From case law approving an alternative pleading model for trust beneficiaries to avoid triggering a no-contest clause, to COVID-19 relief measures, we have seen significant developments in estate planning and business law recently. To ensure that you stay abreast of these legal changes, we have highlighted a few noteworthy developments and analyzed how they may impact your estate planning and business law practice.
Legal developments we will cover:
- IRS Regulations Clarify Treatment of Excess Deductions Passed on to Beneficiaries
- New Interim Final Rule Authorizes PPP Loan Increases for Partnerships
- Virginia Supreme Court’s Ruling on No-Contest Clause Case
- Valuation Discount Disallowed for Lack of Control
- IRS Issues FAQs Regarding COVID-19 Relief for Estate and Gift
- Expenses Paid Using PPP Loan Proceeds Later Forgiven Not Deductible
- Congress Passes PPP and Health Care Enhancement Act
- Temporary Relief for Small Businesses Seeking Funding Through Crowdfunding
Proposed IRS Regulations Clarify Treatment of Excess Deductions Passed on to Beneficiaries
Effect of Section 67(g) on Trusts and Estates, 85 Fed. Reg. 27,693 (proposed May 11, 2020) (to be codified at 26 C.F.R. pt. 1)
The Internal Revenue Service (IRS) has proposed regulations amending income tax regulations (26 C.F.R. part 1) under Sections 67 and 642 of the Internal Revenue Code (IRC) that affect nongrantor trusts (including the S portion of an electing small business trust), estates, and beneficiaries. Public comments on the proposed rulemaking must be received by the IRS no later than June 25, 2020.
The proposed regulations clarify that certain deductions allowed by an estate or nongrantor trust are not miscellaneous itemized deductions, specifically listing the following deductions:
- costs paid or incurred in connection with the administration of an estate or nongrantor trust that would not have been incurred if the property were not held in the estate or trust
- the personal exemption of an estate or nongrantor trust
- the distribution deduction for trusts distributing current income
- the distribution deduction for estates and trusts accumulating income Id.
As a result, these deductions are not affected by the temporary suspension of the deductibility of miscellaneous itemized deductions under the 2017 Tax Cuts and Jobs Act (TCJA), Pub. L. 115-97, 131 Stat. 2054, for taxable years beginning after December 31, 2017, and before January 1, 2026. Prior to the TCJA, trusts and estates could deduct various miscellaneous itemized deductions, and I.R.C. Section 642(h) provided that in the year of termination of the trust or the estate any excess deductions should be passed to the beneficiaries and reported on Schedule K-1.
The proposed regulations also clarify how to determine the character, amount, and manner for allocating excess deductions that beneficiaries succeeding to the property of a nongrantor trust or an estate upon its termination may claim on their individual income tax returns. Under the proposed regulations, each deduction comprising an excess deduction under I.R.C. Section 642(h)(2) retains its separate character as (1) an amount allowed in arriving at adjusted gross income, (2) a nonmiscellaneous itemized deduction, or (3) a miscellaneous itemized deduction. Further, the character of these deductions do not change when they are passed on to a beneficiary at the termination of the trust or the estate.
The proposed regulations require fiduciaries to categorize the expenses giving rise to excess deductions so that those still deductible can be allocated separately from those that are not. The proposed regulations do not change the method of allocating excess deductions among multiple beneficiaries (i.e., in proportion to each beneficiary’s share of the loss or deduction). Taxpayers may rely on the proposed regulations for tax years beginning after December 31, 2017, in which a trust or an estate terminates and on or before the regulations are finalized in the Federal Register.
Takeaways: The proposed regulations are beneficial to taxpayers, as they allow beneficiaries to use deductions to reduce their adjusted gross income. Examples are provided in the Proposed Rule that illustrate the regulations’ application. In addition, the regulations enable trustees and executors to manage trusts and estates more efficiently, eliminating a motivation to delay the termination of trusts and estates longer than necessary.
New Interim Final Rule Authorizes Paycheck Protection Program Loan Increases for Partnerships
SBA, Business Loan Program Temporary Changes; Paycheck Protection Program - Loan Increases, 13 C.F.R. 120 (May 13, 2020)
In an interim final rule issued May 13, 2020, the Small Business Administration (SBA) allows lenders to increase existing Paycheck Protection Program (PPP) loans made to partnerships to cover partner compensation in situations where the partnership’s PPP loan was approved before the issuance of the April 14 interim rule, and as a result, the partnership did not receive the maximum loan amount for which it was eligible. Under the April 14 rule, the SBA stated “if you are a partner in a partnership, you may not submit a separate PPP loan application for yourself as a self-employed individual. Instead, the self-employment income of general active partners may be reported as a payroll cost, up to $100,000 annualized, on a PPP loan application filed by or on behalf of the partnership.”
Because some partnerships did not include partner self-employment income on applications that they filed (or were filed on their behalf) and approved before April 14, they received a PPP loan that only included amounts necessary for the payroll costs of the partnership’s employees and other eligible expenses. Thus, their PPP loan did not reflect the maximum amount for which they were eligible.
The new rule not only authorizes all PPP lenders to increase existing PPP loans to cover partner compensation in accordance with the April 14 interim rule, it also provides an exception to the April 28 interim final rule, which requires PPP loans to be disbursed in a single disbursement. To implement these loan increases, the new May 13 interim final rule authorizes lenders to make an additional disbursement of the increased loan proceeds prior to the submission of the initial SBA Form 1502 that includes that loan (SBA Form 1502 is required to be submitted within twenty calendar days after a PPP loan is approved or, for loans approved before availability of the updated SBA Form 1502 reporting process, by May 22, 2020).
Borrowers must provide their lender with any required documentation necessary to support the calculation of the increase. Guidance describing how partnerships should calculate PPP loan amounts, including the self-employment income of partners, was provided on April 24, 2020. See SBA, How to Calculate Maximum Loan Amounts - By Business Type, Question no. 4 (Apr. 24, 2020).
Trust Beneficiary Allowed Alternative Pleading to Seek Declaratory Judgment as to Whether Proposed Claim Would Trigger No-Contest Clause
Hunter v. Hunter, __ Va. __, 838 S.E.2d 721 (2020)
Chip Hunter and Eleanor Hunter were siblings and the beneficiaries of a trust established by their mother. Eleanor was a trustee of the trust. The trust contained a no-contest clause triggered by conduct seeking to “invalidate, nullify, set aside, render unenforceable, or otherwise avoid” any provision of the trust, which would result in the forfeiture of a beneficial interest in the trust.
After the mother’s death in 2015, Chip received a brokerage statement from Eleanor revealing a substantial decline in the value of the trust assets over a period of less than six years. In response to Chip’s request for additional information from Eleanor about the trust assets, Eleanor (through her counsel) asserted that there was a provision in the trust relieving her of any obligation to provide that information. The provision upon which she relied stated that the settlor “waive[d] the Trustee’s formal requirements to inform and report set for under Section 55-548.13 of the Code of Virginia” (later recodified into Virginia’s version of the Uniform Trust Code’s “inform and report” provision, Va. Code § 64.2-775). Chip asserted that the provision did not relieve Eleanor of her obligation to provide the requested information under other sources of Virginia law, including other sections of the Virginia Uniform Trust Code, as well as common law.
Because Chip did not want to trigger the no-contest clause, he filed a declaratory judgment action with two carefully worded counts. Count two sought to determine the rights of Chip and Eleanor under the terms of the trust to require the trustee to inform and report under the relevant “inform and report” statute and common law. However, count one requested that the court initially decide whether determining Chip’s and Eleanor’s rights and duties under the trust would amount to a contest that would trigger the forfeiture of Chip’s beneficial interest in the trust. It further stated that count two should be considered “if and only if” the court found that the no-contest clause would not be triggered by a consideration of count two. Eleanor filed a counterclaim for a declaratory judgment that Chip’s complaint, read as a whole, triggered the no-contest clause, as it sought to avoid the effect of the “inform and report” waiver provision, which she contended was a contest of a material term of the trust.
The circuit court agreed with Eleanor, declaring that Chip’s beneficial interest in the trust was revoked and ordering Chip to pay Eleanor’s attorney’s fees. The Virginia Supreme Court reversed and remanded the case, expressly approving the alternative pleading model accepted in an earlier case, Virginia Foundation of Independent Colleges v. Goodrich, 246 Va. 435, 436 S.E.2d 418 (1993) (two-part “if and only if” alternative pleading filed by a successful litigant in a case involving a will with a no-contest clause). The court held that it is valid to request that a court make a preliminary determination on whether a no-contest provision would be triggered, and that Chip’s action did not trigger a forfeiture under the no-contest clause.
Takeaways: The Virginia Supreme Court’s ruling allows trust beneficiaries to file an alternative pleading initially seeking a declaratory judgment as to whether a proposed claim will trigger a no-contest clause, allowing them to avoid risking possible forfeiture of their beneficial interest in a trust. Attorneys representing beneficiaries in cases involving no-contest clauses should consider carefully drafting their complaints to include this alternative pleading model using wording similar to the “if and only if” language successfully used by Chip.
Valuation Discount Disallowed for Lack of Control
Estate of Frank D. Streightoff v. Commissioner, 954 F.3d 713 (5th Cir. 2020)
On October 1, 2008, Frank Streightoff formed a limited liability partnership, Streightoff Investments, LP (SILP), in which he held an 88.99 percent limited partnership interest. His children and a former daughter-in-law also held limited partnership interests in SILP. The managing partner of SILP was Streightoff Management, of which Frank’s daughter Elizabeth was the managing member.
That same day, Frank established a revocable trust with himself as the beneficiary and his daughter Elizabeth as the trustee, and assigned his 88.99 percent interest in SILP to the revocable trust. The assignment stated that “by signing this Assignment of Interest, ‘[the assignor and assignee] hereby agree to abide by all the terms and provisions in that certain Limited Partnership Agreement of [SILP].”
After Frank’s death on May 6, 2011, his estate (the Estate) filed a tax return listing the 88.99 percent interest stake as an assignee interest with a value of $4,588,000 as of the alternate valuation date, reflecting discounts claimed for lack of marketability, lack of control, and lack of liquidity. In 2015, the Commissioner issued a Notice of Deficiency of $491,750 to the Estate, asserting a fair market value of $5,993,000 based on the conclusion that the net asset value should be discounted only for a lack of marketability.
The tax court upheld the Commissioner’s findings, determining that the revocable trust had a limited partnership interest in SILP at the alternate valuation date because the 88.99 percent interest in SILP had been assigned as a limited partnership, both in substance and in form. The Estate appealed on several grounds, including that the tax court’s decision was contrary to Texas partnership law in that it relied on a “substance over form” rationale and asserting that the revocable trust had received only an unadmitted assignee interest limited to allocations and distributions.
Under Texas law, the Texas Uniform Partnership Act applies to partnership interests only when the partnership agreement is silent. Further, the SILP agreement (the Agreement) stated that Texas law would apply only if a matter was not specifically provided for in the Agreement. The parties stipulated that the assignment of Frank’s interest in SILP was a “permitted transfer” under Section 9.2 of the Agreement, which allowed a limited partner to transfer their interest to members of their family. Frank complied with this provision, as he effectively assigned the interest to himself when he transferred his interest to his revocable trust, of which he was the beneficiary.
Section 9.7 of the Agreement spelled out certain requirements that must be met for an assignee to be considered a “substituted limited partner,” including that the assignee must obtain consent from the general partner, i.e., Streightoff Management (whose managing member was Frank’s daughter Elizabeth). The Estate claimed that Streightoff Management did not consent to admit an assignee (the revocable trust) as a substituted limited partner. The court agreed with the Commissioner’s position that when Elizabeth, as managing member of Streightoff Management, signed and approved the assignment, she had complied with the Agreement’s consent provision.
In addition, the Fifth Circuit Court of Appeals held that, contrary to the Estate’s contention that the assignment was only an unadmitted assignment, the language of the assignment contained no limitations or restrictions, but instead stated that Frank assigned “all and singular the rights and appurtenances there in anywise belonging.” The court of appeals further agreed with the tax court’s application of the “substance over form” rationale, which permits the court to determine how a transaction should be characterized based on its “underlying substance” rather than its legal form. The court held that because there were no practical differences between the interest held by the revocable trust and the other limited partners, who had not exercised any managerial or oversight powers, the assignment was the functional equivalent of transfer of a limited partnership interest and lacked economic substance aside from tax avoidance.
Takeaways: Merely labeling a transaction as an unadmitted assignment will not establish a lack of control sufficient to support a valuation discount where the interest conveyed is, in substance, the equivalent of the other limited partnership interests.
IRS Issues FAQs Regarding COVID-19 Relief for Estate and Gift
The IRS has published FAQs to help taxpayers digest the coronavirus-related relief it recently provided in Notice 2020-18, Notice 2020-20, and Notice 2020-23, though the FAQs do not discuss all of the relief granted. The questions primarily address the postponement (under specified circumstances) of various deadlines, including the following:
- due dates for estate tax filing and payment
- the time to make a qualified disclaimer
- the time to file a claim for refund of gift, estate, or generation skipping transfer (GST) tax
- the time to make a portability election
- the time to make an allocation of the GST exemption or to elect in or out of an automatic allocation of the GST allocation
- the time to make a timely reformation of a nonqualified split interest trust
- the three-year period to qualify for a gift tax exception for transfers between ex-spouses
- the due date for the split-interest trust information return
- the time to file a six-month extension for Form 706
The FAQs reiterate that no relief has been provided for a late allocation of the GST exemption, and that a late allocation of a GST exemption made on or after April 1, 2020, and before July 15, 2020, is effective on the date of filing. Accordingly, the fair market value of the trust assets for the purposes of determining the trust’s inclusion ratio is the value on the date of allocation or, if elected, the value on the first day of the month in which the allocation was made. In addition, a taxpayer may not elect to treat an allocation of a GST exemption made on or before July 15, 2020, to a 2019 transfer as a late allocation.
Takeaways: The IRS is likely to continue to provide additional guidance regarding coronavirus-related relief. Notices 2020-18, 2020-20, and 2020-23, as well as Rev. Proc. 2018-58, should be reviewed for a complete list of all relief.
Expenses Paid Using Paycheck Protection Program Loan Proceeds Later Forgiven Not Deductible
I.R.S. Notice 2020-32 (Apr. 30, 2020)
In guidance regarding Paycheck Protection Program (PPP) loans, the IRS recognized that no provision of the CARES ACT, including Section 1106(i), which excludes any category of income that may arise from the forgiveness of a PPP loan from the gross income of the recipient, addresses whether deductions otherwise allowable under the IRC for payments of eligible expenses under the CARES Act by a PPP loan recipient are allowed if the loan is later forgiven.
The IRS noted that Section 162 of the IRC provides for a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business, and that the rent, utility payments, and payroll costs covered under the PPP are generally appropriately deductible. In addition, interest paid or incurred on a mortgage obligation of a trade or business, also covered under the PPP loan, is eligible for a deduction under IRC Section 162.
Nevertheless, under IRC Section 265(a)(1), no deduction is allowed to a taxpayer that is allocable to tax-exempt income. To the extent that Section 1106(i) of the CARES Act excludes the amount of a PPP loan that is ultimately forgiven, that amount results in tax-exempt income for which a deduction cannot be allocable. The IRS indicated that this treatment prevents a double tax benefit and is consistent with IRC Section 265, prior guidance of the IRS, case law, and published revenue rulings. Thus, typically deductible ordinary and necessary business expenses will not be deductible if paid using PPP loan proceeds that are later forgiven.
Takeaways: Taxpayers benefiting from the forgiveness of a PPP loan, which is not considered taxable income, will not be permitted a double tax benefit from deducting ordinary and necessary expenses paid from the loan proceeds. This conclusion likely faces challenge, as it is not favorable to taxpayers and some have argued that it is contrary to Congress’s intent.
Congress Passes Paycheck Protection Program and Health Care Enhancement Act
Paycheck Protection Program and Health Care Enhancement Act, Pub. L. 116-139, 134 Stat. 620 (2020)
On April 24, 2020, the Paycheck Protection Program and Health Care Enhancement Act, an amendment to the CARES Act, was signed into law by President Trump. It provided an additional $484 billion in relief for businesses, hospitals and medical providers, and COVID-19 testing.
The new legislation adds $310 billion in funding to the PPP, which provides loans for small businesses that are potentially fully forgivable if the proceeds are spent on payroll costs and other qualifying expenses. The initial $349 billion in PPP funding was quickly exhausted just two weeks into the program. In addition, $60 billion of the new funding was specifically set aside for loans made by smaller credit unions and insured depository institutions, which have been more inclined to provide the loans to small businesses even if they had no previous relationship.
The new legislation also provides an additional $50 billion in funding for economic injury disaster loans (EIDL) and $10 billion for EIDL grants for businesses that have been impacted by the COVID-19 emergency. In addition, the new legislation makes agricultural enterprises of 500 employees or less eligible for the EIDL programs.
Takeaways: Businesses that act quickly can take advantage of the second round of PPP loans that prioritize small businesses. The deadline for PPP applications is June 30, 2020, but the funding will likely run out before then. Larry Kudlow, director of the White House’s National Economic Council, has indicated that the Trump Administration would consider a third round of PPP loans if necessary.
SEC Allows Temporary Conditional Relief for Small Businesses Seeking Funding Through Regulation Crowdfunding
Temporary Amendments to Regulation Crowdfunding, 85 Fed. Reg. 27,116 (May 4, 2020) (to be codified at 17 C.F.R. pt. 227 and pt. 239)
Under new Securities and Exchange Commission (SEC) temporary regulations, small businesses that have been affected by COVID-19 and are in urgent need of capital may use an expedited process for the offer and sale of securities through Regulation Crowdfunding. The relief, which retains appropriate investor protections, relates to the timing of the offering and the availability of financial statements required to be included in the offering materials provided by issuers to investors.
Businesses that issue offers must meet certain additional eligibility criteria: (1) the issuer cannot have been organized or have been operating for less than six months prior to the commencement of the offering, and (2) an issuer that has sold securities in the past through Regulation Crowdfunding must have complied with Securities Act Section 4A(b) and related rules. In addition, businesses must provide clear, prominent disclosures to investors about their reliance on the relief.
Eligible businesses may assess interest in a Regulation Crowdfunding offering prior to the preparation of full offering materials (financial statements may be initially omitted if they are not available). In addition, the regulations allow small businesses to close an offering and access funds more quickly than in the absence of the relief provisions. Small businesses offering more than $107,000 but not more than $250,000 in securities within a twelve-month period are exempt from certain financial statement review requirements.
The amendments are effective from May 4, 2020, through March 1, 2021, and apply to offerings launched between May 4, 2020, and August 31, 2020.
Takeaways: Many businesses adversely affected by COVID-19 may be forced to shut down permanently if they are not able to obtain the necessary capital in a timely and cost-effective manner. The temporary SEC rules are designed to provide relief from certain Regulation Crowdfunding requirements that would impede a small business’s ability to launch a crowd-funding offering and obtain much-needed funding within the time frame necessary to meet their needs
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