The Clintons And Their Residence Trusts

I am looking at a Bloomberg article titled” Wealthy Clintons Use Trusts to Limit Estate Tax They Back.”

I get the hypocrisy. There truly cannot be any surprises left with this pair, but I get it.

I also have no problem with the tax strategy. I would use it unapologetically, if I were within its wheelhouse.

This trust is known as a Qualified Personal Residence Trust (QPRT), pronounced “cue-pert.” I use to see more of them years ago, as this trust works better in a high interest rate environment. We haven’t had high interest rates for a while, so the trust is presently out of its natural element.

You can pretty much deduce that this trust is funded with a house. It can be funded with a main residence or a second home. I have seen it done with (very nice) vacation homes. There are income tax and gift tax consequences to a QPRT. 

Let’s go through an example to help understand the hows and whys of this thing.

Let’s say that we have a modestly successful, low-mileage, middle-aged tax CPA. We shall call him Steve. Steve owns a very nice second home in Hailey, Idaho. Word is he bought it from Bruce Willis. Steve and Mrs. Steve are meeting with their tax advisor, and they are discussing making gifts to their children. The advisor mentions gifting the Hailey residence, using a QPRT.

Mrs. Steve: How does that work?

Advisor:      The house is going to go the kids eventually, someday. We are just putting it in motion. We set up a trust. We put the house in the trust. We have the trust last a minimum number of years – in your case, maybe 15 years. At the end of the trust, the house belongs to the kids. Maybe it belongs to a trust set up for the kids. You can decide that.

Mrs. Steve: What’s the point? In any event the kids will wind up with house anyway.

Advisor:      The point is to save on estate and gift taxes. Someday this house will pass to the kids. If it happens while you are alive, we have to discuss gift taxes. If it happens at your or Steve’s death…

Steve:         I am right here, people.

Advisor:      Just explaining the process. If it happens at death, we have to discuss estate taxes.

Mrs. Steve: So, either way …

Advisor:      … you are hammered.

Mrs. Steve: How do I save money?

Advisor:      You continue to live in the house for a while, say fifteen years. The house is eventually going to the kids, so there is a gift. However the house is not going to the kids for fifteen years, so the value of the gift is the house fifteen years out.

Mrs. Steve: Wait. The house will be worth more fifteen years out. How is this possibly helping me?

Advisor:      I said it wrong. The IRS considers the gift to be made today for something to be delivered fifteen years out. That long wait reduces the value of the gift, which is what drives the gift tax planning with a QPRT.

Mrs. Steve: Should I just invite the IRS to an audit?

Advisor:      Not at all. We can find out what the house is worth today. The IRS has given us tables and interest rates to calculate the fifteen years wait. Since we are using their tables and their rates, it is fairly safe mathematics. There isn’t much to audit.

Steve:         I am stepping out to stretch my legs.

Mrs. Steve: Give me an example.

Steve:         Is there fresh coffee in the break room?

Advisor:      We have seen cases where someone has transferred a house worth $2 million in a ten-year QPRT and the IRS says the gift was only around $550 thousand.

Mrs. Steve: Which does what?             

Advisor:      You get to hold on to your lifetime gift tax exemption as long as possible. You can make more, or larger, gifts and not owe any gift tax as long as you have some lifetime exemption amount remaining.

Mrs. Steve: Who pays for the house; you know, the utilities, the maintenance, taxes and all that?

Advisor:      You do. And Steve, of course.

Steve:         (from outside the room) Did I hear my name?

Mrs. Steve: No! Go find your coffee.  

Mrs. Steve: Who gets to deduct the real estate taxes – the trust?

Advisor:      The trust is “invisible” for tax purposes. It is a “grantor” trust, which means that – to the IRS – there is no trust and it is just you and Steve. You get to deduct the real estate taxes.

Mrs. Steve: Wait a minute. If there is no trust, how can there be a gift?

Advisor:      This part gets confusing. For income tax purposes, the IRS says that there is no trust. For gift tax …

Steve:         (from outside the room) Where’s the cream?

Advisor:      For gift tax purposes, the IRS says there is a trust. Because there is a trust, you can make a gift.

Mrs. Steve: You are kidding.

Advisor:      No. Tax law can be crazy like that.

Mrs. Steve: What happens if after fifteen years I still want to live there? Does the trust boot me out?

Advisor:      Nope. You can rent the house, but you will have to pay fair market value, of course.

Mrs. Steve: Because I no longer own it.

Advisor:      Right. Also, since you do not own it, technically the kids could act against you and sell the house, even if against your will. That is a reason for keeping the house in some kind of trust, even after the QPRT term, as it allows for an independent trustee.

Mrs. Steve: What is the downside to this QPRT thing?

Steve:         (walking back into room, with coffee) We done yet?

Advisor:      You have to outlive the trust.

Steve:         I intend to. What are you talking about?

Advisor:      If the QPRT is for fifteen years, then you have to live at least fifteen years and a day for this thing to work.

Steve:         And if I don’t?

Advisor:      It will be as though no trust, no gift, no anything had ever happened. The house would be pulled back into your estate at its value when you die.

Steve:         Why do I keep dying with you two?

Mrs. Steve: OK. Steve dies before fifteen years. What can I do to minimize the risk to me of him dying….

Steve:         Risk to you?

Mrs. Steve:  … of him dying before his time?

Advisor:      Several things. You and Steve own the house jointly, right?

Mrs. Steve: Of course.

Steve:         (under his breath) As though there was a choice.

Mrs. Steve: What was that, dear?

Steve:         Just blowing on the coffee to cool it down, dear.

Advisor:      We set up two trusts. One for Steve and one for you. It helps with the odds.

Mrs. Steve: I like that.

Advisor:      We can even “supercharge” that by putting fractional interests in the trusts. Say you put a 1/3 fractional interest each. You and Steve would be able to fund six different trusts. We could vary the term of the trusts – say from ten to twenty years – again improving your odds.

Steve:         Are we still talking about me?

Mrs. Steve: It’s not about you, dear.

Believe it or not, this is pretty straightforward and well-marked tax planning for folks who know they will be subject to the estate tax. Few planners would describe QPRTs as aggressive. There are some twists and turns in there – say if the trust sells the house during the trust term, for example – but that can be a blog for another day.

How and why would the Clintons be pursuing this strategy? Remember that they own two houses: one in Washington (worth approximately $2 million) and another in Chappaqua, New York (worth approximately $5 million). They have quite a bit of money tied-up there. They are almost certain to face an estate tax some day, bringing them well within the wheelhouse of a QPRT.

Not bad for dead broke.

Can A Trust Carryback A Loss for A Tax Refund?

I am remembering a tax issue from 2004. The firm I was with had a sizeable business client. The business owner had two daughters and wanted them to participate in the business. One daughter did; the other daughter went on to other pursuits. The father transferred shares to his daughters using special trusts: first a QSST (Qualified Subchapter S Trust), followed by an ESBT (Electing Small Business Trust). Trusts are normally disallowed as eligible S corporation shareholders, but the tax Code makes an exception for a QSST or an ESBT. Dad settled the trusts and acted as their trustee. He was of course also the majority shareholder and CEO of the underlying company.

The company was impressively profitable, but in 2004 it had a loss. It happens.

The company had been profitable. Its shareholders, including the trusts, had previously paid taxes on that profit. Now there was a business loss. Could the shareholders – more specifically, the trusts – use that loss to any tax advantage?

And we walked right into IRS Regulation 1.469-8. As a heads up, there is no Regulation 1.469-8. The IRS reserved that slot to provide its position on material participation by a trust. However the IRS never wrote the Regulation. Practitioners were required to divine whether their client trusts would be “materially participating” in an activity or whether the trust would be “passive” in an activity.

You may remember the “passive activity” rules in the Code. These were passed in 1986 as another effort to limit tax shelters, a task which they accomplished to an admirable degree. It did so by dividing business activities into material participation and passive activities. Generally speaking, losses from passive activities could not offset income from material participation activities.  There were problems, of course, one of which was Congress’ decision to label most real estate activities as “passive.” That may be the case for many, but there are people out there who make their living in real estate. For them real estate is about as passive as my involvement with my CPA firm.

Seven years later Congress corrected this error by enacting Section 469(c)(7), which said that the passive loss rules did not apply to someone who worked at least 750 hours a year in real estate, provided that his/her real estate activities were more than one-half of his/her hours worked for the year.

Now, our client company had nothing to do with real estate but had a lot to do with plastics. Section 469(c)(7) did not apply to them. I was aware that the IRS had informally intimated that a trust could not materially participate because a trust was not a person, and only a person could materially participate. I guess their reasoning made sense if material participation was like breaking a sweat.

The law was relatively new, and no one had yet challenged the IRS. The IRS was in no hurry to publish a Regulation. Why? I thought both then and now that the IRS suspected they had a losing hand, but they were not going to back off until they were forced. The IRS could ride roughshod until someone brought suit.

And I am looking at that someone. The case is Aragona v Commissioner, and it was a Tax Court case decided March 27.

Frank Aragona settled the trust in 1979. He died in 1981, at which time the trust went irrevocable. The trust had several trustees, the majority of which were family members. The trust owned a real estate LLC, which employed several people: family, leasing agents, maintenance workers, clerks, a controller and so on. Three of the trustees worked there and received a paycheck from the LLC. It was clear the LLC was materially participating in a business activity.

During 2005 and 2006 the LLC incurred losses. The trust treated the losses as “material participation” and carried the losses back to the 2003 and 2004 tax years for tax refunds.

The IRS said these were passive losses. No passive losses were allowed, much less operating losses that the trust could carryback for tax refunds. The IRS wanted back almost $600,000 of taxes. In addition, they asserted penalties.

Here was the IRS argument before the Court: a trust is incapable of performing “personal services” because Regulations define “personal services” to mean “any work performed by an individual in connection with a trade or business.” Obviously a trust is not an individual.

The Court immediately spotted the obvious: a trust is a fiduciary vehicle whereby a trustee agrees to act in the best interest of a beneficiary. The trustee may be a “person.” If that “person” in turn performs personal services in his/her role as trustee, then why cannot those personal services be attributed back to the trust?  How else could a trust possibly do anything? The trust would have performed personal services in the only way it can: through its trustees. The same concept applies for example to a corporation. As an artificial entity, a corporation can only act through its officers. It does not have arms and legs and cannot join a softball league. Its officers can, however.

The IRS continued that a trust cannot perform personal services because of words that Congress used in committee reports and selected Code sections. Funny, said the Court. When Congress intended that a Code section disallow trusts, it used the term “natural person.” A trust, not being a natural person, cannot take advantage of that Code section. Congress did not use that term in the Code section addressing material participation. Why-oh-why would that be, asked the Court.

The IRS lost and the Aragona trust won.

Let us say a word about the penalties the IRS wanted. Obviously they became moot when the Aragona trust won, but how could the IRS possibly defend asserting penalties in the first place? It refused to publish Regulations for 28 years, and when someone had the audacity to challenge them it responded by asserting penalties?

Here is an observation from a tax pro: the IRS is all but automatically asserting penalties these days. If there is an adjustment, the IRS clicks through its quiver of available penalties and lobs a few your way. It does not care whether you had authority for your position or whether you were just being zany. The government is going broke and the IRS is chasing money under every seat cushion. However, is this good tax policy? Shouldn’t penalties be reserved for those claiming unsubstantiated deductions, masking transactions or just making up their own tax law?

Here is an idea: if the IRS asserts a penalty and loses the issue, the IRS has to pay you the penalty amount. Force them to risk a losing hand. Maybe that will prompt them to back-off a bit.

Congratulations to the Aragona trust for taking this on. 

Be Careful If You Are An Executor For An Estate

I infrequently see estate returns. Granted, the fact that one does not need to file a federal estate return until one’s taxable estate exceeds $5,250,000 has a lot to do with it. Ohio has also helped by eliminating its estate tax, which used to apply with estates as low as $338,000. Some practitioners call this the “estate estate” return, as one is being taxed for owning property.

Then there is the estate “fiduciary” return. If you consider the estate return as a snapshot of one’s net worth at death, then the estate fiduciary is the income that net worth throws off until assets are finally transferred out of the estate and to the heirs.

One can have a sizeable estate and have no estate fiduciary return. How? Simple. One way is for the assets to transfer independent of a will, such as by joint ownership or by beneficiary designation. For example, a house owned jointly with a spouse will transfer automatically and without intervention of a probate judge. The same goes for IRAs with designated beneficiaries.

We have seen several times this year an estate with an estate fiduciary issue, although no “estate estate” return was required. What caused it? The deceased did not designate a beneficiary for his/her 401(k) at work or IRA outside work. The default is that the 401(k) or IRA goes to the estate. The attorney then holds up distributing cash because of other issues, such as bickering heirs.

Remember: the estate is filing an income tax return, the same as you are next month. An accountant has some discretion over picking the estate’s taxable year, but we cannot make its annual tax filings magically go away. If the estate gets that 401(k) and parks on it, it also gets the tax consequence of a 401(k): that is, there is tax due. There is no difference in tax because it goes to an estate rather than to you.

An estate – like a trust – however is an odd tax animal, as it can “give away” its taxable income. You and I cannot (for the most part) do that. It does so by distributing cash to the heirs, and any taxable income attaches to the cash like a bad cold.  

The estate wants to distribute cash the same year as it receives the 401(k). Why? To pull the income out of the estate fiduciary. Granted, this shifts the income to the heirs, but then again they received the cash.

We were dangerously close in a couple of cases where the attorney was delaying distributing cash and running out of days remaining in the estate tax year.

Then there is the worst-case scenario: the probate takes several years and the attorney holds up distributions until issues are resolved. The attorney finally sends the paperwork to the accountant, who is now reviewing transactions from years before. There is no planning possible. It is too late.

Let’s say that the estate received $700,000 of IRA proceeds in 2012.

The estate finally closed probate in 2014. Perhaps it was held up because of real estate. The attorney writes checks all around, holding back just enough money to pay the accountant.

And the accountant clues the attorney that the estate had tax on the IRA in 2012. So what, says the attorney; he/she made distributions to the heirs. Don’t distributions pull income with them?

Well, yes, but in the same taxable year. 2012 is not the same taxable year as 2014. The estate was supposed to pay tax for 2012. The heirs would like this result, as there would be no tax to them upon distribution in 2014.

But there is no cash left in the estate, says the attorney. What is the downside?

I am looking at U.S. v Shriner, a District Court case from Maryland. The facts are not complicated:

·       Mrs. Shriner passed away in June 2004.

·       She had failed to file income tax returns for 1997 and years 2000 through 2003.

·       The executors (Robert and Scott Shriner) hired a law firm to sort it out.

·       The law firm did and filed tax returns.

·       The IRS informed the law firm that over $230,000 was due in taxes.

·       The estate distributed over $470,000 to Robert and Scott, meaning that …

·       … the estate did not have enough cash to pay the IRS.

Robert and Scott were in trouble. They distributed assets of the estate, rendering it insolvent and unable to pay its taxes. They had better get the Court to believe that they did not know this would happen – and they could not have known this. They however failed to do so. The result? They were personally liable for the tax.

Wait a minute, you say. You mean that someone – let’s say you – could be liable because someone distributed estate assets to you, rendering the estate insolvent? How could you possibly know that?

No. What I am saying is that - if you are the executor and distribute assets in sufficient amount to leave the estate insolvent – you will be personally liable. You are the executor. You are supposed to know these things.

Combine that outcome with above-discussed tax due on a previous year IRA distribution. I have little doubt the attorney was writing distribution checks shortly after our conversation.