In Brief

The sweeping changes of the Tax Cuts and Jobs Act (TCJA) have prompted reconsideration of many financial plans. The realm of estate planning will be especially affected by the TCJA’s doubling of the federal estate tax exemption. The author presents a hypothetical arrangement involving qualified personal residence trust and discusses practical steps CPAs might want to recommend, as well as unexpected consequences those steps might create.

* * *

The author recently had an email interchange with a capable practitioner about planning for a mutual client in the wake of the Tax Cuts and Jobs Act (TCJA). The interchange demonstrated that even a bright professional could miss some of the major implications to planning, as well as the liability exposure to herself and her firm. It indicated that perhaps the myriad of technical articles on estate planning post-TCJA, while helpful, might not be properly communicating more fundamental points that will help CPAs better serve their clients while protecting themselves. This article, loosely based on that series of emails with a colleague who shall remain anonymous, will try to fill this gap.

QPRT Basics

A qualified personal residence trust (QPRT) is a trust to which a person (called the settlor, donor, or grantor) transfers his personal residence. The grantor reserves the right to live in the house for a period of years; this retained interest reduces the current value of the gift for gift tax purposes. Furthermore, all post-transfer appreciation is removed from the estate.

The following is an example illustrating why a QPRT might have been created years ago, and how the TCJA undermines such a plan. In 2002, when the estate tax exemption was $2 million, a 50-year old taxpayer transferred her personal residence valued at $2 million—which alone would have her at the threshold of triggering an estate tax based on the law then in existence—to a QPRT. The QPRT was to last until 2022; the taxable gift on funding would have been about $540,000. Assuming the 50% estate tax rate then in existence, and a 4% growth in value of the house, the house would be estimated to be worth about $4.4 million in 2022, and the estate tax savings realized approximately $1.9 million. Under the TCJA, however, the estate tax savings would be zero, but the appreciation in the home would be well beyond the Internal Revenue Code (IRC) section 121 home sale exclusion, and none of it would qualify for an income tax basis step up because it is held by the QPRT. A formerly useful plan is now a tax negative. This is an issue that will concern many individuals with old QPRTs. How should a CPA advise such an individual?

With a federal estate tax exemption of more than $11 million, the significant estate tax savings that were anticipated when the QPRT was created have disappeared. So why not just deed the house back to the elderly parent and receive a step up in basis upon death? While this is attractive on the surface, careful consideration of all issues involved will help all advisors more carefully evaluate the restructuring of many different types of old plans in light of the TCJA, not just QPRTs. If any estate is under the estate tax exemption, addressing basis inclusion could be beneficial, but it is not necessarily simple or risk free. Advisors should be cautious not to be pressured by individuals seeking a simple solution. Professionals should also be alert for “self-help” activities. If the property tax bill reflected a QPRT owning a house last year, but this year it reflects the name of the parent/transferor, might the individual have, on her own, solicited the help of a tax-unaware real estate attorney to simply deed a house back to her?

Issues and Options to Consider

Assuming that the house is deeded out of the QPRT, when will the elderly parent die? What will be the value of her estate? What will the federal estate tax exemption be in the year of death? What will be the status of any state estate tax at that time? That’s a lot of unknown factors to ponder, which the advisor may want to convey to the individual.

With a federal estate tax exemption of more than $11 million, the significant estate tax savings that were anticipated when the QPRT was created have disappeared.

The federal estate tax exemption will be reduced by half after 2025. It is also possible that a future Congress and President may change the estate tax rules before then and make them even less favorable to taxpayers. How can that risk be assessed? What if the deed moves the house into the parent’s name and the exemption is later reduced to $3.5 million? What if the elderly parent is incapacitated and cannot plan at that time? This latter risk can perhaps be mitigated by assuring that, if the house is retitled, the parent also signs a comprehensive durable power of attorney with a robust gift provision to facilitate future planning, if necessary.

In many cases, individuals are pressuring advisors to unwind old plans that might not have any income tax downside. For example, an individual might not wish to regain an old credit shelter trust. But if there is no significant appreciation in the trust, or if that appreciation can be addressed through portfolio management or distribution of only appreciated assets to the surviving spouse, should the entire trust be terminated? In this case, there may be little income tax benefit to the termination, so the potential for estate tax risk if the law changes might make retaining the trust the best decision. Too often, individuals will only look at the annual cost and hassle of maintaining a trust and not the big picture. CPAs need to take care when responding to demands that are potentially costly and imprudent. At minimum, consider communicating and corroborating the downside risks of unwinding an old plan.

What about the legalities of the transfer of the deed in the above example? Does the trustee of the QPRT have the authority to merely deed the house back to the trust? Without fair consideration for the transfer of the house, this is unlikely. The trustee has a fiduciary duty to the beneficiaries of the QPRT, and the trustee must adhere to the terms of the trust. Deeding a valuable house back to the settlor without commensurate consideration could expose the trustee to liability. What if the beneficiaries under the QPRT are different from the beneficiaries under the settlor’s will? What if the settlor marries a new spouse after the re-transfer? If the transfer of the house was not permitted under the instrument, is the IRS bound to recognize the step up in basis? If the trustee had no authority to transfer the house, will the settlor be able to transfer good title to the house if she ever sells it in the future? If the trustee did not have legal authority to transfer the house, will a future buyer require signoffs by the trustee and beneficiaries of the QPRT in order to receive good title to the property? What are the costs and problems involved in such a transaction?

Regulations prevent taxpayers from taking advantage of the nonrecognition rules to repurchase a house from a QPRT [Revenue Ruling 85-13; Treasury Regulations section 25.2702-5(c)(9)]. After the May 16, 1996, effective date of these regulations, QPRTs had to include in the trust document an express prohibition on the trust selling or transferring the residence, directly or indirectly, to the grantor, or the grantor’s spouse, or even an entity controlled by them. Before the house is simply deeded the house to the grantor, the QPRT document should be reviewed, and the date of the QPRT observed, to determine the applicability of this regulation.

Might rescission be feasible? In Craig Breakiron v. Lauren Breakiron Gudonis (No. 1:09-cv-10427, Aug. 10, 2010), after the term of a QPRT expired, the taxpayer desired to shift his interest in the property to another heir, but was concerned about possible gift tax consequences. He consulted an attorney, who incorrectly advised that he could sign a qualified disclaimer within nine months of the expiration of the QPRT’s term and transfer the property in that manner. The law actually requires that the disclaimer be made within nine months of the creation of the QPRT. Because of this incorrect advice, the disclaimer was not qualified, and the taxpayer incurred a gift tax liability. The taxpayer requested that the court permit him to rescind the disclaimer and void the transfer; because it was based on a mistake that frustrated the purpose of the transfer, the court permitted the rescission, and the taxpayer avoided gift tax. While this case presents an interesting avenue for fixing a plan gone awry, it is not likely to provide a basis to unravel prior planning absent unique circumstances.

Might an argument of mistake permit recasting a no-longer-beneficial transaction? In Simches, Trustee 1 v. Simches, Trustee 2 and Others (433 Mass. 683, Nov. 6, 1996), the settlor created a QPRT to minimize tax but overlooked the generation-skipping transfer tax implications of naming grandchildren as beneficiaries. The court permitted the substitution of the children for the grandchildren, as it was viewed as implementing the grantor’s intent to reduce taxes. Unfortunately, this case would not seem to apply to resolve no-longer-beneficial tax planning that was viable, rather than a mistake, when created.

Apart from the legal issues and impediments in making a transfer, what of the liability exposure of deeding a house out of a trust back to an elderly individual? What becomes of the house if the settlor enters a nursing home? Has a Medicaid/elder law attorney been consulted to assure that planning has been addressed? What about liability and other insurance coverage? Is it adequate? Will the settlor know to update coverage once the trust is no longer owner? An uninsured risk could wipe out the value of the house. What if the settlor is sued? Might the house be lost? How can a CPA quantify the risks that such a transfer, even if permitted, might entail?

If the taxpayer signs a lease to rent the house from the QPRT for $1 per year for life, that would appear to cause estate inclusion without the issues suggested above. Such a lease would appear to constitute a retained enjoyment to the property for life, causing estate inclusion [IRC section 2036(a)]. The IRS has ruled, however, that so long as the property will be leased at fair market value rental, the taxpayer has not retained any economic benefit from the property and thus section 2036(a) does not apply. This conclusion assumes that there is no implied agreement or understanding that the parties can remain in the residence even if they do not pay the rent (IRS Letter Rulings 9714025 and 9829002).

Will the IRS respect such treatment? A lease permitting the settlor to rent the house after the expiration of the QPRT term by paying fair rent should not affect the status of the QPRT (Private Letter Rulings 9425028, 199916030, and 199918042). While the retention of a life estate in the house should cause estate inclusion, there are potential issues to consider. In one case, the settlor’s failure to pay fair rent from the termination of a QPRT until death did not cause the value of the residence to be includible in gross estate (S. Riese Est., T.C. Memo 2011-60).

While this case presents an interesting avenue for fixing a plan gone awry, it is not likely to provide a basis to unravel prior planning absent unique circumstances.

Many states permit nonjudicial modification of a trust. Delaware’s law is particularly robust and, so long as the settlor is alive and other requirements met, a trust can be modified in almost any manner (12 Del. Code section 3342). The trust might therefore be moved to Delaware, which would require appointment of a Delaware trustee. It might be necessary to have the house held in a single-member disregarded LLC so that a Delaware trust does not own real estate in another state. The settlor, trustee, and beneficiaries might then agree to modify the trust, causing estate inclusion. This might avoid the issues with title and perhaps present a stronger position than merely signing a lease, if it were challenged by the IRS.

If the QPRT is modified or the relationship with the house changed (e.g., the lease noted above), might the IRS argue that the modification confirmed that there was no intent to adhere to the regulatory requirements of the QPRT at inception, and that therefore the full value of the house constituted a gift transfer on the date of transfer to the QPRT? If successful, might such a position result in a gift tax due based on a much lower gift tax exemption on the date of the initial transfer? That would be catastrophic if the estate were presently under the estate tax exemption amount.

Many Questions, Few Answers

The TCJA will have CPAs reconsidering many existing estate plans. But caution should be exercised before taking a quick, simple, and perhaps inexpensive approach to attempting to improve a no-longer-optimal old plan, as there could be a myriad of trust and other legal considerations, asset protection issues, and income and estate tax implications to consider.

Martin M. Shenkman, JD, CPA/PFS, AEP is an attorney at Shenkman Law in Fort Lee, N.J.