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The federal estate tax laws changed significantly in 2017. The first such change occurred on June 9, 2017, when the Internal Revenue Service (IRS) issued Revenue Procedure 2017-34. This Revenue Procedure provides for an extension of time to elect portability.
As described below, portability allows the surviving spouse to use the first deceased spouse’s unused federal estate tax exemption. More recently, on December 22, 2017, the President signed the Tax Cuts and Jobs Act (“TCJA”) into law. The TCJA raises the federal gift and estate tax exemption, as well as the generation-skipping transfer tax exemption, beginning on January 1, 2018. It is important for practitioners to be aware of these changes and to advise clients accordingly.
$10,000,000, indexed annually for inflation.2 As such, the federal estate and gift tax exemption in effect for the calendar year beginning January 1, 2018 is $11,200,000. The increased exemption (adjusted annually for inflation) will remain in effect until the applicable provisions of the TCJA expire on December 31, 2025.
The federal gift and estate tax exemption applies on an individual basis for citizens and residents of the United States.3 Portability provides a special benefit for married couples who are United States citizens. The executor of the first deceased spouse’s estate can transfer any unused federal estate and gift tax exemption (otherwise known as the deceased spousal unused exclusion amount, or DSUE) to the surviving spouse by making a portability election. Beginning January 1, 2018, it will be possible for married couples to transfer up to $22,400,000 without paying federal estate or gift taxes.
In some cases, a court-appointed executor or administrator may not be necessary to administer a decedent’s estate. For example, if a married couple has title to all of their assets by joint ownership, probate will not be necessary for the first deceased spouse’s estate. In such a case, an executor would not be appointed by a court.
Fortunately, to elect portability, a court-appointed executor is not required. IRC § 2203 provides that for estate tax purposes, the term “executor” includes “any person in actual or constructive possession of any property of the decedent.”6 Therefore, a surviving spouse or other individuals who receives property from the deceased spouse’s estate is considered an executor, and may file an estate tax return without letters of appointment issued by a court.
If a portability election was made, the statute of limitations remains open on the first spouse’s estate. However, this tolling is limited, as the first deceased spouse’s Form 706 may be re-examined solely to review the calculation of DSUE.8 The IRS has authority to re-examine the DSUE even if the IRS has issued an estate tax closing letter. However, because the re-examination is limited, executors should not be deterred from filing Form 706 to elect portability.
Many executors have failed to timely elect portability, resulting in the loss of increased federal gift and estate tax exemption. The IRS received numerous private letter ruling requests for an extension of time to elect portability. In some requests, the executor was unaware of the need to file Form 706 to make the election. In other requests, the executor of the surviving spouse’s estate discovered that a portability election was never made.9 The IRS recognized a need for continued relief and issued Revenue Procedure 2017- 34 to provide guidance.
Revenue Procedure 2017-34 provides a simplified method to obtain an extension of time to file Form 706 and elect portability. Relief is available for estates of decedents who died after Decem- ber 31, 2010 and were survived by a spouse. The decedent must have been either a citizen or resident of the United States on the date of his or her death.
Now that January 2, 2018 has passed, there are only two ways for an executor to take advantage of Revenue Procedure 2017-34. If filing will occur on or within the two-year anniversary of the decedent’s death, the Revenue Procedure must be used. 13 If filing will occur after such two-year anniversary, the executor must request a private letter ruling. 14 Again, relief is only available if Form 706 was not required to be filed based upon the size of the gross estate.
In addition to the federal estate tax, there is a New York State estate tax applicable to New York resident decedents and non-residents having property located in New York State. The current New York estate tax exemption is $5,250,000.15 New York does not follow the federal rules and does not allow portability of any New York estate tax exemption.
On January 1, 2019, the New York estate tax exemption is scheduled to match the federal amount.16 It is unclear at this time whether New York will amend its estate tax law to the new increased $10,000,000 federal estate tax exemption, as amended by the TCJA. The estate tax portion of the New York Tax Law refers to the IRC with all amendments enacted on or before January 1, 2014.17 As such, beginning January 1, 2019, the New York estate tax exemption will likely track the prior federal exemption at $5,000,000, adjusted for inflation.
Portability is a valuable tool for married couples to take advantage of the maximum federal estate and gift tax exemption. The increased exemptions provide meaningful relief for many clients. Executors of smaller estates must also fully consider the benefits of making a timely portability election. Similarly, attorneys representing executors must fully communicate the benefits of portability to their clients. Attorneys should also review estate plans and trusts in light of the TCJA.
Gregory L. Matalon is a partner in the Estates and Trusts department of Capell Barnett Matalon & Schoenfeld LLP, with offices in Jericho and Manhattan. Erik M. Olson is an associate in the Estates and Trusts department of Capell Barnett Matalon & Schoenfeld LLP.
2 Tax Cuts and Jobs Act § 11061(a). 3 I.R.C. § 2001(a); I.R.C. §2010(a).
5 Treas. Reg. § 2010-2(a)(7)(ii). 6 I.R.C. § 2203.
7 Treas. Reg. § 20.6075-1.
8 Estate of Sower v. Comm’r, 149 T.C. 11 (2017). 9 Revenue Procedure 2017-34 § 2.02(4).
10 Revenue Procedure 2017-34 § 3.01.
Revenue Procedure 2017-34 § 3.02.
Revenue Procedure 2017-34 § 7.02.
Revenue Procedure 2017-34 § 2.02(6).
New York Technical Memorandum TSB-M-14(6)M. 16 Id.
written by Partner Robert S. Barnett, CPA, J.D. and Associate Erik Olson, J.D.
This issue of WealthCounsel Quarterly was sent to the printer in early November 2017. The Tax Cuts And Jobs Act was signed into law after this article was finalized. The Act doubles the exclusion amount beginning January 1, 2018 and ending December 31, 2025.
2017 has been fraught with legislative uncertainty, and pending tax legislation makes planning more difficult. However, there is one aspect of the estate tax law which has actually become more certain, at least for now. On June 9, 2017, the IRS released Revenue Procedure 2017­34, providing a new simplified method for the executor of an estate to obtain an extension of time to file a federal estate tax return (Form 706) to make a portability election, if the estate was not otherwise required to file Form 706. This article briefly discusses portability and describes the mechanics and computations involved in determining whether a late portability election is available.
The federal lifetime estate and gift tax exclusion amount is the largest amount that an individual can pass free of estate tax at death. The exclusion amount is adjusted annually for inflation. For decedents dying in 2017, the exclusion amount is $5.49 million.
Most estates are below the exclusion amount, and the benefit of any unused exclusion may be lost. However, the decedent’s surviving spouse may use the decedent’s deceased spousal unused exclusion (DSUE) by making a portability election. If a portability election is made for the estate of the deceased spouse, the surviving spouse may use the deceased spouse’s DSUE in addition to the surviving spouse’s own exclusion amount. This results in the surviving spouse having an applicable exclusion amount that is the sum of his or her exclusion (which will continue to adjust for inflation under current law) plus the amount of DSUE he or she received from the deceased spouse (which is fixed at the time the time of the first spouse’s death).
Portability was originally afforded by an amendment to Internal Revenue Code (“Code”) § 2010(c). Portability is generally available for estates of decedents dying after December 31, 2010. Estates of decedents dying on or before December 31, 2010, cannot make a portability election.
Why is portability so important? The answer is clear for wealthy clients: Estate tax rates are high (the maximum federal estate tax rate is currently 40 percent), and most people seek to minimize estate taxes in order to benefit their desired beneficiaries. But for clients of more modest means, portability may be a less attractive (and more confusing) option. As described below, making a portability election requires preparing and filing a complete and accurate estate tax return, even if a return is not otherwise required to be filed, typically because the estate is below the filing threshold. Why would a surviving spouse want to pay a professional fee to prepare and file an estate tax return if there is no clear benefit to doing so? Why would a professional discuss the option of portability with clients who may never reap the benefits?
The answer to both of these questions is one of life’s few guarantees: Uncertainty. No one can guarantee a client’s future financial position, and the estate tax, itself, has an uncertain future. It is important to discuss all options with clients. The client is always the person in the best position to determine if it is worth their time and money to make a portability election.
To elect portability, the executor of the deceased spouse’s estate must make the portability election on a timely filed federal estate tax return (Form 706). This raises two important questions: (1) Who may file Form 706 for a decedent’s estate if no executor (or other personal representative) is appointed by a court, and (2) What is considered a timely filed Form 706?
An executor is typically appointed by a court of law after initiating a probate proceeding. However, careful estate planning may eliminate the need to probate a decedent’s will and many people utilize testamentary substitutes, such as beneficiary designations, joint accounts, or fully funded revocable trusts. If there is no court appointed fiduciary, can Form 706 still be filed for an estate?
The instructions to Form 706 provide a similar definition of an executor. For example, if no fiduciary is appointed for a decedent’s estate, but the decedent’s assets have valid beneficiary designations naming the decedent’s surviving spouse, or if the decedent owned all assets in joint tenancy with the surviving spouse, the surviving spouse will be in actual or constructive possession of the decedent’s property. The surviving spouse is therefore considered an “executor” for purposes of preparing and filing Form 706, and may make a portability election on a timely filed Form 706 for the deceased spouse’s estate.
What is a timely filed Form 706? To be considered timely filed, Form 706 must be filed by the nine­month anniversary of the decedent’s death (or fifteen­month anniversary, if the six­month extension request is filed and granted).
Is relief available for estates that do not timely file an estate tax return? The answer depends on whether the estate is “required” to file a return, as discussed below. An executor of an estate that is not required to file Form 706 may make a private letter ruling request for an extension of time to file Form 706 in order to make a portability election. However, the IRS has provided in Revenue Procedure 2017­34 for a new automatic extension of time to file Form 706 in order to make the election, rather than requiring the private letter ruling process for many taxpayers.
Revenue Procedure 2017­34 provides for an automatic extension of time to file Form 706 to make the portability election. The automatic extension allows executors of certain estates to make a late portability election by timely filing a complete and accurate estate tax return by the later of (i) January 2, 2018; or (ii) the second anniversary of the decedent’s death. During such time period, Revenue Procedure 2017­34 is the exclusive avenue for relief; an executor may only make a private letter ruling request after the time to obtain the automatic extension under Revenue Procedure 2017­34 has expired. If the executor had already made a private letter ruling request and the request was pending as of June 9, 2017, the IRS will close the request and refund the fee to the executor, and the executor must seek relief pursuant to the Revenue Procedure.
Like private letter ruling requests, the automatic extension only applies to estates that are not otherwise required to file Form 706 (discussed below). Under the new Revenue Procedure, estates of decedents dying after January 2, 2016, can file Form 706 to make a portability election within two years of the decedent’s death. However, for older estates, the January 2, 2018, deadline is an extremely important opportunity, and executors of estates which are eligible to receive the automatic extension should strongly consider filing Form 706 to make a late portability election. The automatic extension is a potentially simpler, more certain, and less costly means of relief than making a private letter ruling request.
It is important to determine whether an estate must file Form 706 to take advantage of Revenue Procedure 2017­34 or, if relief under the Revenue Procedure is unavailable, whether the estate can make a private letter ruling request (discussed later in this article).
Which estates are “required” to file Form 706? An estate must file if the decedent’s gross estate, plus the value of the decedent’s adjusted taxable gifts, exceeds the applicable federal exclusion amount (Code § 6018). A decedent’s gross estate is computed by totaling the gross value of all of a decedent’s property as of the decedent’s date of death. The executor calculates the gross estate on Form 706 by combining the totals of all of the decedent’s assets, as reported on Schedules A through I of Form 706.
In computing the value of the decedent’s gross estate, the executor should note that the gross estate includes only one­half of the value of all assets reported on Schedule E­1 of Form 706. Schedule E­1 lists all of the decedent’s qualified joint interests. A qualified joint interest is held by the decedent and the surviving spouse either (i) as tenants by the entirety or (ii) as joint tenants with right of survivorship if the decedent and surviving spouse are the only joint tenants of the asset. However, the surviving spouse must be a United States citizen for such interests to be qualified joint interests. All interests which are held jointly between a decedent and a non­citizen spouse are reported on Schedule E­2, and the decedent’s gross estate includes one hundred percent of the value of such interests (unless the executor provides proof of the surviving joint owner’s contribution to such joint interests).
The persons and facts discussed in this example are fictitious and are intended to illustrate the benefits of Revenue Procedure 2017­34, as well as the computation necessary to determine if relief is available either under Revenue Procedure 2017­34 or by private letter ruling request.
Harry and Wilma are United States citizens, and have been happily married for many years. Unfortunately, Wilma passed away on January 1, 2013. At the time of her death, Wilma owned $600,000 of assets in her name alone, which she left to Harry, and also owned $5.4 million of assets in joint tenancy with Harry and no other joint tenants. Wilma made no taxable gifts during her lifetime. In 2013, the basic exclusion amount was $5.25 million, all of which was available to Wilma’s estate, but none of which was needed because her entire estate passed to Harry tax­free, as a result of the unlimited marital deduction.
Ever the dutiful husband, Harry promptly probated Wilma’s will, and the court appointed Harry as executor of Wilma’s estate. However, Harry had always been a do­it­yourselfer, and did not seek the advice of a professional to help him administer Wilma’s estate. Harry was not aware of the benefits of portability, and did not file Form 706 for Wilma’s estate.
On May 1, 2017, Harry passed away, leaving all of his assets to his loving children, Mark and Sally, who are also the nominated co­executors in Harry’s will. At the time of his death, Harry only owned the (i) $600,000 of assets he received from Wilma under her will, and (ii) $5.4 million of assets that he had owned in joint tenancy with Wilma, which were then held in Harry’s name alone after Wilma’s death. For the sake of simplicity, we are not assuming any fluctuation in asset values.
Mark and Sally sought the help of qualified professionals to probate Harry’s will, and the court issued a decree appointing Mark and Sally as co­executors of Harry’s estate. However, when the time came to file Harry’s estate tax return, Mark and Sally realized that Harry died with a gross estate of $6 million and a federal basic exclusion amount of only $5.49 million. Because Harry had not filed Form 706 for Wilma’s estate within the time required by law, no portability election was made. Without portability (and assuming no available deductions), Harry’s estate would be subject to $159,500 in federal estate tax.
Had Harry made the portability election for Wilma’s estate, Wilma’s basic exclusion amount of $5.25 million would have passed to Harry, giving him an applicable exclusion amount of $10.74 million (Harry’s own $5.49 million + Wilma’s $5.25 million). This combined exclusion amount would have more than sheltered Harry’s $6 million of assets from estate tax, and Mark and Sally would have received an additional $159,500 instead of paying that amount in tax.
Can Mark and Sally make a late portability election by filing Form 706 for Wilma’s estate without being appointed as successor co­executors of her estate? Mark and Sally will each receive Wilma’s property because they are the beneficiaries of Harry’s estate, and Harry had received Wilma’s property upon her death. As such, Mark and Sally are in actual or constructive possession of Wilma’s property, and are therefore considered executors for purposes of filing Form 706 for Wilma’s estate.
Can Mark and Sally make a late portability election for Wilma’s estate? Relief is available only to estates which were not required to file Form 706. If the value of Wilma’s gross estate did not exceed the basic exclusion amount in effect upon her death, then Form 706 was not required to be filed for Wilma’s estate, and relief may be available.
The federal exclusion amount was $5.25 million when Wilma died on January 1, 2013. Wilma died with $600,000 of property in her name alone, and held assets in joint title with Harry having a value of $5.4 million. However, as Wilma and Harry were the only joint tenants of the joint assets, only one­half of the value of those assets is included in Wilma’s gross estate. As such, the value of Wilma’s gross estate was $3.3 million ($600,000 + $2.7 million (one­half of the joint assets)). Since this amount was below the 2013 federal exclusion amount, Wilma’s estate was not required to file Form 706.
Mark and Sally realized that they could take advantage of the Revenue Procedure because: (i) Wilma was survived by a spouse; (ii) she died after December 31, 2010; (iii) she was a United States citizen at the time of her death; (iv) an estate tax return was not already timely filed for her estate; and (v) her estate was not required to file Form 706.
Mark and Sally prepared a complete and accurate Form 706 for Wilma’s estate (including the required language on the top of the first page of the return), and filed before the January 2, 2018, deadline, thereby making a valid portability election. Because all of Wilma’s assets passed to Harry and qualified for the marital deduction, Harry’s estate received the full $5.25 million of DSUE from Wilma’s estate. Mark and Sally were then able to add Wilma’s DSUE to Harry’s exclusion amount on Harry’s Form 706, resulting in no federal estate tax due for Harry’s estate.
Like the automatic extension provided by Revenue Procedure 2017­34, 9100 relief is not available for estates that are required to file a return. However, unlike the automatic extension of Revenue Procedure 2017­34, 9100 relief is not guaranteed. The executor of the estate must make a private letter ruling request to the IRS (at a cost to the estate), and the IRS will determine whether to afford relief based upon the facts and circumstances of each case. While private letter rulings provide insight into the IRS’s view of requests for relief, each private letter ruling is unique to the facts and circumstances of a particular case and cannot be relied upon or cited as precedent.
Treasury Regulations § 301.9100­3 provides that relief will be granted if the executor (i) provides evidence that the taxpayer acted reasonably and in good faith in failing to make a timely portability election, and (ii) that granting relief will not prejudice the interests of the government. Acting reasonably and in good faith typically requires that the executor reasonably relied upon the advice of a competent professional. An executor’s reliance would not be considered reasonable if the executor knew or should have known that the professional either was not competent to provide advice regarding the portability election, or that the professional was not aware of all relevant facts to provide advice.
Executors and professionals should pay careful attention to estate tax filing requirements and deadlines, and should take care to timely file Form 706 if it is required or if portability is desired.
There is one important caveat to both the automatic extension afforded by Revenue Procedure 2017­34 and relief obtained by private letter ruling requests. If it is later determined that Form 706 was required to be filed, the IRS’s authority to grant an extension of time to file Form 706 to elect portability may be void retroactively. In Estate of Sower v. Comm’r, 149 TC No. 11 (Sept. 11, 2017), the Tax Court found that the IRS has authority under Code § 2010(c)(5)(B) to reexamine the filed Form 706 of the first deceased spouse’s estate to determine the correct DSUE amount, even if the IRS had issued an estate tax closing letter and even if the statute of limitations to examine the first return had expired. Executors should review all asset and taxable gift information and search for undiscovered estate assets to avoid a potential loss of relief.
This article was written by Partner Robert S. Barnett and appeared in the CPA Journal, January 2018.
The potential of an IRS lien weighs heavily on the minds of many taxpayers, but rarely do they consider liens when receiving gifts or inheritances. The author describes the relevant tax law for liens on inherited property and property received as a gift, providing tips for dealing with any liability arising therefrom.
This article originally appeared in NYS Society of CPA’s Nassau Chapter Newsletter October 2017.
The Internal Revenue Service Office of Appeals (“Appeals”) is an independent organization within the IRS. It is intended to be fair, impartial, and objective. One goal of Appeals is to settle as many cases as possible without going to the United States Tax Court. According to the IRS, the issues of over 100,000 taxpayers are heard by Appeals each year.
Due to budget constraints, the IRS recently decided to cut back on face-to-face conferences with taxpayers at Appeals. There has been considerable pushback on this issue from tax professional groups. According to the National Taxpayer Advocate, limiting face-to-face meetings will increase rather than reduce costs overall for the IRS. In-person conferences are often influential in reaching a resolution. With fewer cases settled at Appeals, additional taxpayers will pursue litigation, at a higher expense to the taxpayer and the IRS. In September 2017, it was announced that in-person conferences will again be available for taxpayers upon request.
Tax practitioners should be aware of the opportunities and limitations of working with Appeals. It may be helpful to look at some of the current procedures.
Thirty-Day Letter: In the field examination context, when the auditor and the taxpayer disagree, the first step should be to request a conference with the auditor’s manager. If that is unsuccessful, the auditor may issue a Revenue Agent Report (RAR) with a cover letter allowing thirty days to file a formal written protest. Known informally as a “30-day letter,” it provides the taxpayer with the opportunity to challenge the auditor’s adjustments at Appeals. This is distinct from the subsequent “90-day letter” which is the Statutory Notice of Deficiency, providing the right to file a Petition in U. S. Tax Court.
There are certain required elements in the formal protest to Appeals, such as attaching the document with the proposed changes, listing the reasons for disagreement, and stating the facts and law to support the taxpayer’s position. The protest must be signed under penalties of perjury.
AJAC: The Appeals Judicial Approach and Culture (AJAC) Project has clarified Appeals policies. The role of Appeals is not to investigate, but to settle disputes. The Appeals Officer generally does not raise new issues or reopen issues where the taxpayer and the auditor have come to an agreement. If the taxpayer submits new information or evidence, the matter may be sent back to audit to be developed further.
Video Conference: In July, 2017, the IRS announced that it was starting a pilot program for virtual web-based video conferences for taxpayers and their representatives. It remains to be seen whether a video conference can achieve the same results as in-person attendance.
Early Referral and FTS: The Office of Appeals can assist in other ways. The Early Referral program allows a taxpayer to request a problematic issue to be heard at Appeals, while the rest of the audit continues with the auditor. Fast Track Settlement utilizes a specially trained Appeals Officer as a mediator between the auditor and the taxpayer, with a goal of an expedited settlement in sixty days. Although FTS is not a new program, recently it has become more widely available for Small Business/Self-Employed audits.
Conclusion: The right to an appeal in an independent forum is guaranteed by the Taxpayer Bill of Rights. As tax professionals, we need to know and understand administrative appeals, so we can take action when appropriate to do so on behalf of our clients.
The need to protect your assets is particularly critical as you approach retirement age. We often advise clients who are in their 60s or nearing retirement to be cautious and strategic when making asset transfers and gift-giving. Many are surprised to learn that those gifts could disqualify them from receiving Medicaid benefits, should they need to live in a nursing home or facility.
In New York, the Medicaid Rules stipulate that Medicaid benefits for nursing coverage will not be granted to an applicant who has made gifts of their assets in the five years prior (“five-year look-back”) to requesting Medicaid coverage. For this reason, Medicaid generally questions transactions in excess of $2,000. As a part of the Medicaid application process, our lawyers thoroughly review a client’s financial records for the last five years.
This meticulous review process gives us a chance to determine whether there will be any issues with the Medicaid application that we need to address before submission. The state Medicaid agency conducts the same investigation of your assets to determine if certain assets were transferred during the look-back period for less than fair market value.
It’s important to know that this guideline only applies to applicants seeking nursing home Medicaid coverage. Community-based or home care Medicaid recipients are unaffected by the five-year look-back period. This in itself is often misunderstood by many would-be applicants; they are deterred from applying for community Medicaid because they mistakenly believe this financial threshold cancels everyone’s eligibility.
Why Do These Asset Transfer Rules Exist?
The rules were established to stop people from taking advantage of the Medicaid process and its resources. The rules prevent scenarios where an elderly person needing care moves into a nursing home, gifts their assets to their children, and then applies for Medicaid.
Nursing home care is more costly than home-based or community care and Medicaid does not want you to impoverish yourself in order to qualify. With no five-year look-back for community care, Medicaid is encouraging people to take care of their loved ones at home rather than in a nursing home.
When Medicaid reviews your financial statements, it excludes retirement assets like IRAs and 401K plans from your total resources. In certain situations, the family residence may be exempt as well.
Transferring assets to a spouse and/or handicapped or disabled children usually remain exempt from penalties. Certain transfers to children may also be exempt.
Generally speaking, people are living longer and retiring in their mid-to-late 60s. That is why we often advise clients to be mindful of the five-year look-back and how it relates to creating an effective asset protection plan. We can help provide cautious estate planning strategies that can help keep your Medicaid eligibility unaffected.
If you have questions regarding Medicaid Transfer Rules, contact us.
Absent action from Congress, the federal estate and gift tax exemption will revert back to $1 million in 2013. Given this looming uncertainty, individuals should take advantage of the current $5.12 million exemption before the end of 2012 by making gifts. In addition, New York State does not currently impose a gift tax, making this an opportune time for New Yorkers to consider gifting strategies.
High-net-worth married couples often hesitate to make outright gifts for fear of losing income and control over assets. One technique couples can use to help alleviate these concerns is to create mutual lifetime credit shelter trusts for the benefit of each spouse. A lifetime transfer to a credit shelter trust would ordinarily be considered a taxable gift to the trust beneficiary, but because the gift is less than or equal to the exemption amount, the gift is a tax-free transfer. The ability to customize the trust instrument according to each spouse’s unique needs and desires, while also providing each spouse with some degree of control, is an attractive feature of the credit shelter trust.
For example, consider Jack and Jill, a husband and wife with a net worth of $20 million and two adult children. Theyare concerned about the possible loss of the current exemption, and would like to reduce the amount of estate taxes that their children will have to pay. Jack and Jill also wish to maintain their cash flow and control over their assets. This dual concern for financial security and control prevents them from currently making gifts to their children.
Lifetime credit shelter trusts might be the ideal instrument for such a couple. Credit shelter trusts allow for creativity and flexibility; the trust can be drafted in a way that ensures each spouse income during life, while still allowing the couple to take advantage of the current exemption. For example, Jack could fund a lifetime credit shelter trust for Jill’s benefit with $5 million of assets, a transfer that would be tax-free under the current exemption. All income would be paid to Jill for her life, with principal distributed according to an “ascertainable standard.” Upon Jill’s death, the trust funds would be available to their children and might be either distributed or held in further trust. In addition, assuming that Jack (the settlor) has not retained any prohibited powers over the trust, its value would not be included in his estate. The trust would also be drafted to avoid inclusion in Jill’s estate. Similarly, Jill could use her $5 million exemption to fund a lifetime credit shelter trust for Jack’s benefit.
One common question that arises when a couple wishes to retain control of their assets is whether a spouse can act as both beneficiary and trustee without incurring adverse tax consequences, such as inclusion of the trust assets in her estate. For example, perhaps Jill, as beneficiary, would like to retain a higher degree of control over the trust assets by participating as trustee. In Revenue Ruling 78-398, the IRS determined that a trust beneficiary who was also named as the sole trustee could have some discretion to make distributions of principal to herself. In that case, the trust assets were not included in her estate because her powers as trustee were limited by an ascertainable standard—namely, only as necessary for her “maintenance and medical care.” As described below, the Treasury Regulations are even more permissive.
This ruling was recently confirmed by Estate of Chancellor v. Comm’r (T.C. Memo 2011-172). In Chancellor, the surviving spouse acted as both beneficiary and trustee of a credit shelter trust created by her husband. The trust instrument provided that the trustee could distribute trust principal to the beneficiary-spouse for her “maintenance, education, health care, sustenance, welfare or other appropriate expenditures.” The Tax Court ruled that the spouse, as both beneficiary and trustee, could exercise her power to make distributions to herself without the trust being included in her estate because her power was limited by an ascertainable standard.
Traditionally, “ascertainable standard” has been defined by Internal Revenue Code (IRC) section 2041 and Treasury Regulations section 20.2041-1 as relating to the beneficiary’s “health, education, sup- port, or maintenance.” These are broad standards, and the Treasury Regulations also permit the trustee to exercise discretion to support the beneficiary’s “accustomed manner of living.” Use of these specific terms is not required, but caution is advised when using alternative terms.
For example, in Chancellor, the IRS asserted that the trustee-beneficiary’s estate should have included the trust because the standard did not relate solely to her health, education, support, or maintenance, but also considered the spouse’s “welfare and other appropriate expenditures.” After examining the settlor’s intent and the applicable state law, the Tax Court ultimately ruled that the power to invade was limited by an ascertainable standard and did not include the trust in the decedent’s estate. This case highlights the importance of careful drafting by illustrating that the IRS may take action if the trust instrument strays from using the exact language contained in the regulation.
An alternative to using an ascertainable standard is to appoint an independent trustee. The independent trustee could act as the sole trustee, or, if the couple wishes to retain more control, the independent trustee could instead act as a co-trustee with the beneficiary. As a co-trustee, the independent trustee could be empowered to make those discretionary distributions that beneficiaries might not be able to make without risking inclusion of the trust in their estates.
Returning to the example above, perhaps Jill feels constrained by a standard limiting her to distributions only for her health, education, maintenance, or support. She could instead, or in addition, appoint a trusted friend to act as an independent trustee. This friend could make those distributions that Jill feels she needs but would otherwise not be necessary for her health, maintenance, education, or support. By using an independent trustee, Jill would not be exercising a power that would risk inclusion of the trust in her estate. IRC section 674(c) generally describes independent trustees as persons who are not immediate family or subordinates or employees of the settlor or trustee. Consideration should be given to appropriate trustee appointment and removal powers.
A third consideration is to include a “five-by-five power.” Under a five-by-five power, as defined by IRC section 2041(b)(2), beneficiaries can retain limited withdrawal powers over principal without the entire trust being taxed in their estates. This ability to withdraw principal must be limited to an annual amount that does not exceed the greater of either $5,000 or 5% of the trust principal.
Mutual lifetime credit shelter trusts do have a hidden danger: the IRS’s reciprocal trust doctrine. This danger can be avoided through careful drafting. Reciprocal trusts are those created by two individuals for the benefit of each other. Application of the reciprocal trust doctrine allows the IRS to “uncross” the trusts and to treat each as a self-settled trust, or one created solely for the settlor’s benefit. As such, the trust is included in the settlor’s estate, obviating one purpose for which the trust was initially created.
For example, if Jack funds a trust with $5 million for the benefit of Jill, and Jill funds an identical trust with $5 million for the benefit of Jack, such trusts would be reciprocal. The IRS could then use the reciprocal trust doctrine to uncross the trusts, deeming Jack to be the beneficiary of the trust that he created and Jill to be the beneficiary of the trust that she created, thereby resulting in estate inclusion.
The doctrine has also been applied when spouses held crossed trustee powers over identical trusts, but did not have an economic interest. In Estate of Bischoff v. Comm’r (69 T.C. 32 ), the couple executed identical trusts for the benefit of their grandchildren and named the other spouse as trustee. Distributions of principal and income were made in the sole discretion of the trustee. If such a power had been held by the settlor, the value of the trust would have been included in the settlor’s estate under IRC sections 2036(a)(2) and 2038(a)(1). Here, the Tax Court ruled that the trustee powers were reciprocal and uncrossed the powers, deeming the spouses to be the trustees of the trusts they created. Thus, each trust was deemed to be part of the settlor’s estate under IRC sections 2036(a)(2) and 2038(a)(1). In its decision, the Tax Court stated that it was not necessary for the settlor to have an economic interest in the property transferred in order for the reciprocal trust doctrine to apply; it was enough for the settlors to have crossed trustee powers.
Each family situation is different and presents opportunities for innovation and creative drafting. For example, in an appropriate situation, one trust might appoint the spouse and children as trustees, whereas the other trust names only the spouse as trustee. Perhaps Jack’s trust allows Jill to invade principal for her health, maintenance, education, and support, whereas Jill’s trust grants Jack a more limited withdrawal power over principal. Alternatively, Jack’s trust might grant the remainder to the children outright, whereas Jill’s trust might hold the remainder in trust for their children and grandchildren, thereby utilizing her generation-skipping transfer tax exemption.
Similarly, in Private Letter Ruling 200426008, the IRS chose not to apply the reciprocal trust doctrine to trusts executed by a husband and wife for the benefit of the other spouse and their child. Each trust contained a life insurance policy on the settlor’s life and named the other spouse as trustee. The trusts were similar in many respects, but also had several important differences. Under his trust, the husband could only receive distributions three years after his wife’s death and only when his net worth and income fell below specified levels. Under her trust, the wife could only receive distributions after the death of their child and only up to $5,000 or 5% of the trust principal. Furthermore, the wife was given a limited power of appointment that could only be exercised after their child’s death. Of course, like all private letter rulings, this decision was limited to the parties at issue and cannot be cited as precedent. The ruling does, however, highlight the types of differences that the IRS will examine in determining whether the reciprocal trust doctrine applies.
In the case of mutual lifetime credit shelter trusts, the parties should strive to avoid the reciprocal trust doctrine by including significant material differences between the trust instruments. These differences need not be arbitrary. Given the general flexibility of the credit shelter trust, material differences can be incorporated by tailoring each trust to the respective beneficiary’s needs. For example, if Jack is elderly or in poor health, Jill’s trust for his benefit might be funded with fewer assets or have a more restrictive distribution scheme. This technique likely has the dual benefits of adapting the trust to accommodate the couple’s unique situation and avoiding the reciprocal trust doctrine. Couples might also consider including a limited power of appointment in the trust that names the spouse and children as trustees. This will help protect the spouse and ensure that the children exercise discretion in their parents’ best interests. The key is to avoid estate inclusion and application of the reciprocal trust doctrine. Careful drafting will achieve both goals, while also protecting each spouse and providing a degree of control.
Another consideration might include drafting the trusts to utilize the generation-skipping transfer tax exemption. The trust may provide that the trust corpus remain in further trust for the benefit of the settlor’s children and grandchildren. The settlor might then allocate his generation-skipping transfer tax exemption to the trust. This will allow the trust assets and any future appreciation to ultimately pass to his grandchildren without imposition of the generation-skipping transfer tax. It is important to note that the current generation-skipping transfer tax exemption, which is equal to the estate tax exemption, is similarly scheduled to revert back to $1 million on January 1, 2013.
Lifetime credit shelter trusts are ideal ways to take advantage of the current estate and gift tax exemption. Their use allows married couples to make gifts while retaining some financial control and a source of income. Credit shelter trusts also allow for flexible and creative drafting, a characteristic that can help avoid inclusion of the trust in the beneficiary’s estate and avoid application of the reciprocal trust doctrine. Because the fate of the $5.12 million estate tax exemption hangs in the balance, couples should act before the end of the year.
New York State conducts residency audits to establish whether a taxpayer is a New York State resident, a nonresident, or a part-year resident in order to determine the correct amount of that taxpayer’s tax obligation.
If you live in more than one place and one of them is in New York, you should prepare for a New York State residency audit. The burden of proof generally is on you to support your claim that you are not a NYS resident. The same rules apply if you have a place in New York City and elsewhere in New York State, and you claim that you are not a New York City resident.
There are two ways to be a New York State resident: either you are domiciled in New York, or you are deemed to be a statutory resident of New York.
Domicile means a permanent home, or the principal establishment to which a taxpayer intends to return whenever absent.
A statutory resident is not domiciled in New York State but maintains a permanent place of abode there for substantially all of the taxable year, and spends in the aggregate more than 183 days of the taxable year in the state. For example, you might live in New Jersey, but commute to Manhattan on workdays and also own a house in the Hamptons to use on summer weekends. In that case, an auditor could argue you should be taxed as a New York resident.
Statutory residency is a separate consideration from domicile, which we’ll further discuss in a future post.
Let’s say you are a native New Yorker who’s fortunate enough to own two homes, one in New York and the other in Florida; you spend the time between November and March enjoying the good weather in Florida, and the rest of the year in New York. The state considers you a New Yorker, and you’re subject to paying taxes on your worldwide income.
But if you were a nonresident of New York, you’d be subject to tax only on that portion of your income attributable to (“sourced to”) New York. Let’s say you spend more time in Florida than in New York and want your taxes to show that you are a Florida resident. Be careful: spending time in Florida is not enough. To establish a new status as a Floridian you must change your domicile, which involves simultaneously lessening your ties to New York and strengthening your ties to Florida. An auditor from the New York State Department of Taxation and Finance initially will consider five primary factors in determining your domicile. You can take steps that might sway the determination in your favor.
1. Home. Which residence is bigger or more expensive? Which is rented or owned? How much have you invested into their upkeep and maintenance? The numbers and dollars don’t lie. Usually, you’re going to put the money and effort into your primary home.
2. Active Business Involvement. If you’re still working, where are your active business interests? An auditor may not be persuaded that you are a Florida resident, if you remain deeply involved in your New York-based businesses.
3. Time. This is where most people get confused. The 183 days refers only to statutory residents. As a general guideline, you should be able to prove that you spend significantly more days out of New York and in your Florida home. If you spend five months in New York, three in Florida and four months traveling, the auditor will see your time in New York as the most prevalent. Documents like bills, phone records, receipts, and passports should support your claims.
4. Near & Dear. Where do you keep valuable items, like family heirlooms, jewelry, cars and art collections? An auditor will assume you’ll want to be in close proximity to the items that have monetary or sentimental value.
5. Family. Where does your family reside? Where do your minor children attend school? It may be difficult to show that a spouse, minor children or dependents have a separate domicile from yours.
You might think that obtaining a Florida driver’s license and voter registration will show a New York State auditor that you are no longer a New Yorker. While these can be helpful, they do not have the weight of the primary factors above and are not determinative. Other factors in this category include where your car or boat is registered, physical location of safe deposit boxes, and citation of domicile in legal documents such as a will or trust.
There are other misconceptions about residency audits that should be addressed.
● Your accountant’s location does not impact your status. He or she can have an office in New York even if your domicile is in another state.
● Your burial plot is also not a factor during a residency audit. Your eternal resting place will not be considered maintaining ties to New York.
● A passive interest in a New York partnership is not considered in evaluating domicile.
You’ll know that the State is looking at your situation if you receive a nonresident audit questionnaire in the mail. Unless you fully understand the rules, you should always consult a legal or tax professional before completing it.
There are other issues and circumstances that can influence an auditor when determining your residency and we can help you plan accordingly and mitigate tax risk. Contact Capell Barnett Matalon & Schoenfeld at (516) 931-8100 or visit here to schedule a consultation.

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