Estate and Tax Planning
Spring 1996 Report
Current Developments
This report highlights several recent developments affecting estate and trust planning and administration.
IRS Revokes Earlier Rulings Relating to a Grantor's Retained Power to Remove and Appoint Trustees
Following its 1979 issuance of Rev. Ruling 79-353, the Internal Revenue Service took the position that if a grantor created an irrevocable discretionary trust but retained the unrestricted power to remove and replace the corporate Trustee, then the trust assets would be subjected to estate tax at the grantor's death. The theory was that the grantor's ability to go "Trustee-shopping" whenever the acting Trustee refused to follow the grantor's directions amounted to the retention of dominion and control by the grantor. In subsequent Private Letter Rulings, the Service went further and asserted that if a beneficiary of a discretionary trust was given the right to remove and replace the Trustee but held no other powers, the trust assets would be subjected to estate tax in the beneficiary's estate at death unless the Trustee's invasion powers were limited by an ascertainable standard.
As a result of court decisions to the contrary, the IRS has now reversed its position, at least as to grantor-held powers. Revenue Ruling 95-58, issued in September, 1995, provides that a grantor's retained power to remove and replace a Trustee will not alone subject the trust assets to taxation in his estate so long as the Trustee to be appointed must be an independent Trustee, i.e., not related or subordinate to the power holder.
The right to remove and replace a Trustee may be an important consideration in any donor's decision to create a trust. This recent Ruling confirms the Service will not seek to tax the trust assets in the grantor's estate solely by reason of his retention of such a power -- as long as the grantor cannot appoint a related or subordinate party as Trustee.
While the Ruling expressly addresses grantor-held powers, the Service's position as to beneficiary-held powers is not yet defined. Some commentators have understood this Ruling to imply similar treatment as to beneficiary-held powers. Nonetheless, until the Service resolves the ambiguity in a future ruling, caution must still be exercised in granting a beneficiary of a discretionary trust the power to remove and appoint a Trustee.
IRS Issues Final Regulations on Qualified Domestic Trusts
In general, property passing from a decedent to his or her surviving spouse qualifies for the unlimited marital deduction, which exempts such transfers from U.S. estate tax. Since 1988, however, the marital deduction has been limited in respect of property passing to a non-U.S. citizen surviving spouse. A marital deduction will be permitted only for property passing or effectively assigned to a Qualified Domestic Trust (QDOT) for a surviving spouse who is not a U.S. citizen. QDOTs are treated differently from marital deduction trusts for U.S. citizen spouses. For example, a distribution of principal from a QDOT to a non-citizen spouse (other than on account of "hardship") is immediately subject to U.S. estate tax at the deceased spouse's estate tax rates. The balance of the QDOT is subject to such estate taxes upon the death of the surviving spouse.
There is relief for surviving spouses who (a) become U.S. citizens prior to the filing of the estate tax return for the predeceased spouse or (b) are subject to the provisions of a bilateral estate and gift tax treaty that may provide more generous treatment.
In early 1993, the IRS proposed regulations governing the treatment of QDOTs. Final Regulations were issued last year, effective for estates of persons dying after August 22, 1995. The Final Regulations clarify the QDOT rules and provide further requirements that must be met in order for the trust to qualify for the marital deduction. Among the many revisions to the QDOT rules are provisions relating to the reformation of trusts, the transfer of property passing directly from a surviving spouse to the QDOT, the treatment of qualifying plan benefits which pass to the surviving spouse, and the use of a foreign trust as a QDOT when certain requirements are met.
The IRS has also issued Temporary Regulations governing security requirements for QDOTs, which are effective for estates of persons dying after February 19, 1996. Under earlier proposed regulations, special rules required the appointment of a corporate trustee or the filing of a bond in the event the QDOT had a date of death value in excess of $2 million. The new Temporary Regulations relax the security rules somewhat and permit the exclusion of a principal residence and related furnishings (not exceeding a total of $600,000) for purposes of determining whether the QDOT surpasses the $2 million threshold.
Although these Regulations provide more guidance, the expanded rules will necessitate a careful review to ensure that property passing to a non-citizen spouse will be subject to a deferred, rather than a current, estate tax. Persons married to non-citizens must be aware of the different treatment accorded non-citizens.
New York Permits Married Persons to Hold Cooperative Apartments as Tenants by the Entireties
New York State has amended the Estates, Powers & Trusts Law to equalize, in certain respects, the treatment of married couples who own real estate and married couples who own cooperative apartments. Effective January 1, 1996, a transfer of a cooperative apartment to a married couple creates in the couple a tenancy by the entirety, unless they expressly declare the ownership to be a joint tenancy or a tenancy in common. Prior to this change, married couples could own a co-op in joint tenancy or as tenants in common, but only real property could be held in a tenancy by the entirety.
The change expands the options available to married persons in respect of co-op ownership. Under prior law, a married couple who bought a cooperative apartment without specifying the nature of the tenancy took title to the co-op as tenants in common. Under such a regime, each spouse owned a share of the co-op with no right of survivorship as to the other spouse's share. With joint tenancy, a surviving spouse automatically succeeds to the ownership of his or her deceased spouse's interest. However, whereas a joint tenancy could be unilaterally severed by one spouse while the other is living, a tenancy by the entirety may be severed only at death or upon divorce. The new law presumes that married couples will prefer to have the co-op pass to the survivor upon the death of the first spouse to die. In addition, the fact that a tenancy by the entirety cannot be severed unilaterally protects the couple from the creditors of one spouse. In a joint tenancy or tenancy in common, on the other hand, the property may be attacked by creditors of one spouse to the extent of his or her interest in the property. Finally, a recent New York case held that a trustee in bankruptcy is prohibited from compelling the sale of property held in a tenancy by the entirety, whereas property held in other forms of ownership does not have such protection.
The statute is applicable to all transfers made on or after January 1st. Married couples who already own a cooperative apartment would have to initiate a re-transfer of their apartment to themselves in order to take advantage of the amended statute's benefits. Depending upon the particular co-op corporation, such a transfer may require formal board review and/or approval. Caution should be exercised by married couples where one spouse is a non-U.S. citizen; in the event of the death of the other spouse, the surviving non-U.S. citizen spouse may fall within the scope of the limited marital deduction rules relating to non-U.S. citizens (discussed above with regard to QDOTs).
New York State Income Taxation of Resident Trusts
A trust created by a New York grantor or decedent is considered a "resident trust" for New York fiduciary income tax purposes. If the trust is a "simple" trust and all the ordinary income is distributable to the beneficiaries, capital gains earned by the trust will be subject to both U.S. and New York State income tax. However, in a recent Advisory Opinion, Moss Trust, the New York Commissioner of Taxation and Finance indicated that New York would not seek to collect a tax from a resident trust where (i) all of the Trustees are domiciled outside of New York; (ii) the trust principal is located outside of New York; and (iii) all income and gains of the trust are derived from sources outside New York (that is, there is no income from real property located in New York or from a trade or business conducted in the State). Further, if the trust consists of intangible assets, the Opinion states that such intangible property will be considered located at the state in which the non-resident Trustee resides. (In a contrary decision in a 1982 case, Katherine P. Cale Trust, the court had held that a trust administered outside New York was still subject to New York tax because it was created by a New York resident and there was no proof the trust corpus had been removed from the State.)
Although the Moss Trust Opinion is limited to the facts of the particular case at issue, the ruling is consistent with New York's treatment of non-resident decedents, in that the State will not impose an estate tax on intangible personal property custodied in New York at the death of a non-resident. The Opinion is also consistent with Article XVI, Section 3 of the New York Constitution, which provides that intangible personal property shall be deemed located at the domicile of the owner, a provision adopted to foster the banking and securities industries in New York.
Individuals who seek the expertise of New York-based investment advisors but who are reluctant to subject a trust to the State's income tax rates could presumably take advantage of the Opinion to shelter a resident trust from such taxes, provided the three conditions of the Opinion are met. In addition, in the event circumstances change with respect to existing resident trusts, such as by the Trustee's death or movement out of New York State, a trust previously subject to New York State income tax may seek to avoid future New York tax on capital gains and accumulated income.
Final Regulations Issues Governing the Application of the GST Tax on Nonresident Aliens
On December 26, 1995, the IRS issued Final Regulations concerning the generation-skipping transfer (GST) tax. Of particular note are several changes in the application of the GST tax to transfers by non-resident aliens. Proposed Regulations issued in 1992 would have subjected a transfer of non-U.S. situs property to GST tax if (i) at the time of the taxable event (either by gift, termination of a trust or distribution from a trust), property passed to a U.S. person more than one generation younger than the transferor (a "skip person"); and (ii) at the time of the initial transfer to the skip person, the skip person's parent was both a descendant of the transferor and a U.S. person. The effect would have been to tax certain transfers of non-U.S. situs property which under other IRS rules were not otherwise subject to U.S. gift or estate tax. The Final Regulations eliminate such rules. The application of the GST rules would now depend upon the situs of the property at the time of the initial transfer, rather than the citizenship or residence of the beneficiary.
The Final Regulations have also clarified the treatment of the exercise of a non-general power of appointment as it relates to intergenerational transfers in trust. Under the proposed regulations, the GST tax did not apply to the exercise of a non-general power of appointment if the exercise did not postpone or suspend the vesting of an interest in property beyond a period measured by lives in being at the creation of the interest plus 21 years. To bring the GST rules into conformity with the Uniform Statutory Rule Against Perpetuities, the Finalized Regulations expand the perpetuities period to a period measured either by (i) lives in being plus 21 years or (ii) 90 years from the creation of the trust. A transferor must choose between the two options; he may not choose the longer of the two periods.
The finalized rules are effective as of December 27, 1995 and include a number of provisions that assist transferors who are not citizens or residents of the U.S. in complying with the GST tax rules, when applicable.
In a related development, the Tax Court, in Estate of Neumann v. Commissioner, decided April 9, 1996 has held that a transfer to skip persons of U.S. situs property by a nonresident alien is subject to the GST tax, even though the transfer occurred prior to enactment of the regulations.
Proposed Regulations Prohibit the Repurchase of a Residence from a QPRT
Among proposed changes to the regulations governing grantor retained income trusts, issued on April 16, 1996, are new restrictions on the operation of Qualified Personal Residence Trusts (QPRTs). Prior to the issuance of the new rules, commentators had recognized that a grantor of a QPRT could transfer his or her residence to the trust and, just prior to the expiration of the retained term, purchase the residence from the trust. The result would be that the grantor would retain the residence, which would receive a step-up in basis if held by him or her at his or her later death, and the remaindermen would receive cash or other assets. The proposed rules would require that any QPRT created after May 16, 1996 prohibit the purchase of the residence, either directly or indirectly, by the grantor, the grantor's spouse or any entity controlled by either the grantor or the spouse. The IRS reserves the option to disqualify any trust created prior to the effective date if the grantor purchases the residence pursuant to a provision in the agreement or other instrument reserving such a purchase right or option.
Although not unexpected, the new rules appear to close a potentially advantageous loophole. The tax savings associated with QPRTs still remain valid for individuals who wish to retain an appreciating second home in the family.
This report is distributed for general information purposes only. No action should be taken solely on the basis of its contents. |
