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IRS Studies Augur a New Age in Estate Planning: Change Your Practice or Become Obsolete

IRS Studies Augur a New Age in Estate Planning:
Change Your Practice or Become Obsolete

by Keith Schiller, Esq.
Schofield & Schiller
Walnut Creek, CA

"Look at the facts, they look at you." Winston Churchill

INTRODUCTION

Tax-motivated estate planning will shift its focus during the next few years, whether or not the estate tax is repealed. The challenge for practitioners will be to adapt their tax practices to the increasing relevance of income tax issues in estate planning and to remain focused on the supremacy of non-tax considerations in the estate planning process.

The most direct threat to the estate tax system is its outright repeal. Yet, regardless of formal repeal, the estate tax will become irrelevant, drawing its quiet breath 1 for even the substantially wealthy. The Economic Growth and Tax Relief Reconciliation Act of 2001 ("2001 Tax Act") ushers in a new age in estate planning, reduces estate tax return filings to a trickle, and requires reconsideration of a range of estate planning strategies.

At its most basic, the 2001 Tax Act increases the applicable exclusion amount to $1.5 million for estates of those dying in 2004 and 2005, to $2 million for those dying between 2006-2008, and to $3.5 million for those dying in 2009, before it returns to pre-2002 levels in 2010. Neither the Democrats nor the Republicans desire a return to the prior law. The generation-skipping transfer tax (GST) exemption will mirror the applicable exclusion amount after 2003. The gift tax applicable exclusion amount remains at $1 million, although the annual exclusion ($11,000 in 2003) will continue to be adjusted for inflation.

It is not being suggested that estate planning practices will die Rather, the nature of estate planning and administration services will change, while estate tax compliance requirements will fall to a trickle and the assumptions and expectations that underlie much of current tax planning will radically change. These conclusions become evident upon evaluation of two significant studies of estate tax return filings conducted by the Internal Revenue Service.

The first study (the "1998 Return Study"), by Barry W. Johnson and Jacob M. Mikow, reviewed federal estate tax returns filed between the years 1998 and 2000, with emphasis on returns filed in 1998. 2 The second study (the "Projection Report"), was prepared for the Internal Revenue Service by the National Office of Research Headquarters by Terry Manzi under the supervision of Rusty Geiman, Chief, Projections and Forecasting Group and predicts tax return filings, including estate and gift tax returns, 3 through 2010. These studies have significant implications for estate planning practices and reflect the fact that a repeal of the estate tax system would benefit relatively few estates subject to estate tax (about 10,000 estates or less per year).

The 1998 Return Study divides estate tax returns among six categories of gross estate: $600,000 to $1 million; over $1 million to $2.5 million; over $2.5 million to $5 million, over $5 million to $10 million; over $10 million to $20 million; and over $20 million. In the year 2000, there were 108,322 estate tax returns filed, of which 52,000 (about 48%) were taxable returns. Non-taxable returns were attributable to claimed charitable or marital deductions, debts, administration expenses, credits or losses. The most significant deduction claimed was the marital deduction.

Of the 52,000 taxable returns, 16,634 reported gross estates under $1 million. Due to the increase in the estate tax exemption equivalent under the 2001 Tax Act, none of these 16,634 returns would have been required had these deaths occurred after 2001. For the same reason, an additional 23,827 returns for gross estates under $2.5 million would not have been required had the deaths occurred in 2009. Thus, 40,461 (or 77.8%) of the 52,000 taxable estates from 2000 would not have had to file returns if they were for decedents dying in 2009, leaving approximately 9,538 taxable estates with gross assets over $2.5 million. Of this group, a sizable portion were likely under $3.5 million in gross assets, and would not have to file a return.

The 1998 Return Study does not distinguish between estates that are over or under the $3.5 million applicable exclusion amount in 2009 under the 2001 Tax Act. From the standpoint of cost-of-living comparison, the $2.5 million threshold in the 1998 Return Study adjusted for inflation by 3% annually between 1998 and 2009 produces an equivalent of approximately $3.5 million. The 9,538 taxable estates with assets over $2.5 million in the 1998 Return Study reflect an average gross estate of $8.28 million.

Table 1 reflects the estimate for future estate tax return filing through 2010 in the Projection Report. This study considers changes in estate tax law and the cost of living. The number of returns reported for each year does not identify the year of death. All estate tax returns filed are reflected in the year of filing rather than in the year of death regardless of whether or not the return was or will be timely or late. Accordingly, timely-filed returns for a given year will include some deaths in that year as well as returns from deaths in the prior year or even from the second preceding year (if death occurred in the last three months and the return is under extension). Increases in the estate tax exemption equivalent will be reflected over three calendar years, with the largest statistical grouping for any year of death reflected for returns filed in the next calendar year.

Table 1: Number of Returns Filed, or to Be Filed, with the IRS, Calendar Years 2001 -- 2009

(Numbers of returns in thousands)

Type of Return:

Actual

Estimate

-----------------------Projected-----------------------

Year

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Estate Tax

122

125

78

83

66

70

49

51

54

20

Gift Tax

304

255

274

285

296

306

315

323

331

340

It may be concluded from these projections that: (1) estate tax return filings will decline by 84% (125,000 to 20,000) from 2002 to 2009; (2) fewer than 10,000 taxable returns will be filed in 2010 if the ratio of taxable estates to total estate tax returns filed remains consistent with the ratio (48%) from the 1998 Return Study (20,000 times 48% = 9,600). At that rate, the practitioner who announces to a conference that he or she prepared three taxable estate tax returns for the year may receive applause for such an active compliance practice. Similarly, IRS estate tax attorneys will need to retrain for other tax auditing skills or audit many more gift tax returns to stay busy even if the estate tax is not repealed.

The Projection Report predicts a significant increase in gift tax returns, from the 2002 estimated filing of 255,000 to 331,000 in 2009 and 340,000 in 2010. However, the Service has not conducted a study of the types of gifts that will trigger these filings, nor has the Service considered the extent to which taxpayer concerns with the possibility of estate tax repeal and the benefit of making adequate disclosure on gift tax returns in order to prevent re-opening issues on estate tax audits encourages gift tax filing. It is unclear whether the elimination of the estate tax would reduce gift tax compliance and, therefore, the accuracy of the Service's estimate of long-term filing.

Expanded Return Filings if Estate Tax Is Repealed

Although the focus of this article is on the compliance and planning implications of a virtually irrelevant estate tax for all but a select number of estates due to the increase in the exemption equivalent amount and the resulting income tax considerations, it is noteworthy that a permanent repeal of the estate tax along the lines of that under the 2001 Act will greatly increase the tax filing requirements for the general public. A repeal would hardly amount to any tax simplification, except for the 20,000 or so decedents' estates to which estate tax will be relevant after 2009.

The modified carry-over basis scheme under §1022 implements a new informational estate tax return, backed up with stiff non-compliance penalties, for estates with values in excess of $1.3 million. 4 With modest inflation, this should cause 150,000 or more informational returns to be filed for the year 2011 with respect to deaths occurring in 2010, an increase of about 750% over the number of filings that would have been required under the final year of the estate tax system in 2009. Section 6018(c) requires, among other, disclosure of the adjusted basis and the fair market value of the decedent's property at the time of death. Taxpayers and their representatives will be making every effort to ensure that estate assets receive the largest increase in basis that can be substantiated, at least to the extent of the $1.3 million/$3 million and principal residence basis step-ups that the modified carryover basis system will allow.

PLANNING AND PRACTICE IMPLICATIONS OF THE INCREASE IN THE EXEMPTION EQUIVALENT AMOUNT

The effect of the increases in the estate tax filing threshold reverberates throughout the estate planning practices of professionals and affect strategic considerations for their clients. Significant non-tax considerations, such as the challenges of fairness and family protection created by multiple marriages, business succession and control issues associated with closely-held business planning, concerns with proper management of assets, creditor concerns, wealth transfer, family values, and concerns with overreaching in-laws (or ex-in laws) will present ongoing planning opportunities. However, the tax strategies that have driven much estate planning will become obsolete or will change, requiring a reconsideration of past expectations and assumptions.

Valuation strategies and their consequences are the threshold issue of this changing dynamic. Valuation decisions have consequences beyond estate tax. Traditionally, clients were satisfied with the trade-off which lowered the amount of the basis step-up on death in exchange for reduced estate tax. Once fewer estates become subject to estate tax, most will receive no benefit in exchange for the lower income tax basis. Tax strategies that have been geared to reducing estate tax will have declining or no utility as the estate tax fades, if it does not vanish.

The impact of the increase in the estate tax exemption equivalent amount will not be felt at once. Rather, it will be felt gradually with the increase in tax-free estates during the next three years. Individuals or couples with little or no expectation of dying with an estate in excess of the exemption equivalent amount will not be likely to need or want a tax-motivated credit shelter trust. Estate administration will be greatly simplified for clients with estates under the increasing exemption equivalent amount. Estate distribution may be completed within a few days or a few weeks after a decedent's death without the delay of estate tax filing in this increasing number of large estates, assuming the absence of creditor or beneficiary disputes.

As clients become less concerned with estate tax strategies, their focus will turn to income tax planning for wealth transfers. Therefore, practitioners will need to reconsider estate planning strategies which have been popular in recent years. Valuation determinations are a central issue in this re-evaluation process.

Judgments reached by accountants, appraisers and attorneys influence real-dollar results in business dealings, the estate tax and the income tax. The value conclusion within any one of these three arenas is not necessarily compatible with the others. For example, valuation discounts may be desirable to save estate taxes. However, that same valuation may not be desired as the basis of a business transaction between unrelated parties if the discounts are hypothetical rather than based on actual business considerations of the particular situation. Similarly, estate tax valuation reductions provide a lower income tax basis adjustment on death when compared to non-discounted values. If estate taxes are irrelevant, heirs would prefer a higher valuation resulting in income tax savings because of the availability of greater depreciation deduction and/or lower capital gains tax on a later sale.

Supremacy of the Business Deal (Non-Tax Considerations)

While attention to the importance of non-tax considerations is a fundamental principle of estate planning, the uncertainties of future estate tax law and the decreasing significance of estate tax to most estates make this principle even more central. Ideally, tax planning is coordinated with the non-tax desires of the client. This principle animates estate planning and business agreements (e.g., buy-sell agreements, leases, employment agreements and shareholder agreements). A tax-motivated plan may become a relationship disaster. The focus should not shift from these non-tax considerations, regardless of the tax regime in place.

Within this framework of real economics, the formula clauses used in agreements to determine valuation assume increasing significance. The supremacy of the business deal over the tax results is nothing new. However, the gap between the deal and the tax effect will widen with the shrinking estate tax for most taxpayers currently affected by estate tax.

With this in mind, practitioners should be careful while drafting business agreements to ensure that drafting terminology does not create unanticipated results. In the context of a partnership or corporate buy-sell agreement, the valuation of a minority interest will entail the application of minority valuation discounts, marketability discounts and other valuation reductions common to estate tax practice. When estate tax becomes less significant, are these valuation adjustments desirable?

If the transferor owns an undivided interest in real property, are fractional interest discounts intended or desired? If the agreement pertains to an interest in an entity, is the application of marketability and minority discounts intended? If the transferor owns a controlling interest, will his or her interest receive a greater value because of a control premium? Depending upon the age differences of the members or owners, the relationship (family or professional), and the dynamic (friendly or strained), the parties may embrace or reject the application of discounts. 5

Impact of Estate Tax Reform or Repeal on Valuation Strategies

Taxpayers face three transfer taxes: estate tax, gift tax, and generation-skipping transfer (GST) tax. The higher rates attendant to these transfer taxes and the payment of these taxes prior to a recognition event (i.e., a sale or exchange) have encouraged taxpayers to seek lower valuations for estate or gift tax savings at the expense of greater capital gains upon the later sale of the asset. The reduction of the capital gain rates under the 2003 tax legislation encourages that approach as well for taxpayers whose estates remain subject to potential estate or GST tax. For taxpayers whose estates fall below the estate tax (or GST tax) filing thresholds, the tradeoff against the capital gains tax will become irrelevant. The capital gains tax for decedents' estates which are not subject to estate tax, and for their beneficiaries, will remain of greater concern.

In this environment, valuation reductions will have a negative impact in situations in which the estate tax is irrelevant. While that concept is not new, the span of its reach certainly is unique. As estate exemption equivalent amounts increase, the capital gains and income tax consequences (i.e., the downside of discounts ) will become even more important. Apart from the tax consequences of valuation determinations, their non-tax effects will be even more significant, particularly in the context of buy-sell provisions or other terms setting value in business and property ownership agreements.

Case law reflects that certain methods of ownership of property will have differing effects on valuation. For example, there is no fractional interest discount with joint tenancy property passing by right of survivorship, 6 while community property that does not pass by right of survivorship or property owned as tenancy in common is eligible for fractional interest discounts. 7 C corporations with built-in gains will most likely receive deeper discounts than S corporations with the same business and built-in gains. 8 Assets held by properly established and operating partnerships generally qualify for deeper discounts than do assets owned outright, including real estate, when minority interest valuation principles apply. 9

Traditional estate planning discount strategies create problems in the following areas: (1) reduced income tax basis due to lower estate tax value; (2) valuation discounts on the death of the first spouse; (3) basis adjustments under partnership income tax rules; (4) valuation of assets for funding marital deduction and charitable deduction shares; and (5) funding pecuniary bequests.

In addition, practitioners will need to consider the disallowance of losses on sales to related parties as well as the provision for ordinary income tax treatment, not capital gains treatment, on the sale of certain types of property (depreciable property or interests in partnerships that own depreciable property and dividend treatment on certain redemptions in family corporations).

General Rule: Estate Tax Valuation Establishes Basis for Income Tax Purposes

Estate tax planning often involves the trade-off of higher income taxes, the payment of which may be delayed until the asset is sold, for the benefit of lower estate tax (imposed at higher rates and immediately payable). Under §1014, the basis of property in the hands of a person who acquired it from a decedent is the fair market value of the property at the date of the decedent's death or at the estate valuation date (if alternate valuation is elected). Under the regulations, the value of property as of the date of the decedent's death as appraised for the purpose of the Federal estate tax is its fair market value. 10

Revenue Ruling 54-97 states that a rebuttable presumption exists that the estate tax value applies for income tax purposes as well. 11 In TAM 199933001, the Service concluded that a taxpayer was not estopped from reporting the basis of stock in a closely-held corporation inherited from a decedent differently from the fair market value used in calculating the tax on the decedent's estate when the taxpayer was not involved in reporting the valuation for estate tax purposes. In the ruling, the taxpayer used the same attorney as the one who represented the estate, but the taxpayer was not an executor of the estate nor involved with the preparation of the estate tax return.

Consistency of Value at Death of Both Spouses

Taxpayers often seek asset valuation discounts when estates are taxable, such as upon the death of the surviving spouse, but prefer to ignore discount principles when valuation reductions do not suit their goals, such as on the death of the first spouse, whose estate is non-taxable. For example, if a husband and wife each own an undivided one-half interest in real estate or a minority interest in a business, do not the same principles that later support a discount on the death of the surviving spouse apply as well on the death of the first spouse? Since the abolition of the family attribution rule, discounts apply notwithstanding a close relationship between decedent/donor and the heir/donee. 12

In the context of the death of the first spouse, or any partial-interest owner, the Service is reasonable in asserting that a consistent approach should apply to discounts. Of course, taxpayers should hold the Service to the same standard. Apart from this concept of fairness, the question may be asked whether or not a duty of consistency applies to valuation in both the non-taxable estate of the first decedent and the taxable estate of the surviving spouse.

As a legal principle, the doctrine of consistency has not been imposed to require similar valuation practices in the estates of different taxpayers. In Cluck Est. v. Comr. 13 and Letts Est. v. Comr., 14 the consistency duty was applied to require the executor to include property in the surviving spouse's gross estate that was deducted in the estate of the deceased spouse despite failure to qualify for a QTIP election.

While there are no reported cases that apply the duty of consistency to valuation practices in different estates, estates which do not take discounts in the estate of the first spouse to die may face a more difficult audit in the estate of the surviving spouse. In Jameson v. Comr., 15 the court indicated its displeasure with the fact that stock had been valued significantly higher in the estate of the predeceased spouse than it was in that of his widow who died a year later.

The imposition of discounts in the non-taxable estate received an indirect boost from the Tax Court, which required the Service to respect separate trusts as distinct ownership interests for valuation purposes. In Mellinger Est. v. Comr., 16 the Tax Court respected the QTIP marital trust and the widow's survivor's trust as separate entities for valuation purposes. As a result, minority interest discounts were respected. The Mellinger approach was further advanced in Nowell Est. v. Comr. 17 (rejecting aggregation of family limited partnership interests held in trust [non-exempt QTIP Trust (17.78% general partnership interest); exempt QTIP Trust (8.72% limited partnership interest); revocable trust (60.41% limited partnership interest); and Trust E (13.07% limited partnership interest)] and Lopes Est. v. Comr. 18

IRS estate tax attorneys cannot "force" an estate to take a discount on a non-taxable estate tax return. However, they can report the issue to the income tax auditors, who may point to the discounts to assert a lower basis for income tax purposes.

Applying these considerations to real estate, practitioners should consider whether or not joint tenancy ownership or community property ownership with right of survivorship is preferable to tenancy in common or community property in the ownership of real property. Of course, the non-tax considerations are paramount. No form of automatic outright transfer would be attractive for a client who did not want the recipient to have complete control over the inheritance. Will fractional interest discounts be a help or a hindrance to the wealth transfer plan of the future? Practitioners must consider this question in light of the circumstances of each client independently of how planning has been done in the past.

Fiduciaries Must Be Aware of the Distribution Consequences of Valuation Discounts

The fiduciary's obligation to fund bequests correctly may compel executors and trustees to make funding adjustments due to valuation discounts. For example, a child of a decedent's prior marriage who receives a credit shelter bequest may be entitled to a larger fractional interest in a building or greater number of shares in a business as a result of a valuation discount applied to that asset. Valuation discounts claimed on the estate tax return of the first spouse to die may also increase the funding of a credit shelter trust or GST exempt marital trust. The discounts can be used to "pack" value into these trusts as a means of avoiding estate tax or GST tax on the death of the surviving spouse.

Illustration: H dies in 2005 with a community property gross estate of $3 million. H's living trust is divided between a Credit Shelter Trust, GST Exempt Marital Trust and a Non-Exempt Marital Trust (or balance added to the Survivor's Trust). The $3 million gross estate value is determined before consideration of discounts on H's community property interest in Blackacre and H's 50% interest in the family business. His estate, net of these discounts, is valued at $2 million, reflected by the following:

Asset

Pre-Discount Value

Discounted Value

1/2 Blackacre

$1,000,000

$ 800,000

50% of business

$1,500,000

$1,000,000

Cash

$500,000

$500,000

Sample Allocation of Assets without Discounts:

Funding Value

Asset(s) Allocated

Credit Shelter Trust

$1,500,000

50.0% of business

Sample Allocation of Assets with Discounts:

Funding Value

Asset(s) Allocated

Credit Shelter Trust

$1,000,000

50.0% of business

$500,000

31.25% of Black
acre

The federal estate tax is imposed with respect to the fair market value of the asset at the time of decedent's death. 19 A controlling interest premium will increase the value of the asset. 20 Following Ahmanson Foundation v. U.S., the Service concluded in TAM 9403005 that the valuation of a marital deduction bequest is of the interest transferred to the surviving spouse, which may be subject to discounts if the interest received represents a minority or fractional interest. This has the undesirable effect of creating a lower marital deduction value than the shares receive on a per share value in the gross estate.

The relationship between discounted value and allocations can be particularly tricky in the distribution of an estate where selected assets (such as a business) go to one child(Jordan), who is in the business, and not to the other child (Dana), who is not in the business. Assume, for example, that Mom and Dad have a $10 million estate (undiscounted fair market value) consisting of ABC, Inc. (100% going concern value of $5 million and an estate tax value of $3 million when valued on a minority interest method under the Mellinger principles) plus $5 million in cash. Assume that estate tax, if any, is paid from other assets. If the parents want the estate to go equally to the children but for Jordan to receive the business: (1) Are these assets treated as valued for $10 million (disregarding valuation principles that apply to each minority interest)? (2) Are these assets valued at $8 million, consistent with estate tax principles? (Does Jordan then receive the stock plus $1 million for a total of $4 million? Is the fact that Jordan is receiving assets with a lower income tax basis and potential capital gain tax liability considered in the planning or allocation?) In this case, valuation principles create significant real-dollar results, which have an impact on money, feelings, family relationships, and the propensity of the displeased to find fault with the estate planning.

Basis Adjustments with Partnerships

Estate tax valuation discounts have a particularly dramatic effect on the inside basis of partnership assets. As a general proposition, a deceased partner's basis in his partnership interest, the so-called "outside basis," becomes its value on the partner's date of death. The decedent's share of the partnership's basis in the partnership's assets (the so-called "inside basis") will be adjusted (up or down) if a §754 election is made. Strategically, the §754 election is attractive when the outside basis is greater than the inside basis. Otherwise, the effect of a §754 election may be detrimental.

Section 754 provides for an election by the partnership and notice by the transferee partner as part of the partnership's first income tax return filed after the partner's death. Practitioners representing decedents' estates may need to coordinate with the accountants for the partnerships to protect the availability of this election.

Making the §754 election triggers the basis adjustment (increase or decrease) under §743. If a partnership interest was heavily discounted on the deceased partner's estate tax return, the basis adjustment may be significantly less than the fair market value of the assets. The starting point for the inside basis adjustment is the fair market value of the deceased partner's interest at date of death. Section 755 then directs the order in which basis adjustments are to be allocated to assets.

The basis adjustment is first allocated to ordinary income property and then to capital assets and §1231 assets ("capital gain property"). The allocation to ordinary income property is based upon the assumption that the assets are sold at fair market value, such that the amount of income (or loss) on the sale that would be allocated to the transferee partner is allocated to the ordinary income property as an upward (or downward) adjustment. While the ordering approach is generally beneficial because it minimizes gains on a subsequent sale of ordinary income property, it has the opposite effect when the partnership owns depreciable capital gain property because only the remainder of the basis adjustment is allocated to the capital gain property. An adjustment that would cause the basis of capital gain property to be reduced below zero must be applied to lower the basis of ordinary income property. 21 Consider the following:

Example: C and D (decedent) were equal partners in CD Partnership, which owned real estate (fair market value of $240,000) plus ordinary income assets with a $60,000 fair market value. Before D's death, C and D each had a basis of $30,000 for the ordinary income assets and $80,000 for the real estate. Assume that D's partnership interest at death is valued for $90,000 (1/2 of $300,000 = $150,000, less applicable discounts of 40% [$150,000 × .6 = $90,000]). With a §754 election, D's inside basis will increase, applying the first $30,000 of basis to equal the fair market value of the ordinary income property, and the $60,000 balance to the real property. This creates an adjusted basis that is considerably less than the fair market value of one-half the real estate before discount (i.e., $120,000 versus $60,000).

Depending upon the asset mix, fair market value, and the relative concerns for estate tax versus income tax, the use of family limited partnerships, and the timing of their creation (i.e., before or after the death of the first spouse), attention needs to be paid to these important income tax consequences of estate tax valuation planning.

Family limited partnerships and limited liability companies have become targets for audits and court challenges. The costs to create the entity, its ongoing operation and maintenance, and eventual defense of the entity (particularly if it does not run a business or is established "too close" to the death of the taxpayer) need to be considered. The Service has been successful with challenges to these entities formed shortly prior to death and those in which the formalities of the partnership and its integrity were not respected by the members of the entity. 22

Effects of Discounts Are Magnified When Funding Marital or Charitable Shares

Discounts can be particularly troublesome when the decedent holds sole ownership of, or a controlling interest in, an asset included in his gross estate at death, but a marital deduction or charitable share is funded with only a fractional or minority interest. The practitioner and fiduciary must consider the value of what is received by these deduction-sensitive shares.

In Chenoweth Est. v. Comr., 23 the Tax Court held that a control block premium increased the value of stock for marital deduction purposes, stating that "changes can be wrought in the nature and value of an asset in a decedent's gross estate by the provisions of decedent's will, which may change the nature of that asset by changing some of its characteristics, and hence its value, by splitting it off from other similar assets and sending it to a different destination." Citing Chenoweth in TAM 9050004, the government discounted a 49% interest in a corporation passing to the marital trust. The nonmarital trust received the other 51% of the stock. In rejecting the estate's argument that the two blocks should be valued as if there were no opportunity for the majority shareholder to abuse the minority shareholder because the trustee of both trusts was the same and owed a fiduciary duty to act impartially to each, the government reasoned that the value should reflect what a willing buyer would pay a willing seller, not what this trustee could do with the respective stockholdings.

In TAM 9432001, the decedent's estate included preferred and common stock in a closely held corporation. The Service addressed two issues: (1) whether the stock is treated as a single block of stock, valued with a controlling interest or as two separate minority interests; and (2) for purposes of the marital deduction, whether a valuation discount applies to the shares allocated to that share. The decedent's plan left the preferred stock to the marital deduction trust and the common stock to the credit shelter trust, which benefited the decedent's son. The Service applied Ahmanson Foundation , above, which held that the value of the gross estate includes all of the decedent's interest as part of the gross estate, while the charitable deduction is valued at what the donee receives. Thus, one test looks at what the donor has and the other to what the donee receives. The Service concluded that the separate interests are aggregated for purposes of the gross estate. However, a marital or charitable deduction is based on the value of the interest passing to spouse or charity. In this regard, see TAM 9403005, Jameson v. Comr. 24 and Simplot Est. v. Comr. 25 The estate plan allocated to the credit shelter trust the voting stock plus whatever amount of non-voting stock was needed to fund the credit shelter trust completely. The resulting underfunding of the marital trust created an estate tax liability.

The effect of this rule is illustrated in the following example:

Example: H's estate consists solely of a 60% interest in the stock of C Corp. valued at $1,666,666. The value includes a control premium of $100,000. H is survived by W. H's Will creates a credit shelter trust and a marital deduction trust. In funding the two trusts, the estate would like to allocate 36% of the total C Corp. shares (i.e., $600,000 of the total value of H's shares) to the credit shelter trust and 24% of the total shares (i.e., $400,000 of the total value of H's shares) to the marital trust. A minority discount must be applied to the value of the shares distributed to the marital trust. In this example, the additional shares required to fund the pre-residuary marital trust completely would leave the credit shelter trust (residue) without enough assets to make full use of the applicable credit amount.

In DiSanto Est. v. Comr. , 26 the decedent held a majority interest in a closely held corporation, to which a valuation premium was added for estate tax purposes. However, the court also held that a discount must be applied to the stock allocated to the marital deduction trust because that trust received only a minority interest.

This line of authority requires estate planners to analyze each bequest to both marital and credit shelter trusts in order to determine if a discount will apply to that bequest. Keep in mind that such required discounts necessitate additional assets in order to fund a pecuniary marital bequest fully, which will reduce or even wipe out the credit shelter share.

Valuation Discounts Interact with Kenan Gain in Pecuniary Bequest Funding

Distributions from an estate may carry out income to trusts or other beneficiaries depending upon the type of the bequests as well as the character and value of the assets used to fund them. Specific bequests of assets do not carry out income, while specific bequests of income do. The specific asset bequeathed must be identifiable both as to kind and amount . 27 For example, if 10 shares of XYZ stock are distributed to satisfy a specific dollar bequest and the value of the XYZ stock has not changed since the relevant valuation date, there is no gain. However, if the date of distribution value is higher, then the gain is part of DNI taxed to the beneficiary. 28

Gain may be recognized on distribution of property in satisfaction of a pecuniary bequest. This gain is often referred to as Kenan gain, after the case that so held. Estates and trusts may recognize gain or loss on distribution of property to a beneficiary in satisfaction of the beneficiary's right to receive a specific dollar amount or to receive specific property other than the property distributed. 29 For example, an estate plan which provides for a marital bequest in the minimum amount needed to avoid estate tax, with the residue going to the credit shelter trust, creates a pecuniary marital deduction gift with a residuary credit shelter share. A pecuniary bequest exists because the marital gift is defined as a sum of money.

Some estate plans intentionally cause Kenan gain to arise in the hope of allocating additional value to the residuary credit shelter trust. For example, if an estate worth $1.5 million at the date of death in 2003 grows to $1.9 million between death and the date of distribution, the $500,000 marital deduction share would still be funded with assets valued at $500,000, leaving the residuary credit shelter trust to receive assets worth $1.4 million at the time of distribution. When estate taxes are the major concern, the trade-off may be worth it. If estate taxes are irrelevant in the estate of the surviving spouse, the payment of capital gain tax on the Kenan gain would be for naught. Potential alternatives to avoid the Kenan gain problem include: (1) allocation to the pecuniary marital share of assets that have not enjoyed post-death appreciation; (2) allocation of assets based on date of death value provided that the trust or Will allows such value to be used, and, in the marital deduction or GST context, the allocation fairly represents post-death appreciation or depreciation; or (3) use of a fractional share formula approach. Therefore, practitioners must be cautious about using pecuniary bequests that may be funded with appreciated assets rather than formula fractional share bequests.

Estate Planning Practices of the Future

Valuation discounts provide a valuable tool for significantly reducing estate taxes. While fewer estates may be burdened with estate tax in the future because of increases in the applicable exclusion amount, the fractionalization of ownership interests into minority interests and other forms of partial ownership will continue. However, in taxable estates, the availability of valuation discounts is not without associated costs. The principles underlying these discounts permeate income and estate tax law and directly influence the funding of trusts and beneficiaries' shares. Especially in the partnership context, the tax and non-tax consequences of these discounts must be carefully analyzed by the client's estate planning team.

The most successful estate planning practices of the future will: (1) focus first on the client's non-tax objectives, (2) recommend tax savings strategies that are suitable for each client, (3) recognize and adapt to the increasing significance of income tax issues in estate planning, (4) develop a multi-disciplined approach among attorneys, accountants, and financial planners to address the wealth transfer needs of the client, (5) continually question assumptions that underlie planning strategies, (6) recognize the benefits and potential costs of suggested strategies and communicate these to the client, (7) develop business plans which take into consideration the anticipated shifts in compliance demands, (8) seek to be recognized as the client's trusted advisor whose professional judgment is respected, and (9) stay tuned for future changes in the law.

Footnotes

1 Allusion to John Keats' "Ode to a Meadowlark."

2 Johnson and Mikow, Federal Estate Tax Returns, 1998-2000. http://www.irs.ustreas.gov.

3 Projections of Returns to be Filed in Calendar Years 2002 through 2009 and Historical Perspective by Calendar Year for United States: Total Number of Returns Filed, by Type of Return. http://www.irs.ustreas.gov. The author wishes to extend his appreciation to Rusty Geiman for providing assistance with respect to the methodology used with these studies. Estimated returns for 2002 are based on actual returns filed through August 2002.

4 §6018.

5 See , Schiller, "Buy-Sell and Other Restrictive Agreements: Weaving the Fine Line Between Business Objectives and Estate Tax and the Importance of Consistency," 23 Tax Mgmt. Est., Gifts & Tr. J. No. 5, 215 (Sept./Oct. 1998); and Schiller, "Valuation Discounts on Sale of Fractional Interests in Real Property and Business Entities: Principles and Applications Continuing Education of the Bar's," Real Property Law Reporter , Vol. 26, No. 2 (March 2003).

6 Young Est. v. Comr ., 110 T.C. 24 (1998); Fratini v. Comr ., T.C. Memo 1998-308.

7 Stevens v. Comr., T.C. Memo 2000-53 (25% discount on 50% interest in commercial rental property); Brocato v. Comr ., T.C. Memo 1999-424 (20% discount on 50% interest in apartment buildings); Williams Est. v. Comr ., T.C. Memo 1998-59 (44% discount applied to a 50% interest in timberland).

8 Dunn Est. v. Comr., T.C. Memo 2000-12, rev'd and rem'd 301 F.3d 339 (5th Cir. 2002); contrast to Gross v. Comr ., T.C. Memo 1999-254, aff'd , 88 AFTR2d ¶2001-5553 (6th Cir. 2001).

9 Weinberg Est. v. Comr. , T.C. Memo 2000-53; Adams v. U.S., 83 AFTR2d 99-1887 (N.D. Tex. 1999), rev'd 2000-2 USTC ¶60,379 (5th Cir. 2000) (54% combined discounts); and Dailey Est. v. Comr., T.C. Memo 2001-263 (40% discount).

10 Regs. §1.1014-3(a).

11 1954-1 C.B. 113.

12 Propstra v. U.S. , 680 F.2d 1248 (9th Cir. 1982), and Rev. Rul. 93-12, 1993-1 C.B. 202 .

13 105 T.C. 324 (1995).

14 109 T.C. 15 (1997).

15 T.C. Memo 1999-43, rev'd on other grounds , 267 F.3d 366 (5th Cir. 2001).

16 112 T.C. 26 (1999), acq., 1999-35 I.R.B. 314.

17 T.C. Memo 1999-15.

18 78 T.C.M. 46 (1999). See , Bonner Est. v. U.S. 84 F.3d 196, 198-199 (5th Cir. 1996).

19 See , Lee Est. v. Comr. , 69 T.C. 860 (1978); TAM 9432001.

20 See , Lewis Hutchens Non-Marital Trust v. Comr ., T.C. Memo 1993-600.

21 Regs. §1.755-1(b)(2).

22 Schauerhamer v. Comr., 73 T.C.M. 2855 (1997) (disregard of entity due to taxpayer conduct); Reichardt Est. v. Comr., 114 T.C. 3 (2000); Harper Est. v. Comr., T.C. Memo 2002-121; Thompson Est. v. Comr., T.C. Memo 2002-246; Kimbell Est. v. U.S., 244 F. Supp. 700 (N.D. Tex. 2003); Strangi Est. v. Comr. (aka Strangi II ), T.C. Memo 2003-145.

23 88 T.C. 1577, 1588 (1987).

24 T.C. Memo 1999-43, rev'd on other grounds , 267 F.3d 366 (5th Cir. 2001).

25 See, TAM 9403005. Accord , Jameson v. Comr ., above; Simplot Est. v. Comr., 112 T.C. 130 (1999), rev'd 249 F.3d 1191 (9th Cir. 2001).

26 T.C. Memo 1999-421.

27 Rev. Rul. 72-295, 1972-1 C.B. 197.

28 Id. ; Kenan v. Comr., 114 F.2d 217 (2d Cir. 1940).

29 Regs. §1.661(a)-2(f)(1); Kenan v. Comr. , above; Suisman v. Eaton 5 F. Supp. 113 (D. Conn. 1935), aff'd per curiam , 83 F.2d 1019 (2d Cir. 1936); Rev. Rul. 67-74, 1967-1 C.B. 194; Rev. Rul. 83-75, 1983-1 C.B. 114; Rev. Rul. 66-207, 1966-2 C.B. 243; Rev. Rul. 82-4, 1982-1 C.B. 99.

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