Sale Of Home To Bypass Trust Or QTIP
By Roy M. Adams
and Glenn Kurlander
Kirkland & Ellis
New York, NY
Q: The Internal Revenue Code Sec. 121 exclusion of gain on the sale of a residence has been allowed for the sale of a home by a grantor trust, such as a Qualified Personal Residence Trust ("QPRT") (see Private Letter Ruling 199912026 referencing Revenue Ruling 85-45). The Service has also acquiesced in the sale of a residence by a trustee in a bankruptcy matter (see IRS v. Waldschmidt) and recently allowed its use for the sale of a home by a Family Limited Partnership (see Private Letter Ruling 20004022). What about the sale of the home (or an interest in the home) by a bypass (credit shelter) trust? Or the even more compelling case by a QTIP trust, where the assets will be in the surviving spouse’s estate?
A: Code Sec. 121 permits a taxpayer to exclude up to $250,000 ($500,000 for married couples filing jointly) of gain realized on the sale or exchange of a principal residence, so long as certain use and ownership requirements are met. The $250,000 exclusion applies if the property has been owned and used by the taxpayer as the taxpayer’s principal residence, within the five year period ending on the date of the sale or exchange, for periods aggregating at least two years.1 The $500,000 amount applies to spouses filing a joint return so long as one spouse meets the above ownership requirement, both spouses meet the use requirement and neither sp
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Gathering Estate Planning Data: Hidden Risksouse has used the exclusion within two years of the date of the sale or exchange. Even if these requirements are not met for a married couple, the $250,000 exclusion can still be used if one of the spouses meets the ownership and use requirements with respect to the property.2
In addition, a taxpayer can choose whether to have the Sec. 121 exclusion apply. This choice can provide a valuable planning opportunity for a taxpayer who meets the ownership and use requirements for two different residences during the five-year period and expects to sell both of the residences within a two year period. Under these circumstances, a taxpayer can reserve the exclusion for the residence that will have the larger gain.
As stated in the question, the Service has recognized that the exclusion applies to the sale of a principal residence by: 1) the owner, for income tax purposes, of a grantor trust, which trust owns such person’s principal residence, 2) a trustee in a bankruptcy matter, and 3) a Family Limited Partnership (where the taxpayer, his spouse and grantor trusts of which they were considered the owners were the sole partners).3 The focus in all of these rulings was whether the taxpayer is the "owner" of the property for purposes of Sec. 121 and whether the use requirements were met.
For example, in Revenue Ruling 85-45, a trust held title to the beneficiary’s principal residence. Because the beneficiary was empowered to compel the trustee to distribute the trust corpus to herself, she was considered the owner of the trust property (including the residence) under Code Sec. 678(a)(1). As a result, the beneficiary was able to utilize the Sec. 121 exemption upon the trust’s sale of the residence.
By contrast, the Sec. 121 exclusion cannot be used by a trust to shelter capital gain on the sale of a residence because a trust cannot have a "principal residence." See Private Letter Ruling 200018021 (January 21, 2000). Only an individual who is treated as the owner of the residence may use Sec. 121 to exclude some or all of his capital gain upon a sale of the residence.
Thus, in the case of a trust as to which the original grantor is no longer living (and thus a trust that cannot be a grantor trust as to such individual), the issue becomes whether the beneficiary who lives in a residence held by the trust will be treated as the owner of such residence for income tax purposes. If so, the beneficiary would recognize gain upon the sale of the residence, but could utilize Sec. 121’s exemption to exclude all or part of the gain from his taxable income. If not, the trust would recognize the capital gain upon a sale, and such gain could not be sheltered from taxation by Sec. 121.
Sec. 678 is the only provision under which a trust could be a grantor trust as to a person who is not a transferor to the trust. Sec. 678 provides that a person (e.g., a beneficiary) will be treated as the owner of any portion of a trust with respect to which he has the power to vest the corpus or income in himself, or if he previously had such a power and released or modified it and still retained such control as would, under the principles of Secs. 671-677, treat a grantor of the trust as the owner thereof.
If a trust gives a beneficiary a continuing power to withdraw the corpus, the beneficiary will be considered the owner of the trust corpus. Thus, he or she would recognize capital gain on a sale of the residence, and Sec. 121 would apply to exclude some or all of the gain.
If a trust beneficiary has the power to withdraw corpus and such power lapses or is released, the beneficiary will be considered the owner of the trust corpus if the beneficiary’s powers and interests would cause him to be the owner under Secs. 671-677 if he had been the transferor to the trust. This requires review of the trust instrument, such as the standard of distribution and the identity of the trustees. If the beneficiary is deemed to be the owner of the trust corpus, then he or she would be subject to capital gains tax on a sale of the residence and Sec. 121 will apply to exclude some or all of the capital gain.
What if a beneficiary is not given the power to withdraw corpus? The trust may provide that all of the trust income shall be paid to the beneficiary, or that the beneficiary has the right to compel the trustee to distribute the income to him or her. In this case, the beneficiary will be treated as the owner of the trust income, and will be taxed on such income irrespective of whether it is actually paid to him or her. Is "ownership" of the trust income by the beneficiary sufficient to qualify under Sec. 121?
Sec. 678 does not state that if one has the power to vest trust income in himself, he is only considered to be the owner of the trust income. Rather, it states that such a person is treated as the owner of "any portion of a trust" with respect to which he can vest the corpus or income in himself. Thus, if one can vest the income from all of the trust assets in himself, is he treated as the owner of the entire trust (income and corpus)? Based on the regulations, the answer appears to be no. Reg. Sec. 1.671-3(b) states that if a person is treated as the owner of a portion of a trust, that portion may or may not include both ordinary income and other income allocable to corpus. The regulation goes on to state that if a person has a power over ordinary income alone, then he is treated as the owner of only ordinary income, and is not treated as the owner of items of income allocable to corpus.
Moreover, Reg. Sec. 1.671-3(c) states that if a person is treated as the owner of a portion of a trust on account of a power only over ordinary income, he will take into account in computing his tax liability those items of income, deduction and credit that would be included in computing the tax liability of current income beneficiary, including expenses allocable to corpus which enter into the computation of distributable net income (DNI). Reg. Sec. 1.671-3(c) refers to the examples in Reg. Sec. 1.677(a)-1(g). In example 1, a trust pays all of the income to the beneficiary for life, with remainder payable to another person. The example states that dividends, expenses allocable to income and expenses allocable to corpus are included in the computation of the beneficiary’s taxable income, but a capital gain recognized by the trust is not.
Based on the foregoing, even if a beneficiary is treated as owner of trust income, such ownership will not be sufficient to cause him to be treated as the owner of the trust corpus, which may include a personal residence. Thus, the beneficiary could not utilize Sec.121 to exclude capital gain realized upon a sale of the residence. This is the case even if such capital gain is taxable to the beneficiary under the DNI rules because the ownership requirements of Sec. 121 would not be satisfied.
One could imagine a trust that gives a beneficiary the right to compel distribution of the income to himself and does not add undistributed income to corpus. If the accumulated income were used to purchase a residence for the beneficiary, it is possible that the beneficiary would be treated as the owner of the residence purchased with "his" income and could utilize Sec. 121 to exclude all or part of the capital gain upon a sale.
Finally, in the rare case in which a trust gives the beneficiary the right to receive all of the trust income, including income allocable to corpus, the beneficiary should be able to utilize Sec. 121 because he will be treated as the owner of the entire portion of the trust from which he can vest the income in himself.
As a consolation, because of the step-up in basis that Code Sec. 1014 grants to recipients of a decedent’s property, often the capital gain upon a sale of a residence held by a testamentary trust (such as a credit shelter trust or QTIP trust) is small.
1. There is an exception to the two year requirement for sales and exchanges due to the taxpayer’s change in place of employment, health or other unforeseen circumstances (see Regs. 1.121 et seq. for examples). If the exception applies, the taxpayer is allowed a reduced exclusion based on the portion of the two year period for which the ownership and use requirements were met. The reduced exclusion is available for spouses filing joint returns if either spouse satisfies the exception.
2. See Code Sec. 121 and Reg. Sec. 1.121-1 et seq.
3. See Rev. Rul. 84-43 (IRS) (allowing the sale of a life estate in a principal residence to qualify for the exemption); 1999 WL 164825 (IRS PLR) (permitting the sale by a qualified personal residence trust to qualify for the exemption); Rev. Rul. 85-45 (IRS) (recognizing the exemption for a marital deduction trust); 1999 WL 33100247 (acquiescing to the use of the exemption for a sale by a bankruptcy estate); 2000 WL 92390 (IRS PLR) (allowing the exemption for a sale by a Family Limited Partnership).
Creditor-Protection Structures Involving Offshore Jurisdictions
Q: How comfortable should clients be with the effectiveness of creditor-protection structures involving offshore jurisdictions? Assume no fraudulent conveyance issues but client is a high-net-worth individual who engages in a high risk business. Recent cases seem to indicate that the effectiveness of offshore planning is not as good as practitioners have led them to believe — not because of any ill-will on the part of practitioners but because of a more aggressive creditor approach combined with willingness of U.S. courts to take the side of creditors.
A: The laws of several offshore jurisdictions permit a settlor to establish a trust that insulates the trust property from the settlor’s own creditors and, at the same time, allows the settlor to retain significant beneficial interests in the trust. (These jurisdictions typically are tax havens as well.) Such trusts are often referred to in the U.S. as offshore "asset protection trusts," (APTs) and are a popular vehicle for those individuals seeking to insulate property from future business torts and other creditors. In fact, it has been estimated that over $1 trillion is now held in offshore APTs.
Despite the popularity of these trusts, and as the question suggests, recent case law has led some estate planners to doubt their effectiveness. A careful analysis of the cases, however, suggests that offshore APTs established for the purpose of protecting property from future, unknown creditors are likely still viable creditor-protection devices.
The most widely talked about case concerning the effectiveness of offshore APTs for U.S. persons is FTC v. Affordable Media and Anderson, 179 F.3d 1228 (9th Cir. 1999). In that case, a husband and wife team (the Andersons) were involved in a telemarketing Ponzi scheme that defrauded thousands of investors. The Andersons created an APT for their own benefit under the laws of the Cook Islands and transferred the fortune they had amassed from the Ponzi scheme into that trust. The Federal Trade Commission brought a civil action claim against the Andersons to recover money on behalf of the defrauded investors, and the District Court entered a preliminary injunction requiring the Andersons to repatriate the assets held in the Cook Islands trust. The Andersons designed the trust so that upon the occurrence of certain defined "events of duress," the trustee would be required to ignore the Andersons’ directions. Thus, when the Andersons instructed the trustee to repatriate the assets, the trustee notified them that the injunction to which they were subject constituted an event of duress and thus the trustee could not abide by their direction. When the Andersons failed to comply with the injunction, the District Court found them in civil contempt and subsequently ordered that they be taken into custody for not purging themselves of their contempt. The Andersons appealed. The Ninth Circuit affirmed the District Court’s order, finding that the Andersons’ "inability to comply" defense was the intended result of their own conduct and that the Andersons had significant power over the trust assets as protectors of the trust.
Similar cases have also arisen in the bankruptcy context (i.e., where an individual established an offshore APT and later declared bankruptcy, claiming he or she had no control over the offshore assets). One such case, In re Stephan Jay Lawrence,251 B.R. 630 (Bankr. S. D. Flor. 2000), involved a situation whereby Lawrence established an APT in the Jersey Channel Islands two months prior to the conclusion of an arbitration dispute with Bear, Sterns & Co. that resulted in a $20.4 million award in favor of Bear, Sterns. Lawrence subsequently amended the trust instrument twice, first to change the governing law of the trust to the Republic of Mauritius and later to exclude himself as a beneficiary. When Lawrence filed a voluntary petition for bankruptcy discharge, the bankruptcy court ordered Lawrence to turn over the assets of the trust, account for its transactions and surrender his passport. Lawrence failed to turn over the assets and the bankruptcy court held him in civil contempt, fining him $10,000 per day, then subsequently ordered that he be incarcerated until he complied. The District Court affirmed the turn over order finding that Lawrence had the ability to comply with the order. The trust instrument granted nearly unfettered discretion to the trustees and Lawrence, through his ability to appoint trustees who could reinstate him as a beneficiary, retained "de facto control" over the trust. Furthermore, the District Court affirmed the contempt and incarceration orders finding that Lawrence failed to meet the burden of showing that he made "in good faith all reasonable efforts" to meet the terms of the turn over order. Although Lawrence allegedly made attempts to contact attorneys in Mauritius and the trustee of the trust, such attempts to purge his contempt were insufficient, and, more importantly, the court held that any impossibility defense was self-created and thus invalid.
Similarly, in In re Coker, 251 B. R. 902 (Bankr. M.D. Flor. 2000), the Cokers created an offshore APT and placed funds belonging to the American Insurance Company in the trust. When a judgment was entered in favor of AIC and against the Cokers in the amount of $225,000, the Cokers filed for bankruptcy protection and claimed they could not retrieve the funds. The bankruptcy court would not recognize the Cokers’ impossibility defense because it was self-created, and held them in civil contempt for failure to comply with the judgment.
These cases have caused many to worry that offshore APTs will no longer provide the asset protection promised by the practitioners advocating their use and the foreign jurisdictions in which they are established. Closer inspection of the cases, however, suggests that the debtors were held in contempt because their claims of impossibility were not believable (or were patently untrue). Furthermore, these cases, and others with similar outcomes, involved debtors who clearly were trying to evade and defraud known creditors. It still is reasonable to believe that a properly structured offshore APT established to protect the settlor’s assets from future, unknown creditors is viable. For example in Reichers v. Reichers, 679 N.Y.S.2d 233 (N.Y. Sup. Ct. 1998), Dr. Reichers established a trust in the Cook Islands to shield family assets in the event of future medical malpractice judgments. The court found that because the trust was established for the "legitimate" purpose of protecting family assets, the court did not have jurisdiction over the corpus of the trust and legal issues (such as whether Dr. Reichers soon-to-be-ex wife would be entitled to trust property) should be left to the Cook Islands court.
It appears that the protections afforded by offshore APTs should be upheld so long as they are created, funded and administered under appropriate circumstances. To maximize the chances that an offshore APT will succeed as effective creditor protection device, we suggest the following:
• Do not use the "events of duress" model to insulate persons who are subject to the jurisdiction of U.S. courts, and make certain that such persons are never vested with the authority to amend or revoke the trust, direct the trustees or other fiduciaries as to the exercise of their discretion, remove or replace trustees or other fiduciaries, or change the trust’s governing law or the situs of trust property. To retain some control over the trust assets, the settlor can consider wrapping the trust’s assets within a limited partnership in which the settlor is a 1 percent general partner and the trust is a 99 percent limited partner, or naming himself or herself as investment advisor with the power to make all investment, but no distribution, decisions.
• Keep all trust property out of the U.S.
• Set up the trust as early as possible and do not seek to avoid current, known creditors.
• If possible, use the trust to accomplish other "legitimate" estate planning goals distinct from creditor protection and document any non-creditor protection planning reasons for placing assets in the trust.
For anyone who is considering establishing an offshore APT but is worried about the current effectiveness of such trusts, it is important to bear in mind that even if the is not completely bullet-proof, its mere existence may facilitate settlements far more favorable to the settlor than would be the case if he or she had not created the trust.u