FIFTH CIRCUIT REVERSES TAX COURT IN KIMBELL CASE
Over the past approximately twenty years, the courts have considered numerous family limited partnership (FLP) cases and, except for cases with bad facts, have upheld the partnerships and their discounts. The IRS has tried numerous theoretical attacks, which have been rejected by the courts. Recently, the IRS pursued what appears to be its last available theoretical argument; that under I.R.C. § 2036 the assets transferred to the FLP should be included in the decendent's gross estate without discount. The Tax Court and one federal district court have agreed with the IRS in three recent cases: Kimbell , Strangi , and Thompson . All of these cases have been appealed to federal circuit courts by the taxpayers. The first appellate decision was rendered in the Kimbell case on May 20, 2004.
The Fifth Circuit reversed the Tax Court and found in favor of the taxpayer.
Internal Revenue Code 2036 has two prongs: under subsection (a)(1), assets transferred by a decedent will be included in the decedent's gross estate if the decedent retained possession or enjoyment of the assets; or, under subsection (a)(2), such assets will be included if the decedent retained the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or income from the assets. We discussed the IRS' arguments and the Tax Court's holding in the recent Strangi case in our Fall 2003 newsletter. It was initially thought that Strangi would be the first case in which an appellate court considered these issues. However, the Fifth Circuit first decided the Kimbell case.
The facts of the Kimbell case are as follows. Approximately two months prior to her death at age 96, Mrs. Kimbell formed a Texas limited partnership. Her revocable trust was a ninety-nine percent limited partner and a Texas limited liability company (LLC) was the one percent general partner. The LLC was owned fifty percent by Mrs. Kimbell's revocable trust and twenty-five percent by each of her two children. Her son was the manager of the LLC. Mrs. Kimbell's revocable trust contributed approximately $2,500,000 to the FLP, and the LLC contributed approximately $25,000 in cash to the FLP. Over eighty percent of the assets were either liquid assets or notes receivable from family members; the remainder consisting of oil and gas working and royalty interests.
After Mrs. Kimbell's death, the IRS argued that all of the assets which the revocable trust had contributed to the FLP should be included in her gross estate, without discount. The Tax Court agreed with the IRS, based upon I.R.C. § 2036(a)(1) and (a)(2). The Estate appealed to the Fifth Circuit Court of Appeals.
Interestingly, the Fifth Circuit did not deal with the I.R.C. § 2036 issues by focusing directly upon subsection (a)(1) and (a)(2). Rather, the court in Kimbell focused on a statutory exception for “a bona fide sale for an adequate and full consideration in money or moneys worth.” The Fifth Circuit held that Mrs. Kimbell's transfer of assets to the FLP in exchange for the FLP interest came under this exception, and therefore the assets should not be included in her gross estate without discount. Rather, the ninety-nine percent FLP interest should be valued and included in her estate with appropriate discounts.
In reaching its decision, the Fifth Circuit discussed a number of relevant facts which included: decedent retained sufficient assets for her support; there was no commingling of partnership and personal assets; formalities were satisfied; assets were actually assigned to the partnership; assets contributed included assets which required active management; the partnership satisfied business strategies that could not be satisfied by merely holding assets in a revocable trust; protection from creditors was accomplished; decedent wanted to continue oil and gas operations beyond her lifetime; reduced administrative costs were achieved by keeping all accounting functions together; property was preserved separately for her descendants; a management succession arrangement was structured, should something happen to her son; and all disputes could be resolved through mediation or arbitration.
In addition, the Fifth Circuit held that the assets which Mrs. Kimbell had transferred to the LLC (which was the general partner of the FLP) should not be included in her estate without discount. The Fifth Circuit stated that Mrs. Kimbell did not retain sufficient control of the assets transferred to the LLC to cause I.R.C. § 2036 to apply. The court pointed out that Mrs. Kimbell only had a fifty percent interest in the LLC, and her son was the manager. This is a very important aspect of the Kimbell case because in the Strangi case the Tax Court judge made statements which implied that if any interest was retained by the decedent then such a retained interest would allow the decedent to participate with others to designate the persons who would enjoy the assets and, therefore, subsection (a)(2) would apply.
Commentators view the Fifth Circuit's opinion in Kimbell as a major blow to the IRS' section 2036 attack on FLPs and FLLCs. We now await the other two pending Court of Appeals decisions with respect to these three recent FLP cases: the Strangi appeal is also pending before the Fifth Circuit and is presently being briefed; the Thompson appeal is pending in the Third Circuit Court of Appeals, which had stated that it was waiting for the decision in the Kimbell case.
WE NEED TO GET “HIP” WITH HIPAA, THE HEALTH INSURANCE PORTABILITY AND ACCOUNTABILITY ACT
Many people will become incapacitated at some point in their lifetime–either through accident or the disabilities of old age. An important part of estate planning is planning for management of your financial affairs in case you do become incapacitated. Such planning has now become more complicated due to the privacy rules of HIPAA, the Health Insurance Portability and Accountability Act of 1996, which took effect in 2003. The goal of this Act is to implement federal standards to protect and guard against the misuse and transmission of protected personal health information. As a result of this legislation, physicians, clinics, hospitals, and other health care providers cannot provide your medical information to other persons without your authorization. If they do so, they can not only be fined, but they can be sentenced to up to three years in jail.
While the goals of keeping personal health information private are important, this new Act and its regulations create complications for your estate planning. Your estate planning documents are designed to protect you and your financial assets if you were to become incapacitated due to accident or illness. At such time, your agent, under your health care power of attorney, will be able to make health care decisions for you. Similarly, your agent, under a general power of attorney for financial purposes, or your backup trustee if you are using a revocable trust, can take over the management of your finances and pay your expenses.
Similarly, another person who is important to your estate planning or your business or investment activities may become incapacitated. That person may be a trustee of a trust which you have created, the general partner of a partnership, the manager of a limited liability company, or an officer or director of a closely held corporation. If such a person becomes incapacitated, it is important that he or she be replaced so that adequate management of the trust, partnership, limited liability company, or corporation will continue.
As you can see, in all of the above situations, it is important the medical information be available so that “capacity” can be determined. If that informa-tion is not available, then the incapacitated person will remain in charge of his or her financial affairs or will remain as trustee, general partner, manager, shareholder or director, even though that person lacks the ability to function in those positions.
o meet the requirements of HIPAA, new provisions need to be added to your estate planning documents. First, it is very important that these provisions be added to your health care power of attorney and your general power of attorney. Your new Health Care Power of Attorney and your Living Will will now take the form of an “Advance Health Care Directive” under Alaska's new legislation (see page 3).
Next, all of the trusts which you have created need to be reviewed to determine if there are existing methods for replacing trustees without a determi-nation of “capacity”. If not, then additional provisions need to be added to those trusts. Third, your partnership agreements, limited liability company operating agreements, buy-sell agree-ments, and corporate bylaws, need to be reviewed to determine if methods exist for replacing trustees, general partners, managers, officers and directors without a determination of “capacity”. If not, then, again, additional provisions need to be added to these documents.
We recommend that you contact our office for an appointment to accomplish the above changes to your estate planning. We remain available to assist you with these matters.
NEW GIFT AND ESTATE TAX PHASE-IN AMOUNTS MAY AFFECT YOUR ESTATE PLANNING
Under the 2001 Tax Act (see our website shaftellaw.com for a summary of this Act), various tax benefits are phased in from 2001 through 2009. In 2004, the estate tax applicable credit amount was increased to $1,500,000. You can use up to $1,000,000 of this amount to offset gifts during your lifetime. For example, a single person could leave $1,500,000 to his or her heirs at death and that person's estate would not have to pay any estate tax. A married couple, with proper bypass trust estate planning, could leave their heirs $3,000,000 without any estate tax. A married couple with $5,000,000 of net worth could gift $2,000,000 ($1,000,000 each) during their lifetimes and then protect another $1,000,000 from estate tax at their deaths. $2,000,000 of their estate would be subject to estate tax, unless they used additional estate planning techniques to reduce this estate.
The federal generation-skipping transfer tax exemption amount also increased to $1,500,000. This is an amount which a person can allocate to gifts or trusts which are for grandchildren or further generations. Once a trust is GST exempt, it will no longer be subject to the gift, estate, or GST taxes.
Finally, the annual exclusion stays in 2004 at $11,000. This exclusion allows you to annually gift up to $11,000 each to as many people as you desire. If such gifts are made to trusts, then temporary withdrawal rights must be given to the beneficiaries in order to qualify these gifts for this tax-free gifting.
We would be happy to assist you in determining whether the above-described changes in the tax law affect your planning.
NEW 2004 ALASKA LEGISLATION
The Alaska Legislature again demonstrated its resolve to support the enactment of very favorable trust and estate provisions which can be used by both residents and nonresidents of Alaska. The Legislature has passed bills improving the Alaska trust and estate statutes in 1997, 1998, 2000, 2001, 2003, and now in 2004.
The newly enacted 2004 provisions cover the following trust and estate subjects.
QPRTs and GRATs.
The new 2004 legislation provides protection for both qualified personal residence trusts (QPRTs), grantor retained annuity trusts (GRATs), and grantor retained unitrusts (GRUTs). QPRTs are used as a method to transfer a principal or second residence to the next generation on a discounted basis. The settlor conveys a personal residence to a QPRT and retains use of the residence for a fixed term. The new 2004 legislation prevents a creditor of the settlor from reaching the settlor's right to use the residence during the fixed term. Typically, at the end of the fixed term, the residence will pass to trusts for the settlor's issue.
As a result of this legislation, an Alaska QPRT becomes an effective planning technique for asset protection. An Alaska principal residence or second home will be protected from the settlor's creditors both during the fixed term and after the fixed term expires. If the settlor were to die during the fixed term, a provision may be used to transfer the assets to the settlor's spouse, to charity, or to trusts for issue. There does not appear to be any reason why a nonresident of Alaska could not use such an approach for an Alaska residence.
GRATs are used as an estate freeze and asset transfer technique. They have become very popular after the Walton decision, which allows zeroed-out GRATs. A settlor will transfer certain assets to the GRAT, often closely held corporate stock, or FLP or FLLC interests, in exchange for a retained annuity interest of equal value. Since the exchange was for equal value, no gift results. If these assets increase in value over the fixed term chosen by the settlor then the excess in value stays with the trust and is distributed in trust for the settlor's beneficiaries. The new 2004 legislation makes it clear that a creditor of the settlor may not reach the settlor's retained interest in an Alaska GRAT. However, once a payment is made to the settlor, a creditor could attempt to reach it.
Additional Domestic Asset Protection Trust Changes.
The 2004 legislation enacted protection for professionals (attorneys, accountants, trust officers, and trustees) who assist in the formation of family limited partnerships and family limited liability companies, the interests of which are contributed to Alaska domestic asset protection trusts. Alaska's statute of limitations for such trusts was further strengthened by certain changes. The Legislature made it clear that such trusts were intended to be spendthrift trusts and, therefore, fall within that exception provided by the Bankruptcy Code. Finally, clarification was made to the statute which allows trusts created in other states to be moved to Alaska.
Limitations on Proceedings Against Trustees.
The new 2004 legislation provides three different methods for a trustee to issue reports or accountings and have future claims barred.
First Method. The first method states that, notwithstanding lack of adequate disclosure, all claims against a trustee who has issued a final report received by the beneficiary and who has informed the beneficiary of the location and availability of records for examination are barred unless a proceeding to assert the claims is commenced within three years.
Second Method. The trustee may petition a court for an order approving a report or accounting that adequately discloses the existence of a potential claim if the trustee has served the report on all beneficiaries to be bound by the report and gives such beneficiaries at least ninety days' notice of the proceeding. Then, all claims of the beneficiaries against the trustee will be barred unless the claims are served on the trustee and filed with the court within sixty days after the beneficiaries receive the report.
Third Method. A trustee may serve a report or accounting on a beneficiary that adequately discloses the existence of a potential claim against the trustee and informs the beneficiary that a proceeding to assert any claim against the trustee must be commenced by the beneficiary within twenty-four months after receipt of the report if it is an interim report or within six months after receipt of the report if it is a final report. Claims not asserted within such periods will be barred.
Virtual Representation.
The doctrine of “virtual representation” allows representation by one person, who has a substan-tially identical interest with respect to a particular issue, to bind another person. Representation is not permitted if there is a conflict of interest. Existing Alaska law contains Uniform Probate Code section 1-403, which provides when parties will be bound by notice to others.
The 2004 Alaska legislation expands the UPC provision both in the types of proceedings in which notice to one person may bind another and the circumstances under which notice may be given. The scope of proceedings are expanded to include non-judicial proceedings and settlements. Not only unborn or unascertained persons can be bound but also “a minor, an incapacitated person, or a person whose identity or location is unknown or not recently ascertainable.” Provisions have been added expressly covering various circumstances when virtual representation will apply. These expanded virtual representation provisions will provide a reasonable method to give notice and to bind existing and future beneficiaries with respect to not only trustee reports and accountings but also in regard to often needed trust construction and modification proceedings.
Voting Trusts.
Existing Alaska law provides for voting trusts and voting agreements. Both of these approaches are used in closely held family situations for control of the business for a period of time. A voting trust involves the transfer of stock to a trust which provides the trustees with the right to vote the stock. A voting agreement is a contract among shareholders that certain persons are given the right to vote the stock or that the shareholders will vote their stock in a certain manner. Under existing Alaska law, voting trusts are limited to a duration of ten years. Voting agreements do not have a durational limit. There does not appear to be a reason for this inconsistency. The 2004 Alaska legislation eliminates the ten-year durational limit for voting trusts.
Advance Health Care Directive.
The Alaska Legislature has rewritten and consolidated the provisions relating to health care decisions, including anatomical gifts. This legislation becomes effective January 1, 2005.
We have incorporated the relevant provisions of this legislation and the HIPAA provisions into a new Advance Health Care Directive that will take the place of your existing Health Care Power of Attorney and Living Will.
ESTATE PLANNING UPDATES WHICH YOU MAY NEED
Here is a reminder list of estate planning matters which are the result of recent law changes, and maintenance items which you may need:
1. Hackl Amendment for Family Limited Liability Companies and Family Limited Partnerships. This subject was discussed in our Fall 2003 newsletter. If you are gifting interests in FLLCs or FLPs, your documents need this update.
2. Strangi Review. This subject was discussed in our Fall 2003 newsletter. This new Tax Court case is pending on appeal to the Fifth Circuit Court of Appeals. If you are using FLLCs or FLPs in your estate planning, it should be reviewed in light of this case.
3. Incapacity Planning. As is discussed in this newsletter, all health care and general powers of attorney need review and probably updates. Similarly, limited liability company, limited partnership, and corporate documents which use “incapacity” to determine when to replace managers will need updates.
4. Retirement Benefit Planning. This subject was discussed in our August 1998 newsletter. Alaska's optional community property system, plus the increases in the applicable credit, can be used to maximize funding of the bypass trust while providing the best income tax planning for retirement interests that are transferred to the surviving spouse.
5. Approximate Equal Division of Assets Between Spouses. This division of assets maximizes your ability to take advantage of both spouses' applicable credit amounts (presently $1,500,000), GST exclusion amounts (presently $1,500,000), and the progressive tax rates. Sometimes, business or other reasons override such equalization.
6. Funding of Revocable Trusts. To obtain the non-tax benefits of a joint or individual revocable trust, it is necessary to transfer all of your assets to the trust.
7. Proper Implementation of Annual Exclusion Gifting. Many of you have formed life insurance trusts, children's trusts, grandchildren's trusts, perpetual trusts, or other types of trusts to which you make annual gifts. Often these trusts are designed so that annual exclusion gifts ($11,000 or less) to the trusts qualify as tax-free for gift tax purposes. However, certain steps need to be accomplished in order to qualify for this tax-free gifting. For example, gift letters need to be signed, contributions need to be held in the trust's accounts for approximately forty-five days, and notice letters need to be signed by beneficiaries.
8. Life Insurance and Life Insurance Trusts. In order to avoid taxation of life insurance proceeds, both the ownership of a policy and the beneficiary designation must be changed to the trust. Has this been accomplished?
9. Managerial Changes. Perhaps one of the most important decisions which you make in accomplishing your estate planning is your choice of personal representatives who will manage the probate process, trustees who will manage the trusts which will be created, and guardians who will raise your children. As time passes, you will want to reevaluate these choices. Should there be changes?
10. Dispositive Changes. Have you reviewed your dispositive plan for your children and grandchildren? Is it still appropriate? Have you considered using the new perpetual trust approach which has been proven to be very popular?
11. Gift Tax Returns. Many of our clients have used estate planning techniques which have produced gifts greater than annual exclusion amounts ($11,000 per donee). This gifting requires the filing of appropriate federal gift tax returns by April 15th of the following year. Such filing satisfies your reporting requirements, and also, if done appropriately, begins the three-year statute of limitations period during which the IRS may challenge the value of the gift. If you have done such gifting, have you directed that such returns be prepared and filed?
12. Generation-Skipping Transfer Tax Exemp-tion Allocation. This subject was discussed in a special letter we sent to you, dated March 19, 2002. The federal GST tax applies when you make gifts or create trusts which skip a generation, such as gifts to trusts for the benefit of your grandchildren or great-grandchildren. When this GST tax applies, it is at a 48% rate. Each person may exempt such gifts from taxation up to a total amount of $1,500,000. However, in order to accomplish such exemption for gifts to trusts, it is often necessary to file a Federal Gift Tax return which expressly allocates a portion of your exemption amount to the trust. If you have made such gifts to trusts, have you directed that Federal Gift Tax returns be prepared and GST exemption be allocated?
13. Public Employees: Check Your Beneficiary Designation; it May Affect Your Spouse's Health Insurance Benefit. If you are a public employee enrolled in the PERS or TERS benefit program, and you have named your revocable trust as the primary beneficiary of your retirement benefits, then your surviving spouse may lose his or her right to continued health insurance after your death. Therefore, if you are in this situation, your retirement beneficiary designation needs to be reevaluated. Often, your spouse should be named first, with your bypass trust or children as contingent beneficiaries.
14. Partial Funding of Standby Trusts. Many clients have created trusts which they do not intend to fully fund at the present time. A typical example is a family perpetual trust or family self-settled discretionary spendthrift trust which serves as a dispositive plan for the family after both spouses have died. Often, these trusts are created, but clients defer gifting to such trusts until a future date or do not plan to do any significant funding of such trusts until both spouses have died. However, at least nominal funding of such trusts should be made. For example, a minimum of $1,000 should be contributed to such a trust and placed in a bank account or brokerage account in the trustee's name.
OUR WEBSITE
You may refer to our website for a variety of information. We have a “What's New” discussion of developing estate planning subjects. We also post our present and past newsletters and many articles. You may refer to them for subjects such as:
Planning under the 2001 Tax Act;
A “checklist” for evaluation of your estate planning;
Estate planning techniques which you should consider;
The Alaska Community Foundation;
A “bottom line” discussion of Alaska trusts, their purposes, who should use them, and how to implement them.
We hope you will visit our web page at your convenience. Please e-mail us at info@shaftellaw.com with your estate planning questions or topics which you would like to see discussed on our website.
OUR WEBSITE
We have added a new legal assistant to our staff:
Suzanne McVicker. Suzanne McVicker was born and raised in Oregon. She moved to Anchorage after graduating from Lewis and Clark Law School in 2003, where, in addition to her J.D., she earned a certificate in Federal Tax Law. While in law school, Suzanne clerked in the corporate counsel department of an investment real estate company and represented low-income taxpayers before the IRS. Prior to law school, Suzanne worked as a legal assistant for a social security disability attorney.
Suzanne obtained a B.A. in International Studies and German, with honors, from the University of Oregon. In the spring of her junior year, Suzanne lived and studied in Köln, Germany. She later returned to Germany where she interned for several months at CARE Deutschland in Bonn.
Suzanne enjoys spending her time in Alaska's great outdoors cross-country skiing, backpacking, hiking and biking with her husband and dog.
Leanna Dreher is back. Leanna worked for our firm from 1998 to 2002. She then took a leave of absence and worked as a Realty Specialist in a term position with the Bureau of Indian Affairs. She recently returned to Anchorage and rejoined our firm.
During her term at the Bureau of Indian Affairs, she dealt with all aspects of ownership and management of Alaska restricted property, including preparation of Indian wills and probates, gifts, leases, easements and sales transactions.
Leanna has over 30 years of experience in the legal field. While working as a Legal Assistant in Santa Barbara, California, she passed a national certification exam and became a Certified Legal Assistant in 1985. She then attended Santa Barbara College of Law and received her J.D. in May of 1992. After passing the July 1992 California bar exam, Leanna practiced law in California as an associate attorney in a Santa Barbara law firm, then later as a solo practitioner.
Leanna's responsibilities include assisting clients with the implementation aspects of their estate planning, such as trust funding, gifting, compliance services, and formation of family business entities.
We hope the above information is helpful to you. We remain available to help you maintain your estate plan and to add appropriate new techniques when you so desire. If you would like to meet with one of our staff to discuss any of the above subjects, please call
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