In This Issue

• 2004 Transfer Tax Update
• IRS Gives Up the Battle Over Walton v. Commissioner
• Estate Administration 101: What To Do When Your Loved One Passes On

2004 Transfer Tax Update

By Erika L. Haupt

As we have reported in several past newsletters, President George W. Bush signed The Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") into law on June 7, 2001. Among other things, EGTRRA significantly increased the gift and estate tax applicable exclusion amounts and the generation-skipping transfer ("GST") tax exemption.

A. Overview of the Transfer Tax System

Federal gift and estate taxes are unified taxes applicable to transfers during life or at death. The applicable exclusion amount is the amount of assets you can transfer during life and/or at your death without paying gift or estate taxes.

Generally, federal GST tax applies to transfers made during life and/or at your death to people two or more generations younger than you. The GST tax is in addition to gift or estate tax. Every donor has a GST tax exemption that can be used during life or at death.

Prior to EGTRRA, the gift and estate tax applicable exclusion amounts (often referred to as the "unified credit") were the same. However, beginning in 2004, the estate tax applicable exclusion amount will increase while the gift tax applicable exclusion amount remains at $1 million. In fact, now the estate tax applicable exclusion amount and the GST exemption will increase at the same rate. For 2004 and 2005, the estate tax applicable exclusion amount and the GST exemption will each be $1.5 million.

B. Exclusions and Exemptions Beginning January 1, 2004

Beginning January 1, 2004, you can make taxable gifts during your lifetime of $1 million without paying gift tax. Taxable gifts are gifts of a present interest that exceed the gift tax annual exclusion. In 2003, the annual exclusion increased from $10,000 per donee to $11,000 per donee. Although the annual exclusion is adjusted each year for inflation, it is rounded down to the next lowest multiple of $1,000. The 2003 increase was the first increase since the inflation adjustment factor was introduced in 1997.

You may also transfer up to $1.5 million at your death without paying federal estate tax. However, taxable gifts made during life in excess of the annual gift tax exclusion are taken into account on your federal estate tax return. A simplified way to determine how much estate tax "credit" will be available at your death is to subtract the aggregate value of the taxable gifts you made during your lifetime from the estate tax applicable exclusion amount available at your death. For example, if you made $200,000 in taxable gifts during your lifetime and the applicable exclusion amount is $1.5 million at your death, you could pass $1.3 million to your heirs without paying federal estate tax.

As with the estate and gift tax applicable exclusions, the GST exemption can be used during your lifetime or at death. A GST tax is imposed on gifts to 2nd or more remote generations to the extent the gifts exceed, or do not qualify for, the annual gift tax exclusion (the $11,000 per person exclusion for present interest gifts). The GST exemption may be allocated to any property with respect to which you are treated as a transferor. The GST exemption not allocated to transfers during your lifetime is available for transfers at your death to 2nd or more remote generations. To the extent you make gifts or bequeath property in excess of your GST exemption, a GST tax equal to the highest federal estate tax rate at the time of the transfers will be imposed. The GST tax is in addition to any gift or estate tax applicable to the transfers.

C. Status of Permanent Repeal

Under EGTRRA, the estate and GST taxes – but not the gift tax – will be repealed in 2010. EGTRRA also includes a "sunset" clause so that its provisions will cease to apply to gift, estate and GST taxes after December 31, 2010. In other words, unless a new federal law is enacted prior to December 31, 2010, on January 1, 2011, the transfer tax system will revert back to the system as it stood pre-EGTRRA. The permanent repeal of the estate tax passed the House on June 18, 2003 (HR 8) but has not yet been addressed in the Senate. By a vote of 239-188, the House defeated a Democratic alternative to permanent repeal that would have increased the estate tax applicable exclusion amount to $3 million beginning in 2004. With an election year upon us, it is anyone's guess as to whether permanent repeal is a possibility in the foreseeable future.

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IRS Gives Up the Battle Over Walton v. Commissioner

By Angela G. Parsons

It is not very often that the IRS admits it is wrong, but in essence that's what it did in Notice 2003-72.

On October 15, 2003, the IRS announced that it will follow the Tax Court's holding in Walton v. Commissioner, 115 T.C. No. 41 (2000), which concluded that Treasury Regulation §25.2702-3(e), Example 5, is invalid. Therefore, in similar fact situations as presented in Example 5, the IRS will treat a retained unitrust interest payable to the taxpayer or the taxpayer's estate as a qualified interest with a value greater than zero for gift tax purposes.

A. Background

On April 7, 1993, Audrey J. Walton established two grantor retained annuity trusts ("GRATs"). Each GRAT had a term of two years and was funded by the transfer of 3.6 million shares of Wal-Mart Stores, Inc. The initial fair market value of each of the trusts was around $100 million. The terms of each GRAT required the trustee to pay an annuity amount to Mrs. Walton equal to 49.35% of the initial trust value at the end of the first year and 59.22% of the initial trust value at the end of the second year. If Mrs. Walton died during the two-year period, the annuity payments would be paid to her estate. At the end of the two-year period, the remaining balance would be distributed to the remainder beneficiaries designated in the trust documents.

Each GRAT was irrevocable, prohibited additional contributions, specified that Mrs. Walton's interest was not subject to commutation, and mandated that no payment be made during the trust term to any person other than Mrs. Walton or her estate.

Mrs. Walton timely filed her U.S. Gift Tax Return, Form 709, for the 1993 tax year. She represented that the value she retained from the GRATs equaled 100% of the value of the Wal-Mart stock on the date of the transfer, and, therefore, there was no taxable gift to the remainder beneficiaries.

B. The IRS Attack

The IRS issued a Notice of Deficiency to Mrs. Walton, stating that she had understated the value of the gifts resulting from the creation of the GRATs. The IRS asserted that the taxable value of each gift was over $3.8 million. The IRS, relying on Treasury Regulation §25.2702-3(e), Example 5, determined that the part of the transfer requiring payment of the annuity to Mrs. Walton's estate was not a "qualified" interest under §2702, and therefore, part of the transfer was a gift.

Code §2702 provides special rules for valuing gifts in trust when the donor or an applicable family member retains an interest in that trust. If the retained interest is not a "qualified" interest, then the interest retained is valued at $0 and the amount of the gift is equal to the fair market value of the transferred property. If the retained interest is a "qualified" interest, then the amount of the gift is the fair market value of the transferred property reduced by the value of any retained interest.

In Example 5 of Treasury Regulation §25.2702-3(e), A transfers property to an irrevocable trust, retaining the right to receive a unitrust amount for ten years. If A dies within the ten-year term, the unitrust amount is to be paid to A's estate for the balance of the term. Example 5 concludes that A's interest is a qualified unitrust interest to the extent of A's right to receive the unitrust amount for ten years, or until A's prior death. However, the unitrust amount paid to A's estate, if A dies within that term of the trust, is not a qualified interest. The actuarial value of the unitrust amount that might be payable to A's estate if A were to die within the term of the trust would have a value of $0 and would be a taxable gift upon the formation of GRAT. This is commonly known as "mortality risk."

C. Walton v. Commissioner

In Walton, the Tax Court found that each GRAT created a single, noncontingent annuity interest payable for a specified term of years. This conclusion was reached by determining that there was no difference between the grantor and the grantor's estate as the beneficiary of the annuity payment. It went on to hold that Example 5 was an unreasonable interpretation and an invalid extension of §2702. Accordingly, the annuity payment was a qualified interest retained by Mrs. Walton. The value of the gift was the initial $100 million fair market value less the fair market value of the interest retained, which Mrs. Walton claimed equaled $100 million.

D. Notice 2003-72

On October 15, 2003, the IRS issued a notice that it would acquiesce in the Walton decision. The IRS will now treat a retained unitrust interest payable to a taxpayer or the taxpayer's estate as a qualified interest. Treasury Regulation §25.2702-3(e), Example 5, will no longer be valid.

E. What Does This Mean for You?

Walton and Notice 2003-72 mean that the Tax Court and the IRS will allow a GRAT that has a $0 taxable gift. You may set the GRAT up for a term of years and retain an annuity interest equal to the amount put into GRAT plus a stated interest amount payable to you or your estate. Any appreciation over the retained interest will pass to the GRAT beneficiaries without being subject to gift tax on the creation of the GRAT. With the "blessings" of the Tax Court and the IRS, you have an estate freezing technique that has no downside other than the implementation and administration costs. The mortality risk of Treasury Regulation §25.2702-3(e), Example 5, has been removed by the IRS's acquiescence in Walton.

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Estate Administration 101: What To Do When Your Loved One Passes On

By Michele S. Worobiec

You received a call last night that your dear family member is critically ill. Now in the midst of grieving and making sense of your loss, you are making funeral plans and wondering what comes next. Fortunately, your attorney can take much of the burden off your shoulders regarding the estate administration process. And, the business of estate administration usually need not begin until you are emotionally ready to take on these responsibilities.

The purpose of this article is to provide you with some basic information regarding what the estate administration process is and how you will be expected to participate when the time comes.

A. Terminology

In a general sense, "estate administration" refers to the process of collecting all of your loved one's assets, paying the necessary expenses and bills, and providing the remaining assets to those entitled to inherit them. The "decedent" is your deceased family member. The estate is referred to as either "testate" (with a will) or "intestate" (without a will). The person in charge of the estate is the "fiduciary" and referred to specifically as either the "executor" (named in the will) or the "administrator" (where there is no will). Note that the "power of attorney" you may have been able to use prior to the decedent's death is no longer valid – it terminated with the death of your family member. The "beneficiaries" are entitled to inherit the decedent's assets, either by virtue of being named in the decedent's will or, in the case of an intestate estate, by virtue of an Ohio law that lists the order in which relatives are entitled to the assets.

B. Opening the Estate

The estate administration process should be started as soon as practicable after the decedent's death. A few weeks to even a couple of months after the death will suffice. Filing an Application to Administer the Estate in the county probate court where the decedent resided opens an estate. The court will also need to receive a certified copy of the death certificate (most easily obtained from the funeral home); a list of the names and addresses of all persons entitled to inherit under the will as well as all persons who would be entitled to inherit if there was no will; and an estimate of the value of the decedent's assets that will be administered through the probate court. Unless waived under the will, a bond for roughly twice the estimated value of the estate will be required. If the decedent left a will, the original must be filed with the court along with an application to probate the will.

The court may schedule a hearing on the applications and require that notice of filing and hearing be provided to those who would be entitled to inherit under either a testate or intestate estate, as well as to those that may also be entitled to administer the estate. If these individuals sign a waiver of such notice, then the court will likely immediately appoint the fiduciary and issue "letters of authority."

C. Inventory

The next major project for the fiduciary is to compile a detailed list of every asset owned by the decedent on his or her death and to provide the court with this list, including the value of each asset. Items such as real estate and antiques will need to be appraised by a court-appointed appraiser. Other assets with a readily apparent value need not be appraised. The inventory is generally due within three months of the appointment of the fiduciary. In some instances, it may be helpful to file this document even earlier, as the probate court will not permit estate assets to be sold or transferred to the estate beneficiaries until the inventory is approved.

Some assets are not administered through the probate court (non-probate assets) and will not be listed on the inventory. For example, life insurance policies and retirement plans that are paid directly to beneficiaries do not require probate court assistance. Bank accounts, real estate or other titled property owned as joint tenants with rights of survivorship or that pass pursuant to a "payable" or "transfer" on death designation also are not administered through the probate court. The best plan is for the fiduciary to collect documentation of all assets along with their form of ownership and values as of the decedent's date of death.

Your attorney will advise you regarding which items must be reported to the probate court and whether any additional paperwork will be required to transfer non-probate assets. Because financial institutions and insurance companies often require a certified death certificate before disbursing the assets in their possession, you should request from the funeral home a certified death certificate for each such company, for the probate court, and a few extras. You may also order certified death certificates from the vital statistics office in the city where the death occurred.

D. Estate Taxes

Just because an asset is not listed on the inventory does not mean it escapes estate tax. In fact, if an estate tax return is required (Ohio return required for estates in excess of $338,333 and Federal return required for estates in excess of $1,500,000 after 1/1/2004), all probate and non-probate assets must be reported. Past income tax returns, gift tax returns and account statements will be helpful in compiling the list of taxable assets. The estate tax return is due within nine months after the decedent's date of death, unless an extension is requested.

E. Accounting

The fiduciary must also pay the debts and administrative costs of the estate, including court costs (generally around $225), appraisal fees, attorney fees, a fiduciary commission (a percentage of most estate assets), maintenance expenses for assets such as real estate and automobiles, and estate taxes. The remaining assets must then be distributed to the beneficiaries in accordance with the will or state statute. It may be necessary or desirable to sell some estate assets prior to distribution. The probate court requires that all assets be distributed and a final account of all estate receipts and disbursements be filed within six months from the date the fiduciary was appointed. An extension of this deadline may be permitted when estate tax returns are required and for other good reasons.

With good organization skills and the assistance of counsel, you are well on your way to a successful estate administration.

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