Wills and Trusts

Wyatt, Tarrant & Combs, LLP


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Graduated GRATs

TD 9555 sets forth the rules for valuing annuity interests that increase over the term of a GRAT. Under the regulations, the amount includible is the greater of: (1) the amount of corpus required to generate sufficient income to pay the annual amount due to the decedent at death, or (2) the amount of corpus required to generate sufficient income to pay the annuity, unitrust, or other payment that the decedent would have been entitled to receive if the decedent had survived the other beneficiary, reduced by the present value of the other beneficiary’s interest. Long-term GRATs with flat annuities may be more efficient than those with increasing annuities. In addition, the final Treas. Reg. §20.2036-1(c)(1)(i) is revised to provide that retained interest payments paid to a decedent’s estate after the decedent’s death are not includible under §2033 if a portion of the trust corpus is includible in the decedent’s gross estate under §2036.

When the §7520 rate is very low, a long term (99 year) GRAT may produce favorable results because an increase in the rate between creation and death will reduce the amount includible in the grantor’s estate. For example, if the section 7520 rate is 2.4%, a 99 year GRAT will zero out with an annuity of $26,536 paid annually. If the section 7520 rate were 5% when the annuitant died, then 53.072% of the GRAT would be included in the grantor’s estate. The 2012 Administration proposals would limit the maximum GRAT term to life expectancy plus 10 years.

Turney P. Berry
Louisville, Kentucky


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SECTION 1014 AND UNDERSTANDING THE TAX NATURE OF CERTAIN ASSETS – Part III

SECTION 1014 AND UNDERSTANDING THE TAX NATURE OF CERTAIN ASSETS – Part III D

Traditional IRA and Qualified Retirement Assets

In 2013, Investment Company Institute estimated that total retirement assets were over $20 trillion (including government plans, private defined benefit plans, defined contribution plans and individual retirement accounts).[1]  Assets in IRAs and defined contribution plans totaled more than ½ of the total at approximately $11.1 trillion.  Although IRA and qualified retirement assets make up one of the largest asset types of assets owned by individuals, they are one of the most problematic from an estate planning perspective.

IRA and qualified retirement assets are not transferable during the lifetime of the owner,[2] so the assets are never candidates for lifetime gifts unless the owner is willing to incur a taxable distribution of the assets.  As such, to the extent not drawn-down prior to death, the assets are includible in the estate for transfer tax purposes,[3] and by definition, the assets will use some or all of the decedent’s Applicable Exclusion Amount, unless the assets to surviving spouse under the marital deduction under section 2056 of the Code or to a charitable organization under section 2055 of the Code.[4]  To make things worse, IRA and qualified retirement assets are considered income in respect (IRD) under section 691 of the Code.[5]   IRD assets are not entitled to a “step-up” in basis,[6] and all distributions (whether paid over time or not) to a beneficiary are taxable as ordinary income.[7]  Even though the beneficiary is entitled to an income tax deduction[8] (“IRD deduction”) for estate taxes payable by virtue of the inclusion of the assets, there is no Federal income tax deduction for state death taxes that might be payable, and given the reduced Federal transfer tax rate of 40% and the cost-of-living increase on the Applicable Exclusion Amount, many taxpayers will have very little or no IRD deduction to shelter the on-going ordinary income tax problem.

A distribution from a decedent’s IRA to a surviving spouse may be “rolled over” to another qualified retirement plan or IRA, thereby deferring the recognition of income.[9]  In addition, if the surviving spouse is the beneficiary of all or a portion of the decedent’s IRA, the surviving spouse may also elect to treat the decedent’s IRA as his or her own IRA.[10]  In both of the foregoing cases, the IRD problem discussed above continues after the death of the surviving spouse (unless the surviving spouse remarries).

Contrast the foregoing treatment with Roth individual retirement plans (“Roth IRAs”).[11]  Roth IRA assets are treated similarly to assets in a traditional IRA in that: (i) the account itself is not subject to income tax;[12] (ii) distributions to designated beneficiaries are subject to essentially the same required minimum distribution rules after the death of the original Roth IRA owner;[13] and (iii) surviving spouses may treat a Roth IRA as his or her own and from that date forward the Roth IRA will be treated as if it were established for the benefit of the surviving spouse.[14]  In contrast to a traditional IRA, distributions to a qualified beneficiary are not taxable to the beneficiary,[15] and as discussed above, are not subject to the Medicare tax.[16]  The overall result for decedents with Roth IRA assets, the qualified beneficiaries of the Roth IRA effectively receive the benefit of a “step-up” in basis.  Since 2010,[17] all taxpayers regardless of adjusted gross income[18] could convert traditional IRA assets into a Roth IRA.  The conversion is considered a taxable event causing the converted amount to be includible in gross income and taxable at ordinary income tax rates.[19]  Direct taxable rollovers from qualified company-based retirement accounts (section 401(k), profit sharing, 403(b), and section 457 plans) into a Roth IRA.[20]  Individuals who have excess qualified retirement assets, have sufficient funds to pay the resulting tax liability from outside of the retirement account, and who are not planning to donate the asset to a charitable organization are great candidates to do a Roth IRA conversion.  Notwithstanding the clear benefits of passing the Roth IRA assets to children and grandchildren outside of the scope of the IRD provisions, not many individuals are willing to pay the income tax cost of the conversion.

Turney P. Berry

Louisville, Kentucky


[1] Investment Company Institute, Release: Quarterly Retirement Data, First Quarter 2013, http://www.ici.org/research/stats/retirement/ret_13_q1,  (03/31/201).

[2] See the anti-alienation provision in § 401(a)(13)(A).

[3] § 2039(a).

[4] The IRS has taken the position that qualified retirement assets used to fund a pecuniary bequest to a charitable organization will be considered an income recognition event, triggering ordinary income.  CCA 200644020.

[5] See e.g., Ballard v. Commissioner, T.C. Memo 1992-217, Hess v. Commissioner, 271 F.2d 104 (3d Cir. 1959), Rev. Rul. 92-47, 1992-1 C.B. 198, Rev. Rul. 69-297, 1969-1 C.B. 131, PLR 9132021, and GCM 39858 (9/9/91).

[6] § 1014(c).

[7] §§ 72, 402(a) and 408(d)(1), assuming the decedent owner had no nondeductible contributions.  See § 72(b)(1) and (e)(8).

[8] § 691(c)(1).

[9] § 402(c)(9).

[10] Treas. Reg. § 1.408-8, Q&A-5(a).

[11] § 408A.

[12] Treas. Reg. § 1.408A-1, Q&A-1(b).

[13] Treas. Reg. § 1.408A-6, Q&A-14.  One specific exception is the “at-least-as-rapidly” rule under § 401(a)(9)(B)(i).

[14] Treas. Reg. § 1.408A-2, Q&A-4.

[15] § 408A(d)(1).

[16] § 1411(c)(5).

[17] Tax Increase Prevention and Reconciliation Act of 2005, P.L. 109-222, effective for tax years beginning after December 31, 2009.

[18] Prior to this change, only taxpayers having less than $100,000 in modified adjusted gross income could convert a Traditional IRA to a Roth IRA.  Former § 408A(c)(3)(B).

[19] § 408A(d)(3)(A)(i).

[20] See Notice 2008-30, 2008-12 I.R.B. 638 (3/24/2008) and Notice 2009-75, 2009-39 I.R.B. 436 (9/28/2009). § 408A(d)(3)(A).


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Application of Section 2036 to Family Limited Partnerships

The Tax Court did not apply §2036 to a family limited partnership in Estate of Beatrice Kelly et al. v. Commissioner, T.C. Memo. 2012-73, on unusual facts. After Mrs. Kelly’s health had declined, without knowing the contents of her Will, her children entered into a settlement agreement among themselves that would ensure each received an equal amount. Sometime later, the children discovered mom’s Will which did not treat them equally:

In the summer of 2002 the children received decedent’s will and discovered that, primarily because of uneven asset appreciation and acquisition, decedent’s will did not divide her estate equally among the children. For example, decedent’s will bequeathed all stock to Bill and Claudia equally, with none going to Betty. Between the signing of decedent’s will in 1991 and 2002, decedent converted nonstock assets into over $1,500,000 in stock. To address this matter, on August 8, 2002, the children signed a second settlement agreement in which they agreed to honor all specific bequests to nonsignatories of the agreement and to distribute the remainder among the children in equal shares.

In order to implement the settlement agreement, the family was advised by Mr. Stewart, an estate planner, to create family partnerships and make gifts. Because mom lacked capacity, the children as co-guardians received court approval for the plan:

Mr. Stewart prepared a plan that called for the creation of four limited partnerships and a corporation which would serve as general partner of the limited partnerships (collectively, the plan). Decedent would create three limited partnerships (i.e., one for the benefit of each of the children), transfer equally valued assets to each of these partnerships, transfer the quarries to a fourth partnership, and retain, in her own name, over $1,100,000 in liquid assets, including certificates of deposit and investment accounts. The real property listed as specific bequests to the children in decedent’s will would be contributed to the partnerships. By contributing property that would otherwise be the subject of unequal specific bequests to the partnerships, the specific bequests would be converted to equal devises of partnership interests, passing pursuant to the residuary clause in decedent’s will.

The children, as coguardians, on May 5, 2003, petitioned the Superior Court of Rabun County, State of Georgia, (superior court) for approval of the plan (superior court petition). See Ga. Code Ann. sec. 29-5-5.1 (2007). The superior court petition provided in part:

The Will of Mrs. Kelly does not divide the estate equally among the children. The children of Mrs. Kelly have entered into a written agreement whereby the children have agreed to divide the estate equally among themselves after the death of Mrs. Kelly. * * * Under the estate plan proposed herein, equalizing the allocation of inherited assets can be achieved in a simple way without the necessity of a complex series of disclaimers and would reduce the risk of potential conflict and disagreement among the heirs.

* * * * * * *

Pursuant to an executed partnership agreement of each of the limited partnerships, the general partner is entitled to a special allocation of the net income of the limited partnerships each year in order to pay the operating expenses of the limited partnerships and a reasonable management charge for the general partner’s management duties and responsibilities. Because the ward will own all the outstanding stock in the corporation that will serve as the general partner, the special allocation of net income for the reasonable management charge will insure that the ward will be provided with adequate income to cover the ward’s probable expenses for support, care and maintenance for the remainder of the ward’s lifetime in the standard of living to which the ward has become accustomed. Specifically, the corporation that will serve as the general partner will receive from each limited partnership a percentage of the net asset value of each limited partnership as determined on December 31 of each year. * * *

The superior court petition included a statement that the proposed plan would result in estate tax savings of $2,985,177.

On June 3, 2003, the superior court held a hearing and entered an order approving the plan. A guardian ad litem represented decedent at the hearing. The superior court found: decedent was incompetent; decedent’s incompetency was expected to continue for her lifetime; implementation of the plan allowed for continued support of decedent during her lifetime; a competent, reasonable person in decedent’s circumstances would likely implement the plan to avoid undesirable tax consequences; and there was no evidence that decedent, if able, would not make the transfers set forth in the plan.

Thereafter the plan was implemented – partnerships for each child’s family and a corporate general partner (KWC). The Court held that the bona fide sale exception was met for the creation of the partnerships:

As evidenced by the three settlement agreements, two of which were signed long before the superior court petition was drafted, decedent’s primary concern was to ensure the equal distribution of decedent’s estate thereby avoiding litigation. In addition, decedent was legitimately concerned about the effective management and potential liability relating to decedent’s assets. Probate court approval was required for basic day-to-day management decisions. By contributing the quarries and other properties to partnerships, decedent limited her liability and reduced her management responsibilities. Through KWC, the children were able to manage the properties as individuals rather than as coguardians. Decedent’s ownership of two quarries, the waterfall property, the post office, and multiple rental homes required active management and would lead any prudent person to manage these assets in the form of an entity.

Further, ownership of KWC was not a retained interest:

The creation of KWC changed decedent’s rights to, and relationships with, the contributed assets. Decedent retained 100% ownership of KWC which, pursuant to the partnership agreements, received a management fee for serving as general partner of the family limited partnerships. In return, KWC provided management and paid expenses including taxes, insurance, salaries, professional fees, repairs, and maintenance. The general partner provided a service (i.e. management) to the partnerships for which the partnerships paid a reasonable management fee. The children, in their role as officers and directors, performed an analysis to determine the appropriate fee and held regular officer/director meetings to address the significant, active management the partnerships required. Cf. Estate of Korby v. Commissioner, 471 F.3d 848, 853 (8th Cir. 2006) (stating that the lack of a management contract, the failure to document management hours, the manner in which payments were made, and the failure of decedent to retain adequate assets in her own name supported rejection of petitioner’s contention that payments to decedent’s living trust were a management fee), aff’g T.C. Memo. 2005-102 and T.C. Memo. 2005-103. Furthermore, not only did decedent have a bona fide purpose for creating the partnerships, decedent had a bona fide purpose for creating KWC to manage the partnerships. Decedent’s health prevented her from managing the partnership property, and thus an entity to act as general partner was a natural choice. The children served as officers and directors of KWC, successfully managed the family business, and avoided potentially divisive intrafamily litigation upon decedent’s passing.

Decedent owned 100% of KWC, the value of which was appropriately included in her gross estate. The payment of the management fee by each of the family limited partnerships to KWC, however, is not, pursuant to section 2036(a)(1), a retention of income which would cause inclusion in decedent’s gross estate of the value of the family limited partnership interests. Decedent did not retain an income stream from the partnership interests. To the contrary, decedent’s implementation of the plan changed decedent’s rights to, and relationship with, the transferred property. In the resulting entity, decedent indeed had an income interest, but this interest does not trigger the applicability of section 2036. The partnership agreements, which were respected by the parties, called for a payment of income to KWC, not to decedent. In essence, respondent is requesting that the Court disregard KWC’s existence, the general partner’s fiduciary duty, and the partnership agreements. We will not do so. Decedent did not retain an interest in the transferred family limited partnership interests. Accordingly, the value of these family limited partnership interests will not be included in decedent’s gross estate.

Turney P. Berry
Louisville, Kentucky


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Federal District Court Invalidates §2032A Regulation

In Carolyn Finfrock v. United States, 860 F.Supp.2d 651 (2012), a Federal District Court in Illinois held that Treas. Reg. § 20.2032A-8(a)(2) is contrary to the statute and is, therefore, invalid. This has happened before:

In Miller v. United States, 680 F.Supp. 1269, the district court found Treasury Regulation § 20.2032A-8(a)(2) invalid by using the test that preceded the test articulated by the United States Supreme Court in Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984). The Miller court found that the Treasury Regulation was an interpretive regulation, promulgated under the general rule-making power of the Code, and represented an invalid exercise of that power. Miller, 680 F. Supp. at 1273-74. The court concluded that Treasury Regulation § 20.2032A-8(a)(2) added a requirement not found in the underlying statute that was inconsistent with the statute. Id.

The opinion summarizes the difficulty:

To qualify for the special use valuation, several conditions must be met. One of those conditions is that “25 percent or more of the adjusted value of the gross estate consists of the adjusted value of real property which meets the requirements of subparagraphs (A)(ii) and (C).” 26 U.S.C. § 2032A(b)(1)(B). The parties agree that Items 1 through 4 represented approximately 68% of the adjusted value of the gross estate.

The Treasury Regulations, however, provide that while an estate need not elect special use valuation with respect to all of the qualifying property, the property actually elected for the special use valuation must constitute at least 25% of the adjusted value of the gross estate. See 26 C.F.R. § 20.2032A-8(a)(2) (“An election under section 2032A need not include all real property included in an estate which is eligible for special use valuation, but sufficient property to satisfy the threshold requirements of section 2032A(b)(1)(B) must be specially valued under the election”); see also Miller v. United States, 680 F. Supp. 1269, 1270 n. 1 (C.D. Ill. 1988) (noting the interpretation of the regulation is that the election must be made on property valued at 25% or more of the adjusted value of the gross estate). Defendant argues that this regulation is valid and, because the property elected for special use valuation (Item 4) constituted only 15% of the adjusted value of the gross estate, Plaintiff is not entitled to the refund. Plaintiff argues that the regulation is invalid and in conflict with the statute.

The Court applied Chevron and held that the regulation is invalid:

Therefore, under the plain language of the statute, to meet the definition of “qualified real property,” 25% or more of the adjusted value of the gross estate must consist of real property that (1) “was acquired from or passed from the decedent to a qualified heir of the decedent” (26 U.S.C. § 2032A(b)(1)(A)(ii)); and (2) has been used for a qualified use for 5 of the 8 years preceding the decedent’s death and for which there was material participation by the decedent or a member of the decedent’s family in the operation of the farm (26 U.S.C. § 2032A(b)(1)(C)). Subparagraph (D) further defines “qualified real property” as “such real property” that is designated in the agreement required by subsection (d)(2). 26 U.S.C. § 2032A(b)(1)(D).

Notably, the statute does not require that real property constituting 25% or more of the adjusted value of the gross estate be “designated in an agreement referred to in subsection (d)(2).” 26 U.S.C. § 2032A(b)(1)(D). The 25% or more requirement is a means to limit the benefit of the special use valuation to family farms and family businesses. Nonetheless, under the plain language of the statute, once the estate meets the thresholds identified in subsections (1)(A), (1)(B), and (1)(C), the only other requirement to qualify as “qualified real property” is to designate the property in the required agreement. Congress did not require that the designation be of all or a certain percentage of the real property in the estate that meets the requirements of 1(A), 1(B), and 1(C). See, e.g., Miller, 680 F. Supp. at 1273 (finding “[t]he language of Code § 2032A(b)(1)(B) . . . cannot be said to be ambiguous with respect to the 25% requirement which the regulation imposes”).

This Court finds that § 2032A(b) is neither silent nor ambiguous on the precise issue — whether an executor can elect for special valuation property that constitutes less than 25% of the gross value of the adjusted value of the gross estate. The statute unambiguously provides that an executor can do so.

Having found the statute unambiguous, the Court next determines if the plain meaning of the statute supports or opposes Treasury Regulation § 20.2032A-8(a)(2). See Bankers Life & Casualty Co., 142 F.3d at 982 (explaining step one of the Chevron test). Here, the regulation imposes an additional requirement that the property designated by the agreement referenced in § 2032A(b)(1)(D) and (d)(2) for special use valuation must constitute at least 25% of the adjusted value of the gross estate. This additional requirement is contrary to the plain language of the statute. See, e.g., Miller, 680 F. Supp. at 1273 (finding that “the regulation clearly imposes an additional, substantive requirement not authorized by the statute”). The regulation neither clarifies an ambiguity in the statute, because the statute contains no ambiguity, nor fills any gap, as there is no gap to fill. Therefore, Treasury Regulation § 20.2032A-8(a)(2) is invalid.

Because this Court finds that the statute is unambiguous and that Treasury Regulation § 20.2032A-8(a)(2) conflicts with the statute, this Court need not proceed to step two of the Chevron test or address Defendant’s arguments with regard to step two of the Chevron test.

Turney P. Berry
Louisville, Kentucky


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SECTION 1014 AND UNDERSTANDING THE TAX NATURE OF CERTAIN ASSETS – Part III

SECTION 1014 AND UNDERSTANDING THE TAX NATURE OF CERTAIN ASSETS – Part III B

Intellectual Property, Intangible Assets and Artwork Owned by the Creator

Generally

(1)  In the hands of the creator, intellectual property, intangible assets and artwork represent the type of asset that, from a tax standpoint, benefits greatly from the “step-up” in basis.  For the most part, during the lifetime of the creator, these assets have little or no basis in the hands of the creator, and the sale, exchange, disposition, licensing or other exploitation of these types of assets are considered ordinary income to the creator.  If the asset is transferred in a “carry-over” basis transaction like a gift, the tax attributes carry to the donee.  On the other hand, if the creator of the asset dies with the asset, the asset is entitled to a “step-up” in basis and the asset becomes a long-term capital gain asset in the hands of the beneficiaries.

(2)  Patents, copyrights, and trademarks are common assets, but intangible rights might also include the right of publicity, defined loosely as the right of an individual to have a monopoly on his or her own name, likeness, attributes, etc.  In the case of well-known artists, actors, and celebrities, this right of publicity can be quite valuable.  Some states, like New York, do not recognize a postmortem right to publicity, while approximately 19 states have specifically codified the postmortem right to publicity [1].  Notably, California[2] has codified the postmortem right to publicity, which lasts for a term of 70 years after the death of the personality.  Further, the California statute specifically provides that such rights are freely transferable during lifetime or at death.

(3)  As one can see, each of these intangible assets has its own peculiarities (for example, the duration of the intangible rights) that may affect its value at the date of transfer (whether during lifetime or at death) and that may affect whether the asset or particular rights can be transferred at all.

Copyrights

(1)  Under U.S. law, copyright protection extends to “original words of authorship fixed in any tangible medium of expression,” which includes: “(1) literary works; (2) musical works, including any accompanying words; (3) dramatic works, including any accompanying music; (4) pantomimes and choreographic works; (5) pictorial, graphic, and sculptural works; (6) motion pictures and other audiovisual works; (7) sound recordings; and (8) architectural works.”[3]  The courts have ruled that computer software constitutes protected literary works.[4]

(2)  Knowing the duration of an existing copyright is critical to understanding what value a copyright may have today and what value a copyright may have in the future.

(a)  For works copyrighted on or after January 1, 1978, a copyright’s duration is based upon the life of the author plus 70 years.[5]

(b)  For works copyrighted prior to January 1, 1978, a copyright’s duration was 28 years, with the author (and his or her estate) having the right to renew and extend the term for another 67 years (for a total of 95 years).[6]

(3)  For works copyrighted on or after January 1, 1978, the author (or the author’s surviving spouse or descendants if the author is deceased) has a right to terminate any transfer or assignment of copyright by the author 35 years after the transfer or assignment.[7]  These termination rights apply “in the case of any work other than a work made for hire, the exclusive or nonexclusive grant of a transfer or license of copyright or of any right under a copyright, executed by the author on or after January 1, 1978, otherwise than by will.”[8]  Because only the author has the right of termination during his or her lifetime, even if a gift is made of the copyright, the author’s continued right of termination calls into question how the copyright will be valued.

(4)  Payments to the creator of a copyright on a non-exclusive license give rise to royalty income, taxable as ordinary income.[9]  An exclusive license (use of substantially all of the seller’s rights in a given medium) is treated as a sale or exchange.  When the creator is the seller, it is deemed to be a sale of an asset that is not a capital asset,[10] so it is taxed at ordinary rates.  By contrast, if the seller is not the creator, capital asset treatment under section 1221 of the Code is available if such seller is not a dealer.[11]  Notwithstanding the foregoing, if the creator/author of the copyright, gifts the asset (carryover basis transaction), a sale or exchange by the donee is not afforded capital treatment either.[12]  A gift for estate planning purposes, therefore, may have the unintended effect of prolonging ordinary income treatment after the death of the author/creator of the copyright.

(5)  In contrast, upon the death of the author/creator who still owns the asset at death, the copyright is entitled to a “step-up” in basis to full fair market value under section 1014 of the Code and the asset is transformed into a long-term capital gain asset. Because the basis of the copyright included in the creator’s estate is no longer tied to that of the creator, the asset no longer falls within the exclusion from capital asset treatment under section 1221(a)(3) and, thus, are capital assets in the hands of the creator’s beneficiaries.  The copyright is deemed to immediately have a long-term holding period even if it is sold within 1 year after the decedent’s death.[13]

Patents

(1)  Individuals who patent qualifying inventions are granted the “right to exclude others from making, using, offering for sale, or selling”[14] such invention for a specified term.  The term for a utility or plant patent is 20 years, beginning on the earlier of the date on which the application for the patent was filed.[15]  The term for a design patent is 14 years from the date of grant.[16]

(2)  Similar to the taxation of copyrights, payments received for a transaction that is not considered a sale or exchange or payments received for a license will be considered royalty income, taxable as ordinary income.[17]

(3)  A sale or exchange of a  patent that does not qualify under section 1235 of the Code (discussed below), may qualify for capital gain treatment because the Treasury regulations specifically provide that a patent or invention are not considered “similar property”[18] to a copyright, which is excluded from capital gain treatment.  However, for the sale of a patent to qualify for capital gain treatment under section 1221 of the Code, the individual generally must be considered a non-professional inventor (otherwise the patent would be considered stock in trade or inventory in the hands of a professional inventor).  Capital gain treatment under section 1231 of the Code is possible but only if the patent is considered to have been “used in a trade or business.”[19]  Often, however, patents held by individuals will not qualify as such.  By consequence, generally, for individuals selling or exchanging a patent, the avenue for capital gain treatment is under section 1235 of the Code.

(4)  Like the tax treatment of the creator of a copyright, if the creator dies with a patent, the asset is entitled to a “step-up” in basis to full fair market value under section 1014 of the Code and the asset is transformed into a long-term capital gain asset.

(5)  Section 1235 Transactions

(a)  Section 1235 of the Code provides that a “transfer (other than by gift, inheritance, or devise) of property consisting of all substantial rights to a patent, or an undivided interest therein which includes a part of all such rights, by any holder shall be considered the sale or exchange of a capital asset held for more than 1 year.”[20]

(b)  Only an individual may qualify as a holder, regardless of whether he or she is in the business of making inventions or in the business of buying and selling patents.[21]  Specifically, a qualified “holder” includes (i) the creator of the patent,[22] or (ii) “any other individual who has acquired his interest in such property in exchange for consideration in money or money’s worth paid to such creator prior to actual reduction to practice of the invention covered by the patent,”[23] provided that in such instance, the individual is not an employer of the creator or related to the creator.[24]  As such, a trust, estate, or corporation will not qualify as a holder under section 1235 of the Code, although a transfer to a grantor trust would not likely disqualify a subsequent sale or exchange to capital gain treatment.[25]  An entity taxable as a partnership does not qualify as a holder, but each individual in the partnership may qualify separately as such.[26]

(c)  A sale or exchange by a qualified holder to a “related person” will not qualify for capital-gain treatment under section 1235.[27]  A “related person” is generally defined by reference to section 267(b) of the Code and includes (i) the holder’s spouse, ancestors, and lineal descendants (but not siblings);[28] (ii) a fiduciary of any trust of which the holder is the grantor; (iii) any corporation, partnership, or other entity in which the holder (and other related persons) own 25% or more of the ownership interests.[29]

(d)  Because of the foregoing limitations of who can qualify as a holder and the related person limitations on who can be the transferee, many estate planning techniques involving patents are limited if capital gain treatment is to be retained.

(e)  If a qualified holder sells his or her interest in a patent under section 1235 of the Code and later dies before all payments are received, the estate and/or beneficiary of the deceased reports the payments as long-term capital gain as income in respect of a decedent.[30]

Artwork

(1)  The taxation of artwork in the hands of the artist is the same as it would be for the creator of a copyright, as discussed above.  Generally, all payments pursuant to a license and a taxable sale or exchange of the artwork give rise to ordinary income.[31]  A third-party collector or investor in the artwork might qualify for capital gain treatment or section 1231 treatment, as long as the property is not held out for sale in the ordinary course of a trade or business (inventory).[32]  Similarly, capital gain treatment is not available  to a donee of the artist because the donee’s basis is determined by reference to the artist’s basis.[33]

(2)  Artwork in the hands of a collector or investor (third-party other than the creator or a donee of the creator) is considered a collectible under the Code and would be subject to the 28% long-term capital gain tax, rather than 20%.[34]  Under the Code, a “collectible” is any work of art, rug, antique, metal, gem, stamp, coin, alcoholic beverage, or any other tangible personal property designated by the IRS as such.[35]

(3)  As with copyrights and patents, the basis of property in the hands of a person acquiring property from a deceased artist is the fair market value of the property at the date of the artist’s death or on the alternate valuation date, if so elected.[36]  The artwork in the hands of the estate or the artist’s beneficiaries becomes a capital asset, qualifying for long-term capital gain treatment.[37]

Turney P. Berry

Louisville, Kentucky


[1] See, Milton H. Greene Archives Inc. v. Marilyn Monroe LLC, No. 08-056471 (9th Cir. 8/30/12), aff’g 568 F. Supp. 2d 1152 (C.D. Cal. 2008).  A good discussion of statues, cases, and current controversies see  http:rightofpublicity.com maintained by Jonathan Faber of the Indiana University McKinney School of Law.

[2] Ca. Civ. Code § 3344.

[3] 17 U.S.C. § 102(a)(1)-(8).

[4] See, e.g., Apple Computer, Inc. v. Franklin Computer Corp., 714 F.2d 1243 (3rd Cir. 1983).

[5] 17 U.S.C. § 302(a).

[6] 17 U.S.C. § 304.

[7] 17 U.S.C. § 203(a).

[8] Id.

[9] § 61(a)(6).  See also Treas. Reg. § 1.61-8.  Rev. Proc. 2004-34, 2004-22 I.R.B. 964, allows certain taxpayers to defer to the next taxable year, certain payments advance royalty payments.

[10] § 1221(a)(3).  § 1221(b)(3) provides a limited exception for copyrights in musical works, pursuant to which the taxpayer may elect to have § 1221(a)(3) not apply to a sale or exchange.

[11] It could also be afforded § 1231 treatment (asset primarily held for sale to customers in the ordinary course of a trade or business).

[12] § 1221(a)(3)(C).

[13] § 1223(9).

[14] 35 U.S.C. § 154(a)(1).

[15] 35 U.S.C. § 154(a)(2).

[16] 35 U.S.C. § 173.

[17] § 61(a)(6). See also Treas. Reg. § 1.61-8.

[18] “For purposes of this subparagraph, the phrase “similar property” includes for example, such property as a theatrical production, a radio program, a newspaper cartoon strip, or any other property eligible for copyright protection (whether under statute or common law), but does not include a patent or an invention, or a design which may be protected only under the patent law and not under the copyright law.”  Treas. Reg. § 1.1221-1(c)(1).

[19] § 1231(a)(3)(A)(i).  The holding period is deemed to start when the patent is reduced to practice.  Kuzmick v. Commissioner, 11 T.C. 288 (1948).

[20] § 1235(a).

[21] § 1235(a)(2) and Treas. Reg. § 1.1235-2(d)(3).

[22] § 1235(b)(1).

[23] § 1235(b)(2).

[24] § 1235(b)(2)(A)-(B).

[25] See Treas. Reg. § 1.671-2(c).  If a holder sells his or her interest in a transfer qualifying under section 1235 of the Code and later dies before all payments are received, the estate and/or beneficiary of the deceased reports the payments as long-term capital gain as income in respect of a decedent.

[26] Treas. Reg. § 1.1235-2(d)(2).  See also, Priv. Ltr. Ruls. 200135015, 200219017, 200219019, 200219020, 200219021, 200219026, 200506008, 200506009, and 200506019.

[27] § 1235(d).

[28] § 1235(d)(2)

[29] § 1235(d)(1).

[30] § 691 and Treas. Reg. § 1.691(a)(3).

[31] §§ 1221(a)(3) and 61(a)(6). § 1221(b)(3) provides a limited exception for copyrights in musical works, pursuant to which the taxpayer may elect to have § 1221(a)(3) not apply to a sale or exchange.

[32] § 1221(a)(1).

[33] §§ 1221(a)(5)(B) and 1015.

[34] § 1(h)(4).

[35] §§ 1(h)(5)(A) and 408(m)(2).

[36] § 1014(a).

[37] See §§ 1221(a)(3) and 1223(9).