Ron Aucutt’s 'Top Ten' Estate Planning and Estate Tax Developments of 2013

In what has become an ever eagerly anticipated annual tradition, Ronald Aucutt, a McGuireWoods partner and co-chair of the firm's private wealth services group, has identified the following as the top ten estate planning and estate tax developments of 2013. Ron is an observer and frequent participant in the formation of tax policy and regulatory and interpretive guidance in Washington, D.C., and is the editor of the Recent Developments materials that are presented each year at the Heckerling Institute on Estate Planning.

Number Ten: Valuation Cases Still Fact-Bound: FLP Furor Is Quieter but Not Silenced: Estate of Koons v. Commissioner, T.C. Memo 2013-94

The fact-specific nature of litigation over the gift and estate tax value of interests in family limited partnerships (FLPs) and LLCs continues to provide both encouragement and warnings to estate planners. This year, for example, Estate of Koons v. Commissioner illustrates the challenges in achieving valuation discounts in the Tax Court for cash-heavy entities. When the decedent died, he owned a total 50.5 percent interest in an LLC, consisting of 46.9 percent of the voting interest and 51.6 percent of the nonvoting interest. (Although the 46.9 percent voting interest was not by itself a controlling interest, it was by far the largest voting interest and could control the LLC when combined with the interests of various trusts, including the 9.9 percent voting interest of a trust over which the decedent held a limited power of appointment.) The LLC, however, had been funded with the proceeds of sale of the decedent's Pepsi distributorship, significantly not with an operating distributorship itself. It held $322 million in cash (92 percent of its total assets of $351 million), and its debts were only $33 million, leaving a net asset value of $318 million. The estate valued the decedent's interest at $117 million on the estate tax return but lowered it to $110 million at trial, reflecting a 31.7 percent discount. For its part, the IRS valued the interest at $136 million in its notice of deficiency but raised the value in its amended answer to $148.5 million, reflecting a 7.5 percent discount.

Before his death, the decedent had proposed to use some of the cash in the LLC to redeem the LLC interests of his children. The children, who in the aggregate could not control the LLC anyway, arguably accepted this redemption offer before their father died. The redemption would have increased the estate's voting interest to 70.4 percent, which was part of the IRS's justification of a lower discount.

After the redemption did close, increasing the estate's voting interest to 70.4 percent, the estate borrowed $10.75 million from the LLC to help it pay the estate tax. The note was a "Graegin loan," prohibiting prepayment as in Estate of Graegin v. Commissioner, T.C. Memo 1988-477, but with the additional unusual feature that the payments to be made over a seven-year period would not start for 18 years, producing total interest payments on the $10.75 million loan of over $71 million, for which the estate claimed a deduction.

The court accepted the IRS's amended value of $148.5 million and disallowed the deduction of interest on the borrowing, which it found to be "not necessary."

Both the facts and the outcome of Koons are a contrast to two taxpayer Tax Court successes featured in the 2012 Top Ten list, Estate of Kelly v. Commissioner, T.C. Memo 2012-73 (a partnership owning operating quarries), and Estate of Stone v. Commissioner, T.C. Memo 2012-48 (a partnership owning and managing woodlands). In Kelly, for example, the legitimate asset-protection and risk-management purposes of the partnership had been highlighted by dynamite blasting at quarries on the partnership property, the discovery of bullets in a campfire site on the property, and an incident of a dump truck collision over which the decedent had been sued. The LLC in Koons held mainly cash.

In other developments related to valuation of interests in family-owned entities, when the Administration released its Fiscal Year 2014 Revenue Proposals in April 2013, it omitted its previous calls for Congress to give Treasury greater regulatory authority to create more durable rules for disregarding restrictions under section 2704(b) in valuing such interests. But the Treasury-IRS Priority Guidance Plan for the 12 months beginning July 1, 2013, includes, as it has every year since 2003, a project described as "Regulations under §2704 regarding restrictions on the liquidation of an interest in certain corporations and partnerships" (page 17). The abandonment of the call for more congressional "cover" might signal waning interest in this subject, or it might signal an intention to go ahead and propose regulations under the authority already conferred by section 2704(b)(4). The latter seems most likely.

Number Nine: What Is Happening in State Will and Trust Law?

This Top Ten list typically focuses on federal tax law developments that obviously have a wide impact, even though every year also brings many legislative and judicial developments among the states that are sure to have a local impact and often also represent trends spreading across the nation. But in 2013, an unusually large number of interesting developments involving state law issues or mixed federal-state law issues have attracted attention to trends that bear watching.

Asset Protection. In re Huber , 201 B.R. 685 (Bankr. W.D. Wash.), set aside an Alaska asset-protection trust created by a lifelong Washington resident and funded with interests in an Alaska LLC created for that purpose to which the debtor had transferred substantially all of his assets, all located in Washington except for one $10,000 certificate of deposit in Alaska. To be sure, the court found the debtor's transfers to have been "fraudulent," within the meaning of the federal Bankruptcy Code, when they were made. The decision therefore does not necessarily imply the general ineffectiveness of asset-protection trusts created by citizens of one state in other states, even though the court employed the Ninth Circuit's known choice of federal conflict of laws rules in following Washington law. But it gives pause, particularly because the facts seem somewhat more favorable to the debtor than the previous relevant case of Mortensen v. Battley, 2011 WL 5025288 (Bankr. D. Alas. 2011). Meanwhile, Ohio's domestic asset protection law, which had been enacted in December 2012, took effect on March 27, 2013, but no state enacted domestic asset protection trust legislation in 2013.

Arbitration. Courts continue to ponder the implications of provisions in trust instruments that might diminish the power of courts to resolve claims of trust beneficiaries or discourage those beneficiaries from seeking help from the courts. The most dramatic context may be the requirement in a trust instrument of binding arbitration, generally disfavored by courts in the absence of an explicit state statute (found only in Arizona and Florida), until Rachal v. Reitz, 403 S.W.3d 840 (Tex. 2013), in which the Texas Supreme Court labored to allow mandatory arbitration under a Texas statute applicable generically to "agreements." In extending that statute to trust beneficiaries, the court "found assent by nonsignatories to arbitration provisions when a party has obtained or is seeking substantial benefits under an agreement under the doctrine of direct benefits estoppel," which it viewed as "a type of equitable estoppel."

In Terrorem Clauses. Another context for courts to be protective of their power is the applicability of harsh "in terrorem" clauses. Callaway v. Willard, 739 S.E.2d 533 (Ga. Ct. App. 2013), refused to apply an in terrorem clause to a challenge to trust administration and fiduciary conduct because such clauses "are not favored in the law" and "cannot be construed so as to immunize fiduciaries from Georgia law governing the actions of such fiduciaries." Hamel v. Hamel, 299 P.3d 278 (Kan. 2013), applied Kansas law that presumed no contest clauses to be valid unless probable cause existed and then found probable cause in that case.

"Superwills." Eyebrows were raised by Manary v. Anderson, 292 P.3d 96 (Wash. 2013), which affirmed the use of "superwills" or "blockbuster wills" that are allowed to dispose of non-probate assets, as authorized by state law (RCW §11.11). The court allowed a will to redirect the disposition of real estate held in a previously revocable joint trust that had become irrevocable when the testator's spouse predeceased him. The will described the real estate but did not mention the trust.

Decanting. Morse v. Kraft , 992 N.E.2d 1021 (Mass. 2013), held that, even in the absence of a decanting statute, a trustee had the authority to "decant" trust assets to new trusts similar to the existing trusts but adding the settlors' sons as trustees. Massachusetts thus becomes the first state since the enactment of the federal generation-skipping transfer tax to join Florida and New Jersey in recognizing that trustees have "decanting" powers where trust instruments give the trustees broad distribution powers. Phipps v. Palm Beach Trust Co., 142 Fla. 782 (1940); Wiedenmayer v. Johnson, 106 N.J. Super. 161, 164-65 (App. Div.), aff'd sub nom. Wiedenmayer v. Villanueva, 55 N.J. 81 (1969). The GST tax, which the Morse court specifically acknowledged, is important because under Reg. §26.2601-1(b)(4)(i)(A)(1)(ii) a distribution of a GST tax-exempt trust to a new trust (that is, decanting) will not jeopardize the exempt status of the trusts if "at the time the exempt trust became irrevocable, state law authorized distributions to the new trust or retention of principal in the continuing trust, without the consent or approval of any beneficiary or court," even if the new trust extends the term of the trust, as long as it is not extended beyond lives in being at the creation of the old trust plus 21 years. Because...