2016 was a busy year for tax law. Here are some highlights.
New proposed regulations relating to basis reporting
The Treasury issued proposed regulations which would implement the new basis reporting requirements that became law in July 2015.
Several of the provisions are surprising. First, if property is discovered after filing a federal estate tax return or omitted from the return for any other reason and isn’t reported before the period of limitations on assessment expires, then the basis is zero. This results in significant income tax implications for beneficiaries receiving assets not properly reported on an estate tax return, even if they only discovered the assets after the assessment period expired.
There’s also a new reporting requirement for beneficiaries for certain transfers of inherited property. This provision considerably expands the reporting requirements to include not just executors but also beneficiaries.
The proposed regs also introduce some confusion as to to whom executors must furnish a reporting statement. They provide that the executor must furnish the statement to each beneficiary, and the definition appears to include contingent beneficiaries, which in many cases would be impractical and, largely, useless.
On a positive note for executors, the proposed regs state that the following don’t need to be included on the information statements: cash, income in respect of a decedent, tangible property (unless an appraisal is required because the value of an item exceeds $3,000) and property that’s sold or otherwise disposed of by the estate.
However, even that bit of help comes with a potential drawback, as if an executor isn’t sure what property will be used to satisfy a beneficiary’s interest, the executor must list all of the property that could possibly be used to do so. This requirement will likely result in duplicative reporting (not to mention providing the beneficiary with a lot more information than he would otherwise be entitled to and potentially more than the decedent would wish).
A for some of the less surprising provisions:
- If an executor has provided the basis information to a beneficiary for all property that may be used to satisfy the beneficiary’s interest, the executor doesn’t need to file a supplemental statement later to confirm which assets were actually received.
- The filing requirements of Section 6035 don’t apply to federal estate tax returns filed only for the purposes of portability or the generation-skipping transfer (GST) tax.
- The basis consistency requirement applies only to property that increases the federal estate tax liability; property that qualifies for the charitable or marital deduction isn’t subject to these rules.
- If the beneficiary is a trust, estate or business entity, the executor may provide the statement to the trustee, executor or entity and not to the beneficiaries or owners.
Estate & Gift Tax
Assets held in family limited partnerships (FLPs) may be includible in decedent’s estate
A pair of cases weighed in on different aspects of this issue this year.
In the first, Holliday v. Comm’r, the Tax Court held for the IRS.
Sarah Holliday moved into a nursing home in 2003. She had two sons who managed her day-to-day financial affairs. She established an FLP and funded it with marketable securities. She owned all of the FLP interests (99.9 percent). A limited liability company (LLC) that she owned was the general partner (GP) with a 0.1 percent interest. On the same day she formed the FLP and the LLC, she also formed an irrevocable trust. Less than a week later, all on the same day, she gave 10 percent of her FLP interest to the irrevocable trust and sold her interest in the LLC to her two sons. Sarah retained substantial assets out of the FLP for her support.
The FLP held marketable securities until Sarah’s death. The securities weren’t actively managed and were traded only on limited occasions. Following Sarah’s death, the IRS asserted that the assets of the FLP were includible in her estate under IRC Section 2036, which applies to include assets transferred by a decedent during life if the decedent retains certain rights or beneficial interests in the property, unless the transfer is made for full and adequate consideration.
The Tax Court held that because the FLP agreement required cash distributions to be made if the FLP held sufficient funds in excess of its operating needs, Sarah retained a right to income from the transferred assets. Based on testimony from her sons, the court also found that distributions would have been made to Sarah if she needed the funds. The court essentially disregarded the ownership of the GP interest by the LLC (and the sons) when it found that there was an understanding between Sarah and her sons that the FLP assets were available to her if she needed them.
Perhaps more importantly, the court noted that Sarah was apathetic regarding the FLP and its structure: She didn’t actively participate in the process but merely went along with whatever her sons and the attorney decided. The court also noted that none of the partnership formalities were observed: There were no family meetings held, no books kept and no compensation paid to the GP.
The Holliday case shows the importance of having a factual record that supports the stated non-tax purposes of the partnership and shows that the formalities of the partnership structure were followed. If taxpayers don’t respect the structure, neither will the IRS.
In the second case, Estate of Beyer et al., the estate failed to show that the decedent’s transfers to an FLP qualified for certain exceptions to Section 2036; thus, the assets were includible in his taxable estate.
Edward Beyer, a former CFO of Abbott Laboratories, through the exercise of various options, had accumulated about 800,000 shares of the company. As part of his estate plan, he established an FLP in October 2003 and funded it with the Abbott shares. Initially, Edward’s Living Trust owned the FLP interests. One year after the FLP was funded, in April 2005, Edward established an irrevocable trust. At the end of that year, in December 2005, the Living Trust sold its entire interest in the FLP to the irrevocable trust. Edward died in May 2007.
The value of a gross estate includes the value of property transferred (other than a bona fide sale for adequate and full consideration) if the transferor retains for his life the possession or enjoyment or the right to the income from the property.
The bona fide sale exception, which is the issue in question here, will apply only if the estate can prove that a legitimate non-tax purpose was a significant and motivating factor in establishing the FLP.
The court found that there was no significant and legitimate non-tax purpose to establishing the FLP because the alleged reasons for setting up the FLP could have been achieved by other means. For example, the estate claimed the purpose of the FLP was to allow Edward to keep the stock in a block, transition his nephew Craig into managing the property and provide for continuity of management. The court found that Edward could have kept the block of stock intact in other ways (by amending his Living Trust) and that the FLP didn’t achieve this goal (it didn’t require the stock to be held as a block and allowed the sale of the stock).
The court also found that Edward didn’t receive full and adequate consideration because the FLP didn’t maintain capital accounts for its partners that showed the interests the partners received in exchange for the initial and subsequent contributions to the FLP.
Lastly, the court found that Edward had an implied understanding that he would continue to be able to access the transferred property for his own benefit. The court based this conclusion primarily on certain distributions made directly from the FLP to Edward’s Living Trust after the Living Trust had sold its interests to the irrevocable trust and was no longer a partner. The largest such distribution was of almost $10 million from the FLP to the Living Trust after Edward’s death to pay for estate taxes.
Plenty went wrong in this case: The distributions to pay for gift taxes and estate taxes were problematic, as was the failure to adhere to the formalities of establishing the FLP in the first place. And, while the estate raised some good potential reasons for establishing the FLP, the facts didn’t show that the FLP in fact addressed those needs.
Transcripts may be provided in lieu of estate tax closing letters
For all estate tax returns filed after June 1, 2015, the IRS will only issue estate tax closing letters by request of the taxpayer (that is, the estate). If a taxpayer doesn’t wish to request an estate tax closing letter, he may instead obtain an estate tax account transcript. The IRS asks that the executor wait at least four to six months after filing Form 706 to obtain the transcript.
Transcripts will reflect if the IRS has accepted Form 706 and whether it completed an audit. Each line of the transcript shows a transaction code with an explanation of the code, the date and the dollar amount, if applicable. Transaction Code 421 indicates an estate tax return has been accepted as filed or that the examination is complete. If that code isn’t displayed, the tax return is still under review.
There are two ways to access the transcript: (1) registered tax professionals can access it online if they have an executed Form 2848 on file, or (2) the estate can submit Form 4506-T by fax or mail.
New process allows do-it-yourself method to complete a rollover despite missing the 60-day deadline
In Rev. Proc. 2016-47, the IRS created a do-it-yourself process that allows some taxpayers who were unable to complete a rollover from one retirement plan to another within the required time to implement the rollover without it being considered a taxable distribution. This process will be a great help for taxpayers who’ve been unable to complete rollovers within the 60-day period because of administrative errors, which are often the main culprits interfering with timely rollovers.
A distribution from a retirement plan is taxable unless it’s rolled over to the same or another retirement plan within 60 days. If a taxpayer misses the 60-day period, historically there have been only limited means of rectifying the mistake. Most recently, the only way to do so was seek a waiver from the IRS by filing a request for a PLR, which is a slow, expensive and burdensome process.
Now, under Rev. Proc. 2016-47, a taxpayer who’s missed making the rollover within the required 60 days can certify to the plan administrator that he was unable to do so for certain reasons. The plan administrator can rely on that certification alone and then accept the rollover. To qualify, certain requirements must be met. First, the taxpayer may not have previously been denied a waiver for the distribution by the IRS. Second, the reason for the missed deadline must be one of 11 reasons listed in the revenue procedure (reproduced below). Lastly, the taxpayer must complete the rollover as soon as practicable (and within 30 days after the reason for the delay no longer exists is a safe harbor).
The reasons that justify the self-certification waiver are:
- An error was committed by the financial institution receiving the contribution or making the distribution to which the contribution relates;
- The distribution, having been made in the form of a check, was misplaced and never cashed;
- The distribution was deposited into and remained in an account that the taxpayer mistakenly thought was an eligible retirement plan;
- The taxpayer’s principal residence was severely damaged;
- A member of the taxpayer’s family died;
- The taxpayer or a member of the taxpayer’s family was seriously ill;
- The taxpayer was incarcerated;
- Restrictions were imposed by a foreign country;
- A postal error occurred;
- The distribution was made on account of a levy under IRC Section 6331, and the proceeds of the levy have been returned to the taxpayer; or
- The party making the distribution to which the rollover relates delayed providing information that the receiving plan or IRA required to complete the rollover despite the taxpayer’s reasonable efforts to obtain the information.
The revenue procedure provides a sample letter for taxpayers to use. The certifications are subject to audit, and while the taxpayer may treat the distribution as a rollover until further notice, the IRS may ultimately determine that the distribution didn’t meet the requirements and assess penalties.
New guidelines on when the IRS may disregard a QTIP election
A QTIP trust enables a grantor to provide for a surviving spouse and to maintain control of how the trust's assets are distributed once the surviving spouse dies.
Fifteen years ago, the IRS established procedures for when it would disregard a Qualified Terminal Interest Property trust (QTIP) election that wasn’t necessary to eliminate estate tax. This rule was actually intended to protect and benefit taxpayers. At that time, a QTIP election that was unnecessary most likely provided little benefit with potentially significant adverse tax consequences (that is, lost use of a decedent’s estate tax exemption). However, in 2010, with the introduction of portability, executors of estates may in fact wish to make QTIP elections, even if unnecessary to avoid tax, to take advantage of portability.
Rev. Proc. 2016-49 provides some added flexibility for taxpayers to reflect this new reality. A QTIP election will now be treated as void if all three of the following conditions are met: (1) the estate’s federal estate tax liability was zero, regardless of the QTIP election, (2) no portability election was made, and (3) the estate follows the procedural requirements of filing a supplemental return (either a Form 706 for the decedent or the decedent’s surviving spouse or a gift tax return for the surviving spouse) with a notation of “Filed pursuant to Rev. Proc. 2016-49” at the top of the form and an explanation of why the QTIP election should be treated as void.
State Income Tax
Massachusetts Supreme Judicial Court rules that trusts are subject to Massachusetts fiduciary income tax even though corporate trustee had domicile outside of the state
In Bank of America v. Comm’r., the Supreme Judicial Court of Massachusetts upheld a decision by the Appellate Tax Board, which ruled that Bank of America was an inhabitant of the state even though it wasn’t domiciled there. Massachusetts imposes a fiduciary income tax on resident trusts, and to be considered a resident trust, several requirements must be met. One of those requirements is that at least one trustee must be an inhabitant of the state.
The question under debate was how to determine whether the bank was an inhabitant.
The Appellate Tax Board held that a corporation is an inhabitant if it maintains a permanent place in the Commonwealth, continues to be present for the required period of time (183 days a year) and conducts trust administration activities in Massachusetts, which include, in particular, material trust activities relating specifically to the trusts at issue. Under this rule, Bank of America was an inhabitant of the Commonwealth, causing the trusts to be considered resident trusts and subject to Massachusetts tax. Although Bank of America’s headquarters and principal place of business was in North Carolina, the court found the bank had over 200 branches in Massachusetts and performed activities in Massachusetts offices to fulfill its obligations to the trusts, such as: maintaining relationships with the beneficiaries; deciding when to make distributions; maintaining records; conducting research; and discussing issues with the grantors, beneficiaries and their representatives.
Though this decision only affects Massachusetts, it could have wide ranging implications if other states adopt similar rationales.
Valuation discounts could be reduced under IRC 2704
The Treasury released proposed regs regarding lapses of voting and liquidation rights and transfers of interests in closely held entities. The proposed regs expand the types of restrictions that will be ignored when valuing a transfer; therefore eliminating the justifications for various commonly used discounts. Section 2704 generally applies to interests in corporations and partnerships—the proposed regs clarify that they would also apply to LLCs.
Further information about these potential changes can be found here.
IRS sets certain inflation-adjusted tax items for 2017
For an estate of any decedent dying in calendar year 2017, the basic exclusion amount is $5.49 million (a $40,000 increase) for determining the amount of the unified credit against gift and estate tax. The exemption for GST tax, which is determined by reference to the unified credit, will also be $5.49 million.
The annual exclusion remains the same. For calendar year 2017, the first $14,000 of gifts to any person (other than gifts of future interests in property) isn’t included in the total amount of taxable gifts made during that year.
For calendar year 2017, the first $149,000 (a $1,000 increase) of gifts to a spouse who isn’t a U.S. citizen (other than gifts of future interests in property) isn’t included in the total amount of taxable gifts made during that year.
This is an adapted and abbreviated version of the authors’ original compilation in the January 2017 issue of Trusts & Estates.