Mid-Year Report

alfway through 2003, we are revisited by several familiar topics from the past two years-attempt to make the repeal of the estate tax permanent, the return of the family limited partnership issue in the case of Strangi v. Commissioner, amendments to the proposed split-dollar life insurance regulations, and a major change in tax laws has arrived.

Estate Tax Repeal

In June, the House of Representatives voted 264 to 163 to make the repeal of the estate tax permanent. Under the Senate's budget rules, 60 votes are needed to eliminate the "sunset scenario" in which the estate tax would be phased out in 2010 only to reappear in 2011.

Observers indicate that the Senate is several votes short of reaching the necessary 60 votes. Democrats have offered an alternative bill sponsored by Representative Earl Pomeroy of North Dakota. The alternative would exempt $3 million of an individual's estate and $6 million of a married couple's estate from any estate tax. It is claimed that such exemptions would exempt 99.65% of all estates from estate taxation.

McCord

In, McCord v. Commissioner, a limited partnership was formed by spouses, their four sons, and another partnership. The spouses each had 41% Class B shares in the partnership. The spouses made a significant transfer. The children were to receive the first $6,910,933 of the gift. If the gifted interests exceeded that amount, the next $134,000 was to go to a symphony. Amounts beyond $7,044,933 were to go to Communities Foundation of Texas. However, under a separate agreement the charity was assigned a 3.62% LP interest.

The IRS concluded that the value of the gifts was grossly understated and assessed gift tax notices of deficiency. A majority of the Tax Court found that agreement only transferred economic interests since the partnership had not consented to the admission of additional partners. The Court also applied a 15% minority interest discount and a 20% lack of marketability discount. The total value of LP interests was determined to be $9,883,832. Could the transfers qualify for a charitable deduction for $2,838,899 (i.e., the amount in excess of $7,044,933? No, the 3.62% formula in the separate agreement was binding. McCord v. Commissioner, 120 T.C. 13 (May, 2003),

The Return of Strangi

It's starting to feel Strangi familiar. We have all been here before. Two months before his death, Albert Strangi exchanged $10 million of assets for a 99% interest in an FLP. The FLP was found to have economic substance; §2703 was found to be inapplicable; the formation of the FLP did not constitute a taxable gift; and the FLP qualified for a 31% valuation discount-effectively transforming $10 million into $6.9 million for estate tax purposes.

Too good to be true? After Strangi, taxpayers enjoyed a long winning streak of FLP victories. Previous issues of this publication warned that these successes could be short lived. Anything purporting to perform financial alchemy on such a grand scale is certain to arouse IRS attention. The IRS may lose a battle, but it can win any war. The IRS can regroup, switch legal arguments, and if all else fails, generate new legislation to change the rules of the game.¹

The United States Court of Appeals for the Fifth Circuit permitted the IRS to amend its claim and argue that assets transferred to the FLP were includible in the decedent's gross estate under §2036. Procedurally, it is a minor issue-a motion to amend the claim was made 52 days prior to trial. There was no indication by the Tax Court that such an amendment would unduly burden the parties or delay the proceedings, so it was an abuse of discretion not to permit the claim to be amended. Estate of Strangi, Court of Appeals, 5th Cir., USTC 2002-2, No. 01-60538 (June, 2002).

Upon remand, the IRS has now prevailed. The transferred assets were included in the Decedent's gross estate under §2036(a) because he retained the right to designate who benefited. Nor was there consideration for the transfer. Strangi, which only recently represented taxpayer success with FLPs, now is a symbol of IRS resolve. T.C. Memo 203-145 (May, 2003).

New Split-Dollar Regs

Another familiar topic has resurfaced. The IRS had broken its 35-year silence in 2001 with Notice 2001-10 to prevent the use of P.S. 58 rates because taxpayers were using those rates to understate the economic benefits provided under split-dollar arrangements. A new table was provided on an interim basis.

Organizers of split-dollar plans apparently felt Notice 2001-10 not only didn't affect them adversely, they felt it actually strengthened their position in some ways. In July, 2002, the Treasury responded with Notice 2002-8 and proposed regulations on the valuation of split-dollar insurance interests.²

The proposed regulations provided two mutually exclusive methods for taxing split-dollar life insurance arrangements: an "economic benefit" regime for endorsement arrangements and a "loan" regime applicable to collateral assignment arrangements. One year later, the Treasury is back with several amendments to the proposed regulations (Reg. §1.61-22) with respect to the valuation of the benefits of equity split-dollar life insurance under the economic benefit regime. Specifically, the amendments provide that the value of a non-owner's economic benefit is equal to the cost of insuring the non-owner, the non-owner's current access to cash value, and any other benefits. A public hearing was scheduled for July 29, 2003. Proposed Regulation, NPRM REG-164754-01.

Tax Reform, 2003

A significant tax act has arrived with changes affecting dividends and capital gains. The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) provides $330 billion of tax cuts. The law was been described as "front loaded" because 83 % the tax cuts arrive during the next three years. After that time, tax rates return to their current levels. Although temporary tax cuts have been designed as an economic stimulus for current conditions, Congress will face political pressures to extend tax cuts rather than allow them to expire.³ Tax brackets about 15% (i.e., 27%, 30%, 35%, and 38.6%) will be reduced for 2003 through the end of 2010 to 25%, 28%, 33%, and 35%. The following provisions take effect only during 2003 and 2004:

More income will be taxed in the 10% bracket
The 15% bracket is greatly expanded for married couples, addressing the "marriage penalty"
The standard deduction for married couples rises from $7,950 to $9,500
The child tax credit rises from $600 to $1,000
The alternative minimum tax exemption rises from $49,000 to $58,000 for married individuals filing jointly; exemptions for individuals are adjusted as well.

To fully understand the impact, however, latest tax changes must be seen in the context of the previous two tax legislation packages. The bill would accelerate several income tax reductions enacted as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16), including: the increase in the child tax credit; the 15% rate bracket expansion for married taxpayers filing jointly; the increase in the standard deduction for married taxpayers filing jointly; the 10% rate bracket expansion; and the reduction in income tax rates.

Dividends and Capital Gains:

At one point, the elimination of the tax on stock dividends had long been considered the centerpiece of the President's plan. Last January, Senate Democratic Leader Tom Daschle said the dividend tax cut was "dead on arrival." Addressing the dividend tax remained a priority but as the total tax cut was reduced, a concession on this cut became more likely.

Ultimately, the tax on most dividends (other than dividends on stock held less than 60 days and certain other types of dividends) was lowered to be the same as the tax on capital gains. And the basic tax on long-term capital gains was reduced from a top rate of 20% to 15%. A 5% tax rate applies to long-term capital gains that would previously have been taxed at 8% or 10%. For 2008, capital gains as well as dividends for taxpayers in this category will be tax free. But all of the reductions for capital gains and dividends expire at the end of 2008.

Early on, experts considered whether a complete elimination of the tax on dividends would make it preferable to invest in tax-sheltered retirement plans. On the surface, tax-free or low-tax dividends would appear preferable to distributions from a retirement plan which are taxed as ordinary income. But tax-free accumulations mean a better long-term result by continuing to contribute to tax-sheltered accounts. Gaining employer matching contributions to company 401(k) plans is another important factor.

Estates and Trusts:

None of the changes directly affects estate tax, gift tax, or generation-skipping transfer tax. But one can't make significant changes to the tax system without triggering an across-the-board reevaluation of existing financial-planning strategies.

Consider the juxtaposition of capital gains and income tax. It was recently a gap between a 28% ceiling on capital gains and 39.6% for the top rate. This 11.6% differential grew to be an 18% differential under the basic rates of 20% for long-term (one-year) gains and 38.6% as the top income tax rate. With a top capital gains rate of 15% and income tax rates peaking at 35%, the differential has reached 20%.

Now add in the factors of how long these changes may or may not apply and the future limitation on the stepped-up basis. Previously, one could hold an appreciated asset until death knowing that it can pass to an heir with a stepped-up basis, thereby triggering no income tax. Having lower rates on capital gains and less chance for a stepped-up basis in the future are two reasons that will combine to encourage current transfers of appreciated assets over long-term retention of such assets.

Technical References

¹ "How NOT to FLP", The Estate Analyst (July, 2002); "An Achilles heel for FLPs?", The Estate Analyst (Oct. 2001).

² Moshman, "Treasury Addresses Split Dollar and Current Issues" The Estate Analyst (September, 2002). Split decisions on split dollar, The Estate Analyst (May, 2001). After a 35-year silence, the Treasury issued three Notices in quick succession. First came Notice 2001-10 and Notice 2002-8. When high-profile press coverage of the use of split-dollar plans arose, the Treasury finally put its foot down with Notice 2002-59, which establishes emphatically that there was no legitimate loophole that was ever open in the first place: "[The] Treasury and the Service understand that, under certain split-dollar life insurance arrangements (some of which are referred to as `reverse' split-dollar), one party holding a right to current life insurance protection uses inappropriately high current term insurance rates, prepayment of premiums, or other techniques to confer policy benefits other than current life insurance protection on another party. The use of such techniques by any party to understate the value of these other policy benefits distorts the income, employment, or gift tax consequences of the arrangement and does not conform to, and is not permitted by, any published guidance."

³ The 2001 tax cut was the biggest since 1981. Originally, the President's tax package for 2003 sought to cut $726 billion. This was reduced to $550 billion in April and approved by the House of Representatives on May 9, 2003. By the time the Senate was done, the tax cuts had shrunk to $350 billion-which was still the third largest tax cut in U.S. history. The Senate vote was deadlocked and Vice President Cheney broke the tie.

© R. Moshman, 7/03