Nov 1, 2006 12:00 PM, Rorie M. Sherman Editor in Chief

By: Rorie M. Sherman Editor in Chief

From David A. Handler in the Chicago office of Kirkland & Ellis LLP, we have this report:

• No general power of appointment under state law. In Private Letter Ruling 200637021 (issued June 2, released Sept. 15), a testamentary trust provides that the trustee may distribute to the taxpayer-beneficiary “such sums from principal as the trustee, in his sole discretion, shall deem reasonable, necessary, or advisable for her care, maintenance and support.” The taxpayer was going to become the sole trustee. The trust agreement does not state which state law governs its interpretation and administration. The trust was executed in one state (State 1) but the taxpayer resides in another state (State 2).

  The law of State 1 provides that if a person is a beneficiary and trustee of a trust that confers the power to make discretionary distributions to, or for, his own benefit, that person may exercise the power only in accordance with an ascertainable standard relating to health, education, support or maintenance within the meaning of Internal Revenue Code Section 2041(b)(1)(A) or 2514(c)(1). State 2 law provides that when a person is a beneficiary of a trust that permits him, as a trustee, to make discretionary distributions of income or principal to, or for, his own benefit, he may exercise that power in his favor only for his health, education, support or maintenance within the meaning of Internal Revenue Code Sections 2041 and 2514.

  At issue was whether the taxpayer would hold a general power of appointment if that taxpayer acted as trustee. The Internal Revenue Service held that, “[w]hile federal law controls what rights or interests shall be taxed after they are created, creation of legal rights and interests in property (such as the breadth and scope of a power of appointment over the corpus of a testamentary trust) is a matter of state law,” citing United States v. Pelzer, 312 U.S. 399 (1941) and Morgan v. Commissioner, 309 U.S. 78 (1940). Therefore, the taxpayer's powers as trustee are limited according to state law. Because the law of both States 1 and 2 limit a taxpayer's power to making distributions to himself only for his health, education, support or maintenance within the meaning of IRC Sections 2041 and 2514, the taxpayer does not have a general power of appointment if he serves as trustee, regardless which of these state laws applies, based on Revenue Procedure 94-44, 1994-2 C.B. 683.

• No income tax deduction for trust's payment to charity pursuant to power of appointment. In Brownstone v. United States, 2006-2 USTC para. 50,528 (2d Cir. Sept. 27), Lucien Brownstone created a trust in his will for the benefit of his wife Ethel. He gave Ethel a testamentary power of appointment over the trust, exercisable in favor of anyone she chose; in default of such exercise, the trust assets would pass to a charitable foundation.

  Ethel died in October 1996. Her will exercised her power of appointment over the trust, directing the trustee to transfer the trust assets to her estate. Her will also provided that, after payment of debts and expenses, cash bequests would be made to specified family members and friends, with the remainder distributed among eight charities.

  In 1997, the trust transferred $1 million to Ethel's estate, and subsequently filed an amended income tax return that treated this $1 million distribution as a contribution for charitable purposes and sought to receive a refund of the taxes paid. The IRS denied the deduction. The trust filed suit challenging the denial of the deduction and seeking a refund of taxes.

  A federal district court granted summary judgment to the government. The U.S. Court of Appeals for the Second Circuit affirmed the district court's decision that the distribution was not “pursuant to the governing instrument.” To qualify for an income tax charitable deduction under IRC Section 642(c)(1), the amount must be paid for charitable purposes “pursuant to the terms of the governing instrument.” The court concluded that the “governing instrument” in this case is Lucien's will, and not Lucien's will combined with Ethel's exercise of her power of appointment.

• Stock and notes valued for gift tax purposes. In Robert Dallas v. Commissioner, T.C. Memo 2006-212 (issued Sept. 28), Robert Dallas in 1999 transferred nonvoting stock in a closely held business to two trusts, one for each of his sons, in exchange for a total of $248,000 in cash and promissory notes for $2.232 million. In 2000, he transferred additional stock to the trusts for $192,140 in cash and promissory notes for about $1.729 million. The 1999 notes were self-canceling in the event Robert died before the notes were paid off. The IRS claimed the stock was worth more than the notes, making the gifts taxable.

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