EFTA01104587.pdf

SELECTED PLANNING TECHNIQUES ACTEC REGIONAL MEETING Annapolis, Maryland September 11 - 12, 2004 Ellen K. Harrison Shaw Pittman LLP 2300 N Street, NW Washin on, DC 20037 EFTA01104587  SELECTED PLANNING TECHNIQUES By Ellen K. Harrison Shaw Pittman LLP 2300 N Street, NW Washington, DC 20037 (202) 663-8316 I. INTRODUCTION 1 II. INCOME TAX STRATEGIES 1 A. Basis Step Up Trust, Tax Basis Joint Revocable Trusts And The Grantor Trust Bypass Trust 1 B. Fixed Term NIMCRUT 8 D. Selecting a Situs 11 E. Avoiding §684 12 F. Springing Charitable Remainder Trusts 13 G. Assets Subject to Liabilities in Excess of Basis in Trust 14 III. GIFT TAX STRATEGIES 16 A. Formula Gifts 16 B. GRAT Sales 23 B. Sales to a §678 Trust 23 C. Sale of Preferred Partnership Interests to a Grantor Trust 24 D. Gift of Preferred Partnership Interest to a Charitable Lead Trust 25 E. Dynasty Trusts 26 IV. ESTATE PLANNING IDEAS 28 A. Avoiding §2035 on Transfers of Life Insurance 28 B. EPTL §10-6.6 29 C. Family Limited Partnership for Estate Planning 30 D. Graegin Notes 31 E. Defined Value Strategies for Estate Tax Planning 31 F. Deathbed Gifts to Avoid State Death Taxes 33 V. GENERATION-SKIPPING TRANSFER TAX STRATEGIES 33 A. Inter-Vivos Reverse QTIP Trust 33 B. Cascading Crummey Powers 35 C. Generation Jumping 36 D. Assignments of Remainder Interests 36 E. Qualified Severances 38 F. Postponing Taxable Terminations and Distributions 39 EFTA01104588  INTRODUCTION This paper incorporates a number of planning ideas from my colleagues, Stacy Eastland and Jonathan Blattmachr, who joined me in presenting a program for ACTEC in March 2002 and at the University of Miami Heckerling Institute on Estate Planning in January 2003 during which we discussed various strategies that we have employed to assist clients in minimizing taxes. In order to avoid duplicating a voluminous set of written materials published for that program, I have summarized some of the ideas presented in that program. Rather than present the ideas in a narrative form, I have used examples of situations in which these ideas would be useful. In order to give some structure to this presentation, the suggestions are categorized as strategies to minimize income tax, gift tax, estate tax and generation-skipping transfer ("GST") tax. I presume that the reader is familiar with the basic concepts and relevant statutes. INCOME TAX STRATEGIES A. Basis Step Up Trust, Tax Basis Joint Revocable Trusts And The Grantor Trust Bypass Trust I. The Facts: Adam owns partnership units that are subject to liabilities in excess of his basis -- his share of partnership liabilities is $2,000,000 and his basis is $500,000. If Adam's share of the fair market value of partnership assets is $2,100,000, upon a sale of his interest for $100,000, Adam would realize gain of $2,100,000. This is the sum of the cash plus the share of partnership liabilities that are treated as amounts realized by Adam on the disposition of Adam's interest. The tax due would exceed his cash receipts. Upon Adam's death, the units will acquire a new basis under §1014. The basis adjustment is allowed even if the units pass to his wife, Alice, and no estate tax is due because the assets qualify for the marital deduction. However, if Alice predeceases Adam, there would be no adjustment to basis. The goal is to structure an arrangement whereby a basis adjustment is available regardless of which spouse dies first (and possibly again at the death of the surviving spouse). In addition, Adam would like depreciation deductions to be available to Adam for his lifetime, even if Alice predeceases him. This result is easily obtained if Adam and Alice live in a community property state, but the same benefits are not available to them if they live in states that do not follow community property law. 2. Proposal: a. Alternative A: Adam transfers the partnership units to an inter-vivos trust for Alice. Alice has the right to all of the income and a general testamentary power of appointment. Alice also has the right to require that the trustee invest to produce a reasonable amount of income. Adam has the right to reacquire the assets and substitute assets of equivalent value. Adam retains the right to direct that all or any portion of the principal shall be distributed to Alice at any time. Upon complete distribution, the trust would terminate. If Alice does not exercise her power of appointment and Adam survives Alice, the principal remaining at Alice's death funds typical marital and bypass trusts for the benefit of Adam in accordance with a tax EFTA01104589 formula. Adam continues to have the right to reacquire assets of either the marital or bypass trust and substitute other assets of equivalent value. b. Alternative B: Same as above except that the inter-vivos trust is an "estate trust" from which discretionary distributions of income may be made but at Alice's death the remaining principal is paid to Alice's estate. Income tax Because Alice is a beneficiary, the trust is a grantor trust under §677. Therefore, there is no gain on the transfer of the partnership units to the trust.' Adam's power to reacquire assets and substitute other assets of equivalent value also causes the trust to be a grantor trust.2 However, the IRS takes the position that the power to reacquire assets does not cause grantor trust status unless in practice it is exercised in a nonfiduciary capacity. (2) Gift tax The trust in Alternative A qualifies for the gift tax marital deduction as a general power of appointment trust under §2523(e). The trust in Alternative B qualifies because it is not a terminable interest. (3) Estate tax Because Adam retains the right to direct that principal be distributed to Alice at any time, he has the right to alter or terminate the trust within the meaning of §2038(a)(1). Therefore, the trust is included in Adam's estate if he predeceases Alice. The power to invade principal for a beneficiary, unless limited by an ascertainable standard, causes the property to be included in the grantor's estate under §2038.4 However, in Alternative A, the amount includable in Adam's estate may be reduced by the actuarial value of Alice's income interest. Adam did not retain control over the timing of Alice's receipt of income in Alternative A.5 However, Madorin v. Commissioner, 84 T.C. 667 (1985); Rev. Rul. 77-402, 1977-2 C.B. 222. 2 Code §675(4). 3 Reg. §1.675-I(b)(4); PLR 200010036 (whether power to reacquire assets is exercisable in a fiduciary or nonfiduciary capacity is a question of fact that depends on the terms of trust and the circumstances surrounding its creation and administration). 4 Lober v. U.S., 74 S.Ct. 98 (1953) (holding that trusts giving senior, as trustee, the power to distribute all or any part of trust principal to beneficiaries at any time mandated inclusion in settlor's estate upon his death); Rev. Rul. 73-143, 1973-1 C.B. 143. 5 Estate of Schuithess v. U. S., 510 F.2d 617 (9th Cir. 1975); Rev. Rul. 70-513, 1970-2 C.B. 194. -2- EFTA01104590  in Alternative B, the entire value of the trust would be included in Adam's estate since he retained control over the timing of the receipt of income as well as principal. Alice's general power of appointment does not prevent the application of §2038. Had the trust been structured as a QTIP, however, the QTIP election would have precluded the application of §2038. Code §2523(0(5)(A) provides: "In the case of any qualified terminable interest property (i) such property shall not be includable in the gross estate of the donor spouse, and (ii) any subsequent transfer by the donor spouse of an interest in such property shall not be treated as a transfer for purposes of [chapter 12]." Code §2523(f)(5)(B) provides that subparagraph (A) does not apply "with respect to any property after the donee spouse is treated as having transferred such property under section 2519, or such property is includable in the donee spouse's gross estate under section 2044." If Alice predeceases Adam, her general power of appointment causes the assets of the trust under Alternative A to be included in Alice's estate.° Under Alternative B, the assets are payable to her estate and would be included in her gross estate. (4) Basis adjustment The basis of a partnership interest acquired from a decedent is the fair market value of the interest at death, less §691 items, increased by the successor's share of partnership liabilities.' Therefore, upon the death of Adam or Alice, the basis of the property becomes $2.1 million. However, §1014(e) bars a basis adjustment if the decedent acquired the asset within a year of death and bequeaths the asset to the person from whom the decedent acquired the asset. By its terms, §I014(e) is not applicable if Alice does not die within a year of Adam giving the partnership interest to the trust (or, even if Alice does die within that period, Code §1014(e) is not applicable unless the property returns to Adam). If the assets pass to a trust in which Adam has a non- discretionary interest, such as the right to receive all of the income currently, then the IRS takes the view that the actuarial value of Adam's income interest is not eligible for a basis adjustment.8 Adam's gift to the trust is complete when the transfer is made, so that the one-year period for purposes of §1014(e) begins to run when the trust is funded. Adam's power to accelerate distributions to Alice does not postpone the completion of Adam's gift to the trust. "A gift is not considered incomplete ... 6 Code §2041. Reg. §1.742-1. 8 PLR 9026036. -3- EFTA01104591  merely because the donor reserves the right to change the manner or time of enjoyment.' 9 Consequently, this trust is different from the situations in the tax basis joint revocable trust rulings, discussed at Paragraph (7) infra, where the gift is not complete until the donor spouse dies. The fact that the trust under either Alternative A or B is a grantor trust should not preclude a basis adjustment under Code §1014 when Alice dies. If Adam's deemed ownership of the assets controls for purposes of Code §I014, which would be the only reason for disallowing a basis step up upon Alice's death, then the foundation would be laid for arguing that assets in a grantor trust acquire a basis adjustment under Code §1014 upon the grantor's death whether or not the assets are included in the grantor's estate for estate tax purposes. If grantor trust status prevents a basis adjustment at the donee spouse's death, no inter-vivos QTIP trust would qualify for a basis adjustment when the assets are included in the donee spouse's estate under Code §2044. All inter vivos QTIP trusts are grantor trusts. Code §1014(b) provides that for the purposes of the basis adjustment rules, property includable in the decedent's gross estate by reason of a power of appointment and property included in the gross estate of the decedent under Code §2044 shall be considered to have been acquired from or to have passed from the decedent.10 No exception is made for trusts that are treated for income tax purposes as owned by the surviving spouse under the grantor trust rules. In PLR 9309023, a spouse conveyed one-half of her residence to an inter- vivos QTIP trust and made a QTIP election. Upon the death of the donee-spouse without exercising his limited testamentary power of appointment, the trust would continue for the benefit of the donor spouse for life. The ruling concluded that the trust would be a grantor trust as to the donor spouse both before and after the death of the donee spouse but would nevertheless obtain an adjustment to basis under Code §1014. Thus, the grantor's deemed ownership of trust assets for income tax purposes did not prevent an adjustment to basis on the donee spouse's death. (5) Income tax consequences at Adam's death before Alice The cessation of grantor trust status will not incur income tax if the §1014 basis adjustment is considered to occur immediately before the termination of 9 Reg. §25.2511-2(d). See also, Estate ofGoelet v. Commissioner, 51 T.C. 352 (1968) (distinguishing right to change time or manner of enjoyment, which does not postpone completion, from right to change the interests of beneficiaries between themselves, which renders gift incomplete, in case where settlor, as trustee, had power to distribute one beneficiary's share to other beneficiaries). 10 Code §§1014(b)(9); 1014(b)(10). -4- EFTA01104592  grantor trust status. Grantor trust status will terminate at Adam's death. This situation is no different from one where the decedent owned assets subject to debt in excess of basis either outright or in a revocable trust, and the IRS has never argued that gain is recognized at death in those situations. The general rule is that death does not cause gain to be recognized." The IRS's position is confirmed in regulations under §684, which provide that gain is not recognized at the death of the grantor of a foreign grantor trust if the trust is includable in the grantor's 12 estate. However, if basis is not adjusted at death then Reg. §1.684-3(g) Example 3 says that the grantor is treated as having transferred the property of a grantor trust immediately before his death, and, in the case of a transfer to a foreign non-grantor trust, must recognize gain at that time. In this case, by analogy since the assets would be included in Adam's estate, the basis should be adjusted immediately before his death. (6) Income tax consequences upon Alice's death before Adam (Grantor bypass trust) The Treasury regulations define the "grantor" as the person who gratuitously funds a trust. These regulations also provide that the identity of the grantor of a trust does not change unless the principal of the trust is appointed to another trust by a person's exercise of a general power of appointment." Thus, Adam remains the grantor for income tax purposes under Alternative A (general power of appointment trust) if Alice does not exercise her power. Therefore, grantor trust status may continue after Alice's death, if (a) Alice does not exercise her general power of appointment and (b) Adam survives her. If Alice does not exercise her general power of appointment, and if the provisions of the trust applicable following Alice's death include a provision that causes Adam to continue to be treated as the owner of the trust (e.g. Adam is a beneficiary), grantor trust status will continue. Code §2036 will not apply to make the assets of the bypass trust includable in Adam's estate if he is a discretionary beneficiary because he is not considered to be the transferor for gift and estate tax purposes.14 However, if under applicable state law, Adam is viewed as the transferor and therefore Adam's creditors can levy on the trust assets, the IRS could take the view that 11 "The mere passing of property to an executor or administrator on the death of the decedent does not constitute a taxable realization of income even though the property may have appreciated in value since the decedent acquired it." Footnote 73 H. Rep. No. 1337, 83nd Cong., reprinted in 3 U.S.C.C.A.N. 4017, 4331 (1954) and S. Rep. No. 1622, 83nd Cong. (2d Sess.), reprinted in U.S.C.C.A.N. 4621, 4981 (1954). 12 Reg. §1.684-3(c). 13 Reg. §1.671-2(e)(5). 14 PLR 200101021; cf. Reg. §25.2523(0-1(f), Example 11 applicable to QTIP trusts. -5- EFTA01104593  Adam had a general power of appointment.15 The definition of transferor may be different for tax law and state law purposes. Under Alternative B, the trust established by Adam terminates upon Alice's death. If Alice establishes a trust under her will that benefits Adam, Adam will not be the grantor of any such trust. He could be treated as the owner for income tax purposes of any trust established by Alice only if §678 applies. Section 678 prescribes the circumstances in which a beneficiary will be treated as the owner of trust income. For example, a beneficiary is treated as the owner of trust income if the beneficiary has the right to withdraw assets from the trust. However, if the trust is a bypass trust, it is important that Adam be considered the owner of the trust only for income tax purposes and not for gift and estate tax purposes. To accomplish this goal, Adam cannot have a right of withdrawal. However, if Alice's will establishes a bypass trust for the benefit of Adam that is eligible to be a qualified subchapter S trust as defined in §1361(d)(3), if the trustee transfers the trust assets (the partnership interest) to a newly formed subchapter S corporation, and if Adam makes the election under §1361(d) to be treated as the owner of that portion of the trust which consists of stock in an S corporation, then items of income and deduction accruing to the S corporation should be reported on Adam's income tax retum.16 If the trust continues to be a grantor trust during the period following Alice's death when Adam is still living, Adam can continue to enjoy the benefits of grantor trust status, one of which is that depreciation deductions will continue to flow through to him. In addition, Adam can pay tax on income accruing to the bypass trust from other sources, and Adam can exchange the assets in the trust for other assets of equivalent value without incurring any income tax." If he does this, then the assets purchased from the trust would again acquire a new basis upon his death. If the asset Adam purchased from the trust is stock of the S corporation, then the stock owned by him at death will acquire a new basis at that time under §1014. However, the partnership interest owned by the S corporation will not be entitled to a basis adjustment since it is not owned directly by Adam. However, if the S corporation liquidates following Adam's death, the net result is almost the same as a basis adjustment to S corporation assets. The distribution of assets in liquidation of the S distribution to Adam's estate will be treated as a sale by the corporation.18 The resulting gain flows through to the shareholder and increases 15 Paolozzi v. Commissioner, 23 T.C. 182 (1954), acq. 1962-2 C.B. 3; Rev. Rul. 62-13, 192-1 C.B. 180; cl Rev. Rul. 77-378, 1977-2 C.B. 347; PLR 199917001. 16 Code §§678(e) and 1361(d)(1)(B). 17 Rev. Rul. 85-13, 1985-1 C.B. 184. 18 See §§1371(a) and 336. -6- EFTA01104594  the shareholder's basis in the stock.I9 Because the shareholder acquires a basis in excess of the value of the assets the shareholder will receive on liquidation, the liquidation also causes the shareholder to realize a loss that offsets the gain. (7) Comparison to Tax Basis Joint Revocable Trusts In PLRs 200210051, 200101021 and 9308002, the IRS applied 1014(e) to tax basis joint revocable trusts to disallow a basis adjustment. In those rulings, spouses contributed joint and separate property to a single trust that was revocable by either of them unilaterally. The spouses also retained broad powers of appointment that did not exclude themselves as possible appointees. The IRS held that the trust assets were includable in the estate of whichever spouse died first under §§2038 and 2041. However, the IRS found that, because each spouse had the right to revoke the trust until death, no completed transfer to the other occurred until the power of revocation expired at his or her death. Consequently, even though the assets were includable in the estate of the first to die, a basis adjustment was not allowed for assets contributed by the surviving spouse if the assets passed back to the surviving spouse. As the applicable credit amount increases, the application of §I014(e) is less of an issue. If the surviving spouse's interest in the bypass trust is wholly discretionary, the basis adjustment should not be disallowed for assets passing to the bypass trust. These PLRs also concluded that (i) the gift from one spouse to the other that occurred on death when the decedent's power of revocation expired qualified for the gift tax marital deduction; (ii) the surviving spouse would not be treated as making a gift to the bypass trust; and (iii) the assets contributed by the surviving spouse that were allocated to the bypass trust fbo the surviving spouse and children would be excluded from the surviving spouse's estate upon his or her subsequent death. These rulings are questionable. The ruling that each spouse had a general power of appointment seems erroneous. A general power of appointment does not include a power exercisable only in conjunction with the creator of the power. Since each spouse had a unilateral right of revocation, the power of appointment was not exercisable without the implicit consent of the creator of the power. Thus the power would not be a general power, at least until after one of the spouses died. The rulings ignore whether the amount includable in the estate of the spouse who dies first should be reduced by the consideration furnished by the surviving spouse, who also contributed assets to the trust.20 19 See §§1366 and 1367. -7- EFTA01104595  The conclusion that the marital deduction is available for the deemed gift that occurs upon a spouse's death is questionable because the gift could be viewed 2' as made not to the spouse but to the spouse's estate. Only gifts to a spouse, not to a spouse's estate, qualify for the marital deduction. Although the rulings held that the surviving spouse would not be treated as the transferor to the bypass trust for gift and estate tax purposes, a private ruling has no reliance value. Factually, it would not be difficult to conclude that the surviving spouse was the deemed transferor for gift and estate tax purposes since his or her ownership was transitory. If state law treated the surviving spouse as the transferor, then creditors might be able to reach the bypass trust assets. See note 16 supra. In that case, the bypass trust would be includable in the estate of the surviving spouse under §2041. These rulings are attractive plans for modest estates, particularly as the applicable credit amount increases. It would be a service to the public if the IRS would issue a published ruling on tax basis joint revocable trusts so that taxpayers could rely on the rulings. B. Fixed Term NIMCRUT 1. Facts: Sam wishes to diversify out of a concentrated stock position, to defer income and benefit charity. 2. Proposal: You advise Sam to transfer an asset with a value of $100 million to a family limited partnership in exchange for three classes of interests, Classes A, B and C. Class A will be owned by Sam's LLC. It will be entitled to I% of income and losses and will be a general partnership interest. It has an initial value and capital account of $1 million. Class B will be a preferred limited partnership interest. It will have a liquidation preference of $90 million and will be entitled to a cumulative preferred return on that liquidation preference of 10% ($9,000,000 per year) payable only to the extent of partnership profits. However, the preferred return is not due until the partnership term expires. The partnership term expires in 1912/ years. The Class B interest is valued at par - $90 million — which is the amount of its capital account. Class C is a "common" limited partnership interest. It is entitled to 99% of income after the Class B cumulative preference is paid. It has an initial value (and capital account) of $9 million. Sam contributes the Class B preferred limited partnership interest to a "net income with make up charitable remainder unitrust" ("NIMCRUr). The unitrust rate is set to produce a 10% 20 See §2043. 21 But see PLR 200403094 in which the Service ruled that a husband's grant of a testamentary general power of appointment to his spouse would result in a gift that qualifies for the marital deduction if the wife predeceases the husband and exercises the power. -8- EFTA01104596 remainder. Assume that the unitrust rate is 10%. Sam has a $9 million income tax deduction for the present value of the remainder interest given to charity. (The remainder interest has a value of 10% of $90 million.) The partnership sells the asset contributed by Sam and reinvests in a diversified portfolio. The gain accruing to the partnership must be allocated in accordance with §704(c)(1)(A) of the Code. When a partner contributing an appreciated asset to a partnership transfers his or her partnership interest, the §704(c) adjustments ("built-in gain") are transferred to the transferee 22 partner. If a portion of a partner's interest is transferred, the share of built-in gain proportionate to the interest transferred must be allocated to the transferee partner.23 There is little guidance as to what "proportionate to the interest transferred means".24 A reasonable method of allocating the built-in gain would be in proportion to the capital account transferred to the transferee partner. Using this method, 90% of the gain would be allocated pursuant to §704(c) to the Class B interest conveyed to the NIMCRUT. 10% of the §704(c) gain would be allocated to Sam as the owner of the Class A and Class C interests in the partnership. That 10% gain would be offset by Sam's charitable deduction allowed on Sam's gift to the NIMCRUT. 99% of income (other than built-in gain) will be allocated to Class B interests until the amount allocated equals the Class B cumulative preference. After the Class B interests have been allocated income equal to the cumulative preference, 99% of income is allocated to Class C interests. 1% of income always will be allocated to the Class A interests. The allocations of income under the partnership agreement will be respected as long as the "substantial economic effect" standard in Reg. §1.704-1(b)(2)(i) is satisfied. Generally, an allocation has substantial economic effect if capital accounts are maintained properly and liquidating distributions to partners are made in accordance with capital accounts. Apart from the §704(c) allocation of built-in gains, the allocation of taxable income is in accordance with the partners' distribution rights. The Class B interests should be viewed as equity rather than as debt because the preference is paid only to the extent of profits and the liquidation preference is paid only if the partnership has sufficient assets to pay the preference. "Debt" is an unratified right to receive a sum certain at a fixed maturity date regardless of the debtor's income.2 The IRS could assert that the arrangement violates the anti-abuse regulations in Reg. §I.701-2. These regulations grant the IRS broad authority to attack partnerships the IRS asserts were formed or availed of with the principal purpose to reduce substantially the partners' tax liability inconsistent with the intent of subchapter K. Due to the breadth of these regulations, there never can be complete certainty that the IRS will not assert its authority to attack the 22 Reg. §1.704-3(a)(7). 23 Id. 24 See T.D. 8902, 65 Fed. Reg. 57,092, 57,094 (September 21, 2000)(preamble to Reg. §1.1(h)-1) acknowledging a lack of guidance in this area. 25 Gilbert v. Commissioner, 248 F.2d 399 (2d Cir. 1957). -9- EFTA01104597 partnership. However, the income tax reduction in this case is a result of the ownership of an interest by a charitable remainder trust, the trust must be recognized as a partner under §704(e) (because capital is a material income-producing factor) and the allocation of income to the NIMCRUT is in accordance with §704(c) and Reg. §I.704-1(b)(2). Therefore, it is hard to see how the IRS would prevail in any assertion that the partnership was abusive. For 1912/ years, the NIMCRUT has no fiduciary accounting income because no distribution is made from the partnership to the NIMCRUT. Therefore, the NIMCRUT is not required to make a distribution to Sam. The NIMCRUT defines fiduciary accounting income in accordance with state law except that under no circumstances may pre-contribution gain be allocated to income.26 Fiduciary accounting income under state law is income received by the trust, and not income allocated to the trust for federal income tax purposes. Therefore, for 191/2 years, 99% of all taxable income accruing to the partnership is "taxable" to the NIMCRUT. This income is not taxed because the NIMCRUT is tax exempt (provided that it has no unrelated business income). Sam receives no distributions from the NIMCRUT for 1912/ years. However, a make up account is maintained for Sam equal to the unitrust percentage. Sam's make up account grows because the unitrust percentage is applied to the value of the trust's assets each year. The value of the trust assets is increased by the yield on partnership assets that is reinvested at the partnership level. At the end of the term of the partnership, the NIMCRUT receives the accrued preferred return. Under the terms of the instrument, that return is allocated to fiduciary income. Under the make-up provisions of the NIMCRUT, the make up amount is paid to Sam. Sam has deferred income for almost 20 years. In 1997, the IRS announced that it was studying "whether a trust that will calculate the unitrust amount under §664(d)(3) [a NIMCRUT] qualifies as a §664 charitable remainder trust when a grantor, a trustee or a beneficiary can control the timing of the trust's receipt of income from a partnership or a deferred annuity contract to take advantage of the difference between trust income under §643(b) and income for federal income tax purposes for the benefit of the unitrust recipient."27 The IRS will not issue rulings with respect to charitable remainder trusts that own partnership interests.28 However, the issuance of further guidance on this subject is not on the IRS business plan. The grantor does not control the timing of receipt of income where the timing of the payment of the preference is mandated by the terms of the instrument. Therefore, the arrangement falls outside of the suspect category of NIMCRUTs. 26 See, Reg. §1.664-3(a)(1)(i)(b)(4) providing that post-contribution gain but not pre- contribution gain may be allocated to income. 27 Rev. Proc. 97-23. 28 Rev. Proc. 2003-3. -10- EFTA01104598  The arrangement described above should be valid because it does not compromise the policy that underlies §664. The NIMCRUT in the example does not diminish the value of the charity's remainder interest, which cannot be less than the original value of the trust principal. The preference will be paid only to the extent of partnership income, which cannot include gains representing pre-contribution value. The fact that the grantor also benefits from the arrangement is permitted because the grantor is a beneficiary and permitted to benefit. For example, in PLR 9825001, the IRS ruled that a NIMCRUT funded with a deferred annuity contract did not adversely affect the trust's qualification as a charitable remainder unitrust and was not an act of self-dealing under §4941 even though the annuity arrangement allowed the beneficiary to defer income. If Sam made a gift of the Class C interest to his descendants, the value of the interest given may be subject to Chapter 14 special valuation rules because Sam has retained indirectly the right to receive a preferred return from the NIMCRUT.29 C. Selecting a Situs 1. Facts: Jonathan is a resident of New York but he has a relative who is a resident of Alaska. Jonathan would like his estate and the trusts under his will to escape paying income taxes in New York. Alaska would not impose an income tax on Jonathan's estate or any trust under Jonathan's will. 2. Proposal: Jonathan names his brother, a resident of Alaska, as his executor and as trustee of the trusts under his will. Jonathan's will specifies that his estate will be probated in Alaska and that the situs of his testamentary trusts is Alaska. Alaska will take jurisdiction of Jonathan's estate and will not impose income tax on Jonathan's estate or trust. New York income taxes will be avoided. Alaska has adopted a statute that allows non-residents to probate their estates using Alaska probate courts provided that there is an individual or corporation resident in Alaska serving as an executor. Alaska Stat. §13.06.068. Alaska also does not tax the income of trusts established by nonresidents. State income taxes also may be avoided by establishing irrevocable inter-vivos trusts having a situs in states that do not impose income tax on the undistributed trust income. The same result may be obtained, following the grantor's death, from using a revocable trust. The chance of avoiding income tax in the grantor's state of domicile is increased if the trust does not receive additions from the probate estate administered in the decedent's state of residence. Some jurisdictions, such as the District of Columbia and Connecticut, by statute assert the right to tax inter-vivos and testamentary trusts established by persons who are residents regardless of whether the jurisdiction has any other contact with the trust. This assertion of taxing jurisdiction survives the grantor-resident's death. Both laws were recently challenged on 29 See §2701(e)(3) attributing ownership through trusts. -11- EFTA01104599 constitutional grounds." The trustees argued that there was not a sufficient connection with the jurisdiction of the grantor's residence to justify taxing the income of the trusts under either the due process or commerce clauses of the Constitution. The Constitutional arguments failed.3I However, in both cases, each of the trusts had a connection to the taxing jurisdiction in addition to the residence of the grantor that supported the right of the District of Columbia and Connecticut to tax the income of the trusts. Importantly, the District of Columbia case, in footnote 11, reserves judgment on the constitutionality of the assertion of jurisdiction to levy tax where the trust had not availed itself of the right to resort to local courts. We express no opinion as to the constitutionality of taxing the entire net income of inter vivos trusts based solely on the fact that the settlor was domiciled in the District when she died and the trust therefore became irrevocable. In such cases, the nexus between the trust and the District is arguably more attenuated, since the trust was not created by probate of the decedent's will in the District's courts. An irrevocable inter vivos trust does not owe its existence to the laws and courts of the District in the same way that the testamentary trust at issue in the present case does, and thus it does not have the same permanent tie to the District. In some cases the District courts may not even have principal supervisory authority over such an inter vivos trust. The idea of fundamental fairness, which undergirds our due process analysis, therefore may or may not compel a different result in an inter vivos trust context.32 Therefore, there remains the possibility that residents of high tax jurisdictions may be able to move the situs of their trusts and of their estates to friendlier jurisdictions. D. Avoiding §684 1. Facts: Hal is the grantor of a foreign trust. Although the trust is administered in the U.S. by a U.S. trustee, it is classified as foreign under the "hair trigger" rules of §7701(a)(31) because a non-U.S. person has the right to remove and appoint trustees. The trust is a grantor trust for income tax purposes while Hal is alive because Hal is a U.S. grantor and the trust has U.S. beneficiaries. §679 makes a foreign trust a grantor trust if the trust has a U.S. grantor and U.S. beneficiaries. However, the trust is not includable in Hal's estate for federal estate tax purposes. Therefore, upon Hal's death, when the trust ceases to be a grantor trust, §684 would apply. §684 causes gain to be realized when the U.S. grantor of a foreign grantor trust ceases to be treated as the owner of the trust at his/her death unless the assets acquire a new basis under 30 District of Columbia v. Chase Manhattan Bank, 689 A.2d 539 (D.C. App. 1997); Chase Manhattan Bank v. Gavin, 733 A.2d 782 (Conn. 1999), cert. denied, 528 U.S. 965 (1999). 31 See Gavin, at 205, 206. 32 District of Columbia v. Chase, at 547, n I1. -12- EFTA01104600 §I014.33 If the assets do not acquire a basis under §1014, then the grantor is treated as having sold the assets immediately prior to death.34 2. Proposal: Hal creates a second irrevocable trust that is a U.S. trust and gives the trustees of the U.S. trust the unrestricted right to withdraw assets from the foreign trust. This right of withdrawal makes the U.S. trust the owner of the foreign trust assets under §678, but only after Hal's death. A trust will be treated as the owner of another trust to the extent it has the power to withdraw that trust's assets.35 For so long as Hal is alive, §678(b) provides that the grantor, and not the beneficiary who has powers of withdrawal, shall be treated as the owner of the income of the trust. For purposes of subpart E of Subchapter J, "income" not otherwise defined means taxable income and not fiduciary income.36 Therefore, fiduciary accounting income as well as income allocable to corpus is deemed to be owned by Hal. However, upon Hal's death, §684 should not apply because a U.S. trust, rather than a foreign trust, is now deemed to own the trust assets. Following Hal's death, if the trustees of the U.S. trust are directed to sell the assets and distribute the proceeds to a foreign person (which may include a foreign trust), the income realized by the U.S. trust is deductible under §661. As long as the income is not the sort of income that is taxable to non U.S. persons, the income realized by the U.S. trust is not taxable to the foreign beneficiaries of the U.S. trust. The character of the income realized by a foreign beneficiary determines whether it is subject to U.S. income tax.37 Therefore, in some circumstances, the unrealized appreciation would not be taxed. E. Springing Charitable Remainder Trusts 1. Facts: Earl, a young single computer entrepreneur, funded a highly successful GRAT for the benefit of his parents. The annuity term has expired. The trust holds a concentrated position in the stock of Earl's company which stock has a very low basis. Earl also has a significant number of shares of the same low basis stock. Earl would like to diversify his holdings and the holdings of the trust but is concerned about the tax cost. 2. Proposal: The GRAT remainder trust is a grantor trust. A selector has the power to add charities as beneficiaries and the trustee has the power to create and fund a charitable remainder trust for the benefit of any of the beneficiaries. 33 Reg. §1.684-3(c). 34 Reg. §1.684-3(g) Example 3. 35 Reg. §1.671-2(e)(6) Example 8. 36 See Reg. 1.671-2(b)("[W]hen it is stated in the regulations under subpart E that 'income' is attributed to the grantor or another person, the reference, unless specifically limited, is to income determined for tax purposes and not to income for trust accounting purposes.") 37 Martin-Montis Trust v. Commissioner, 75 T.C. 381 (1980), acq. 1981-2 C.B. 2 (1981). -13- EFTA01104601  The trustee exercises the power to fund a charitable remainder trust. Earl benefits from a charitable contribution deduction for the value of the remainder interest. The charitable remainder trust is tax exempt. The annuity payments to Earl's parents are taxable to them rather than to Earl, but not until payments are made. The grantor trust may establish a split interest trust because the assets are deemed owned by the grantor until conveyed to the transferee trust. Although a charitable remainder trust must be qualified under §664 from inception, the trust's inception occurs when it ceases to be a grantor trust.39 A deduction is allowed to the grantor under §170 for the value of the interest given to charity. A grantor is allowed a deduction for charitable gifts made by a grantor trust.39 A charitable remainder trust could not be funded from a non-grantor trust. Although a non-grantor trust is allowed a deduction for amounts distributed to charity in accordance with §642(c), Reg. §1.664-1(a)(iii)(a) provides that a trust is not a charitable remainder trust unless a deduction under §§170, 2055 or 2522 was allowed for the transfer. If Earl's trust were not a grantor trust, it might be changed to become a grantor trust to facilitate funding a charitable remainder trust, provided that the trustee's powers were broad enough to permit it. F. Assets Subject to Liabilities in Excess of Basis in Trust 1. Facts: John is the primary beneficiary of a trust which upon his death will continue for the benefit of his descendants. John has a limited power of appointment, and the assets will pass to his descendants free of federal estate tax. The primary asset held by the trust is an interest in an office building which has a basis and a value of $100 million but is subject to a liability of $120 million. Therefore, the net value is zero and the "negative basis" is $20 million. John is concerned that upon his death, his children will inherit an asset with a potential income tax liability of $5 million or more. 2. Proposal: If John can exercise the limited power of appointment to spring the so- called "Delaware tax trap" under §2041(a)(3), then the assets will be included in John's estate and acquire a new basis, thereby relieving his descendants of this potential income tax burden. §2041(a)(3) applies if a power of appointment created after October 21, 1942 is exercised to create another power of appointment which, under the applicable law, can be validly exercised so as to postpone the vesting of any estate for a period without regard to the date of the creation of the first power. The exercise of a limited power of appointment to create an immediately exercisable general power of appointment may spring the trap. The exercise of a general power of appointment usually starts the running of a new perpetuities period. Suppose, however, that John's trust expressly prohibits the exercise of the power of appointment to expose the trust to estate tax under §2041(a)(3). Is there another solution? Assume that the trustee has the power to invade principal in favor of John. If the interest in the 38 Reg. §1.664-1(a)(4). 39 Reg. §1.671-2(c). -14- EFTA01104602 building is distributed outright to John (so that it will be taxable in his estate), what are the tax consequences? The general rule is that gain is not recognized when assets are distributed to a beneficiary of a trust unless the trustee elects to do so.4° There is another general rule, however, that gain is realized when a partnership interest is transferred and the transferor's share of partnership liabilities is reduced.41 There is no express exception for trust distributions. If §643(e) did not exist, a distribution of a partnership interest could trigger gain as a result of the partnership provisions. Authorities disagree on which statute prevails. One author states, "[Mote the significance of the lack of cross reference to subchapter K and the absence of pertinent regulations or rulings as in §§752 and 1001 to suggest that §643(e) is not predominate for distributions by a fiduciary, resulting in no 'triggering' of income from debt relief on such a distribution."4 Another author states, "[I]t seems that an otherwise tax-free distribution by an estate or trust of a partnership interest constitutes a sale or exchange to the extent that the estate is treated as having realized partnership liabilities under