Foresight Estate and Tax Planning Newsletter Vol. 4, No. 3

How does this affect the administration of the trust? With this new language in place, the current beneficiary doesn't need to be concerned about the specific selection of the trust's investments. Whether the trustee invests in government bonds or growth stocks, she will get five percent of the trust's value each year. Her only concern is that the trust grow at a reasonable rate (as the trust grows, so does her five percent) and that the investments are not too risky. Likewise, the remainder beneficiaries favor steady growth without undue risk.

The example above is a simplified one. In actual practice, total return trust provisions usually incorporate some refinements. For example, the percentage is often applied to a rolling average of the previous three years' market values, rather than the value at the beginning of each year. This helps to smooth out fluctuations in value that may result from wide market swings from year to year. In addition, the trustee or a third party may be given the power to modify the percentage used in calculating the payout. Particularly in long-term trusts, this allows consideration of future circumstances that may not be foreseeable at the time the trust is set up. Finally, the trust often permits distributions of trust assets in addition to the percentage amounts, if the beneficiary needs funds for living costs or extraordinary expenses.

Advantages of the Total Return Trust

Harmony of interests. As we've seen, one of the advantages of the total return trust is that it harmonizes the interests of the current and future trust beneficiaries. With distributions no longer pegged to the amount of income earned, both sets of heirs favor the same result: a high total return on trust assets, regardless of whether that is achieved through the receipt of income or growth of principal.

Sound investment practices. The total return trust separates investment decisions from the calculation of current distributions. This frees the trustee to invest the trust assets in accordance with modern portfolio theory. That theory emphasizes diversification and asset allocation. In a traditional income trust, the trustee is forced to vary from sound investment principles so as to assure that sufficient income is produced. The pressure to produce income is not present in the total return trust.

Predictability. The total return trust also tends to produce a more predictable, steady flow of cash to the current beneficiary than an income-only trust. Particularly when a smoothing mechanism is included as described above, the current beneficiary can easily predict from year to year the amount that will be distributed from the trust, and can plan accordingly.

Limitations

The total return concept is not appropriate for all trusts. A trust intended to qualify for the federal estate tax marital deduction, for example, must provide for the distribution of all income to the surviving spouse. For these trusts, the total return concept can be modified to require the distribution, at a minimum, of all income.

Some trusts, by their nature, give the trustee total discretion over the making of distributions. Examples in this category are a trust set up to care for a young child and a special needs trust established for a disabled beneficiary. Payments based on a percentage of assets would run counter to the purposes of these trusts.

Final thoughts

It is not always easy leave the comfortable familiarity of an established practice. The income/remainder pattern is well known, and will remain useful. But the total return trust offers several advantages to trust beneficiaries and to those charged with the task of trust administration.

Further Reading

In Growth We Trust - Forbes, March 8, 1999. By Carrie Coolidge.

Proposed Regs on Qualified Tuition Plans Address Estate and Gift Tax Issues
(REG-106177-97)

Section 529 of the tax code, enacted in 1996, permits a state or state agency to establish a qualified state tuition program (QSTP). Although contributions to such a plan are not income- tax deductible, the earnings are not currently taxed, and when funds are withdrawn to pay tuition they are taxable at the student's rate. The 1997 Taxpayer Relief Act revised the rules governing the estate and gift tax treatment of payments to these plans. The IRS has issued proposed regulations implementing the new law. The changes described below apply to contributions to a QSTP made after August 5, 1997.

Under the proposed regulations, contributions to a QSTP are eligible for the $10,000 annual federal gift tax exclusion, even though the beneficiary/student may not benefit from the funds until many years from now. Normally, gifts of future interests do not qualify for the annual exclusion. Moreover, the contributor to a QSTP may elect to treat the gift as made ratably over five years, rather than all in one year. Thus, one person may contribute up to $50,000 ($10,000 times 5) for each beneficiary in a single year.

Contributions to a qualified plan are also excluded from the taxable estate of the donor. Under the normal estate tax rules, the account would be includible in the estate because under most plans, the donor retains the right to transfer the account to another beneficiary or to obtain a refund if the child does not attend college. However, if the contributor has elected to spread the gift over five years, the portion applicable to years beginning after the date of death is subject to estate tax.

The proposal also contains rules governing the generation-skipping tax aspects of QSTP contributions and the tax effects of transferring the account from one beneficiary to another.

The 1999 federal budget bill signed into law on October 21 offers winners of lottery, casino and sweepstakes prizes a new option.

The new law says that prize winners who have the choice of taking the prize as a lump sum or as an annuity may choose the annuity option and pay income tax on the funds as they are received. Currently, if a prize winner has the option to choose between lump sum and periodic payments, the entire jackpot is taxed immediately even if the deferred payout is chosen. To qualify for this special treatment under the new law, the choice must be made within 60 days after becoming entitled to the prize. Eligible are prizes or awards from contests, lotteries, jackpots, games or similar arrangements that provide a series of payments over a period of at least 10 years and do not require the performance of services by the winner.

The new law takes effect immediately, and applies retroactively to past jackpots provided that the winner is given the right to choose a lump sum payment during the 18-month period beginning July 1, 1999.

The Joint Committee on Taxation estimates that this provision will raise about $1 billion in taxes over five years.

Comment: How can a law that increases taxpayer options result in an increase in revenue? Congress is betting that once the new law becomes common knowledge state lotteries, casinos and other contest sponsors will change their rules to allow the choice between lump sum and annuity payout. (Many currently permit only an annuity.) It is predicted that many winners who are currently receiving deferred payouts will decide to take a lump sum, triggering immediate income tax on billions of dollars of income.

Tax Court Values Shares of Family Grocery Business
Estate of Ann H. Brookshire v. Commissioner, T.C. Memo. 1998-365 (10/8/98)

A recent decision of the United States Tax Court places a value on shares of stock in a family business, and applies a 40% discount to reflect the stock's lack of marketability.

The case involves the estate tax value of Ann Brookshire's 9.8% stake in Brookshire Grocery Company, a closely held Texas corporation. The company operated grocery stores in rural communities in Texas, Louisiana and Arkansas. When Ann Brookshire died in 1993, the company's stock was owned by two groups of shareholders: 1) relatives of company founder Wood T. Brookshire and 2) 200 current and former company employees and their families. A long-standing buy-sell agreement gave the company the right of first refusal to purchase at book value any stock that a shareholder proposed to sell.

Under a stock purchase agreement, the company was obligated to purchase from Ann's estate stock worth $7.8 million, which was the amount of life insurance owned by the company on her life. The purpose of this agreement was to provide liquidity for estate taxes. The estate reported the stock on the estate tax return at a value of $58.75 per share, which was the book value as determined under the buy-sell agreement. On audit, the IRS accepted that value for the shares that were subject to the buy-sell agreement. For the other shares, however, it determined a value of $73.43 per share. Shortly before trial, the government submitted an expert's report valuing all of the decedent's shares at $89.14, representing an increase of more than $5 million over the value determined on audit.

At trial, the Tax Court denied the government's motion to increase the deficiency above the amount determined on audit. Then, after considering the testimony of three appraisers (one retained by the government and two by the taxpayer), the court found the freely traded value of the stock to be $107.59 per share. To that it applied a 40% discount for lack of marketability to bring the per- share value to $64.55. According to the court, the 40% discount was necessary to reflect "the lack of a ready market on which to sell the stock, the restrictive buy-sell agreements, the lack of transactions involving large blocks of stock similar in size to decedent's shares of Brookshire stock, and the fact that decedent's stock reflects a minority interest."

Gift to Corporation Doesn't Qualify for Annual Exclusion
Lavonna J. Stinson Estate v. United States, U.S. Dist. Ct., N. Dist. Indiana, October 2, 1998

In 1981 Lavonna Stinson's five children and two grandchildren formed a family corporation under the name of Stinsons, Inc. Lavonna sold some farmland to the corporation for roughly $400,000. The corporation agreed to pay her in installments over 20 years.

From 1982 to 1985, Lavonna forgave $147,000 of payments due from the corporation to her under the installment agreement. She treated the gifts as transfers to the seven shareholders of the corporation. Calculating that seven $10,000 annual exclusions fully sheltered the transfers from gift tax each year, she did not report them on gift tax returns.

After Lavonna died, however, the IRS asserted that the transfers didn't qualify for the $10,000-per-donee exclusion because the gifts were not present interests.

The estate argued that the gifts were eligible because they immediately increased the company's capital, and thus the value of each shareholder's investment. All shareholders were free to sell their shares at any time.

The court, however, agreed with the IRS and determined that the gifts were taxable. Citing previous decisions by other courts, the court held that the shareholders of a corporation have no present or immediate right to use, possess, or enjoy the donated property or the income from that property. They can do that only upon liquidation of the corporation or declaration of dividends, which requires approval by the corporation's shareholders and directors. The court rejected the estate's argument that its decision elevated form over substance because Stinson could just as easily have received corporate stock for her contribution and given the stock to the children and grandchildren.

To make matters worse, the court also rejected the estate's contentions about the value of the gifts. The estate argued that since the shareholders could not obtain immediate access to the funds, the amount of the gifts should not be the $147,000 face value of loans forgiven, but should be much less. The District Court rejected this analysis, reasoning that the amount subject to gift tax is what the donor gave up, not what the donees received.

New Law Amends Procedures for Anatomical Gifts in New Jersey
P.L. 1998, Chap. 81

An anatomical gift for research or for transplant may be expressed in a will, a donor card, designation on a drivers license, or in another written document. A new law signed by the Governor on August 24 is designed to streamline the process of completing organ donations.

The new law makes it clear that a valid anatomical gift may not be revoked by the family of the decedent, and specifies that the family's consent to the donation is not required.

As reported in a prior issue of Foresight, the New Jersey legislature enacted legislation earlier this year conforming the income taxation of Roth IRAs in New Jersey to the Federal law. The Division of Taxation has issued a Technical Bulletin with details on how to report Roth IRA distributions. If you have the free Adobe Acrobat reader, you can download the Technical Bulletin from http://www.state.nj.us/treasury/taxation/tb-44.pdf

To a Los Angeles, California couple, the O.J. Simpson "trial of the century" was more than a media circus -- it was a casualty that caused the value of their home to plummet.

Gerald and Kathleen Chamales entered into a contract to buy their $3 million home at 359 North Bristol Avenue, a block from the Simpson home, just before the murders began making headlines. They wanted to withdraw from the deal but their attorney advised them that they would be liable for breach of contract if they did.

They went through with the purchase. However, on the advice of their accountant, they claimed a $751,427 casualty loss deduction, representing the decreased property value, on their 1994 income tax return.

The IRS challenged the deduction and assessed additional tax of almost $300,000 and a $58,000 penalty. In a petition filed in the US Tax Court in September, the couple has challenged the IRS assessment.

FORESIGHT is a publication of De Maio & De Maio, Attorneys at Law. It is not intended as and does not constitute legal advice, nor does it create an attorney-client relationship. The information contained in this publication should not be acted upon without first obtaining the advice of a professional advisor.

De Maio & De Maio is a law firm located in central New Jersey. We provide legal services in the areas of estate planning and administration, tax planning, business formation and transfer, trust administration, and related fields.

COPYRIGHT 1998 De Maio & De Maio. Permission is granted to reproduce and redistribute this newsletter for noncommercial purposes PROVIDED that 1) the entire newsletter, including this copyright notice, is reproduced without alteration, and 2) no fee or other charge is imposed.

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