Mid-Year Review, 2008 & Celebrity Estates

Reprinted from The Estate Analyst, July 2008

By Robert L. Moshman, Esq.

t has become our mid-year tradition to set aside our more studious and technical topics and run freely along the broad shores of the financial world to select the most savory and intriguing of items for your review.

Without further adieu, we invite you to put aside this year's concerns of stupendous gas prices, suspicious tomatoes, and global warming, and travel with us on a tour of new developments.

Just My Luck

First, the good news: John Doe is one lucky man-he has won the lottery. He will receive $1 million per year for the next 25 years!

Now for the kicker: John Doe dies only six months later. Alas, poor John. He will not get to buy cars two at a time, bath in champagne, travel around the world, or become a big man on campus. His "bucket list" will remain empty. He barely got to enjoy his windfall. Does not a collective "ouch" emanate from mankind?

But empathy does not color the calculus of the IRS, and stripped of the surrounding human story, this unhappy tale boils down to a valuation issue. For estate tax purposes, the lottery victory is a taxable asset of the estate. But how should one value such a stream of income at the time of death. The answer, at the moment, depends on where you live.

In the Second and Ninth Circuits, the Court of Appeals have allowed the fair market value of streams of revenue to be determined under section 2031 in such circumstances. The Fifth circuit has applied the actuarial tables of section 7520.

In the recent case of, Anthony v. United States, 520 F.3d 374, (5th Cir. 2008), the executor of an estate has taken on the IRS and appealed the Firth Circuit's conclusion with a writ of certiorari to the U.S. Supreme Court. The executor argued that the fair market value of a stream of revenues should apply and that because this approach would lower the value established using IRS actuarial tables under section 7520, a tax refund of $427,624 applied.

Case law in the various circuits was summarized in the taxpayer's writ of certiorari: "The Fifth Circuit's decision in this case along with its prior decision in Cook v. Commissioner of Internal Revenue, 349 F.3d 850 (5th Cir. 2003), conflict with the Ninth Circuit's decision in Shackleford v. United States, 262 F.3d 1028 (9th Cir. 2001), and with the Second Circuit's decision in Estate of Gribauskas v. Commissioner of Internal Revenue, 342 F.3d 85 (2nd Cir. 2003).

This and the other three cases have decided the same issue of law - whether restrictions on the transfer of receivable rights payable to a beneficiary through an annuity owned by a third party require valuation by the Section 2031 fair market value method rather than under the Section 7520 tables. The Ninth Circuit in Shackleford and the Second Circuit in Gribauskas, departed from the Section 7520 tables and used the Section 2031 fair market value method, but the Fifth Circuit here and in Cook remained with the Section 7520 tables.

The Ninth Circuit in Shackleford, upon observing that the statutory restrictions on transfer reduced the marketability and, thereby, the fair market value of the right to receive future lottery payments, agreed with the District Court that using the Section 7520 tables produced a substantially unrealistic and unreasonable result which did not accurately reflect economic reality. Similarly, the Second Circuit in Gribauskas found that the application of the Section 7520 tables produced a substantially unrealistic and unreasonable result. Accordingly, Shackleford and Gribauskas required departure from the Section 7520 tables and the use of the Section 2031 fair market value method of valuation."

"C-3PO, MC5, and L3C"

If that is the answer divined by the Great Carnac, having never before seen the question in an envelope that has been sealed inside a mayonnaise jar under Funk and Wagnall's front porch, then the question may be, "Name a 'bot, a band and a new LLC."

C-3PO is, of course, the solid little robot that accompanies Luke Skywalker in Star Wars. And the MC5 was a rebellious garage band with five members from Detroit, the Motor City, from the late 1960s to the early 70s.

But the newest member of this acronym collection, L3C, is a type of charitable LLC that is of fairly recent origins.

The L3C is a low-profit limited liability company. Writing for InsideCounsel, Bruce Collins notes the misnomer of this new business organization since there are three "Ls" and not three "C's" in the name.

What is the purpose of low-profit LLCs? The answer lies in the tax law requirements on foundations.

IRS regulations require most private foundations to give away 5% of net assets each year. Assets can be given to a for-profit entity which is a program related investment (PRI). But demonstrating that a for-profit entity qualifies as a PRI requires a private letter ruling or a leap of faith.

Filling the need for a reliable PRI, someone designed an LLC that makes profits and shareholder interests secondary to achieving social benefits. Because LLCs are accepted in all 50 states such a L3C entity could, conceivably, provide a reliable solution for private foundations in most if not all jurisdictions.

Unbundling Trust Expenses

In our February issue we covered the U.S. Supreme Court decision in, Knight v. Commissioner in which the 2% threshold for deductions was applied to investment advise received by a non-grantor trust or estate under section 67(a) based on certain tests. A door was left open for those trusts which have some unique investment objective that requires specialized advice.

By late February, the IRS issued interim guidance on the issue in Notice 2008-32 in which it announced that it expects to issue final regulations under § 1.67-4 of the Income Tax Regulations consistent with the Supreme Court's holding in Knight.

"The final regulations also will address the issue raised when a nongrantor trust or estate pays a Bundled Fiduciary Fee for costs incurred in-house by the fiduciary, some of which are subject to the 2-percent floor and some of which are fully deductible without regard to the 2-percent floor."

Notice 2008-32 then provides interim advice as follows:

Taxpayers will not be required to determine what portion of a "Bundled Fiduciary Fee" is subject to the 2% floor under section 67 for any taxable year beginning before January 1, 2008.

Instead, for each such taxable year, taxpayers may deduct the full amount of the Bundled Fiduciary Fee without regard to the 2-percent floor.

Payments that are made directly to third parties for expenses subject to the 2% floor, such as advisory fees considered in the Knight Supreme Court decision, that are readily identifiable as encompassed by that decision, must be treated separately from bundled fees, and are subject to the 2% non-deductible floor for tax returns currently being filed by fiduciaries.

The IRS and the Treasury Department anticipate that final regulations under § 1.67-4 will be published without delay after the extended comment period granted in the Notice. The final regulations may contain one or more safe harbors for the allocation of fees and expenses between those costs that are subject to the 2-percent floor and those that are not. Any safe harbors in the final regulations for determining the allocation of a bundled fiduciary fee between costs subject to the 2-percent floor and those not subject to the 2-percent floor may be available for taxpayers to use for taxable years beginning on or after January 1, 2008.

Extension of AMT Patch

On December 26, 2007, President Bush signed a one-year extension of the alternative minimum tax (AMT) patch. The patch is effective January 1, 2007. Without the temporary fix, an estimated 25 million taxpayers would pay an additional $2,000 in taxes on average for the 2007 tax year.

Under the Tax Increase Prevention Act of 2007 (HR 3996) the AMT exemption amount for 2007 increases to $44,350 for single taxpayers and heads of households, $66,250 for married couples filing jointly, and $33,125 for married couples filing separately. The new law allows taxpayers to use most nonrefundable personal tax credits to offset AMT liability. These include the dependent care, HOPE and lifetime learning education credits and the District of Columbia first-time homebuyer's credit.

Tax Treaties with Mandatory Arbitration

A new precedent was set in the Senate last December regarding tax treaties with Germany and Belgium. For the first time, the Senate approved income tax treaties that would require mandatory binding arbitration.

Note: A tax treaty with Canada with mandatory arbitration is to be considered in 2008. The Bush administration supports binding arbitration. Some senators on the Foreign Relations Committee initially had opposed it. Binding arbitration will come up again in 2008 in a new protocol with Canada.

The binding arbitration process takes effect automatically after two years if the countries' competent authorities cannot reach an agreement. Each side picks an arbitrator, who then pick a third arbitrator. The panel must choose one side's offer or the other; it cannot compromise them. The panel's decision will not be used as a precedent.

IRS Malfeasance

The Tax Court upbraided the IRS for fraud and malfeasance and released a law firm from a closing agreement with the IRS that had been procured through those illicit tactics.

The case of Jewell, 2007-2 USTC, involved the amendment of employee benefit plan documents. The amendments were filed on time with substantially correct content. It was improper for IRS agents to request minor corrections, then find the plans untimely and impose penalties to coerce an agreement.

Celebrity Estates

An article entitled, "Wills of Famous Washingtonians on Display," by Eun Yan, which is now posted online at nbc4.com reports on an exhibit at the District of Columbia Superior Court with the wills of 13 famous Washingtonians.

The exhibit was assembled by the Court's Register of wills and features the wills and other testamentary writings of Frederick Douglass, Alexander Graham Bell, Oliver Wendell Holmes, and several presidents and first ladies.

Frederick Douglass

Born a slave, Frederick Douglass became the first African American to be nominated as a vice presidential candidate. He ran on the Equal Rights Party ticket with Victoria Woodhull, who was the first woman to run for President of the United States. Frederick Douglass also earned and accumulated an impressive fortune and his will is notable for leaving equal amounts to each of his children, regardless of sex.

Douglass died in 1895 leaving bequests of $15,000 to each of his children. He also left 15 acres of land and $20,000 to his wife.

Grant, Vanderbilt, and Twain

Also included in the exhibit was the will of first lady Julia Dent Grant, wife of Ulysses S. Grant, which was notable for providing a history of each item she left to family members.

A tangential note of interest is warranted here about the near loss of many of those possessions. Late in his life, Ulysses S. Grant had borrowed $150,000 from William Vanderbilt only to be defrauded of everything in 1884 by a swindler.

The Grants signed over all of their property and delivered all of their valuables to Vanderbilt, who, upon returning from Europe, found these items in his foyer and immediately tried to return them and forgive the debt. Vanderbilt, the son of a railroad mogul, had inherited $100 million.

Grant then turned to writing and was about to sign a publishing contract that would have provided him with a meager 10% of revenues.

Fortunately, Mark Twain (Samuel Clemens) befriended Grant and became a publishing advisor. It was 1885, 20 years since the Civil War, and Grant's memoirs became a profitable venture generating over $1 million.

Ironically, during the Civil War, Twain had been a confederate soldier who deserted and was captured by Grant's army.

Sadly, Grant died before his memoirs came off press and never signed a single printed copy. He died in 1885 (as did William Vanderbilt). However, thanks to Mark Twain's intervention, Julia Grant ultimately received between $420,000 and $450,000 from the book revenues.

Oliver Wendell Holmes

Also included in the Court's exhibit is the will of Supreme Court Justice Oliver Wendell Holmes, who served until he was 90 years old. Thereafter, while riding in a carriage, he spied a young woman and reportedly said, "oh, to be 70 again."

Holmes left his entire estate to the United States government. He was a principled man who is often quoted and one such quote was as follows: "Taxes are the price we pay for civilization."