As part of our ongoing efforts to keep wealth management professionals informed of recent developments related to our practice area, we have summarized below some items we think would be of interest. Please let us know if you have any questions.
January AFR at All Time Historic Low for GRATs, QPRTs and Split Interest Charitable Trusts
The January applicable federal rate (AFR) for use with CRTs, CLTs, QPRTs and GRATs is 2.4%. This is a decline from December. Remember that lower rates work best with GRATs and CLATs. And, because of a special rule in the Internal Revenue Code, a taxpayer can elect to use the most favorable rate for a three month period with respect to a CLAT. Thus, given the strong possibility that income tax rates will go up in 2009, it makes sense to fund a grantor type CLAT in the first quarter of 2009, in order to obtain a 2009 income tax deduction and take advantage of the historically low January interest rate (if rates rise after January, an election may be made in February or March that will allow you to use the January rate) and higher income tax rates. Keep in mind that it is possible that rates will continue to drop.
The AFRs used in connection with intra-family loans are .81% for loans less than 3 years, 2.06% for loans less than 9 years and 3.57% for long-term loans. Thus if a $1 million loan is made to a child and the child can invest the funds and obtain a 5% return, the child will be able to keep any returns over the mid-term AFR of 2.06%. These same rates are used in connection with sales to defective grantor trusts.
Exit Strategies for “Underwater” GRATs
Given the recent downturn in the financial markets, many clients are saddled with “underwater” grantor retained annuity trusts (GRATs)—those having assets that have performed so badly that it is likely that, after paying the grantor his or her annuity, there will be nothing remaining in the GRAT for its remainder beneficiaries. If the grantor expects the GRAT to perform better in the future, rather than leaving those assets in an unsuccessful GRAT, it may make sense for the grantor to remove those assets from the unsuccessful GRAT and contribute them to a new GRAT using this month’s historically low AFR. Although the IRS has not provided guidance on this issue, the following may be some available strategies for exiting the unsuccessful GRAT. If the terms of the GRAT instrument give the grantor a power of substitution (i.e., a power to reacquire trust assets in exchange for assets of equal value), the grantor can reacquire the GRAT assets in exchange for other assets that the grantor does not expect to perform as well. If the grantor does not have a power of substitution, or the grantor does not have readily available assets to substitute, he or she may consider purchasing the GRAT assets in exchange for an interest bearing promissory note. Each time an annuity payment is due, it would be satisfied by having the GRAT distribute the note, or a portion of the note, to the Grantor, who would then let the note lapse.
Extension of Interim Guidance on Bundled Fiduciary Fees – Notice 2008-116, 2008-52 I.R.B. ________ (Dec. 29, 2008)
In Notice 2008-116, the IRS issued interim guidance addressing the treatment of “Bundled Fiduciary Fees”—that is, investment advisory fees and other costs that are integrated as part of one commission or fee paid to a trustee or executor. On January 16, 2008, the U.S. Supreme Court issued its decision in Knight v. Commissioner, 101 AFTR 2d 2008-544, 128 S. Ct. 782 (2008), holding that Bundled Fiduciary Fees are subject to the 2% floor on miscellaneous itemized deductions under Internal Revenue Code Section 67(e), rather than their being fully deductible. The IRS and the Treasury Department expect to issue regulations consistent with the Supreme Court’s holding in Knight. The regulations will also address the issue raised when a nongrantor trust or estate pays a Bundled Fiduciary Fee for costs incurred in-house by the fiduciary, some of which are subject to the 2% floor and some of which are fully deductible. However, the regulations will not be issued in time to apply for the 2008 tax year. Therefore, in Notice 2008-116, the IRS provided that taxpayers will not be required to determine the portion of a Bundled Fiduciary Fee that is subject to the 2% floor for any taxable year beginning before January 1, 2009. Instead, for such taxable year, taxpayers may deduct the full amount of the Bundled Fiduciary Fee without regard to the 2% floor.
Regulations Made Final for Reporting Certain Employer-Owned Life Insurance Contracts. – Treas. Reg. §1.6039I-1, T.D. 9431; 73 F.R. 65981-65982 (Nov. 6, 2008)
The IRS has made final temporary regulations issued in November 2007 which set forth reporting requirements for employer-owned life insurance. The regulations were intended to prevent perceived abuses of employer-owned life insurance, where employers were insuring the lives of low-level employees, often without their consent or knowledge. The regulations provide that every employer owning one or more employer-owned life insurance contracts issued after August 17, 2006 must file a Form 8925 with its income tax return providing:
(1) The number of employees of the applicable policyholder at the end of the year;
(2) The number of such employees insured under such contracts at the end of the year;
(3) The total amount of insurance in force at the end of the year under such contracts;
(4) The name, address, and taxpayer identification number of the applicable policyholder and the type of business in which the policyholder is engaged; and
(5) That the policyholder has a valid consent for each insured employee (or, if such consents are not all obtained, the number of insured employees for whom such consent was not obtained).
Estate Entitled to Refund Due to Informal Claim Doctrine – L.S. Wilshire Estate, DC Ohio, 2008-2 USTC ¶60,569
An estate was entitled to a refund for the overpayment of estate tax because the executor had made an informal claim for refund prior to the expiration of the statute of limitations, which was later perfected by a formal claim. The decedent died in September 2000. Her will explicitly stated that charitable bequests should not be charged with the payment of estate taxes. The executor filed the estate’s Federal estate tax return with a note explaining that the charitable deduction was interrelated with the taxes due and that an amended return would be filed upon the completion of the calculation. In November 2001, the executor filed the amended return; however, the accountants incorrectly charged the charitable bequest with the tax. Over the next two years, the executor made informal written and oral requests for a refund; however, no formal claim was made until 2004, after the close of the statute of limitations for bringing the refund claim.
The court held that a notice fairly advising the IRS of the nature of the taxpayer’s claim, which the IRS could otherwise reject because it does not comply with formal requirements, will nevertheless be treated as a claim, where the formal defects are remedied by an amendment after the lapse of the statute of limitations. An informal claim exists where the facts and circumstances demonstrate that the IRS was on notice that the taxpayer was asserting its right to a refund. Here, the court determined that the executor’s informal written and oral requests for a refund put the IRS on notice of the estate’s asserted right to a refund. Accordingly, the estate was entitled to the refund.
Substitution Power Did Not Cause Trust to Fail to Qualify as GRAT – PLR 200846001 (Nov. 14, 2008)
Private Letter Ruling 200846001 considered the gift and income tax implications of a grantor’s retained power of substitution with respect to a GRAT. The grantor held such power in a fiduciary capacity and proposed to exercise the power from time to time by transferring into the GRAT stock in one publicly-traded company in exchange for that of another publicly-traded company. The IRS held that the grantor’s retention of the power of substitution did not cause the trust to fail to qualify as a GRAT, and the exercise of the power would not constitute a gift for gift tax purposes. From an income tax perspective, the IRS held that the exercise of the power of substitution would not cause the recognition of gain or loss, and the GRAT constituted a grantor trust both before and after the expiration of the GRAT annuity term.
Broad Discretionary Distribution Standard in Spendthrift Clause Did Not Constitute General Power of Appointment – TAM 200847015 (Nov. 21, 2008)
In Technical Advice Memorandum 200847015, the IRS considered whether a broad discretionary distribution standard in a trust’s spendthrift clause effectively gave a beneficiary-trustee a general power of appointment. During her life, Decedent was the trustee and income beneficiary of a bypass trust created in her late husband’s will. The will provided that Decedent could pay income and principal to herself for her health, support and maintenance. The will also contained a spendthrift provision, which provided that when the trustee deems appropriate to carry out the sprit and purpose of the spendthrift clause, payment to the beneficiary could be discontinued and, in lieu thereof, the trustee could expend for the account of such beneficiary and for his or her support, comfort, happiness and welfare, such amounts as would otherwise be paid over directly to such beneficiary. The IRS auditor argued that the spendthrift provision’s broader distribution standard of support, comfort and maintenance effectively granted Decedent a general power of appointment.
The National Office disagreed, finding that the broader distribution standard applied only if the beneficiary triggered the spendthrift provision—for example, by attempting to assign the trust interest to a third party, or if a third party attempted to execute against the trust interest. At the time of Decedent’s death, there was no indication that she met any criteria that would trigger the spendthrift provision. Therefore, because the exercise of the broad distribution power was contingent on circumstances that did not actually take place, Decedent did not possess a general power of appointment upon her death.