Capital Letter No. 31
By Ronald D. Aucutt
Washington, D.C.
February 27, 2012
Treasury’s “Greenbook” gets attention by proposing broad changes to the estate tax treatment of grantor trusts.
Dear Readers Who Follow Washington Developments:
In connection with the rollout of the Administration’s proposed fiscal 2013 budget on February 13, 2012, the Treasury Department released its General Explanations of the Administration’s Fiscal Year 2013 Revenue Proposals (popularly referred to as the “Greenbook”).  Most of its proposals are carried over from previous years with little or no change, but a proposal to “coordinate certain income and transfer tax rules applicable to grantor trusts” has generated lots of attention and will renew the reexamination of a decades-old disconnect.
Return to 2009 Rates and Exemptions, with Permanent Portability
Consistently with the Obama Administration’s previous budget proposals, the Greenbook proposes, effective January 1, 2013, to return the estate, gift, and GST taxes to their 2009 levels, which, as in past years, the Greenbook quixotically calls “parameters.”  That would mean an essentially flat 45 percent estate and GST tax above a $3.5 million exemption and an almost flat gift tax (starting at 41 percent) for cumulative taxable gifts over an exemption of $1 million.
The Greenbook points out that before 2002 the top tax rate was 55 percent, plus a 5 percent surcharge on the amount of the taxable estate between approximately $10 million and $17.2 million, with an exclusion of $675,000 that was scheduled to rise to $1 million by 2006.  It views the 2010 Tax Act as “a substantial tax cut to the most affluent taxpayers that we cannot afford to continue” and concludes that “[w]e need a permanent estate tax law that provides certainty to taxpayers, is fair, and raises an appropriate amount of revenue.”  Nevertheless, the revenue projections assume that 2012 law is permanent for purposes of calculating the budget “baseline,” with the result that the proposed return to 2009 law is estimated to raise federal revenues by $119 billion over the fiscal years 2013 through 2022, which, as far as the estate tax is concerned, corresponds roughly to decedents dying in calendar 2012 through 2021.  In fact, these tax increases effective January 1, 2013, are projected to increase revenue by $103 million for fiscal 2012, which ends September 30, 2012.
The Greenbook also repeats last year’s proposal that the portability provisions enacted in December 2010 be made permanent, albeit at an exemption level of $3.5 million for the estate tax and $1 million for the gift tax.  As described elsewhere, for example in ACTEC’s Comments on Portability Guidance, the limitations Congress imposed on portability in the 2010 Tax Act have presented a number of challenges regarding the coordination of the gift tax and the estate tax for purposes of portability.  Customizing portability to the revived 2009 dual gift tax-estate tax exemption would present still further challenges, but perhaps also an opportunity for Treasury and Congress to examine ways to simplify the operation of portability across-the-board.
“Require Consistency in Value for Transfer and Income Tax Purposes”
This proposal would require the value of property transferred at death or by gift that is used to compute the recipient’s basis to be the value that is finally determined for estate or gift tax purposes.  It includes a few refinements of the similar proposals in recent years, including acknowledgment of the allocations of basis increases on Form 8939 by the executors of decedents who died in 2010, even though the proposal would apply only to transfers on or after the date of enactment.
Ever since the first appearance of this proposal in the 2009 Greenbook and its analysis in a 2009 Joint Committee on Taxation publication, discussed in Capital Letter Number 18, there has been cause for concern that the implementing legislation might actually limit basis to the amount reported on an estate tax return, even if that value is increased in an estate tax audit.  Therefore, Capital Letters has monitored the glimpses of the statutory language that we have seen in section 6 of the “Responsible Estate Tax Act,” introduced by Senators Sanders (I-VT), Whitehouse (D-RI), Harkin (D-IA), Brown (D-OH), and Franken (D-MN) as S. 3533 on June 24, 2010, and by Rep. Linda Sanchez (D-CA) as H.R. 5764 on July 15, 2010; by section 309 of the “Middle Class Tax Cut Act of 2010” offered as an amendment to pending tax legislation on December 2, 2010, by Finance Committee Chairman Max Baucus (D-MT); and in section 5 of the “Sensible Estate Tax Act of 2011,” H.R. 3467, introduced on November 17, 2011, by Congressman Jim McDermott (D-WA).
The November 2011 version of Congressman McDermott’s bill (H.R. 3467) is most significant, because it is the most recent and because it clearly addresses and dispels the concern about the effect of an estate tax audit on basis.  Under this bill, new sections 1014(f)(1) and 1015(f)(1) would direct that the value subsequently used to determine basis be the value “as finally determined” for estate or gift tax purposes.  The only exception, in new sections 1014(f)(2)9 and 1015(f)(2), would require use of the value initially reported to the heir or donee only if “the final value … has not been determined.”  That could influence the timing of sales while the estate tax audit is still open, but, essentially limited in time to that scenario, it seems to be a reasonable compromise.
H.R. 3467, by the way, includes other helpful technical provisions.  Section 2(c) would prevent the notorious “claw back” that might otherwise recapture benefits of today’s large gift tax exemption if the donor dies when the estate tax exemption is lower.  Section 2(d) would correct a divergence between the statutory portability language and Example 3 in the 2010 legislative history, by confirming that the legislative history reflected true congressional intent.  As a significant tax increase with an exemption of about $1.3 million and a 55 percent top rate, H.R. 3467 has no future in the current Republican-led House of Representatives.  But this evidence of ahead-of-the-curve attention to technical issues at the staff level is a source of reassurance about any estate tax legislation Congress might entertain in 2012 or early 2013.
The consistency proposal in the Greenbook is estimated to increase revenues by $2 billion over ten years.
“Modify Rules on Valuation Discounts”
This proposal to expand regulatory authority under section 2704(b)(4) was first described in Capital Letter Number 17 and is unchanged from recent years.  Treasury estimates that it would increase revenue over ten years by $18.079 billion, an estimate that has been declining slightly each year since this proposal first appeared in the 2009 Greenbook.  But the proposal is not likely to be viewed as a revenue-raiser by congressional estimators, because its effect depends entirely on regulations that have not yet been promulgated.  Possibly for that reason, recent statutory proposals, including Congressman McDermott’s H.R. 3467, do not adopt this proposal, but merely reproduce aggregation and look-through valuation rules that date back to the Clinton Administration or arguably to “Tax Reform for Fairness, Simplicity, and Economic Growth” (popularly called “Treasury I”) published on November 27, 1984, by the Reagan Administration.
“Require a Minimum Term for Grantor Retained Annuity Trusts (GRATs)”
Another perennial Greenbook entry, which was actually approved by the House of Representatives three times in 2010, this proposal to amend section 2702 to require a ten-year minimum term for GRATs has one change from last year, an additional requirement of a maximum term equal to the life expectancy of the annuitant plus ten years. That would limit the use of very long-term “Walton-style” GRATs with a low annual payout that would result in a reduced inclusion in the gross estate under Reg. § 20.2036-1(c)(2)(i). Like previous Greenbooks, however, while the 2012 Greenbook would require the remainder interest in the GRAT to have “a value greater than zero at the time the interest is created,” it confirms that “a minimum term would not prevent ‘zeroing-out’ the gift tax value of the remainder interest.” Obviously near-zeroing-out is what is meant.
This proposal is estimated to increase revenues by $3? billion over ten years, slightly up from estimates in past years.
“Limit Duration of Generation-Skipping Transfer (GST) Tax Exemption”
This proposal to sunset the allocation of GST exemptions after 90 years is not substantively changed from the 2011 Greenbook, where it first appeared.  Not surprisingly, it is said to have a “negligible revenue effect” in the first ten years.
“Coordinate Certain Income and Transfer Tax Rules Applicable to Grantor Trusts”
Most of the rules treating a grantor as the “owner” of a trust were crafted in the 1930s and 1940s to curb the shifting of taxable income to taxpayers in lower income tax brackets, even to the spouses of grantors in common law states before 1948 when joint income tax returns were introduced.  At least since the promulgation of Rev. Rul. 85-13, 1985-1 C.B. 184, in which the Service held that an apparent sale between a grantor trust and its grantor would not be regarded as a sale for income tax purposes, the disconnect between the grantor trust rules and the gift and estate tax rules has inspired considerable effective planning with so-called “defective” grantor trusts.  It is hard to argue, for example, that the grantor’s payment of income tax on someone else’s income is not economically equivalent to a gift, but, because the tax is the grantor’s own obligation under the grantor trust rules, it escapes gift tax.  And sales to grantor trusts are often viewed as economically equivalent – or superior – to GRATs, but without the policing of sections 2702 and 2036 or the “ETIP” restrictions of section 2642(f) on allocating GST exemption.
So it is not surprising that there is interest from time to time in closing the gap between the two sets of tax rules.  This has been true even as recent developments have seemed to actually ratify and validate the widespread use of grantor trusts in estate planning, including
  •   Rev. Rul. 2004-64, 2004-2 C.B. 7, addressing the estate tax consequences of provisions regarding the reimbursement of the grantor for income tax on the grantor trust’s income,
  •   Rev. Rul. 2007-13, 2007-11 I.R.B. 684, holding that the transfer of life insurance contracts between two grantor trusts treated as owned by the same grantor is not a transfer for valuable consideration for purposes of section 101,
  •   Rev. Rul. 2008-22, 2008-16 I.R.B. 796, providing reassurance regarding the estate tax consequences under sections 2036 and 2038 of the grantor’s retention of a section 675(4)(C) power, exercisable in a nonfiduciary capacity, to acquire property held in trust by substituting property of equivalent value,
  •   Rev. Rul. 2011-28, 2011-49 I.R.B. 830, extending that reassurance to section 2042 and cases where the trust property includes policies of insurance on the grantor’s life, and
  •   Rev. Proc. 2008-45, 2008-30 I.R.B. 224, promulgating sample inter vivos charitable lead unitrust forms, including forms for both nongrantor and grantor CLUTs, where the feature used to confer grantor trust status is such a substitution power in a person other than the grantor.
The current Greenbook proposal, simply put, would include the date-of-death value of all grantor trusts in the grantor’s gross estate and subject that value to estate tax.  Specifically, the proposal states:
To the extent that the income tax rules treat a grantor of a trust as an owner of the trust, the proposal would (1) include the assets of that trust in the gross estate of that grantor for estate tax purposes, (2) subject to gift tax any distribution from the trust to one or more beneficiaries during the grantor’s life, and (3) subject to gift tax the remaining trust assets at any time during the grantor’s life if the grantor ceases to be treated as an owner of the trust for income tax purposes....  The proposal would reduce the amount subject to transfer tax by the value of any taxable gift made to the trust by the deemed owner.  The transfer tax imposed by this proposal would be payable from the trust.
This proposal is very broad.  For one thing, it apparently would subject many life insurance trusts to estate tax, because the authority (at least implicitly) to use trust income to pay premiums could confer grantor trust status under section 677(a)(3) (although the introductory language to section 677(a) would provide some workarounds in some cases).  The proposal will be criticized for perpetuating outdated and sometimes quirky income-shifting restrictions that a more modern approach might reject or refocus.  For example, grantor trust status can come and go under section 674 with changes in the trustee or can depend on spousal attribution under sections 672(e) and 677(a), concepts that would be anomalies in the estate tax arena.  But proposals like this – indeed, modern Administration budget proposals as a whole – are not realistically intended to be immediately enacted.  Rather, this proposal is a statement intended to keep an important topic on the long-term agenda.
The Greenbook also states:
The proposal would not change the treatment of any trust that is already includable in the grantor’s gross estate under existing provisions of the Internal Revenue Code, including without limitation the following: grantor retained income trusts (GRITs); grantor retained annuity trusts (GRATs); personal residence trusts (PRTs); and qualified personal residence trusts (QPRTs).
This is an odd concession that will bear watching.  For example, the implication is that the treatment of GRATs does not have to be changed because GRATs already are treated consistently with the Greenbook proposal.  In fact, while it is assumed that all or most GRATs are grantor trusts (which can facilitate payment of the annuity in kind without capital gain), the value of a long-term GRAT might not be fully included in the grantor’s gross estate, as noted above in the discussion of the proposed minimum term for GRATs.  Moreover, the termination of a GRAT’s grantor trust status, which may or may not occur at the end of the GRAT term, is not currently treated as a taxable gift.
The Greenbook proposal would apply to trusts created on or after the date of enactment and to other trusts to the extent of contributions made on or after the date of enactment.  With regard to contributions to pre-enactment trusts, the Greenbook states that “[r]egulatory authority would be granted, including the ability to create transition relief for certain types of automatic, periodic contributions to existing grantor trusts.”  This is presumably aimed, for example, at life insurance trusts, where the periodic payment of premiums, while not exactly “automatic,” is typically done under the terms of a preexisting insurance contract.
But this effective date discussion highlights the fact that a seemingly unavoidable consequence of reform in this area is to consign estate planners and the IRS to several decades of working with parallel systems.  That is not a principled reason to avoid reform, but it will make it even more understandable if the immediate response is not enthusiastic.
The proposal is said to increase revenue by $910 million over ten years.
“Extend the Lien on Estate Tax Deferrals Provided Under Section 6166”
Although it would make no change to substantive tax rules, this proposal to extend the ten-year estate tax lien under section 6324(a)(1) to cover the last four years and nine months of the potential deferral period under section 6166 will be very important as a practical matter to some successors to family businesses.  As proposed, it would apply both to the estates of decedents dying on or after the date of enactment and the estates of decedents who died before the date of enactment if the ten-year lien under section 6324(a)(1) had not expired before the date of enactment.  Probably for that reason, this proposal is estimated to increase revenue by $160 million over ten years.
Ronald D. Aucutt
© 2012 by Ronald D. Aucutt. All rights reserved