and Trust Section Newsletter

No. 112 Published by the Section on Probate and of The Philadelphia Bar Association August 2005

Have a restful and rein- vigorating summer – we’ll see you Report of the Chair in the fall! By JULIA B. FISHER

The Probate Section – as usual through our hard-working and amazingly productive committees – has had a number of opportunities so far this year to respond to “late breaking” developments that impact all of its members.

In late December of 2004, the Treasury published sweeping revisions to the Circular 230 regulations that establish standards of practice for tax pro- Inside this fessionals. The changes, for the most part, became effective on June 20, 2005. The Education Committee worked with the Tax Section on very short notice to Issue...... prepare an outstanding April 19 presentation on “Giving Tax Advice after June 20: Can You Comply with Circular 230?” Comment Letter to the IRS...... 2 On April 18, 2005 the IRS released Revenue Procedure 2005-24 which imposes new rules and requirements for charitable remainder trusts created after June 28, 2005. The Legislative Committee leaped into action and prepared a Section Events comment letter to the Service – you can find a copy of their work in this issue Calendar...... 3 of the newsletter. In addition, the Committee will consider a legislative solution to the issues the Revenue Procedure creates for Pennsylvania practitioners. The Family Office Phenomenon...... 4 Another project in which members of the Section are participating is the recently launched Philadelphia Register of Wills’ website and computerization project. The project is intended to provide, among numerous other things, for Pennsylvania electronic filing, the prospect of using .pdf fill-in forms, and the possibility of Impressionists short certificates issued upon probate. All of these are very exciting and much Surge on the Art desired applications of technology to our area of practice. Market...... 5 Save the date! The Probate Section’s Annual Meeting will be held on December 13, 2005. The program for this year’s annual meeting promises to be Tax Update...... 6 an interesting and topical subject – “What is Family? New Issues Confronting the Estate Planner in the 21st Century”. The panel will address the many ways Ethics Column...... 20 parent/child and spousal relationships are formed today and what this means to the estate planner. Our speakers include Susan N. Gary, Associate Professor, University of Oregon Law School; Nancy J. Knauer, Peter J. Liacouras Professor New Bankruptcy Act of Law, James E. Beasley School of Law of Temple University and Marilyn C. Extends Broad Sanborne, Ballard Spahr Andrews & Ingersoll LLP. Creditor Protection to Retirement Plans...21 Probate and Trust Law Section Newsletter No. 112 1 Comment Letter to the IRS July 13, 2005 Public Accounts (AICPA) and by the a different jurisdiction which did American Counsel on Annuities not provide for a spousal election The Honorable Mark W. Everson (ACGA) concerning this revenue or which provided for a waiver in a Commissioner procedure. We agree with both or- form insufficient to satisfy Pennsyl- Internal Revenue Service ganizations that the issues they raise vania law. Courier’s Desk are of very real concern to attorneys 1111 Constitution Avenue, NW whose practice includes the creation of Although one of the alter- Washington, DC 20044 charitable remainder trusts. In addition natives suggested by the revenue to agreeing with the concerns of these procedure is to have Pennsylvania Re: Rev. Proc. 2005-24 Re- organizations, we would like to com- law changed to exclude charitable garding Guidance on Spousal ment more specifically on the impact remainder trusts from the assets Election Rights and Charitable of Rev. Proc. 2005-24 on Pennsylvania subject to election by the surviving Remainder Unitrusts under residents. spouse, this would be directly con- IRC Section 664 trary to the public policy of Penn- Pennsylvania is one of the sylvania as reflected in its current Dear Commissioner Everson: states whose legislature has chosen statute. For example, to permit a surviving spouse to elect if the statute were to be so changed, I am writing on behalf of the against the will of a deceased spouse a Pennsylvania resident could disin- Legislative Committee of the Probate and receive a share of the decedent’s herit his or her spouse by transferring Section of the Philadelphia Bar As- estate regardless of the terms of the his or her entire estate to an inter sociation to comment on Rev. Proc. will. The elective right extends to a vivos charitable remainder trust, 2005-24. This revenue procedure conveyance by the deceased spouse retain the annuity or unitrust pay- concerns the tax consequences to the during his or her lifetime (whether ment for life, and have the property grantor of a charitable remainder an- before or after the marriage) in which pass to on his or her death. nuity trust or a charitable remainder principal could have been used for the The public policy of Pennsylvania unitrust where the surviving spouse benefit of the deceased spouse. Since has consistently prohibited a spouse of the grantor has the right under ap- an inter vivos charitable remainder from disinheriting his or her spouse plicable state law to receive a share trust created by the deceased spouse in a situation where the deceased of the assets of the trust by electing to would be such a conveyance, we be- spouse has retained such an inter- receive a share of the grantor’s estate lieve that Rev. Proc. 2005-24 would est in an inter vivos trust created in the event of the grantor’s death. require a waiver by the spouse of a during the lifetime of the deceased Pennsylvania grantor of the spouse’s spouse. If the charitable remainder right to elect against the grantor’s trust is to receive its anticipated tax charitable remainder trust in order to Recommendation: treatment, the revenue procedure have the charitable remainder trust provides a special waiver provision qualify as such for tax purposes. Rev. Proc. 2005-24 pro- requiring the non-grantor spouse vides a safe harbor for charitable to waive his or her elective right to Although obtaining such a remainder trusts in existence before share in the income or principal of the waiver may not be difficult in many June 28, 2005, which would cause charitable remainder trust upon the cases, it is evident that there may be them to be disqualified for tax pur- death of the grantor. Failure to waive very common situations in which it poses only if the surviving spouse such right would cause the charitable will be difficult to do so or, worse, actually elects against the trust and remainder trust not to qualify as a where the waiver will not be obtained the election requires some or all of charitable remainder trust under §664 for readily anticipated reasons of in- the trust assets to be paid to the sur- of the Internal Revenue Code. advertence. As an example, a waiver viving spouse rather than charity. would be required at the time a married I understand you have grantor changes his or her residence to We recommend that this received extensive comments from Pennsylvania in the case of a grantor approach should be adopted for all the American Institute of Certified who established a charitable trust in continued on Page 3 Probate and Trust Law Section Newsletter No. 112 2 Comment Letter to the IRS, continued JOIN A charitable remainder trusts, regard- charity rather than the surviving less of when they are created. The spouse should still qualify for the es- COMMITTEE possible right of election against tate tax charitable deduction so that the such assets should not disqualify charitable deduction would be reduced the trust for favorable tax treatment. by the value of the assets passing to The Sectionʼs Com- However, if the surviving spouse the surviving spouse. If the charitable mittees depend on the actually elects against the estate of remainder trust continues for the life of steady flow of people, a deceased spouse and the assets a successor beneficiary, the estate tax of the deceased spouse’s charitable charitable deduction for the continu- energy and ideas. remainder trust are responsible for ing charitable remainder trust should Join one! the payment of any part or all of such be reduced to take into account the elective share, then the charitable amount that passed to the surviving Fill in the form below remainder trust would be disqualified spouse from the charitable remainder and send it to the Sec- for an income tax deduction so as to trust at the grantor’s death. tion Chair: include in the final income tax return of the deceased spouse any income We welcome the opportunity tax charitable deduction allowed to to discuss our comments with you or Julia B. Fisher, Chair the decedent when the trust was cre- others at the IRS and the Treasury ated. Department. JPMorgan Private Bank Discussions among experi- Sincerely yours, One Liberty Place enced practitioners across the coun- try strongly suggest that instances of Robert I. Friedman 47th Floor spousal elections against charitable Chair, Legislative Committee 1650 Market Street trusts are very few and far between, The Philadelphia Bar while the potential negative impact Association Philadelphia, PA of the revenue procedure on other- 19103 wise properly drawn and adminis- (215) 640-3520 tered charitable trusts, which are in fact providing the charitable benefits julia. intended, will be disproportionately b.fisher@jpmorgan. severe. Our recommendation is in- com tended to preserve the integrity of Section Events the charitable deduction where chari- CALENDAR table trusts operate as intended and to Name: preserve the integrity of the tax law where charitable benefits are actually Probate Section Annual Meeting – compromised by a claim against the December 13, 2005 Address: charitable trust. “What is Family” — New Issues We further recommend that Confronting The Estate Planner in E-Mail: any additional guidance in this area the 21st Century” address the estate tax consequences in the estate of the deceased grantor Faculty: Susan N. Gary Committee where his or her spouse exercises Nancy J. Knauer Preferences: a right of election which is satis- Marilyn C. Sanborne fied from the charitable trust. With respect to the estate tax charitable First: deduction, property passing to the Second: Third:

Probate and Trust Law Section Newsletter No. 112 3 The Family Office Phenomenon

By JOSEPH ROSKOS PRESIDENT, FBO SERVICES, INC. KING OF PRUSSIA

What do some of your clients in your practice have in common with the King of England and robber barons? Wealth, and the need for family office services.

The family office can be During the period from the have an additional purpose that the traced back to the King of Eng- 1920’s through the 1980’s, the per- traditional offices did not have: the land, who had his exchequer. The sonal family office was still maintained latest version of the family office exchequer basically managed and through significant historical events tends not just to account for and accounted for the King’s personal such as the Great Depression and manage the personal assets (meaning wealth, collected the income and World War II. But these events, and houses, farms, art objects, etc.) but made disbursements. For the robber particularly the increase in income also to manage the investments of barons in the 19th Century, their great and estate tax rates, caused the family the wealthy individual – at this point concentrations of wealth required the offices to reduce in both number and it is the source of the wealth. This services of the family office. During visibility. The family office became is a subtle but important distinction that time, the family office was an limited pretty much to the heirs of the in the evolution and characteristics integral, yet not highly visible, part super rich – the “old money.” of the modern family office. The of the ecosystem of the rich. As one shift from operating businesses to tours the summer home mansions in investments is often occasioned by During the last two decades, Newport, Rhode Island, it is noted a liquidity event in the economic the concept of the family office has that the wealth of commoners in the life of the family, in which the fam- begun to re-emerge with a higher pro- US far exceeded the wealth of royalty ily business or source of wealth file, but with a bit of a new twist on a in Europe, much to the astonishment is turned into cash or diversified very old concept. Clearly, one of the of the royalty. None the less, these investments. With this fundamental watershed events for the recognition, fabulously wealthy commoners development, the nature and purpose visibility, and proliferation of family needed someone to account for their of the family office shifted from offices was Sara Hamilton’s forming assets, collect their income, and make that of the traditional family office. of Family Office Exchange in Chicago the disbursements for their personal We now see the emergence of large around 1990. Hamilton’s Exchange living activities. The lifestyle of banks and investment firms offer- provided a forum for information the robber barons included multiple ing family office services, having about this old service to a new group households, distinct household staffs, special groups that cater to family of wealthy families. During this time, expensive art collections, extensive offices, or even calling themselves the growing economy, reduction of travel and elaborate hobbies. Such family offices. While banks and tax rates, and generational transfer of a lifestyle required an entity –the investment firms naturally focus on wealth resulted in a proliferation of office-- which served primarily per- capital transactions, the primary and wealth and with this wealth came the sonal financial management and nonetheless very necessary manage- need for a family office, separate from accounting, separate and distinct ment and accounting of a family’s the commercial enterprises, to manage from the accounting function of the personal wealth and lifestyle is still the accounts associated with personal business or businesses that gave rise best served by a traditional family life activities. to the wealth of the family. This office model. separate “family office” provided an essential, personal privacy to the But this most recent class of As estate planners, you wealthy by a group dedicated solely the wealthy differs in an important way may recognize your client’s need to the family’s service. from the “old money” out of which for the kind of personal accounting arose family offices in the country. The twist that I referred to above is that many of the new family offices continued on Page 5

Probate and Trust Law Section Newsletter No. 112 4 Pennsylvania Impressionists Surge on the Art Market

By MATTHEW S. WILCOX VICE PRESIDENT OF TRUSTS & ESTATES FREEMAN’S AUCTIONEERS PHILADELPHIA

In the last ten years, a What binds the group generally is the sues of quality, size, condition, sub- group of early 20th century painters immediate sensation of colorful, nat- ject matter, color, and provenance from New Hope, Pennsylvania has ural scenes executed with energetic, all impact the value the art market begun to receive serious recognition bravura brushwork. will bear. All paintings not being by both the art market and academia. equal, a good rule of thumb for the Referred to as “Pennsylvania Im- Pennsylvania Impression- amateur collector is: never invest in pressionists”, the spiritual founder ism has emerged as one of the most a painting you wouldn’t mind seeing of the movement was New Hope quickly appreciating sectors of the on your wall for a long, long time. painter William Langson Lathrop art market. Paintings by such art- Of course, as in all matters of busi- (1859-1938), who became an inspi- ists as Fern Isabel Coppedge, Walter ness, seeking the counsel of experts rational mentor for many genera- Baum, Kenneth Nunamaker, Walter is always sage advice. tions of painters. His studio, once Schofield, and John Fulton Folins- the heart of the New Hope art colony, bee have all increased in value quite Matthew S. Wilcox is a later evolved into a vital community significantly in recent years. Among graduate of Bowdoin College and art center, which continues today. the most notable artists of the Penn- holds a Master’s Degree in Art His- sylvania Impressionists are Daniel tory from UNC-Chapel Hill. The Pennsylvania Impres- Garber, Edward Redfield and Roy sionists chose to paint outside, en Nuse. Last year a Nuse painting esti- plein air, not in the studio, and typi- mated from $70,000 - $100,000 sold THANK YOU! cally focused their subject matter for a world record $311,750. That on nature’s beauty: Pennsylvania record, and most other world records Susan Collings, of landscapes, snowy winter scenes, for the Pennsylvania Impressionists, Drinker, Biddle & the great outdoors. Their art is not were realized locally, in Philadelphia, defined by any one common style, where collector interest in the genre Reath, has retired after but by an array of distinct individual is strongest. several years of service styles rooted loosely in late 19th- as editor of this news- century tonalism and impressionism. According to Alasdair Nich- ol, painting specialist at Freeman’s, letter and chair of the The Family Office “the market for Pennsylvania Impres- Section’s Publications sionists has accelerated so quickly Phenomenon, over the last few years it is difficult to Committee. It is a dif- continued predict how long it can be sustained ficult task to persuade at these high levels,” but he adds that and managerial services associated people to take the time “with each subsequent auction, new with the traditional family office as collectors emerge, so the prognosis is to write articles for the well as the investment management good.” associated with the latest spin on newsletter and Susan the family office. In a future article, For those intending to dab- deserves the thanks of I will cover the emergence of the ble in art investment, a cautionary all Section members multi-family office (MFO) and how note should be added. While a Red- for her hard work and to analyze whether a family office field painting sold last December for or multifamily office is the best for $300,750, another Redfield in the dedication to the task. your client. same sale reached only $8,225. Is- Probate and Trust Law Section Newsletter No. 112 5 TAX UPDATE By JOAN AGRAN MCCAUSLAND, KEEN & BUCKMAN I. TREASURY REGULATIONS netting rules generally applicable to or after December 31, 1998. other noncorporate taxpayers, in net- Final Regulations Issued on Order- ting capital gains and losses, the gains Final Regulations Issued on Elec- ing Rules for Charitable Remain- and losses of the long-term capital gain tion out of GST Deemed Alloca- der Trusts classes should be netted before netting tions a short-term capital loss against any In T. D. 9190, 70 Fed. Reg. class of long-term capital gain. In T.D. 9208, 70 Fed. Reg. 12793 (3/16/05), the Treasury is- 37258 (6/29/05), the Service issued sued final regulations amending the The final regulations clarify final regulations addressing: (i) the proposed ordering rules for character- that the character of all amounts a Code Sec. 2632(c)(5)(A)(i) election izing distributions from charitable charitable remainder trust distributes to not have the Code Sec. 2632(c)(1) remainder trusts to provide guidance or is deemed to distribute at any time deemed allocation of unused GST tax on the treatment, under Code Sec. during a taxable year must be deter- exemption apply to certain transfers 664(b), of qualified dividend income mined at the end of the charitable to a Code Sec. 2632(c)(3)(B) GST and different classes of capital gains remainder trust’s taxable year and trust; and (ii) the election under Code and losses. that the tax rates on a distribution or Sec. 2632(c)(5)(A)(ii) to treat a trust deemed distribution are the tax rates as a GST trust. The final regulations re- applicable to the classes of income tain the position of the proposed from which the distribution is derived The proposed regulations regulations that charitable remainder in the year of distribution rather than permitted transferors to elect out of trusts must maintain separate classes the rates applicable to those classes in (i) a current transfer only or (ii) a within a category of income when the year when the charitable remainder current-year transfer and all future two classes are only temporarily trust receives the income. transfers to the same trust. The final subject to the same tax rate. The regulations give transferors the ad- final regulations also continue to Treasury added examples to ditional option of electing out of: require that dividends must not only the final regulations illustrating: (i) the (i) only certain designated future satisfy the Code Sec. 1(h)(11) defi- end result of a short-term capital loss transfers to a trust; or (ii) all future nition but must also be received by and a combination of long-term capital transfers made by the transferor to the charitable remainder trust after gains and losses that net to a long-term any trust (regardless of whether the 2002 to be eligible for inclusion in capital loss; (ii) the end result when an trust exists at the time of the election the qualified dividend income class. income class has a net-loss amount that out). The transferor may elect out of Treasury rejected a suggestion that is carried forward without affecting future transfers even if the transferor the final regulations should include the tax character of distributions; and has not made a current-year transfer a provision similar to that in Regs. (iii) the treatment of the distribution of and is not otherwise required to file § 1.664-1(d)(4)(ii) to allow a qualified five-year gain between Janu- a federal gift tax return. The Service to correct an incorrect distribution ary 1, 2004 and December 31, 2008. added examples illustrating language resulting from a fiduciary accounting that may be used in the election out mistake so that the charitable remain- The final regulations are statement to satisfy the requirements der trust could receive the benefit of generally effective for taxable years for the various election out options. the correction in the year when the ending after November 20, 2003. correction is made, stating that the However, the rules providing for the The final regulations spe- proper remedy in such a case is the netting of capital gains and losses and cifically confirm that an election out filing of an amended return rather requiring long-term capital gains to of the automatic allocation rules for than a current-year adjustment. be distributed in a specified order, as future years is limited to automatic well as certain transitional rules, are allocations to indirect skips made For consistency with the effective for taxable years ending on continued on Page 7 Probate and Trust Law Section Newsletter No. 112 6 an ETIP that are either direct skips or If a transferor is subject to transfer tax Tax Update, continued indirect skips at any time prior to the on the property on more than one oc- during the transferor’s lifetime under due date of the federal gift tax return casion, then the individual’s interest is Code Sec. 2632(c) and has no effect for the calendar year during which considered established or derived on on the automatic allocation rules the ETIP closes. Transferors may the earliest of those occasions. The that apply after the transferor’s death elect out of the automatic allocation interest of a remainder beneficiary under Code Sec. 2632(e). rules on the gift tax return reporting of a trust for which a QTIP election the transfer to the trust, or on a gift under Code Sec. 2523(f) or Code Sec. For indirect skips made after tax return filed for any calendar year 2056(b)(7) has been made is deemed December 31, 2000, to which Code subsequent to the year of the transfer to have been established or derived, Sec. 2642(f) (the estate tax inclusion up to and including the calendar year to the extent of the QTIP election, period or ETIP rules) does not apply, in which the ETIP closes. To apply the on the date as of which the value of a transferor’s unused GST exemption election out to prior-year transfers that the trust corpus is first subject to tax is automatically allocated to the prop- are subject to an ETIP, the election-out under Code Sec. 2519 or Code Sec. erty transferred. The final regulations statement must specifically (i) describe 2044. However, under the final regs, clarify that in the case of an automatic the prior-year transfers to be covered this rule does not apply to a trust to allocation to an indirect skip under by the election out; (ii) state that those the extent that a reverse QTIP elec- Code Sec. 2632(c), the automatic al- transfers are subject to an ETIP; and tion under Code Sec. 2652(a)(3) has location is effective as of the date of (iii) state that the transferor wishes to been made for the trust because, to the the transfer, and becomes irrevocable elect out of the automatic allocation extent of a reverse QTIP election, the on the due date for filing the federal to those prior-year transfers. Except spouse who established the trust will gift tax return, for the calendar year in in that limited circumstance, the final remain the transferor of the trust for which the transfer is made, whether or regulations provide that an election GST purposes. not a gift tax return is filed reporting out does not apply to any prior-year the transfer. transfer to a trust, including a transfer Under the proposed regu- subject to an ETIP, even if the ETIP lations the predeceased parent rule If a transferor makes an in- closes after the election has been wouldn’t apply to transfers to collat- direct skip and affirmatively allocates made. Once an affirmative allocation eral heirs if, at the time of the transfer, GST exemption in an amount that is of GST exemption is made (including the transferor (or the transferor’s less than the value of the property to a transfer subject to an ETIP), the spouse or former spouse) has any transferred, the transaction is, in ef- allocation may not be revoked. living lineal descendants. In response fect, an allocation of the amount that to comments that this inappropri- was affirmatively allocated and an IRS Finalizes Regs on the GST Tax ately narrowed the application of the election out of the automatic alloca- `Predeceased Parent Rule’ predeceased parent rule, the Service tion rules for the value of the property removed the parenthetical language. not covered by the exemption amount In T.D. 9214 (07/15/2005), Reg. § 26.2651-1(b) now requires affirmatively allocated. Therefore, an the Service has finalized proposed that, for the predeceased parent rule affirmative partial allocation of GST regulations (issued in 2004) on the to apply to transfers to collateral heirs, exemption is treated as an election GST tax predeceased parent rule with only the transferor must have no liv- out of the automatic allocation rules several changes. The final regulations ing lineal descendants at the time of with regard to the balance of that apply for terminations, distributions, the transfer. transfer. and transfers occurring after July 17, 2005. However, for transfers Under proposed Reg. § The rules regarding the after Dec. 31, 1997 and before July 26.2651-2(b), if an adoptive parent le- automatic allocation to an indirect 18, 2005, taxpayers may rely on any gally adopts an individual who is: (i) a skip subject to an ETIP are revised to reasonable interpretation of Code Sec. descendant of a parent of the adoptive conform to Code Sec. 2632(c)(4) and 2651(e). parent (or the adoptive parent’s spouse provide that the automatic allocation or former spouse); and (ii) under the to a direct skip or an indirect skip is The final regulations provide age of 18 at the time of the adoption, deemed to be made at the close of that for purposes of Code Sec. 2651(e), then the adopted individual would the ETIP. Therefore, a transferor an individual’s interest in property or a be treated as a member of the gen- may elect out of the automatic al- trust is established or derived when the eration that is one generation below location rules for transfers subject to transferor is subject to estate or gift tax. continued on Page 8 Probate and Trust Law Section Newsletter No. 112 7 II. COURT DECISIONS created an irrevocable stock trust and Tax Update, continued funded it with stock of his wholly the adoptive parent for purposes of Held Not to owned corporation. Some years later, determining whether a transfer from Have an Insurable Interest following advice that pooling all of the adoptive parent (or the spouse or the corporation’s stock in a holding former spouse of the adoptive parent, In Chawla, Trustee for company would better position the or a lineal descendant of a grandpar- Harald Giesinger Special Trust, v. corporation for a corporate liquidity ent of the adoptive parent) to the ad- Transamerica Occidental Life Insur- event, considered necessary to raise opted individual is subject to GST tax. ance Company, 200 SWL 405405, capital and remain competitive, de- The final regulations retain this rule, Civil Action No. 03-CV-1215 (ED cedent and the trust transferred their but add an additional requirement that VA, Feb. 3, 2005), decedent, in 2000, respective shares of the corporation’s the individual not be adopted primar- tried to obtain a life-insurance policy stock to an LLC, in exchange for ily for GST tax-avoidance purposes. on his life, naming his physician’s which they received LLC class A and This determination is to be based on wife as the owner and . class B membership units. facts and circumstances, with the When the insurer refused to issue the most significant factor being whether policy because the proposed owner and At about the same time, de- there is a bona fide parent/child rela- beneficiary wasn’t a relative and didn’t cedent and the trust formed a family tionship between the adoptive parent have an insurable interest in decedent, limited partnership to which dece- and adoptive individual. the decedent made the proposed owner dent transferred all of his LLC class and beneficiary a trust in which both B membership units in exchange for The preamble to the final he and the physician’s wife were co- a 99% limited partnership interest, regulations states that although an ad- . The insurer issued the policy and to which the trust transferred a opted individual is treated as related to the trust. portion of its LLC class B member- by blood to the adoptive parent under ship units in exchange for a 1% gen- Code Sec. 2651(b)(3) and generally Following the decedent’s eral partnership interest. About one is treated as his child under state law, death, the insurer denied the claim, year later, decedent gifted a 7.72% the adopted individual also continues alleging decedent failed to disclose partnership interest to his wife. He to be the blood relative of his birth key medical information. The trustee made no other of his partnership parents. Thus, the generation assign- sued for breach of in the U.S. interest before his sudden death the ment of the adopted individual with District Court for the Eastern District following year. regard to a transfer from an ancestor of Virginia. The court (applying of the birth parent is measured under Maryland law because the policy was The Service determined Code Sec. 2651(b), but, subject to delivered to the trustee in Maryland, that the corporation’s stock trans- the exception in Reg. §26.2651-2(b), where she lives) ruled in favor of the ferred to the LLC was includible in the relationship between them may insurer, finding that decedent misrep- decedent’s gross estate under Code be subject to Code Sec. 2651(f)(1), resented his medical history on his Secs. 2035(a) and 2036(a) and issued which provides that an individual who applications for the policy, omitting a notice of deficiency, stating that would be assigned to more than one some serious health issues. The court over $50 million in additional estate generation is assigned to the youngest further stated that the policy would tax was owed. of those generations. In addition, if also be void because the trust had no an individual’s generation assignment insurable interest in decedent’s life. The Tax Court agreed with is adjusted with regard to a transfer The court stated that the trust gained the estate that the stock transfer was either under Code Sec. 2651(e) or more financially upon decedent’s death a bona fide sale for adequate and full as a result of an adoption described than when he was alive, and the trust consideration in money or money’s above, a corresponding adjustment `suffered no detriment, pecuniary or worth and that there was a significant with respect to that transfer is made otherwise’ when decedent died. to the generation assignment of that and legitimate nontax reason for the transfer. Decedent and the trust each individual’s spouse or former spouse, Estate Could Exclude Stock Trans- received an interest in the LLC that that individual’s descendants, and the ferred to LLC But Not LLC Units represented adequate and full con- spouse or former spouse of each of Transferred to FLP that individual’s descendants. sideration reducible to money value and therefore Code Sec. 2036(a) did In Estate Of Wayne C. Bon- gard, 124 TC No. 8 (2005), decedent continued on Page 9 Probate and Trust Law Section Newsletter No. 112 8 Tax Update, continued est. In addition, Code Sec. 2035(a) partners. From the beginning of 1995 required his estate to include the 7.72% to decedent’s death, son transferred not apply. This holding precluded limited partnership interest transferred funds between the partnership and the the application of Code Sec. 2035(a) by decedent to his wife within 3 years trust 40 times. Until decedent’s death, to some gifts decedent made of his of his death (although this interest the partnership paid those expenses LLC units within three years of his should qualify for the marital deduc- which exceeded her monthly income. death. tion). The partnership did not make any distributions to any other partners With regard to the transfer of Real Estate Transferred From Rev before decedent died. Soon after her LLC units to the partnership, the Tax Trust To FLP Included In Transfer- death the property was sold and final Court noted that (i) estate tax savings or’s Estate partnership distributions were made played a significant role in motivat- to the partners. ing the transfer to the partnership, In Estate of Virginia A. Big- (ii) the record did not support that elow, TC Memo 2005-65 (3/30/05), The estate did not include nontax reasons for the partnership’s decedent in 1991 gave a 1/175 un- the value of the property on the estate existence were significant motivating divided interest in her home which tax return but included the value of factors, and (iii) the partnership did was worth $1.75 million to each of the decedent’s limited partnership not perform a management function her three children (one of whom later interest discounted for lack of mar- for the assets it received and never died before she did) and transferred ketability and her general partner- engaged in any businesslike transac- her remaining interest to her revocable ship interest, applying a 35% control tions, either before or after decedent’s trust, of which she and her son were the premium. The Service determined an contribution of membership units to trustees. Her son was also her agent estate tax deficiency, after conclud- the partnership. In reality, decedent under a durable power of attorney from ing that the real property transferred did not receive any benefit beyond 1986 until her death in 1997 and ex- to the partnership was includible in transfer tax savings from placing his ecutor of her estate. In 1992 decedent, decedent’s gross estate under Code membership units in the partnership after suffering a stroke, moved into an Sec. 2036(a)(1). and, therefore, the bona fide sale assisted-living facility, at which time exception did not apply. she gave each of her daughters an ad- The Tax Court found that ditional .75% interest in the property. decedent’s use of partnership income The court then determined to replace the income lost because that decedent retained possession In January 1993, the trustees of the transfer of the property to the and enjoyment of the transferred and the children exchanged the home partnership showed that there was property under an implied agree- for another residential property and an implied agreement between dece- ment. Decedent controlled whether $125,000 in cash. In 1994, the trust dent and her children that she would the partnership could transform its and decedent’s children formed a retain the right to the income from sole asset, the class B membership limited partnership to engage in the the property. After the transfer of the units, into a liquid asset. As CEO business of owning and operating resi- property to the partnership, the prop- and sole member of the corporation’s dential real property, with the trust as erty continued to secure decedent’s board of directors, he determined both the sole general partner and a lim- legal obligation to pay the bank loan when the corporation redeemed its ited partner, and the three children as and the bank line of credit, evidencing stock in each of the seven instances limited partners. The trust transferred her retention of the economic benefit of redemptions before his death. By the property (but not a debt secured by of ownership of the property after it choosing not to redeem the member- it) to the partnership. Decedent, in her was transferred to the partnership. ship units held by the partnership, he capacity as grantor and beneficiary of The court further concluded that exercised practical control over the the trust, agreed to hold the partnership there was no bona fide sale because partnership and limited its function harmless for a bank loan and line of the transfer was not made in good to simply holding title to the class B credit secured by the property. faith in that the transfer impoverished membership units. On this basis, the decedent, partnership formalities decedent’s gross estate had to include The partnership agreement al- were not respected, and the transfer the value of the class B membership located 1% of the net operating profits did not provide any nontax benefit to units held by the partnership on his and losses of the partnership to the decedent. death that was proportionate to his general partner and 99% to the limited 91.28% limited partnership inter- continued on Page 10 Probate and Trust Law Section Newsletter No. 112 9 Tax Update, continued tables. The Service issued a defi- ciency notice to both estates, claiming Decedent’s Unassignable Lottery Family Limited Partnership Assets that the full values of the partnership Winnings Constitutes Annuity Included in Decedent’s Estate Under assets were includible in the gross Valued by Use of Tables §2036(a)(1) estates under Code Secs. 2036(a)(1) and (2) and 2038(a)(1) and reducing In Donovan Est. v. U.S., In Korby Est. v. Comr., T.C. the estate’s adjusted taxable gifts to 95 AFTR 2d 2005-885 (D. Mass. Memo 2005-102 (5/10/05), in 1993, reflect the exclusion of the 1995 gifts 4/26/05), decedent won the lottery decedent and her husband were diag- of partnership interests. on January 4, 1999, on which date nosed with serious medical conditions Massachusetts issued him the first of and moved to a nursing home where The Tax Court held that the 20 annual $100,000 checks, the only they resided until their deaths in 1998 decedent and her husband had an check he received prior to his death within five months of each other. They implied agreement that they would in July 1999. Under Massachusetts were survived by four sons. receive income as needed from as- law, he was not permitted to assign sets she transferred to family limited the winnings. Decedent’s estate tax Decedent and her husband partnership, thus causing assets to be return showed no estate tax due, had created a revocable trust in 1993, included in each estate under Code listing the remaining 19 payments as funding it with assets they owned Sec. 2036(a)(1). The court found an asset appraised at $367,482. The jointly and individually. The follow- that husband had an implied agree- Service calculated the asset as being ing year, decedent, her husband and ment (on his own behalf and on his worth $1,091,553 by reference to their sons executed a family limited wife’s behalf) with the sons that the statutory annuity tables, resulting in partnership agreement governed by assets transferred to the partnership an additional tax liability of $173,610 Minnesota law, to which the revocable would be available to the couple for plus interest. The estate paid tax and trust transferred a money market ac- as long as they needed income. Note filed a claim for refund, which the count in exchange for a 2% general that the formalities of the partnership Service rejected. The estate then partnership interest. Decedent and her agreement were not followed and the sued in District Court. husband then contributed assets to the couple did not retain sufficient assets partnership, with husband receiving in their names or in the revocable trust The only issue for the a 58.46% limited partnership inter- to cover their expected expenses. district court was the value to be est and decedent receiving a 38.26% included in the estate, based on limited partnership interest. The sons Stock Transfers to Trusts Bona whether the lottery prize won by contributed 1.28%. The couple gave Fide Sales for Full Consideration decedent constituted an annuity. a 24.5% limited partnership interest to Rejecting the estate’s contention that each of four irrevocable trusts created In Schutt Est. v. Comr., T.C. lottery winnings were a “restricted for the sons, which gifts they elected to Memo 2005-126 (5/26/05), Decedent beneficial interest” excepted from split and were reported on 1995 gift tax died in 1999. His wife’s father had the Code Sec. 7520 tables by Regs. returns. The returns applied a 43.61% established a trust in 1940 for the §20.7520-3(b)(1)(ii), the court found discount in valuing the partnership benefit of his descendants, which was that the lottery prize was an ordinary interests. The partnership agreement to terminate no later than 21 years annuity to be valued using the valua- provided for management fees to be after the death of the last survivor of tion tables. The court found that the paid to the revocable trust as general his then-living issue, and his sons-in- nonmarketability of lottery winnings partner, in an amount determined by law. Wife’s father had established a did not warrant valuation outside the the general partner, and for the reim- second trust in 1936 for the benefit annuity tables. Noting that at the bursement of partnership expenses of wife’s descendants which was to time of decedent’s death, he held an incurred by the general partner. From terminate on the date the youngest enforceable right to receive set an- 1995 to 1998, the partnership and the grandchild living at wife’s death nual payments from a most reliable trust paid many of decedent’s and her reached 40. Decedent and his wife, source, the court concluded that the husband’s household living expenses. who had died in 1989, established unassignable nature of the decedent’s In addition to their social security various trusts for the benefit of their right did not lessen its worth to benefits, the trust used cash from the descendants. The same trust com- decedent’s estate in any way signifi- partnership to pay for nursing home pany served as trustee of all of these cant for tax purposes or in a way not expenses, other expenses and made trusts. already contemplated by the annuity cash payments to husband. continued on Page 11 Probate and Trust Law Section Newsletter No. 112 10 the business trusts in a timely manner, generated steady rental income, were Tax Update, continued entity and personal assets were not transferred to three family limited Decedent was concerned commingled, the decedent was not partnerships of which she and her regarding sales by family members of financially dependent on distributions children were partners. Between core stockholdings and had a desire from the business trusts and retained 1995 and 1997, when she died, to extend and perpetuate his buy and sufficient assets outside of the busi- decedent, through her guardian, hold investment philosophy over ness trusts to amply support his needs transferred percentage interests of her family assets in order to preserve and lifestyle, and decedent was not share in the partnerships to her chil- the family wealth. To this end, in effectively standing on both sides of dren and their families. The estate 1998, decedent negotiated with the the transactions. In addressing the is- included the percentage interests in trust company for the establishment sue of adequate and full consideration, the partnerships still held by dece- of two Delaware business trusts to the court noted that others contributed dent at her death and valued these hold the stock of the family trusts more than half of the property funding interests by applying minority and and decedent’s stock. The purpose the entities. The court found that dece- lack of marketability discounts. The of the Delaware business trusts was dent employed his capital to achieve a Service issued a deficiency notice, to consolidate all the trust assets of legitimate nontax purpose and was not including the property transferred to which decedent was either the direc- merely recycling his shareholdings. the partnerships in the estate under tor or investment advisor, including Code Sec. 2036. a substantial portion of decedent’s Citing Bongard Est. v. Comr., own portfolio, thereby resulting in 124 T. C. No. 8 (2005), the court noted The Tax Court ruled in favor a consistent investment policy with that (i) each participant in the business of the Service, stating that it was clear, respect to the assets in which the trusts received an interest proportionate from the probate court’s decree and family had an equitable interest. in value to its respective contribution, from the testimony of the children and (ii) the capital contributions made were guardians about their understanding Following decedent’s death, properly credited to each transferor’s of the decree, that decedent’s support the Service sought to include in capital account, (iii) distributions needs were treated as an obligation decedent’s estate for federal estate required a negative adjustment in the of the partnerships, and that she was tax purposes his personal assets distributee’s capital account, and (iv) entitled to any and all funds gener- transferred to the business trusts liquidating distributions would also ated from the partnerships. Only under either Code Secs. 2036(a) or be made in accordance with capital after her support needs were met 2038. The Tax Court disagreed with account balances. could the children/limited partners the Service, holding that the transfers receive their proportionate share of were excepted from inclusion in Property Transferred to FLPs Set the partnership income. Therefore, decedent’s gross estate under either up for Incapacitated Individual decedent retained the enjoyment and Code Sec. 2036(a) or Code Sec. 2038, Included in Her Estate use of the property transferred to because the transfers constituted the partnerships within the meaning bona fide sales for adequate and full In Estate of Ida Abraham, of Code Sec. 2036(a)(1). The Tax consideration. (2005, CA1) 95 AFTR 2d P2005- Court also found that initial sales by 1018), decedent suffered from Al- decedent of partnership interests to The court based its holding zheimer’s disease and had to be placed her two daughters for $160,000 each on the fact that decedent’s motives under a guardianship. To ensure that were not bona fide sales for adequate under his unique circumstances were her financial needs would be met consideration, because the estate did more than merely testamentary. His and to prevent her estate from being not produce sufficient to desire to prevent the sale of core hold- drained by the contentious litigation demonstrate the fair market value for ings in the family trusts in the event among her children, in 1995 a state the partnership interests on the dates of a distribution to beneficiaries was probate court entered a stipulated de- of the transfers. real, was a significant factor in mo- cree requiring the establishment of an tivating the creation of the business estate plan for decedent. She died on On appeal, the First Circuit trusts, was appreciably advanced by June 9, 1997. agreed with the Tax Court that the formation of the business trusts, and estate failed to show that the daugh- was unrelated to tax ramifications. As part of the estate plan, ters paid adequate consideration for The court noted that the contributed in 1995 three pieces of commercial property was actually transferred to property owned by decedent and which continued on Page 12 Probate and Trust Law Section Newsletter No. 112 11 Tax Update, continued ers from building on the property’s those transfers which require that the lake-front lots. Taxpayers could still donee hold the easement exclusively their interests. The court also noted develop the portion of their shoreline for conservation purposes (i.e., that that Service applied Code Sec. 2043 property unencumbered by the conser- they not be transferable by the donee to reduce the amount includible in vation easements in any way consistent in exchange for money, other prop- the estate by the $160,000 consid- with the zoning requirements. erty, or services). The Tax Court eration paid by the daughters. The interpreted ‘exclusively’ to require court noted, in addition, that all Under Code Sec. 170(h)(1), a the donee’s holding of a qualified parties understood that the guardian taxpayer can take a charitable deduc- real property interest in perpetuity had the discretion and the approval tion for a contribution of a partial inter- exclusively for one or more of the of the family to use all partnership est in real property if it is a `qualified Code Sec. 170(h)(4) conservation income, if necessary, for decedent’s conservation contribution’ (a contribu- purposes. The donee in this case is support. The First Circuit stressed tion of a qualified real property interest a legitimate, long standing nature that Code Sec. 2036 does not require that is made to a qualified organization conservancy, and the holding of the the decedent to have retained a legally exclusively for conservation purpos- conservation easements is directly enforceable interest as the estate was es). Under Code Sec. 170(h)(4)(A)(ii) related to its tax-exempt purposes. contending but that Code Sec. 2036 and Reg S 1.170A-14(d)(3), one of the The donee dealt at arm’s length with will apply if enjoyment of the trans- ways a contribution qualifies as being the taxpayers and agreed (and has the ferred property is retained under an for a conservation purpose is when the commitment and financial resources) arrangement or understanding. interest protects a significant relatively to enforce the preservation-related natural habitat in which a fish, wildlife, restrictions included in the easements Gifts of Easements on Lake-Front or plant community, or similar ecosys- in perpetuity, and any later holder of Property are Qualified Conserva- tem, normally lives. A contribution the conservation easements must be tion Contributions of a qualified real property interest an entity fully committed to carry- that meets this significant habitat or ing out the contributions’ charitable In Glass, 124 TC No. 16 ecosystem test is deductible even if the purposes. Further, these restrictions (2005), over a two-year period, public’s right to access that property is are legally enforceable to limit in taxpayers donated conservation ease- restricted. perpetuity any inconsistent use of the ments on part of their property on the encumbered shoreline. Lake Michigan shoreline, including On the basis of these facts, much of a high, undeveloped bluff the Tax Court held that the easements Note that the Staff of the on that shoreline, to the Lake Tra- satisfied the conservation purposes Joint Committee on Taxation has verse Conservancy Trust, an exempt test because they protected a relatively proposed changes which, if adopted, organization that has operated for natural plant or wildlife habitat. The would (i) treat the protection of the more than three decades to preserve encumbered shoreline, in its natural natural habitats described in Code land and wilderness in trust for con- undeveloped state, was a relatively Sec. 170(h)(4)(A)(ii) as exclusively servation and for the recreation and natural habitat for threatened plant for conservation purposes only if it education of the people of Michigan. species, bald eagles, and other wild- is pursuant to a clearly delineated Taxpayers deducted the value of life. The conservation easements governmental policy, i.e., it furthers donated easements, but the Service protect and preserve significant natural a specific, identified conservation denied these deductions, claiming habitats by limiting the development project, and (ii) not treat a qualified the easements weren’t exclusively or use of the encumbered shoreline. real property interest as contributed for conservation purposes. Similarly, the conservation easements exclusively for a conservation pur- operate to protect or enhance the vi- pose if the donor (or a family member The easements did not re- ability of an area or environment in of the donor) has a right to use all strict taxpayers’ use or enjoyment of which a wildlife community and a or a portion of the real property as a their property (with three buildings plant community normally live or oc- personal residence at any time after on it including a log cabin, a guest cur. the contribution. house, and a garage) first as a vaca- tion home, and later as their primary The Tax Court said the residence. They did, however, limit taxpayers also met the exclusive pur- the development of the encumbered poses requirement, which is intended shoreline, preventing the taxpay- to limit deductible contributions to continued on Page 13 Probate and Trust Law Section Newsletter No. 112 12 Court of Appeals for the Fifth Circuit The estate also argued that the `bona Tax Update, continued has upheld the 2003 Tax Court deci- fide sale for an adequate and full con- Deduction for Advisory Fees Paid sion that the full amount of the assets sideration’ exception should apply to by Trust Subject to 2% Floor transferred to a family limited partner- the transfer of assets to the partner- ship must be included in decedent’s ship. While agreeing that there was In Rudkin Testamentary estate under Code Sec. 2036(a). full and adequate consideration, the Trust v. Comr., 124 T. C. No. 19 Shortly before his death in 1994, Mr. Tax Court found there was no bona (6/27/05), the trustee of a trust en- Strangi transferred 98% of his assets fide sale. Stating that a sale is bona gaged an outside firm to provide to a family limited partnership. The fide if it serves a substantial business investment management advice for Tax Court held: (i) the partnership or other non-tax purpose, the Fifth the trust and paid $22,241 for such was valid under state law and would Circuit found no ‘clear error’ by the services during the 2000 taxable year. be recognized for estate tax purposes, Tax Court in rejecting the non-tax The trust deducted these fees in full (ii) Code Sec. 2703(a) did not apply rationales advanced by the estate on its federal income tax return. The to the partnership agreement, and (iii) for Mr. Strangi’s transfer of assets Tax Court held that the investment the transfer of assets to the partnership to the partnership, but not whether advisory fees paid by the trust are was not a taxable gift. The Service re- they would have reached the same not fully deductible under the excep- quested leave to amend in order to add conclusion. tion provided in Code Sec. 67(e)(1) a Code Sec. 2036 claim whereby the with respect to costs that are paid or estate would be required to include the Estate Tax Value Of Stock Reduced incurred in connection with adminis- assets transferred by Mr. Strangi to the By, Discounted, Not Full, Built-In tration of the trust that would not have partnership rather than just his partner- Capital Gain Tax been incurred if the property were ship interest in partnership. The court not held in trust. Under Code Sec. denied the Service’s request. Estate of In Estate Of Frazier Jelke 67(a), the investment advisory fees Albert Strangi v. Commissioner, 115 III, TC Memo 2005-131 (3/31/05), are deductible only to the extent that T.C. No 35 (Nov. 30, 2000). decedent’s revocable trust owned a they exceed 2% of the trust’s adjusted 6.44% interest) in a C corporation gross income, the court held. The Fifth Circuit disagreed whose only activity was to hold and with the Tax Court’s denial of the Ser- manage investments for the benefit The court noted that there is vice’s leave to amend and reversed the of its shareholders. Decedent’s rela- a split of authority on this issue, with Tax Court on that issue. Rosalie Gulig tives owned the remaining interests in the Sixth Circuit holding in O’Neill v. v. Commissioner, No. 01-60538 (CA5 the company through various trusts, Comr., 994 F.2d 302 (6th Cir. 1993), June 17, 2002). Upon remand, the Tax none of whose terms prohibit the that the 2% limitation did not apply, Court determined that the transfers sale or transfer of corporate stock. and the Fourth Circuit holding in to the partnership met the tests under The primary investment objective of Scott v. U.S., 328 F.3d 132 (4th Cir. both Code Sec. 2036(a)(1) and Code the company was long-term capital 2003), and the Federal Circuit hold- Sec. 2036(a)(2) and ruled that the full growth, resulting in low asset turn- ing in Mellon Bank N. A. v. U.S., 265 amount of the assets transferred must over and large unrealized capital F.3d 1275 (Fed. Cir. 2001), that the be included in decedent’s estate. Estate gains. As of the date of decedent’s fees are deductible subject to the 2% of Albert Strangi v. Commissioner, death, the board of directors had no limitation. The Tax Court in this case T.C. Memo 2003-145 (No. 4102-99). plans to liquidate an appreciable por- agreed with the interpretation of the tion of the company’s portfolio, and Fourth and Federal Circuits. Appeal On appeal, the Fifth Circuit they intended to operate the company in this case would be to the Second determined that there was no clear as a going concern. Circuit, which has not ruled on the error in the Tax Court’s finding under issue. Code Sec. 2036(a)(1) that there was The company’s holdings an implicit agreement with the Strangi were mostly in marketable securities Fifth Circuit Upholds Service’s children that Mr. Strangi would retain and the Service and the estate agreed Position on Code Sec 2036 in enjoyment of his property after the as to the value of the company’s Strangi transfer to the partnership. Mr. Strangi underlying assets. They also agreed held few assets outside the partnership that a discount for the built-in capi- In Albert Strangi et al. v. and relied on partnership distributions tal gain tax was proper. However, Commissioner, No. 03-60992, (CA to pay a number of personal expenses 5, July 15, 2005), the United States as well as many post death expenses. continued on Page 14

Probate and Trust Law Section Newsletter No. 112 13 Tax Update, continued under which the Service will disre- which show how the safe harbor gard the right of election for purposes works, one which illustrates a situa- they differed as to the amount of the of determining whether the CRAT tion in which a waiver is not needed, reduction for the potential capital or CRUT meets the requirements of and one which explains the effect on gain tax. The Court agreed with the Code Sec. 664(d)(1)(B) or Code Sec. a trust when no waiver is made. Service that the built-in capital gain 664(d)(2)(B) continuously since its tax liability should be discounted to creation if the grantor’s spouse irre- Death Benefit Paid Under Deferred reflect when it is reasonably expected vocably waives the right of election Annuity Contract is IRD to Ben- to be incurred rather than reducing in the manner set forth in the revenue eficiary the stock’s value by the entire built-in procedure. capital gain as of the date of death as In Rev Rul 2005-30, 2005- the estate contended. The court held For charitable remainder 201RB, decedent bought a deferred that an assumption of liquidation was trusts that would be subject to the annuity contract with annuity pay- not appropriate in this case and that spouse’s right of election under state ments to be made to him beginning the tax liability for the capital gain law created on or after June 28, 2005, as of a date specified in the contract. should be calculated on the basis of the failure of the spouse to waive Decedent could surrender the con- the company’s established history of the right of election will result in the tract during his life for a value deter- securities turnover. On this basis, the CRAT or CRUT failing to qualify mined by a specified formula. If he Service allowed an 11.2% reduction under Code Sec. 664(d) continuously died before the annuity starting date, in value for built-in capital gain tax li- since its creation, whether or not the his named beneficiary would receive ability. The court also allowed a 10% spouse exercises the right. For those a death benefit equal to the account lack of control discount and a 15% trusts created before June 28, 2005, value as determined by the formula. discount for lack of marketability. the failure of the spouse to waive the The beneficiary could choose to right of election, combined with the receive the death benefits in a lump III. IRS REVENUE RULINGS, spouse’s exercise of that right of elec- sum or as periodic payments. Dece- REVENUE PROCEDURES AND tion, will result in the trust’s failing dent died before the annuity starting NOTICES to qualify under Code Sec. 664(d) date and the beneficiary received continuously since its creation. A the death benefit under the contract, New Safe Harbor For CRTs Sub- waiver of the spouse’s right of election which exceeded decedent’s invest- ject To Spouse’s Elective Share will provide certainty that the right of ment in the contract. election won’t cause the trust to fail On the basis of these facts, In Rev. Rul. 2005-24, 2005- to qualify under Code Sec. 664(d) the Service ruled that the death ben- 16 IRB, the Service has issued a safe continuously since its creation. efit is taxable to the beneficiary as harbor for charitable remainder trusts income in respect of a decedent to the created during life and which become For CRATs or CRUTs cre- extent the amount received exceeds subject to the grantor’s spouse’s ated on or after June 28, 2005, the the deceased owner-annuitant’s in- right of election to take against the waiver must be effective on or before vestment in the contract. The Service grantor’s will. A trust whose assets the date that is 6 months after the due noted that had decedent surrendered under state law may be used to sat- date (excluding extensions of time to the contract and received the amounts isfy a spouse’s elective share cannot file actually granted) of Form 5227, at issue while alive, the amount qualify as a CRAT under Code Sec. Split-Interest Trust Information Re- received would have been income 664(d)(1)(B) or as a CRUT under turn, for the year in which the later of to him under Code Sec. 72(e) to the Code Sec. 664(d)(2)(B). These rules the following occurs: (i) the creation of extent it exceeded his investment generally prevent a trust from quali- the trust; (ii) the date of the grantor’s in the contract. Accordingly, the fying as a charitable remainder trust marriage to the spouse; (iii) the date amount that the beneficiary received if amounts other than the permitted the grantor first becomes domiciled in excess of decedent’s investment in annuity or unitrust amount may be or resident in a jurisdiction whose law the contract is IRD under Code Sec. paid to or for the use of a person provides a right of election that could 691 and is includible in her gross in- other than the charity receiving the be satisfied from assets of the trust; come and she does not receive a basis remainder interest. or (iv) the effective date of applicable adjustment in the contract. However, state law creating a right of election. she is entitled to a deduction under This revenue procedure Rev Proc 2005-24, Sec. 5 provides a safe harbor procedure includes several examples, some of continued on Page 15 Probate and Trust Law Section Newsletter No. 112 14 Tax Update, continued validly disclaims 30% of spouse’s disclaimed amount and the income entire interest in the principal and attributable to the disclaimed amount Code Sec. 691(c) for any estate tax income of the balance of the IRA are paid to the beneficiary entitled imposed on decedent’s estate that is account remaining after the required to receive the disclaimed amount, attributable to the contract. The result minimum distribution for 2004 and or are segregated in a separate ac- would be the same whether the ben- after reduction for the pre-disclaimer count; and (iii) a person disclaiming eficiary received the death benefit in a income attributable to the required his or her entire remaining interest lump sum or as periodic payments. minimum distribution. As soon as in an IRA will not be considered a the disclaimer is made, child is paid designated beneficiary of the IRA Qualified in 30% of the excess of the remaining for purposes of Code Sec. 401(a)(9), Decedent’s IRA After Receiving account balance over the income if the qualified disclaimer is made RMD for Year of Death attributable to the required minimum on or before September 30th of the distribution. calendar year following the calendar In Rev. Rul. 2005-36, 2005- year of the account owner’s death, 26 I.R.B. 1368, decedent died in 2004 3. In the last situa- and if, on or before that September the owner of an IRA. Decedent’s tion, the facts are again the same as 30th, the disclaimant is paid the `required beginning date’ was prior in Situation 1, except that child is income attributable to the required to 2004, and decedent was receiving designated as the sole beneficiary of minimum distribution amount, so annual distributions from the IRA the IRA after decedent’s death, with that the disclaimant is not entitled to prior to the time of death, but had spouse designated as the beneficiary any further benefit in the IRA after not received the required minimum in the event child predeceases September 30th of the calendar year distribution for the 2004 calendar decedent, and the required minimum following the calendar year of the year. The revenue ruling addresses distribution for 2004 is paid to child account owner’s death. three different fact situations: three months after decedent’s death. Seven months after decedent’s death, In all three situations, the 1. In the first child disclaims the entire remaining beneficiary’s receipt of the required situation, decedent’s spouse is balance of the IRA account except for minimum distribution from the IRA designated as the sole beneficiary the income attributable to the required constitutes an acceptance of corpus, of the IRA after decedent’s death minimum distribution. As soon as the plus the income attributable to that and their child is designated as the disclaimer is made, the balance of the amount. However, the beneficiary’s contingent beneficiary if spouse IRA account, less income attributable acceptance of these amounts does not predeceases decedent. Three months to the required minimum distribution, preclude the beneficiary from making after decedent’s death, the IRA is distributed to spouse as successor a qualified disclaimer with respect to custodian pays spouse the required beneficiary. all or a portion of the balance of the minimum distribution for 2004. IRA. Seven months after decedent’s On the basis of these facts, the death, spouse disclaims in writing Service ruled that: (i) a beneficiary’s In Situation 1, assuming a pecuniary amount of the IRA disclaimer of a beneficial interest in the other requirements of Code account balance plus the income a decedent’s IRA is a qualified dis- Sec. 2518(b) are satisfied, spouse’s attributable to the pecuniary amount claimer under Code Sec. 2518 (if all disclaimer constitutes a qualified earned after the date of death. As of the requirements of that section are disclaimer under Code Sec.2518(b) soon as the disclaimer is made, child, met), even though, prior to making the of the pecuniary amount, plus the as successor beneficiary is paid the disclaimer, the beneficiary receives the income attributable to the disclaimed pecuniary amount disclaimed, plus required minimum distribution for the amount. that portion of IRA income earned year of the decedent’s death from the between the date of death and the IRA; (ii) the beneficiary may make a In Situation 2, as in Situ- date of the disclaimer attributable to qualified disclaimer under Code Sec. ation 1, spouse’s receipt of the dis- the pecuniary amount. 2518 with respect to all or a portion tribution also constitutes acceptance of the balance of the account, other of the income attributable to the 2. In the second than the income attributable to the amount distributed and spouse may situation, the facts are the same required minimum distribution that except that, instead of disclaiming the beneficiary received, provided that a pecuniary amount, spouse at the time the disclaimer is made, the continued on Page 16

Probate and Trust Law Section Newsletter No. 112 15 Tax Update, continued withdraw his or her contribution and On the basis of these facts, direct investment and distribution of the Service ruled that under Reg. not disclaim any portion of that in- assets from the account. Shortly after §25.2518-3(a)(1)(ii), wife’s dis- come. Therefore, the disclaimer of husband’s death, on the advice of her claimer of the assets held in the 30% of spouse’s entire interest in the stockbroker that the brokerage account Estate Account and the estate’s one- principal and income of the balance could not be held under the social half share of the TIC Account was a of the IRA account remaining after security number of a deceased indi- qualified disclaimer. Each spouse’s the required minimum distribution vidual, wife directed the stockbroker contributions to the account were in- for 2004 and after reduction for the to transfer title to the account to her complete gifts until husband’s death pre-disclaimer income attributable name. During the eight months after and under Reg. §2518-2(c)(4)(iii), to that amount constitutes a qualified husband’s death, wife directed the sale the transfer creating wife’s survi- disclaimer. and/or purchase of certain securities in vorship interest in husband’s share the brokerage account and withdrew of the brokerage account occurred The results in Situations cash from the account. at husband’s death; and under Code 1 and 2 would be the same if the Sec. 2518(a), wife had nine months amount disclaimed, plus that portion On the advice of the lawyer from his death to disclaim any part of of the post-death IRA income attrib- engaged by wife six months after her her survivorship interest in husband’s utable to the disclaimed amount, is husband’s death to administer his estate share. Wife’s transfer of title to the not distributed outright to child, but and within ninth months of husband’s account to her name did not result in instead is segregated and maintained death, she disclaimed her survivor- an acceptance by wife of husband’s in a separate IRA account of which ship interest in husband’s share in the share in the account because, under child is the beneficiary as described brokerage account minus the assets in Reg. §2518-2(d)(1), the mere transfer in Regs. § 1.401(a)(9)-8, A-3. that share (and earnings on those as- of title to the account to wife’s name sets since husband’s death) in which is not treated as her acceptance of Again in Situation 3, child’s wife had accepted benefits. The stock husband’s interest in the account or as receipt of the required minimum broker was then directed to establish benefiting her for purposes of Code distribution also constitutes an ac- and fund three separate accounts, the Sec. 2518. In addition, wife’s cash ceptance of the income that is deemed TIC Account, the Wife’s Account, and withdrawals from the account during attributable to the required minimum the Estate Account. The TIC Account, the eight months following husband’s distribution and child may not dis- which was held by wife and the estate death did not affect the validity of claim any portion of that income. as tenants in common, consisted of as- the disclaimer because the cash and Therefore, child’s disclaimer of the sets that could not be evenly divided, securities are severable assets. entire principal and income balance not including proceeds from securities of the IRA remaining after the pay- sold in the eight months following Charitable Deduction Permitted ment of the required minimum distri- husband’s death or any securities pur- for Transfers to Charities and bution for 2004, except for attribut- chased during that period. The Wife’s Private able income from the distribution, Account held assets attributable to her constitutes a qualified disclaimer. contributions to the brokerage account In PLR 200505008, dece- and assets attributable to husband’s dent’s Will directed his executor to IV. IRS PRIVATE LETTER contributions with respect to which distribute the remainder of his estate RULINGS AND TECHNICAL wife directed sales or purchases after to his revocable trust. The trust ADVICE MEMORANDA husband’s death. The Estate Account directed his trustee to distribute to held assets attributable to husband’s three Gift Trusts sufficient property Disclaimer Of Joint Brokerage Ac- contributions with respect to which to make gifts to several charitable and count Qualified Despite Withdraw- wife made no withdrawals and directed non-charitable beneficiaries. Gift als And Purchases no sales or purchases after husband’s Trust 1 is to distribute specific cash death. Each account also held the earn- gifts to three charities and Gift Trust In PLR 200503024, husband ings from the date of husband’s death 2 and 3 are to distribute specific cash and wife opened a joint brokerage on the assets placed in the respective gifts to four noncharitable beneficia- account with rights of survivorship. account. The Estate Account and the ries. Trustee is directed to distribute Each one contributed equally to estate’s one-half interest in the TIC the balance to a , the account during their joint lives, Account represented the disclaimed unless this would result in a loss of and each one could unilaterally interest. continued on Page 17 Probate and Trust Law Section Newsletter No. 112 16 The residue of his estate passed to a the trust payable annually, as required Tax Update, continued trust for wife’s primary benefit. Dur- under either Code Sec. 2056(b)(5) the charitable deduction, in which ing wife’s lifetime, trustee is to distrib- or Code Sec. 2056(b)(7), because case the trustee is to distribute the ute, subject to certain limitations, the (i) wife is entitled to only so much balance to a fourth charity. net income to wife in such amounts of the income as desired for certain and at such times as wife, in her sole specified purposes, (ii) the amount of Each Gift Trust provides discretion but in consultation with the income to be distributed to wife is to that the trustee is to distribute the trust trustee, desires for her maintenance, be determined `in consultation with property to each listed beneficiary af- health, or support commensurate with the trustee,’ and therefore is subject to ter the trustee has determined: (i) that her station in life. Additionally, if at the trustee’s approval, if not consent, all of the death taxes and expenses of any time, or from time to time in wife’s and (iii) the trust provides that any administration have been paid; (ii) opinion, trust income is insufficient, income not distributed is to be added that the beneficiary has not initiated the trustee, taking into consideration to principal, thus evidencing the un- a contest; and (iii) that the trust gift all the sources of income or other derstanding that not all trust income beneficiary has provided the trustee available capital, is authorized and would necessarily be distributed to with a release containing all condi- directed to distribute to wife portions wife. tions the trustee requires and stating of trust principal in such amounts as that the beneficiary will not initiate a she desires, in her sole discretion but Although wife can also contest. in consultation with trustee, for her request a corpus distribution, her maintenance, health and support. Any power is limited and does not meet the On the basis of these facts, income not distributed is to be added requirements of Reg. §20.2056(b)- the Service ruled that the conditions to principal. At wife’s death, all the 5(f)(6), under which a power over as set forth in the revocable trust, principal and accrued net income of corpus can cause the income require- including the condition precedent the trust is to pass to a trust for the ment to be considered met. Like that the charitable beneficiaries of benefit of decedent’s children and their income distributions, principal distri- Gift Trust 1 would contest the will, descendants. butions are to be made in consultation are so remote as to be negligible with the trustee, and are to be made and, under Reg. §20,2055-2(b)(2), The estate tax return treated only if trust income is not sufficient do not preclude a deduction under the property passing to the trust as to provide for wife’s maintenance, Code Sec. 2055(a) for the amount QTIP, and claimed a marital deduc- health and support, commensurate distributed to Gift Trust 1. Further, tion for its value. Although the Will with her needs. Further, in autho- citing Rev. Rul. 83-20, 1983-1 C.B. contained no reference to the estate rizing a principal distribution, the 231, the Service determined that the tax marital deduction and no specific trustee must take into consideration individual beneficiaries’ interests and statement indicating decedent’s intent all the sources of income or other the charitable interests are severable; that the trust qualify for the estate tax capital available. Thus, the power the noncharitable beneficiaries of Gift marital deduction, decedent’s estate is not exercisable in all events, and Trusts 2 and 3 take their bequests im- submitted file copies of two letters cannot be exercised to draw down the mediately and completely and do not to decedent from the attorney who entire corpus, as required under Reg. retain any interest in the residuary or drafted the will, both stating that under §20.2056(b)-5(f)(6). in Gift Trust 1. Therefore, the Service the terms of the draft, wife has the right concluded that the estate is entitled to to obtain all income and principal from Disclaimers Achieve Result That a deduction under Code Sec. 2055(a) the trust by making the request to the Deferred Comp Benefits Pass to for the amount distributed to Gift trustee. In addition, decedent’s estate Surviving Spouse Than to Rollover Trust 1 and to the foundation. submitted a letter from the attorney to IRA a trust officer stating that decedent has Marital Deduction Denied `maintained his decision that he wants In PLR 200505030, de- his wife to have complete discretion cedent, a State employee who had In PLR 200505022, de- with respect to the disposition of the participated in the State’s eligible cedent, who died with a pre-1981 trust assets...’ deferred compensation plan as de- Will, was survived by his wife and The Service denied the mari- fined in Code Sec. 457(b), died prior children. Decedent bequeathed all tal deduction, finding that the wife’s to attaining age 70 1/2. Under the his interest in his personal residence income interest was not an unqualified and all personal property to his wife. right to receive all of the income from continued on Page 18 Probate and Trust Law Section Newsletter No. 112 17 residue of decedent’s estate, including exemption from the generation- Tax Update, continued the plan distribution, will pass to wife skipping transfer tax, (ii) the initial terms of the plan, upon a participant’s by operation of state law and within 60 contribution transferred to the trust death, the plan proceeds become pay- days of receipt of the plan distribution, by the taxpayer and his spouse is to able to the participant’s designated wife will roll over the distribution into constitute separate trusts for the sons, beneficiary, or if there is none, to an individual retirement account set up which is to be called collectively the the participant’s estate. Decedent and maintained in her name. exempt share, (iii) any additional failed to designate a valid beneficiary transfers to this trust are to be held in and the proceeds became payable to On the basis of these facts, separate trusts, which shall be called decedent’s estate. the Service ruled that: (i) the proposed collectively the nonexempt share, (iv) disclaimers by the trust beneficiaries discretionary distributions of princi- Under the terms of dece- of their respective interests in the trust pal from a trust shall be charged first dent’s Will and revocable trust, the will be qualified disclaimers under against the nonexempt share until it principal remaining at his death was Code Sec. 2518; (ii) the disclaimers is exhausted and thereafter against to be divided into a marital trust and to be executed by decedent’s issue the exempt share, (v) distributions of a credit trust. On wife’s death, with respect to their interests as heirs principal or income to skip persons the property of both trusts would pass at law, will be qualified disclaimers may be made from the exempt or non- to decedent’s then living issue, per under Code Sec. 2518; (iii) an estate exempt shares as the trustee, in his stirpes. If decedent had no then liv- tax marital deduction will be allowed absolute discretion, determines will ing issue, the remaining trust property under Code Sec. 2056 for the value of best minimize the taxes imposed. would be distributable one-half to his the residue passing to the wife; (iv) as sister-in-law, or her then-living her a result of the disclaimers, wife will be The taxpayer reported the issue, per stirpes, and one-half to his treated as having received decedent’s transfer to the trust on a timely-filed sister, or her then-living issue, per interest in the deferred compensation gift tax return but failed to make an stirpes. plan directly from the decedent for entry on Schedule C allocating GST purposes of Code Sec. 457(e)(16); (v) exemption to the trust. However, the All of the beneficiaries and pursuant to Code Sec. 457(e), wife trust agreement was attached to the prospective beneficiaries of the trust is eligible to roll over a distribution return. The taxpayer requested a rul- including a guardian appointed for the of decedent’s interest in the plan into ing that he had substantially complied three minor beneficiaries proposed to an individual retirement account set with the requirements of making a disclaim their respective interests un- up and maintained in her name; and timely allocation of GST exemption der the trust. Under state law, as a re- (vi) wife will not have to include in to the trust with respect to the gift tax sult of the disclaimers by all the trust her federal gross income for the year return filed. beneficiaries, the disclaimants are of distribution and rollover any por- treated as if they had all predeceased tion of the distribution from the plan On the basis of these facts, decedent and the estate residue (in- timely rolled over into an IRA set up the Service ruled that the trust agree- cluding the plan proceeds), after the and maintained in her name. ment attached to the federal gift payment of debts and expenses, will tax return contained sufficient in- become distributable to decedent’s Substantial Compliance Makes GST formation to constitute substantial intestate heirs. Decedent’s issue Allocation Timely compliance with the requirements further proposed to disclaim each of for making a timely allocation of their intestate interests in decedent’s In PLR 200510026, taxpayer taxpayer’s GST exemption to the estate. As a result, under state law, and his spouse each made contribu- trust. Although taxpayer did not wife will become the sole beneficiary tions to a trust which was immediately comply with the instructions on of decedent’s , includ- divided into separate subtrusts for the Form 709, in that Schedule C of the ing the interest in the plan benefits. benefit of each of their three sons and gift tax return was left blank, a copy their descendants, each subtrust to of the trust agreement was attached The proposed disclaimers continue for the maximum period al- to the gift tax return, which trust will accord with state law and will lowed under the applicable rule against agreement specifically stated that a be filed with the local county reg- perpetuities. material purpose of the trust was to ister of wills within nine months of The trust agreement provides, utilize the available exemption from decedent’s date of death. Upon the in part, that (i) a material purpose the generation-skipping transfer tax. approval filing of the disclaimers, the of the trust is to utilize the available continued on Page 19 Probate and Trust Law Section Newsletter No. 112 18 under Code Sec. 2053 in calculating 2035, as long as the premiums are not Tax Update, continued the amount of federal estate tax due paid from trust income. The Service Interest Payable On Advances only if, under Reg. §20.2053-3(a), concluded that taxpayer will not pos- From Related Partnership Not the expense is (i) incurred in the ad- sess any incidents of ownership in the Deductible By Estate ministration of the decedent’s estate, policies because taxpayer renounced (ii) actually and necessarily incurred, her rights as co-trustee in connec- In PLR 200513028, dece- and (iii) allowable by the of the tion with the policies and ultimately dent’s estate consisted primarily of his jurisdiction under which the estate is resigned as co-trustee. The Service 99% interest in a limited partnership. being administered. noted that taxpayer will not contribute One of his sons held the 1% general assets to either trust or maintain the partnership interest. The partnership In this case, the loan was not policies with her own assets. assets primarily consisted of 57.6% necessary because (i) the partnership publicly traded stocks, bonds and held substantial liquid assets and, on cash, 17.5% real property 24.7% decedent’s death, the estate succeeded personal notes. Decedent’s Will to his 99% partnership interest, (ii) the divided the residue of his estate into partnership was not engaged in any ac- equal trusts for the benefit of his two tive business that would necessitate the children. The Will provided that all retention of liquid assets, nor was there estate taxes were to be paid from the any fiduciary restraint on son’s ability residue of his estate. His son and to access the funds, and (iii) the same his accountant were executors of the parties (closely related family mem- estate and the accountant was also bers whose proportionate interests trustee of each trust. in the estate were virtually identical NEWSLETTER to their proportionate interests in the ARTICLES The partnership advanced partnership) stood on all sides of this funds to the estate to pay Federal transaction. estate taxes and the state death tax. Decedent’s son and the accountant, as Life Insurance Proceeds Not Includ- What would you like to see executors, and son, as general partner, ible in Estate in future issues of the executed a promissory note designat- Probate and Trust Law ing the estate as the borrower and the In PLR 200518005, taxpayer Section Newsletter? partnership as the lender. Interest was is to receive the net income of two to accrue on advanced funds until the trusts for her life. Taxpayer did not The Communications note matured in 10 years, at which establish either trust. Upon taxpayer’s Committee is looking time all principal and interest would death, the principal of both trusts is to for articles and ideas of be due. Prepayment of principal be held for taxpayer’s children. On a interest to the probate or interest was prohibited. On the date certain, taxpayer renounced all of bar. Please send any estate’s federal estate tax return, the her rights as a co-trustee of both trusts executors claimed a deduction under as to insurance policies on her life. articles or ideas to: Code Sec. 2053(a) for the interest to Subsequently, the trusts purchased be paid to the partnership on the due insurance policies on taxpayer’s life date of the note. with trust principal. Taxpayer later Robert H. Louis, Esquire resigned as a co-trustee of each of the Saul Ewing LLP On the basis of these facts, trusts. Taxpayer will not contribute the Service concluded that the inter- assets to either trust or maintain the 3800 Centre Square West est payable by the estate in 10 years insurance policies with her personal 1500 Market Street was not a deductible administration assets. Philadelphia, PA 19102 expense because the transaction could Based on Rev. Rul. 84-179, 215-972-7155 not properly be viewed as necessary 1984-2 C.B. 195, the Service ruled that email: [email protected] to the estate’s administration. In the proceeds of the life insurance poli- reaching this conclusion, the Service cies held as assets of each trust will not noted that administrative expenses be included in taxpayer’s gross estate are deductible from the gross estate under Code Sec. 2042(2) or Code Sec.

Probate and Trust Law Section Newsletter No. 112 19 ETHICS COLUMN By PAUL C. HEINTZ OBERMAYER, REBMANN, MAXWELL & HIPPEL, LLP

In the course of the attorney’s representation of the executor of a Will, a brother of the execu- tor, not included as a beneficiary in the Will, initiates a alleging that the execu- tor-client, a named beneficiary, procured the Will through undue influence. May the attorney continue to represent the client both as an executor and beneficiary during the Will contest?

Generally, it would be per- to act as both witness and an advocate, fairly liberally so the attorney-scriv- missible under the Rules of Profes- particularly in a bench trial where no ener would even be permitted to sional Conduct to continue repre- jury is involved, but the practice is help the advocate prepare for the senting the client as the executor. discouraged. Two Pennsylvania cas- hearing. That representation is different from es provide helpful understanding of the representation of the client as an the application of the Rule: Comm. However, if the attorney- individual and as one who has been v. Gibson, 670 A.2d 680 (Pa. Super. scrivener is somehow implicated in accused of improperly procuring the 1996) and Comm. v. Willis, 552 A.2d the action and accused of some form benefits of the Will. Furthermore, 682 (Pa. Super. 1988). of wrongdoing, it would not even be the subject of the Will contest is the appropriate for the law firm of the distribution of the estate, not its ad- Although the attorney-scriv- attorney-scrivener to represent the ministration. ener should not serve as an advocate executor in his capacity as a benefi- at the hearing, the attorney may have ciary. It is highly probable that Rule Whether the attorney may someone else in his or her firm serve 1.7 principles would apply. represent the client, accused of im- as trial counsel at the hearing. Rule properly procuring benefits of the 1.10, which imputes disqualification See Opinion 94-153 issued Will, in the course of the Will con- to others in one’s firm, does not ap- by the Pennsylvania Bar Associa- test is the more difficult question. If ply to Rule 3.7 matters. Furthermore, tion Committee on Legal Ethics and the attorney is going to be called as Pennsylvania courts apply Rule 3.7 Professional Responsibility. a fact witness, and the scrivener is frequently called as such, the attor- ney would normally be precluded by Rule 3.7 from acting as an advocate in the Will contest hearing. The Rule is based on concerns that a lawyer’s credibility may be enhanced once he or she is sworn in as a witness or, if that lawyer’s credibility is effective- WHAT WOULD YOU LIKE TO SEE IN FUTURE ly questioned during cross-exami- ETHICS COLUMNS? nation, the lawyer’s persuasiveness as an advocate may be diminished. Send your questions and ideas to: Furthermore, combining the roles of lawyers and witnesses may diminish the effectiveness of our system of Paul C. Heintz, Esquire justice and may raise the appearance Obermayer, Rebmann, Maxwell & Hippel, LLP of impropriety. 1617 JFK Boulevard One Penn Center Pennsylvania courts have 19th Floor on occasion permitted trial counsel Philadelphia, PA 19103

Probate and Trust Law Section Newsletter No. 112 20 New Bankruptcy Act Extends Broad Creditor Protection to Retirement Plans

By SUSAN G. COLLINGS DRINKER BIDDLE & REATH LLP1

The recent amendment to Exclusions alienation provision. Consequently, the Bankruptcy Code, the Bankruptcy argued the bankruptcy trustee, such Abuse Prevention and Consumer Under §541(c)(2) the bank- provision did not constitute an en- Protection Act of 2005 (the “2005 ruptcy estate is narrowed to exclude forceable restraint on alienation under Act”), provides broad protection from a debtor’s beneficial interest in a trust nonbankruptcy law for purposes of bankruptcy creditors for qualified that includes a restriction on transfer §541(c)(2). The Court held that if a retirement plan benefits and IRAs. that is enforceable under applicable plan covers one or more employees Prior to the 2005 Act, ERISA plans nonbankruptcy law. Thus, a trust other than the business owner and such as pension and profit sharing that includes a spendthrift provision his or her spouse, then the working plans generally were shielded from enforceable under nonbankruptcy law owner qualifies as a participant in the reach of creditors in a bankruptcy will be excluded from the debtor’s the ERISA plan and qualifies for the proceeding, but IRAs, Roth IRAs bankruptcy estate. protections ERISA provides other and SEPs did not uniformly enjoy plan participants. Accordingly, the similar protection. The 2005 Act ERISA requires that all quali- anti-alienation provision constituted covers more than ERISA type plans fied retirement plans include a spend- an enforceable restraint on alienation and extends this protection to IRAs thrift provision restricting assignment under applicable nonbankruptcy law and Roth IRAs, as well as to section or alienation of such benefits by the for purposes of §541(c)(2). 457 deferred compensation plans participant. 29 U.S.C. §1056(d)(1). and 403(b) tax-deferred annuities. In Patterson v. Shumate, 504 U.S. Similarly, there has been Although the 2005 Act resolves 753 (1992), the Supreme Court ruled considerable litigation over the ques- many important issues concerning that an anti-alienation provision in an tion whether IRAs are excluded from the ability of bankruptcy creditors to ERISA-qualified pension plan consti- the bankruptcy estate by reason of reach retirement benefits, there are tutes a restriction on transfer enforce- §541(c)(2). IRAs are not creatures numerous ambiguities arising under able under “applicable nonbankruptcy of ERISA, and there is no federally the statute that need to be clarified. law” and, accordingly, such property mandated requirement that IRAs in- is excludable from the debtor’s bank- clude an anti-alienation provision. This article will analyze the ruptcy estate. Because IRAs are generally consid- provisions of the 2005 Act as they ered self-settled trusts under state law, relate to retirement plan benefits. To Not surprisingly, creditors an anti-alienation provision in an IRA start, however, it may be useful to sought to limit application of the Pat- would be ineffective. Nevertheless, review the federal law prior to enact- terson ruling. For example, in Yates many states, including Pennsylvania, ment of the 2005 Act. v. Hendon, 541 U.S. 124 (2004), a have enacted state laws exempting bankruptcy trustee sought to include IRAs from creditors’ claims. BACKGROUND in the debtor’s bankruptcy estate his interest in an ERISA profit sharing The courts have reached Under the Bankruptcy Code, plan where the creditor, who was the inconsistent conclusions on the a debtor’s estate is broadly defined sole shareholder and president of a question whether or not to apply the to include “all legal or equitable professional corporation, was one of exclusion under §541(c)(2) to IRAs. interests of the debtor in property as four participants in the plan. The For example, in In re Yuhas, 104 F.3d of the commencement of the case.” bankruptcy trustee argued that, as sole 612 (1997), the Third Circuit held that 11 U.S.C. §541(a). Property can be shareholder, Yates was an employer a New Jersey debtor’s rollover IRA removed from the bankruptcy estate rather than an employee and under was excludable from the bankruptcy in two ways—either through an ex- ERISA did not qualify as a participant clusion or through an exemption. who could enforce the plan’s anti- continued on Page 22

Probate and Trust Law Section Newsletter No. 112 21 Following Rousey, a bankruptcy New Bankruptcy Act, continued debtor could exempt an IRA only estate because the New Jersey stat- Internal Revenue Code IRA constitutes upon a showing of need and only if ute exempting the IRA from credi- a trust for purposes of §541(c)(2)). the federal exemptions were elected tors’ claims constituted a restriction -- if the state exemptions were cho- on transfer within the meaning of Exemptions sen, exemption of the IRA was still §541(c)(2). The court articulated subject to the vagaries of state law. five requirements for determining Although property initially The significance of Rousey appears whether an IRA is excluded from the may be included in the debtor’s to have been rendered moot by Con- bankruptcy estate under §541(c)(2): bankruptcy estate and not subject to gress’ enactment of the 2005 Act. (1) the IRA must constitute a “trust” exclusion, various exemptions apply within the meaning of 11 U.S.C. to remove certain interests. Under THE 2005 ACT 541(c)(2); (2) the funds in the IRA the Bankruptcy Code, debtors have must represent the debtor’s “benefi- the option of electing exemptions Statute Applies Broadly, Includ- cial interest” in that trust; (3) the IRA provided under federal law or state ing IRAs must be qualified under Section 408 law, unless the governing state law has of the Internal Revenue Code; (4) the “opted out” of the federal exemptions, The 2005 Act explicitly state statute exempting IRAs from in which case debtors must choose the exempts a broad range of ERISA the claims of creditors must be a “re- state exemptions. Pennsylvania has and non-ERISA plans. Moreover, striction on the transfer” of the IRA not opted out of the federal exemptions the exemption for such plans ap- funds and (5) this restriction must be and therefore both alternatives, federal plies regardless of whether the state “enforceable under nonbankruptcy and state, are available to Pennsylvania or federal exemptions are elected. law.” debtors. 2 NORTON BANKR. L. & Under §522(b)(3)(A) of the 2005 PRAC. 2d §46:5 (2005). Act, a debtor who chooses the state Applying the Yuhas test exemptions (or who is forced to use to Pennsylvania debtors, the courts Section 522(d)(10)(E) of the such exemptions under his or her have reached a contrary result. In In Bankruptcy Code provides that the applicable state law) may exempt re Clinton, the bankruptcy court held debtor may exempt from the debtor’s from the bankruptcy estate any assets that an IRA does not constitute a trust estate the right to receive “a payment exempted under the state exemption within the meaning of §541(c)(2) and under a stock bonus, pension, profit statute and, as provided in subpara- therefore cannot be excluded from sharing, annuity, or similar plan or graph (C) of that section, “retire- the bankruptcy estate. In re Clinton, contract on account of illness, dis- ment funds to the extent that those 290 B.R. 83 (2003). The bankruptcy ability, death, age, or length of service, funds are in a fund or account that is court distinguished the Third Circuit’s to the extent reasonably necessary exempt from taxation under section holding in Yuhas, concluding that the for the support of the debtor and any 401, 403, 408, 408A, 414, 457, or Pennsylvania exemption statute, un- dependent of the debtor. . . .” Because 501(a) of the Internal Revenue Code like its New Jersey counterpart, fell the federal exemption statute does not of 1986.” 11 U.S.C. §522(b)(3)(C). short of declaring a custodial IRA explicitly address the exemption of Similarly, if the federal exemptions a “trust,” and the debtor’s IRA did IRAs, numerous cases have litigated are elected pursuant to §522(b)(2), not possess the necessary character- whether or not IRAs are covered by subparagraph (d)(12) has been added istics of a trust, such as separation the statute. The issue was finally to provide the same exemption as of legal and beneficial title. Id. at resolved by the recent Supreme Court provided in subparagraph (b)(3)(C) 87-89. See also In re Galloway, case of Rousey v. Jacoway, 125 S. Ct. applicable to state exemptions. The 308 B.R. 709 (2001) (neither IRC 1561 (2005). In Rousey, the Court exemptions do not depend on the §408 nor Pennsylvania exemption concluded that a rollover IRA is suf- existence of an anti-alienation clause statute deems a custodial IRA to be ficiently similar to the types of plans (as in Patterson) or whether there is a a trust and therefore custodial IRA explicitly included in the exemption “trust” (as required by Yuhas and its is not excluded from bankruptcy under §522(d)(10)(E). Therefore, the progeny). Instead, the exemptions estate under §541(c)(2)); Cf., In re Court ruled that, to the extent needed apply to a broad range of plans, as Davis, 108 Fed. Appx. 717 (3rd Cir. for the support of the debtor and his long as they are exempt from tax un- 2004)(remanded to bankruptcy court dependents, a debtor who chooses the der the Internal Revenue Code. Thus, to determine whether under either federal exemption statute may protect IRAs (§408), Roth IRAs (§408A) and Pennsylvania exemption statute or his IRA from a bankruptcy creditor. continued on Page 23 Probate and Trust Law Section Newsletter No. 112 22 cap applies solely to the “contribu- Although the statute is not explicit on New Bankruptcy Act, tory” portion of an IRA, and not to this latter point, the provisions of sub- continued any amounts rolled over, the cap will paragraphs (b)(4)(C) and (D) of §522 likely have limited impact for the near can be read to reach this conclusion. SEPs (§408(k)) are explicitly covered future. The Internal Revenue Code These subparagraphs provide that by the exemptions under the 2005 imposes limitations on the amount that retirement funds resulting from roll- Act, regardless of whether the state can be contributed annually to an IRA overs (either direct or within 60 days or federal exemptions are elected. and, therefore, the maximum amount of distribution) from either a qualified Furthermore, a sole business owner’s that could have been contributed to plan or IRA to either a qualified plan interest in a qualified plan should now an IRA would be $67,000 ($69,000 or IRA “shall not cease to qualify for be exempt even if there are no other for a person over age 50).4 In order exemption under paragraph (3)(C) or participants as was required by the 2 to exceed the $1,000,000 cap, an- subsection (d)(12)” by reason of such Yates ruling. nual investment returns would need rollover. 11 U.S.C. §522 (b)(4)(C) to have consistently exceeded 15%. and(D). Since funds initially held in Cap Imposed on Certain IRAs See Choate, ESTATE PLANNING a qualified plan would enjoy full ex- FOR RETIREMENT BENEFITS: RE- emption under subparagraphs (3)(C) In the case of IRAs and Roth CENT DEVELOPMENTS, ALI-ABA or (d)(12), neither the initial rollover IRAs, however, the 2005 Act imposes Advanced Estate Planning Practice (by reason of subparagraph (n)), nor a limitation on the exemption, thereby Update—Spring 2005. any subsequent rollover (by reason of providing somewhat less favorable the above-quoted rollover provisions) treatment to these retirement vehicles. In practice, many individuals should change that result. New subparagraph (n) of §522 pro - have combined IRAs funded by roll- vides as follows: over contributions with IRAs funded The statute does not explic- by annual contributions. The statute itly address the consequences of a (n) For assets in individual provides no guidance on how to cal- spousal rollover. Nevertheless, funds retirement accounts described culate the fully exempted portion and rolled over by a surviving spouse in section 408 or 408A of the the portion subject to the $1,000,000 from a deceased spouse’s qualified Internal Revenue Code of 1986, cap. In the absence of further guidance plan should be exempt from the other than a simplified employee on this issue, presumably some sort $1,000,000 cap as such rollover is pension under section 408(k) of of tracing or formulaic approach may authorized under §402(c)(9) of the such Code or a simple retirement be used to make this determination. Internal Revenue Code and there- account under section 408(p) of Nevertheless, for future rollovers it fore falls within one of the sections such Code, the aggregate value would be advisable to maintain such enumerated in subparagraph (n) of of such assets exempted under rollovers in a separate IRA rather than the 2005 Act. Similarly, a spousal this section, without regard to combine them with one funded by an- rollover of an IRA should not subject amounts attributable to rollover nual contributions. funds to the $1,000,000 cap where contributions under sections the initial source of the decedent’s 402(c), 402(e)(6), 403(a)(4), In order to exempt the roll- IRA was a qualified plan. See §522 403(a)(5), and 403(b)(8) of the over portion of an IRA from the (b)(4)(C) and (D). Although the stat- Internal Revenue Code of 1986, $1,000,000 cap, subparagraph (n) ute is silent with respect to treatment and earnings thereon, shall not provides that such rollover must fall of an IRA that a surviving spouse exceed $1,000,000 in a case filed within certain enumerated sections, all has elected to treat as his or her own by a debtor who is an individual, of which pertain to rollovers from cer- pursuant to Regulation §1.408-8, except that such amount may tain qualified plans.5 Thus, an IRA- to- A-5(a) under the Internal Revenue be increased if the interests of IRA rollover cannot be used to convert Code, there seems to be no policy justice so require. IRA assets subject to the $1,000,000 basis to treat such an IRA differently

cap to fully exempt assets that have no from a spousal rollover of an IRA. Thus, the statute imposes a cap. However, where funds initially Nevertheless, in the absence of any $1,000,000 cap on the “contributory” are rolled over from a qualified plan to guidance on this point, if creditor portion of an IRA and Roth IRA, an IRA and subsequently rolled over protection is any concern, it would but allows unlimited exemption for to another IRA, the second rollover be more advantageous for a surviving the portion attributable to qualified should not preclude the funds from be- spouse who inherits an IRA from his rollovers and the earnings on those ing exempted from the $1,000,000 cap. rollovers.3 Because the $1,000,000 continued on Page 24 Probate and Trust Law Section Newsletter No. 112 23 IRA assets subject to the cap-- rather New Bankruptcy Act, continued than to the “amounts attributable to or her spouse to do a spousal rollover that the anti-alienation provision re- rollover contributions”. However, rather than elect to treat such IRA as quired by ERISA serves to protect such since “value” of an asset ordinarily his or her own. benefits only while in the hands of the includes the earnings thereon, the plan administrator and not after they phrase “and earnings thereon” 8 An additional issue arising are distributed to the participant. The would seem to be superfluous if under the 2005 Act is whether the 2005 Act seemingly gives preferential read to relate to the value of assets $1,000,000 cap under subsection (n) treatment to qualified plan distribu- subject to the cap rather than to is intended to apply to IRAs exempted tions compared to IRA distributions. amounts attributable to rollover under state law. Section 522(b)(3) Thus, distributions from IRAs need to contributions. Moreover, excluding allows a debtor who chooses the be rolled over in order to continue to the earnings on any rollover state exemptions to exempt an IRA enjoy continued creditor protection. amounts from the $1,000,000 cap is under the state exemption statute consistent with the statute’s overall and under the exemption provided by Conclusion intent to afford unlimited protection new subsection (b)(3)(C). If the state to qualified plan assets. Therefore, exemption statute allows for exemp- The 2005 Act goes far in a better reading of the statute is that tion of a contributory IRA in excess extending creditor protection in bank- the $1,000,000 cap does not apply to of $1,000,000, it is unclear whether ruptcy proceedings to IRAs and other earnings on rollover contributions. the $1,000,000 cap imposed under non-ERISA type plans and provides subsection (n) is intended to over- uniformity to an area that previously 4 IRAs, which were created by ride the state exemption or whether allowed disparate results depending Congress in 1974, were initially its application is limited solely to on the applicable state law governing subject to a contribution limit of IRAs exempted under new subsection a debtor’s rights. Consequently, retire- $2,000. The $2,000 limit increased 6 (b)(3)(C). ment benefits will generally not be a to $3,000 for contributions in 2002- factor for a bankruptcy debtor decid- 2004, and $4,000 for 2005-2006. 26 A further issue under the ing whether to elect state or federal U.S.C.A. §219. 2005 Act is whether inherited funds exemptions. Nevertheless, the 2005 fall within the overall protection af- Act raises many issues, and, as with 5 For purposes of this article, this forded retirement funds under §522. any new legislation, the issues will includes plans qualified under Although an inherited plan might be need to be resolved by the courts or 401(a), 403(b) and 457. However exempt from taxation under the sec- technical corrections. there is some ambiguity whether the tions of the Internal Revenue Code cap applies to amounts rolled over enumerated in §522(b)(3)(C) and FOOTNOTES from a 457 plan. §522(d)(12) and therefore fit within the literal language of such exemption 1 The author wishes to thank Mark 6 For example, the Pennsylvania provisions, query whether such inher- M. Brown and Nora E. Pomerantz for exemption statute limits the ited benefits constitute “retirement their review and comments. However, contributory portion that can be benefits” within the meaning of the any mistakes belong to the author. shielded from creditors to amounts statute. contributed by the debtor that do not 2 A qualified plan under §401(a) exceed $15,000 within a one-year Finally, the 2005 Act adds need not have participants other period. As long as the contributions uncertainty to the question whether than the owner/employee. See IRC made within each one-year period plan benefits are protected from credi- §401(c)(1)(A) and §401(c)(3)-(4). are below $15,000, Pennsylvania tors’ claims even after distribution provides no overall limitation on from the plan. A technical reading of 3 An initial reading of the statute the amount that can be protected the statute suggests that certain distri- might raise the question whether the from creditors’ claims, regardless of butions from qualified plans continue $1,000,000 cap also applies to earnings subsequent appreciation or income to be exempt from creditors’ claims on rollovers. It would be possible on such contributory portion. See even if not rolled over to another to read the phrase “and earnings 42 Pa.C.S. §8124(b)(ix). Depending 7 qualified plan or IRA. The majority thereon” as relating to “the aggregate on investment performance, it is of circuit courts that addressed this value of such assets exempted under issue prior to the 2005 Act concluded this section”-- i.e., the IRA and Roth continued on Page 25 Probate and Trust Law Section Newsletter No. 112 24 New Bankruptcy Act, continued

possible that the contributory portion protection, but no similar requirement could exceed $1,000,000. is imposed on the receipt of “eligible rollover distributions”. 7 New section 522(b)(4)(D) provides exemption for any distribution 8 Compare Hoult v. Hoult, 373 F.3d that is either an “eligible rollover 47 (1st Cir. 2004)(post-retirement distribution” within the meaning of receipt of ERISA benefits required IRC §402(c) or that is described in to be placed in specified bank clause (ii) of §522(b)(4)(D). Internal account to satisfy judgment against Revenue Code §402(c), which relates participant); Wright v. Riveland, to qualified plan rollovers, defines 219 F.3d 905 (9th Cir. 2000)(ERISA “eligible rollover distribution” to anti-alienation provision does not mean any distribution made from a preclude Department of Corrections qualified plan to a plan participant, from making mandatory deductions other than a minimum required from benefits received by prisoners distribution, a hardship distribution, from qualified plans to meet costs or a distribution that is part of a series associated with incarceration and of substantially equal payments victims’ compensation); Robbins over the life of the participant v. DeBuono, 218 F.3d 197 (2nd Cir. (or the participant and his or her 2000)(no violation of ERISA anti- beneficiary). Subparagraph (c)(3) alienation provision where state social of §402 generally requires that such service department considered amount “eligible rollover distribution” be of pension benefits institutionalized rolled over into an eligible retirement participant could transfer to non- plan, which includes a qualified plan, institutionalized spouse for purposes IRA, or 457 Plan, within 60 days in of determining Medicaid eligibility); order to avoid income tax on the Guidry v. Sheet Metal Workers Nat’l distributed funds. Thus, in order to Pension Fund, 39 F.3d 1078 (10th be an “eligible rollover distribution,” Cir. 1994(en banc)(garnishment such distribution need not be rolled of qualified pension benefits not over, although income tax deferral precluded by ERISA anti-alienation will only be achieved if a rollover provision following distribution of is accomplished in accordance with benefits to participant); Trucking subparagraph (c). Employees of North Jersey Welfare Fund v. Colville, 16 F.3d 52 (3rd By contrast, clause (ii) of new Cir. 1994)(ERISA anti-alienation section 522(b)(4)(D) includes any provision no bar to recovery where distribution from certain enumerated funds no longer in hands of plan exempt funds, including IRAs trustee and have been distributed and Roth IRAs, to the extent such to a beneficiary) with U.S. v. Smith, distribution is deposited in another 47 F.3d 681 (4th Cir. 1995)(ERISA’s such fund within 60 days. Thus, anti-alienation provision precludes clause (ii) clearly requires that the restitution order from reaching rollover of funds be completed in qualified plan benefits received by order to enjoy continued creditor participant after retirement).

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