• Revenue procedure provides new guidelines on when the IRS may disregard a QTIP election—Fifteen years ago, in Revenue Procedure 2001-38, the Internal Revenue Service established procedures for when it would disregard a qualified terminable interest property (QTIP) election that wasn’t necessary to eliminate estate tax. At that time, a QTIP election that was unnecessary most likely provided little benefit with potentially significant adverse tax consequences. However, with the introduction of portability in 2010, 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 now addresses this situation.
Rev. Proc. 2016-49 supercedes 2001-38 and provides that a QTIP election will be treated as void if all three of the following conditions are met: (1) the estate’s federal estate tax liability is zero, regardless of the QTIP election, (2) no portability election is 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.
Unless these special circumstances apply, a QTIP election may not be revoked. Therefore, in larger estates that use QTIP marital trusts, the QTIP election will be necessary to reduce the estate tax to zero and so can’t be undone. In smaller estates that are under the federal exemption, if a portability election is made, the QTIP election will be permanent.
• Tax Court rules on issue of first impression relating to theft loss claim for Madoff investments—In Estate of James Heller, et al., 147 T.C. No. 11 (Sept. 26, 2016), the Tax Court ruled for an estate and held that it was entitled to a theft loss deduction under Internal Revenue Code Section 2054 for the lost value of investments managed by Bernie Madoff. A limited liability company (LLC) held the investments, and the decedent owned 99 percent of the LLC, the only asset of which was an account with Madoff’s investment firm. The issue of whether an estate could be entitled to a theft loss deduction relating to an LLC interest hadn’t been addressed before.
The value of the LLC’s assets (the investments with Madoff) on James’ date of death was about $16.5 million. In the spring of 2008, the executors of James’ estate withdrew $11.3 million to pay taxes and administrative expenses. At the end of 2008, Madoff was arrested and, as a result of the exposure of his Ponzi scheme, the assets held by the LLC and the estate were worthless.
In the spring of 2009, the estate filed an estate tax return that claimed a theft loss deduction of over $5 million: the date-of-death value of the account, less the withdrawals made prior to Madoff’s arrest. The IRS issued a notice of deficiency, holding that the estate wasn’t entitled to the theft loss because the LLC, not the estate, incurred the loss.
IRC Section 2054 provides that an estate is entitled to deductions for “losses incurred during the settlement of the estate arising from theft.” When interpreting the statute, the court focused on the verb “arising” and held that it required sufficient nexus between the loss and the theft. In the case at hand, it determined that there was a significant nexus between the theft from the LLC and the estate’s loss and therefore upheld the deduction.
• Tax Court holds that estate includes value of assets transferred to FLP under IRC Section 2036—In Estate of Beyer, et al., T.C. Memo. 2016-183 (Sept. 29, 2016), the estate failed to show that the decedent’s transfers to a family limited partnership (FLP) qualified for the exceptions to Section 2036(a)(1). As a result, the assets transferred to the FLP were includible in the decedent’s 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, in consultation with an attorney, he established an FLP in October 2003. He funded it with the Abbott shares six months later in April 2004. Initially, Edward’s Living Trust owned the FLP (the general partner was another trust, known as the Management Trust, of which Edward’s two nephews were co-trustees). 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 (the 99 percent limited partnership interest) to the irrevocable trust for nearly $21 million, payable by a promissory note and secured by an interest in the accounts. Edward died in May 2007.
The IRS claimed that the estate should include the value of the transferred shares under Section 2036(a)(1), and the court agreed, finding that the facts didn’t support the estate’s position. Under Section 2036(a)(1), the value of the 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 will apply 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 that the stock be held as a block and allowed the sale of the stock). It noted that Craig already was named as Edward’s agent in a durable power of attorney, and he could have been named as a trustee of the Living Trust. Or, Edward could have given him further authority to manage the stock without the FLP. Similarly, naming Craig as a co-trustee of the Living Trust would have provided for continuity of management. All in all, the court found that Edward could have met these goals without the FLP and that the FLP didn’t, in fact, address the purported non-tax reasons for its existence (and noted that none of the reasons were included in the “boilerplate” list of reasons for establishing the FLP in its partnership agreement).
The court also found that Edward didn’t receive full and adequate consideration because it found that 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. Edward’s estate plan directed that estate taxes be paid from his Living Trust. However, after the Living Trust sold the interests in the FLP to the irrevocable trust, it was left without sufficient funds to pay the taxes. Distinguishing it from Estate of Mirowski v. Commissioner, T.C. Memo. 2008-74, the court held that Edward could have amended his estate plan or otherwise funded the trust to provide for the tax payments. Therefore, he must have assumed that his estate would still be able to access the value of the FLP assets. Similarly, during his life, Edward received distributions from the FLP (when he and his Living Trust were no longer partners) to pay gift taxes. Since he couldn’t pay his expenses, the court concluded that he was relying on the FLP assets because he didn’t retain sufficient assets himself.
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.