A Guide to Wills, Estate, Trust and Guardianship Litigation

Code § 645 provides that the executor of an estate and the trustee of a “qualified revocable trust” may elect to treat the qualified revocable trust as part of the estate for all taxable years of the estate ending after the date of the decedent’s death and before the “applicable date.” If an election is made, all tax items reported by the qualified revocable trust are consolidated on the fiduciary income tax return of the estate (IRS Form 1041). The trust is therefore not treated as a “separate trust” for income tax purposes.

A “qualified revocable trust” means any trust (or portion thereof) which was treated as a grantor trust (discussed below) as owned by the decedent of the estate by reason of a power in the grantor under Code § 676, excepting a reserved power under Code § 672(e). Code § 645(b)(1). This means that generally any trust that is revocable by a grantor on his or her date of death will qualify for the 645 election.

The election must be made not later than the time for filing the fiduciary income tax return for the first taxable year of the estate including any extension. Code § 645(c). Once made, the election is irrevocable. The election is made by filing IRS Form 8855, Election to Treat a Qualified Revocable Trust as Part of an Estate, with the estate’s fiduciary income tax return. The election must be signed by the executor of the decedent’s estate and the trustee of the qualified trust. In addition, line G of IRS Form 1041, U.S. Income Tax Return for Estates and Trusts, should be checked by the estate indicating the election has been made and providing the trust’s tax identification number.

Once made, the election lasts for the longer of 2 years after the date of the decedent’s death or, if a federal estate tax return is required to be filed (IRS Form 706), the date which is 6 months after the date of final determination of  estate tax liability (generally considered the date of the closing estate tax letter received by the estate). Code § 645(b)(2).

If no election is made, the qualified revocable trust is a separate trust for income tax purposes unless another exception applies.

What is a “Grantor Trust”?

A grantor trust, in general terms, is a trust in which the settlor or another statutorily identified party retains or possesses certain powers or rights over all or a portion of the trust that cause the income and other tax items of the trust to be reported to the party retaining or holding the qualifying power or right. Importantly, the grantor trust rules appear in Subchapter J of the Code and therefore pertain only to income taxation. A trust which is functionally disregarded for income tax purposes as an entity separate from the grantor may nonetheless be respected for wealth transfer tax purposes. Estate planners regularly utilize this distinction to create tax savings for clients.

Code §§ 671-679 contain what are commonly referred to as the “grantor trust rules.” The Code takes a functional approach to taxation and draws definitive lines regarding what powers if retained or possessed by a party will cause the party to be considered the “owner” of the portion of the trust to which the power relates.  Code § 671 provides that “where it is specified in this subpart that the grantor or another person shall be treated as the owner of any portion of a trust, there shall then be included in computing the taxable income and credits of the grantor or the other person those items of income, deductions, and credits against tax of the trust which are attributable to that portion of the trust to the extent that such items would be taken into account under this chapter in computing taxable income or credits against the tax of an individual on the grounds of his dominion or control over the trust….”

Most commonly grantor trust status arises due to a retained power or right in the settlor (or a nonadverse party holds such right and it may be statutorily attributed to the grantor). The list of powers or rights that if retained or held cause grantor trust status are as follows:

• Subject to certain limited exceptions, the retention of a reversionary interest in the income or principal of the trust property. Code § 673.
• Subject to certain limited exceptions, the power to control the beneficial enjoyment of the trust without the consent of an adverse party. Code § 674.
• The power to deal with trust property for less than adequate and full consideration. Code § 675(1).
• The power to borrow trust property without adequate interest or security. Code § 675(2).
• The power over certain administrative matters which may be exercised in a nonfiduciary capacity by the grantor in favor of the grantor without the consent of another person acting in a fiduciary capacity including (i) a power to vote or direct the voting of stock or other securities of a corporation in which the holdings of the grantor and the trust are significant from the viewpoint of voting control; (ii) a power to control the investment of the trust funds either by directing investments or reinvestments, or by vetoing proposed investments or reinvestments, to the extent that the trust funds consist of stocks or securities of corporations in which the holdings of the grantor and the trust are significant from the viewpoint of voting control; or (iii) a power to reacquire the trust corpus by substituting other property of an equivalent value. Code § 675(4).
• Subject to certain limited exceptions, the power to re-vest in the grantor title to trust property exercisable by the grantor or a non-adverse party, or both. Code § 676.
• The power, exercisable by the grantor or a nonadverse party, or both, to use trust income without the consent or approval of an adverse party for (i) a distribution to the grantor or the grantor’s spouse; (ii) to be held or accumulated for future distribution to the grantor or the grantor’s spouse; or (iii) applied to the payment of premiums on policies of insurance on the life of the grantor or the grantor’s spouse, except policies irrevocably payable to charitable beneficiaries. Code § 677(a).

Planners will generally carefully select from among the foregoing powers to intentionally trigger grantor trust treatment without also retaining certain powers or rights that trigger estate tax inclusion for estate tax purposes. Common examples of grantor trusts include:

• “Living” or “Revocable” Trusts. Revocable trusts are common estate planning tools for clients of all net worth. Such trusts generally provide that the settlor may revoke all or any portion of the trust at any time therefore triggering grantor trust status.
• Grantor Retained Annuity (or Unitrusts) Trusts. Grantor retained annuity trusts (aka “GRATS”) are a common estate tax planning tool for clients desiring to make gifts to third parties in a tax advantaged manner. GRATS are a statutorily approved planning technique and generally involve a grantor transferring property in trust for a defined number of years or for a measuring lifetime. The trust must pay an “annuity” to the grantor annually based on certain IRS tables and standards.[1] If the investment returns of the trust exceed the annuity payment, the remaining balance at the end of the trust term may be transferred to the identified beneficiaries. The grantor only reports the value of the remainder interest for gift tax purposes and may often “zero-out” the trust using applicable IRC guidelines to cause the remainder interest in the trust to be valued at zero for gift tax purposes.
• Intentionally Defective Grantor Irrevocable Trusts. While not specifically statutorily approved as in the case of GRATS, a common planning tool that has been repeatedly approved by IRS rulings is the use of intentionally defective grantor trusts (“IDGTs”). An IDGT is an irrevocable trust designed to be excluded from the grantor’s gross estate for estate tax purposes but reportable to the grantor for income tax purposes. This dichotomy is available due to the grantor’s ability to retain certain powers over trust property that are not considered sufficient to cause estate tax inclusion under the estate tax rules but otherwise trigger the grantor tax rules for income tax purposes. Commonly, the retained power to substitute assets of equivalent value is used for this purpose. Perhaps the most significant advantages of such arrangements include the ability to sell assets to the trust without income tax consequence and the ability of the grantor to pay the trust’s tax burden from non-trust property without such payment to be considered an additional “gift” for gift tax purposes.

A person other than the settlor of the trust may be considered the “owner” of the trust property under the grantor trust rules. Code § 678(a) provides that “a person other than the grantor shall be treated as the owner of any portion of a trust with respect to which (1) such person has the power exercisable solely by himself to vest the corpus or the income therefrom in himself or (2) such person has previously partially released or otherwise modified such a power and after the release or modification retains such control as would, within the principles section 671 to 677, inclusive, subject the grantor of a trust to treatment as the owner thereof.” Certain exceptions exist when the grantor of the trust also retains powers that would cause the grantor to be considered the owner of the trust or if the power only enables the person, in the capacity of trustee, to apply income to the support or maintenance of a person the powerholder is obligated to support. Code § 678(b)(c)

Finally, Code § 679 provides certain rules applicable to persons making transfers to foreign trusts. Generally, a living person who transfers assets to a foreign trust will be considered an owner of the assets transferred to such trust during any taxable year there is a United States beneficiary of such trust. These rules, however, are subject to certain exceptions and caveats that are beyond the scope of this post.

Reporting Requirements for Grantor Trusts

The general rule is that a grantor trust must file IRS Form 1041 and report the name, address and tax identification number of the trust to the IRS. The filing puts the IRS on notice that the tax items of the trust will be reported to the deemed owner of the trust. This is most common when the assets of the trust are titled with the payor (brokerage institution, partnership, etc.) reporting the tax items directly to the trust using the trust’s tax identification number. The trustee must then provide a separate statement to the grantor reporting the tax items and indicating that the items should be included on the grantor’s individual tax return. Reg. 1.671-4. However, the trustee of a grantor trust has two alternative reporting methods which avoid the filing of Form 1041.

First, instead of filing Form 1041, the trustee may issue appropriate Form 1099s to the grantor reporting the taxable items to the grantor. Reg. 1.671-4(b). The 1099s list the trust as the payor and the grantor as the payee. The assets of the trust continue to be titled in the name of the trust and use the tax identification number of the trust with the trust’s payor institutions. This method is even more administratively burdensome than filing Form 1041 and therefore, in the author’s experience, not commonly utilized.

Second, instead of filing Form 1041, the trustee may simply list the ownership of trust assets with the payor in such a way as to show the grantor as the deemed owner of the assets. Reg. 1.671-4(b). This method is available if the grantor trust is treated as owned only by one person and the trustee furnishes to all payors of income (i) the grantor’s name; (ii) the grantor’s taxpayer identification number (usually his or her social security number); and (iii) the trustee’s address. Accordingly, the income from the payors is reported to the IRS as belonging to the deemed owner of the trust and not the trust. The parties must, however, be careful to ensure that actual title to the assets is in the name of the trust otherwise the asset may actually not have been transferred to the trust.

[1] Instead of an annuity payment, the trust may provide for a set percentage of the trust to be distributed to grantor annually. The set percentage is considered a “unitrust” amount.

1) Operations

a) Computation of Tax and Liability

Code § 641 provides that the taxable income of a trust “shall be computed in the same manner as in the case of an individual, except as otherwise provided in [Subchapter J].” Accordingly, the same general principles of taxation applicable to individuals apply to trusts: (i) all items of gross income should be aggregated; (ii) deductions are then applied to reduce gross income; (iii) the tax on the taxable income is calculated using the applicable rate schedule; and (iv)  credits are offset against the liability to determine the amount of net tax due. Zaritsky, Lane and Danforth, Federal Income Taxation of Estates and Trusts, ¶ 2.02 (3^rd Ed. 2001 & Supp. April 2017).  The “except as otherwise provided” language of Code § 641 is significant. Code § 642 immediately addresses and provides limitations on certain credits and deductions that would otherwise be available to individuals, including the foreign tax credit, deductions for the personal exemption, charitable deductions, and deductions for depreciation, depletion and amortization, among others.

b) Exemptions, Deductions and Credits

Unlike individuals, taxable trusts do not generally receive a personal exemption. Instead, Code § 642 provides that trusts which are required to distribute all of their fiduciary accounting income to their beneficiaries receive a $300 exemption. A trust which is not required to distribute all of its fiduciary accounting income in the current tax year receives only a $100 exemption. Certain trusts created for the benefit of certain disabled individuals are entitled to the personal exemption available to a single individual. Code § 642.

Code § 642(c) provides that a trust may be entitled to a charitable deduction for an amount paid or permanently set aside for a charitable purpose. This is similar to but not the same as the charitable deduction allowed to individuals pursuant to Code § 170. Significant differences include the lack of a ceiling on the amount of the deduction for a trust and that the trust’s governing instrument must specifically provide for the distribution to or for the benefit of the charitable organization or purpose in order to receive the deduction.

Trusts are permitted a net operating loss if their expenses and deductions incurred in operation of a trade or business exceed the sum of the gross income from that business plus the taxable income earned from all other sources during the taxable year. Code § 642(d). Of course to claim a NOL, the trust must be engaged in a “trade or business” and not just an investment activity. The distinction is not always clear, but it is generally understood that the ownership and management of income-producing real estate is a trade or business. See, e.g., Reiner v. U.S., 222 F.2d 770 (7^th Cir. 1955).

Trusts are also permitted a deduction for depreciation, depletion and amortization for assets with an ascertainable useful life. Code § 642(e). A complex series of statutes, however, apply to determine whether the beneficiary or the fiduciary will be allocated the deduction. A discussion of these more complex allocation rules is beyond the scope of this post, but such deductions may be significant depending on the type of assets held by the trust.

Trusts may also receive the benefit of business-related tax credits subject to passive activity rules and at-risk rules. Code § 21, 22. Again, special allocation rules apply to the allocation of the credit between the fiduciary and the beneficiary.

c) Distributable Net Income

“Distributable Net Income” (“DNI”) is, in simple terms, the limit on the amount of net income a trust can deduct for distributions to the trust’s beneficiaries. See Code §§ 651, 661. The concept of and rules governing DNI is crucial to many provisions of Subchapter J.

DNI is technically calculated by taking the taxable income of the trust and increasing it by (i) the amount of the exemption under Code § 642(b), (ii) tax exempt interest (less any expenses attributable to tax exempt interest or income attributable to charitable contributions under Code § 642(c)) and (iii) any capital loss used in calculating taxable income. The result is then decreased by (i) capital gains included in gross income if they are not paid, credited or required to be distributed to a beneficiary and not deductible as a charitable contribution, and (ii) by any extraordinary dividends received by simple trusts if such dividends are not paid to the beneficiary. Foreign trusts are subject to certain further adjustments not discussed here. DNI therefore is generally designed to track fiduciary accounting income which may be distributed during the taxable year to the beneficiaries.

Several important concepts relating to DNI substantially affect the taxation of trusts and beneficiaries.

First, capital gains or capital losses are excluded from DNI except in certain limited circumstances, namely when the governing instrument specifically provides that the fiduciary may distribute the capital gains to the beneficiary or the capital gains are actually distributed to the beneficiary. This distinction is often a significant consideration for fiduciaries as trusts are subject to a 3.8% surtax on net investment income under Code § 1411 for gains exceeding $12,400.[1] The individual threshold for application of the surtax begins at $200,000 for single individual taxpayers, meaning that a fiduciary may, at least for tax purposes, desire to pass through capital gains to take advantage of the beneficiary’s lower individual tax rate.

Second, practitioners should be careful to distinguish between fiduciary accounting income and DNI. While the two concepts are meant to be parallel in many respects, there can be differences. Fiduciary accounting income constitutes the “income,” as opposed to the “principal,” of the trust as calculated under state law and the governing instrument. Taxable income is a broader concept and generally includes capital gains and extraordinary dividends which would generally be allocated to principal under state law. A series of complex rules exist for state law purposes that permit a fiduciary to make certain reasonable adjustments between income and principal based on investment selection and performance. The result may be that DNI includes less income than was actually distributed to the beneficiary under certain circumstances.

A trust generally receives a distribution deduction for the lesser of DNI or the amount actually or required to be distributed to a beneficiary during the taxable year, including any amount deemed distributed to the beneficiary within the 65 day period following the end of the taxable year pursuant to Code § 663(b).[2] Code § 661. DNI passed-through to a beneficiary is reported to the beneficiary and the beneficiary is responsible for reporting the income on his or her individual tax return and paying the associated tax. The character of the tax items passing through to the beneficiary is retained, meaning capital gains, interest, dividends, etc. retain their character for reporting purposes. Code §§ 652, 662.

[1] This threshold adjusts for inflation. The threshold for individual taxpayers does not adjust for inflation.

[2] A distinction exists over the extent of the available deduction depending on whether the applicable trust is a “simple” or “complex” trust for income tax purposes. This distinction is not discussed here as, in the authors’ experience, most trusts constitute complex trust for income tax purposes.

2) Reporting Requirements

A taxable trust is required to file IRS Form 1041, U.S. Income Tax Return for Estates and Trusts, for each taxable year of the trust in which its gross income exceeds its personal exemption amount set forth in Code § 642 or if it has any taxable income. Code § 6012(a)(4). If a trust has a nonresident alien beneficiary, the trust must file a return regardless of the amount of its gross or taxable income. Code § 6012(a)(5).

Trusts are calendar year taxpayers and must, like individuals, file their returns on or before the date that is four months and 15 days following the end of the calendar year. Code § 644. A trust may generally file and receive an automatic 5 month extension to file its return by filing IRS Form 7004. Accordingly, the initial filing deadline matches the deadline for individuals, but the extension deadline requires the trust to file its return at least 30 days prior to the extension deadline of individuals. A trust must provide each applicable beneficiary a Schedule K-1 reporting the tax items passing-through to the beneficiary, which is also filed with the IRS.

Certain trusts may either be exempt from income taxation or functionally exempt from income taxation due to the charitable purpose of the trust. An exempt trust is a trust that is exempt from income taxation pursuant to 501(c)(3) of the Code. Accordingly, the trust is a charitable trust either because its purposes qualify for religious, scientific or charitable purposes set forth in Code 501(c)(3) or its beneficiaries are all 501(c)(3) organizations. Most charitable trusts are classified as private foundations for tax purposes unless they otherwise qualify as a public charity or supporting organization. As a result, charitable trusts must comply with the more restrictive provisions applicable to private foundations including the rules against self-dealing and jeopardy investments as well as the mandatory five percent (5%) distribution requirement. To obtain charitable trust status, the trust must file Form 1023, Application for Recognition of Exemption under 501(c)(3) of the Internal Revenue Code, and receive an exemption determination from the IRS. Contributions to a charitable trust are tax deductible to the contributor pursuant to Code § 170.

A trust that fails to file Form 1023 and receive recognition of its exemption under 501(c)(3) and whose unexpired interests are dedicated to 501(c)(3) purposes is generally considered a non-exempt charitable trust. A non-exempt charitable trust is subject to tax on its investment income under rules for taxable foundations rather than tax-exempt foundations.  However, Code § 4947(a)(1) provides that a non-exempt trust is subject to the special private foundation rules in the same manner as an exempt trust if any contributor to the trust received a deduction for income or wealth transfer tax purposes.

An exempt charitable trust whose annual receipts exceed $25,000 must file Form 990-PF, Return of Private Foundation on or before the 15^th day of the 5^th month following the close of the trust’s taxable year. The return is available for public inspection. A non-exempt charitable trust must file both Form 1041 and Form 990-PF by the deadlines applicable to the filing of those returns by taxable trusts and exempt trusts.

Trust arrangements are commonly utilized to generate charitable deductions for both income and wealth transfer tax purposes in situations when the grantor does not wish to depart completely with the property transferred in trust. These “split-interest” trusts permit the grantor to retain a beneficial interest in the trust while also granting an interest in the trust property to one or more charitable organizations.

Split-interest trusts are statutorily approved and must comply with certain terms and conditions in order to provide tax benefits to the grantor. Split-interest trusts are created when a grantor irrevocably transfers property in trust for the benefit of charitable beneficiaries but retains either the right to an annuity payment or unitrust amount for the grantor’s life or a term of years (a “charitable remainder trust”) or the trust property is payable to one or more noncharitable beneficiaries after a term of years (a “charitable lead trust”). See Code § 664. CRTs are generally not subject to any tax except the tax on unrelated business income under Chapter 42. However, CRT distributions to a noncharitable beneficiary are taxable to the extent taxable income is distributed from the trust to the beneficiary. Code § 664(b).

Subject to certain limited exceptions, split-interest trusts are required to file Form 5227, Split-Interest Trust Information Return, annually which reports the income, deductions, accumulations and distributions for the year. Form 5227 is open for public inspection and is generally due 4 months and 15 days following the end of the trust’s taxable year. CRTs must also file Form 1041 if the trusts have unrelated business income during the taxable year.

A foreign trust is any trust that is not a “United States person.” Generally, a foreign trust person is any trust that fails either of two tests: (i) the trust not subject to the primary jurisdiction of a U.S. Court or (ii) substantial decisions regarding the trust are not controlled by one or more U.S. persons. Reg. § 301.7701-7. A comprehensive discussion of foreign trusts is beyond the scope of this post. However, substantial reporting requirements apply if a U.S. person creates a foreign trust, transfers any money or property to a foreign trust, receives a distribution from a foreign trust, or is treated as the owner of a foreign trust pursuant to Code § 679. In addition, trustees of foreign trusts must file Form 1040NR, U.S. Nonresident Alien Income Tax Return, if the foreign trust has any U.S. source income.[1] Form 1040NR must be altered by the trustee as needed to conform to the requirements of Subchapter J. In the authors’ experience, this is a cumbersome process and specialized experience with foreign trusts is generally required.

[1] Tax liabilities and reporting requirements may be altered by one or more applicable treaties with the foreign jurisdiction in which the trust is located. Practitioners should be careful to review any applicable tax treaties for their effect on foreign trusts.

Prior to 2001, the estate and gift tax permitted a taxpayer to transfer an “exclusion amount” of up to approximately $600,000, either through lifetime or at death or through a combination of both, without incurring any tax.[1] If transfers exceeded this “unified credit” they were subject to a tax rate of 55%. In 2001, the federal estate and gift tax were substantially overhauled by the Economic Growth and Tax Relief Reconciliation Act (“EGTRRA”), which provided for annual increases in the estate tax exemption from $1,000,000 in 2002 to a maximum exemption of $3,500,000 in 2009. In 2010, EGTRRA repealed the estate tax and GST tax for one year.

Notably, EGTRRA de-unified the federal estate and gift tax unified credit amount. While the estate tax exemption increased annually, the gift tax exemption increased only to a maximum of $1,000,000 based on the reasoning that the gift tax was not only meant to prevent transfers to avoid estate tax but also to avoid taxpayers from transferring highly appreciated assets to others subject to lower income tax rates. The gift tax, however, unlike the estate tax, was not repealed for 2010. Rather, the applicable tax rate was lowered to the then maximum individual income tax rate of 35%.

EGTRRA’s “sunset” provisions meant that the estate tax was to return to its pre-2001 form beginning in 2011. In December 2010, however, Congress passed the 2010 Tax Act which retroactively reinstated the estate and GST tax for 2010 at a maximum rate of 35% and an increased exemption amount of $5,000,000. Interestingly, the estate of a decedent dying in 2010 was given the choice to either (i) be subject to the reinstated estate tax, or (ii) elect into a so-called “carry-over basis” regime, in which the decedent’s estate would not be subject to estate tax, but would receive only a limited step up in basis in the decedent’s assets for income tax purposes. The Tax Act provided that the reinstated estate and GST tax would remain in effect through 2012, but would again “sunset” at the end of 2012 and return to pre-2001 levels.

The American Taxpayer Relief Act (“ATRA”) of 2012 (technically passed in January 2013) avoided the “fiscal cliff” created by the 2010 Tax Act. ATRA retained the $5,000,000 exemption (indexed for inflation) for estate, gift and GST taxes and the top marginal rate of 40%.

On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act of 2017 (“TCJA”) which substantially amended the Internal Revenue Code, including certain provisions relating to wealth transfer taxation. Effective January 1, 2018 and applying to persons dying or gifts made before January 1, 2026, the estate and gift tax exemption and the GST exemption of $5,000,000 is doubled and continues to be subject to inflation-adjustment. For 2018, the exemption was $11.2 million per individual or $22.4 million for a married couple. On January 1, 2026, the exemption will revert back to their 2017 levels. The tax rate of 40% is retained.

The turbulent history of wealth transfer taxation since 2001 caused concern for many planners. Taxpayers were faced with a decision to use what could be vanishing exemption to transfer assets before a return to onerous pre-2001 levels. With the 2018 exemption being $11.2 million per taxpayer, the current estate, gift and GST regime affects very few taxpayers. However, for those affected, it remains a considerable concern. The following represents an introduction to the nuts and bolts of the federal estate tax, gift tax and generation-skipping transfer tax.

[1] The exclusion amount of $600,000 existed from 1987 through 1999. In January 2000, the amount increased to $675,000.

Chapter 11 of the Code imposes a tax on the transfer of the “taxable estate of every decedent or resident of the United States.” Code § 2001(a). The tax imposed is calculated by multiplying the applicable tax rate on the sum of the “taxable estate” plus the amount of “adjusted taxable gifts” and reducing the result by the amount of tax payable on lifetime gifts made after 1976. Code § 2001(b).

“Adjusted taxable gifts” means the total amount of taxable gifts made by the decedent after December 31, 1976, other than taxable gifts taken into account in determining the gross estate (discussed below). Code § 2001(b). Accordingly, gifts that are included in the decedent’s gross estate are not counted twice. The concept of taxable gifts is discussed more in Section 2 below regarding “Gift Tax.”

The “taxable estate” is the total “gross estate” less the value of any applicable deductions under Code §§ 2053-2058. As planners generally focus planning efforts on removing property from a decedent’s “gross estate” or reducing the value of the property included in the “gross estate,” the scope of the “gross estate” is crucial to understanding estate taxation.

Code §§ 2031-2046 govern what constitutes a decedent’s “gross estate” for federal estate tax purposes. Broadly, the “gross estate” is defined as the value at the time of the decedent’s death of all property, real or personal, tangible or intangible, wherever situated. Code § 2031. The gross estate, therefore, has two primary features: (i) it is meant to include all of the decedent’s property interests[1] and (ii) it is further meant to include the value of those interests as of the decedent’s date of death. Value in this context is “fair market value” defined as “the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.” Reg. § 20.2031-1(b).

This general rule requiring valuation on the date of death is subject to exception. Code § 2032 provides that an estate may select an alternate valuation date which, if selected, requires the valuation of all property as of the date 6 months after the decedent’s death unless the property is distributed, sold, exchanged, or otherwise disposed of within 6 months following the decedent’s date of death, in which case the value as of distribution, sale, exchange, or other disposition is to be used. Importantly, this election is only available if it decreases the gross estate and the resulting estate tax. Code § 2032(c).

Whether an interest rises to the level of “property” and what “value” is to be assigned to a particular property interest is the subject of numerous Code sections, regulations, rulings and tax controversies. A complete discussion of “gross estate” is beyond the scope of this post, but the primary code provisions are discussed here. Whether an interest raises to the level of a “property” interest for purposes of Code § 2031(a) is in many cases resolved by statute or regulation and may include actual property interests or rights retained or given to a decedent that the Code deems sufficient to constitute an interest in the property over which the right pertains. A summary of the applicable Code provisions addressing specific property or rights is as follows:

[1] See Code § 2033 stating that “the value of the gross estate shall include the value of all property to the extent of the interest therein of the decedent at the time of his death.”

• Section 2031(b): Unlisted Stock and Securities. Non-publicly traded securities held by a decedent are to be valued “by taking into consideration, in addition to all other factors, the value of stock or securities of corporations engaged in the same or similar line of business which are listed on an exchange.” As this definition and the general pronouncement in Reg. 20.2031-2(f)(2) provide limited guidance with respect to the valuation of closely-held business interests, the IRS issued Revenue Ruling 59-60 which provides eight factors to consider in valuing a closely held business. These factors include: (i) the nature of the business and the history of the enterprise from its inception; (ii) the economic outlook in general and the condition and outlook of the specific industry in particular; (iii) the book value of the stock and the financial condition of the business; (iv) the earning capacity of the company; (v) the dividend-paying capacity; (vi) whether or not the enterprise has goodwill or other intangible value; (vii) sales of the stock and the size of the block of stock to be valued; and (viii) the market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the-counter. The valuation of closely held businesses has been the subject of numerous tax controversies, particularly when coupled with aggressive valuation discounts for attributes like lack of marketability and lack of control.
• Section 2031(c): Qualified Conservation Easements. A popular planning tool in recent years is the use of qualified conservation easements which may provide income tax and estate tax benefits. A qualified conservation easement generally exists when a donor of land grants a conservation easement to a land trust or public agency but retains certain permissible development rights on the property. A myriad of special rules and regulations apply and donors that attempt to retain aggressive rights over the property have been the subject of notable tax court cases which reduce or eliminate any claimed deductions for the grant of the conservation easement. Code § 2031(c) provides certain rules for determining the extent of the value of the property subject to the easement that may be excluded from the decedent’s gross estate in certain circumstances.
• Section 2032A: Valuation of Real Property consisting of Certain Farm and/or Trade or Businesses. A common argument against the imposition of the estate tax is its potential devastating effect on family owned farmland or closely held businesses that depend on highly valued real property for their operations. In an effort to address these concerns, Code § 2032A provides certain special valuation rules for real property used as a farm for farming purposes or used in a trade or business other than the trade or business of farming. Code § 2032A generally permits qualifying real property to be valued at its “use” value rather than its fair market value subject to a reduction in value limited to an inflation-adjusted $750,000.
• Section 2034: Dower or Curtesy Interests. Code § 2034 makes clear that a decedent’s gross estate is to include the value of all property to the extent of any interest therein of the surviving spouse, existing at the time of the decedent’s death as dower or curtesy, or by virtue of a statute creating an estate in lieu of dower or curtesy.
• Section 2035: Adjustments for Certain Gifts Made Within 3 Years of Decedent’s Death. Code § 2035 provides a claw back of transfers made by a decedent during the 3-year period ending on the decedent’s date of death. The purpose of the statute is to prevent the decedent from attempting to gift away assets in an effort to avoid the estate tax. Notably, transfers include both ownership changes and the relinquishment of a power with respect to any property that would have caused the property to be included in the estate under 2036, 2037, 2038 or 2042. Accordingly, the statute is primarily aimed at the transfer of incidents of ownership over a life insurance policy and the relinquishment of retained rights in property, such as a life estate. If an asset falls within the scope of Code § 2035, the value of the asset is included in the decedent’s gross estate to the same extent as it would have been under Code §§ 2036, 2037, 2038 or 2042.
• Section 2036: Transfers with Retained Life Estates. Some taxpayers attempt to avoid the inclusion of property in their gross estate by transferring a remainder interest in the property to another person. Code § 2036 broadly provides that any effort to do so will not be successful. In addition, § 2036 provides that the decedent’s retention of the possession or enjoyment of, or the right to the income from, the property, or the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom is sufficient to cause estate tax inclusion. This provision is regularly utilized to claw back assets when the transferor did not properly sever ties with the enjoyment of, or right to control, the property.
• Section 2037: Transfers Taking Effect at Death. Another claw back provision largely aimed at the same concerns as Code § 2036, Code § 2037 provides for a more explicit provision regarding a decedent’s conditional transfer of property. If (i) the decedent transferred property and another beneficiary can only receive possession or enjoy the property at or after the decedent’s death and (ii) the decedent retained the possibility of receiving the property back or the property being transferred back to the decedent’s estate, then the property will be claw backed into the decedent’s estate.
• Section 2038: Revocable Transfers. In some cases, a decedent may transfer an interest in property but retain the right either alone or in conjunction with another person, to alter, amend, revoke, or terminate the transfer, or relinquish such power in the 3-year period ending on the date of the decedent’s death. While certain obvious retained powers, like the power to invade corpus or accelerate a beneficial interest invoke this provision, a power over investment decisions in a trust may also invoke this provision because of the ability to effect the remainder beneficiaries’ interest through the type of investments selected.
• Section 2039: Annuities. A decedent’s gross estate includes the value of any annuity or other payment that was payable to the decedent, either alone or in conjunction with another for his life or for any period not ascertainable without reference to his death or for any period which did not in fact end before his death. The amount to be included is only the decedent’s proportionate share of the annuity or other right to payment.
• Section 2040: Joint Interests. A decedent’s gross estate includes the decedent’s interest in property held as a joint tenant with right of survivorship or as a tenant by entirety. Generally, the value of the property to be included is equal to the decedent’s fractional interest in the subject property.
• Section 2041: Powers of Appointment. Any property over which a decedent retains a general power of appointment is to be included in the decedent’s gross estate. A general power of appointment is a power exercisable in favor of the decedent, his estate, his creditors or the creditors of his estate. Code § 2041(b)(1). Notably, a power that is limited by an ascertainable standard relating to health, education, or maintenance of the decedent is not considered a general power of appointment. Code § 2041(b)(1)(A). Also, a power exercisable only in conjunction with the creator of the power or a person having a substantial adverse interest in the subject property is generally not a general power of appointment. Code § 2041(b)(1)(C). The release or lapse of a general power of appointment by the decedent will not cure the problem except to the extent the release is limited to $5,000.00 or 5 percent of the aggregate value of the property subject to the power at the time of the release of such power. Code § 2041(b)(2).
• Section 2042: Proceeds of Life Insurance. While life insurance proceeds are not subject to income tax, life insurance proceeds are potentially subject to estate tax. Any life insurance proceeds that are payable to the decedent’s estate on a policy insuring the decedent’s life are included in the gross estate. Code § 2041(1). In addition, a decedent that maintains any “incidents of ownership” over a life insurance policy payable to other persons will be considered the owner of that policy upon his or her death. “Incidents of ownership” is not limited to ownership of the policy but may include the right of the insured to the economic benefits of the policy, including the right to change the beneficiary, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, or to obtain from the insurer a loan against the surrender value of the policy. Reg. 20.2042-1(c)(4).
• Section 2043: Transfers for Insufficient Consideration. As the sale or exchange of property for full and adequate consideration is an exception to a transfer under §§ 2035-2038, it is no surprise that if a sale or exchange is not for full and adequate consideration, the difference between the value of the property transferred and the amount paid will be included in the decedent’s gross estate. Code § 2043(a). A transfer to a spouse in satisfaction of a dower or courtesy or other similar marital interest is not considered to be a transfer made for full and adequate consideration. However, assets transferred to a spouse pursuant to a property settlement agreement are considered made for adequate and full consideration. Code § 2043(b)(2).
• Section 2044: Certain Property for which Marital Deduction was Previously Allowed. If an interest held by the decedent was previously subject to a marital deduction in the decedent’s spouse estate, the property is generally includable in the estate of the decedent to the extent the decedent had a qualifying income interest. This rule ensures that property passed to a surviving spouse on a estate tax free basis due to the unlimited marital deduction (discussed below) is subject to the estate tax in the surviving spouse’s estate.

While the foregoing generally introduces the scope of the “gross estate,” including the retention of powers and rights over property purportedly transferred to or for the benefit of third persons, the scope of each provision and application to a particular decedent’s estate or planning strategy should be carefully reviewed in consultation with a qualified tax professional. As with most tax rules and regulations, general rules are subject to exceptions, which are themselves, often subject to exceptions. Accordingly, a careful reading of the applicable Code provisions, regulations, IRS rulings and applicable court cases is necessary to adequately review the purpose and effectiveness of any estate tax planning strategy.

The “taxable estate” is equal to the total value of the gross estate less the deductions permitted for expenses, indebtedness, taxes, charitable contributions, property passing to the surviving spouse, and state death taxes. Code §§ 2051-2058. Notable among these deductions is the unlimited deduction for public, charitable or religious uses under Code § 2055 and the unlimited marital deduction for assets transferred to a spouse under Code § 2056. Accordingly, an estate left entirely to a qualifying charitable organization and/or surviving spouse will not incur any estate tax.

In order for property to be considered passing to the surviving spouse, the property must not be “terminable interest” property, meaning that the rights of the spouse will terminate or fail due to the lapse of time or the occurrence of an event or contingency. Code § 2056(b). The asset devised to the surviving spouse must in fact be for the sole benefit of the spouse. Many taxpayers, however, wish to leave assets for the benefit of the spouse but desire to ensure that upon the spouse’s death any remaining assets are payable to children or other beneficiaries. Code § 2056(b)(7) permits the use of certain “qualified terminable interest property” arrangements to meet these objective while also obtaining the benefit of the marital deduction.

“Qualified terminable interest property” means property that (i) passes from the decedent, (ii) in which the surviving spouse has a qualifying income interest for life, and (iii) to which the decedent’s estate has elected to treat as a qualifying income interest. Code § 2056(b)(7)(B). The surviving spouse has a qualifying income interest if the surviving spouse is entitled to all the income from the property, payable annually or at more frequent intervals, and no person has a power to appoint any part of the property to any person other than the surviving spouse. Code § 2056(b)(7)(B)(ii). A decedent may, therefore, transfer assets in trust for the benefit of the surviving spouse provided the surviving spouse is the sole lifetime beneficiary of the trust, has the right to all income from the trust during the spouse’s lifetime, and that interest cannot be appointed to another person.

A decedent whose gross estate plus adjusted taxable gifts and specific exemption is more than the basic exclusion amount ($11.2 Million in 2018) must file Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return. Likewise, an estate desiring to transfer a deceased spouse’s unused exclusion amount to the surviving spouse, regardless of the size of the decedent’s gross estate, must file an estate tax return.

Form 706 is due within 9 months after the date of the decedent’s death unless Form 4768, Application for Extension of Time to File a Return and/or Pay U.S. Estate (and Generation-Skipping Transfer) Taxes is filed and an automatic 6 month extension of time to file is obtained. Estate taxes are due, however, within 9 months of the date of the decedent’s death unless the estate receives an extension of time for payment or is eligible for and elects to pay in installments under Code § 6166 or postpones the payment under certain circumstances applicable to tax attributable to a reversionary or remainder interest.

Form 706 requires considerable attachments in support of the valuations used for the return as well as copies of testamentary instruments, trust instruments, inventories, and other similar estate documents. In the authors’ experience, Form 706 requires considerable time to prepare and assemble, particularly for estates involving hard to value assets like closely-held business interests or fractional interests in commercial real property.

What constitutes a “Gift”?

It does not take much imagination to anticipate the disputes that have arisen over whether a “transfer” has been made, whether the “transfer” is a “gift,” and the value to be assigned to “gift.” Accordingly, the Code and regulations attempt to specify what constitutes a “gift” and, in many cases, the rules governing the valuation of the specific type of gifted property.

Code § 2511(a) provides that, subject to certain limitations, the gift tax applies “whether the transfer is in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible….” The regulations make clear that “a taxable transfer may be effected by the creation of a trust, the forgiving of a debt, the assignment of a judgment, the assignment of the benefits of an insurance policy, or the transfer of cash, certificates of deposit, or federal, state or municipal bonds.” Reg. § 25.2511-1(a). As a result, the scope of transfers to which the gift tax applies is very broad. “Donative intent on the part of the transferor is not an essential element in the application of the gift tax to the transfer. The application of the tax is based on the objective facts of the transfer the circumstances under which it is made, rather than on the subjective motives of the donor.” Reg. § 25.2511-1(g)(1). As long as the transfer is of a beneficial interest in property, was not made for money or money’s worth and was not part of an ordinary business transaction, then the gift tax is likely implicated.

A important concept in federal gift taxation particularly applicable to trust arrangements is the distinction between a complete and incomplete gift. Situations may arise where a donor transfers property to or for the benefit of a third person but retains certain rights over the trust property. The question is whether the donor has retained sufficient powers over the transferred property to cause the gift to be incomplete. A gift is considered “complete” when the donor “has so parted with dominion and control as to leave in him no power to change its disposition, whether for his own benefit of the benefit of another….” Reg. § 25.2511-2(b). If the donor has not sufficiently parted with dominion and control over the property, then the gift is incomplete. It is possible to have a partially completed gift and a partially incomplete gift. The regulations make clear that the facts and circumstances of the reserved power must be carefully analyzed to determine whether a completed gift has occurred. Reg. § 25.2511-2(b). What is clear is that a gift is incomplete “in every instance in which a donor reserves the power to re-vest the beneficial title to property to himself or change the beneficial interests in the property unless the power is subject to a fixed or ascertainable standard.” Reg. § 25.2511-2(c). A donor is considered as retaining any power exercisable by the donor in conjunction with any person not having a substantial adverse interest in the disposition of the transferred property or income from the property. Reg. § 25.2511-2(e).

If a gift is “incomplete” for federal gift tax purposes, the subject property continues to be an asset of the donor and will be considered part of the donor’s gross estate for federal estate tax purposes. This is significant as planners may employ strategies for a donor to place assets in trust but retain certain powers that prevent a completed gift depending on the tax objectives of the client.

Valuation

The value of the property on the date of the gift is to be considered the amount of the gift. Code § 2512(a). And if property is transferred for less than adequate and full consideration in money or money’s worth, then the amount of the value of the property transferred which exceeds the consideration paid is deemed a gift. Code § 2512(b). Regulations § 25.2512-1 through 25.2512-5A provide rules and guidelines regarding the valuation of certain property, including stocks and bonds, business interests, promissory notes, annuities, unitrust interests, income interests, remainder or reversionary interests, and certain life insurance and annuity contracts. A discussion of the valuation rules for these various property interests is beyond the scope of this article. However, a qualified appraisal of real estate and closely held business interests is generally required and is often the subject of substantial planning efforts.

Spousal “Gift-splitting”

Another important consideration is the concept of “gift-splitting.” Code § 2513 provides that a gift made by one spouse to a person other than his or her spouse may be considered as made one-half by him and one-half by his spouse provided both spouses are citizens and residents of the U.S. at the time of the gift. Reg. § 25.2513-1(a). Both spouses must signify their consent to treat all gifts for the applicable calendar period as made one-half by each spouse. Consent is given by both spouses indicating the same on a gift tax return. Reg. § 25.2513-2(a). If both spouses consent to gift-splitting, then both spouses are jointly and severally liable for the entire gift tax for the calendar period at issue. Reg. § 25.2513-4.

Certain gifts are excluded from being considered in the total amount of gifts for a year. Three such exclusions are particularly notable and commonly utilized. The first $15,000 (which is inflation adjusted annually) transferred to a person by a donor is excluded from the total amount of taxable gifts for a year. Accordingly, a donor may transfer the so-called “annual exclusion” on a gift tax free basis. The annual exclusion is regularly utilized in conjunction with irrevocable life insurance trusts as a method to fund insurance premium payments in the trust.

Donors may transfer an unlimited amount for the education of an individual provided the educational organization is a qualified 501(c)(3) organization and the funds are used for the education or training of the individual. Code § 2503(e). Importantly, the transfer must be to the educational organization and not to the individual for later transfer to the educational organization.

Donors may also transfer payments for medical care for a individual without the payment being considered a gift. Code § 2503(e)(2)(B). Any such payment should again be made to the individual providing the service and not to the individual receiving the service.

If a gift is not otherwise excluded from inclusion as a taxable gift, the gift may nonetheless be effectively excluded if made to certain donees. Like the estate tax, donors may make unlimited gifts to certain tax exempt organizations and unlimited gifts to his or her spouse. Code §§ 2522, 2523. The rules for when assets are considered transferred to a charitable organization or spouse are very similar to the rules governing the estate tax charitable deduction and marital deduction discussed above.

A donor must file Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return to report a taxable gift. A gift tax return is not generally required for transfers to a spouse, transfers for educational expenses or medical expenses, or certain transfers to tax exempt organizations. However, it may still be advisable to file a gift tax return in one or more of such instances to report the gift and begin the running of the statute of limitations on the transfer. Form 709 must be filed by the same deadline for filing the donor’s individual income tax return. The filing of an extension for the income tax return generally operates as an extension for the filing of the gift tax return, although the payment of any associated gift tax is due by the initial due date of the return.

Code § 2601 imposes a tax on “every generation-skipping transfer.” The tax imposed is calculated by determining the “taxable amount” of the transfer multiplied by the “applicable tax rate.” Code § 2603(a)(1) provides that in the case of a “taxable distribution,” the tax is to be paid by the transferee. In the case of a “taxable termination” or a “direct skip” from a trust, the tax is to be paid by the trustee. Code § 2603(a)(2). And, in the case of a direct skip (other than a direct skip from a trust), the tax is to be paid by the transferor. Code § 2603(a)(3). These concepts are discussed more fully below.

A “generation-skipping transfer” generally includes any one of three potential classifications of transfers: (i) a “taxable distribution;” (ii) a “taxable termination;” or (iii) a “direct skip.” The first two types of transfers are applicable only to trust arrangements.[1] A “taxable distribution” means any distribution from a trust to a skip person other than a taxable termination or a direct skip. Code § 2612(b).  A “taxable termination” means the termination (whether by death, lapse of time, release of power, or otherwise) of an interest in property held in trust unless immediately after such termination, a non-skip person has an interest in the property transferred, or at no time after the termination may a distribution be made from the trust to a skip person. Code § 2612(a). A direct skip is any transfer of an interest in property to a skip person implicating the federal estate or gift tax. Code § 2612(c).

Based on the above definitions, it is only possible to have a generation-skipping transfer if the transfer at issue involves a “skip person.” A “skip person” is (i) any natural person assigned to a generation which is 2 or more generations below the generation assignment of the transferor, or (ii) a trust if all interests in such trust are held by skip persons or if there is no person holding an interest in the trust and at no time after such transfer can a distribution be made from the trust to a non-skip person. Code § 2613(a). A “non-skip person” is anyone other than a skip person. Code § 2613(b). Generation assignments are prescribed by Code § 2651 with different rules applicable depending on the status of the transferee as a lineal descendant of the transferor or not. Code § 2651. These rules generally result in each person in the line of lineal succession of the transferor being considered a separate generation except that if a parent of a lineal descendant of the transferor is deceased at the time of the transfer the lineal descendant generally receives a higher generational assignment which may avoid the application of the GST tax.[2] See Code § 2651(e).

The above definitions make sense in the context of the perceived problem attempting to be remedied by the GST tax. A transfer is considered a generation-skipping transfer in three basic circumstances all of which involve the transfer of property to someone who is more than one generation removed from the transferor. First, if grandparent simply transfers property to a grandchild (whose parent is not deceased), the transferor has made a “direct skip.” Second, if the same grandparent transfers property in trust for the benefit of the same grandchild and thereafter the trustee distributes all or a portion of the trust property to the grandchild, a “taxable distribution” has occurred. Finally, if the grandparent transfers property in trust for the benefit of his son and thereafter the son dies and the property is distributed to the grandchild without the property being considered part of the son’s gross estate for federal estate tax purposes, a “taxable termination” has occurred. Without the GST tax, the grandparent’s above transfer skips a generation and therefore the opportunity to impose tax on the future transfer of that property at that next generational level would be lost.

[1] Importantly, the term “trust” includes “any arrangement (other than an estate) which, although not a trust, has substantially the same effect as a trust,” including “life estates and remainders, estates for years, and insurance and annuity contracts.” Code § 2652(b).

[2] A person who is married to a lineal descendant of the transferor is assigned to the same generational level as his or her spouse. Code § 2651(c).

Several significant exclusions from the GST tax are regularly utilized by planners to mitigate or even eliminate the potential GST tax implications of certain transfers. Like the estate and gift tax, the GST tax is subject to an exemption which is equal to the basic exclusion amount for estate and gift tax purposes ($11.2 Million in 2018) and applies whether the transfer occurs during lifetime or at death of the transferor. Code § 2631. The GST exemption is subject to certain automatic allocation provisions which may be opted out of on an appropriate return reporting the transfer. See Code § 2632.

Practitioners regularly use the allocation of GST exemption to create GST exempt and non-exempt trusts. For example, assume a grandparent creates a trust for the benefit of son for son’s lifetime and at son’s death grandparent wants to the property to continue to be held in trust for the benefit of his grandchildren and great-grandchildren. Grandparent’s transfer of property to the trust will implicate the GST tax as son’s death will be a “taxable termination.” If the grandparent allocates sufficient GST exemption to the transfer in trust, the trust will be GST exempt and son’s death will not result in a taxable termination. Accordingly, the use of GST exemption is a primary method for creating so-called “dynasty” trust scenarios where assets remain in trust for a virtually unlimited period of time and outside of the wealth transfer tax system.

The GST tax also affords an annual exclusion in the same manner as the gift tax. Code § 2642. The GST annual exclusion rules largely track the gift tax annual exclusion rules, including the amount of the exclusion. However, a significant distinction exists for gifts made to trusts. Gifts to trusts subject to certain withdrawal rights of beneficiaries (Crummey withdrawal rights) that otherwise qualify for the gift tax annual exclusion do not qualify for the GST annual exclusion unless the trust has only one beneficiary and the trust will be included in the estate of that beneficiary. Reg. § 26.2612-1(a).

The computation of the GST tax is based on a formula: GST tax = Taxable amount x Applicable Rate.

The “taxable amount” in the case of a taxable distribution is the value of the property received by the transferee reduced by any expense incurred by the transferee in connection with the determination, collection or refund of the tax. Code § 2621(a). The taxable amount in the case of direct skip is the value of the property received by the transferee. Code § 2623. Finally, the taxable amount in the case of a taxable termination is the value of all property with respect to which the taxable termination occurred, reduced by any deduction permitted for amounts attributable to the property under principles similar to Code § 2053 (relating to expenses, indebtedness, and taxes). Property is generally valued as of the date the generation-skipping transfer occurred. Code § 2624.

The “applicable rate” means the maximum federal estate tax rate multiplied by the inclusion ratio with respect to the transfer. The “inclusion ratio” is determined in accordance with Code § 2642 and generally results in a fraction of the property in trust (or the property subject to the direct skip) being subject to the GST tax when exemption is partially allocated to the trust or direct skip.

GST tax on direct skips occurring due to testamentary transfers are reported on Form 706. GST tax on direct skips for lifetime transfers are reported on Form 709 in the year after the year in which the transfer occurs. GST tax on taxable terminations are reported for the year of the taxable termination (not on the date the trust is funded) on Form 706-GS(T) which is due by April 15^th of the year following the year of the termination.