NORTHERN JERSEY CHAPTER OF THE SOCIETY OF FINANCIAL SERVICE PROFESSIONALS

January 22, 2008

Heckerling Institute Highlights 2008

Presented by:

Jerome A. Deener, Esq. Deener, Hirsch & Shramenko, P.C.

Two University Plaza Hackensack, NJ 07601

201-343-8788 jdeener@deenerlaw.com

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TABLE OF CONTENTS Page

January 2008 Highlights.................................................................................................. 1

Analysis of an Estate Plan – Utilizing Graegin Note........................................................ 7

529 College Savings Accounts...................................................................................... 15

Section 2053 Proposed Regs. on Estate Tax Deductions for Claims, Etc..................... 33

Gifts of Fractional Interests in Art .................................................................................. 41

Valuation Clauses ......................................................................................................... 45

Estate Planning for Retirement for the Rich and Famous ............................................. 49

Problems with Your Irrevocable Trust: State Law and Tax Consideration in Transferring Assets to a New Trust ............................................................................... 52

Rudkin Case: U.S. Supreme Court, January 16, 2008................................................. 60

Curriculum Vitae: Jerome A. Deener, Esq.................................................................... 61

Heckerling Institute

January 2008 Highlights

I. Repeal of Estate Tax

A. Highly unlikely.

B. Reform – probably not until after 2008 Presidential election.

C. Type of Reform (guesses)

1. $3.5-million to $5.0-million exemption – Phased in $250,000 to $500,000 per year.

2. Rates: 35% and 45%

3. Portability of exemption

a) Each spouse will automatically possess (say) $3.5-million exemption without necessity of credit shelter trust.

b) Kiss the Credit Shelter/Marital Will disposition goodbye if that happens.

II. Treasury/IRS 2007/2008 Priority Guidance Plan

A. Restrictions on estate assets during the 6-month alternate valuation period.

1. D dies with marketable securities. Can Executor form FLP within 6 months of death and claim discount in value?

2. Kohler case – involved reorganization of a corporation. Held: Non-taxable event was not a disposition of old stock, and therefore value new stock at alternate value date.

B. Will power to exchange assets under Section 674(c) to make trust a Grantor Trust for income tax purposes result in a Section 2036 reservation, and therefore estate tax inclusion?

1. Government may contend the right by the Grantor to call a valuable asset in the trust results in a reservation under 2036.

2. Can bona fide sale exemption apply to avoid Section 2036?

3. Current drafting: Can Grantor retain power to exchange assets until such power is deemed to be a 2036 inclusion? Thereafter, the

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power is relinquished. Use other powers such as power to loan assets to Grantor without security.

4. Will this be applied retroactively?

III. Importance of tax apportionment clauses in Wills – Lee case. N.J. Ap. Div.

A. Involved litigation over whether a charitable beneficiary or individual legatees should bear the estate tax burden.

B. Case involved a QTIP Trust with two pecuniary gifts passing to individuals and the balance passing to a charity on the death of the surviving spouse. The Will was not clear on the issue. The testimony of the attorney who drafted the Will was required in order to ascertain the intent of the testator. The attorney testified the testator’s intent was for the two pecuniary gifts to pass free and clear of tax to the two individuals and to diminish the interest passing to the charity. This involved a circular calculation of the tax and effectively increased the amount of the tax.

C. The lesson of the case is to draft the apportionment clause with specificity and clarity after a full discussion with the testator. This could have avoided expensive litigation.

IV. Avoiding ancillary probate to reduce state estate tax consequences

A. Formation of LLC prior to death creates intangible property interest.

B. Some states look through single- member LLCs. Therefore, consultation with local attorney may be essential.

V. Sale by Trustee of Life Insurance owned by Revocable Life Insurance Trust to a new Irrevocable Life Insurance Trust

A. Purpose: Ability to change undesirable dispositive provisions that may exist in the first trust.

B. Rev. Rul. 2007-13 holds that the sale by one grantor trust (first insurance trust) to the second grantor trust is not transfer for value under the principles of Rev. Rul. 85-13.

C. The value of the policy transferred may not necessarily be its cash surrender value.

D. Is such a sale a breach of fiduciary duty by the Trustee?

VI. 100% of built-in gain capital gains tax is to be considered in valuing C Corporation. Jelke – CA-11.

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A. Jelke reversed Tax Court that said it would take 16 years to sell off the assets to create the tax liability and therefore discounted the liability to its present value.

B. This Court held that the sale of appreciated assets will be determined to be sold at the moment of death.

C. Is this arbitrary? It is contrary to other Circuit Court decisions.

D. If the same assets were held in a Family Limited Partnership or LLC, and a Section 754 election were made, there would be no taxable gain. (Income Tax)

1. Which is better?

2. Obtaining immediate Federal Estate Tax reduction for the potential income tax will probably trump income tax savings under a Section 754 election in most cases.

E. Reasoning of Jelke does not usually follow in the context of S Corporations.

F. In the real world of business, discounts are negotiated in actual buyouts where there is a built-in gain. The discount, therefore, may have been overstated in Jelke.

VII. Estate tax valuation of a 50% interest in artwork (Stone California District Federal Court)

A. Estate’s expert opined for a 44% fractional interest discount.

B. IRS allowed a 5% discount.

C. Court accepted IRS 5% discount.

VIII. Family Limited Partnership Discount Issues

A. Summary of bad facts from various cases in which no discount was permitted:

1. No negotiations among partners upon creation.

2. Created by child on death bed using Durable Power of Attorney.

3. De minimus contributions by persons other than the decedent.

4. Transfer of virtually all assets to FLP without attention of enough liquid wealth outside FLP to live on.

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5. Disproportionate distributions to senior family member and attempts to create accounting interests calling such payments loans or management fees.

B. Bona fide sale exception will not benefit taxpayer in a 2036 situation where the facts are “bad facts” as indicated above.

C. What if there are no bad facts? Does this mean that 2036 will not apply and discounts may be obtained?

1. Example: Deathbed partnership is formed with (say) $5-million which constitutes one-half of client’s $10-million portfolio, leaving $5-million to live one (assumed to be more than enough to live on).

2. Children contribute approximately $50,000 and receive a 1% general partnership interest (the client receives a 99% limited partnership interest for his contribution).

3. No distributions are ever made from the partnership and client dies 6 months later.

4. IRS could argue there is no legitimate non-tax reason for the partnership. However, that argument is almost universally made in the context of whether the bona fide sale exception to 2036 will apply.

5. Under these facts, it seems very difficult for IRS to assert Section 2036 because it cannot be said there was a reservation of any interest by the taxpayer.

a) There were no partnership distributions made. The general partner, who had the right to make partnership distributions, was not the senior family member. There was no implied reservation of income from the partnership to support the senior family member because he retained sufficient assets to live on outside the partnership.

D. Other advice to enhance the success of a FLP

1. Accountant should be hired to create the books and records for the partnership immediately upon formation of the partnership and contribution of assets to the entity. Don’t wait until filing the 1065 form to engage the accountant, and don’t use the 1065 form as the “books and records” of the partnership.

2. Defer the transfer of FLP interests from the senior family member (where that may be part of the planning process) for some period of

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time following the funding and formation of the partnership. (Preferably, a deferral into the next calendar year.)

E. Drafting an FLP Agreement to avoid 2036(a)(2) and possibly 2036(a)(1) argument.

1. If decedent is the GP, his ability to make partnership distributions should be limited by an ascertainable standard. That is, GP should possess a fiduciary duty to consider the reasonable business needs of the FLP, including expansion, future investments and the like, before making distributions. The ability to make unfettered distributions can be harmful. See Cohen 79 T.C. 1015 (1979).

2. This argument was made in Rector by the taxpayer since that language did exist. However, the Court pointed out that decedent owned virtually all of the partnership interest, and therefore there was no one to whom the decedent owed a fiduciary duty.

F. Estate planning letters to the client setting forth the benefits of an FLP should be prepared as though they will be produced at trial.

G. Communication by the GP to Limited Partners during the operation of the FLP can be very helpful.

H. The latest partnership case (Rector – December 2007)

1. Facts.

a) 92 year old forms FLP while in a convalescent hospital.

b) Virtually all assets are contributed to the FLP, leaving only assets of a Credit Shelter Trust outside the FLP.

c) Credit Shelter Trust allowed distributions to Mr. Rector, but the trustees (his children) in their discretion made no distributions from the trust, intending to enhance the trust assets so that they would pass estate tax free to them on Rector’s death.

d) The partnership assets were then used to fund Rector’s needs for the 3-year period until he died.

e) Rector made a gift of FLP interests during his lifetime which was reported on his Gift Tax Return, but was not included as part of his adjusted taxable gift on his Estate Tax Return after he died.

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f) Partnership assets were used to fund his estate tax after his death.

2. The Tax Court held:

a) Although a modest 19% discount was claimed, the entire discount was disallowed under 2036(a)(1).

b) An implied agreement existed to use the partnership assets and income for decedent’s needs during his lifetime.

c) Use of the partnership funds after his death to satisfy the estate tax was further evidence of a reservation under 2036(a)(1).

I. How is the estate tax to be funded, particularly if the sole asset of the decedent is a FLP interest.

1. Distributions from the FLP will result in a 2036(a) retention under Rector, Strangi and other cases.

2. A redemption as in the case of Rosen v. Commissioner was also deemed a 2036(a) retention.

3. Loan from the partnership to the estate may be the best choice.

a) If assets are available from other sources, such as a Credit Shelter Trust, those assets should be considered for loan.

4. Consider a Graegin loan (see outline attached of Graegin loan fact pattern).

a) Deduction of all interest by the estate up front.

b) See, however, proposed Regs. under Section 2053.

c) Use commercial rate of interest, not AFR rate.

d) Prohibit right to prepay.

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ANALYSIS OF AN ESTATE PLAN

UTILIZING GRAEGIN NOTE

I) Facts:

A) Client, Age 70, a widow, is inflicted with a terminal disease and not expected to live beyond six months. Client has three adult children:

1) One daughter resides with client and, due to disability, has minimal expectation of earning sufficient income to sustain her living needs;

2) A second daughter is described as a “spendthrift”; and

3) A son who is well educated, possesses business savvy, and capable of making appropriate business and financial choices for the family.

B) Client’s objectives:

1) Permit the disabled daughter to continue to reside in the family residence following client’s demise. In fact, client’s pre-existing Will so indicates this objective.

2) Divide assets equally among all children, subject to disabled daughter’s right to reside in client’s family residence, if feasible.

3) Provide a mechanism to control disposition of at least a portion of client’s assets, in light of issues involving two daughters.

4) Minimize potential Federal Estate Tax consequences.

II) Client’s estate assets are (000 omitted):

IRA $2,000 Annuities 30 Bank Account 70 Client’s Family Residence 1,100 Liquid Assets 1,000 Out-of-state vacation home (listed for sale) 300 Total potential taxable estate $4,500 Add: Credit Shelter Trust assets from pre-deceased husband’s estate [3rd party (uncle) is trustee; trust continues for client’s 3 children for their lives, then to issue] 1,300

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Total Family Assets $5,800

III) Potential Federal and State Estate Tax: $1,500

Other potential estate liquidity requirements 200 $1,700

IV) Planning Considerations:

A) Form LLC with $1,000,000 liquid assets and $300,000 vacation home.

1) Client will possess only non-voting interest in the LLC.

2) Son will be the manager of the LLC

3) Gift or retention of client’s non-voting LLC interest?

(a) Considerations for retention: sufficient assets for client’s needs exist outside of transferred LLC assets. Additionally, it can be demonstrated that significant non-tax benefits for the LLC exist.

(i) Avoidance of ancillary probate for out-of-state vacation home.

(ii) Management of LLC assets performed by son with business acumen.

(iii) On client’s death, decedent’s non-voting LLC interest can ultimately pass to three children, subject to desired control by decedent’s son.

(b) Considerations for gift of interest

(i) Step transaction issue (Senda case). The entity was funded two weeks prior to client’s decision to retain or gift her interest.

(ii) Should decedent own an interest in the LLC prior to death?

(c) Under Graegin analysis below, gift option appeared to be more advantageous than retention option. Also, gift would reduce state estate tax.

B) Assume appraiser opines that the non-voting LLC interests have a discounted value of $820,000 (37% discount).

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C) Client dies approximately three weeks after LLC is formed, assets are contributed, and gift of non-voting interest is made. The gift was made two weeks after the entity was formed and funded.

V) Potential estate tax and other liquidity needs of the estate before Graegin loan: $1,400,000 (potential estate tax reduced to $1,250,000, assuming LLC discount is unchallenged), plus other liquidity needs for estate administration of $200,000.

VI) Consideration of Graegin Loan to further reduce tax and fund tax payment

A) Goals of Graegin Note

1) Defer payment of interest until loan principal is satisfied.

2) Deduct full amount of deferred interest (undiscounted by present value) currently against Federal Estate Tax.

3) Arbitrage current estate tax reduction against future income tax cost to lender when loan is repaid.

4) Preserve FLP or other entity discount

5) Avoid below-market sale of non-liquid estate assets to satisfy estate tax.

B) There is authority for the deduction under Section 2053 of projected interest payable on third party loans taken to pay Federal and state estate/inheritances taxes, to avoid a forced sale of assets, or where the estate consists primarily of illiquid assets. Est. of Todd, 57 T.C. 288 (1971), Est. of Huntington, 36 B.T.A. 698 (1937), Est. of Bahr, PLR 9449011, PLR 199952039, PLR 199903038.

C) In Est. of Graegin v. CIR, T.C. Memo 1988-477, the Tax Court permitted the deduction of projected interest payable on a loan from a subsidiary of the decedent’s closely held corporation.

D) Analysis of Graegin v. Commissioner

1) In Estate of Graegin, T.C. Memo 1988-477, Tax Court held that a single balloon payment of interest due on maturity of a 15-year loan incurred to pay estate tax was a deductible administration expense under Section 2053(a)(2). Total interest, without “present value” analysis was allowed. Lender was a subsidiary of a closely held family corporation.

2) In Graegin, the decedent's estate owed $ 200,000 in federal estate tax and had available liquid assets of $ 20,000. Prior to his second marriage, decedent entered into an antenuptial agreement, and

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established a "spouse's revocable trust". The property in the spouse's revocable trust included what became the marital residence and cash. In keeping with the antenuptial agreement, the trust provided that if the second wife survived the decedent she was entitled to reside in the residence for life. The spouse's revocable trust would pay all expenses of the residence and all remaining income of that Trust would be paid to the surviving spouse. Invasion of the Trust principal was permitted solely for the surviving spouse's benefit and solely to pay expenses of the marital residence. On the surviving spouse's death the assets would pour over to a second revocable trust established by the decedent for his sole benefit, and would be available to meet the decedent's estate tax obligations.

3) The decedent contributed 5130 shares of preferred stock of Graegin Industries, Inc. (a closely held corporation) to his separate revocable trust. On decedent's death, his residuary estate poured into the trust; the trust was responsible for payment of all taxes and expenses of his estate. Decedent died, survived by his second wife. Instead of selling the decedent's shares in Graegin Industries to pay estate taxes, the Estate borrowed from a subsidiary of the company. The Estate's Promissory Note had a 15 year term (the widow's life expectancy - so that assets in the spouse's revocable trust could fund part of the Estate’s repayment obligation), charged 15% simple interest (the then prime rate) and provided that all interest and principal were to be paid in a single payment at the end of the term. The Note prohibited pre-payment and was unsecured. The Estate's borrowing was approved by the local probate court. The Estate took a deduction for the total amount of interest to be paid on the Note. The IRS disallowed the deduction and the Estate sued in Tax Court.

4) Applying the requirements of Code Section 2053, the Graegin court held:

(a) the interest payable was reasonable, fixed and determinable,

(b) the evidence was clear that the parties intended to repay the loan, and

(c) the interest was a reasonable and necessary expense, incurred to avoid the sale of the Estate's stock in the Decedent's closely held company at a discount.

5) The Service had argued that the loan was not true debt; that the repayment of the loan was tenuous because the borrower (the estate) and lender (the closely held subsidiary corporation) were

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both controlled by the decedent's son; and that the loan was unsecured, further evidencing the sham nature of the loan.

6) The Tax Court held that the character of a transaction as a loan depends on the facts and circumstances of the case (Busch v. Com'r, 728 F.2d 945 (CA 7 1984); among these are whether the parties intended for the loan to be repaid (Tollefsen v. Com'r., 431 F 2d 511(CA 2 1970), aff'g. 52 TC 671 (1969)), and while the loans "between a debtor and creditor having an identity of interest require close scrutiny, such identity of interest per se is not fatal…." Graegin, at 481.

7) The Tax Court found the son's testimony regarding intention to repay credible. In addition, it was important that there was an outside shareholder owning shares of Graegin Industries, Inc., who presumably, would complain if the obligation was not repaid. Finally, the third party Co-Executor and the guardian ad litem for the decedent's grandchildren beneficiaries concurred in the decision to borrow from the subsidiary, lending creditability to intent to repay and the bona fide character of the loan.

8) All of these facts, and the probate court's approval of the transaction, led the Tax Court to hold for the Estate - permitting the entire amount of interest on the note to be deducted currently on the Estate's 706 Return.

9) The Service has issued several favorable Private Letter Rulings since Graegin (see PLR 199952036 and 199903038, approving third party loans) and the Tax Court, as well, has permitted the interest deduction in Estate of Gilman, TC Memo 2004-286 (also a third party loan). However, in Technical Advice Memorandum ("TAM") 200513028, the Service disallowed the upfront deduction of interest on a loan made by a family limited partnership ("FLP") to an Estate owing 99% of the FLP interests.

10) The interest deduction was disallowed in the TAM based on the Service's conclusions that::

(a) the FLP owned significant liquid assets to cover the estate tax and expenses,

(b) a child of decedent was both executor of the Estate and general partner of the FLP, with power to liquidate FLP assets,

(c) while the Estate could not require the FLP to make a distribution to it since the Estate's 99% interest was a mere

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assignee interest, the same person “stood on both sides of the transactions”

(d) even if the loan was repaid, which the TAM found doubtful, the economic position of the individuals would remain unchanged because the FLP partners (i.e. effectively the lenders) and the Estate beneficiaries (i.e. effectively the borrowers) were the same individuals.

11) The within Estate's position is distinguishable from that in the TAM.

(a) Decedent's Estate does not own any interest in the Credit Shelter Trust funds.

(b) The assets of the Credit Shelter Trust will be liquidated to fund the loan, however, the Trustee of the Trust into which the Credit Shelter Trust passes, has no power to distribute these proceeds to Decedent's Estate.

(c) The Trustee's only power is to lend the funds with adequate security, and upon reasonable terms

(d) Loan is secured with a mortgage on the residence. There is an ear-marked fund for the Estate's repayment, the proceeds of sale of the client’s family residence, anticipated to occur at the expiration of 15 years.

(e) A written agreement is in place granting the disabled daughter the right to continue to reside in the client’s family residence for 15 years.

(f) Finally, the presence of the remainder interests in the Credit Shelter Trust following the children's life interests in their separate share Trusts, like the outside shareholder in Graegin, would likely complain if the Trust's loan is not repaid with interest, insuring the repayment by decedent's Estate.

VII) The facts surrounding the within Decedent's Estate are not dissimilar from Graegin. In particular:

A) During lifetime and under Will, Decedent expressed intention that disabled daughter be permitted to remain in residence, thereby creating a need to retain the residence which was the sole probate asset.

B) The estate and disabled daughter entered into an agreement giving the disabled daughter the right to reside in the residence for 15 years subject to the disabled daughter satisfying all carrying costs associated with the

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residence (her earnings were sufficient for this limited purpose). If the disabled daughter elected to abandon the residence and reside elsewhere before the 15-year period expired, the estate could then sell the asset. However, the proceeds of sale could not be used to prepay the loan obligation prior to 15 years. Instead, the proceeds would be held as collateral security to satisfy the loan obligation. The 15 year term was arrived at by anticipating time when disabled daughter might reasonably be expected to move from the residence to assisted living, thereby freeing the property to be sold. The disabled daughter would then be age 67.

C) Ear marking of sale proceeds of the residence to repay the loan is evidence of the intent to repay.

D) The lender, i.e. the predeceased husband’s Credit Shelter Trust, had an independent Trustee who authorized the loan. Independent Trustee possessed a fiduciary obligation to the beneficiaries of the Credit Shelter Trust, including remaindermen who were not affected by the loan.

E) Finally, under applicable State law, interest on an Estate's loan may be deductible as an expense if it is necessary and the estate lacks sufficient liquidity.

F) The following is a comparison of the total Gift and Estate tax liability without and with a Graegin loan:

Total Federal and State estate tax and liquidity needs before borrowing $ 1,440,000

With Graegin loan – amount borrowed: $1,000,000 Gross Estate $ 4,020,000 Less: Estimated Administration Expenses ( 200,000) Less: 15 years Interest payable on Graegin loan ( 805,000) Taxable Estate $ 3,015,000

Liquidity Requirements – Post-Graegin: Federal and State Estate Tax $ 800,000 To Administration Expenses 200,000 Total Liquidity Necessary $1,000,000 Interest: 5.36% (AFR) per annum x 15 Years

on $ 1,000,000 805,000

The Graegin loan can result in an overall tax savings in excess of $400,000, thereby reducing liquidity requirements by that amount.

VIII) Cases when Graegin loan should be considered

A) Estate with insufficient probate assets to satisfy tax.

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B) Estate can demonstrate either:

1) A bona fide need to retain the illiquid probate assets.

2) The sale of the illiquid assets would be at a loss

C) The borrower (Executor) is not the same person as the lender (GP of FLP, or Trustee of a Credit Shelter Trust).

D) Demonstrate convincing facts of intent to repay obligation

1) Separate identity of lender and borrower

2) Duty of lender to persons not affected by loan (unrelated shareholders in the case of a corporate loan, remaindermen in the case of a trust loan).

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529 COLLEGE SAVINGS ACCOUNTS Abbreviations Used in Outline 529SA: 529 savings account

QSTP: Qualified state tuition program QTP: Qualified tuition program

UGMA: Uniform Gifts to Minors Act UTMA: Uniform Transfers to Minors Act

I. Advantages and Disadvantages of 529 Savings Accounts

A. Advantages 1. No Income Limits. There are no income limitations on who can

contribute to a 529SA. 2. Income Tax Exemption. Earnings are exempt from federal income

tax, and either exempt or deferred from state income tax. 3. Front-Loaded Annual Exclusions. Up to five times the annual gift

tax exclusion amount (currently $12,000) can be deposited in a 529SA immediately without incurring gift tax.

4. GST Annual Exclusion Available. Contributions to a 529SA that qualify for the gift tax annual exclusion will also qualify for the GST tax annual exclusion, so grandparents can make a large contribution to a 529SA for a grandchild without having to allocate any GST tax exemption.

5. Beneficiary Has No Control. The beneficiary has no direct access to, or control over, the 529SA funds. The account owner typically controls the distribution of funds from the account.

6. Beneficiary Can Be Changed. The account owner can change the beneficiary.

7. Account Owner Can Reacquire Funds. The account owner can withdraw the funds from the account. A donor can set aside funds for a beneficiary’s education, but retrieve the funds if the beneficiary does not attend college, the donor needs the funds, or any other reason.

8. Funds Can Be Used for Education Costs Not Permitted under §2503(e). 529SA funds can be used for room and board and other required expenses (such as books), in addition to tuition and fees.

9. Financial Aid. A 529SA does not count as an asset of the student if the student is a dependent.

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10. Available to Adult Beneficiaries. Adults can open accounts for themselves in many states, so 529SA programs can be used to save for a return to school.

11. Education Credits Still Available. The Hope Scholarship Credit and the Lifetime Learning Credit are still available to the account owner, even if the account owner has established a 529SA.

12. State Income Tax Deduction. Some states offer state income tax deductions to residents who invest in their own state program.

13. Creditor Protection. 529SAs have special protection in bankruptcy. In addition, some states protect 529SAs from other creditors.

14. Extension of Benefit. Qualified withdrawals made after December 31, 2010 will continue to be exempt from federal income tax under PPA 2006.

B. Disadvantages 1. Distribution Limitations. Qualified distributions may be made only

for qualified higher education expenses. 2. Excess Funds. If the beneficiary does not use all of the 529SA

funds for qualified higher education expenses, undesirable tax consequences may result if the remaining funds are distributed.

3. Account Owner Can Reacquire Funds. Choice is important since a successor account owner can withdraw the funds rather than direct a distribution to the beneficiary. This can produce an unexpected result.

4. Limited Investment Options. Although there are some limits, most donors should be able to find a suitable investment option.

5. Limit of Investment Control. The ability to change investment options is limited to one time per year, or upon a rollover to another plan, or when the beneficiary is changed.

6. Tax Traps. Rollovers, investment changes and changes of beneficiary can result in some negative tax consequences if the account owner is not careful.

7. Inclusion in Beneficiary’s Estate. On the death of a beneficiary, the funds in a 529SA may be included in the beneficiary’s estate.

8. Uncertainty How Programs Will Develop. 9. Final regulations to § 529 have not yet been issued. The provision

grants the Secretary broad regulatory authority to clarify the tax treatment of certain transfers and to ensure that qualified tuition program accounts are used for the intended purpose of saving for higher education expenses of the designated beneficiary, including

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the authority to impose related recordkeeping and reporting requirements.

II. Account Management A. Changing Investment Options.

1. Future Contributions. The account owner should be able, at any time, to designate a different investment option for future contributions without violating the Code § 529(b)(4) prohibition against participating in investment decisions.

2. Existing Accounts. Notice 2001-55, 2001-2 C.B. 299 (September 7, 2001), permits a QTP to allow investments in a 529SA to be changed annually without rolling over the account to a program in another state. The program permits a change in investment strategy once per calendar year and upon a change in the designated beneficiary

3. Account Aggregation. If an account owner has multiple accounts under a state program for the same beneficiary, the accounts will be aggregated for this purpose. Thus the account owner could change the investment choices for any or all of the accounts once per calendar year, provided the changes are all done on the same day.

B. Rollovers. Most states allow an account owner to switch to another state’s program by making a rollover. Any rollover from one state program to another must take place within 60 days of the distribution, or it will be treated as a nonqualified distribution. However, a rollover is permitted only once in any given twelve-month period for a beneficiary. The Internal Revenue Service is concerned about the use of multiple rollovers to circumvent the restriction on investment direction. The ”once every 12 months” limitation is a per beneficiary limitation, not a per account limitation. Thus, an account owner could roll over a 529SA for a beneficiary without realizing that a 529SA for the same beneficiary, but with a different account owner, had been rolled over within 12 months. 1. Rollover with Beneficiary Change. A rollover to another state plan

can still be made at any time without adverse tax consequences if (a) the beneficiary is changed, (b) the new beneficiary is a member of the family of the old beneficiary and (c) the new beneficiary is not in a younger generation than the old beneficiary. Code §529(c)(3)(C)(i)(II).

2. State Income Taxation a) Outgoing Rollover: Income Tax Deduction Recapture. In

some states, if a state income tax deduction was received for a contribution to a 529SA and the account is then rolled

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over to a different state, the income tax deduction would be recaptured.

b) Outgoing Rollover: Nonqualified Withdrawal Treatment. New York treats rollovers from New York’s College Savings Program as nonqualified withdrawals for New York income tax purposes.

c) Incoming Rollovers: Income Taxation. Some states may tax the earnings on an incoming rollover for an account owned by a state resident.

d) Incoming Rollovers: Income Tax Deduction. In some states, such as New York, rollover contributions (or at least the principal portion of the rollover), as well as original contributions, to the state program might qualify for the state income tax deduction. In other states, rollover contributions do not qualify for the state income tax deduction or are only deductible if not previously deducted).

C. Successor Account Owner. Proposed Regulation § 1.529-1(c) defines an “account owner” as the individual “entitled to select or change the designated beneficiary of an account, to designate any person other than the designated beneficiary to whom funds may be paid from the account, or to receive distributions from the account if no such other person is designated.” Therefore, the identity of the account owner is important. Most programs permit the account owner to designate a successor account owner when opening the 529SA. 1. Voluntary Changes during Account Owner’s Life. A number of

programs permit a change of account owner during life. 2. Incapacity of Account Owner. Programs differ in how the account

is managed if the owner becomes incapacitated during life. 3. Death of Original Account Owner. The program may permit the

original account owner to designate a successor account owner. If, at the original account owner’s death, no contingent account owner is effectively designated as permitted under the plan, the program’s policy determines who will become the account owner.

III. Beneficiary Changes A. Changing the Designated Beneficiary. Generally, the account owner can

change the designated beneficiary at any time. Code § 529(c)(3)(C). There are no tax consequences to changing the designated beneficiary as long as (1) the new beneficiary is a member of the family of the old beneficiary and (2) for GST tax purposes, the new beneficiary is assigned to the same generation as (or a higher generation than) the old beneficiary.

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1. Family Members. “Member of the family” is defined to mean: (a) A son or daughter, or a descendant of either; (b) A stepson or stepdaughter; (c) A brother, sister, stepbrother, or stepsister; (d) The father or mother, or an ancestor of either; (e) A stepfather or stepmother; (f) A cousin; (g) A son or daughter of a brother or sister; (h) A brother or sister of the father or mother; (i) A son-in-law, daughter-in-law, father-in-law, mother-in-law,

brother-in-law, or sister-in-law; or (j) The spouse of the designated beneficiary or the spouse of

any individual described in paragraphs (1) through (9) of this definition. Prop. Treas. Reg. § 1.529-1(c); Code § 529(e)(2).

2. Income Tax Consequences. If the new beneficiary is not a member of the family of the old beneficiary, the change in beneficiary is treated as a nonqualified distribution to the account owner. Prop. Treas. Reg. § 1.529-3(c)(1). The account owner would have to include the earnings portion of the distribution in his or her gross income, and the distribution is also subject to the penalty tax.

3. Gift Tax and GST Tax Consequences (a) New Beneficiary Not Family Member. It is likely that if the

beneficiary is changed and the new beneficiary is not a member of the family of the old beneficiary, then the change of beneficiary is treated as a new gift from either the old beneficiary or the account owner to the new beneficiary.

(b) New Beneficiary in Younger Generation. Regardless of family relationship, the change of beneficiary is treated as a gift if the new beneficiary is one or more generations below the old beneficiary, and is also treated as a GST transfer if the beneficiary is two generations or more below the old beneficiary.

c) Annual Exclusion. The deemed gift would be to a 529SA for the new beneficiary and thus would qualify for the gift tax annual exclusion. The proposed regulations provide that the five year averaging rule may be applied to this deemed transfer.

d) Who Is Donor? The proposed regulations treat the old beneficiary as the donor, even though the account owner controls the change of beneficiary. Thus the old beneficiary is responsible for any gift and GST taxes if the new beneficiary is of a lower generation! There

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are legal and practical problems with treating the old beneficiary as the account owner.

IV. Creditors’ Rights Over 529 Savings Accounts. Creditor protection for 529 savings accounts is provided by federal law in the case of bankruptcy (with significant limitations) and in many states by statute or regulation in the case of creditors’ claims generally (which includes creditors’ claims brought outside of bankruptcy proceedings). A. Federal Bankruptcy Protection. Contributions made to a 529SA for a

child, grandchild, stepchild or step grandchild more than two years prior to filing the bankruptcy petition are protected to the extent they do not exceed the amounts permitted to be contributed per beneficiary by the program. Funds contributed to a 529SA for a child, grandchild, stepchild or step grandchild more than 365 days but less than 720 days prior to filing bankruptcy are protected only up to $5,000 per beneficiary.

B. State Creditor Protection Statutes. 1. Bankruptcy Limitations. For bankruptcy purposes, the applicable

state law is the state in which the debtor has been domiciled for at least 730 days prior to filing.

2. Limited to State’s Own Program. Most of the states (including New Jersey and New York) limit the creditor protection to programs established within that state.

3. Whose Creditors? A number of state statutes protect 529SAs from creditors’ claims generally, without specifically limiting the protection to the claims of creditors of the beneficiary, the claims of creditors of the account owner or the claims of creditors of the contributor. Other states specify that the protection is specifically from the creditors of the contributor and the beneficiary (New Jersey). For custodial accounts held for beneficiaries who are minors under state law, protection would not generally be needed because generally minors cannot incur enforceable debts (with some exceptions). Nonetheless, a statute that expressly protects an account from the creditors of a beneficiary may provide some protection in the event of a custodial account where the beneficiary incurs debts after attaining majority but before attaining the statutory age for distribution of a custodial account. Protection from the creditors of the account owner is critical, because the account owner generally has the right to withdraw the account. Most of the state statutes specifying who receives creditor protection universally include the account owner, but New Jersey does not protect the account owner.

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V. Income Tax Deductions A. No Federal Deduction. Contributions to a 529SA are not deductible for

federal income tax purposes. B. State Deductions. In some states, contributions are deductible for state

income tax purposes, often subject to a cap. Generally deductions are permitted only for contributions to the QSTP in

the taxpayer’s state of residence. C. Donor Restrictions. The deduction may be available only for contributions

to accounts of which the donor is the account owner. In some states, the deduction may be available only for certain donors, such as a parent or guardian of the beneficiary.

D. Contribution for Self. If a contribution is being made to an account of which the account owner is also the beneficiary, the account owner should check whether state law permits a deduction under such circumstances.

E. Caps on Deductions. In most states there is a cap on the annual deduction permitted (e.g., $2,000 per beneficiary per year), but some states have no deduction limits.

VI. Distributions A. Federal Income Tax Exemption. The income earned on a 529SA is not

subject to federal income tax, provided it is used to pay qualified higher education expenses (“qualified distributions”).

B. State Taxation of Account. Some states base the state income tax on federal taxable income, federal adjusted gross income or federal tax liability. In these states, the annual income earned on a 529SA should not be subject to state income tax (absent a special provision in state law subjecting it to income tax).

C. State Taxation of Qualified Distributions. In determining state taxation of a qualified distribution, the relevant state is the state of residence of the beneficiary.

D. Annuity Taxation on Nonqualified Distributions. Nonqualified distributions are federally taxed under the annuity rules of Code § 72. Subject to Code §§ 72(e)(2)(B) and 72(e)(9), distributions are treated as consisting of two components: 1) principal or contributions, which are generally not taxed, and 2) earnings, which may be subject to tax. Note that the earnings portion is taxed as ordinary income, regardless of what portion of the earnings is attributed to capital gains. 1. Earnings. The earnings portion of the account is equal to the value

of the account at a particular time minus the investment portion of the account. The earnings ratio for the account is equal to the earnings portion of the account divided by the total value of the account. The earnings portion of a particular distribution is

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determined by multiplying the earnings ratio by the amount of the distribution.

2. Time of Determination. The earnings portion shall be determined as of the date of distribution.

3. Distributee’s Tax rate. Nonqualified distributions are taxed at the distributee’s tax rate.

E. Losses. If a nonqualified distribution is taken from an account that has a loss, the distributee can claim the loss as a miscellaneous itemized deduction. You can take the loss only when all amounts from that account have been distributed and the total distributions are less than your unrecovered basis. Your basis is the total amount of contributions to that QTP account. 1. Aggregation of Distributions. All distributions during the year must

be aggregated in determining losses. 2. AMT. A 529 loss could cause a taxpayer to incur AMT.

F. Aggregation of Accounts. The proposed regulations provide that “it is expected that the final regulations will provide that only accounts maintained by a § 529 program and having the same account owner and the same designated beneficiary must be aggregated for purposes of computing the earnings portion of any distribution.” However, an IRS notice indicates that the IRS anticipates that accounts established by the same donor for the same beneficiary, but under different state programs, will not be aggregated for purposes of determining the taxable earnings portion of a nonqualified withdrawal. This provides a planning opportunity. Instead of establishing a single account with a balanced portfolio (or a fixed income account and an equity account under the same QTP), the donor could establish a fixed income account under one QTP and an equity account under another QTP. Assuming that the equity account has a greater proportion of earnings than the fixed income account, if a nonqualified withdrawal is taken, the account owner could take it from the fixed income account to minimize income taxes.

G. Federal Penalty on Nonqualified Distributions. Section 529 imposes a 10% federal penalty on the earnings portion of a nonqualified distribution. Taxable income is not reduced by the penalty. The federal penalty does not apply if the distribution meets one of the following requirements: (a) is made to the beneficiary’s estate after the beneficiary’s death; (b) is attributable to the beneficiary’s being disabled; or (c) is made on account of a scholarship, allowance or payment described in Section 25A(g)(2) received by the account holder to the extent the amount of the distribution does not exceed the amount of the scholarship, allowance or payment.

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VII. Entities. Section 529(b)(1)(A) provides that a QTP includes a program under which a “person” may make contributions to a 529SA. Section 7701(a)(1) defines “person” to include “an individual, a trust, estate, partnership, association, company or corporation.” The term also includes a guardian, executor, administrator, conservator or any person acting in a fiduciary capacity. However, not all QTPs permit corporations, trusts and custodians to open 529SAs. A. Transfer of UTMA Funds. Many programs permit a UTMA or UGMA

custodian to open a 529SA. 1. Segregation. You cannot add custodial monies to a pre-existing

noncustodial 529SA for the beneficiary. This is because the beneficiary is the legal owner of a UTMA account and therefore must also be the legal owner of a 529SA created with UTMA funds.

2. Restrictions. Transferring UTMA funds to a 529SA does not remove the funds from the rules of the UTMA. The funds are still subject to the UTMA restrictions. A custodial account owner cannot change the beneficiary of the account, and the beneficiary must become the account owner upon attaining the age at which the custodianship is terminated.

3. No Gift Tax Consequence. Because the UTMA assets have already been given to the beneficiary of the UTMA account, there should be no gift tax consequences to contributing UTMA assets to a 529SA with the UTMA custodian as account owner and the UTMA beneficiary as the 529SA beneficiary.

4. Liquidation Required. However, because only cash can be contributed to a 529SA, the UTMA investments may first need to be sold, possibly incurring capital gains tax.

VIII. Estate Tax. A. Exclusion from Donor’s Estate. Except as provided below with respect to

the five-year averaging election, the value of a 529SA will not be included in the gross estate of the account owner for federal estate tax purposes. Code § 529(c)(4)(A).

B. Inclusion in Beneficiary’s Estate. If a beneficiary dies, the value of the account may be included in the beneficiary’s estate. Code § 529(c)(4)(B).

IX. Five-Year Spread and Recapture. A donor electing the five-year spread must survive into the fifth year (but not to the end of the fifth year) to have the entire amount of contributions excluded from his or her estate. Code § 529(c)(4)(A) provides “No amount shall be includible in the gross estate of any individual for purposes of chapter 11 by reason in an interest of a qualified tuition program.” Code § 529(c)(4)(C), however, provides that “In the case of a donor who makes the election described in paragraph (2)(B) and who dies before the close of the 5-year period referred to in such paragraph, notwithstanding subparagraph (A), the gross estate of the donor shall include the portion of such contributions properly allocable to periods after the date of the death of the donor.”

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A. Appreciation. If the donor dies before the close of the five-year period, the portion of the contribution allocable to calendar years beginning after the date of death of the decedent is includible in the gross estate. However, any earnings on the account escape estate tax inclusion. On the other hand, if the account declined in value, the amount includible would still be based on the contributions.

B. Gift-Splitting. The IRS has informally indicated that if gift-splitting was elected, the death of one spouse would not cause inclusion of any part of the contribution attributable to the other spouse.

C. Source of Payment. If the estate is taxable, the source for paying the estate tax on the included portion of the 529SA will depend upon the directions in the Will for payment of taxes or, if none, state law on the apportionment of taxes.

D. GST Treatment. To the extent a portion of a 529SA is included in the donor’s estate, are there GST consequences if the beneficiary is a skip person? This is unclear under current rules.

X. Financial Aid. A. Federal Financial Aid. A student’s expected family contribution (“EFC”) is

calculated based on information submitted on a Free Application for Federal Student Aid (FAFSA). 1. Student’s Income. One-half of the student’s income (less certain

allowances for living expenses and taxes) is included in the EFC. 2. Student’s Assets. Twenty percent of the student’s assets are

included in the EFC. 3. Parents’ Income. A portion of the parents’ income, after reduction

for certain allowances, is included in the EFC. 4. Parents’ Assets. Up to 5.6% of the parents’ assets are included in

the EFC. Equity in the family home is not considered. B. 529 Savings Accounts.

1. Treatment as Asset. Effective for the 2009-2010 academic year, a qualified education benefit shall be considered an asset of (1) the student, if the student is an independent student, or (2) the parent if the student is a dependent student, regardless of whether the owner of the account is the student or the parent. A “qualified education benefit” is defined as a qualified tuition program (as defined in section 529(b)(1)(A) of the Internal Revenue Code) or certain other educational benefit programs. The 2007 Act does not explicitly address the treatment of a 529SA owned by someone other than the student or parent.

2. Income Treatment. The 2007 Act also provides that a qualified distribution from a 529SA, a state prepaid tuition plan or a

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Coverdell education savings account is not reportable as income or support.

3. Planning Opportunities. The rules provide some opportunity to protect assets previously given to the student, which would otherwise be heavily assessed in financial aid calculations. (a) If a dependent student has assets in his or her own name, it

would seem that the student could cause them to be treated as a parental asset by placing such assets in one or more 529SAs.

(b) If the terms of a trust for child’s benefit permitted a distribution to the student, and the student placed the distributed funds in a 529SA, more favorable financial aid treatment might be available by causing the assets to be treated as parental assets.

(c) If assets are held in a UTMA account, normally they would count as an asset of the beneficiary. However, the custodian could use the UTMA assets to fund a 529SA for the student, in which case the assets may be treated as parental assets.

(d) Note that to implement these strategies, the assets would have to be liquidated to cash before they could be invested in a 529SA, and capital gains could result from the liquidation. However, if the assets were going to be used in any event for education expenses, placing them in a 529SA may only accelerate the liquidation by up to a few years.

D. State and School Financial Aid. States and schools may use different methods to determine non-federal financial aid.

E. Trusts. The Federal Student Financial Aid Handbook (2006 – 2007) provided to colleges and universities by the Department of Education requires the following reporting for trusts on FAFSA: Trust funds in the name of a student, spouse, or parent should be reported as that person’s asset on the application, generally even if the beneficiary’s access to the trust is restricted.

XI. Gift and GST Tax. The estate and gift tax treatment of contributions to a QSTP and interests in a QSTP is generally different from the treatment that would otherwise apply under generally applicable estate and gift tax principles.

A. No § 2503(e) Exclusion. Contributions to 529SAs after August 5, 1997 do not qualify for the tuition exclusion from gift tax under Code § 2503(e).

B. Annual Exclusions. Contributions to a 529SA are treated as completed present interest gifts from the donor to the beneficiary.

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1. GST Annual Exclusion. The portion of a contribution excludible from taxable gifts under Code § 2503(b) also satisfies the requirements of Code § 2642(c)(2) and, therefore, is also excludible for purposes of the generation-skipping transfer tax imposed under Code § 2601. Therefore, the contributions qualify for the annual exclusion for both gift and GST tax purposes.

2. When Is Gift Complete? Under the gift tax rules, a gift is considered complete when the donor has so parted with dominion and control as to leave in the donor no power to change its disposition. The gift tax rules generally applicable to gifts made by check should apply here to determine when a contribution made to a 529SA by check is considered complete for gift tax purposes. The IRS’s position is that when a gift is made by a check to a non-charitable donee, the gift is complete on the earlier of (1) the date on which the donor parts with dominion and control or (2) the date on which the donee deposits the check. Under Revenue Ruling 96-56 and Metzger, 100 T.C. 204 (1993), a gift by check to a 529SA should be deemed to be made in the year in which the 529 program deposits the check. Thus caution should be exercised in making year-end gifts to ensure that there is ample time for the 529 program to deposit the check before the end of the year. The best practice is to make all annual exclusion gifts, including gifts to 529SAs, at the start of each year.

C. Gifts that Do Not Qualify for the GST Annual Exclusion. To the extent that a gift to a 529SA does not qualify for the gift tax annual exclusion under Code § 2503(b), because prior gifts during the calendar year utilized the available annual exclusion, or because the gifts to the 529SA exceeded the gift tax annual exclusion, the gifts would not qualify for the GST annual exclusion.

D. Front-Loading. The donor can make five years of annual exclusion gifts in one year. That means the donor can contribute $60,000 in 2008 without incurring gift tax or GST tax. 1. Five-Year Averaging. Section 529 provides that a donor can elect

to have contributions to an account treated as if made ratably over five years beginning with the year of the contribution. The donor can make the election for some beneficiaries but not for others.

2. Split Gifts. Gift-splitting is permitted, so a married donor can contribute up to ten times the annual exclusion amount ($120,000 in 2008) per beneficiary in a single year without incurring gift tax or GST tax. However, if gift-splitting is elected, both spouses must make the election on their respective returns.

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If you elect gift splitting, apply the gift splitting rules before applying these rules. Each spouse would then decide individually whether to make the QTP election. Applying the gift splitting rules first is consistent with the IRS’s informal position that if one spouse dies during the five-year period, only that spouse’s portion of the gift is brought back into the estate.

3. Absorbs Annual Exclusions. If the donor makes a contribution of five times the annual exclusion amount in Year 1, and makes the election, the donor cannot make additional annual exclusion gifts to the same beneficiary in Years 2, 3, 4, and 5, except to the extent the annual exclusion is increased for inflation in one of those years. Remember this if the donor is using annual exclusions for other purposes, such as funding an insurance trust.

4. Election. The donor must make the “five-year spread” election on the Form 709 gift tax return. (a) Check Box. (b) Attach Explanation. An explanation must be attached to the

gift tax return that includes the following: (1) total amount contributed per beneficiary; (2) the amount for which the election is being made; and (3) the name of the individual for whom the contribution was made.

5. Proration of Excess Over Annual Exclusions. If the gift equals or is less than five times the annual exclusion amount, and the election is made, the donor reports one-fifth of the total contribution on the initial return and one-fifth on gift tax returns for the next four years.

6. Five-Year Proration Required. The donor does not have the option to prorate the gift over a lesser number of years.

7. Late Election. The instructions to Form 709 state: “The election must be made for the calendar year in which the contribution is made.” This does not make clear whether an election can be made on a late filed gift tax return for the calendar year, in the same manner that a split gift election can be made on a late filed return under some circumstances.

8. Second 5-Year Averaging Election. It is unclear whether a second election can be made with respect to another contribution during the five-year period. An example in the regulations suggests no, but there appears to be no reason to prohibit a second election provided that the combined elections do not attribute to any year a gift in excess of the annual exclusion.

E. Distributions Are Not Gifts. Distributions from a 529SA are not treated as taxable gifts. Code § 529(c)(5)(A).

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XII. Medicaid Qualification. Each state administers Medicaid with its own rules. States Counting 529 Accounts. It appears that New York has determined that 529SAs are counted as part of the account owner applicant’s assets, minus any penalties for a nonqualified withdrawal. However, federal, state and local income taxes are not deductible in determining the resource value. A. Changing Account Owner. What should an individual who is the account

owner of 529SA assets and who wishes to qualify for Medicaid do? Although under current law it does not appear that this would be a gift from the old account owner to the new account owner for gift tax purposes, it may still be considered a transfer of assets for less than fair market value for Medicaid eligibility purposes. Keep in mind that the look-back period for all transfers is now 60 months.

B. Non-qualified Distribution. Alternatively, the potential Medicaid applicant could make a nonqualified distribution to himself from the 529SA, pay the income tax and penalty on the earnings, and use the proceeds for his support for as long as possible. When the potential applicant’s assets, including the 529SA, are exhausted, he could then apply for Medicaid.

XIII. Trusts as Account Owners. A Section 529SA provide a new investment opportunity for trusts with beneficiaries who have not completed their higher education. Although the trust can be the account owner, the trust itself cannot be the beneficiary because Code § 529 requires that an individual be the beneficiary. The trustee, as the account owner, would then have the power to change the beneficiary of the 529SA, to direct a qualified distribution from the 529SA to the beneficiary, to take a nonqualified distribution, to change the investment options, and to roll over the 529SA to another qualified tuition program, subject to the terms of the trust, the restrictions of the QTP, and the general rules of Code § 529 of the Internal Revenue Code.

1. No Multiple Beneficiaries. The trustee cannot designate more than one beneficiary for a single 529SA, although the trustee may establish more than one 529SA with different beneficiaries if the trust has multiple beneficiaries.

2. Tax Issues. The trustee should be alert to tax issues that may arise when a trust invests in a 529SA. a. Non-qualified Withdrawal. First, if the trust is a non-grantor

trust and takes a nonqualified distribution, the trust would pay income tax on the earnings of the 529SA at the trust’s income tax rate (the trust would also pay the penalty tax).

b. DNI. Second, a qualified distribution from the 529SA to the beneficiary, although itself not subject to income tax, might carry out distributable net income (DNI) to the beneficiary.

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A. Advantages of Trust as Account Owner. There are a number of advantages to having a trust, instead of an individual, own a 529SA for a beneficiary. 1. Trust Benefits Only Beneficiaries. Under current law the account

owner appears to have no fiduciary duty to the beneficiary of the 529SA. But when the donor becomes incapacitated or dies, the successor individual account owner may be able to frustrate the donor’s intent. In contrast, if a trust is the account owner, the trustee is bound by the terms of the trust and has a fiduciary duty to the trust beneficiaries.

2. Non-qualified Distributions. If a trust is the account owner and the donor has not retained any rights under or powers over the trust that would cause inclusion of the trust in the donor’s estate, the funds would be trust assets and would not be back in the donor’s estate.

3. Account Owner Succession. A trust-owned 529SA may solve the problem of providing for a successor account owner if the account owner becomes disabled or dies.

4. Impartiality if Multiple Beneficiaries. If a trust is the account owner, the trustee must treat the beneficiaries impartially.

5. Creditor Protection. The trust may contain a spendthrift clause that protects the trust assets from the beneficiary’s creditors.

B. Disadvantages of Trust as Account Owner. 1. No Front Loading of Trust Contributions. No similar election is

available for gifts to a trust, even if the trustee intends to invest the assets in a 529SA.

2. Gift Tax Annual Exclusion. Section 529 provides that gifts to a 529SA qualify for the gift tax annual exclusion. However, this provision would not apply to a gift to a trust, even if the trustee eventually invests the funds in a 529SA. Therefore, gifts to a trust must qualify for the gift tax annual exclusion under other tax rules.

3. GST Annual Exclusion. Gifts to trusts qualify for the GST annual exclusion only if (1) they qualify for a gift tax annual exclusion, (2) the trust is for a single beneficiary, and (3) the trust will be included in the beneficiary’s estate.

4. Income Tax Rates. In the event of a nonqualified distribution, income taxes on the earnings portion of a trust-owned 529SA would be paid at the trust’s income tax rate, if the trust is a nongrantor trust and does not make a distribution that carries out DNI, or at the grantor’s rate if the trust is a grantor trust with respect to the account owner. The trust’s or grantor’s income tax bracket could be higher than the beneficiary’s income tax bracket.

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5. No Refund to Donor. 6. Financial Aid. A beneficiary’s interest in a trust is treated as an

asset of the beneficiary for federal financial aid purposes. A 529SA is treated as an asset of the account owner for federal financial aid purposes.

XIV. Trust as Successor Owner. It may be possible to have the best of both alternatives by naming the individual contributor as the initial account owner and naming a trust as the successor account owner upon the contributor’s death or incapacity? So long as the contributor is living and not incapacitated, the contributor can still make a nonqualified distribution for his or her own benefit and can retain complete freedom to change the account beneficiary, subject to the tax rules of § 529. However, once the contributor can no longer act as account owner, the new account owner will be a trust, and the trustee will have a fiduciary duty to use the funds only for the benefit of the trust beneficiary or beneficiaries. The trustee could not take the funds for himself, and could not change the beneficiary except as permitted by the trust. A. Change of Account Owner Under Incapacity. You should carefully review

the program documents to determine (1) whether the account owner may designate a successor account owner to take effect upon the account owner’s incapacity and (2) how incapacity is determined.

B. Revocable Trust. 1. Gift Tax Consequences of Becoming Account Owner. If the

revocable trust becomes the account owner by reason of the contributor’s incapacity, no gift tax consequences should result from the change of account owner.

2. Estate Tax Consequences of Account Owner Upon Incapacity. If the revocable trust becomes the account owner by reason of the contributor’s incapacity, would the 529SA be included in the contributor’s estate upon the contributor’s subsequent death? The answer should be no. § 529 was intended to override the more general provision of Code § 2031, which includes in a decedent’s estate the “value at the time of his death of all property, real or personal, tangible or intangible, wherever situated.” § 529 appears to override all of the estate tax inclusion provisions of the Code, including Code § 2041, but there are not yet any favorable rulings or cases on point.

3. Estate Tax Consequences if Account Owner Upon Death. Code §§ 2036 and 2038 should have no potential application, but Code § 2041 could still be at issue. Any potential application of Code § 2041, however, could be avoided by prohibiting the trustee from using 529SA to pay debts or taxes.

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4. Drafting Considerations. Careful attention must be given to ensure that the trust contains appropriate provisions permitting the trustee to manage the 529SA as the grantor intends.

C. Irrevocable Trust. The contributor may establish an irrevocable trust that can be designated as the successor account owner. If the irrevocable trust becomes the account owner by reason of the contributor’s incapacity, under current law no gift tax consequences should result from the change of the account owner. The 529SA should not be included in the contributor’s estate.

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State

Statutory Exemption

Limited To State’s Own Program

Statute Specifies Protection from Creditors Of

____________________________________ Account Donor Owner Beneficiary

Other Limitations

New Jersey

N.J. Stat.

§ 18A:71B-41.1

Y Yes Yes Provides exemption for moneys paid out of an account for higher education expenses.

New York

NY CLS CPLR

§ 5205

Y Exemption is very limited. See the statute.

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Section 2053 Proposed Regs. on Estate Tax Deductions for Claims, Etc. I. Overview of I.R.C. § 2053.

A. The Statute. 1. IRC § 2053(a)(3) provides, as a general rule, that the taxable estate

is determined by deducting from the value of the gross estate the following items: … claims against the estate.

2. Limitations. a. Deductions for claims against the estate “when founded on a

promise or agreement” are limited “to the extent that they were contracted bona fide and for an adequate and full consideration in money or money’s worth.” IRC § 2053(c)(1)(A). Gratuitous promises to pay, except for certain charitable pledges, are not deductible under Section 2053.

B. Section 2053(a)(3) Regulations for Claims Against the Estate. Background. The most significant impact of the proposed regulations is on the valuation of claims against the estate. Where the proposed regulations greatly expand the discussion of section 2053(a)(3), the current regulation relating to the deduction of claims is brief. Treas. Reg. § 20.2053-4 provides that:

a. Personal obligations of the decedent, whether matured or not, and accrued interest as of the date of death may be deducted as claims.

b. Even if the executor elects alternate valuation under section 2032, accrued interest may be deductible only to the extent accrued through the date of death.

c. Claims are deductible only if they are enforceable against the decedent’s estate.

d. A claim founded upon a promise or agreement is deductible only to the extent the liability was contracted bona fide and for an adequate and full consideration in money or money’s worth.

e. Liabilities imposed by law or arising in tort are deductible. II. Claims Against Estates – Split in the Circuits.

Courts have struggled for years with the extent to which claims are allowed against a decedent’s estate, particularly claims which at the time of the decedent’s death were uncertain, contingent, or difficult to value. A. Date-of-Death Valuation of Claims.

The Supreme Court in 1929 decided the case of Ithaca Trust Co. v. United States, 279 U.S. 151 (1929). This decision began a line of cases in which

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courts held that post-death facts should never be considered in valuing deductions for estate tax purposes.

B. Claims Actually Paid. 1. The Eighth Circuit Court of Appeals took a different approach a few

months after the Supreme Court issued its decision in Ithaca Trust. In Jacobs vs. Comm’r, the decedent entered into a prenuptial agreement under which he was obligated to provide his wife $75,000 from his estate in lieu of her marital rights. At the time of his death, his will provided that his widow, in lieu of the $75,000 payment required by the premarital agreement, could elect to be paid the income for her lifetime from a trust having a value of $250,000. After the decedent’s death, the widow elected to accept the income interest in the trust in lieu of the $75,000. The executors filed an estate tax return on which they deducted the $75,000 claim from the value of the gross estate. The Commissioner disallowed the deduction and was upheld by the Board of Tax Appeals. The Eighth Circuit Court took what it described as a practical approach and determined that Congress intended that claims to be deducted “were actual claims, not theoretical ones.” Some years later in Sachs v. Comm’r, 856 F.2d 1158 (8th Cir. 1988), the Eighth Circuit confirmed its holding in Jacobs, notwithstanding an intervening string of cases to the contrary from other circuits and stated: “In this Circuit, however, the date-of-death principle of valuation does not apply to claims against the estate deducted under section 2053(a)(3).”

II. Proposed Regulations. A. Rationale for Adoption.

1. General Comments. This is an attempt to settle the question of whether post-death events are to be considered when determining the amount deductible under section 2053(c)(3). The proposed regulations indicate that post-death facts will be considered in determining deductions from the gross estate under Section 2053 and deductions will be allowed only for claims and expenses actually paid. In situations where the amount to be paid cannot be determined with certainty on the date of death, the remedy for the estate is to file a protective claim for refund and deduct the claim or expense only after it has become certain and has been paid. Note: The regulations will not be effective until the Final Regulations are issued, and should apply only to decedents dying

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after the effective date. The Proposed Regulations are not yet binding, but indicate the IRS position.

2. Alternative Considered: Date-of-Death Value. This approach often requires “the taxpayer and the IRS to retry the

substantive issues underlying the claims against the estate in a tax controversy setting.”

The date-of-death approach is expensive, time-consuming and frequently results in a deduction different from the actual amount paid on the claim. Additionally, the date-of-death valuation approach often requires that the taxpayer take positions in the estate tax return and in the substantive court action that are contradictory to one another, possibly increasing the taxpayer’s potential liability.

B. The New Rule: Actual Claims Paid. An estate can deduct under section 2053(a)(3) only amounts actually paid.

If the resolution of a contested or contingent claim cannot be reached prior to the expiration of the statute of limitations, a protective claim for refund may be filed.

C. Summary of Changes. The proposed regulations will amend the regulations under section 2053

to make the following changes: 1. Post-death events will be considered when determining the amount

deductible under section 2053 and these deductions are limited to amounts actually paid.

2. Final court decisions as to the amount and enforceability of the claim will be accepted in determining the amount of the deduction if the court ruled on the facts upon which deductibility depends.

3. Settlements are accepted if they are reached in bona fide negotiations between adverse parties with valid claims recognizable under applicable law and if the settlement is not inconsistent with the applicable law.

4. A protective claim for refund may be filed before the expiration of the statute of limitations to preserve the estate’s right to claim a refund if the amount of the liability is not ascertainable by the expiration of the statute of limitations.

5. A deduction is not allowed to the extent the expense or claim is compensated by insurance or otherwise reimbursed.

6. No deduction may be taken for a claim that is potential, unmatured, or contested at the time of the filing of the return.

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7. When a claim involves multiple defendants, the estate may deduct only the decedent’s portion of the liability.

8. Claims by family members or other beneficiaries of a decedent’s estate will be strictly scrutinized to ensure that their claims are legitimate.

9. If a claim becomes unenforceable after the decedent’s death, no deduction will be allowed.

10. If a claim represents a decedent’s obligation to make recurring payments that may extend beyond the final determination of the estate tax liability, a deduction is allowed only as each payment is made, provided that the statute of limitations has not expired or the estate has preserved a claim for a refund.

11. Alternatively, a deduction is allowed for the cost of a commercial annuity purchased by the estate from an unrelated dealer in satisfaction of an obligation to make recurring payments.

D. The Proposed Regulations. 1. Deductions for Expenses, Indebtedness, and Taxes—In General

Prop Reg. § 20.2053-1. a. Amounts Actually Paid. b. Protective Claim for Refund. The protective claim for refund need not state a particular

dollar amount or demand an immediate refund but must identify the outstanding liability that would have been deductible under section 2053(a) had it been paid and must describe the reasons and contingencies delaying the determination of liability or the actual payment of the claim. The Service will act on the protective claim when it has been notified that the contingency has been resolved. (1) Example One. State law provides that the personal representative

shall receive compensation equal to 2.5% of the value of the probate estate. The executor (E) may claim a deduction for estimated fees equal to 2.5% of D’s probate estate on the estate tax return filed for D’s estate as an estimated amount, provided the amount will be paid to E after the estate tax return is filed.

2. Deductions for Expenses of Administering Estate—Prop. Reg. § 20.2053-3. a. Executor’s Commissions.

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Executor’s commissions may be deducted on the estate tax return in an amount that has been actually paid or in an amount that may reasonably be expected to be paid. No deduction may be taken if no commissions are to be collected. If the amount of commissions is not fixed by court order the deduction will be allowed to the extent that all three of the following conditions are satisfied: (i) The Commissioner is reasonably satisfied that the

commissions claimed will be paid. (ii) The amount claimed as a deduction is within the

amount allowable by the laws of the jurisdiction in which the estate is being administered.

(iii) It is in accordance with the usually accepted practice in the jurisdiction to allow such amount in estates of similar size and character.

b. Attorneys’ Fees. Attorneys’ fees may be deducted in such amount as has

been actually paid or an amount that at the time of filing of the return may reasonably be expected to be paid. A deduction may be allowed on examination even if the fees have not been awarded by a court or have not been paid if the Commissioner is reasonably satisfied that the amount claimed will be paid and does not exceed a reasonable amount for the services rendered taking into consideration the size and character of the estate and local law and practice.

3. Deduction for Claims Against the Estate—Prop. Reg. § 20.2053-4. a. Bona Fide Claims.

Claims against a decedent’s estate are limited to amounts for legitimate and bona fide claims that: (i) Represent personal obligations of the decedent

existing at the time of the decedent’s death; (ii) Are enforceable against the decedent’s estate at the

time of payments; and (iii) Are actually paid by the estate in settlement of the

claim. b. Unmatured or Contested Claims. No deduction may be taken on an estate tax return for a

potential or unmatured claim or to the extent the estate is contesting the decedent’s liability. In the case of unmatured

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or contested claims, the executor has the option of filing a protective claim for refund.

Note: A claim for money due to the estate must be valued at the date of death as an asset, based on the executor’s best estimate of its true value. However, a counterclaim against the estate cannot be deducted at all until it is actually paid. If a claim that is an asset ends up being worth less at the end of the litigation than the asset value on the Form 706, you can send supplemental information to the IRS, but the post-death facts are not allowed to determine the value that you estimate on date of death, so it may not reduce the asset value. Also, be careful when estimating asset value of a claim, because it can be used against you in the substantive litigation as an admission against you (i.e., if you estimate on the Form 706 that your claim for $1,000,000 is only really worth $500,000, your opponent can use that as evidence that you don’t believe you have a good claim).

c. Claims Against Multiple Parties. The estate may deduct only the portion of the claim payable

by the estate less any amount to be received by another party or insurance or by other reimbursement.

d. Claims by Family Members. The proposed regulations create a reputable presumption

that all claims by a family member or related entity are not legitimate and bona fide and, therefore, are not deductible. The estate carries the burden of rebutting the presumption and may do so by bringing evidence that the claim arises from circumstances that would reasonably support a similar claim by unrelated persons.

e. Unenforceable Claims. The executor must be vigilant. Probate statutes contain

specific time periods for the allowance of claims against an estate. To the extent a claim is paid by the executor after the claims period expired or without proper presentment by the claimant, the deduction may be lost.

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f. Recurring Payments—Non-Contingent. An example of a non-contingent recurring payment is an

obligation to make payments under a buy-sell agreement. If the decedent were obligated at the time of his death to make payments of $100X per year for five years under a shareholder agreement, the liability could be deducted on the estate tax return as an estimated amount by calculating the present value of the five payments. However, since the present value of the payments will be less than the actual amounts paid, the executor may instead wish to take the deduction of the actual amounts as paid by filing a protective claim for refund and preserving the deduction until all the payments are made. The ability to take the deduction as an estimated deduction appears to be permissible, not mandatory.

g. Recurring Payments—Contingent Obligations. The estate may either file a protective claim for a refund or

deduct the payments as they are actually made or purchase a commercial annuity to satisfy the obligation and deduct the cost of the annuity. The cost of the commercial annuity is deductible if it is purchased from an unrelated dealer in an arm’s-length transaction.

A common example of a contingent recurring obligation is a support obligation under a divorce decree that terminates upon death or remarriage. In this situation, the proposed regulations do not allow a deduction based on the present value of the obligation, presumably because the debt is uncertain. Instead, a deduction may be taken as each payment is made (requiring the protective claim for refund to be filed) or for the cost of a commercial annuity.

VI. Protective Claim for Refund. The claim must:

(1) Set forth in detail the grounds upon which a refund is claimed and facts sufficient to apprise the Commissioner of the exact basis hereof;

(2) Be verified under penalties of perjury; (3) Be submitted on the appropriate form, generally Form 843;

and (4) Be filed with the Service Center serving the district in which

the tax was paid. The requirement that the claim state the grounds and supporting facts on which it is based is to be interpreted liberally and “so long as the claim is sufficiently clear

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and definite to apprise the Service of the essential nature of the claim” it will satisfy this requirement. Thus a refund claim may be valid even though it does not fully state facts sufficient to establish that the taxpayer is actually entitled to the refund. Before filing a form 706, consider any potential claims against the estate, and file a protective claim if there are any. The protective claim must be filed before the earlier of (i) 3 years from filing the Form 706, or (ii) 2 years from payment of tax. Best if file Form 843 with Form 706 (so don’t miss time for filing) but not necessary. Note: Filing the Form 843 is just to protect the later claim for refund. When you have the actual facts of how much will be paid, you must file an actual claim for refund, and it is suggested that you file a Form 706 marked “amended” to indicate how the estate tax should be calculated based on the actual amounts paid.

VII. Conclusion. No deductions will be allowed on the estate tax return for claims against the estate until the claims have actually been paid, unless the deduction falls within the category of “estimated amounts” for claims which are ascertainable with reasonable certainty. For the most part, claims against the estate will be dealt with by filing protective claims for refund to preserve the deduction when the claim amount is finally determined and paid.

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Gifts of Fractional Interests in Art

A. FRACTIONAL GIFTS TO CHARITABLE ORGANIZATIONS

Prior to August 17, 2006, an immediate charitable deduction was allowable for the value of the undivided fractional interest donated.

1. Fractional Gifts – After August 17, 2006

The Internal Revenue Service was concerned that there was abuse of the fractional gift technique – that is, situations were discovered where a taxpayer claimed a deduction for a fractional interest in a work of art yet retained physical possession of the donated property for the full year. Under new section 170(o) introduced by the PPA, effective for contributions made after August 17, 2006, fractional gifts are no longer desirable.

i. Valuation Limitation

Under Section 170(o), the collector’s initial contribution of a fractional interest in a work of art is determined as under current law and described above (full fair market value times the fractional interest donated). For purposes of determining the deductible amount of each additional contribution in the same work of art, the fair market value of the donated item is now limited to the lesser of: (1) the value used for purposes of determining the charitable deduction for the initial fractional contribution: or (2) the fair market value of the item at the time of the subsequent contribution.1

ii. Timing Limitation

The collector must complete the donation of his entire interest in the work of art before the earlier of (1) ten years from the initial fractional contribution or (2) the donor’s death.2

iii. Use Limitation

Under the new provisions, the donee charity of a fractional interest in a work of art must (1) have substantial physical possession of the work of art during the donor allowed possession period (maximum of 10 years) and (2) use the

1 I.R.C. § 170(o)(2). 2 I.R.C. § 170(o)(3)(A)(i).

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work of art for an exempt use during such period (i.e. Must satisfy the related use rule).3

iv. Recapture of Deduction.

If the collector violates the 10 year timing limitation or the use limitation (the substantial possession or related-use requirement), then the collector’s charitable income and gift tax deductions for all previous contributions of interests in the work of art are recaptured, plus interest.4 In any case in which there is a recapture of a deduction, the statute also imposes an additional tax in an amount equal to 10 percent of the amount recaptured.

v. Danger of Fractional Gifts.

The PPA contains similar limitations as described above for gift and estate tax purposes.5 The estate tax provision limits the estate tax charitable deduction to the lesser of: (1) the fair market value at the time of the initial fractional contribution; or (2) the fair market value at the time of the subsequent contribution.6 As an example, collector donates a 50% interest in a painting to a museum when it is worth $1,000,000. On his later death, when the painting is worth $2,000,000, this would mean that the collector’s estate would have a 50 percent interest in a painting going to a museum with a value of $1,000,000 (for the 50 percent interest) for which the estate was only entitled to a $500,000 deduction resulting in the estate having to pay an estate tax on the remaining $500,000. This trap does not appear to be the intended result. Until the sections of the Internal Revenue are corrected, the best advice is not to make a fractional gift to a charitable organization.

B. FRACTIONAL TRANSFERS – VALUATION ISSUES

For estate tax purposes, in the past the IRS has determined that the amount included in a deceased donor’s gross estate under sections 2031 and 2033 with respect to a retained undivided fractional interest is the fair market value of the item of artwork multiplied by the donor’s fractional interest therein, and that the amount deductible under section 2055 when it passes to charity with respect to such item is the value included in the donor’s gross estate.

3 I.R.C. § 170(o)(3)(A)(ii). 4 I.R.C. § 170(o)(3)(A). 5 I.R.C. § 2055(g); I.R.C. § 2522(e) 6 I.R.C. § 2055(g)(1).

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C. THE STONE CASE

In August 2007, the case of Robert G. Stone v. United States,7 allowed a 5% discount to an estate that owned an undivided 50% interest in nineteen paintings that were left to family members. The Stone case is the first case to reflect on whether or not discounts based on lack of control, minority ownership, or lack of 100% interest with respect to ownership of works of art can lead to a discount for estate tax purposes as it does for real estate. In Stone the estate claimed a 44% discount for the undivided 50%. The court concluded that a hypothetical willing seller of an undivided fractional interest in art would likely seek to sell the entire work of art and split the proceeds, rather than seeking to sell his or her fractional interest at a discount. Therefore, at a minimum, because an undivided interest holder has the right to partition, a hypothetical seller under no compulsion to sell would not accept any less for his or her undivided interest than could be obtained by splitting proceeds in this manner.

The taxpayer could not meet his burden of persuading the court that a hypothetical buyer would demand, and a hypothetical seller would agree to, a discount greater than 5%. The case is a warning sign that art is treated differently from real estate or closely held businesses when it comes to discounts.

With no market data available for the sale of an undivided fractional interest in art, it could just as easily be assumed as not, that a hypothetical willing buyer would be willing to pay a percentage times the full fair market value of a painting equal to his percentage of ownership, in order to own and have personal use of the painting, even if it is only for a percentage of each year.

D. BASIS FOR PURPOSES OF SALE

Property included in a decedent’s gross estate for federal estate tax purposes acquires a “step-up” in basis for income tax purposes equal to its federal estate tax value.8

E. THE JANIS CASE

The Janis9 case is an example of a taxpayer who tried to “whipsaw” the IRS. The decedent was an art dealer with a gallery. The IRS Art Panel first determined the total value of the works of art owned at death to be $36,000,000 based on a per item appraisal submitted by the executors. The

7 Robert G. Stone v. United States, 2007 U.S. Dist. LEXIS 38332 (N.D. Cal., May 25, 2007); Robert G. Stone v. United States, 2007 U.S. Dist. LEXIS 58611 (N.D. Cal., August 10, 2007). 8 I.R.C. § 1014. 9 Janis v. Commissioner, 87 T.C. Memo 1322 (2004).

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panel then allowed a $13,600,000 discount based on the following arguments made by the taxpayer:

(1) there were numerous works by individual artists; (2) some of the art would be sold in the dealer market as

opposed to the retail market; (3) the executor’s inability to sell the gallery in the retail market

for the sum of the value of the individual works of art; (4) the fact that a buyer of the gallery would not pay the full

resale price of the underlying assets in a bulk sale; and (5) any buyer would consider the cost of maintaining the

business for a reasonable period of time.

The IRS Art Panel agreed to further apply a blockage discount. The panel first acknowledged that the blockage concept generally applies to a large number of works by one artist, usually in an artist’s estate. The end result was a total combined discount of approximately 60.42% for estate tax purposes.

When the heirs of the estate sold some of the artworks, they used as their

new stepped-up basis the original per item appraised value accepted by the IRS Art Panel before the application of the 60.42% discount.

The Tax Court found that because the substantive effect of the blockage

discount was to establish a proportionate value for each work of art in the collection, it follows that the “appraised value” contemplated by section 1.1014-3(a) is a value limited to the discounted per artwork value.

The Ninth Circuit10 affirmed the Tax Court’s decision, holding that the Tax

Court did not clearly err in determining the value of the art collection and was correct in concluding that the “duty of consistency” required the parties to use the same value on the income tax returns as agreed to for estate tax purposes. The duty of consistency applies when there is (1) a representation by the taxpayer, (2) on which the IRS relies, and (3) after the statute of limitations runs, the taxpayer changes his previous representation. The Ninth Circuit determined that the heirs had represented that the art collection had a value for estate tax purposes, the IRS had agreed to that value, and to allow the heirs to now take the position that the art collections had a different value would “gut the duty of consistency.”

10 Janis v. Commissioner, 461 F.3d 1080 (2006).

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Valuation Clauses

I. Problem:

A. Hard to value assets, such as FLP interests, interests in closely-held businesses, fractional interests in real estate and artwork.

B. Gifts or sales of such interests can produce gift tax consequences and possible penalties should the IRS disagree with taxpayer’s value.

II. GRAT Solution – No Gift Tax Risk

A. Self-adjusting clause that is mandatory in a GRAT will avoid gift tax consequences. An IRS adjustment will result in additional assets passing back to the Grantor. This may not meet the Grantor’s objectives of transferring a specific portion of the GRAT assets to the Grantor’s children.

B. Solution: Create two separate trusts:

1. A family trust funded with $1-million of cash and/or marketable securities.

2. A second trust, which is the two-year GRAT, is funded with either an FLP interest or other difficult-to-value asset. Assume the GRAT is funded with an FLP interest discounted at 35%. The FLP has $1-million of underlying assets.

3. The GRAT two-year trust requires 53.3% of the fair market value of the initial assets to be paid to the Grantor each year. At the end of the second year, the GRAT assets will pass to the Family Trust in which the $1-million was funded. Assume that the underlying securities in the Family Partnership (or other assets held by the GRAT) appreciate by 4% per year for a 2-year period.

a) The first year required payment for the GRAT is $364,450. (53.3% x $1,000,000 - $350,000 discount = $364,450)

b) The Family Trust loans $364,450 to the GRAT at the end of the first year, and the GRAT makes its payment to the Grantor.

c) In the second year, the partnership assets have appreciated to $1,040,000.

d) The Family Trust loans the GRAT $364,450 and the GRAT pays the annuity to the Grantor.

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e) The GRAT terminates at the end of the second year.

(1) The GRAT repays the loan to the Family Trust ($364,450 x 2, plus interest for one year at 4.6% on $364,450 = $745,665).

(2) The Partnership interest (with the remaining assets of $1,040,000 [less: $745,665] passes to the Family Trust ($294,353)

(3) Total to the Family Trust ($1,040,000 from GRAT).

III. Formula clauses on sales of FLP interest, closely-held stock interests or other hard-to-value assets to avoid gift tax.

A. Two categories of formula clauses:

1. Fix-up clause, or adjustment clause

2. Defined value clause

B. Adjustment Clause (fix-up clause)

1. Retroactively adjusts the gift or purchase price in response to subsequent valuation adjustment by IRS

C. Definition Clause – defines transfer by reference to the value, which could be larger.

D. Price or property adjustment clauses are contrary to public policy. Rev. Rul. 86-41; McClendon, Proctor. But see King (involving arm’s length sale and not contrary to public policy. The clause in King actually was used to prove arm’s length).

1. IRS would have no incentive to conduct an audit if the clauses were upheld.

2. Would render any tax decision moot.

E. Value definition clause works simultaneously with transfer, rather than after, as in the case of an adjustment clause. Defines the gift or consideration.

1. Example: TP sells or gifts a fractional share of property (FLP interest, closely held, etc.). The numerator is $1-million and the denominator is the value of the property as finally determined in a gift tax proceeding.

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2. The value will always be $1-million. The variable is the percentage interest of the property transferred.

3. If IRS successfully claims the tax value is $1,500,000, then a 2/3 interest will have been transferred ($1,000,000/$1,500,000 x $1,500,000 = 2/3 x $1,500,000 = $1,000,000).

4. TP may be happy no gift tax is due, but unhappy that only 2/3 interest is transferred.

F. Consideration definition clause – similar to GRAT concept –works simultaneously to define amount of gift or consideration.

1. Provides gift tax protection

2. Also, assures the transferor that the desired value (percentage interest) of the property will be transferred.

3. Assume pre-existing trust with assets (say $2,000,000) of marketable securities.

a) Trustee transfers $2-million to newly formed LLC (X Co.) – no discount – any member can withdraw at any time. Therefore, 100% value.

b) In exchange for transfer of property (FLP interest), Trustee transfers fractional interest in X. Numerator: $1-million of value, as finally determined, of property sold. Denominator - $2-million. If government argues additional value, seller owns more of X Co. Therefore, the description of property transferred will never change.

c) Concept is similar to disclaimer and CRT regulations, both sanction definition clause.

G. McCord – true valuation definition clause, but inconclusive result.

1. 5th Circuit – dollar values of gifts were sufficient to limit the gifts to sons.

2. But didn’t rule on Proctor issue.

3. Allocation to charities that were separately represented by counsel.

IV. Use of traditional valuation clause to obtain finality

A. Goal: Satisfy public policy objection by making clause so that have a small gift tax.

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B. Eg.: Numerator = $1-million + 1% of value of property transferred, over $1-million.

V. Administering the transfers while the amount transferred is unascertained, pending IRS audit. Eg., shares of stock or LP interests sold.

A. Transfer entire interest to a Trustee, and Trustee eventually divides the interest into two separate pieces.

B. Trustee has obligation that can’t be determined, pending finality of gift tax.

C. Eg., Sell 25% interest to Trustee who will give percentage to kids and second portion to QTIP or zeroed out GRAT upon final determination for gift tax. Protects excess value from gift tax and solves administrative problem, pending IRS audit.

D. Use Grantor Trusts to avoid gift tax reporting issues.

E. Alternatives: Use escrow arrangement.

VI. To achieve finality - §2001 - value reported on gift tax return with adequate disclosure or value as finally determined by Court or settlement with taxpayer.

VII. Incomplete Gift approach – should never fail:

A. Example:

1. Wife owns hard to value asset. Husband establishes a spray trust for benefit of wife and children. The trust gives wife a special power of appointment exercisable in favor of their children. The Trustee has the power to separate the trust into two separate trusts, if it were determined that the wife had made a part-gift/part-sale of the property. The Trustee would separate the trust in accordance with the relative portion of sale and gift.

2. Wife sells the hard to value asset to the trust for a Promissory Note. The transaction must be reported on a gift tax return with adequate disclosure for a non-gift completed transfer.

3. The result is that any excess gift is incomplete, because the wife has a special power of appointment as to the excess value. The wife has become the transferor with respect to the excess value, as an incomplete gift.

4. Assume the trust is a grantor trust as to the husband, because his spouse is beneficiary (§677). Therefore, the sale is protected from income tax by §1041, because it is treated as a sale by the wife to the husband, who created the trust.

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Estate Planning for Retirement Plans for the Rich and Famous I. Example 1 involves a stretch-out between parent and child. Parent’s assets

include IRA of $1,000,000, liquid investments of $1,500,000 and residence of $500,000. Example 2 involves stretch-out between parent and child , where parent’s assets included IRA of $5,000,000, liquid investments of $50,000,000 and residence of $10,000,000.

II. Options include:

A. Distribute entire plan currently;

B. Distribute entire plan immediately prior to death;

C. Distribute plan immediately after death;

D. Stretch-out with plan bearing its share of death tax;

E. Stretch-out with plan bearing minimum death tax;

F. Stretch-out to accumulation trust-not a conduit trust;

G. Roth IRA conversion stretch-out with plan bearing minimum death tax. III. In both examples, the stretch-out provided approximately double the amount of

additional cash after tax compared to the immediate payout, and the Roth IRA provided almost four times.

IV. Consideration for this client of a trusteed IRA rather than the standard custodial

IRA. A trusteed IRA would permit the IRA to hold unique assets other than cash, marketable securities, bonds, such as real estate or partnership assets.

V. Trusteed IRA still requires a bank or financial institution as trustee and the

same rules apply (such as minimum distribution rules). A trusteed IRA would allow for a more complex dispositive scheme for the IRA, rather than trying to custom design an institution’s standard beneficiary designation form.

VI. Probably should not use a trusteed IRA with a marital trust, because the required

minimum distribution rules to the spouse would deplete the IRA to the detriment of the remainder beneficiary, which may be the opposite result from what is intended.

VII. Possible concerns with alternative investments for the IRA. If the IRA has

income tax from business activity or debt financed or leveraged assets, such as partnership interests with underlying debt, that income is ordinary income taxed to the IRA at ordinary income rates. In effect, an otherwise tax-exempt IRA is paying income tax.

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VIII. Consideration with unique assets of the prohibited transaction rules. This

includes transactions with disqualified persons who, among others, include the IRA owner, spouse or controlled entities. If the IRA engages in a prohibited transaction with a disqualified person such act causes the disqualification of the IRA resulting in an immediate distribution of the IRA to the owner and taxed at that time.

IX. Just recently, Rev. Rul. 2008-5 concluded that the wash sales rules apply to sale

at a loss by an individual and the reacquisition of such security by individual’s IRA within the proscribed period of Section 1091.

X. PPA allows non-spouse rollovers, but the current status of the law is that the IRS

will not require plans to include provision. XI. IRA conversion rules and the law that will apply in calendar year 2010 that will

allow conversions without an income limitation and coupled with the income being spread over two years. Suggest that individual fund one’s IRA, including non-deductible IRAs, as much as possible.

XII. Whether IRA assets or non-IRA assets should be given to charity. With the

same fact pattern of parent with a child, interestingly giving charity non-IRA assets and using stretch-out for child produced a better result.

XIII. With a parent, a child and a grandchild, the strategies examined included (among

others) allocating non-IRA assets to grandchild versus IRA to a grandchild. Better result was obtained with assets allocated to grandchild stretch-out even with the IRA share bearing the GST tax. As with prior example stretch-out with IRA to Roth IRA produced best result.

XIV. Summary of dispositive plan considerations for the high net worth individual.

A. Designate spouse as beneficiary with heirs as alternates. Although this produces an estate tax deferral, the stretch-out benefit is limited to the assets remaining at spouse’s death.

B. Skip spouse and designate young heirs as beneficiaries. Even though

this approach generates estate tax, the stretch-out may be more valuable. Consider whether there are any spousal rights that may need to be waived or consented to.

C. Spouse as beneficiary with a right to disclaim.

XV. Considerations when naming the children or other younger non-skip

beneficiaries.

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A. Confirm plan permits stretch-out.

B. Simplest is an outright distribution. If there is a possibility of a minor or incompetent receiving assets, consider a trust. Alternatively, consider an UTMA account if do not want to use trust, but caution if state’s UTMA statute allows funds to be maintained in account beyond age 21.

XVI. Considerations when grandchildren and skip persons are beneficiaries.

A. Coordinate with GST exemption and possible GST tax.

B. Designate grandchildren directly if assets will not exceed GST exemption amount.

C. If assets exceed GST exemption amount, consider a formula gift also

integrated with a trusteed IRA.

D. Disclaimer with amount disclaimed passing to children not to a trust not to a grandchild has any beneficial interest in trust that receives disclaimed assets.

XVII. Some clients wish to make modest gifts from estate to their grandchildren.

Consider use of retirement assets with a longer deferral period as the assets to use to make the gift to grandchildren.

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Problems With Your Irrevocable Trust: State Law and Tax Considerations in Transferring Assets to a New Trust

Problems often arise because irrevocable trusts that no longer reflect the clients’ objectives. However, it may be possible to modify an “irrevocable” trust. I. Circumstances When One Might Seek to Modify Irrevocable Trusts A. Dealing with Changed Circumstances.

1. Extending the Termination Date of a Trust a. While the direction to distribute at a certain age may have

seemed appropriate when the trust instrument was drafted, intervening events – such as significant trust appreciation, the beneficiary’s other wealth or the beneficiary’s lack of maturity – may render the mandatory distribution counterproductive.

b. Other unanticipated developments include a beneficiary who has developed a drug, alcohol or gambling problem, or a beneficiary who has creditor issues or is going through a divorce.

2. Adding or Modifying Spendthrift Provisions a. A trustee of a trust without a spendthrift provision may be

concerned that a beneficiary may develop creditor problems. b. A situation might arise where it might be helpful to a

beneficiary of a trust with spendthrift provisions to assign his or her interest in the trust.

3. Creating a Supplemental Needs Trust a. A beneficiary may become disabled. b. To protect the trust assets and to ensure that the beneficiary

is eligible for public assistance, the trustee may consider distributing the trust assets to a supplemental needs trust.

B. Consolidating Trust Assets. 1. Helping Satisfy Trust Obligations

a. One trust may have on-going obligations (say, to pay life insurance premiums or interest and principal payments on a loan), while another trust may have available liquidity.

2. Merging similar trusts into a single trust may reduce administration expenses.

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C. Modifying Administrative Provisions. 1. Altering Trusteeship Provisions.

a. Creating or Eliminating a Removal Power b. Changing the Succession of Trustees c. Changing Trustee Compensation

2. Naming a Protector a. The use of a Protector in domestic trusts recently has

increased. 3. Modifying Investment Powers

D. Changing a Trust’s Situs or Governing Law a. Some states expressing require trustees to disclose

information to beneficiaries, while other states are silent on this issue.

b. Still other states, such as Delaware, permit a settlor to limit the trustee’s duty to disclose.

c. Consider whether a trustee who otherwise has a duty to disclose (as distinct from the settlor) could vary or limit that obligation by transferring the trust assets to another trust which restricts disclosure.

d. It also may be more convenient to change the situs or governing law of the trust to a different jurisdiction to facilitate trust administration.

E. Correcting Drafting Errors 1. Changes may be warranted because of drafting errors, case law

developments or shifting interpretations of the tax law. F. Dividing Trust Property to Facilitate Planning Strategies

1. State Income Tax Planning a. Under many state’s tax laws, an irrevocable trust created by

a resident of that state, or a revocable trust created by a grantor who is a resident of that state at the time such trust becomes irrevocable, is considered to be a resident trust of that state. States generally tax their resident trusts on their capital gains and accumulated income. (1) However, if there is a sufficient break in the nexus

between the state and the resident trust, the trust is not subject to state income tax on its capital gains and accumulated income.

2. Varying Investment Strategies for Different Beneficiaries

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3. Creating GST Exempt and Non-Exempt Trusts 4. Creating Marital and Non-Marital Deduction Trusts

II. Common Law Principles A. Distributions for the Benefit of a Beneficiary

1. Many trusts permit distributions not only to a beneficiary, but also for the benefit of such beneficiary.

2. Arguable, such authority permits a distribution to another trust for the benefit of the beneficiary.

3. A recent private letter ruling involved a matter where a state court confirmed that a trustee’s authority to distribute “to or for the benefit of” a beneficiary permitted a distribution to another trust for the same beneficiary. Priv. Ltr. Rul. 200530012

B. Distribution Power Akin to Power of Appointment a. Restatement (Second) of Property states that a trustee’s

power to make discretionary distributions is a power of appointment.

b. If there is authority to distribute to a beneficiary outright, there is authority to distribute in further trust for the benefit of such beneficiary.

1. Restatement (Third) (as yet unpublished) specifically states that a trustee’s power to distribute is not akin to a power of appointment. The rationale is that the distribution power, unlike a power of appointment, is exercisable in a fiduciary capacity. However, an outright distribution power also can be exercised with a distribution in further trust.

C. Cases 1. In Phipps v. Palm Beach Trust Co., 196 So. 299 (Fla. 1940), the

trustee had sole discretion to sprinkle income and principal among a class of beneficiaries. The trustee exercised the power by distributing the trust property to a new trust. The court approved the distribution, stating that “[a]n examination of the trust indenture in this case leaves no doubt of the power of the individual trustee to create the second trust provided one or more of the descendants of the donor of the original trust are made the beneficiaries.”

2. Matter of Widenmayer, 254 A.2d 534 (N.J. Super. Ct. App. Div. 1969) As long as in beneficiary’s “best interests”, the trustees’ power to distribute outright also could allow the trustees to condition the distribution upon beneficiary setting up a new trust.

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III. Statutory Authority to Decant A. Overview

1. New York was the first state to enact a statute authorizing trustees to appoint trust property in favor of another trust. New York practitioners increasingly have been relying on this powerful statute to achieve important objectives, some of which were described earlier.

2. Five other states – Alaska, Delaware, Tennessee, Florida and South Dakota – have enacted decanting statutes.

B. N.Y. EPTL § 10-6.6(b) 1. Statutory Prerequisites

a. Unfettered Discretion to Invade Principal (1) If the trustee may invade principal, but only in

accordance with an ascertainable standard (such as for the beneficiary’s health, education, maintenance and support), EPTL § 10-6.6(b) is not available.

b. Cannot Reduce Fixed Income Right (1) The exercise of the power cannot reduce the fixed

income right of any beneficiary. (2) This requirement generally ensures that the marital

deduction for estate and gift tax purposes is available where a spouse is to receive all of the income from a trust.

c. In Favor of the Proper Objects d. Public Policy Limitations

(1) The new trust cannot contain provisions deemed to violate public policy.

(2) The proscribed provisions are (i) the exoneration of the trustee from liability for failure to exercise reasonable care, diligence and prudence and (ii) the power to make a finding and conclusive fixation of the value of any asset for purposes of distribution, allocation or otherwise.

(3) It appears that this prohibition does not apply if the invaded trust is an inter vivos trust.

e. Rule Against Perpetuities (1) The exercise of the decanting power may not violate

the rule against perpetuities as measured by reference to the original trust.

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2. Utilizing the Statute a. If the foregoing statutory prerequisites are satisfied,

EPTL §10-6.6(b) can be utilized with or without court approval. (1) The trustee must sign a document carrying out the

decanting, which must be acknowledged by the trustee.

(2) The trustee must file the acknowledged writing with the court that has jurisdiction over the trust.

(3) The trustee must serve the acknowledged instrument on “all persons interested in the trust.”

C. Changing the Governing Law to Gain Access to a Decanting Statute 1. If a trust is not governed by the laws of a state with a decanting

statute, or the laws of a state with helpful common law, and there is no authority in the governing instrument to decant, changing the governing law of the trust may provide relief.

IV. Tax Consequences of Modifying an Irrevocable Trust A. GST Tax

1. GST “Exempt Trusts” a. A “GST exempt trust” is defined as

(1) A trust that was irrevocable on September 25, 1985; or

(2) A Will or revocable trust executed before October 22, 1986; if the decedent died before January 1, 1987.

b. Post-effective date additions will cause a grandfathered trust to lose its GST exempt status.

c. There are two types of additions: (1) Actual additions; and (2) Constructive (or deemed) additions.

2. Extending GST Exempt Trusts a. Careful planning often calls for extending a GST exempt

trust for as long as the law permits. (1) A beneficiary’s extension of an exempt trust by an

exercise of a non-general power of appointment in favor of another trust does not expose the trust to a GST tax.

(2) However, one must take care not to make an actual or constructive addition to the trust.

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b. Treas. Reg. § 26.2601-1(b)(4)(i)(A) provides that an extension of an exempt trust will not taint GST exempt status if:

(a) Authority under applicable state law permitting a trustee to appoint in further trust existed at the time the exempt trust became irrevocable;

(b) Authority can be exercised without the consent or approval of any beneficiary or court; and

(c) New trust does not extend the time for the vesting of any beneficial interest in the trust beyond 21 years plus a life in being at the date the original trust became irrevocable.

B. Gift and Estate Tax 1. Assuming the beneficiary is not a trustee (and therefore is not

exercising the power to decant), and assuming the consent of the beneficiary is not required, a trustee’s exercise of the decanting power should not be a taxable gift.

2. It is conceivable that the IRS might argue that, unless the beneficiary objects to the modification, distribution or extension, the beneficiary has made a gift. a. This argument, if advanced, should not prevail. No such

transfer occurs when the trustee initiates the act. C. Income Tax

1. General Rule a. The general rule is that exercising the power to appoint in

further trust is a non-recognition event for income tax purposes.

b. In general, gain or loss is realized if (1) an action involving a trust represents a sale or exchange of property and (2) the property received is materially different from the property surrendered. (1) In the Cottage Savings case, the court held that the

exchanged interests did embody legally distinct entitlements because the mortgages were made to different obligors and secured by different homes and therefore the financial institution did realize losses when it exchanged its interests.

d. However, in more recent rulings, the IRS appears to recognize that a distribution in further trust does not constitute a recognition event for a beneficiary if the

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distribution is authorized either by (i) the trust document or (ii) local law. (1) Under Private Letter Ruling 200743022, the

beneficiaries of the new trusts acquire their interest by reason of the exercise of the trustee’s existing authority so there does not appear to be an reciprocal exchange involving the legal rights and entitlements of the beneficiaries under the trusts here.

2. Encumbered Property a. Special rules might apply if the trustee transfers encumbered

property or a partnership or LLC interest with a negative capital account.

b. I.R.C. § 1001 provides that gain from the sale or other disposition of property is the amount realized over the property’s adjusted basis.

c. In Crane v. Comm’r., 331 U.S. 1 (1947), the amount realized included the full amount of the liability.

d. Treas. Reg. § 1.100-2(a)(4)(v) further provides that liabilities from which a transferor is discharged as a result of the sale or disposition of a partnership interest include the transferor’s share of the partnership liabilities. Similarly, I.R.C. § 752(d) provides that, in the case of a sale or exchange of a partnership interest, partnership liabilities are to be treated in the same manner as liabilities in connection with the sale or exchange of other property.

e. On the other hand, distributions from a trust generally do not trigger gain unless the trustee elects to recognize gain. I.R.C. § 643(e). The question is which rule – nonrecognition under § 643(e) or recognition under §§ 752 and 1001 – prevails. (1) The Madorin case (as well as Example 5 of Treas.

Reg. § 1.1001-2(c)) presumably is distinguishable because that case involved the termination of, and therefore the deemed transfer from, a grantor trust.

f. If I.R.C. § 643(e) trumps I.R.C. §§ 752 and 1001, the receiving trust will have carryover basis (and therefore the potential for future gain), deferring the recognition until the disposition of the property.

g. If the transferring trust and the receiving trust are both grantor trusts for income tax purposes, this issue does not arise.

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(1) This is because transactions between two grantor trusts (with the same taxpayer as the grantor) generally are ignored for income tax purposes.

V. Uniform Trust Code 1. Twenty jurisdictions have enacted the UTC... 2. The UTC does not include a decanting provision. However, there

are provisions permitting modifications of trusts, reformations to correct mistakes and combinations and divisions of trusts.

A. Modification by Consent a. UTC § 411(a) provides, in part: “A noncharitable irrevocable

trust may be modified... upon consent of the settlor and all beneficiaries, even if the modification... is inconsistent with a material purpose of the trust.

b. “A noncharitable irrevocable trust may be modified upon consent of all of the beneficiaries if the court concludes that modification is not inconsistent with a material purpose of the trust.

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Rudkin Case: U.S. Supreme Court, January 16, 2008

I. Case affirmed Circuit Courts that fees for trust investment advice are subject to

the 2% floor, as is the case with individuals. A. The only expenses to qualify for the exception to the 2% rule are those

expenses of administration that would not have been incurred if the property was not held in trust.

B. Proposed regs. target a strategy of avoiding the 2% floor by the bundling of expenses (non-deductible advisory fees and deductible trustees fees (into a single fee)).

C. Supreme Court held that in determining whether a particular type of cost incurred by a trust would not have been incurred if the property were held by an individual, Code Sec. 67(e)(1) excepts from unlikely, for an individual to incur.

D. Some trust related investment advisory fees may be fully deductible if the investment advisor were to impose a special additional charge applicable only to its fiduciary accounts.

E. Taxpayer in Rudkin argued that he engaged an investment advisor because his fiduciary duties under state law required a trustee to invest as a prudent investor.

F. The court held that a hypothetical prudent investor in the trustees’ position would reasonably solicit investment advice. Accordingly, it could not be said that the investment advisory fees were unusual or uncommon if the property were held by an individual investor.

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JEROME A. DEENER, ESQ. Jerome A. Deener is the Senior Partner of Deener, Hirsch & Shramenko, P.C., a law firm located in Hackensack, New Jersey, specializing in the fields of individual, corporate, and estate planning, real estate and taxation. He has been practicing tax law since l968. Mr. Deener received a Masters Degree in Taxation from New York University, and was an adjunct professor of taxation at Fairleigh Dickinson University in the Graduate School of Business for five years. He is listed among top trusts and estate tax attorneys in State of New Jersey in New Jersey Magazine in 1997, 1999, 2003, 2004, 2006 and 2007. He is listed in Who’s Who in American Law. Mr. Deener is a Fellow in the American College of Trust and Estate Counsel, the past Chairman of the Probate Committee of the Bergen County Bar Association, past Chairman of the Tax Committee of the Bergen County Bar Association, and a past President of the Estate Planning Council of Bergen County. Mr. Deener has authored the first, second and third editions to Estate Planning Strategist (2007), a treatise published by the Institute for Continuing Legal Education for attorneys and accountants on the subject of sophisticated tax and estate planning topics, including recommended forms. He has authored numerous articles on estate planning topics and has been quoted on that subject in the New York Times. Among the articles are: “Hackl Debacle: Are the Annual Exclusions and Discounts Mutually Exclusive for Gifts of Closely-Held Business Interests?” published in the ACTEC Journal Fall 2002 ; “IRS Now Taking a Bite of Gifts of Family Businesses” published in the New Jersey Law Journal in May, 2002; “Kohlsaat Confirms Viability of Crummey/Cristofani Trusts --- and More,” was published in volume 23 of ACTEC Notes (1997) and “How to Deal Effectively with Expanded IRS Attacks on Crummey/Cristofani Trusts,” appeared in volume 22 of ACTEC Notes (1996). Mr. Deener has lectured extensively before ICLE and other professional groups on the subjects of taxation and estate planning, including the New Jersey State Bar Association, the Minnesota State Bar Annual Convention, Bergen and Passaic County Chapters of the New Jersey State C.P.A. Society, various chartered life underwriting groups and has served as Chairman of the Fairleigh Dickinson Tax Seminar presented for the benefit of tax professionals in the Northern New Jersey region. Mr. Deener’s firm conducts monthly tax seminars for CPAs and is an approved sponsor of Continuing Professional Education Credits in New York and New Jersey for Certified Public Accountants, Certified Financial Planners and Certified Life Underwriters. Mr. Deener planned, litigated and successfully resolved the Tax Court case of Karmazin v. Commissioner involving a sale of limited partnership interests to a Grantor Trust.