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Estate Planning Update

Pennsylvania Inheritance Tax Rates Change

Thursday, November 09, 2000

Pennsylvania imposes an inheritance tax upon certain transfers at death. The tax rate on transfers to ancestors, lineal descendants (including adoptees), stepchildren and their descendants and spouses of children was recently reduced from 6 percent to 4.5 percent. In addition, the rate on transfers to siblings was reduced from 15 percent to 12 percent. Outright transfers to surviving spouses and transfers to certain trusts for spouses remain exempt from Pennsylvania inheritance tax. Also non-taxable as the result of the new law are transfers to a parent by a child who dies before reaching age 22. As before, a 15 percent tax is imposed on transfers to all other individuals. There is no tax on gifts to charity. The changes are effective for decedents dying on or after June 30, 2000.

Annual Exclusion Gift Reminder

If you have not made your annual exclusion gifts for 2000, now is the time to do so. Each person may give cash, assets and other property totaling up to $10,000 per person per year without incurring a gift tax or using any part of the donor’s exemption amount (presently $675,000). This $10,000 gift tax exclusion applies to outright gifts and to some gifts in trust if the gift qualifies as a "present interest." Gifts must be made by December 31, 2000.

Going forward, the limitation on gifts which a donor may give to a donee will remain at $10,000 for 2001. The Applicable Exclusion Amount will remain at $675,000 per person for decedents dying in 2001.

The GST Exemption, which is indexed for inflation, has not yet been announced, but is expected to increase to $1,060,000 from the 2000 exemption amount of $1,030,000.

Tax Court Sends Warning That Charitable Trusts Must Be Properly Administered

Estate of Melvine B. Atkinson v. Comm., 115 TC No. 3, July 26, 2000 serves as a strong reminder that careful administration of a charitable remainder trust is every bit as important as careful drafting.

In August 1991, Ms. Atkinson created a Charitable Remainder Annuity Trust (CRAT) and funded it with almost $4 million. The trust document contained all the right terms. The attorney who drafted it touched all the bases. It even contained a condition that the individual beneficiaries provide funds to pay their share of any state or federal death taxes for which the trust would be liable upon the settler's death.

But, two fatal flaws were made during the administration of the trust. First, Ms. Atkinson never took the 5 percent annuity payments that she was entitled to under the agreement. Second, she gave one of the secondary individual beneficiaries a signed and notarized document stating that she would not be liable for her share of estate taxes. The decedent’s separate estate was not large enough to cover all of the administration expenses and death taxes, and it was actually necessary to invade the CRAT to make up the shortfall. The agreement relieving the beneficiary from the tax liability was clearly a fatal error. Somewhat more surprising was the decision that Ms. Atkinson’s failure to take the annuity payments also doomed the deduction.

Her failure to take her annuity payments certainly did not reduce the amount ultimately passing to charity. However, one of the goals of the legislators in drafting Section 664(d)(1)(A) was to limit the amount that could be accumulated tax free, and, in parity with the treatment of private foundations, to insure that each year a minimum amount would be returned to the economy and subjected to tax. The failure to take the annuity payments was held by the Tax Court to be a fatal omission and disqualified the trust from a charitable deduction in Ms. Atkinson’s estate.

We believe that the IRS would have looked favorably on the Atkinson trust if the trustee had carried an account payable on the trust books and paid the accrued annuity amounts to the grantor’s estate upon her death.

Atkinson is a clear warning to practitioners and trustees that it is not sufficient just to recite qualifying language. One must also administer charitable trusts in compliance with their governing instruments.

Family Limited Partnerships Must Be Properly Administered

Charitable trusts are not the only entities that require careful administration. The same problems exemplified by Atkinson can exist in family limited partnerships.

Shortly after being diagnosed with cancer, Dorothy formed three limited partnerships, one with each child. Each agreement named Dorothy as the managing (general) partner. The partnerships were funded with rental properties, raw land and marketable securities. Dorothy then transferred limited partnership interests to family members, valuing those interests at a discount for gift tax purposes. Although partnership bank accounts were opened, Dorothy continued to deposit the rentals in her own bank account until her death.

The court ignored the partnership structure and taxed the partnership in Dorothy’s estate as if no transfers had occurred, citing I.R.C. §2036, which provides that the gross estate includes any interests transferred for less than full and adequate consideration where the decedent retained for life the possession or enjoyment of the property or the income from the property. No discount was allowed for the partnership form. (Estate of Dorothy M. Schauerhamer v. Comm., TC Memo 1997-242.)

The Schauerhamer case is no fluke. In March 2000, similar facts brought the same result in Estate of Charles Reichardt, 114 TC 144. In this case, real estate, including the taxpayer’s home, was transferred to a family limited partnership. Noting that the taxpayer continued to live in the home without paying rent, that he commingled partnership funds with his own funds, and that the managers of the real estate were the same parties both before and after the transfer of the real estate to the partnership, the Tax Court ignored the partnership and taxed the assets in the taxpayer’s estate, without allowing a discount for the partnership form.

The lesson is clear. If you form a family limited partnership, manage it as if the other partners are business associates and not family members. The assets of the partnership belong to the partnership and not to the person who contributed them. Maintain a separate set of books and a separate bank account for the partnership, and if you absolutely must use partnership property for your own purposes, pay the partnership a fair price or fair rental for such use.

Qualified State Tuition Programs

A Qualified State Tuition Program (QSTP) is a vehicle for individuals to contribute money toward the education of their beneficiaries without incurring gift or estate tax. Section 529 (b)(1) of the Internal Revenue Code defines a QSTP as a program established and maintained by a state (or agency or instrumentality thereof) under which an individual may purchase tuition credits on behalf of a designated beneficiary which entitle the beneficiary to the waiver or payment of qualified higher education expenses or to make contributions to an account for meeting the qualified higher education expenses of a designated beneficiary. To qualify as a QSTP, the program must meet several requirements under section 529 of the Internal Revenue Code and the related regulations.

A QSTP account may be a useful alternative to a custodian account under the Uniform Transfer to Minors Act as a way of putting aside savings for college.

"Qualified higher education expenses" include tuition, fees, the cost of books, supplies and equipment, and room and board (with certain limitations) incurred by a designated beneficiary while attending an "eligible educational institution." An "eligible educational institution" is described in section 481 of the Higher Education Act of 1965 (20 USC 1088) as in effect on August 5, 1997, and must be eligible to participate in a program under Title 4 of the Act. Generally, these institutions are accredited post-secondary educational institutions offering bachelor’s degrees, associate’s degrees, a graduate-level or professional degree or another recognized post-secondary credential.

Unlike a custodian account, where income tax is paid currently, the earnings within the QSTP pay no current income tax. However, when a distribution is made from a QSTP, the beneficiary (college student) receives taxable income that year, generally based on the income earned by the QSTP account during its existence. Usually, the student will be in a low income tax bracket. Also, once a custodian account is created, it belongs to the beneficiary. In the case of a QSTP, the person creating the account maintains some control over the fund and can even get the fund back, although subject to a penalty.

Unlike an education IRA (see next article), there is no restriction on the income level of who can contribute to a QSTP, and little restriction on the amount. However, the contribution itself is not tax deductible for income tax purposes.

A contribution made on behalf of a designated beneficiary to a QSTP after August 20, 1997 is deemed a completed gift of a present interest under section 2503(b) of the Internal Revenue Code, and is, therefore, eligible for the $10,000 annual gift tax exclusion. In addition, a donor may elect to take contributions into account ratably over a five-year period in determining the amount of gifts made during the calendar year. So an individual currently could contribute as much as $50,000 to a QSTP for a single beneficiary (assuming that would not be treated as an excessive contribution) and treat the contribution as a $10,000 gift qualifying for the annual exclusion in the contribution year and in each of the succeeding four years.

In the case of a decedent who makes the section 529(c)(2)(B) election but dies before the close of the five-year period, the portion of the excess contribution allocable to calendar years after the decedent’s date of death will be included in the decedent’s gross estate.

The portion of a contribution excludable from taxable gifts under section 2503(b) is also excludable for purposes of the generation-skipping transfer tax.

Education IRAs

An education individual retirement account (IRA) is a trust that is created exclusively for the purpose of paying the qualified higher education expenses of a designated beneficiary. An education IRA also is exempt from taxation, except for taxes imposed under section 511 (unrelated business income of charitable organizations).

Except in the case of rollover contributions, the annual contribution to an education IRA cannot exceed $500 per beneficiary and is available in full only to a contributor with modified adjusted gross income (MAGI) of $95,000 or less ($150,000 for joint filers). The $500 maximum is phased out ratably for contributors with MAGI between $95,000 and $110,000 (between $150,000 - $160,000 for joint filers).  Individuals with MAGI in excess of $110,000 ($160,000 for joint filers) cannot contribute to an education IRA.  

In general, the terms "qualified education expenses" and "eligible educational institution" for the purposes of the education IRA have the same meaning as with QSTPs.

Both contributions to and earnings on an education IRA are excluded from a beneficiary’s gross income.  Distributions are generally taxed under rules similar to the annuity rules under section 72(b) of the Internal Revenue Code, and generally will be considered to consist of principal (which is excludable from gross income) and earnings (which may or may not be excludable from gross income).

If a beneficiary’s qualified higher education expenses in any year equal or exceed the total distributions for that year, the distributions are entirely excluded from the beneficiary’s gross income. However, if the distributions exceed the qualified higher education expenses of the beneficiary in a year, the amount includable is reduced by the amount which bears the same ratio to the amount which would otherwise be includable in gross income as the expenses bear to the distribution.

Rules similar to the rules on the estate and gift tax treatment of contributions to and distributions from QSTPs apply to education IRAs.

Gift Tax Disclosure:  What Constitutes Adequate Disclosure Under the New Regulations

The IRS issued final regulations addressing the valuation of gifts and adequate disclosure on a gift tax return to commence the running of the statute of limitations on gift valuation. Once the period of limitations has run, the gift may not be revalued for either gift or estate tax purposes. The regulations apply to all gifts made after 1996 for which gift tax returns were filed after December 3, 1999.

The general rule provides for a three-year period of limitations once the gift is adequately disclosed on a gift tax return. If a gift is not adequately disclosed, there is an unlimited statute of limitations.

For adequate disclosure, the following information must be provided on a gift tax return:

  1. A description of the transferred property and any consideration received by the transferor.
  2. The identity of and relationship between the transferor and transferee.
  3. If the property is transferred in trust, the trust’s tax identification number and a brief description of the terms of the trust. In lieu of a description, a copy of the trust instrument can be submitted.
  4. A detailed description of the method used to determine the fair market value of the property transferred, including financial data and a description of any discounts for lack of marketability, blockage, or minority or fractional interests claimed.
  5. A statement describing any position taken that is contrary to any proposed, temporary or final Treasury Regulation or Revenue Ruling published at the time of the transfer.

Completed transfers to members of the transferor’s family that are made in the ordinary course of operating a business (such as salary) will be deemed to be adequately disclosed even though the transfer is not reported on a gift tax return if the transfer is property reported by all parties for income tax purposes. In addition, any other completed transfer that is reported in its entirety as not constituting a transfer by gift and is adequately disclosed can start the statute running.

Adequate disclosure of a transfer that is reported as a completed gift on the gift tax return will commence the running of the statute of the period of limitations for assessment, even if the transfer is later determined to be an incomplete gift.

Adjustments are precluded with respect to all issues relating to the gift once the limitations period has expired for a gift that meets the disclosure requirements. If the time has expired for assessments for gift tax purposes for a prior gift, the value of the prior gift as finally determined for purposes of the gift tax is used both for purposes of computing subsequent gift tax as well as the federal estate tax.

The taxpayer has the choice of giving the IRS the bare minimum of information required or inundating it with paper. If the objective is to commence the running of the statute of limitations, the more information provided, the better.

Separate Account For IRAs Present Planning Options

Naming a beneficiary of an Individual Retirement Account (IRA) can affect how the account is distributed both during the account owner’s lifetime and after his or her death. Sometimes an account owner and his or her beneficiaries will be better served by dividing a single IRA into separate accounts with separate beneficiaries.

As a rule, at an account owner’s death, the balance in the account may be paid out to the beneficiary over the beneficiary’s life expectancy. However, if more than one beneficiary is named (such as the account owner’s children) the account balance will be paid out over the life expectancy of the beneficiary having the shortest life expectancy, i.e., the oldest child. If, instead, the account is divided into separate accounts and a separate child is named beneficiary of each account, after the death of the account owner, distributions from each separate account will be made over the life expectancy of the child who is named as beneficiary of that account. This will allow greater tax deferral for younger children.

In some situations, the separate accounts can be created after the death of the account owner. For example, if the beneficiary is the spouse of the account owner, he or she has the option of rolling the account balance into separate accounts in the spouse’s name and naming individual children as beneficiary of each new IRA. But to ensure that this technique is available, an account owner may be well advised to create the separate accounts during his or her lifetime.

Maintaining separate IRAs during the lifetime of the account owner will have little impact on distributions during the account owner’s lifetime. Minimum distributions will be computed on the joint life expectancy of the account owner and child, however, during the account owner’s lifetime, the minimum incidental benefit rule will require the child’s life expectancy to be 10 years younger than the parent. At the death of the account owner, the child’s own life expectancy will be used to distribute the balance of the account. This same rule applies where the surviving spouse creates separate accounts after the death of the account owner.

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The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts.


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