Ode to the Estate Tax Return...
a Poetic Approach to Form 706, Audits and Estate Planning

By Keith Schiller[1]

While estate tax returns remain with us, it is altogether fitting and timely to integrate pragmatic practice pointers in a poetic setting. So we take this unique, and hopefully joyful approach, to reminders for effective estate planning with each pointer set-off in rhyme.

$ When a QTIP trust is part of the play,
extend the time to file and pay.

Overwhelming, it is preferable to pay no estate tax on the death of the first spouse. Taxes are often best deferred, and with the potential repeal of the estate tax, the eventual tax on the death of the surviving spouse may never arise. Furthermore, estate taxes are the “kid’s problem” because the tax can be deferred until the death of the surviving spouse.

There are a few occasions, however, in which it may be prudent to pay estate tax on the death of the first spouse. The most common of these would be the multi-marriage estate in which the children from prior marriage(s) are close in life-

expectancy or age to that of the surviving spouse. In that instance, the children will receive little or nothing if estate tax is deferred until the surviving spouse dies.

However, even in the one marriage family, or any normal occasion in which it is desired to defer estate tax until the surviving spouse dies, the estate tax preparer should always submit a timely application with the IRS to file and pay estate tax whenever the marital deduction is established or may be created as a QTIP trust.

The additional time allowed by the extensions enables the fiduciary and return preparer to determine whether or not events unfold up to 15 months after the death of the deceased spouse which would encourage the payment of estate tax on the death of the first spouse. The most obvious of these would arise when the surviving spouse dies or contracts a terminal illness after the death of the first spouse to die. In that context, the payment of estate tax on the death of the first spouse can save significant estate taxes from two sources.

First, there may be a small bracket ride by having the estates equalized. However, the increase in the estate tax exemption equivalent to $1.5 million in 2004 (45% starting rate), $2 million in 2006 (46% flat rate), and $3.5 million in 2009 (45% flat rate) offer little differential when compared to the declining maximum estate tax rates (currently 48% declining to 45% by the year 2007).

The big potential savings is with the credit for prior transfer tax (“PTC”).) The PTC will arise in the estate of the surviving spouse when the surviving spouse receives a life estate or fixed income interest in the estate of the deceased spouse, provided the trust was estate taxed in the estate of the deceased spouse. In other words, the estate of the first spouse cannot defer all estate tax for this credit to apply. In addition, the PTC is available in the estate of the surviving spouse even though the trust to which the surviving spouse is an income beneficiary is not included in the gross estate of the surviving spouse.

Code Section 2013 provides for a credit for prior transfers based on a graduated scale when the transferor predeceases the decedent‑transferee:

This value of the life estate (or income interest) that was subject to estate tax on the death of the deceased spouse will receive a PTC based on the life expectancy of the surviving spouse, provided that the surviving spouse’s death does not arise in a common disaster, or in the event that the surviving spouse’s health at the time of the death of the deceased spouse is projected to be at least a 50% probability that the surviving spouse would not die within one year of the deceased spouse. Reg. §§20.7520-3(b)(3)(i); 20.7520-3(b)(3)(iii). In the context of common disaster, see, Estate of Harrison v . Comr. 115 TC 13 (2000).

When there are successive transfers of property (i.e., property passed through several estates), the credit is allowed only for the transfer from the last transferor to the decedent. When there are multiple transfers from several transferors, each transfer qualified for the credit and the limitations and the credit are determined separately as to each transferor. Reg. Sec. 20.2013-6; Estate of Meyer 86-1 USTC Par. 13,650 (3^rd Cir. 1986).

The term “property” includes any interest in property (legal or equitable) in which the transferee received a beneficial interest. The transferee is the beneficial owner of property over which the transferor has a general power of appointment (not a limited power only). Reg. Sec. 20.2013.5(b). Bare legal title does not constitute property.

Application of the PTC to trusts or other life interests even though it is not included in the gross estate of the transferee-decedent is further supported by Rev. Rul. 59-9, 1959-1 C.B. 232; Rev. Rul. 77-156, 1977-1 C.B. 269; and Rev. Rul. 75-550, 1975-2 C.B. 357; and, Rev. Rul. 85‑111, 1985‑2 C.B. 196.

The rationale for a life estate qualifying for the prior transfer credit is based on the theories that the life estate produces income that is itself partially reinvested and turns into principal which is taxed when death occurs and/or the life estate allows the life tenant to conserve his other assets which are then taxed when he dies. This rule was demonstrated in Rev. Rul. 59‑9, 1959‑1 C.B. 232. The decedent (D) was left an income interest from the parent and D died within ten years after the father's death. The value of the property included in the residual trust had been included in the father's gross estate and a federal estate tax was paid thereon. The income interest was not included in D’s gross estate for federal estate tax purposes. The IRS ruled that if property was included in the transferor's gross estate and an estate tax was paid on it, “the credit may be applied to the interest received by the transferee, notwithstanding the fact that such interest is not included in the transferee's estate for federal estate tax purposes.”

The following is an example of the value of the PTC with a $6 million community property estate (i.e., each spouse with a $3 million estate) in the case of a $2,325,000 marital trust, taxed in the estate of the deceased spouse (i.e., to the extent that a QTIP election is not made and the trust is not shielded by the unified exemption equivalent), for a 65-year old surviving spouse and the applicable federal rate of 7%. If the marital trust has a value of $2,325,000 the value of the income interest is $1,607,235 ($2,325,000 x .62913). The estate tax on the $2,325,000 estate of the deceased spouse is $945,000 (assuming a $1 million estate tax exemption equivalent). Of that amount, the federal estate tax is $752,000 and the state death tax credit is $182,000. (There is no PTC on the state death tax credit amount.) If the surviving spouse dies within two years of the deceased spouse, the PTC is $611,975 ($752,000 x [$1,607,235/$3,000,000 - $945,000).

For additional discussion on this point, see, Schiller, Don’t QTIP Too Soon, BNA, Estate Planning, Probate and Trusts Journal (Nov., 2001).

Therefore, preparers of Form 706 should secure as much time as possible to decide whether or not estate tax will be fully deferred without causing penalties for late filing or late payment to arise during that decision making process.[2] Code §6161. This maximum time can be obtained by timely filing an application for an additional six months for the filing of the estate tax return, and an additional twelve months to pay estate tax. The Application for Extension of Time to File, etc. (Form 4768) is used to secure these extensions.

The estate tax return can be filed within nine months of death, if desired, even with an approved extension of time to file and pay estate tax. Given the concern of many clients to move administration to conclusion, or perhaps concern with deemed sale treatment in the funding of a pecuniary gift, there may be valid reason to file within the un-extended time period. However, by obtaining the extension, a QTIP election that was timely made can also be timely revoked. Regs. §20.2056(b)-7(b)(4). This enables the fiduciary and advisors to move forward, with at least the return filing, while preserving the maximum time to undue a prior QTIP election.

The author recommends that these extension applications be filed soon after death so that any last minute rush is avoided and the response is received from the IRS well in advance of filing deadlines in the event that any issues arise.

The following is language that has been successfully used by the author to obtain an extension of time to pay estate tax on the death of the first spouse:

“The executor is unable to determine the amount of estate tax, if any, that may be required. Accordingly, a timely submitted extension of time is being filed herewith to extended the time within which to file the estate tax return for an additional six (6) months.

The decedent’s estate includes a martial trust to which a QTIP election may be made under IRC Section 2056(b)(7). In the event that a full QTIP election is made, there will be no estate tax payable. In the event that said election is not fully made, there will be estate tax payable. However, that fact may not be known until the return is filed. Unless an extension is granted, the estate would be in the position of having to sell property on adversely short notice to pay estate tax and avoid a penalty for late payment that may result in the event the QTIP election is not fully made and the return is timely filed under extension. Accordingly, the extension is needed in order to avoid undue hardship to the estate. Therefore, request is made for an extension of time to pay estate tax to the date that is twelve (12) months after the initial due date for the filing of the estate tax return, to wit, to and including __________, 200__.”

$ While fat may not be how you return from a spa,
a fat return let’s you sign “tra-la, tra-la.”

The best estate tax audit is the one that never arises. Estate tax audits may not only raise challenges to issues that are evident from the return, but also from events or matters that are not part of the return, or which become apparent in audit. Examples of these surprises may include gifts that were not included in the estate tax return, valuation of lifetime gifts, missing assets, 2036 operation issues with partnerships and entities, and transactions reflected in the bank or brokerage statements that were not evident when the return was filed.

The “fat” estate tax return is a great practice approach toward avoiding a field audit. Reference to “fat” means a return in which all relevant documents are attached so the IRS does not need to request additional paperwork. This would include at least a copy of the Will and all trusts, all filed gift tax returns, all appraisals, an affidavit of the surviving joint tenant of contribution on non-qualified joint tenancies, and perhaps a copy of the estate tax return of the predeceased spouse.

Historically, all estate tax returns are at least reviewed by an estate tax attorney. The author understands that this practice has continued, although the Cincinnati Service Center has been badly backed up and certain estate planning groups have had to allow batches of returns to go without any review. Those few are the “lucky” ones. While virtually all returns receive at least a brief review, the field audit percentages have gone down in recent years (from about 38% as late as the mid 1990's to about 10% currently).

In 1999, the author surveyed estate tax attorneys in California regarding practice pointers that they recommended to practitioners.[3] All of the IRS respondents recommended fat estate tax returns as a practice approach to avoiding audits.

Thus, “low carb” returns are not recommended.

$ Fund subtrusts, file their returns to do what’s right-
If the clients object, you can assure them a fight.

The best feature of living trusts is the offer of simplicity. The worse feature with living trusts arises from the failure to follow fundamentals and administrative discipline as a result of that simplicity. Living trusts create problems, particularly when the client lacks the desire or discipline to keep assets in trust title and respect the trust entity after the death of the first spouse. The “unfunded subtrust” can create tax and non-tax difficulties following the death of the first spouse to die and on the death of the surviving spouse.

From the non-tax perspective, the unfunded subtrust can lead to abuse. Even in the most loving family, the lonely widow or widower may long for companionship after the death of a spouse. This new relationship creates pressure over the tracing of assets, segregation of pre-marital and marital property, and the ultimate inheritance rights of the children of the first marriage and those of the surviving spouse. The outright dysfunctional family creates even greater risk of post-death litigation over an improperly administered trust. Now, the children are fighting whomever they can target and may not have compassion for “mom’s” or “dad’s” advisors who were assisting the deceased parent with cost savings. There may be some clients whom practitioners cannot afford to keep. Isn’t the client who does not want to pay to have the job done right while creating more liability for the practitioner a very expensive client for the practitioner to keep.

From the tax perspective, the unfunded subtrust leaves open the issue: how much value does belong in that subtrust?

On the death of the surviving spouse, the Service will scrutinize subtrusts for proper funding…. and avoid overfunding to credit shelter trusts. Where the credit shelter trust is not funded, issues arise as to whether or not appreciation is allocated to the credit shelter trust or to another trust (such as the survivor’s share of the estate), whether there has been a gift to remaindermen, and whether or not gains or losses were incurred by the trust or reflect loans.

CPAs, attorneys, bankers and financial planners do a great service for the client

by reminding the client to place assets in trust title, file fiduciary returns for each subtrust, and respect the trust entity. If the client is unwilling or too “thrifty” in their approach to professional services to do the job correctly, then the CPA or other professional advisor should cover himself or herself against the expense and difficult fallout that may later result.

The CPA receives annual reminders in the form of 1099's, K-1's, real estate tax bills and the like that reflect the nature of title — whether in trust or held individually. Stockbrokers and financial advisors may receive monthly or quarterly reminders of title.

Accountants must be on guard against the practice of a widow directly reporting

credit shelter trust or QTIP trust events on the Form 1040 and not Form 1041. This can lead to significant income tax errors and inaccuracy in the funding allocated to the subtrusts. Don’t assist the client in short-cutting proper procedures with tax return filing that reports income to the incorrect taxpayer. When the trust has income, gains, losses or whatever, report them on the trust’s return. When the kids are looking to point the finger, the accountant’s preparation of returns reporting events to the wrong taxpayer may become an issue against that practitioner.

The duration of estate or trust administration as well as the existence of appreciation or depreciation in the value of trust assets can affect the value allocated to respective trusts as well as the potential for income tax to be recognized upon allocation. For example, the allocation of appreciated property to satisfy a pecuniary bequest can create a taxable sale— so called “Kenan gain.”[4] On the other hand, a minimum worth marital deduction gift allowed several million dollars of appreciation to pass without recognition of gain to a credit shelter trust in Aubin v. Comr. TC Memo. 1998-328.

$ FLPs can make a really hip score,
but not when made on death’s door,
or when the decedent dies with little more,
or to the formalities you do ignore.
And yet, the courts have not be steady
in determining what investments and schemes
will be honored, upheld and heady
in pursuit of tax-savings dreams.

Partnerships – their bona fides and valuation – are the hottest of all audit issues before the Service and the source of almost monthly reported tax litigation.

Before addressing the tax benefits of FLPs (limited liability companies) or other entities, practitioners and their clients should consider the non-tax consequences of entity creation and joined ownership. The discounts for lack of marketability and minority interest exist because assets become less liquid and control is given up, at least by the non-manager. Some people do not belong together. Unfortunately, many of these combatant types are members of the same family. Bringing people who hate or distrust one another, much less having different needs, create heartbreak, stress and strain among the family members. In my own practice, I know that some of the best partnerships we ever did were ones we never did.

From an estate tax savings perspective, FLPS can achieve significant valuation savings, particularly with minority interests in operating companies.[5] Lesser discounts are available as well with investment related FLPs.[6]

Partnerships with a business purpose have been recognized for years for income tax and estate tax purposes. In these respects, a legitimate business purpose should exist, capital must be a material income producing factor (family partnerships), and the capital accounts need to be honoured for allocation purposes. [7]

The greater challenges lodge with partnerships that are not respected by the partners, partnerships formed close to death, and partnerships in which the decedent transfers an illogically large percentage of his or her wealth when measured from a non-tax perspective.

Several cases disregard the entity and impose estate tax under Code Section 2036 because the family did so in the operation of the entity. For example, in Estate of Schauerhamer v. Comr. 73 T.C.M. 2855 (1997), the Tax Court agreed with the Service that the decedent’s apparent retention of control caused estate tax inclusion. An “implied agreement” was found based on the fact that the partnership form was not respected, the decedent deposited and used partnership income for her personal expenses and that nothing in practice changed from the prior facts of control by the family matriarch. This implied agreement approach was followed in Estate of Reichadt v. Comr. 114 T.C. 3 (2000); Estate of Harper TC Memo 2002-121; a; Estate of Thompson, supra, and Estate of Shepherd v. Comr. 115 TC 376 (2000), aff’d 2001-USTC ¶ 20001- (11^th Cir.), wherein funds were commingled and gifts made before the partnership was established were treated as gifts of undivided interests in the underlying property.

The Service has prevailed in a series of cases in which the Court has determined

that partnership lacked a legitimate business purpose or amounted to a testamentary substitute. Estate of Harper v. Comr., supra, Estate of Thompson v. Comr. TC Memo. 2002-246, aff’d (3^rd Cir. 9/1/04 Case No. 03-3173); Strangi II; Hillgren Est. v. Comr. TC Memo. 2004-46 (but IRS loses on other valuation issues); Estate of Abraham v. Comr. TC Memo. 2004-39 .[8] On the other hand, the taxpayer prevailed in Estate of Stone, III v. Comr. TC Memo. 2003-309, when FLPs were formed for valid family-dispute resolution purposes.

The appellate decision in Estate of Kimbell v. US 2003-1 USTC ¶60,455 (ND TX), reversed 2004-1 USTC Par. 60,486 provides some hope for the taxpayer and reflects a different approach than concluded by the Third Circuit in the Thompson appellate decision.

The Kimbell appeal arose after the District Court granted a summary judgment for the Service and denied the taxpayer’s summary judgment request over the issues of whether or not the transfer of property to a FLP formed two months prior to death in exchange for partnership interests was for full and adequate consideration and whether or not the decedent had retained control under IRC Section 2036.

The 96-year old decedent was the owner of 50% of an LLC, the other 50% being owned 25% by her son (the petitioner in the case) and the wife of the son. The son managed the LLC. The partnership was owned by the LLC and the decedent’s revocable living trust. The LLC contributed 1% of the capital and was the general partner while the trust contributed 99% of the capital as was only a limited partner. Valuation discounts of 49% underscore the case. The decedent retained about $450,000 in cash outside of the entities. No elements of mismanaging assets, improper treatment of cash flow, or failure to transfer assets that were present.

Code section 2036(a) provides that an interest is included in the gross estate of a transferor who retains either (1) the possession or enjoyment of the right to income from the property, or (2) the right, either alone or in conjunction with any person, to designate the persons who shall possess the property or the income therefrom, unless the transfer was for full and adequate consideration .

Applying 2036, the District Court considered (1) whether or not there was a bona fide sale in the transfer of assets to the partnership controlled by the son (which concluded there was not citing Harper v. Comr. 83 T.C.M. 1641 because the sale was between related parties); and (2) whether or not an express or implied agreement existed that the decedent would retain the economic benefit of the property. The District Court rejected the taxpayer’s assertion that the partnership was governed by fiduciary principles. See, US v. Byrum 408 US 125 (1972). Kimbell forebode the broader anti-Byrum application in Strangi II T.C. Memo. 2003-145. Fortunately, the Fifth Circuit reversed on both grounds, vacated the District Court decision, and directed that the District Court consider whether the decedent’s interest was an assignee or partnership interest.

The Fifth Circuit applied the business-judgment approach to the consideration test when unrelated parties consider entering into a partnership, exchanging the benefit of management and the partnership agreement for reduced freedom and control over their investments. It rejected the application of a fair market value test. The court ruled that this standard applies in the family context “unless (1) the evidence demonstrates there was a sham transaction, motivated solely by tax avoidance, or (2) Congress or the courts change long-established law.

The Fifth Circuit found that the partnership was not a façade to “recycle value” and held that the transfer of assets to the partnership was a bona fide sale. The court noted that (1) the decedent retained sufficient assets outside of the partnership; (2) the partnership formalities were satisfied and the assets were actually assigned to the partnership; (3) the assets contributed to the partnership included working interests in oil and gas properties which do require active management; and (4) several credible and unchallenged non-tax business reasons for the formation of the Partnership that could not be accomplished via the decedent’s trust. Non-tax purposes included increase of family wealth; support annual gifts without fractionalizing assets; promote family ownership; protect against creditors and divorce interference; support planning not available through a trust; and promote family knowledge of the business.

The court rejected the retained interest application to the FLP because the transfer was within the exception of fair and adequate consideration and refused to impose the retained interest doctrine to the LLC under Section § 2036(a)(1) and(2) because the decedent did retain sufficient votes or contractual rights to control the LLC. Byrum was not even discussed.

On the other hand, in the Thompson appeal, the Third Circuit concluded that an implied agreement existed among the family members so that the decedent could continue to enjoy the economic benefit of the assets transferred. It further held that no bona fide sale for full and adequate consideration existed because the partnership did not engage in a valid, functioning business enterprise. The decedent transferred 95 percent of his assets to the partnerships, leaving him with only $153,000 in personal assets, an annual income of $14,000, and annual expenses of $57,202. Distributions were made to fund the decedent's gifts to family members and to provide cash for his personal expenses. The court concluded that the primary purpose was not to engage in or acquire active trades or businesses. The court found the tax savings benefits too overwhelming under the set of facts in that case. This decision also opens the door for potential dispute among the circuit courts in light of Kimbell in regards to the level of business purpose required to satisfy the full and adequate consideration exception under Section 2036 in light of the loss of overall value caused by FLP discounts. In the final analysis, the Third Circuit Court states, “Nonetheless, we believe this sort of dissipation of value in the estate tax context should trigger heightened scrutiny into the actual substance of the transaction.”

From the perspective of anticipating an estate tax challenge, the following action steps should be considered by the taxpayer and his or her advisors:

1. Advise clients of the risks and rewards of entity planning.
2. Include some operating business or real estate investment in the partnership.
3. Create the partnership well before death.
4. Keep on top of the details. (Transfer assets into partnership title, operate as provided in the partnership agreement, avoid having to make accounting for accrued obligations or rights to family members that are not paid when due, and run the partnership as though the partners were strangers.)
5. Use different trusts as partners, particularly after the death of the first spouse. This will make it easier to fractionalize ownership. (Estate of Mellinger v. Comr. 112 TC 4 [1999].)
6. Document business purpose. Sensitive estate tax oriented letters should be protected by the attorney-client privilege. Avoid circulating confidential documents in a manner that would waive the privilege.
7. Keep discounts within amounts that are less likely to draw audit attention, particularly in tough cases.
8. Leave the decedent liquid apart from the FLP.
9. Have annual partnership meetings to update events.
10. Review the general ledger and cash for business purpose.
11. When possible, have each partner contribute capital to the partnership, not relying exclusively on gifts of partnership interests.
12. After the death of the first spouse, make sales—not gifts—of FLP interests. Promissory note payments provide income to the older generation, the younger generation will likely still have a positive cash flow from the pro-rata share of the entity income relative to the payments on the note (at AFR rates); and the younger generation may acquire a larger share in this manner. Consider Sec. 1239 if the partnership owns depreciable property.

$ If to IRS attorneys you rudely speak,
their ire you may tweak and peak.
But to what end they will surely ask--
why do you hide and fail your task?

As part of the Survey Article cited in footnote 3, the IRS Estate Tax Attorneys were asked, “What practice or activity do you see practitioners follow that you believe most significantly harms the credibility of the practitioner?”

Among the significant responses were inconsistent positions, misapplication or misstatement of law or facts, and hardball tactics (including personal attacks on the Estate Tax Attorney).

The IRS Estate Tax Attorneys understand that there are different perspectives. As people in general, and as attorneys in particular, the Estate Tax Attorneys do not want to be personally challenged. It will most likely make them work harder, or slower on your case. Most IRS attorneys are contentious in their approach to their work and will respond better to analysis, disclosure and reason than to personal challenge. Those who are not reasonable in the first place will likely be even more unfair when personally challenged. When faced with a difficult Estate Tax Attorney, ask for a meeting with the Group Manager. Document the areas of disagreement. It is likely that you will not be the first one to have had a problem with that attorney.

From the author’s perspective, I prefer to provide documents when requested in a timely manner and confirm that responses are complete to the request. Keep the cases moving forward so that any differences can be resolved either through a pre-docketed appeal or a fast track mediation before the appeals level. Timely cooperation with requests can save time in un-agreed cases so that more expensive Tax Court litigation can be avoided, and help shift the burden of proof to the IRS.

$ A durable power of attorney may have appeal
and if the donor wants gifting, state that deal;
while running the risk of a Paraguay fleeing,
but from the gross estate you do a keeping.

Durable powers of attorney can provide great assistance with organizing and managing the affairs of the incapacitated individual. They can also assist with annual exclusion gifts and other tax-oriented fine tuning to the estate plan. On the other hand, these powers can also create opportunities for the holder of the power to implement estate planning and gift changes that benefit the attorney in fact. Most power of attorney forms do not include direction for conduct and the protections of a trust. Is the holder of the power who feathers their own nest through changes to a living trust or making of gifts really acting in the best interests of the grantor of the power? Will conflicts arises with other beneficiaries once the grantor of the power dies? Is the estate so large and conduct of the attorney in fact so offensive that he or she may consider moving to a country without extradition to the United States?

In order to protect citizens from their loved ones or trusted advisors, many states require that the holder of a power of attorney may not make gifts to themselves unless the power specifically grants such authority. Thus, powers of attorney are best created with due regard for the personalities, strengths and weaknesses of those involved, and with consideration for checks and balances to protect against the holder of the power “assuming” something for their own benefit that may or may not really be an appropriate assumption.

The authority, and therefore, the effectiveness of gifts or living trust amendments carried out by an attorney in fact for an incapacitated party under a Durable Power of Attorney is largely an issue of state law. If the gift is not effective, it is brought back into the gross estate of the decedent under Code Section 2038. As a general rule, most states, including California (Probate Code §4264), require that the durable power of attorney include an express authorization to make gifts.

This article does not attempt to review the laws of the various states. Casey Est. v. Comr. 91-2 USTC ¶60,091 (4th Cir. 1991) and Swanson Estate v. U.S. 2000-1 USTC ¶60,371 (Ct. Cl.) (California durable power of attorney) are reflective of a line of cases under Section 2038 that apply 2038 state law, resulting in gross estate inclusion, on the grounds that making gifts under a power of attorney that did not expressly grant the power to make gifts were voidable. The grantor of the power may ratify the gift to make it effective, provided the ratification is effective under state law. California requires that the ratification be in writing. Civ. Code. §2310. Other states may look more to the circumstances at the time of execution of the power even without express gifting authority. Est. of Ridenour v. Comr., TC Memo 1993-41, aff'd, 94-2 USTC ¶60,180 (4th Cir. 1994).

Therefore, durable powers of attorney can provide great tax and non-tax benefits, which can reduce the gross estate when acts are authorized. At the same time, checks and balances, co-power holding, and other safeguards to protect against temptation or ineptitude should be considered when crafting durable powers of attorney.

$ If discounts in a fraction your clients seek,
avoid joint tenancies, they badly reek.

Fractional interest discounts are available with co-tenancy property and community property provided that the decedent’s interest does not pass by right of survivorship.

Fractional interests discounts, including co-ownership between spouses, family members and otherwise have been a recognized element of estate planning and valuation for years. Propstra v. U.S. (1982, CA9) 82-2 USTC ¶13475. Valuation cases in recent years have centered around the issue of the amount of the discount and the relative significance of partition in the valuation mix. See, Estate of Barge v. Comr. T.C. Memo. 1997-188; Brocato v. Comr. T.C. Memo. 1999-424 ( 20% fractional interest discount with valuation of 50% interest in two apartment house properties); Estate of Williams v. Comr. T.C. Memo (1998-59) (20% lack of marketability discount plus a 30% discount for lack of control (which totaled a 44% discount) with an undivided 50% interest in timberland); Estate of Busch v. Comr. T.C. Memo. 2000-3 (10% discount based on partition in kind of undeveloped real property allowed after judge expressed displeasure with appraiser’s underlying valuation); Estate of Stevens v. Comr. T.C. Memo. 2000-53 (25% fractional interest discount granted to undivided 50% interest in commercial leased properties); Estate of S. LeFrak v. Comr. 1993-526 TCM (30% combined discount-- 20% minority interest and 10% lack of marketability for gift of fractional interest (6-7.5%) in real property; and Estate of Cervin v. Comr. T.C. Memo 1994-550, aff’d (5^th Cir. 1997) 97-1 U.S.T.C. ¶ 60,274 (20% discount). See, Schiller, Anticipating the Estate Tax Audit and Proving the Real Estate Valuation Case in Tax Court, California Trusts and Estates Quarterly. Vol. 6, No. 1, Spring, 2000, which reviews fractional interest and blockage discounts cases with real property and approaches toward audit and litigation.

However, fractional interest discount applies when the surviving joint tenant receives his or her interest automatically as a result of survivorship. Estate of Young v. Comr. 110 TC 24 (1998); Fratini v. Comr. T.C. Memo. 1998-308. This same principle should apply to community property with right of survivorship.

Whether or not valuation discounts on the death of the first spouse to die are desirable or not is a valid issue. No discounts may be desired because discounts would achieve a smaller basis adjustment on death. Code Section 1014. For clients who are not concerned about estate taxes and who are satisfied with leaving real property outright to a loved one (and not in trust for a non-tax reason or to protect the inheritance of children), joint tenancy or community property with right of survivorship may make a lot of sense. On the other hand, clients who want valuation discounts or to add value to credit shelter trusts should be particularly mindful to avoid joint tenancy or other right of survivorship ownership.

Therefore, consider severing joint tenancy ownership, either with a new deed, agreement, or other means recognized under applicable state law.

Joint tenancies in real property may also be severed into tenancy in common so that each co-owner is treated as an equal owner, rather than having ownership determined under tracing principles of Section 2040, and the filing requirements of Schedule E. Such severance may not be a gift, yet achieve significant gross estate reduction, if the deceased co-owner made a contribution greater than an equal share to the property.

$ Estate tax returns tell the end story,
of the good and bad of financial glory,
of plans done right or not done at all;
but then the IRS takes the largest call.
So urge your clients to see you soon,
while they are still with you in the room.
With their thoughts and options at hand,
you can lower the tax to single-digit land.

The estate tax return represents the report card of the successor, or failure of transfer-tax estate planning.

In preparation for this grading event, practitioners and their clients may wish to “begin with the end in mind.” In other words, what is needed in an estate plan, what action steps can be taken before death, and what documentary record can be established and protected to support the desired estate-tax result.

The estate tax is basically a voluntary tax. That statement does not advocate or suggest tax evasion. Rather, the estate tax system with its significant deductions (charitable and marital), estate tax exclusion for life insurance that is excluded from the taxable estate, beneficiary tax avoidance through extended exemption trusts (i.e., GST or estate tax exempt trust), entity-level discounts, and time-value discounts (i.e., GRATS, private annuities, and the like), increased exemption limits, separateness of family ownership interests for valuation purposes, fractional interest discounts, and entity-level discounts for lack of marketability and minority interest enable clients who are willing to invest in estate planning to reduce the effective estate tax rate to one that is closer to a sales tax rate when compared to the unplanned estate. See, Anti-taxidents and Estate Planning—Prescriptions for a Healthy Estate posted on the author’s Web Site. (Initially published in the Contra Costa Lawyer, July, 2000.)

Planning is best done well in advance of death, particularly with the creation of entities that have an estate-tax savings benefit. The estate tax return of the first spouse to die offers significant planning opportunities as well. The funding of trust can lay the groundwork for valuation reductions and reduced growth in the estate of the surviving spouse. In summation, the estate tax return is the thing in which to test the forethought of the king (or at least the decedent or his/her advisors).