Commissioner, T.C. Memo. 2015-64 (Tax Ct. 2015). In Mikel, the IRS argued that the Crummey powers weren’t legally enforceable due to the following features in the trust instrument: (1) the presence of an in terrorem clause under which a beneficiary’s beneficial interest would be forfeited if he challenged a trust distribution and (2) the existence of an arbitration clause that required any disputes concerning the interpretation of the trust agreement “be submitted to arbitration before a panel consisting of three persons of the Orthodox Jewish faith” (a “beth din”). The trust instrument conferred withdrawal rights on 60 beneficiaries, and the IRS denied the gift tax annual exclusion as to all 60.
The Tax Court in Mikel rejected the IRS’ argument and held in favor of the taxpayer. First, the court construed the trust instrument’s in terrorem clause not to apply to withdrawal powers. In addition, the IRS conceded that the trust instrument’s arbitration provisions were unenforceable, as they hadn’t been consented to by the beneficiaries. Accordingly, the beneficiaries’ withdrawal demands couldn’t be “legally resisted” by the trustees. Consequently, the donor’s transfers to the trust constituted present interests that qualified for the gift tax annual exclusion.
The more effective approach for the IRS to attack Crummey powers would be through legislation. The Obama Administration’s Fiscal Year 2016 Greenbook proposals would eliminate the present interest requirement for gifts that qualify for the gift tax annual exclusion and establish a “$50,000 super-category” of annual exclusion gifts that would envelop all of a donor’s gifts to trusts. The proposal would define a new category of transfers (without regard to the existence of any withdrawal or put rights) and impose an annual limit of $50,000 (indexed for inflation after 2016) per donor on the donor’s transfers of property within this new category that will qualify for the gift tax annual exclusion. This new $ 50,000 per-donor limit wouldn’t provide an exclusion in addition to the annual per-donee exclusion; rather, it would be a further limit on those amounts that otherwise would qualify for the annual per-donee exclusion. Thus, a donor’s transfers in the new category in a single year in excess of a total amount of $50,000 would be taxable, even if the total gifts to each individual donee didn’t exceed $14,000. The new category would include transfers in trust (other than to a trust described in IRC Section 2642(c)(2)), transfers of interests in pass-through entities, transfers of interests subject to a prohibition on sale and other transfers of property that, without regard to withdrawal, put or other such rights in the donee, can’t immediately be liquidated by the donee. The proposal would be effective for gifts made after the year of enactment.