For the last year and a half, the Treasury Department's Bureau of Public Debt has scrutinized its regulations governing the redemption of "flower bonds" or deep discount bonds used to pay the federal estate tax. Flower bonds are U.S. Treasury bonds that can currently be purchased on the market at approximately 75 percent of par value and are redeemable at par (the blossoming of the flower) to the extent of the federal estate tax liability.
Treasury Department Circular No. 300 provides that bonds will be accepted for redemption only if two conditions are met. First, the bonds must have been owned by the decedent at the time of death, and second, the bonds must constitute part of the estate. These requirements are satisfied in the trust situation if (a) the trust actually terminates in favor of the decedent's estate or (b) if the trustee is required to pay the decedent's federal estate tax under the terms of the trust instrument or otherwise, or (c) to the extent that the debts of the decedent's estate, including costs of administration, state inheritance and federal estate taxes, exceed the assets of the estate without regard to the trust estate.
Often the estate plan provides for a large trust holding flower bonds along with other assets and a modest probate estate subject to a pour-over will. The estate planner must be careful that both instruments contain the proper language to satisfy the requirement that the trust is required to pay the estate tax with flower bonds.
In Detroit. Bank and Trust Co. V. Grunewald, the tax payment clauses of the decedent's trust and will were incongruous. The trust article provided that if trust assets were included in the decedent's gross estate, the trust would pay its share of the estate tax liability. The decedent's will provided that all estate and inheritance taxes were to be paid out of the estate residue whether the property passed under or outside the will of the decedent. The will also contained a direction against the apportionment of taxes.
The Court referred to Michigan's Uniform Estate Tax Apportionment Act3 and held that the provisions of the will controlled so that tax liabilities were satisfied out of the probate residue and not from the trust assets.
Redemption of flower bonds was not at issue here, but had the estate plan envisioned the use of flower bonds from the trust to pay estate taxes, the plan would have failed. Grunewald and the Michigan Apportionment Act lead to the following conclusions regarding tax clauses in trusts and wills:
The best way to insure the use of flower bonds. is to draft trust and will provisions that will satisfy the Department of the Treasury and the Uniform Estate Tax Apportionment Act. The following trust and will provisions satisfy the aforementioned, thereby preserving the benefits of flower bonds.
If the Trustee considers it to be in the best interest of the Settlor's estate, heirs, or the beneficiary of any trust created by this Agreement, the Trustee may pay any portion of an estate, inheritance or succession tax (including interest or other additions thereto) that may be imposed upon any of the assets belonging or passing to any trust created by this Agreement, whether by virtue of an apportionment statute or for any other reason, or that is directed by will to be paid from the residue of the Settlor's. estate; and if the trust holds any U.S. Treasury Bonds that may be redeemed at par in payment of the federal estate tax, the Trustee shall be required to pay the federal estate tax to the extent of the face amount of such bonds plus accrued interest to the date of redemption.
I direct that there shall be paid out of my estate, without apportionment or right of recovery among or against any of my successors and transferees, and as if they were debts of mine, all estate, inheritance, succession and other taxes (together with any interest or penalty thereon), assessed because of my ownership or control of property at or before my death or the transfer or devolution thereof to take effect at, in contemplation of or by reason of, my death, imposed by the government of the United States, or any state or territory thereof, or by any foreign government or political subdivision thereof, in respect of all property required to be included in my gross estate for estate or like tax purposes by any such governments, whether the property passes under this will or otherwise, including property over which I have a power of appointment, without contribution by any recipient of any such property; provided, however, that my Executor shall be required to direct the payment of any such taxes from the assets includible in my gross estate for federal estate tax purposes held by any trust created by me during my lifetime including any U.S. Treasury Bonds that may be re deemed at par in payment of the federal estate tax.
Another problem estate planners have encountered with the Bureau of the Public Debt and the Internal Revenue Service is the government's position that flower bonds purchased while the decedent was mentally incompetent do not satisfy the requirement that the bonds were owned by the decedent at the time death
In a recent suit, the Estate of Arthur K. Watson has challenged the Treasury Department's refusal to redeem bonds with a face amount of $4,742,000. The decedent had executed a power of attorney in 1970 which permitted the buying and selling of securities. After an accident which left the decedent incapacitated, the attorneys in fact purchased the bonds. The issue has not yet been resolved.
The government bases its position on the fact that in most of the fifty states, a power of attorney terminates hen the principal becomes mentally incompetent. The state of New York has responded to this problem by enacting a statute which preserves the effectiveness of a power of attorney when the principal is incompetent. Alaska, Arizona, Idaho, Kentucky, Maryland, New Jersey, Oregon and Virginia already have had similar laws.
The Treasury Department's position has the effect of severely limiting the last-minute purchase of flower bonds. While the bonds are attractive because of their appreciation at death their relatively low interest rates, co pared to other investments, dictates that their purchase be put off as long as possible unless need for income is not a consideration.
The use of an inter vivos trust solves this competency question. The issue of the decedent's competence will not arise, so that the trustee will be free to purchase the bonds at any time prior to the death of the decedent. Finally, as long as the trust and will provisions are carefully drafted to require the trust to redeem the flower bonds for the payment of the federal estate tax the purpose for purchasing the flower bonds will have been met.
The Michigan Inheritance Tax statute bases its value of assets subject to the tax on "clear market value." In the past this has meant the market value of the flower bonds. The Michigan Department of Treasury is objecting to this valuation, insisting that clear market value is equal to the redemption value of the bonds. What the Department seems to be saying is that the value for inheritance tax purposes should be the same as the value for federal estate tax purposes. This argument ignores the fact that the United States government is a limited market, e.g. the bonds are redeemed at par value only if there is an estate tax liability and only to the extent of this tax liability.
An examination of the definition of clear market value and an analysis of the opposing arguments regarding valuation are beyond the scope of this article. One Wayne County probate judge has ruled in favor of the taxpayer, and this decision has been affirmed by the circuit court. The circuit court order is before the Court of Appeals. In other states such as (Illinois and Montana) where the inheritance tax statute contains the same language (valuation at the "clear market value"), the courts have held that the bonds are to be valued at their market value and not at par.
The issue is raised to alert the estate planner of the potential additional tax liability so he or she can better evaluate the advantages and disadvantages of purchasing flower bonds.