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Christopher Stoneman Estate Planning Articles
XIll - Federal Transfer Taxes - Part 3
We come next to the six remaining inclusionary estate-tax provisions of the Code:
2039 Annuities
2040 Joint Interests
2041 Powers of Appointment
2042 Proceeds of Life Insurance
2043 Transfers for Insufficient Consideration
2044 Certain Property for Which Marital Deduction was
Previously Allowed
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Annuities (2039)
In its present incarnation 2039 is brief, having been cut down by repeals so that all that remain are subsections (a) and (b), subject, however to this caveat: if one is dealing with the estate of a decedent whose death occurred on or before October 22, 1986, 2039 should be checked in order to determine the extent, if any, to which the now repealed but complex provisions of its subsections (c), (d), (e) and (f) may still apply. The following discussion is limited to post-10/22/86 decedents and accordingly deals only with subsections (a) and (b) of 2039.
A . General Rule (2039(a)). The statute enumerates the following inclusionary elements:
(i) an annuity or other payment
(ii) receivable by any beneficiary
(iii) by reason of surviving the decedent
(iv) under any post-March 31, 1931 contract (other than insurance on the decedent’s life)
(v) under which contract an annuity or other payment (A) was payable to the decedent or
(B) he or she had the right to receive it
(i) alone or
(ii) in conjunction with another person
(1) for the decedent’s life, or
(2) for a period which is not ascertainable without reference to the decedent’s death, or
(3) for a period which does not end before the decedent’s death.
B. Amount includible (2039(b)). But 2039(b) inclusion under subsection (a) is limited to that part of the value of an annuity or other payment falling within the preceding definition which is proportionate to that part of the purchase price for the underlying contract which was contributed by the decedent or by the decedent’s employer or former employer.
Examples. A buys an annuity by the terms of which he is to receive the sum of $500 on the first of every month for the rest of his life. The contract provides that after A’s death the monthly sum of $300 will be paid to A’s widow for her life; if A leaves no widow, a specified sum will be paid to A’s child by a prior marriage. The value at A’s death of the amount(s) then payable will be included in his gross estate. If A’s employer and A eachcontributed equally to the purchase of the contract, the inclusion will be the same, since A is deemed to have made his employer’s contributions as well as his own. If A’s employer fires A a year before his death, the result will be the same (based, of course, upon the amount A’s employer put into the contract while A was still employed).
A is employed by X Corporation which has no retirement plan. A was with X Corporation for 25 years and was regarded as a very valuable employee. After his death, in recognition of his long and faithful service, the X Corporation directors voted to give his widow a lump-sum award of $100,000. Since A had no legal right to the award - however well-merited it may have been - no part of it will be included in A’s estate. Nor will it be included in A’s widow’s gross income.
Score: Mr. and Mrs. A - 2; IRS -0.
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Joint Interests (2040).
A. General Rule (2040)(a)). 2040 deals with the estate taxation of property held by the decedent jointly with another person or persons*.
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* As the regulations point out, 2040 has no application to tenancies in common. If A and B own land as equal tenants in common (be they or be they not married to one another) and A dies, his interest will constitute part of his probate estate, with its value being includible in his gross estate, but it will not pass to B “by operation of law.”
Thus, subject to certain provisos, a decedent’s gross estate includes all or a part of the value of all property which he or she holds:
(i) as joint tenant with right of survivorship (JTROS) with another; or (ii) as tenant by the entirety with his or her spouse; or
(iii) as a depositor with a bank in his or her name jointly with another.
This basic 2040 rule is modified in certain cases. Thus, where some part of the jointly-owned property is shown to have originally belonged to the decedent’s joint tenant (rather than to the decedent) and never to have been received or acquired by him or her for less than an adequate consideration in money or money’s worth, that part (i.e., that part which is proportionate to the consideration furnished by such other person) will not be included in the decedent’s gross estate.
But
(a) Subject to 2040(b), discussed below, where the property has been acquired by gift, bequest, devise or inheritance by the decedent and his or her spouse in a tenancy by the entirety, one half of the value of the property shall be excluded from the estate of the first to die; and
(b) Where the property has been acquired by the decedent and one or more other
persons as JTROS (and their interests are not otherwise specified or fixed by law), that fraction of the value of the property shall be so excluded which represents the total of such value divided by the number of such joint tenants.
Example. X dies and devises her residence to her nephew N and his wife as tenants by the entirety. N’s estate inclusion is limited to one half of the value of the property at the time of his death. If; X’s devise had been to her four nephews as JTROS equally, the inclusion at the death of the first to die would be one fourth of the value of the property, one third at the death of the second to die, and so on.
B. Certain Joint Interests of Husband and Wife (2040(b)). Notwithstanding the
provisions of 2040(a) - to the extent that they purport to deal with tenancies by the entirety - 2040(b) sets up a rule governing the estate-tax treatment of certain (but not all) joint interests of a husband and wife.
If the couple’s tenancy meets the statutory definition of a “qualified joint interest,”
the inclusion in the estate of the first to die is one half of the value of the entire property
(2040(b)(1)).
2040(b)(2) defines a “qualified joint interest” as follows:
….For purposes of paragraph (1), the term “qualified joint interest”
means any interest in property held by the decedent and the
decedent’s spouse as ---
(A) tenants by the entirety, or
(B) joint tenants with right of survivorship, but
only if the decedent and the spouse of the decedent are
the only joint tenants.
Example. H and W own Blackacre which they inherited from W’s parents. W dies. One half of Blackacre’s value is included in her estate. If H dies first, the result is the same for his estate. But if, to revert to the preceding example of X and her nephews, X had left her residence to, say, two of her four nephews and their wives (again as JTROS), 2040(b)(2)(B) would preclude the application of 2040(b), and inclusion vel non would be determined under 2040(a).
Powers of Appointment (2041).
The power of appointment (POA) is widely acknowledged as one of the handiest of estate-planning tools but, like the table saw, must be used carefully. Its non-tax characteristics have been summarized in an earlier article and will not be repeated here. But it should be noted that for all its usefulness the POA’s versatility must be balanced against its potentially adverse estate-tax status, which we will examine in this segment, under the following heads:
A What are the main estate-tax features of a 2041 POA?
B. Is the POA a general POA within 2041?
C. What causes the property subject to a general POA in the decedent to be included in his gross estate?
D. What causes the otherwise includible property subject to a general POA to be excluded from the decedent’s gross estate?
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A. What are the main estate-tax features of a 2041 power of appointment?
To get an idea of the estate-tax scope of this term, it will be helpful to start out by quoting at length from Reg.Sec.2.2041-1(b) of the estate-tax regulations:
(b) Definition of “power of appointment”.--(1) In
general.--The term “power of appointment” includes all
powers which are in substance and effect powers of appoint-
ment regardless of the nomenclature used in creating the
power and regardless of local property law connotations.
for example, if a trust instrument provides that the bene-
ciary may appropriate or consume the principal of the
trust, the power to consume or appropriate is a power
of appointment. Similarly, a power given to decedent to
affect the beneficial enjoyment of trust property or its
income by altering, amending, or revoking the trust inst-
rument or terminating the trust is a power of appointment.
If the community property laws of a State confer upon the
wife a power of testamentary disposition over property in
which she does not have a vested interest she is considered
as having a power of appointment. A power in a donee to
remove or discharge a trustee and appoint himself may
be a power of appointment. For example, if under the
terms of a trust instrument, the trustee or his successor
has the power to appoint the principal of the trust for the
benefit of individuals including himself, and the decedent
has the unrestricted power to remove or discharge the trustee at any time and appoint any other person including himself, the decedent is considered as having a power of
appointment. However, the decedent is not considered to have
a power of appointment if he only had the power to appoint a
a successor, including himself, under limited conditions which
did not exist at the time of his death, without an accompanying
unrestricted power of removal. Similarly, a power to amend
only the administrative provisions of a trust instrument, which
cannot substantially affect the beneficial enjoyment of the trust
property or income, is not a power of appointment. The mere
power of management, investment, custody of assets, or the
power to allocate receipts and disbursements as between ncome
and principal, exercisable in a fiduciary capacity, whereby the
holder has no power to enlarge or shift any of the beneficial
interests therein except as an incidental consequence of the
discharge of such fiduciary duties is not a power of appointment.
Further, the right in a beneficiary of a trust to assent to a periodic
accounting, thereby relieving the trustee from further account-
ability, is not a power of appointment if the right of assent does
not consist of any power or right to enlarge or shift the beneficial
interest of any beneficiary therein.
As this makes clear, the definition of a POA under the Code goes far beyond its “common law” parameters and comes down to whether the decedent, directly or indirectly, had the power to alter the beneficial enjoyment of the property in question.
Whether this power constitutes a “general” POA is a separate question.
B. Is the POA a general POA within 2041?
A “general” POA (2021(b)(1)) (as distinguished from one that is “special”) is one which is “exercisable in favor of the decedent, his estate, his creditors or* the creditors of his estate.
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* Note that the conjunction is “or,” not ”and.”
C. What causes the property subject to a general POA in the decedent to be included in his gross estate? *
Subject to the exceptions discussed under D below, the following conditions or events will cause such inclusion:
(i) Ownership of such a POA at death;
(ii) Exercise of the POA at any time
by a disposition which is of such nature that if it were
a transfer of property owned by the decedent, such
property would be includible in the decedent’s gross
estate under sections 2035 to 2038**, inclusive;
(iii) Release of the POA at any time by a disposition described in (ii) above;
(iv) Creation of another power in certain cases;***
(v) The lapse of a post-October 21, 1942 POA during the life of the power-holder- which lapse, by the first sentence of 2041(b)(2), is treated as a release of the POA (see (iii) above.
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* Discussion limited to POAs created after October 21, 1942. POAs created before that date are dealt with in 2041(a)(1).
** 2035 - Adjustments for Certain Gifts Made Within Three Years of Decedent’s Death; 2036 - Transfers with Retained Life Estate; 2037 - Transfers Taking Effect at Death;
2038 - Revocable Transfers.
*** As per 2041(a)(3):
To the extent of any property with respect to which the decedent---
(A) by will, or
(B) by a disposition which is of such nature that if it were
[a] transfer of property owned by the decedent such property would be includible in the decedent’s gross estate under section 2035, 2036, or 2037, exercises a power of appointment created after October 21, 1942, by creating another power of appointment which under the applicable local law can be validly exercised so as to postpone the vesting of any estate or interest in such property, or suspend the absolute ownership or power of alienation of such property, for a period ascertainable without regard to the date of creation of the first power.
D. What causes the otherwise includible property subject to a general POA to be excluded from the decedent’s gross estate?
These exclusions are enumerated in 2041(b)(1) and (2):
(i) 2040(b)(1)(A) - a power to apply property for the decedent which is limited by “an ascertainable standard” relating to his “health, education, support, or maintenance.”
The notion here is to permit the power-holder’s invasion of principal for purposes which are sufficiently well-defined to enable a court to determine whether a distribution meets the prescribed criteria. The casebooks are replete with decisions on the point.
The following have been held to pass muster, i.e., to allow a POA to escape “general” status: the donee’s support, maintenance, maintenance (or support) in reasonable health or comfort, education, and health. The following have been ruled to be insufficient: the donee’s comfort (i.e., without the qualifying “reasonable”), happiness, or welfare.
Examples. “I leave my residuary estate in trust for my grandson, G, until he reaches the age of 50 or dies before reaching said age. My trustee shall pay or in its discretion apply the entire net income of this trust to or for the benefit of G, at annual or more frequent intervals, together with such amounts, if any, from time to time out of principal as it in its discretion shall from time to time determine to be necessary or advisable for G’s welfare.”
1. G is named as trustee - POA is general and trust is includible in G’s estate, if he dies before reaching 50.
2. XYZ Trust Company is named as trustee, but G is empowered to remove XYZ and appoint anyone he selects (himself included) as successor trustee - trust is similarly includible.
3. XYZ is named as trustee; it may resign or be removed by G, who may appoint XYZ’s successor, which must be a bank or trust company - no inclusion. 4. Same facts as 1 or 2, but principal may only be invaded for,say, G’s education - no inclusion, regardless of who is trustee,
(ii) 2041(b)(1)(B) - pre-Oct. 21, 1942 POA is exercisable by the decedent only in conjunction with another person.
(ii) 2041(b)(1)(C) - a post-Oct. 21, 1942 POA exercisable by the decedent only in
conjunction with another person is not a general POA if it comes within either of the following situations:
a. Such other person is the creator of the power;
b. Such other person has “a substantial interest in the [appointive] property… which is adverse to exercise of the power in favor of the decedent…”
Example. A and B are co-trustees of a trust the income of which is to be paid to A for life. Principal may be paid to A. At A’s death the remainder is payable to B. Since B’s interest is substantially adverse to an exercise of the POA in favor of A, A’s POA is not a general POA.
(iv) 2041(b)(2) - Although, as noted, the lapse of a general POA during the life of the power-holder is normally treated as a release of the POA (and, accordingly is taxable), there is a special rule (2041(b)(2)), the so-called “5 and 5” exception, which excludes certain minor lapses. Thus, the lapse of a general POA during the taxable year is considered to be a taxable release....only to the extent that the property, which could have been appointed by exercise of such lapsed powers, exceeded in value at the time of such lapse, the greater of the following amounts:
(A) $5,000, or
(B) 5 percent of the aggregate value at the time of such
lapse, of the assets out of which, or the proceeds of which,
the exercise of the lapsed powers could have been satisfied.
Example. A transfers $200,000 to a trust with all of the income to be paid to B for life, with remainder to B’s issue living at B’s death. B is given the non-cumulative right to withdraw the greater of $5,000 or five percent of the value of the trust (the value of which, for purposes of this example, is assumed to remain constant throughout B’s life). B’s failure to exercise his withdrawal right will not cause any part of the principal of the trust to be included in his gross estate other than $10,000 (5% of the value of the trust with respect to the year of B’s death).
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