Ron Aucutt’s 'Top Ten' Estate Planning And Estate Tax Developments Of 2014

In an ever eagerly anticipated annual tradition, Ronald Aucutt, a McGuireWoods partner and co-chair of the firm's private wealth services group, has identified the following as the top ten estate planning and estate tax developments of 2014. Ron is a Past President of The American College of Trust and Estate Counsel, an observer and frequent participant in the formation of tax policy and regulatory and interpretive guidance in Washington, D.C., and the editor of the Recent Developments materials that are presented each year at the Heckerling Institute on Estate Planning.

Number Ten: Foreign Account Tax Compliance Act (FATCA) Takes Effect

2014 has been a challenging year for identifying "top ten" developments. The usual candidates - significant cases, groundbreaking rulings, important regulations - are hard to find. That, together with a permanent estate tax statutory environment for the first time since 2001, made 2014 a lean year for "recent developments." In the absence of actual developments, much of this summary will address themes, trends, and general climates. But the Foreign Account Tax Compliance Act (FATCA) actually produced an event in 2014. It took effect.

FATCA was enacted as part of the Hiring Incentives to Restore Employment Act (HIRE Act) (Public Law 111-147), signed into law on March 18, 2010. It is codified in sections 1471 through 1474 of the Internal Revenue Code of 1986, as amended ("the Code"). Its purpose is to combat tax evasion by taxpayers with undisclosed foreign financial accounts and other offshore assets, by requiring reporting with respect to those accounts and assets by both U.S. taxpayers and foreign financial institutions, and backing up that requirement by a 30 percent withholding obligation at the source of the income.

Proposed regulations were published on February 15, 2012 (77 Fed. Reg. 9022), numerous public comments were received, a public hearing was held on May 15, 2012, and final regulations were promulgated by T.D. 9610 on January 29, 2013. Withholding on some U.S.-source income payable to foreign financial institutions took effect on July 1, 2014.

Meanwhile, the worldwide commitment to the transparency FATCA encouraged has been strong. According to Announcement 2014-38, 2014-51 I.R.B. 951, as of July 1, 2014, 101 foreign jurisdictions had substantially committed to one of the two model intergovernmental agreements (IGAs) the Treasury Department had promulgated in 2012.

Number Nine: A Cloud over Trust Protectors: SEC v. Wyly, (S.D.N.Y. Sept. 24, 2014)

A case that was not even a tax case became one of the most discussed cases in the fourth quarter of 2014. In a civil enforcement action, a jury convicted two brothers, Samuel and Charles Wyly, of nine counts of federal securities law violations regarding their use of trusts and other entities in the Isle of Man to trade in the stock of public corporations on whose boards they sat. In this decision, the court imposed the familiar securities law penalty of disgorgement, in the amount of almost $620 million. Included in that sum was an amount calculated with reference to the federal income taxes the Wylys saved when the stock was sold on the theory that the stock was owned and sold by the trusts, not by them. The court found that the trusts were grantor trusts, by reason of the Wylys' ability to control the discretionary actions of the trustees through trust "protectors," who among other things had the power to remove and replace the Isle of Man trustees. The protectors were the Wylys' family attorney, the chief financial officer of the Wylys' family office, and the chief financial officer of another Wyly entity.

The court was struck by the fact that the investment recommendations of the Wylys, passed on by the protectors, appeared to be consistently followed by the trustees. With little or no analysis or elaboration, the court found that that indicated that the trustees "made no meaningful decisions" and the Wylys themselves "freely directed the distribution of trust assets." The section 674(c) "independent trustee" exception, the court said, did not apply.

It is hard to defend the Wylys, given the facts and jury verdict in this case. And for income tax and estate tax purposes, it would be hard to defend collusion between the grantor and the protectors whereby the grantors had de facto control of the trusts. But it is also unsettling to imply that a court might find such de facto control merely in a record of the trustees' consistent agreement that the grantors' suggestions were good. To be sure, a domestic corporate trustee, for example, could probably be counted on to document its exercise of due diligence in accordance with its published policies, something the trustees in the Wyly case apparently did not do. But the court's open-ended reasoning could leave a cloud over the independence of trustees and other fiduciaries in far more sympathetic cases where grantors understandably choose trusted friends, associates, and advisors as protectors.

Number Eight: Application of the Material Participation Standard to Trusts: Frank Aragona Trust, Paul Aragona, Executive Trustee v. Commissioner , 142 T.C. No. 9 (March 27, 2014)

There is a fascination these days with income tax rates and the step-up in basis of appreciated assets at death. Both are affected by the highest-ever estate tax exemption, which shifts the attention of many to income tax planning and results in a lower overall estate tax cost of including the value of appreciated assets in the gross estate to obtain a stepped-up basis. The basis analysis lends itself to exaggeration and probably has been exaggerated, to the extent it overlooks the fact that some assets will be sold during life, some will not be sold until long after death, and there is obviously more control over the timing of sales than of death in any event.

The focus on income tax rates in general is driven by legislation that took effect in 2013. For 2012, the top income tax rate on trusts and estates was 35 percent for taxable incomes over $11,650. For 2013, under the American Taxpayer Relief Act of 2012, the regular top rate jumped 4.6 percent to 39.6 percent for taxable incomes over $11,950. Also in 2013 the 3.8 percent tax on net investment income under section 1411 enacted by the 2010 health care reconciliation legislation took effect. The result was a total top rate of 43.4 percent - a comparative 24 percent tax increase over the 2012 rate of 35 percent. The level at which those rates apply increased modestly to $12,150 for 2014 and $12,300 in 2015.

The 3.8 percent tax on net investment income seems to have attracted much more attention from estate planners than the 4.6 percent increase in the regular rate. Why is that? Simply because the separate 3.8 percent tax has an optional or voluntary element, driven by the exemption of income from a trade or business that in general, as stated in section 1411(c)(2)(A), is not "a passive activity (within the meaning of section 469) with respect to the taxpayer." Suddenly, section 469, enacted by the Tax Reform Act of 1986 to curb tax shelters, became relevant to estate planners and others using trusts. We rediscovered that section 469(c)(1) generally defines "passive activity" as "the conduct of any trade or business ... in which the taxpayer does not materially participate" and section 469(h)(1) defines material participation as involvement in the operations of the activity on a "regular, continuous, and substantial" basis, but the places for regulations that might have applied those principles to trusts had been merely "reserved" since 1988. Such regulations, under section 469, not exclusively section 1411, are being worked on, to supplement the detailed regulations under section 1411 promulgated in 2013 (including Reg. §1.1141-3 relating to estates and trusts). "Guidance regarding material participation by trusts and estates for purposes of §469" is on the Treasury-IRS 2014-2015 Priority Guidance Plan published August 26, 2014.

How a trust "materially participates" - a distinctly human notion - is a challenge. Mattie K. Carter Trust v. United States, 256 F. Supp. 2d 536 (N.D. Tex. 2003), held that "common sense" and the notion of the "trust" as the "taxpayer" dictate that "material participation" in the context of a trust be determined with reference to the individuals who conduct the business on behalf of the trust, but that approach seems way too broad and, if applied to individuals, for example, could erode the anti-tax-shelter impact of section 469. In Technical Advice Memorandum 201317010, the IRS took the position that the substantial business activity of a "special trustee" who was also the president of an operating company was attributable to his role as an "employee" and not attributable to his role as trustee and hence to the trust, but that approach seems way too narrow and would frustrate the congressional expectation that "[a]n estate or trust is treated as materially participating in an activity ... if an executor or fiduciary, in his capacity as such, is so participating." S. Rep. No. 99-313, 99th Cong., 2d Sess. 735 (1986). In the view of many observers, the IRS position was tantamount to a refusal to acknowledge that any trust could ever materially participate in a trade or business for purposes of the passive loss rules of section 469.

That appears to have been essentially the IRS position in Aragona, and the Tax Court (Judge Morrison) rejected that position. The court held that a trust operating a real estate business could avoid the per se characterization of a real estate business as passive under section 469(c)(2), as could a natural person, if, as provided in section 469(c)(7)(B), "(i) more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and (ii) such...