Transfers of Limited Partnership Interests Fail to Qualify for Annual Gift Tax Exclusion – Analysis and Practical Insights

Christopher D. Perry, Esq., Northern Trust Bank, FSB
Bradley Van Buren, Esq., Holland & Knight LLP

Since the Tax Court decided Hackl in 2002, estate planners have worried that making gifts of limited partnership interests may entitle the donor to a valuation discount or a gift tax annual exclusion—depending on the terms of the partnership agreement—but not both. See Hackl v. Commissioner, 118 T.C. 279 (2002), affd. 335 F.3d 664 (7th Cir. 2003). Two recent decisions raise more concern for estate planners in this area. See Price v. Commissioner, T.C. Memo 2010-2 (January 4, 2010); Fisher v. United States, 105 AFTR2d 2010-1347 (March 11, 2010).

In Price v. Commissioner, the annual gift tax exclusion was held not to apply to the donors’ transfers of limited partnership units to their children. Following Hackl v. Commissioner, the Tax Court held that the donees possessed a “future interest” in the transferred property under IRC §2503(b), focusing on:

  • the inability of the donees to transfer their partnership interests without the written consent of all the partners,
  • the inability of the donees to withdraw their capital accounts,
  • the fact that there was no time limit on the partnership’s exercise of its right of first refusal, and
  • the fact that there was no immediate guaranteed cash flow to the donees.

The taxpayers claimed “substantial discounts” for lack of control and lack of marketability of the transferred partnership interest, stating on their gift tax returns that the investments were “illiquid.” The IRS stipulated that the fair market values of the gifts were correctly reported. The very factors that contributed to the IRS upholding the valuation discounts appear to have resulted in a finding that the donees did not possess a “present interest” under Treas. Regs 25.2503-3(b).

In Fisher v. U.S., the District Court for the Southern District of Indiana ruled against the taxpayers on a summary judgment motion regarding whether the taxpayers’ transfers of LLC units to their seven children qualified as present interests for the gift tax annual exclusion. The District Court held:

  • the right to receive distributions upon a sale of a capital asset was contingent upon several factors, one being the general manager’s determination to make a distribution from the LLC (the general manager also being the donor of the LLC units);
  • the right to use the land on Lake Michigan held in the LLC was a “possessory benefit,” not a substantial present economic benefit (i.e., the right to use the land did not enable the donees to convert the interest to cash);
  • the right of first refusal to the LLC was a contingency that hindered the children from realizing a substantial economic benefit (i.e., the LLC could pay the child with non-negotiable promissory notes payable over a period of time not to exceed 15 years).

It appears from this line of cases that the valuation discount and the annual exclusion may be mutually exclusive when the donor makes gifts of partnership interests to their children. Can a partnership be structured in such a way to enable the donor to take advantage of both valuation discounts and annual exclusions? Perhaps, but it appears to be a very fine line, and attempting to do so may undermine some of the taxpayer’s larger estate planning and corporate governance goals.

For example, if the operating agreement directs the partnership to exercise its right of first refusal by redeeming the donee with cash, the taxpayer will have lost an important factor contributing to the valuation discount, and will have relinquished an important level of corporate control. Similarly, if the operating agreement requires the partnership to make distributions to the limited partners of earnings and profits, or even to make distributions for the payment of income taxes attributable to the limited partners’ interests in the partnership, the valuation discount may be reduced. Furthermore, the distribution requirement may hinder the partnership’s overall investment and business purposes.

Taking a step back from the Price and Fisher decisions, it may be that the number of taxpayers who are simply making annual exclusion gifts of limited partnership interests and claiming a valuation discount is on the decline for the following reasons:

  • In an environment of low interest rates and depressed equity values, taxpayers may want to take advantage of estate-freeze opportunities by implementing transfer techniques, such as GRATs, sales to intentionally defective grantor trusts and other leveraged-gifting strategies. The use of one or more of these leveraged-gifting strategies will likely permit the taxpayer to immediately transfer a greater limited partnership ownership interest than otherwise would be available with annual exclusion gifting at potentially its lowest value and subject to considerably favorable interest rates, with little or no gift tax cost. By slowly making incremental annual exclusion gifts over time, the taxpayer may lose the opportunity to leverage the gift through low interest rates and current low values.
  • The Administration’s “Green Book” proposal to limit certain valuation discounts on intra-family transfers could also be a reason for taxpayers to accelerate their valuation discount gifting strategies.
  • The appraisal needed to support a valuation discount can be costly. For entities holding truly difficult to value assets, such as private equity, it may not be worth the cost associated with appraising the entity if the ultimate estate planning benefit is limited to the relatively small annual exclusion amount. Further, depending on the number of annual exclusion donees available to the taxpayer, the recurring appraisal cost generally required for an annual exclusion gifting program focused on the transfer of limited partnership interests may be overly burdensome.

In light of the Hackl, Price and Fisher decisions, there is reason to be concerned that transferors who make gifts of limited partnership interest to children may not be able to claim both a valuation discount and the gift tax annual exclusion. In any event, there may be better ways to make leveraged gifts in this environment of low interest rates and depressed equity values.

IRS Issues Rulings to Clarify Tax on Sale or Surrender of Life Insurance Policies

Author:Amy R. Lonergan, Esq., Edwards Angell Palmer & Dodge LLP

On May 1, 2009, the Internal Revenue Service (“IRS”) issued two revenue rulings to address particular tax consequences of the sale or surrender of a life insurance policy. Revenue Ruling 2009-13 deals with the tax treatment of an individual who sells or surrenders a life insurance contract on his own life. Revenue Ruling 2009-14 focuses on investors, and addresses the taxation of death benefits and gains realized on the resale of life insurance contracts, as well as the taxation of death benefit proceeds paid to foreign investors. Both revenue rulings provide legal conclusions through the use of varying but related fact patterns, as summarized below.

Rev. Rul. 2009-13: Tax Consequences to the Insured
Situation 1: An individual (“Insured”) entered into a life insurance contract with cash value on his own life. Eight years into the contract, Insured paid premiums totaling $64,000, and the cash value of the contract was $88,000. Insured surrendered the policy and received $78,000 after the issuer collected $10,000 of surrender and other charges incurred under the policy (“cost-of-insurance”).

The surrender value received by Insured is included in his gross income to the extent it exceeds his investment in the contract, which is the $64,000 in premiums paid. Therefore, Insured must recognize $14,000 of ordinary income ($78,000 net cash surrender value less $64,000 premiums paid).

Situation 2: The facts of Situation 2 are the same as in Situation 1, except that Insured sold the life insurance contract for $80,000 to an unrelated person who otherwise would suffer no economic harm upon Insured’s death.

Insured must recognize as income the excess, if any, of the sale proceeds received over his investment in the contract. For this purpose, Insured’s investment in the contract is equal to the premiums paid by Insured, reduced by the cost-of-insurance (i.e. the surrender and other charges that would have been incurred if the policy was then surrendered instead of sold to a third party). The IRS explains that the basis must be reduced by the cost-of-insurance charges because such costs represent the continuing insurance protection that was part of the consideration offered in exchange for the contract. Insured paid total premiums of $64,000 and his cost-of-insurance charges were $10,000, resulting in an adjusted basis of $54,000. Insured received $80,000 from the proceeds of the sale, and therefore must recognize $26,000 of income ($80,000 less $54,000).

Whether Insured’s $26,000 of income is categorized as ordinary income or capital gain depends on an application of the “substitute for ordinary income” doctrine, which is limited to the amount that would be recognized as ordinary income if the contract were surrendered (the “inside build-up” under the contract). To the extent the income recognized on the sale exceeds the inside build-up under the contract, the excess is characterized as capital gain. The inside build-up of Insured’s life insurance contract was $14,000 ($78,000 cash surrender value less $64,000 in premiums paid). Therefore, of Insured’s $26,000 of income, $14,000 is ordinary income, and the remaining $12,000 is long-term capital gain.

Situation 3: The facts of Situation 3 are the same as in Situation 1, except that the contract was a term life insurance contract without cash surrender value. Insured’s premium for the contract was $500 per month. Insured paid a total of $45,000 in premiums through June 15 of the eighth year of the contract, at which point he sold the contract for $20,000 to an unrelated third party who would suffer no economic harm upon Insured’s death (“Buyer”).

As stated in Situation 2, the adjusted basis of a life insurance contract is equal to the total premiums paid less the cost-of-insurance. For a term life insurance contract, the cost-of-insurance is presumed to be the aggregate premiums paid under the contract, absent other proof. In most scenarios, the adjusted basis will equal zero, or a modest amount of prepaid premiums.

Here, the cost-of-insurance provided to Insured was $500 (Insured’s monthly premium) multiplied by 89.5 (number of months that Insured held the contract), or $44,750. Insured’s adjusted basis in the contract on the date of sale was $250 ($45,000 total premiums paid by Insured, less $44,750 cost-of-insurance). Insured must recognize $19,750 as income ($20,000 proceeds received less $250 adjusted basis). Term life insurance has no cash surrender value, and therefore there is no inside build up under the contract to which the substitute for ordinary income doctrine may apply. Thus, Insured’s $19,750 of income is categorized as long-term capital gain.

Rev. Rul. 2009-14: Tax Consequences to an Investor
Situation 1: One June 15, 2008, an investor (“Buyer”) purchased a life insurance contract from Insured for $20,000. The contract was a term life insurance contract on Insured’s life with a monthly premium of $500. The contract was issued by a corporation located in the United States (“Issuer”). Insured died on December 31, 2009 and Buyer collected the $100,000 death benefit paid by Issuer. Buyer paid a total of $9,000 in premiums to keep the contract in force.

Amounts received under a life insurance contract paid by reason of the death of the insured generally are not included in gross income. However, if the life insurance contract was transferred for valuable consideration, § 101(a)(2) provides that the amount excluded from gross income shall not exceed an amount equal to the sum of the actual value of the consideration and premiums paid by the transferee.

Buyer’s purchase of the life insurance contract from Insured was a “transfer for valuable consideration” under § 101(a)(2), which states that the amount excluded from gross income shall not exceed the sum of the actual value of the consideration paid for the transfer ($20,000) and the premiums subsequently paid by Buyer ($9,000). Therefore, Buyer must include $71,000 in his gross income ($100,000 death benefit received less $29,000 in consideration and premiums paid). While the life insurance contract purchased by Buyer is a capital asset, the receipt of death benefit proceeds on a life insurance contract is not a sale or exchange of a capital asset. Therefore, the $71,000 income recognized by Buyer is ordinary income.

Situation 2: The facts of Situation 2 are the same as Situation 1, except that Insured does not die and Buyer sells the contract to a third party unrelated to both Insured and Buyer for $30,000 on December 31, 2009.

In determining Buyer’s adjusted basis in the contract, the premiums paid by a secondary market purchaser of a term life insurance contract must be capitalized; that is, Buyer’s basis in the contract is increased by the total premiums paid by Buyer to keep the contract in force. In contrast to the treatment for the insured as set forth in Rev. Rul. 2009-13, Buyer’s basis in the contract is not reduced by the allocable cost-of-insurance.

Buyer realized $30,000 from the sale of the life insurance contract. Buyer paid $20,000 to acquire the contract, and subsequently paid $9,000 in monthly premiums, resulting in an adjusted basis of $29,000. Therefore, Buyer must recognize $1,000 of long term capital gain income, as the contract was a capital asset held for more than one year and then sold.

Situation 3: The facts are the same as in Situation 1, except Buyer is a foreign corporation not engaged in a trade or business in the United States. In this scenario, the death benefit payable by a U.S. insurance company to the non-U.S. investor upon the death of a U.S. citizen would be considered U.S. source income. As in Situation 1, Buyer must recognize $71,000 of ordinary U.S. source income, which qualifies as “fixed or determinable annual or periodical” income under § 881(a)(1). Buyer is subject to withholding tax under § 881(a) with respect to this income.

Criticism and Omitted Information
Both revenue rulings have been highly criticized by insurance companies and settlement providers. The primary area of criticism centers around the disparate treatment in the reduction of basis by the cost-of-insurance for insured individuals but not by life settlement investors.

With respect to investors, Rev. Rul. 2009-14 limits its holdings to term life insurance contracts and does not address the tax treatment of gain realized by an investor on the transfer of a permanent (non-term) insurance policy when the gain is wholly or partly attributable to investment income built-up inside the policy. The ruling implies that gains attributable to inside build up would be ordinary in character but does not specifically address this issue in the same manner as Rev. Rul. 2009-13 with respect to non-term life insurance contract gains realized by the insured policyholder. Rev. Rul. 2009-14 also fails to address the tax treatment of income from a sale of a life insurance contract by a foreign corporation to a U.S. third party.

Estate Planning for Private Equity Fund Principals

Bradley M. Van Buren, Esq., Holland & Knight

There has been considerable debate on Capitol Hill over the taxation of a Carried Interest in the context of a Private Equity Fund (“PEF” or the “Fund”). At the same time, there has been public discussion of the role that the private equity industry will have in our economic recovery. In the realm of estate planning, PEF Principals possess unique opportunities to shift the performance of their interest in a PEF to future generations potentially resulting in very significant estate tax savings.

Generally, those individuals who founded and operate a PEF are referred to as the “Principals” of the Fund. More specifically, Principals are those individuals who ultimately posses an interest in the general partner entity of the PEF. A “Carried Interest” is an allocation of future profits distributed to a Principal (via his or her interest in the general partner entity of the PEF). The Carried Interest is generally satisfied after the following distributions:

• a return of capital contribution to all investors;
• a proportionate distribution of aggregate profits equal to the stated investment hurdle rate of the PEF (the “Hurdle Distribution”); and
• a catch-up allocation to the Carried Interest holders to make up for the Hurdle Distribution.

Typically, the PEF Agreement will provide that the profits remaining after these allocations will be distributed 20% to the general partner entity as Carried Interest and the remaining 80% will be divided proportionately among the investors. The cash flow distributions of a PEF are commonly referred to as the “Waterfall Distribution.”

A Carried Interest is currently characterized as capital gain for income tax purposes, which by the nature of the long-term investment strategy of a PEF, permits a Principal to recognize his or her Carried Interest allocation as a long-term capital gain (taxed currently at a 15% federal tax rate). From an income tax perspective, the current debate over how to tax a Carried Interest hinges on two competing arguments:

• Capital Gains Argument: A Carried Interest is an interest in the future realized profits of the PEF, which is comprised of aggregate realized capital gains. Therefore, the character of that income should be maintained as capital gain.

• Ordinary Income Argument: Notwithstanding the capital gains character of the profits generated in a PEF, a Carried Interest received by the Principals has a disproportionate relationship to the capital contributions made by them via the general partner entity (generally a modest 1%-5% of total capital contributed to the Fund). Since the Principals are benefiting from the capital contributions of other investors, the Carried Interest is compensatory in nature. Accordingly, distributions received by a Principal via his or her Carried Interest should be subject to ordinary income rates (potentially also subject to self-employment tax).

Whether the income tax treatment of a Carried Interest will be changed in upcoming legislation is still unclear. If a re-characterization of the tax treatment of a Carried Interest does come to fruition, the specifics associated with the implementation of the change will ultimately determine the level of effect it will have in the estate planning context.

In the meantime, due to the methodology inherent in valuing a Carried Interest, implementing wealth transfer techniques leveraged upon the performance of a Principal’s Carried Interest to shift wealth to future generations remain viable and effective estate planning strategies. In addition to the marketability and minority valuation discounts that are generally afforded a Principal’s interest in a PEF, the uncertainty of the financial future of many investment classes, including private equity, as well as the tax fate of Carried Interests, provide further speculation and potential discounting when valuing a Principal’s Carried Interest for gift tax purposes. That is to say, will the fund portfolio produce a return sufficient to exceed the priority rights stipulated in the Waterfall Distribution under the PEF Agreement? Due to the low current value of the Carried Interest and its potential for significant appreciation, the Carried Interest is an optimal asset to shift wealth to future generations at little or no gift tax cost.

If you would like to read more about the estate planning techniques available to Private Equity Fund Principals, please go to the following link:

Federal Estate Tax Repeal: Planning Considerations

Adrienne M. Penta, Esq., Brown Brothers Harriman & Co.

The federal estate tax is gone (for now), but not forgotten. Congress failed to take action before the end of 2009, resulting in the “sunset” of the estate tax in 2010. Currently, there is no federal estate tax for decedents dying in 2010, and no federal generation-skipping transfer (“GST”) tax for GST transactions completed in 2010. The gift tax, however, remains in place at a rate of 35%. This sunset was enacted as part of tax legislation passed in 2001.

If Congress does not address transfer taxes before the end of the year, the federal estate tax will come back with a vengeance in 2011. The federal estate tax exemption amount will be $1,000,000—a significant reduction from the 2009 exemption amount of $3,500,000—and the top marginal rate will escalate to 55%—10% higher than the 2009 rate of 45%. In addition, there will be a 5% surcharge on estates exceeding $10,000,000. The GST tax will also return in 2011 with a $1,000,000 exemption amount and a rate of 55%, and the gift tax rate will revert to 45%. Many practitioners believe that Congress will enact estate and GST taxes for 2010 and make them retroactive to January 1, but right now, in the words of Senate Finance Committee Chairman Max Baucus, there is “massive, massive confusion.”

Although there are no readily available answers, to help sort through the confusion there are five issues listed below that estate planners should keep in mind when drafting and reviewing estate planning documents.

1. Formula Clauses. If no estate tax is enacted for 2010, many current estate plans may not accomplish the clients’ desired goals. Most plans for married couples written in prior years allocate as much property as can pass free of estate tax (i.e., the exemption amount) to the family or “credit shelter” trust and the remaining property to the marital trust. Under some formula clauses, in a no-tax environment, all of the estate’s assets may pass to the family trust. If the surviving spouse is not a beneficiary of the family trust, the decedent could unintentionally disinherit her spouse. The plans at greatest risk are likely those drafted for clients with children from a prior marriage and for individuals living in states with no state estate tax. Formula clauses determining bequests to charity should also be reexamined as they may not function as the client would desire if there is no federal estate tax.

2. Carry-Over Basis Regime. If Congress does not act, the current law imposes a carryover basis regime on decedents dying in 2010. Under the carry-over basis system, the basis of assets transferred at death will be the lower of (a) the decedent’s tax basis and (b) the fair market value of the asset on the date of death. For example, if a share of stock was bought by Dad in 1945 for $1, inherited by Daughter at a value of $75 and then sold for $100, the Daughter’s tax basis would be $1, and she would realize a capital gain of $99. This system requires everyone to track the cost basis of all assets. Further cost basis complications beyond the scope of this article may arise for decedents in states that impose a state estate tax.

3. Allocation of Basis Adjustment. Under the 2010 carry-over basis regime, each estate will receive a limited step-up in basis equal to $1,300,000. This “exemption” may be used to increase the basis of the estate’s assets to their fair market value, but no higher. In addition, $3,000,000 will be available to each estate to increase the cost basis of assets passing to the surviving spouse. To qualify for the spousal step-up in basis, however, the property must be either held in a marital trust that that meets the requirements for a QTIP or transferred outright to the spouse from the decedent. Many estate plans drafted in 2009 and prior years do not take this new carryover basis system into consideration, and if all of the decedent’s property is distributed to a family trust, the $3,000,000 spousal basis adjustment will be wasted. In addition, executors are required to allocate the basis adjustment on an asset-by-asset basis. Any person named as an executor should ask about the testator’s intent with respect to which assets and which beneficiaries should reap the reward of a stepped-up basis.

4. Taxable Gifts. Currently, the gift tax rate is 35%, reduced from 45% in 2009. If a client makes a taxable gift this year, he may pay gift tax at a rate of only 35%. It is possible, however, that Congress will raise the gift tax rate to 45% and apply that rate retroactively to all gifts made in 2010. Therefore, clients should be advised of the significant risk of relying on a 35% gift tax rate.

5. Gifts to Crummey Trusts. Finally, if Congress takes no action in 2010, grantors may be unable to allocate GST exemption to Crummey gifts made this year to insurance trusts and other irrevocable Crummey trusts that are intended to be wholly GST exempt. Although the GST tax treatment of these gifts is unclear when the GST tax returns in 2011, one possibility is that the trust would have an inclusion ratio between zero and one due to the non-exempt 2010 Crummey gifts. If so, the grantor would have to make a late allocation of GST exemption to make the trust wholly GST exempt. Alternatively, for an insurance trust, the grantor could lend the trust enough assets to make the premium payments in 2010 and avoid the GST issue; however, the grantor may not have enough annual exclusion gifts in the following year both to (i) pay that year’s insurance premiums and (ii) repay the loan.

Good luck!

Legislative Update: Massachusetts Uniform Trust Code (“MUTC”)

Authors: Matthew R. Hillery, Esq., Edwards Angell Palmer & Dodge LLP
Suma V. Nair, Esq., Goulston & Storrs, P.C.

In 2000, the Uniform Law Commission promulgated a Uniform Trust Code for consideration by the states. In 2005, an Ad Hoc Committee of Massachusetts attorneys convened to review the Uniform Trust Code in detail. That Committee has described the Uniform Trust Code as an attempt to codify the rules relating to trusts comprehensively and uniformly and in some cases to include innovative provisions thought to improve upon the common law.

In reviewing the Uniform Trust Code, the Ad Hoc Committee (1) evaluated current Massachusetts law, preserving it where the committee thought it was superior to the Uniform Code and (2) in some cases, rebalanced the power between the beneficiaries, the trustee and the settlor where the Committee disagreed with the balance struck in the Uniform Trust Code. The eventual product of the Ad Hoc Committee was the MUTC. The MUTC would concentrate in one place the Massachusetts statutory law of trusts, which should make it easier to know the law. The MUTC would supersede the Massachusetts common law of trusts to the extent that they are inconsistent.

The Steering Committee of the Boston Bar Association’s Trusts and Estates Section has voted to support enactment of the proposed Massachusetts Uniform Trust Code (“MUTC”). The Steering Committee’s vote followed an approximately two month review period that included an open discussion meeting on January 22, 2010, in which all members of the Section were invited to participate. Most of the members of the Ad Hoc Committee that drafted the MUTC participated in the January 22 discussion. While a majority of the members (15) of the Steering Committee voted to support enactment of the MUTC, a minority of the members (3) voted not to support enactment of the MUTC at this time. A summary of each of the majority view and the minority view follows:

Majority View. The Uniform Trust Code, with state specific modifications, has been adopted by 23 states to date, including New Hampshire, Vermont and Maine. As with any uniform statute, a primary purpose of the Uniform Trust Code is to make the administration of trusts more uniform among the states, a reasonable goal in the 21st Century given that trust law in most states, including Massachusetts, is based largely on case law. Adoption of the MUTC will be seen favorably as moving Massachusetts into the modern era of trust law and administration. The Ad Hoc Committee that drafted the MUTC was comprised of well-regarded members of the Massachusetts Bar who debated each section of the uniform statute. The result of that debate, which included whether or not the MUTC is even needed, is a statute that will (in the words of the Ad Hoc Committee) “simplify and make more accessible the law of trusts in Massachusetts while leaving our vast common law on the subject largely intact.” The Committee’s Report includes an extensive introductory section and comments on each section of the proposed MUTC. The MUTC has been endorsed without any recommended changes by the Probate Section of the Massachusetts Bar Association and by the Massachusetts Bankers Association.

Minority View. A small group of the Steering Committee voted against approval of the draft MUTC at this time. The main concern was that the act is moving forward too quickly and that its possible effects had not been fully considered by members of the Section and of the bar. The act explicitly changes many long-standing rules that have been relied on in the formation and administration of trusts in Massachusetts (for instance, by changing the current default rule requiring unanimity among trustees) and introduces new rules and requirements not previously seen. Most of these changes are applied to all trusts, regardless of when created or made irrevocable. Furthermore, some members felt that the Committee Report should be expanded to explain more fully the rationale behind the proposed changes to Massachusetts law and to the model UTC.

The Steering Committee has already voted to approve the draft MUTC, but the legislative process has only just begun. We urge those of our members who have not yet had the opportunity to review the draft act and committee report to do so now. We welcome your comments.

An Act Further Regulating the Rights of Adopted Children and its Impact on the Trusts and Estates Bar: An Update

Marc J. Bloostein, Ropes & Gray LLP

In the Spring 2009 Newsletter I reported on chapter 524 of the Acts of 2008, which went into effect on April 15, 2009. That new law, called “An Act Further Regulating the Rights of Adopted Children,” changed the effective date of the current rule of construction applicable to terms like “child”, “grandchild” and “issue” in wills, trusts and similar instruments executed before August 26, 1958. The current rule of construction is found in G.L. c. 210, § 8 and presumes that adopted descendants are included in such class gifts (I will refer to this as the “Modern Rule”). The Modern Rule’s original effective date provision limited its application to instruments executed on or after August 26, 1958. The prior rule of construction, which presumed inclusion of persons adopted by the testator or settlor and presumed exclusion of persons adopted by others, continued to apply to pre-1958 instruments. Chapter 524 made the Modern Rule applicable to all instruments, whenever executed, excepting from its application only distributions under “testamentary instruments” made before May 1, 2009.

Chapter 524 came as a complete surprise to members of the trusts and estates bar, who had relied on the longstanding effective date rules in advising clients. As a result of the efforts of the Boston Bar Association, the Massachusetts Bankers Association and others, the Legislature temporarily repealed chapter 524 in the June budget bill, reinstating the old effective date rule for the period from July 1, 2009 to July 1, 2010. St. 2009, c. 27, §§ 101-102 and 159-161. The chapter 524 replacement, which will become effective July 1, 2010, reads as follows: “Section 8 of chapter 210 of the General Laws shall apply to all grants, trust settlements, entails, devises, or bequests executed at any time, but this section shall not affect distributions made before July 1, 2010 under testamentary instruments executed before September 1, 1969.” St. 2009, c. 27, § 102. (The 1969 date relates to the effective date of the current effective date provision of G.L. c. 210, § 8.)

The good news is that this development postpones application of the Modern Rule to pre-1958 instruments until next July. The bad news is that the chapter 524 replacement retains the same unclear limitation that prevents the Modern Rule from applying retroactively to distributions made before July 1, 2010 only with respect to distributions under “testamentary instruments.” This leaves open the question of whether the Modern Rule will be applied retroactively to distributions made today under pre-1958 instruments that are not “testamentary instruments.”

Generally, the word “testamentary” pertains to a will or similar document that disposes of property at a person’s death. According to Black’s Law Dictionary (6th ed. 1990), a testamentary instrument is “[a]n instrument in the nature of a will; an unprobated will; a paper writing which is of the character of a will, though not formally such, and, if allowed as a testament, will have the effect of a will upon the devolution and distribution of property.” So, the term clearly includes a will and a trust established under a will. One could argue that it includes a trust established under an inter vivos instrument that took effect at a person’s death (i.e., a revocable trust), on the theory that such an instrument is a will substitute and transfers property at death. However, it would be hard to treat a typical irrevocable inter vivos trust as a testamentary instrument. Such a trust might be established for one or more children or grandchildren, and would take effect immediately and not at the time of the settlor’s death.

If a trustee is administering a pre-1958 trust established under a will, then the chapter 524 replacement clearly does not apply the Modern Rule to any distributions made prior to July 1, 2010. If, however, a trustee is administering a pre-1958 irrevocable inter vivos trust, there is nothing in the chapter 524 replacement to suggest that the Modern Rule will not be applied retroactively to prior distributions. It would be sensible to read “testamentary instruments” very broadly, but a court cannot ignore entirely the language the Legislature chose.

Of course, it would be difficult to argue that a trustee should be responsible for making a distribution in contravention of the new effective date of the Modern Rule prior to the trustee having reasonable notice of it. So, an adopted individual who by virtue of the new effective date will become a beneficiary of an inter vivos trust would likely have a difficult time arguing come July 1, 2010 that she should have received distributions going back to the inception of the trust long before 2009. However, that same beneficiary might have a claim come July 1, 2010 with respect to distributions made today under an inter vivos trust because arguably by today a trustee should be on notice that the Modern Rule will be apply retroactively to the trust starting next July. A trustee administering a pre-1958 inter vivos trust with a potential adopted beneficiary should at least consider retaining from any current distribution sufficient assets to pay an adopted beneficiary come July 2010.

Another aspect of this legislative development relates to events that occurred between April 15 (when chapter 524 became effective) and July 1, 2009 (when that statute was repealed). The June legislation stated that the temporary repeal of chapter 524 “shall [not] affect the validity of any action taken pursuant to chapter 524 of the acts of 2008 between April 15, 2009 and [July 1, 2009].” St. 2009, c. 27, § 159. Clearly any distributions made to an adopted beneficiary under color of chapter 524 were not affected by the new law. But what if a pre-1958 trust terminated during the period and the beneficial interests vested though no distribution was made? There’s a strong case to be made that the termination date is the relevant date and the distribution should include adopted beneficiaries even if made after July 1, 2009. The answer, however, is not entirely clear from the statute. It is also possible that an adopted person who became a discretionary beneficiary of a trust on April 15, 2009 could argue that the temporary repeal deprived her of her beneficial interest in violation of her due process rights. There would not, however, be much support for such an argument as there would have been little reliance on her very short-term status as beneficiary.

There are still many questions to be answered in connection with chapter 524 and its replacement. In addition to the interpretational questions, there may well be an effort to repeal the statute, and there will likely be one or more constitutional challenges to the statute.

New Rule Eliminates Income Limits for Roth IRA Conversions

Michelle Addison, Bingham McCuthchen LLP

Enacted in 2006, the Tax Increase Prevention and Reconciliation Act eliminates the existing $100,000 modified adjusted growth income cap for converting a traditional individual retirement account (IRA) to a Roth IRA starting on January 1, 2010. While the conversion from a traditional IRA to a Roth IRA is treated as a taxable distribution, the taxpayer may choose to pay income tax on the entire converted amount in 2010 or have one-half of the taxable converted amount taxed in 2011 and the other half in 2012. The client also has the option of converting in installments over a number of years to take less of a one-time tax hit, instead of converting the entire IRA in 2010.

The major benefit of converting to a Roth IRA is that earnings and withdrawals are income tax-free so long as the individual (i) has held the Roth IRA for a minimum of five years from the date of conversion and (ii) is at least age 59½ at the time of withdrawal. Roth IRAs also have no required minimum distributions after age 70½. In addition, by paying the income tax on the IRA upon conversion, the client’s taxable estate would be reduced by the amount of income tax paid—in Massachusetts, this should be advantageous even after taking into account the IRD deduction allowed traditional IRAs under Section 691.

All other things being equal, in deciding whether to convert to a Roth IRA, a primary consideration is the client’s marginal income tax bracket—both the current rate and estimated future rate. If the client’s predicted future tax bracket is lower than his or her current marginal rate, conversion might be less attractive than it would be if tax rates or the client’s income were predicted to increase. If the client’s current and future marginal income tax brackets are the same, then a converted Roth IRA should produce the same amount of wealth as a traditional IRA after the payment of income taxes. Of course, all situations are unique and clients should consult legal counsel and/or financial advisors to determine if conversion is advisable for them.

Another concern is whether the client will be able to pay the taxes resulting from the conversion without dipping into the IRA’s assets. Conversion may not make sense for a client if he or she cannot pay the taxes from an independent source of funds. If a client converts a traditional IRA to a Roth IRA but reserves a portion of the IRA funds to pay the tax, the 10% early withdrawal penalty will also apply if the client is under age 59½. Therefore, for younger clients unable to pay the income tax from non-IRA assets, a Roth conversion may not be efficient.

The recent market decline, which has resulted in lower value of many IRAs, makes conversion attractive as the tax cost is reduced. Conversion will also protect the IRA from any future tax increases. After careful analysis of each client’s estate and income tax planning considerations, 2010 may be a good year to convert for many.

10 Tips on Community Property for the Common Law Estate Planner

Leiha Macauley, Day Pitney LLP
Kate Hilton, Hauser Center for Nonprofit Organizations

1. History and Policy: Community property law developed from Germanic tribal practices introduced in Spain following the fall of the Roman Empire. In the United States, the Spanish system was retained in territories acquired from Spain, Mexico, and France. On admission to statehood, several southwestern states adopted community property statutory provisions. Other states, having no substantial contact with Spanish culture or institutions, nevertheless adopted the community property system to attract women as settlers and provide for women’s property rights, because community property is a commitment to the equality of spouses. It treats marriage as a partnership in which spouses devote their particular talents, energies, and resources to their common good, and acquisitions and gains that are directly or indirectly attributable to partners’ expenditures of labor and resources are shared equally.

2. Geography: In the following eight states, the community property system is mandatory for residents unless they enter into an agreement opting out of the system.

Arizona Idaho New Mexico Texas

California Louisiana Nevada Washington

Although a number of community property rules are applicable among the community property jurisdictions, considerable local variations exist. Note also that Wisconsin is a default community property regime, though couples may “opt-out”; and Alaska permits couples to “opt-in” to a community property regime.

3. Community property vs. separate property vs. quasi-community property: Community property is all property acquired by either spouse during marriage while domiciled in a community property state, excluding property received by gift or inheritance. Community property provides each spouse a one-half, undivided, legal or equitable, vested or contingent, present or future interest in the property. Separate property refers to property acquired before marriage or property acquired after marriage by gift, bequest, devise or inheritance. Quasi-community property treats acquisitions of property made outside the state that would have been community property had they been acquired in-state as community property. Quasi-community property laws were designed to protect a nonmonied spouse following a move from a common law state to a community property law state.

4. Characterizing Community Property: Title is generally irrelevant to the characterization of property in community property states. Rather, the presumption is that a married couple owns all the property that they acquire during marriage as community property. This presumption can be rebutted only by strong proof to the contrary, referred to as “tracing.” Unless separate property can be traced, commingling community and separate property generally results in all commingled property being considered as community property.

5. Step-Up (or Down) in Basis: Under federal income tax law, all community property receives a new basis at the death of the first spouse to die equal to the property’s then fair market value, even though only the decedent’s one-half community property interest is included in his gross estate. The basis adjustment for the survivor’s interest in community property is a unique advantage that has no counterpart in common-law states.

6. Tangible Property vs. Real Estate: The character of tangible property is fixed at the time of acquisition in accordance with the law of the marital domicile, whereas the character of real property is generally determined by the law of the real property’s situs. For example, real property located in a community property state owned by spouses who reside in a common law state is generally considered community property.

7. Estate and Gift Tax: Community property automatically equalizes estates between spouses. Because each spouse owns one-half of the property, each spouse can dispose of only one-half of the couple’s community property at death. When the first spouse dies, his or her gross estate includes one-half of each and every item of the couple’s community property. Community property allows both spouses to take full advantage of their estate, gift and GST exemptions without re-titling assets.

8. Conflict of Laws, Federal Preemption and International Jurisdictions: Generally, the law of the matrimonial domicile governs in ascertaining the rights which each party acquires in the property of the other, except when federal laws preempt state laws. For instance, ERISA preempts application of a state’s community property laws to an ERISA-governed pension plan. Also beware that property located in foreign countries following a community property regime generally retains its community property nature even after the couple moves to a common law country or state.

9. Planning for Clients Moving from a Community Property State to Massachusetts: When spouses relocate from a community property jurisdiction to a common law property jurisdiction, the couple’s rights and interests in property that can be moved will be governed according to the law of the spouses’ marital domicile at the time of acquisition. It is advisable to: (1) determine community property assets with a written inventory; (2) ascertain whether clients have a community property agreement that characterizes assets as separate; (3) protect the double basis step-up; and (4) develop a plan to preserve community property (or re-characterize it as separate property).

10. Planning for Clients Moving from Massachusetts to a Community Property State: Most pre-existing assets will be viewed as quasi-community property, while assets that begin to accumulate from spouses’ personal efforts after the move are automatically community property. Remember that commingling separate and community property taints the character of separate property because the presumption is that all property is community property. To avoid this issue, consider transmutation. Transmutation is an interspousal agreement that alters the character of the property through a written statement that the ownership of the property is altered. Before the move, it is advisable to: (1) ask for an inventory of all property at the time of relocation (which thereby provides an itemized list of all of the spouses’ separate property); (2) advise spouses to maintain separate checking and savings accounts to avoid and/or trace any commingling; (3) suggest that clients develop a practice of maintaining basic records noting the source of funds to pay for major investments; and (4) determine whether the spouses wish to enter into a post-marital agreement. Pre- and post-marital agreements provide clarity and limit disputes when the rights of the spouses change after changing domicile from a common law state to a community property law state during marriage. Pre-marital agreements entered into by spouses residing in a common law property jurisdiction are cause for concern if they do not take into account a future move to a community property jurisdiction. Spouses moving to a community property jurisdiction who are interested in preserving the separate nature of property are advised to enter into a post-marital agreement fixing the character of that property.