Griff’s Notes, January 4, 2022: Recent Tax Determinations
Tax, trusts and estates updates from around the country
Today’s installment of Griff’s Notes brings gifts from the IRS, in the form of a Chief Counsel Advice Memorandum and a Private Letter Ruling issued at the end of 2021.
CCA 202152018 (December 30, 2021)
Central Issue: Use of an old 409A appraisal for gift tax purposes when a merger is contemplated
Value Added Score: 7.5
Rule: While an appraisal for gift tax purposes usually determines the fair market value as of the date of the valuation, such value can be forward-looking if a willing buyer would consider a pending merger, and a failure to determine such added value can cause a retained annuity interest to have a zero gift tax value under IRC Section 2702.
It is common to gift business interests prior to a sale of the business, in order to remove appreciation resulting from the bump in value attributable to the appeal of the business to outside buyers. While past rulings have made it clear that you cannot assign income (for example, by transferring a business interest subject to a binding sale commitment prior to closing), the question of appraisal is more of a gray area. It is common to complete the gift before receiving indicators of interest (or IOIs), or offers.
In this memorandum, a corporation was shopped around to potential buyers, many of whom presented offers. Three days after receiving the offers, the founder of the target corporation gifted some shares to a GRAT, and used a 7-month old 409A appraisal (which predated shopping the company around) to calculate the annuity amount and remainder. Ultimately, the corporation was sold for a multiple of 3x over the value used to create the GRAT.
The IRS concluded that the receipt of offers created a pending merger, which should have factored in to the fair market value when calculating the GRAT because a willing hypothetical buyer at the time would reasonable have considered such offers. Even worse, the GRAT was a 2-year GRAT, and this memorandum was issued after the end of the GRAT term. The IRS concluded that there was not a qualified annuity interest under IRC Section 2702 for the duration of the GRAT term, because the annuity was underpaid by 34 cents on the dollar. Thus, the retained interest was not qualified and is valued at zero for gift tax purposes. While not addressed in the ruling, there will be an adjustment to the underreported value on the gift tax return, most likely leading to the loss of a zeroed-out GRAT.
So, long story short, make sure you complete gifts before receiving offers for the sale or exchange of property, or a merger. Otherwise, the fair market value takes into account those pending offers. It may be safer to complete gifts prior to even seeking or receiving indicators of interest from buyers.
PLR 202152006 (December 30, 2021)
Central Issue: Tax effects of reformation of trust
Value Added Score: 3
Rule: The IRS may accept a reformation of a trust from a state court, even if not from the highest court in the state, so long as the IRS determines that the reformation is consistent with such state’s applicable law
Before diving into the facts, this ruling had probative value with regards to drafting but added little to existing tax law.
Any time you draft a trust which does not limit discretionary distributions to an ascertainable standard, you must be careful to consider the need for an independent trustee. Without doing so, any beneficiary who is a trustee, or who can remove and replace a trustee with a related or subordinate party, may be deemed to have a general power of appointment. Such a power cannot be released without gift tax liability, and may create an ETIP limiting the settlor’s allocation of GST exemption. And, such a power over a marital trust may disqualify the trust from the QTIP election.
This is exactly what happened here. The surviving spouse was a co-trustee of a marital trust created under the deceased spouse’s revocable trust, and subsequently resigned. The trustee of the marital trust had broad discretionary distribution powers, not limited by an ascertainable standard. The revocable trust (which created the marital trust) had been through many rounds of amendment during the deceased spouse’s life, the most recent of which had been subject to the client feedback every attorney dreads – “My trust is too long.”
The attorney here, in an attempt to satisfy the (now deceased) client, trimmed provisions which were thought to be unnecessary. But, guess what was inadvertently trimmed? If your guess was the language limiting the spouse’s ability to remove and replace a trustee, with the qualifier that the successor trustee cannot be related to or subordinate to the spouse under IRC Section 672(c), you are correct! So, the drafting attorney fell on her sword, and assisted independent counsel with a court-ordered reformation to add this language.
Once reformation was ordered, the client had to seek this private letter ruling, as the reformation was not issued by the highest court in the state (as suggested under Bosch) and thus was not binding on the IRS. Luckily, the IRS agreed with the tax effects of the reformation. Otherwise, the marital trust would not have qualified for the QTIP election or the reverse QTIP election, and worse, the spouse’s resignation as trustee and release of any power to remove or replace trustees would have been a taxable release of a general power of appointment.
One item to note here – many states (including my home state of Colorado) have a statutory presumption that an interested trustee-beneficiary will have their discretionary distribution authority automatically limited to an ascertainable standard, unless the trust expressly waives this presumption. Many trust forms, or trusts generated by drafting software, also contain a savings clause with similar language. I am surprised that neither of these safety nets applied here, but a good lesson would be to make sure you don’t have to rely on these safety nets in the drafting phase. (And, perhaps, these safety nets were also trimmed in the editing process).